Doug Noland: Faltering Bubbles (Italian Drama)

Keep in mind that it’s not unusual for U.S. equities to go on their merry way right into trouble. The S&P500 rallied to record highs after the subprime eruption in 2007…2000. 1987. 1929. 


As I see it, cracks are opening in the greatest Bubble of all time. Serious fissures have developed in EM, Europe and China. Meanwhile, the stimulus-driven U.S. economic boom runs unabated. Global fragilities place downward pressure on U.S. market yields, while faltering Bubbles elsewhere stoke (self-reinforcing) outperformance – and speculative excess – within the U.S. equities market. The Fed faces a difficult challenge of weighing buoyant U.S. economic data and inflating asset prices against heightened global market fragilities.

Let’s begin with U.S. data. May non-farm payrolls increased a stronger-than-expected 223,000. The Unemployment Rate declined a tenth to 3.8%, matching the low going all the way back to 1969. Average hourly earnings were up 0.3% in May and 2.7% y-o-y. The ISM Manufacturing Index increased 1.4 points to a stronger-than-expected 58.7. There have been only nine stronger monthly readings looking all the way back to August 2004. Prices Paid rose slightly to 79.5, the high since April 2011. ISM New Orders jumped 2.5 points to 63.7, the high since February. The Employment component rose 2.1 points to a solid 56.3. The Chicago Purchasing Managers index surged 5.1 points to 62.7, the high since January. The Dallas Manufacturing Outlook recovered five points to the high since February. A Friday afternoon CNBC (Jeff Cox) headline: “The US economy suddenly looks like it’s unstoppable.”

April Construction Spending was up a much stronger-than expected 1.8% (strongest since January), led by an 8.7% y-o-y increase in residential construction. This followed stronger-than-expected S&P CoreLogic house price inflation (up 6.79% y-o-y). May Conference Board Consumer Confidence gained 2.4 points to 128, just below February’s 130, the strongest reading going all the way back to November 2000. The Conference Board Present Situation component jumped 4.2 points to 161.7, the high back to March 2001. Also indicative of boom time conditions, Personal Spending jumped 0.6% in April. May auto sales almost across the board surpassed expectations, with sales estimated up 5% from a year ago.

In most backdrops, such robust data would have the markets fretting both a more diligent Federal Reserve and surging market yields. Yet 10-year Treasury yields traded as low as 2.76% during Tuesday’s session, before closing the week down three bps to 2.90%. Interestingly – and reflective of rapidly shifting expectations for Fed policy – after beginning the week at 2.48%, two-year yields dropped to 2.29% on Tuesday before reversing course and ending the week little changed.

Global markets, of course, were buffeted this week by developments in Italy. Italian 10-year yields surged 47 bps Tuesday to a four-year high 3.13%. At that point, Italy’s 10-year yields were up more than 100 bps in six sessions. The spike at the front end of the yield curve was even more dramatic. Italian two-year yields jumped an extraordinary 181 bps Tuesday to 2.64%, the highest level since the 2012 European crisis. Panic buying saw German 10-year yields drop to 18 bps, after trading as high as 58 bps on May 21. Incredibly, German two-year yields dropped to negative 82 bps after ending the previous week at negative 63 bps.

Tuesday’s mayhem followed the Italian President’s veto of the Five Star and League coalition government. With the rejection of the coalition’s first choice for Finance Minister, it appeared Italian voters would be heading back to the polls in an election that could have evolved into a referendum on the EU and the euro. The crisis backdrop spurred political compromise. By week’s end, a new – and seemingly less hostile to the euro – Finance Minister had been proposed and a new coalition populist government formed. In a big relief for the markets, the need to call a snap election had been averted.

May 29 – Bloomberg (Nikos Chrysoloras and Helene Fouquet): “A surging dollar and a capital flight from emerging markets may lead to another ‘major’ financial crisis, investor George Soros said, warning the European Union that it’s facing an imminent existential threat. The ‘termination’ of the nuclear deal with Iran and the ‘destruction’ of the transatlantic alliance between the EU and the U.S. are ‘bound to have a negative effect on the European economy and cause other dislocations,’ including a devaluing of emerging-market currencies, Soros said in a speech… ‘We may be heading for another major financial crisis.'”

May 31 – Bloomberg: “Morgan Stanley Chief Executive Officer James Gorman said that investor George Soros’s contention another major global crisis may be in store is unrealistic, and that the Federal Reserve will probably hike interest rates three more times in 2018 despite recent volatility. ‘Honestly I think that’s ridiculous,’ Gorman said in an interview… when asked about Soros’s comments this week, which included a warning that the European Union is at risk of breaking up amid Italy’s challenges. ‘I don’t think we’re facing an existential threat at all,’ Gorman said of the EU.”

I regret that George Soros has become such a polarizing political figure. My analytical framework owes considerable debt to his analysis and philosophy with respect to Credit, the markets and finance more generally. Soros’ decades of experience, analysis and success navigating global markets are unequaled. I would not dismiss his warnings.

I hold the view that the euro monetary experiment has been deeply flawed in both its structure and implementation. European nations sacrificed sovereignty for the considerable benefits provided by a common currency that would compete globally against the U.S. dollar. Sharing the euro with Germany and others dramatically lowered borrowing costs and loosened Credit Availability more generally. Regrettably, there was no mechanism to effectively regulate Credit expansion, especially for members at the “periphery” that rather suddenly enjoyed access to cheap global finance like never before.

The boom was spectacular; the subsequent bust is proving rather everlasting. Since 2012, Draghi’s “whatever it takes” collapsed borrowing costs and market yields, while stoking asset inflation and economic recovery. Historic monetary inflation has not, however, changed economic structure, history or distinctive cultures. ECB policies, along with central bank reflationary policies globally, have only exacerbated wealth inequalities, economic maladjustment and financial Bubbles. This is an especially intractable problem for the eurozone.

In an interview on German television, the EU’s budget chief made a headline-grabbing assertion about the prospects for another Italian election: “My concern and my expectation is that the coming weeks will show that markets, that government bonds, that Italy’s economic development could be [affected in a manner so] drastic that this could be a possible signal to voters not to choose populists from the left and right.”

Understandably, this type of rhetoric doesn’t sit well in Italy or in other countries that see outside political bodies holding a gun to their heads. It is, however, a view held as the gospel in the markets. As financial markets have evolved to command the world, there are two unassailable truths: First, central banks will do whatever it takes to ensure strong markets and economic expansion. And, second, markets are prepared to dish out sufficiently brutal punishment to ensure that politicians and voters fall in line. The electorate may be disgruntled and openly hostile, but they’re not suicidal.

Eventually, fed up electorates will refuse being held hostage by the securities markets. I expect the euro system will at some point badly falter, and I suspect this view is quietly shared within the marketplace. This helps explain why things can so abruptly go haywire in the markets. As I have posited in the past, I don’t believe the Germans and Italians will share a common currency forever. As cultures, societies and governments, they grow only more discordant. So, there will come a time when savers, investors and speculators choose not to wait and see how the inevitable destabilizing transition plays out. The genie was almost out of the bottle back in 2012.

There are, as well, sophisticated market operators with plans to be among the first wave out, appreciating that ECB and Italian government support will go only so far in stabilizing a hopelessly unstable arrangement. Expect more attention to ECB “Target2” balances (assets/liabilities to the euro financial system created from surpluses/deficits in trade and financial flows). Italy’s accumulated Target2 liabilities ended April at an astounding $426 billion, much of it owed to Germany. This obligation will likely expand rapidly as flows exit Italian banks for refuge elsewhere. Perhaps the latest Italian Drama will spur an upswell of German support for Bundesbank President Jens Weidmann taking the helm of the ECB when Draghi’s term ends in November 2019.

I have long admired Bill Gross. His long-term performance speaks for itself. Mr. Gross is struggling in this market environment, not unlike other seasoned market operators. The appearance of markets operating normally is only superficial. I’m compelled to mention the extraordinary 3% loss experienced by Bill Gross’ unconstrained bond fund in wild Tuesday trading. Many public funds of this ilk posted notably large losses Tuesday, and I’ll assume there were scores of hedge funds that were hit as hard or harder.

For the almost four-year period June 2, 2014, to May 7, 2018, the Italian to German two-year sovereign yield spread averaged 49.5 bps. The high for this period was 98 bps briefly back in February 2017. This spread had averaged about 30 bps for 2018 through early-May. Well, the Italian to German two-year yield spread blew out to 353 bps in chaotic Tuesday trading. After trading last week as high as 58 bps, ten-year German yields sank Tuesday to as low as 18 bps. At Tuesday’s highs, Italian 10-year yields were 288 bps higher than bund yields, widening 113 bps in a week. Derivatives and leveraged speculation run amuck.

Wild market gyrations were not limited to European bonds. Ten-year Treasury yields, after trading as high as 3.13% the previous week, sank to 2.76% in Tuesday trading. In just five sessions, two-year yields dropped 30 bps to Tuesday morning’s low of 2.29%.

May 29 – Financial Times (Robert Smith): “Yields on Italian bank bonds surged dramatically on Tuesday, as increasing political turmoil in the eurozone’s third-biggest economy put heavy selling pressure on the debt of the country’s lenders. Riskier forms of bank debt that count towards financial institutions’ capital ratios have seen the sharpest sell-off. These bonds are more exposed to losses when banks need to be rescued, as seen when Spanish lender Banco Popular’s additional tier 1 and tier 2 bonds were wiped out last year. Monte dei Paschi di Siena’s €750m 10-year tier 2 bond plummeted as much as seven cents to 81.5 cents on the euro… This equates to a yield of more than 9.5%, a sharp increase from the 5.375% the bond was originally sold at in January.”

A semblance of calm returned to Italian (and periphery) markets with Friday’s swearing in of political novice Giuseppe Conte as Italy’s new prime minister. Meanwhile in Madrid, socialist Pedro Sanchez appears poised to replace Mariano Rajoy who suffered a humiliating vote of no confidence after members of his People Party were convicted in a widespread political corruption scandal. The immediate risk to the euro may have subsided, but the political instability that has erupted in the eurozone’s periphery will overhang increasingly fragile European financial markets. A Friday evening Financial Times headline: “Italy’s new government: Europe on edge after palace takeover.”

If messy European politics weren’t enough, there were the Trump Tariffs.

May 30 – Reuters (Jason Lange and Ingrid Melander): “Canada and Mexico retaliated on Thursday after Washington imposed tariffs on steel and aluminum imports while the European Union had its own reprisals ready to go, reviving investor fears of a global trade war. Germany’s Economy Minister said early on Friday the EU might look to coordinate its response with Canada and Mexico. The tariffs, announced by Commerce Secretary Wilbur Ross, ended months of uncertainty about potential exemptions and suggested a hardening of the U.S. approach to trade negotiations. The measures, touted by President Donald Trump in March, drew condemnation from Republican lawmakers and the country’s main business lobbying group and sent a chill through financial markets.”

With the small caps ending the week at all-time highs, that’s a rather balmy market chill. Believing strong equities remain presidential Priority One, markets now scoff at administration trade threats. Surely, tariffs are but a negotiating ploy to extract favorable trade concessions. But if markets don’t take the administration’s trade threats seriously, why would our trading partners/adversaries? And that we are negotiating trade terms with various parties concurrently, why wouldn’t these countries be motivated to all covertly band together in a strategy to forcefully nip Trump’s Tariffs in the bud. Reuters: “U.S. isolated at G7 meeting as tariffs prompt retaliation.”

I understand market complacency with respect to steel and aluminum tariffs. It’s the unfolding trade confrontation with China with the distinct potential to rattle markets. More than trade, it’s a brewing battle royale pitting the world’s lone superpower against the aspiring superpower. And as fissures continue to surface in Chinese Credit, I can envisage Beijing contriving scenarios where they will lay blame upon the U.S. and other foreigners. It’s worth mentioning that the Shanghai Composite dropped 2.1% this week, trading Wednesday at a one-year low. China’s currency declined 0.45% vs. the dollar to a four-month low.

Largely overlooked as attention turned to Italy, stress continued to mount in EM. The Brazilian real dropped 3.0% this week, pushing one-month losses to 6.9%. The Mexican peso fell 2.0%, and the Argentine peso declined 1.6%, with one-month losses of 5.0% and 17.8%. The South African rand lost 1.6% this week, with the Chilean peso down 1.2%. The beleaguered Turkish lira sank 2.6% in Friday trading, quickly wiping out much of the recovery from earlier in the week. Turkish 10-year dollar yields surged 20 bps this week to 6.73%. Brazil’s dollar bond yields surged 39 bps to a two-year high 5.68%, and Mexico’s dollar yields rose 16 bps to near multi-year highs at 4.53%. Local currency bond yields surged 25 bps in Brazil (11.45%) and 18 bps in Mexico (7.62%).

It was another week of important corroboration of the Global Bubble Thesis. Market historians might look back at Tuesday’s Italian debt “flash crash” and sovereign bond dislocation as another warning of impending illiquidity and general market mayhem. How much leverage and systemic risk are embedded in perceived low-risk derivative trading strategies? Keep in mind that it’s not unusual for U.S. equities to go on their merry way right into trouble. The S&P500 rallied to record highs after the subprime eruption in 2007. U.S. stocks advanced strongly right into July 1998 – only weeks from near Financial Armageddon. Q1 2000. 1987. 1929.

Original Post 2 June 2018

TSP & Vanguard Smart Investor

Categories: Doug Noland, Perspectives