Doug Noland: 2019 in Review

It cannot be overstated: Bubbles are of paramount importance – for markets, finance more generally, economies, and social and geopolitical stability. Two U.S. bursting episodes over the past twenty years would seem to make this proposition indisputable. I would add that Bubble Dynamics have never been more pertinent than they became over the past year. Apply monetary stimulus to a historic financial Bubble and you’re asking for serious trouble: The Story of a Perilous 2019.

Yet “Bubble” these days has no part in conventional analysis or dialogue – for central bankers, economists or market pundits. To even utter the word on CNBC or Bloomberg would suggest one is hopelessly detached from reality. From my vantage point, bullishness and New Paradigm thinking these days rivals that of the early-2000 peak. Today’s faith in central banking is unrivaled – the willingness to embrace egregious excess unmatched.

To summarize the 2019 policy backdrop in one word: capitulation. It was to be a year of monetary policy normalization. The new Fed chairman was to finally return policy rates to a more reasonable level. After leaving rates near zero for seven years, the Fed belatedly took a baby step in December 2015. A full year went by before mustering the courage for a second cautious step. And a year full later (December 2017) rates were still at 1.00%.

Policy rates were only up to 1.25% to 1.50% when Powell took the reins. Having delayed the process much too long, “normalization” was not going to go smoothly. Rates were taken to 2.25% (to 2.5%) by the end of 2018, and the wheels almost came off. Powell’s January 4th dovish U-turn essentially ended any notion of rate normalization. Avoiding market instability was the priority – and celebratory markets took full advantage. In 2019, the odds central bankers would ever actually tighten monetary conditions became exceedingly low.

To accurately comprehend 2019 demands attention to key Bubble Dynamics. First of all, to employ monetary stimulus in the late stage of a Bubble ensures instability. Conventional thinking – both in policy circles and the markets – was that with limited ammunition central bankers should utilize stimulus early and aggressively. Late-cycle Bubbles, by their nature, connote financial and economic fragilities.

There are at the same time powerfully-entrenched inflationary biases – including expansive infrastructures fostering higher asset prices. Policymaker focus on bolstering system resiliency ensures a precarious extension of “Terminal Phase” excess – in Credit, speculation, speculative leverage, risk intermediation, malfunctioning markets, resource misallocation and associated financial and economic maladjustment.

In the late phase of history’s greatest global financial Bubble, there’s the thinnest of lines between the onset of crisis and rip-roaring bull markets.

On Thursday, January 3rd, Goldman Sachs Credit default swap (5yr CDS) prices surged 19 to 131 bps – the high since March 2016 and the largest one-day move since 2013. In the currency markets, a “flash crash” saw stunning moves including an 8% intraday move in the Japanese yen/Australian dollar. Dislocation had begun to unfold across global derivatives markets. Panic buying saw Treasury yields sink 15 bps, pushing the collapse from November 8th highs (3.24%) to 70 bps. Corporate Credit spreads were blowing out, especially in junk debt. Deleveraging dynamics were global. For example, the spread between 10-year German bunds and the European periphery (i.e. Italy and Portugal) widened markedly. A major de-risking/deleveraging event had gathered momentum. Equities were under pressure, with the DJIA sinking 660 points during that fateful session.

The following day Chairman Powell joined Janet Yellen and Ben Bernanke for a panel discussion at a meeting of the American Economic Association. Only two weeks since the Fed’s December 19th rate increase and press conference, Powell’s comments were not expected to be monetary policy-focused. But the Chairman pulled out prepared comments and orchestrated a dramatic “dovish U-turn”:       “…Policy is very much about risk management.” “We will be patient as we watch to see how the economy evolves…” “…Always prepared to shift the stance of policy and to shift it significantly if necessary…” “We will be prepared to adjust policy quickly and flexibly and to use all of our tools to support the economy…”

Despite economic resilience and a 3.9% unemployment rate, the Fed was prepared to add monetary stimulus to support the markets. The DJIA rallied 747 points January 4th on Powell’s comments. It was a prescient market move signaling the Year of Monetary Disorder.

M2 “money” supply surged $1.024 TN, or 7.1%, in 2019, easily surpassing 2016’s record $880 billion expansion. This was 65% ahead of average annual M2 growth over the preceding decade. Moreover, Institutional Money Fund Assets (not included in M2) jumped $407 billion, or 21.9%, up from 2018’s $27 billion increase – and the strongest money market fund expansion since 2007. In a year of strong Credit growth, total third quarter U.S. Credit (Non-Financial, Financial and Foreign U.S. borrowings) jumped a nominal $1.075 TN (from Fed’s Z.1), the strongest quarterly gain since Q4 2007.

2019 was the year of “the everything rally;” FOMO – fear of missing out – the year’s amalgamation of Greed and Fear. Stocks, Treasuries, corporate Credit at home and abroad. Don’t ask why – just buy, and the more levered the better. With an enduring U.S. economic expansion, the S&P500 returned 32.61%. With Germany’s economy stagnating, the DAX index returned 25.48%. Fighting persistent recessionary forces, Italy’s MIB index returned a prosperous 33.80%. Recession or, in the case of the U.S., stagnant earnings were irrelevant.

After trading to a January high of 2.79%, 10-year yields sank below 1.50% in August. By late-July, the S&P500 had already gained more than 20%, with the Nasdaq100 up 26% and the Semiconductors surging almost 40%. Who was wrong, booming stocks or booming safe haven bonds? Monetary Disorder made everything seem right.

In a replay of the fall of 2007, Treasuries and safe haven government bonds rallied robustly in the face of bubbling equities prices. There was certainly a short squeeze element bolstering the marketplace, as hedges against Fed “normalization” were unwound. But, mainly, safe havens could monitor Bubble excess in the U.S. and a faltering Chinese Bubble and enjoy high confidence that global central bankers would be soon following through on promises to do “whatever it takes.” Lower market yields were instrumental in fostering risk market excess, and the greater the Bubbles inflated the more the safe havens anticipated rate cuts and more QE.

Treasuries, bunds, Swiss bonds, and Japan’s JGBs were transformed into the most enticing financial instruments imaginable. Central banks were essentially guaranteeing they would perform well. And in the event of global instability they would provide spectacular returns. A sure moneymaker as well as a trustworthy hedge against “risk off,” the safe haven bond rally morphed into a historic speculative blow-off. Ten-year Treasury yields traded to a low of 1.46% on August 3rd – an embarrassingly high relative yield. Bund yields collapsed all the way to negative 0.71%, with Swiss bonds down to negative 1.12%. Japanese 10-year government yields fell to negative 0.29%.

In a historic development (and emblematic of Acute Global Monetary Disorder), at the August peak $17 TN of global bonds traded with negative yields. Governments in Slovenia, Slovakia, Latvia, Austria, Ireland, Finland, Netherlands, Belgium and France enjoyed charging creditors for holding their money. After trading to 4.37%, Greek yields sank as low as 1.14%. Italian yields dropped from 2.95% to 0.81%, and Spain from 1.51% to 0.03%. Portuguese yields fell from 1.81% to 0.07%. Crazy.

May 28 – Bloomberg: “Is it the start of a new era for China’s $42 trillion financial industry, or a one-time shock that will be quickly forgotten? Five days after the first government seizure of a Chinese bank in 20 years, investors are still grasping for answers. The takeover of Baoshang Bank Co. — announced with scant explanation on Friday night — left China watchers guessing at whether it marks an end to the implicit backstop for banks that has served as a linchpin of the country’s financial stability for decades. Regulators have said they’ll guarantee Baoshang’s smaller depositors, and while they’ve warned some creditors of potential losses, they haven’t said what the final payouts could be or given public guidance on whether the takeover will be a blueprint for other lenders.”

China financial and economic fragilities were a growing market concern over the summer. Instability erupted in China’s money market, with the vulnerable (and now large) small banking sector struggling for financing. And with U.S. trade tensions escalating, the prospect of Beijing officials losing control was palpable. China’s currency faltered in August, with the dollar/renminbi breaching the key 7.00 level on August 5th – on its way to 7.18 by September 3rd.

After repeated failed attempts to rein in Credit excess, tightening measures adopted by a more resolute Beijing actually slowed Credit growth in 2018. Akin to U.S. rate “normalization”, this was not going to go smoothly. And that financial and economic vulnerabilities rapidly manifested with China in the throes of heated trade negotiations with the Trump administration ensured Beijing would once again let off the brake and pump the accelerator.

China saw record total system Credit growth (approaching $4.0 TN) in 2019 – as double-digit Credit growth compounds year after year. In the first 11 months of 2019, Aggregate Financing (excluding central government borrowings) expanded $3.028 TN, 19.3% ahead of comparable 2018 growth. November Consumer (chiefly mortgage) borrowings were up 15.3% y-o-y (36% in two, 66% in three and 139% in five years), as stimulus doused gas on China’s historic mortgage finance and apartment Bubbles.

Fueled by China, Trillion dollar U.S. fiscal deficits and fiscal stimulus around the world, 2019 likely saw record global Credit growth. In the end, systemic fears and the resulting summer global bond price melt-up bolstered vulnerable financial systems and economies. Argentine bonds and the peso crashed in August, but for the most part liquidity abundance sustained both emerging and developed market Bubbles. A less accommodative world of tighter finance and risk aversion would have been inhospitable to the likes of Turkey, Lebanon, Indonesia, Chile and many others. Booming liquidity and markets made a dud out of Brexit.

As the marginal source of EM finance and economic demand, a bursting – as opposed to inflating – Chinese Bubble would have had profoundly negative consequences. It’s remarkable how bullish markets have become on EM considering the rising vulnerability of Asia, Latin America and Eastern Europe to “risk off” trading dynamics.

From my Q3 2019 Z.1 analysis: “Total “repo” (“Federal Funds and Security Repurchase Agreements”) Liabilities jumped another $222 billion during the quarter to $4.502 TN, the high going back to Q3 2008. Over the past year, “repo” surged a record $932 billion, or 26.1%. For perspective, “repo” Liabilities rose on average $51.9 billion annually over the past five years (2014-2018). And the $932 billion gain during the past four quarters is more than double the biggest annual rise over the past decade (2010’s $422bn gain that followed the $1.672 TN two-year crisis-period contraction). Ominously, the past year’s gain also surpasses the previous record four-quarter gain ($824bn) for the period ended in June 2007.”

My thesis holds that unprecedented speculative leverage has accumulated throughout this most protracted period of monetary stimulus. Securities finance has boomed in so-called “repo” markets in the U.S., Europe and Japan, along with China and throughout Asia and the offshore financial centers (i.e. Cayman Islands, Luxembourg, etc.). Derivatives now truly rule the world. The Fed’s bullish U-turn, the ECB’s quick restart of QE, Japan’s endless stimulus, and scores of rate cuts globally incentivized wild speculative excess that culminated during the summer. “Blow-offs,” however, ensure vulnerability to abrupt reversals, deleveraging and liquidity issues.

Instability erupted in the U.S. repo market in September. Pundits pointed to a confluence of huge Treasury auctions, corporate tax payments and a shortage of available bank reserves. Yet it was no coincidence that illiquidity issues accompanied an abrupt bond market reversal. After trading at 1.47% on September 4th, 10-year Treasury yields were back up to 1.90% by September 13th.

(Worth noting at about this time, on September 16th, there were attacks on Saudi oil facilities. WTI crude prices immediately spiked from $53.94 to a high of $60.37, though prices closed back below $55 by September 27th.)

The “repo” market is sacred financial “plumbing”. It was, after all, the epicenter of 2008’s crisis eruption. Critical lessons were either never learned or conveniently forgotten. Building upon the dovish U-turn, the Powell Fed embraced “whatever it takes” to ensure liquidity was not an issue during the fourth quarter and especially for typical year-end funding pressures. Recalling Y2K, it was in the end a bogeyman that had the Fed pouring fuel on a raging speculative Bubble. Powell’s “midcycle adjustment” was completely abandoned. There was for now and the foreseeable future one cycle: easy “money” – and the only uncertainty: How easy? The Ultimate Asymmetric Policy.

Federal Reserve Credit expanded $395 billion in the final 16 weeks of year. Like rates, a year that began with expectations of Federal Reserve balance sheet “normalization” ended with aggressive quantitative easing operations. The Fed announced in October it would purchase $60 billion of T-bills monthly through at least the first-half of 2020, with Fed Credit ending 2019 at $4.121 TN (high since November 2018).

Goldman Sachs CDS ended 2019 at 52.39 bps, only a couple basis points from the low going all the way back to 2007. From a high of 465 on January 3rd, high-yield corporate CDS sank to lows since 2007 (ending 2019 at 280 bps). A notable 80 bps of the high-yield CDS decline ensued following the October announcement of the Fed’s balance sheet expansion strategy. And after trading to a high of 95.5 on December 24, 2018, investment-grade CDS closed out 2019 at 45.3, also near the lows since before the ’08 crisis.

The S&P500 returned 10.4% in the 11 weeks following the Fed’s announcement. The Nasdaq100 (NDX) returned 13.1%, while the Semiconductors (SOX) jumped 19.4%. The Banks (BKX) returned 17.9% and the Broker/Dealers (XBD) 17.3%. The small cap Russell 2000 returned 12.7% in 11 weeks. The NYSE Healthcare Index returned 14.9%, as the Biotechs (BTK) surged 21.7%.

Quite a squeeze unfolded. The Philadelphia Oil Services Index returned 26.2% between the Fed announcement and year-end. Tesla jumped 71% in 11 weeks. Advanced Micro Devices surged 62% to end 2019 with a 148% gain. Target gained 94% for the year, outpacing Chipotle’s 93.9% and Lululemon’s 90.5%. Apple rose 86.2%, trouncing Facebook (56.6%), Microsoft (55.3%), Adobe (45.8%) and Google (29.1%). Xerox jumped 86.6%. There were 56 stocks within the Nasdaq Composite that posted 2019 gains of better than 200% (174 at least doubled).

The announcement of a “phase one” U.S./China trade deal stoked the year-end rally. There is still little to indicate must substance in this agreement but, like with so many things, it doesn’t really matter. The geopolitical backdrop was fraught with great risk – that markets were content to ignore. Even Thursday night’s U.S. assassination of Iran’s Qassem Soleimani hit the S&P500 for only 0.7% (Russell 2000 down 0.35%). As has become typical, safe haven assets seem more keenly focused. Ten-year Treasury yields sank nine bps Friday to 1.79%, with bunds down six bps to negative 0.29%. Riding blustery Monetary Disorder and geopolitical tailwinds, Gold surged $42 this week to a six-year high $1,552.

It was a year of excess too many to mention. Hedge fund billionaire paid a record $238 million for a central park apartment – followed by $122 million for a London mansion and $99 million for a property neighboring his oceanside Palm Beach estate. “Beauty mogul” Kylie Jenner becomes a billionaire at 22. Art and collectable markets continued to go bananas. From MarketWatch: “An Italian artist duct-taped a banana to a gallery wall in Miami as part of the Art Basel festival — and it sold for $120,000.”

Compared to financial markets, the economy was rather mundane. Real GDP expanded 3.1% in Q1, 2.0% in Q2 and 2.1% in Q3. Inverting during the summer, the yield curve proved a much better harbinger of central bank stimulus than a predictor of the real economy. The IPO market had its ups and downs, with the more ridiculous deals (i.e. WeWork) performing poorly or not at all. While the U.S. was not immune to global manufacturing woes, the service sector boom soldiered on. Not receiving the attention it deserved, U.S. housing gathered momentum. Homebuilder confidence jumped to a 20-year high, as building starts and permits rose to the strongest levels since before the crisis.

The year of Monetary Disorder only exacerbated wealth inequalities. The country became only further divided. When it hardly seemed possible, the political environment digressed further into the embarrassing and alarming. President Trump was impeached. There should be ample shame to be spread around. Both parties should be ashamed of the fiscal recklessness that became firmly entrenched in 2019. Debt and deficits don’t matter. Where is the morality in leaving such debt to our children and grandchildren? As the Fed capitulated on “normalization,” markets completely renounced their function of disciplining excess.

In all the Roaring 2019 payoffs in securities, derivatives and asset markets, Capitalism atrophied into a shell of its former self. Chronically Unsound Money & Credit and the Inevitability of Monetary Disorder. Things can go crazy at the end of cycles. 2019 Welcomed Wacko and Unhinged. In a nutshell, it’s one hell of a portentous backdrop – that passes for now as a permanent plateau of prosperity. I’ll leave future prospects for another day.

Original Post 4 January 2020


TSP & Vanguard Smart Investor



Categories: Doug Noland, Perspectives