Doug Noland: Double Trouble

After such a historic year of monetary inflation, efforts to pull back will expose myriad fragilities. Unparalleled debt and speculative leverage in a backdrop of rising inflation risk and more cautious central bankers create a high-risk backdrop. Toss in an epic speculative mania in equities, derivatives trading, cryptocurrencies and the like, and it’s difficult to envisage an environment fraught with greater risk. All eyes on the global leveraged speculating community.


March 1 – Daily Sabah: “Turkey’s economy grew a less-than-expected but still robust 5.9% in the fourth quarter of 2020 and 1.8% in the year as a whole…, emerging as one of only a few globally to skirt a contraction amid the coronavirus pandemic… The Central Bank of the Republic of Turkey (CBRT), which has repeatedly said it would target inflation more strongly under new Governor Naci Ağbal, has raised its policy rate by 675 bps to 17% since November to cool inflation… Inflation is expected to have risen to more than 15% last month… Ensuring price stability is Turkey’s main priority in 2021, Minister Elvan said. ‘Our policies fighting inflation will pave the way for more qualified and sustainable investment, production and growth,’ he stated.”

What a difference a few weeks makes. President Erdogan last weekend sacked central bank governor Ağbal after only four months, replacing him with an academic economist critical of rate increases. The lira immediately collapsed almost 15%, with a tepid recovery cutting losses for the week to 11%. Ten-year lira bond yields surged 420 bps to 17.88%, with dollar-denominated yields up 125 bps to 7.22%. One-month deposit rates doubled to 35.5%. Turkey’s sovereign CDS surged 160 bps to 466 bps, while the BIST 100 equites index sank 9.6%.

March 23 – Financial Times (Adam Samson, Ayla Jean Yackley and Joshua Oliver): “Turkey’s money market showed signs of stress on Tuesday, a day after the president’s firing of a respected central bank chief rattled investors and sparked heavy selling in the country’s assets. The offshore overnight swap rate, the cost to investors of exchanging foreign currency for lira over a set period, soared to an annualised 1,400% on Tuesday… It had eased to a still-elevated 500% by 3pm in Istanbul. Analysts said the big increase was a sign it was becoming more difficult for foreign investors to hedge their exposure to lira assets, unwind their bullish positions or bet against the currency… ‘Foreign investors are trying to liquidate long lira positions in a rush this week following the unexpected development over the weekend of the dismissal of the [central bank] governor,’ said Onur Ilgen, head of treasury at MUFG Bank Turkey. He said this had triggered a ‘significant liquidity squeeze in the offshore lira swap market’.”

A key to Turkey’s current predicament was buried in Q4 GDP data: “Financial sector activity drove growth in 2020, surging 21.4%, the TurkStat data showed.” Crisis Dynamics have been festering in Turkey for a while now. Turkish yields spiked in the second half of 2018 as global liquidity tightened, then again under similar circumstances in the summer of 2019 and during the March 2020 pandemic global market dislocation. Yet each episode was followed by a further easing of monetary policies by the world’s leading central banks, which spurred outsized EM speculative inflows and a loosening of financial conditions in Turkey and EM generally.

Recall that EM received record inflows last November ($107bn), followed by huge flows in January ($53.5bn) and February ($31.2bn). With consumer price inflation reaching almost 15% in December and the lira under pressure, Turkey’s new central bank chief hiked rates to almost 17%. Such enticing overnight funding rates in a world of scant yields and over-liquefied global markets attracted major speculative “hot money” flows into Turkey’s Bubble.

A glance at Turkey’s debt data is illustrative. According to Q4 data from the Institute of International Finance (IIF), Turkey’s debt load in 2020 surged from 138% of GDP to 174%, one of the more pronounced Credit splurges in the EM universe. Financial Sector debt jumped from 23.6% of GDP to 32.5% in a year, with Government Sector borrowings surging from 34.2% to 47.3%. Ominously, much of this debt is denominated in foreign currencies. Of Financial Sector borrowings, 79% are foreign currency denominated, with 56% of Government debt non-lira. Of Turkey’s $354 billion of non-financial corporate borrowings, a troubling 45% is in foreign currency debt. The weaker the lira, the more unmanageable the debt burden.

Turkey is said to have $140 billion of debt coming due over the next year, of which 44% is dollar-denominated. Though according to MUFG’s Ehsan Khoman (quoted by Reuters), Turkey’s total 2021 external financing requirements exceed $200 billion (in excess of 20% of GDP). Meanwhile, Turkey holds only $54 billion of international reserves, down from $81 billion at the end of 2019 and a peak of $113 billion back in 2014.

March 24 – Financial Times (Ayla Jean Yackley): “President Recep Tayyip Erdogan has called on Turks to cash in their gold and invest their savings to shore up financial markets roiled by his abrupt decision to sack the central bank chief… ‘I want my citizens to invest foreign currency and gold kept at home, which is our national wealth, in various financial instruments to benefit our economy and production,’ Erdogan said. Financial institutions that comply with Islamic tenets in particular provide customers with favourable returns, he added.”

Erdogan’s desperate call for Turks to “cash in their gold and invest their savings to shore up financial markets” is reminiscent of the devastating 1997 “Asian Tiger” Bubble collapse. Turkey would today appear to have all the characteristics of acutely fragile financial and economy structures vulnerable to a currency/debt crisis of confidence.

Sure, Turkey has repeatedly dodged bullets over recent years, bailed out by the loosest global financial conditions and associated yield-searching “hot money” EM flows imaginable. But will global markets once again prove so accommodative? I have serious doubts.

My thoughts returned this week to 2014 and an exceptional research report from Merrill’s Ajay Kapur, Ritesh Samadhiya and Umesha de Silva’s: “Pig in the Python – the EM Carry Trade Unwind.” “Since 3Q2008, the US Federal Reserve QE has unleashed a massive $2 TN debt-driven carry trade into emerging markets, disproportionately increasing their forex reserves (by $2.7 TN from end-3Q2008), their monetary bases (by $3.2 TN), their credit and monetary aggregates (M2 up by $14.9 TN)…”

The premise of the report was that, with Fed QE winding down, EM economies were at heightened vulnerability to a tightening of global financial conditions. More specifically, EM asset markets and economies had been inflated by an unprecedented surge in debt, too much of it denominated in foreign currencies and financed through levered “carry trades.”

Was the “Pig in the Python” analysis flawed, or is it more a case of the global Bubble somehow stretching out for another six years? To be sure, massive post-2008 EM “carry trade” leverage did not unwind. And while the Fed put QE on hold for a few years, the FOMC was loath to actually tighten financial conditions. Meanwhile, the Chinese Credit boom went to unimaginable extremes. Since the end of 2014, China’s banking system assets surged $23 TN, or 86%, to an astounding $50 TN. The big “Pig in the Python” has since 2014 been cultivated to carouse and replicate. In rough terms, six years and Double the Trouble.

Overall global debt (from the IIF) ended 2020 at $281 billion, having increased $24 TN, or 9.3% for the year. This was up from about $215 billion to end 2014. As a percentage of GDP, total global debt jumped to a record 355% from 2019’s 320%. And from the IIF, “EM debt/GDP topped 250% in 2020, up from 220% in 2019.” EM ended 2020 with a staggering $8.6 TN of foreign denominated debt. It’s worth noting, as well, that key EM countries ran quite large fiscal deficits in 2020, including South Africa at almost 12% of GDP along with Turkey, Indonesia, Nigeria and Brazil all near 6%.

Brazil’s local currency 10-year yields surged 46 bps this week to 9.19%. Yields are up 234 bps so far in 2021 to the highest level since December 2018. Brazil CDS jumped 30 this week to a five-month high 222 bps. The Brazilian real sank 4.6% this week, increasing 2021 losses to 9.7%. Colombian yields jumped 22 bps to 6.90% (up 151bps y-t-d), with the peso down 3.2% for the week (down 6.5% y-t-d). Chilean yields jumped 23 bps this week to 3.49% – to highs since March 2020, with the Chilean peso down 1.8%. Despite Friday’s 15 bps drop, Mexico’s local bond yields rose another nine bps this week to 6.77% (up 125bps y-t-d), with the peso’s marginal decline pushing y-t-d losses to 3.3%. The Russian ruble declined 2.1% this week, with the South African rand falling 1.8%.

And while EM bonds and currencies have been under significant pressure, there is generally little concern at this point for a systemic emerging market crisis. Indeed, this week’s eruption of instability in Turkey coincided with a rally to record highs for the major U.S. equities indices. There were some incipient indications of fledgling risk aversion early in the week (i.e. higher corporate and bank CDS prices), along with a drop in energy prices. At Thursday’s lows, the small cap Russell 2000 Index was down 8.2% for the week (a late rally cut losses to only 2.9%).

Yet, for the most part, heightened instability at the “Periphery” underpinned the “Core.” The dollar index gained 0.9% to a four-month-high. Importantly, after trading as high as 1.75% last Friday, 10-year Treasury yields were down to 1.59% by Wednesday – as safe haven bids developed for Treasuries, bunds and JGBs. Instead of inflation trepidation and nightmares of a “behind the curve” Fed impelled to “slam on the brakes,” holders of Treasuries could again daydream of global EM instability, another round of disinflation and QE forever.

The analysis is exceptionally challenging. Fundamentals are in place for a major EM crisis, and I see reasonable probabilities of an unfolding crisis in Turkey providing the catalyst. We’re seeing significant weakness in key EM bonds and currencies, as I would expect preceding an acceleration of Crisis Dynamics.

Meanwhile, complacency in “developed” markets remains formidable. Is systemic crisis even possible while the major central banks are running full speed ahead with zero rates and QE?

Especially after 2020’s mind-blowing crisis response, it’s not irrational for markets to assume “whatever it takes” central banking has everything well under control. I am, however, reminded of the summer of 1998. The IMF, Federal Reserve and global central bank community had pulled the global system back from the 1997 (Asian/EM) crisis precipice. At July 1998 highs, the S&P500 was up 22% y-t-d, with U.S. Bank stocks gaining better than 25%. Indications of fledgling global instability were easily disregarded: “The West will never allow Russia to collapse.” But only weeks following record highs, markets were caught incredibly unprepared for the Russia/Long-Term Capital Management debacle. In less than three months, the S&P500 dropped more than 20%, and the Banks sank (at their lows) 40%.

I’ll briefly outline why I believe markets are much too complacent regarding unfolding EM instability. Despite ongoing QE, global financial conditions have begun to tighten. China has commenced a process of tightening system liquidity and curbing excessive Credit growth. While this has been initiated with understandable cautiousness, I expect the strength of China’s economic recovery to provide Beijing the confidence necessary for a determined effort to impose restraint.

Inflationary pressures are mounting globally. Turkey, Brazil, and Russia have all recently moved to raise rates to counter a significant jump in inflation. Mexico and others will likely follow. I expect central banks in both the developing and developed worlds to be compelled to pull back some excess liquidity while attempting to restrain overheated Credit systems. While the Fed, ECB and BOJ have for now firmly dug in their heels, heightened inflationary pressures have begun to impinge upon central bank flexibility.

After such a historic year of monetary inflation, efforts to pull back will expose myriad fragilities. Unparalleled debt and speculative leverage in a backdrop of rising inflation risk and more cautious central bankers create a high-risk backdrop. Toss in an epic speculative mania in equities, derivatives trading, cryptocurrencies and the like, and it’s difficult to envisage an environment fraught with greater risk. All eyes on the global leveraged speculating community.

I believe a major de-risking/deleveraging cycle has begun. In particular, various hedge fund strategies have suffered losses and been forced to pare some risk and leverage. Long/short strategies have been hurt by out of control speculation, market dislocation, and a resulting phenomenal short squeeze. Various factor “quant” strategies have also suffered at the hand of anomalous market behavior. Surging Treasury yields have hurt “risk parity” and myriad levered strategies. Now popular EM and “carry trade” strategies are taking body blows.

And despite Trillions of QE, there remain deep-seated liquidity issues. The Treasury market, the ETF universe, corporate Credit and derivatives are all liquidity accidents in the making – and all have been providing inklings of serious issues. And that gets to the heart of the problem with contemporary Bubble Finance: it works almost miraculously on the upside, though will quickly succumb to illiquidity, dislocation and crisis on the downside.

Turkey’s crisis has pushed EM Crisis Dynamics forward. De-risking/deleveraging in Turkish instruments will marginally reduce global liquidity while stirring risk aversion. There was notable contagion this week, most visibly with vulnerable Brazil. Vulnerability is systemic – for EM and the entire world.

The week also indicated the worst-case scenario is anything but a long shot. Instability at the “Periphery” feeds “Terminal Phase Excess” at the “Core.” A faltering EM stokes speculative flows to booming U.S. and “developed” currencies, equities market manias, and corporate Credit. The Manic “Core” douses fuel on the burning “Periphery” – Double Trouble. Things turn really crazy at the end of cycles. Monetary Disorder, Manias and Market Dysfunction. The parallels to 1929 turn only more compelling and ominous.

Original Post 27 March 2021


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