Doug Noland: Weird

The President is diagnosed with COVID-19, with rapidly worsening symptoms prompting a Friday evening Marine One flight to Walter Reed Medical Center. By Monday, he is back to the White House apparently feeling spryer than when he was a man 20 years younger. Reversing course on Tuesday, the President abruptly calls off stimulus negotiations “until after the election.” Negotiations were back on Wednesday, with the administration pursuing piecemeal stimulus (airlines, individual stimulus checks). By midweek the President was referring to his COVID infection as “a blessing from God.” Thursday President Trump was calling for a “skinny” stimulus package. Friday morning saw the White House suddenly “open to going with something bigger,” and by lunchtime Larry Kudlow was on Fox News saying, “The President has approved a revised package. He would like to do a deal.” Appearing with Rush Limbaugh later in the afternoon, it was “I would like to see a bigger stimulus package, frankly, than either the Democrats or the Republicans are offering.” A little Weird.

Meanwhile, Senate Majority Leader McConnell on Friday stated passage of stimulus legislation was unlikely prior to the election. If the week wasn’t Weird enough, with 54 million watching, a fly lands on the vice president’s head during the VP debate and – to the delight of comedians everywhere – made itself at home for a full two minutes.

At least for now, for the markets it’s Weirder the Better. The S&P500 gained 3.8% this week, its strongest advance in three months. The Banks (BKX) jumped 6.4%, and the Transports rose 5.0%. Curiously, the Utilities gained 4.8%. The broader market outperformed. The small cap Russell 2000 surged 6.4%, with an 11-session rise of 12.8%. The S&P400 Mid-Cap Index gained 4.9% for the week and 11.4% over 11 sessions. Jumping 8.0% this week, the Semiconductors ended the week at all-time highs. The Biotechs (BTK) advanced 5.7%.

Post the presidential debate and the President’s COVID infection, Joe Biden has further extended his lead in the polls. The possibility of a “blue wave” has become real – and markets are fine with it (why do I sense markets would be just as fine with a big Trump lead?). An almost certain reversal of President Trump’s large corporate tax cut (in the event of a Biden win) is apparently more than offset by prospects for mammoth fiscal stimulus. Senator Harris’s more conciliatory comments regarding China stirred the imagination of a more constructive U.S. tone for fraught U.S./China relations.

News, analysis and punditry (i.e. “the narrative”) invariably follow market direction. The notion of a “blue wave” would not have been so comforting to the markets a few months back. Traditionally, higher taxes and redistribution policies were anathema to equities. Treasury and bond markets would in the past have fiercely protested today’s massive structural deficit spending (as far as the eye can see).

I hold out some hope markets have not completely turned history on its head. The formidable Biden lead raises the odds of a decisive election-night outcome, averting the awful scenario of a contested election, a drawn-out court fight and potentially violent protests across the country.

I have posited the U.S. election is history’s single largest event for market hedging (“Brexit” not as clearly an individual event). The possibility of an unwind of hedges creates uncertainty and the distinct possibility of confounding market reactions to election developments.

With Biden’s lead appearing increasingly insurmountable (with less than four weeks to go), we can assume there was this week significant buying associated with the partial reversal of market hedges. Especially in such a highly speculative market environment, the prospect of an unwind of a massive hedging position stokes speculative zeal (to get ahead of this train). Throw in prospects for yet another brutal short squeeze and one can explain the impetus behind this week’s manic markets.

It’s worth noting stocks this week surged 5.0% in Mexico, 3.7% in Brazil, 4.7% in India, and 2.6% in China (CSI 300). In EM currencies, Brazil’s real rallied 2.8%, Mexico’s peso 2.3%, Russia’s ruble 1.8% and Poland’s zloty 1.7%. China’s renminbi surged 1.58% in Friday trading, in what Bloomberg called “its biggest rally in more than 13 years.” From U.S. small caps and Utilities to EM equities and currencies, market operators have been attempting to identify vulnerable markets that would be expected to suffer in the event of U.S. election mayhem (with traditional hedges, including Treasuries and equities put options, less than appealing).

Well, “par for the course” in the Age of Market Dysfunction. This trade has blown up in everyone’s face. Markets these days are much more a reflection of speculative dynamics than underlying fundamentals.

October 5 – Associated Press (Andrew Taylor): “New, eye-popping federal budget figures… show an enormous $3.1 trillion deficit in the just-completed fiscal year, a record swelled by coronavirus relief spending that pushed the tally of red ink to three times that of last year. The Congressional Budget Office released the unofficial 2020 figures…, saying the deficit equaled 15% of the U.S. economy, a huge gap that was the largest since the government undertook massive borrowing to finance the final year of World War II. The government spent $6.6 trillion last year and borrowed 48 cents of every dollar it spent, CBO said. The numbers amount to a 47% increase in spending, led by $578 billion for the Paycheck Protection Program for smaller businesses, and a $443 billion increase in unemployment benefits over the past six months alone.”

Will the bond market remain okay with the “blue wave” scenario? Is a repeat of this year’s stunning $3.1 TN (15% of GDP!) fiscal deficit possible? My baseline would be annual deficits approaching 10% of GDP for the next few years – although a fiscal 2021 deficit again exceeding $3 TN is a distinct possibility in the event of multiple stimulus bills from a new administration working together with a Democratically controlled House and Senate.

The stock market now relishes the thought of ongoing massive deficit spending. This is to feed incomes and corporate earnings, all without the traditional fear of rising policy rates, surging bond yields and general market instability. “Crowding out” is the latest time-honored concept relegated to history’s ash heap.

How did enormous deficits become integral to the stock market miracle? Why does the Treasury market not shudder at the prospect of unending Trillions of new supply?

Federal Reserve Credit expanded $3.294 TN over the past 56 weeks. Multiple Fed officials this week made it clear the Fed was willing and able to continue this experiment in unbridled Federal Reserve “money” creation.

October 6 – CNBC (Jeff Cox): “Federal Reserve Chairman Jerome Powell called… for continued aggressive fiscal and monetary stimulus for an economic recovery that he said still has ‘a long way to go.’ Noting progress made in job creation, goods consumption and business formation, among other areas, Powell said that now would be the wrong time for policymakers to take their foot off the gas. Doing so, he said, could ‘lead to a weak recovery, creating unnecessary hardship for households and businesses’ and thwart a rebound that thus far has progressed more quickly than expected. ‘By contrast, the risks of overdoing it seem, for now, to be smaller,’ Powell added… ‘Even if policy actions ultimately prove to be greater than needed, they will not go to waste. The recovery will be stronger and move faster if monetary policy and fiscal policy continue to work side by side to provide support to the economy until it is clearly out of the woods.’”

Chairman Powell made his contribution to Weird Week. For the record, note Powell’s endorsement of massive fiscal deficits just as the Treasury had closed the books on fiscal 2020 (with a deficit surpassing $3 TN) and with election day only a few weeks away. In a key week for stimulus negotiations, the Fed solidified its now tight fraternity with fiscal policy. This transformational development did not go unnoticed by the Wall Street Journal editorial board.

October 7 – Wall Street Journal (Editorial Board): “Federal Reserve officials understandably, and righteously, invoked their need for independence last year when President Trump berated them on Twitter to keep interest rates low. But what if the Fed itself decides to compromise its independence by snatching an ever-greater role in fiscal policy that is usually reserved for elected officials? That’s the question teed up by Jerome Powell’s extraordinary political intervention on Tuesday into the coronavirus relief talks. The Fed Chairman delivered a speech… in which he urged Congress to pass what he called more ‘policy intervention,’ both fiscal and monetary. Mr. Powell didn’t mention specific fiscal measures. But the speech… was clearly made with an intention to influence debates on Capitol Hill. This put him publicly on the side of House Speaker Nancy Pelosi, who wants to spend $2.2 trillion more on all and sundry federal programs. It’s important to understand how unusual this is. The Fed’s job is monetary policy and financial regulation.”

Monetization has become the Fed’s primary job – and it would appear at this point a lifetime appointment. Why is the bond market not in a tizzy over the prospect of a “blue wave” and years of massive Treasury supply? Because of the assumption the Fed will sop up whatever quantity necessary to peg bond yields at extremely low levels (prices in the stratosphere). Markets may today celebrate the prospect of massive cost-free 2021 fiscal spending. But there is an immense institutional price to be paid for the Federal Reserve as it presents the appearance of siding with the Democrats and redistribution policies.

With the Fed having bestowed Washington a blank checkbook, how will Republicans now view enormous handouts for the troubled blue states? It was inevitable – and certainly spurred on by COVID: The Federal Reserve has interjected itself into the deep divide of social and political acrimony and conflict. From 2008 to the present, the Federal Reserve faced no serious pushback to its QE experiment. Why do I imagine the Republican Party emerging from a traumatic election as born-again monetary conservatives?

The country is struggling – many of our citizens and businesses are suffering. But at this point I’m leery that potential benefits justify the enormous risks associated with unchecked fiscal and monetary stimulus. A deeper and more problematic crisis awaits when this runaway Bubble has finally run its course. And don’t for a second succumb to the notion that more “money” and spending will resolve problems. I fear the nightmare scenario where market confidence in the Fed and Washington falters right when the system is in the throes of a bursting financial Bubble.

The World Health Organization Friday reported a one-day record 350,766 global COVID infections. The rate of new cases doubled in a week in England to record highs. France reported a record 19,000 infections on Wednesday. Germany and Italy posted their largest increases since March. Spain’s government imposed an emergency lockdown on Madrid. Friday saw one-day infection records in Russia, Ukraine and Poland. WHO’s Dr. Mike Ryan summed it up: “This virus is clearly showing that it has a lot of life left in it.”

According to Bloomberg, “the seven-day average of new [U.S.] cases climbed to 46,824 on Thursday, the most since Aug. 19… Thursday’s single-day total of 56,145 was the second-highest since the June-August Sun Belt surge.” According to Johns Hopkins data, 28 states are demonstrating rising infection trends while only two are showing declines. Trends are troubling, COVID fatigue is an issue, and we’re heading into the winter months.

Much remains unclear. When does a vaccine become widely available? What percentage of the population will be willing to be vaccinated? How effective will the vaccine prove to be? At this point, a return to a semblance of normalcy still seems months away. Even with another major shot of stimulus, long-term unemployment will be a serious issue. Business failures will continue to mount. And it’s difficult to envisage a scenario where Credit losses don’t mount.

October 6 – Reuters (Marc Jones): “The COVID-19 shock will double company default rates across the United States and Europe over the next 9 months, ratings agency S&P Global said…, although it noted that the record downgrade pace of recent months was now slowing. S&P predicted U.S. corporate default rates would rise to 12.5% from 6.2% and saw Europe’s rate going to 8.5% from 3.8%. This year’s crisis has already seen more than 2,000 companies’ or countries’ ratings or ‘outlook’ scores cut and nearly $400 billion worth of debt drop into ‘junk’ territory, but in the months ahead focus will shift to defaults and survival. Alexandra Dimitrijevic, S&P’s Global Head of Research, said that with the number of firms on downgrade warnings at record levels — 37% of the companies S&P rates and 30% of the banks — and credit quality dropping, default rates are set to jump.”

A 12.5% U.S. corporate default rate would be incongruous with record stock prices. It would certainly conflict with current corporate bond yields (and ETF share prices). Why the extraordinary divergence between ebullient markets and a depressing spike in corporate defaults?

In spite of the dismal Credit backdrop for many companies, overall financial conditions remain extraordinarily loose. Weird. The vast majority of companies today enjoy ultra-easy access to cheap finance – compliments of bountiful monetary and fiscal stimulus. Yet the system is acutely vulnerable to any de-risking/deleveraging dynamic and attendant tightening of financial conditions.

How might this play out around the election? The dollar should be vulnerable to prospects for ongoing egregious monetary and fiscal stimulus. One would think massive supply on the horizon makes Treasuries susceptible, although bonds glare at the Weird stock market and see a Bubble very much on borrowed time. One of these days, instability in the dollar and Treasury market might have the Fed thinking twice about boundless QE. A clean sweep by the Dems could prove more of a test than currently anticipated by an irrationally exuberant stock market.

Original Post 9 October 2020

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Categories: Doug Noland, Perspectives

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