Doug Noland: Monetary Disorder

Historians will surely look back at this period and struggle to understand why global central bankers after all these years were so reticent in reducing extraordinary monetary stimulus. Bitcoin and the cryptocurrencies have gone parabolic. U.S. and global equities grind further into record territory; global bond prices are indicative of one of history’s greatest financial Bubbles; real estate prices continue to inflate in most markets globally; debt issuance is on record pace and financial conditions remain incredibly loose virtually everywhere.


Monetary Disorder

Global Credit, Bubble and market analysis is turning more interesting.

China August Credit data were out Friday. Total (aggregate) Social Financing jumped to 1.48 TN yuan ($225bn), up from July’s 1.22 TN and above the 1.28 TN estimate. New Loans were reported at a much stronger-than-expected 1.09 TN (estimates 750bn yuan), up from July’s 825bn. New loans expanded 13.2% y-o-y. Through August, Total Social Financing is running 18% above 2016’s record pace. Total system Credit growth (“social financing” plus govt. borrowings) appears on track to surpass $4.0 TN. While “shadow banking” has of late been restrained by tighter regulation, household (largely real estate) borrowings remain exceptionally strong.

It was the weaker Chinese economic data that made the headlines this week. Retail sales (up 10.1% y-o-y), industrial production (up 6.0%) and fixed investment (up 7.8%) were all somewhat below estimates. At the same time – and I would argue more importantly – Chinese inflation is running hotter than forecast. Considering the scope of the ongoing Credit expansion, inflationary pressures should come as no surprise.

September 10 – Bloomberg: “Inflationary pressure emanating from the factory to the world is proving more resilient than economists have anticipated. China’s producer-price inflation accelerated to 6.3% in August from a year earlier, exceeding all but one of 38 estimates… That data… followed 5.5% readings in the prior three months… The surprise strength gives support for global inflation spanning from metals to fuel and shows the effects of resilient domestic demand and reduced supplies of some commodities.”

Up 1.8% y-o-y, Chinese August CPI was the strongest since January. This follows last week’s stronger-than-expected import data. China is demonstrating classic signs of a Credit-induced Bubble economy – one where domestic Credit excesses are seeping into the global inflationary backdrop through commodities and some modest upward pressure on goods and services prices.

It’s now only about a month until the (10/18) start of the National Congress of the Communist Party of China. Financial stability will be a primary focus, though I question whether the party appreciates how unstable things have become. Chinese officials have dabbled with myriad (“macro prudential”) tightening measures. For the most part, stop and go policies have attempted to balance mounting financial risks against a determination to meet growth targets. Fatefully, policymakers have been willing to accommodate ever-expanding Credit expansion. And for how much longer?

At this late stage of the cycle, Beijing’s bid to direct finance into productive economic investment will surely achieve about the same results as similar desires during the late-twenties U.S. Bubble period. Officials at some point will need to bite the bullet and rein in system Credit.

It’s the nature of Credit Bubbles that risk rises exponentially during “Terminal Phase” excess. In simple terms, the quantity of new Credit expands greatly while quality deteriorates rapidly. A hypothetical chart of systemic risk – that had been rising left to right steadily for years – takes a moon shot. A surge in risky mortgage Credit fuels unsustainable real estate inflation, while business borrowings expand rapidly from entities that will struggle with solvency issues as soon as the Bubble falters. The real economy suffers deep maladjustment that remains largely masked so long as rampant Credit growth (and self-reinforcing asset inflation) runs unabated.

Global policymakers have delusions of controlling Bubble Dynamics. Or should I say that the appearance of being able to manage Bubbles creates the complacency necessary for immense, out-of-control Bubble inflations. A dangerous notion took hold that, rather than permitting Bubbles to burst, they will simply be inflated away. Surely part of the underlying angst affecting central bankers (from Washington to Frankfurt to Tokyo to Beijing) these days is the realization that they indeed do not control inflation dynamics. Instead of inflating consumer prices so as to catch up with inflated asset prices, their reflationary measures are exacerbating price instabilities and inflationary divergences.

A key aspect of global Bubble analysis is that inflationary policymaking and resulting monetary disorder have badly distorted economic and financial structures. QE and other monetary inflation were supposed to rectify the dilemma of insufficient “aggregate demand.” Yet all this “money” and Credit sloshing around the global system is creating dangerous market contortions, destabilizing speculation and ubiquitous price Bubbles. China’s financial system is straining under the burden of intermediating $4.0 TN of 2017 Credit growth into perceived “money-like” instruments (that folks are willing to hold).

September 13 – Wall Street Journal (Yifan Xie and Chuin-Wei Yap): “In just four years, a money-market fund created by an affiliate of China’s Alibaba Group… has become the world’s largest, providing millions of the country’s savers a high-returning place to park their money. Now, it is facing pressure from regulators to slow down. Fueled by contributions from some 370 million account holders, the fund, known as Yu’e Bao—which means ‘leftover treasure’—has grown rapidly to manage $211 billion in assets. It is more than twice the size of the next largest money-market fund, a U.S. dollar liquidity fund managed by J.P. Morgan… Yu’e Bao’s assets doubled in the past year alone, and the fund now makes up a quarter of China’s money-market mutual fund industry.”

A Yu’e Bao investor provided the salient point from the above WSJ article: “I am not too concerned about what Alibaba does with my money since it’s too big to collapse.” Yu’e Bao these days provides an enticing return of 4.02%, compared to 1.50% for one-year bank deposits and a 3.6% yield on 10-year government debt. “The fund invests most of its money in certificates of deposits issued by Chinese state-owned or state-supported banks.” So, this massive (circuitous) flow of funds to Chinese banks provides liquidity to fund late-cycle lending, including to China’s booming population of “zombie” corporations and uneconomic ventures and enterprises.

September 4 – Financial Times (Gabriel Wildau): “China will impose tighter regulation on ‘systemically important’ money-market mutual funds, potentially forcing Ant Financial’s popular fund to de-risk its portfolio and reduce yields for investors. MMFs have exploded in popularity in recent years, as Chinese investors seek high-yielding alternatives to bank deposits. Total assets reached Rmb5.48tn ($848bn) at the end of June… But analysts warn that even as Chinese investors shift en masse from bank deposits to MMFs, the funds are not subject to the same capital and liquidity regulations as banks.”

The first Chinese mutual fund opened in 2003. Assets were only about $20bn to begin 2013 but have since swelled to $848bn. From the WSJ: “Investors continue to pile in. In July alone, another $114 billion flowed into Chinese money-market funds…”

For investors in Chinese money market funds, various bank liabilities, local government debt, corporate Credit and real estate, confidence is higher than ever that Beijing will not tolerate a crisis. And whether it’s money market assets, Chinese bank negotiable certificate of deposit borrowings, “repo” financing or “shadow banking” more generally, China confronts an unprecedented (and rapidly escalating) risk intermediation problem. For too long Beijing has nurtured the financial alchemy necessary to transform progressively risky Credit into perceived safe and liquid instruments. There will be no unobtrusive approach to reining in the beast.

Before I segue from China, it’s worth noting that China’s currency declined almost 1% this week, a sharp reversal after a rally that saw the renminbi appreciate almost 7% versus the dollar y-t-d. Beijing’s efforts to stabilize its currency proved too successful. I ponder how much “hot money” has over recent months been enticed by China’s combination of high yields and an appreciating renminbi – and what this week’s currency policy adjustment might mean for speculative flows.

September 10 – Wall Street Journal (Lingling Wei): “China is reversing a range of measures it had put in place to support its currency, a response to a recent surge in the value of the yuan that has hurt Chinese exporters and added to the country’s economic headwinds. Starting Monday, the People’s Bank of China will scrap a two-year-old rule that made it more expensive for traders to bet the yuan will fall in value… The move, which ends a deposit requirement on trades called currency forwards, will make it less expensive for companies and investors to buy dollars while selling the yuan. That would put some pressure on the currency to decline, traders and analysts said. The step will ‘fend off macro-financial risks,’ said the central bank notice…”

On the subject of China, unstable Bubble Finance and newfound regulator zeal, how about bitcoin?

September 15 – Bloomberg (Olga Kharif and Belinda Cao): “Bitcoin’s meteoric summertime surge risks coming to a painful end as Chinese policy makers move to restrict trading amid growing warnings of a market bubble. The biggest cryptocurrency dropped as much as 40% since reaching a record high of $4,921 on Sept. 1, cutting about $20 billion in market value. The collapse extended to as much as 30% this week since China began sending stronger signals of a clampdown on Sept. 8, making this the biggest five-day decline since January 2015, when it traded at around $200.”

Historians will surely look back at this period and struggle to understand why global central bankers after all these years were so reticent in reducing extraordinary monetary stimulus. Bitcoin and the cryptocurrencies have gone parabolic. U.S. and global equities grind further into record territory; global bond prices are indicative of one of history’s greatest financial Bubbles; real estate prices continue to inflate in most markets globally; debt issuance is on record pace and financial conditions remain incredibly loose virtually everywhere.

A few – not necessarily market-friendly – headlines worth pondering: “UK inflation rate rises to 2.9%”; “Euro zone wage growth surges, making ECB taper more likely”; “Bank of Canada open to alternatives to inflation target”; “Inflation data prompt rethink on US rates”; “Inflation is heating up with some help from the hurricanes”.

Recent inflation readings have generally surprised on the upside, including those in China, UK, U.S. and India. The GSCI commodities index gained 2.2% this week to trade to highs since April. Crude (WTI) was back above $50 this week. While down this week, industrial metals have been on fire. Meanwhile, Harvey and Irma will now make U.S. economic and inflation analysis even more of a challenge. Interestingly, market probabilities for the Fed to boost rates again before year-end have increased to almost 50%.

Global bond markets have begun taking notice. UK yields surged a notable 32 bps this week to 1.32%, near a seven-month high. Ten-year yields were up 10 bps in Canada to an almost three-year high. Australian 10-year yields were up 16 bps to 2.74%, near the high since March. Sweden saw yields jump 13 bps to 0.85%, the high since January 2016. German bund yields rose 12 bps to 0.43%.

Ten-year Treasury yields rose 15 bps this week to 2.20%. Two-year Treasury yields jumped 12 bps to 1.38%, quickly closing in on early-July’s multi-year high of 1.41%. Five-year Treasuries were under heavy selling pressure, with yields jumping 17 bps to 1.81%. Meanwhile, currency trading continues to indicate underlying instability. Two currencies popular in speculative trading strategies – the Japanese yen and British pound – both posted big moves this week. The pound surged 3.0%, while the yen sank 2.7%.

September option expiration helped U.S. equities push higher into record territory. There was likely a decent amount of hedging (North Korea, Trump, etc.) in September derivatives. Then we saw hurricane Irma bearing down on Florida, with the potential for a catastrophic direct hit on Miami. Markets were also concerned that North Korea might follow up the previous week’s nuclear test with another ICBM launch on Saturday. When worst fears failed to materialize over the weekend, equities rallied big on Monday as hedges and short positions were unwound.

The fact that markets continue to so readily disregard risk is consistent with Bubble Dynamics. We’ve seen it all before – except never on a such an all-encompassing, multi-asset class and global basis. I would argue that bond yields have been held artificially low by a combination of complacent central bankers, mounting geopolitical risks, Trump uncertainties and the general view that equities and risk markets have become increasingly vulnerable. There is at least some indication that global central bankers are becoming a little less complacent.

Original Post 16 September 2017

Categories: Doug Noland, Perspectives