Doug Noland: Regime Change

Deutsche Bank (DB) operates, after all, in the core of global derivatives markets and securities finance… Derivatives lurk at the epicenter of global financial crisis risk. It’s right here where global central bank policies have fomented the greatest distortions and associated fragilities. The perception – the implied guarantees – of liquid and continuous markets. And when DB’s stock is sinking (down 13%) and its CDS is blowing out (33bps this week!), then the issue of counterparty risk and derivative market dislocation begins to creep into market psychology (and positioning). 


Deutsche Bank (DB) dropped 13% this week to a 15-month low. DB is now down 28% y-t-d. European banks (STOXX) sank 5.0% this week. Hong Kong (Hang Seng) Financials were down 4.9%. Japan’s TOPIX Bank index fell 3.3%. In the U.S., banks (BKX) were slammed 8.0%, the “worst loss in two years.” The Broker/Dealers (XLF) fell 7.3%.

It was also an active week in Washington. The Powel Federal Reserve raised short-term interest rates, and the new Chairman completed his first news conference. President Trump announced trade sanctions against China. There was more shuffling within the administration, including John Bolton replacing National Security Advisor H.R. McMaster.

Let’s start with the FOMC meeting. Analysts – along with the markets – were somewhat split between “hawkish” and “dovish.” As expected, the Fed boosted short rates 25 bps. On the dovish side, the Fed’s “dot plot” showed a median expectation of three rate increases in 2018 versus pre-meeting average market expectations of 3.5 – and fears of four hikes. The Fed upgraded its view of GDP prospects and lowered its forecast of the expected unemployment rate. Steady as she blows for normalization – markets not so much.

Chairman Powell did nothing overtly to rattle the markets. The message, at least for the near-term, was continuity. He was clear and concise. There were, however, important subtleties.

A couple of headlines worth noting: From the Financial Times: “Jay Powell Plays it Safe in Federal Reserve Debut.” From Bloomberg, “Powell Disses Dots Again as He Stresses Limit of Fed’s Knowledge” and “Powell Debuts as Show-Me Fed Chair in Shift From Theory, Models.”

Jerome Powell faces an extraordinary challenge as Fed Chairman. If he does not move quickly and aggressively to flood the global financial system with liquidity upon the onset of financial crisis, history books will surely have him tarred and feathered. Greenspan, Bernanke and Yellen hold responsibility for history’s greatest Bubble. Yet it will be on Powell’s watch when the Fed faces the harsh consequences. In the end, he’ll be left with little alternative than more QE and zero rates – surely deemed too little too late in hindsight. Winless.

I’ve been impressed with our new Fed Chairman. For the first time in (at least) a couple decades, I can listen intently to the head of the Federal Reserve (testimony and press conferences) without that recurring urge to roll my eyes. I feel respectful.

Alan Greenspan was the master of obfuscation. His conversations seemed guided by some game theory, and I was too often left pondering what went unsaid – and why. Greenspan’s ego, free-market ideology and personal ambitions over time fostered an overly-powerful cult status. With direction from an intellectual advocate, market pricing mechanisms can be all the more awe-inspiring. The wonder of bolstering securities markets with a few enlightened words or, when necessary, 25 bps. No unelected individual should ever assume such power. And when a central banker is idolized in real time, he’s surely too accommodative. As financial innovation quickened and Bubble Dynamics took hold, Greenspan became incapable of correcting – or even admitting – mistakes.

Ben Bernanke had his own issues. Dr. Bernanke’s formidable biases revolved around his academic research and unconventional theories. His limited experience with the markets only heightened the insecurities facing anyone replacing “The Maestro.” Bernanke had spent much of his academic career fashioning his theory that the Fed’s failure to print money after the 1929 crash was the prevailing cause of the Great Depression. A seemingly modest man had become convinced he’d unearthed the “Holy Grail of Economics”. He promised Milton Friedman on his 90th birthday that the Fed had learned from its catastrophic mistake and wouldn’t allow it to happen again. The opportunity presented itself early in his term as chairman, and Bernanke unleashed history’s greatest monetary experiment. His radical reflationary doctrine captivated – and then changed – the world.

The Wall Street Journal’s Jon Hilzenrath once referred to Bernanke as a “gun slinger.” This monetary cowboy was incapable of unbiased analysis and decision-making. As his inflationary experiment mutated beyond short-term crisis management measures, Bernanke increasingly dug in his heels. In the throes of untested monetary doctrine, he turned defensive and “100% certain” of too many things.

For traders in the market, it’s seeing a losing short-term trade morph into a long-term “investment.” With everything invested in his runaway global experiment, Dr. Bernanke lost touch with reality – not to mention monetary conventions. He turned hostage to the financial markets, somehow promising that he would not tolerate any tightening of financial conditions – let alone a bear market, recession or crisis. What unfolded was a complete breakdown of responsible central banking.

Chair Yellen followed too comfortably in Dr. Bernanke’s footsteps. The unassuming market darling that wouldn’t dare do anything that might rock the boat; another seasoned academic with a theoretical framework that essentially posed no risk to raging market Bubbles. Gratified that unemployment was declining as core consumer inflation stayed below target, she discerned nothing problematic unfolding in the markets or economy that might risk future crisis. In the final analysis, it was a four-year term notable for a complete failure to tighten financial conditions when the backdrop beckoned for significant tightening measures. No “gun slinger”, but a competent and pleasant enabler of vicious “Terminal Phase” Bubble excess.

This history rehash is to emphasize the stark contrast between Chairman Powell and his predecessors. He’s from a completely different mold. For the first time in decades, the Fed Chairman is not beholden to ideology, academic theory nor activist monetary doctrine. This allows straightforward answers to questions. No obfuscation necessary – no extoling nor canonizing. Academic dogma need not eclipse studious observation and common sense. Powell respects the institution. And I believe his leadership will promote a soberer perspective, clearer analysis and sounder policy from our central bank.

While pundits underscore “continuity,” the markets must contemplate what this means for the Greenspan/Bernanke/Yellen “market put”. Of course, the Powell Fed’s support will be there in the event of crisis. But the timing: how much time – and market value – will pass before central banks come to the rescue? Does Powell appreciate how previous Fed policies nurtured dangerous securities market excess? Would the Chairman prefer to return to more traditional central bank management – hesitant to resort to QE, rate cuts and other tools of market intervention? Would he rather let markets deal with volatility without members of the Fed jumping to render vocal support?

The implied government guarantee of GSE obligations was a root cause of the mortgage finance Bubble. Washington was content to let the markets operate as if the Fed and Treasury would always be there with a backstop. For years now, there has been an implied guarantee that global central bankers would freely offer liquidity backstops to financial markets. Markets inflated, which implicitly increased the scope of this implied guarantee. Meanwhile, responsible central bankers, more appreciative of mounting risks, should be compelled against further emboldening Bubble markets. Implicit guarantees must be reined in.

I believe Chairman Powell understands the dangerous role the “Fed put” has played over the years. His bias would be to wean the markets off central bank liquidity, excessively low interest rates and aggressive “activist” market intervention. Markets would be healthier standing on their own – to reacquaint themselves with risk and prudence.

In Wednesday’s press conference, Chairman Powell was notable for downplaying the “dot plots” and underscoring the limitations of Fed forecasts. It was subtle, but my thoughts drifted back to ECB President Trichet’s “We do not pre-commit.” The Fed Chairman was cautious and adept, as he commenced the process of dialing back market expectations for certainty, accommodation and unconditional support from our central bank. Fixated on continuity, markets have thus far been unable to focus on Regime Change. Policy doctrine is changing, creating major uncertainty for a marketplace increasingly coming to terms with myriad mounting risks.

March 21 – Bloomberg (Alex Harris and Liz McCormick): “From Riyadh to Sydney, short-term funding markets worldwide are starting to feel the effects of soaring U.S. dollar Libor rates. The surge in recent weeks in this key global short-term financing indicator may have a mostly technical explanation, meaning it’s probably not flashing warning signals like it was during the credit crunch or the European sovereign debt crisis. Nonetheless, it’s still making funding more costly for some borrowers outside the U.S. The three-month London interbank funding rate rose to 2.27% Wednesday, the highest since 2008. The concern is that the Libor blowout may have more room to run, a prospect that borrowers and policy makers in various markets are just beginning to grapple with.”

The Libor/OIS interbank Credit spread widened further this week, indicative of tightening liquidity conditions. It’s my view that risk premiums are now generally rising partially on concerns for the Fed and global central bank liquidity backstops. For years, the implied central bank market backstop worked to depress the cost of all varieties of market “insurance” – from the VIX in U.S. equities, to hedging costs in global equities, corporate Credit, sovereign debt and, last but certainly not least, the currencies. The scope of Bubbles has inflated tremendously, while confidence in the future efficacy of central bank support measures has just begun to wane. The cost of market protection is now rising rapidly, with profound ramifications for myriad interrelated global Bubbles.

March 23 – Bloomberg (Molly Smith and Austin Weinstein): “U.S. companies are finding that the flow from the foreign-money spigot is slowing. Foreigners showed signs of being net sellers of U.S. investment-grade corporate debt this week, according to Bank of America… Any selling pressure comes after international investors bought just $38 billion of U.S. investment-grade corporate debt in the fourth quarter, according to UBS…, the least since the beginning of 2016… Overseas money managers are a key pillar for the market, having bought more than $1.4 trillion of the securities since 2013, UBS said. With the dollar extending losses after plunging last year and hedging costs near decade-highs by one measure, overseas investors have fewer reasons to buy… The securities are on track for their worst first quarter since 1994… For many foreign investors, rising hedging costs are eating into or erasing the extra yield to be earned from a U.S. corporate bond. European investors must sacrifice around 2.7 percentage points in annual yield to hedge using rolling three-month forwards for a year when buying in U.S. dollars and hedging back to euros, data compiled by Bloomberg show. The Japanese have to forfeit about 2.4 percentage points when hedging back to yen, around the highest level since 2008… ‘The math just doesn’t work anymore,’ said Josh Lohmeier, head of U.S. investment-grade credit at Aviva Investors… ‘It’s driving away foreign investors that hedge.'”

The rising cost of hedging, widening Credit spreads, waning demand for corporate Credit and abating general market liquidity now pose a major challenge for vulnerable global markets. No longer will it be so easy to dismiss risk. And with various risks now coming into clearer view on a daily basis, markets must confront the harsh reality of significantly higher hedging costs across the spectrum of risk markets.

The Washington spectacle has finally become a major market issue. Tariffs and trade wars do matter, at this point more from a financial standpoint than economic. Members of the Trump cabinet matter. The composition of Trump’s foreign policy team matters. The nature of his advisors and attorneys matter. The mid-terms will matter, perhaps profoundly. It is said that the President is becoming more comfortable in the job – and ready to call the shots. Markets are increasingly uncomfortable.

With fragilities surfacing, global markets have turned increasingly vulnerable. The threat of foreign selling of U.S. Treasuries, corporate debt, equities and dollar balances is now real and consequential – just as liquidity becomes a festering issue. The stock market is sliding – prices along with its standing on the President’s priority list.

Initially spooked by steel and aluminum trade tariffs, markets were relieved by prospects they’d be watered down. Markets had remained surprisingly relaxed at the prospect of tariffs and trade measures directed at China. Suddenly, markets are spooked at the thought that the President’s issue with China might go way beyond U.S. trade deficits and manufacturing jobs. Is the unspoken objective to rein in China’s global superpower ambitions?

March 23 – Financial Times (Shawn Donnan): “Viewed from the standpoint of big business and classical economics, Donald Trump’s increasingly protectionist trade policy has looked like a collection of impetuous acts of economic self-harm in recent weeks. But is there political method in the economic madness? Ordering new tariffs on up to $60bn in Chinese imports on Thursday, Mr Trump declared that his administration was out to punish Beijing for its systematic theft of American intellectual property and reverse the loss of US factory jobs. ‘We’re doing things for this country that should have been done for many, many years,’ he declared. The president then added: ‘It’s probably one of the reasons I was elected; maybe one of the main reasons.’ … ‘I don’t agree with President Trump on a whole lot, but today I want to give him a big pat on the back. He is doing the right thing when it comes to China,’ said Chuck Schumer, a long-time China hawk who leads the minority Democrats in the Senate.”

March 22 – New York Times (Carlos Tejada): “Arranged marriages. Whispered warnings. Outright theft. For years, American companies have complained that the Chinese government finds ways to get them to hand over their most valuable trade secrets. Those companies – which usually complain anonymously, fearing Chinese retribution – have found a sympathetic ear in the Trump administration. American trade officials on Thursday cited those practices as a major motivation for their plans to levy tariffs and penalties on $60 billion in Chinese imports and to take a tougher stance on the vast and lucrative trade relationship between the two countries. The report outlines in blunt terms how intellectual property – everything from product designs and sensitive data to general know-how – has become a point of contention in global trade relations, joining longstanding areas of dispute like steel.”

March 20 – Financial Times (Charles Clover, Lucy Hornby, Sherry Fei Ju and Xinning Liu): “Xi Jinping has promised that China will ‘ride the mighty east wind of the new era’ and ‘charge forward with a full tank’, in a patriotic speech that parted decisively with the previous era of caution in Beijing’s foreign relations. The president’s nationalistic message came in closing remarks to the National People’s Congress, the rubber stamp legislature, which this month confirmed changes to the constitution that would allow Mr Xi to rule for life. He used the occasion to outline his vision for China’s peaceful ‘rejuvenation’ as a world power, but also to warn against foreign plots. ‘All acts and tricks to split China are doomed to failure and will be condemned by the people and punished by history,’ he said, alluding to Beijing’s longstanding goal of taking back the breakaway territory of Taiwan.”

Beijing has been getting prepared. For what, is an open question. China’s initial response to Trump Tariffs has been restrained. Like many of us, they’re surely working to comprehend what he’s really up to. The President has rather hastily assembled a hawkish foreign policy team. To be sure, Beijing will not stick to modest measures if they suspect Trump’s Chinese ambitions go beyond measured trade adjustments. They have big levers to pull: Treasuries, U.S. securities, Taiwan, and currency devaluation, to name a few. Beijing has taken measures to exert significant control over China’s markets and economy. I’ll assume Beijing believes China is better prepared to manage through global market turbulence than their adversary.
There’s a general complacency deeply embedded in U.S. financial markets. No toxic securities Bubble at the brink. There is no Lehman vulnerable to a run and swift collapse. Interestingly, however, from the global financial markets Bubble perspective, there is Deutsche Bank and its double-digit stock decline this week. It seems to be the first place global players look when risk begins to be an issue, financial conditions start to tighten and risk premiums escalate. DB operates, after all, in the core of global derivatives markets and securities finance.

Derivatives lurk at the epicenter of global financial crisis risk. It’s right here where global central bank policies have fomented the greatest distortions and associated fragilities. The perception – the implied guarantees – of liquid and continuous markets. And when DB’s stock is sinking (down 13%) and its CDS is blowing out (33bps this week!), then the issue of counterparty risk and derivative market dislocation begins to creep into market psychology (and positioning).

Greed to Fear. “Risk On” shifting to “Risk Off.” This week had the feel of de-risking/de-leveraging dynamics gathering important momentum. This was no VIX (24.87 close) accident. This was a general widening of Credit spreads, waning liquidity and overall market instability. Dollar weakness reemerged this week, which sparked a nice safe haven bid in gold and the precious metals. Crude surged. Curiously, it also awakened a bit of safe haven buying for Treasuries (with widening corporate Credit spreads).

I couldn’t help but to ponder the possibility that the rising cost of hedging dollar risk is a game changer for U.S. corporate debt. There’s a huge amount of leverage there, along with big foreign ownership. It’s certainly not a strong position for instigating tariffs and risking trade wars. It’s instead a backdrop increasingly susceptible to panic selling, liquidity shocks and derivative issues.

Original Post 24 March 2018


TSP & Vanguard Smart Investor


Categories: Doug Noland, Perspectives