TSP Investing: The Last Dance

Smart Bird Comments: Probably the most surprising part of credit-driven market tops is how long they take to play out. The early crash, the central bank pushes back, the highly-leveraged speculative melt-up, then the initial blow ups (Archegos) that force banks to pull back (tighten financing), the momentum highs on market complacency, the final high.

In 2007, the initial blow ups happened in July and the market put in a final high in September. In 2008, the market crashed. In 1998, the market corrected hard, the central bank dropped rates, the market surged over 50 – 100% into the 2000 double tops.

In early 2020, the market crashed. The Fed stood up 11 money-printing programs from the 2008 financial crisis era in a few days in March. The market has surged since on trillions of global money printing and central bank insurance (US buying corporate bonds). This melt-up is larger than them all because of the new policy to pre-bail out the markets.

But the law of financial physics has not been altered.

Doug Noland recaps the 2007 runup to the financial crisis in today’s post. We see some eerily similar patterns not to mention we have surpassed all previous records in leveraged trading, mania buying, SP500 valuations, corporate debt, and central bank panicked buying to save the system last year.

This top will see more of two possible outcomes, maybe both. The markets top or the global central bank’s balance sheets continue to surge on panicked buying. Either way, the markets are broken today. They do not reflect current of future corporate cash flows, they reflect leveraged buying and central bank money printing.

How far will we allow the alternate governments – the central banks – to go. For example, why are *they* adding climate change to their mandate. How is this possible when they have failed Capitalism with their other mandates?


Excerpts first:

We know equities margin borrowings have inflated parabolically (almost 50%!) over the past year to a record level. We can assume a similar trajectory for levered holdings throughout the global leverage speculating community, a view supported by the egregious leverage exposed at Archegos. A guesstimate of tens of Trillions of speculative leverage having accumulated globally over this extraordinary cycle is not preposterous...

“Melt-up,” indeed. It all reeks of a historic market topping process. A tightening of conditions throughout speculative finance has commenced. Global bond yields have been rising. China has begun a tightening cycle fraught with extreme risk. Vulnerable emerging markets have sustained the first round of de-risking/deleveraging. And the global central bank community is facing a confluence of runaway speculative manias and mounting inflationary pressures.

The risk of market liquidity accidents is highly elevated – and rising. Those that dispute this analysis should ponder the scenario where the leveraged speculating community and public race to the exits simultaneously: panicked speculator deleveraging and a run on the ETF complex (kind of like March 2020 but bigger). It’s not farfetched. At this point, with the Bubble inflating so late-cycle crazily, it’s not clear how such a scenario is to be avoided.

And while Archegos has started the clock ticking, inebriated markets are hell-bent on Keeping the Dance Party Rolling.


Keeping the Dance Party Rolling

by Doug Noland

While ebullient markets have briskly moved on, I’m not done with Archegos. The thesis holds that speculative leverage evolved into an integral source of liquidity throughout historic global market Bubbles. The spectacular collapse of Archegos marks a significant inflection point, ushering in a tightening of lending conditions at the “margin” for increasingly vulnerable Bubbles.

April 8 – Bloomberg (Erik Schatzker and Sonali Basak): “Credit Suisse Group AG is tightening the financing terms it gives hedge funds and family offices, in a potential harbinger of new industry practices after the Archegos Capital Management blowup cost the Swiss bank $4.7 billion. Credit Suisse has been calling clients to change margin requirements in swap agreements so they match the more restrictive terms of its prime-brokerage agreements… Specifically, Credit Suisse is shifting from static margining to dynamic margining, which may force clients to post more collateral and could reduce the profitability of some trades… Swaps are the derivatives trader Bill Hwang used to take highly leveraged positions in stocks at Archegos… When his positions suddenly lost value the week of March 22, Archegos blew through its margin and equity, and Hwang lost $20 billion in just a few days.”

I drew comparisons last week to the June 2007 collapse of two Bear Stearns structured Credit mutual funds. Below is a Reuters article from the day of the initial bailout.

June 22, 2007 – Reuters (Dan Wilchins): “Bear Stearns… on Friday said it would provide up to $3.2 billion in financing for a struggling hedge fund it manages, raising concern about other funds that invested in bonds linked to subprime mortgages. The biggest bailout since Wall Street’s 1998 rescue of Long-Term Capital Management signaled that the funds’ main investments — a type of bond known as a collateralized debt obligation (CDO) — may be riskier than previously reckoned. ‘The big worry is: Are there other funds like this out there? Are whole markets going to seize up?’ said James Ellman, president of financial services hedge fund Seacliff Capital, adding that he thought concerns were overblown. Analysts said in the worst-case scenario, the stock market could broadly decline as companies could face higher borrowing costs and leveraged buyouts could grow less attractive.”

The S&P500 was trading near record highs and pulled back only about 3% on the initial Bear Stearns saga – before promptly rallying almost 5% to new record highs by mid-July. It was during this rally (July 9th) that Citigroup CEO Chuck Prince bestowed market historians with his infamous remark: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

After a five-year boom, where the S&P500 almost doubled from 2002 lows while Credit market conditions turned extraordinarily loose, bullishness was well-entrenched. It was easy to dismiss the relevance of a couple smallish mutual funds. Sure, post-2008 collapse, it was as if the Bubble had been rather obvious all along. But in early-summer 2007 – at the pinnacle of Bubble excess – few recognized the scope of the Bubble, and even fewer appreciated the ramifications of the Bear Stearns fund collapses. Most believed subprime was a relatively small issue and clearly not systemic.

Yet in less than two months, crisis dynamics were in full force. Key markets had turned illiquid. In particular, liquidity for high-risk mortgage loans, securities and derivatives had all but evaporated. Institutions – including the highly-levered hedge funds, securities firms and insurance companies – were unable to accurately value holdings. Scores of mortgage companies had lost access to new borrowings and were failing. Even lending behemoths Countrywide and Washington Mutual were facing funding market disruptions. CDS prices were spiking higher.

Lenders, certainly including Countrywide, were rapidly tightening lending standards and trying to slash subprime exposures. The marketplace began questioning the viability of the entire mortgage insurance industry (Radian and MGIC, in particular) – whose guarantees were fundamental to “AAA” ratings for pools of hundreds of billions of less-than-pristine Credits.

Then, on August 15th, Countrywide Financial sank 13% after liquidity and solvency concerns prompted a “sell” rating from Merrill Lynch. Market disarray brought comparisons to the 1998 “LTCM” crisis, as deleveraging and illiquidity contagion propagated across the Credit market. The so-called “subprime” crisis had engulfed “Alt-A” mortgages along with corporate Credit and LBO finance. After trading at a near-record 1,555 on July 19th, the S&P500 had sunk to an intraday low of 1,371 less than a month later on August 16th.

When the Bear Stearns Credit funds faltered, 10-year Treasury yields were hovering above 5.0%. Fed funds were at 5.25%, leaving the Fed ample room to operate. They slashed the discount rate 50 bps during an unscheduled August 16th meeting, with the financial media referring to Ben Bernanke (appointed Fed chair the previous year) as a “rock star” and “the new maestro.” Fed funds were cut 50 bps to 4.75% in a surprise move on September 18th. Rates were down to 4.25% by December 11th. Ten-year Treasury yields had sunk to about 4.0% by year-end – on their way to a March low of 3.34%.

Even during mid-August 2007 market tumult, there was a lack of understanding with regard to myriad risks posed to financial and economic stability. St. Louis Fed president William Poole captured the general complacency: “It’s premature to say this upset in the market is changing the course of the economy in any fundamental way.” And, for a while, this complacency appeared justified. From August 16th lows, the S&P500 rallied 15% to a record high 1,576 on October 11th. The Bernanke Fed had seemingly saved the day – and the mighty bull market. GDP expanded 2.5% during the fourth quarter, the strongest growth in a year.

Almost everyone was blindsided by the scope of the 2008 financial crash and subsequent economic downturn. Somehow, policymakers remained oblivious to how mortgage Credit had come to dominate both financial and economic spheres. The unprecedented expansion of speculative leverage had become key to financing the housing Bubble, with the tsunami of “Bubble finance” fostering systemic distortions and maladjustment. When risk aversion eventually took hold, the dramatic tightening of market liquidity conditions forced deleveraging and an abrupt reassessment of lending terms. Mortgage Credit tightened, home prices began to sink, and prices of trillions of dollars of securities were increasingly detached from the harsh unfolding reality.  Destabilizing adjustments were unavoidable.

Each cycle is different, with individual characteristics and analytical nuance. The mortgage finance Bubble was chiefly fueled by an unprecedented expansion of risky mortgage Credit, much of it intermediated through money-like “AAA” securities and derivatives. Over the course of the Bubble, the global leveraged speculating community accumulated enormous amounts of highly levered holdings (securities and derivatives). The raging Bubble ensured the entire system was increasingly vulnerable to any unwind of speculative leverage and resulting illiquidity and Credit slowdown; the proverbial ticking time-bomb.

The world is now more than a decade into the historic “global government finance Bubble.” In contrast to the previous Bubble period, government “money” (sovereign bonds and central bank Credit) has been a principal Bubble fuel. Policymakers have enjoyed incredible latitude to inflate government finance, a unique dynamic that has worked (miraculously) to prolong this incredible cycle. Consistent with the mortgage finance Bubble, speculative leverage has expanded momentously over the course of this cycle – to the point where it has greatly exceeded previous cycle peaks. I’m convinced it has ballooned exponentially over recent years, as the incredible lengths policymakers were willing to go to sustain the boom emboldened the speculator community .

April 7 – Wall Street Journal (Alexander Osipovich and David Benoit): “Investors are borrowing huge sums of money to buy stocks. Is that a problem? The ‘everything rally’ that started in stocks last year has been boosted by investors betting money they have borrowed. That includes both small players like the day traders on Robinhood Markets Inc. and heavyweights like Archegos Capital Management… As of late February, investors had borrowed a record $814 billion against their portfolios, according to data from the Financial Industry Regulatory Authority, Wall Street’s self-regulatory arm. That was up 49% from one year earlier, the fastest annual increase since 2007, during the frothy period before the 2008 financial crisis.”

We know equities margin borrowings have inflated parabolically (almost 50%!) over the past year to a record level. We can assume a similar trajectory for levered holdings throughout the global leverage speculating community, a view supported by the egregious leverage exposed at Archegos. A guesstimate of tens of Trillions of speculative leverage having accumulated globally over this extraordinary cycle is not preposterous.

Markets, understandably, are content to fixate on the stability of government monetary inflation as ensuring an irrepressible boom. At this point, “whatever it takes” central banking is a proven commodity. And now markets have grown comfortable with the notion that no amount of government debt is too large to be financed by the marketplace at low yields. This new and phenomenally powerful financial structure has demonstrated itself as robust and, to this point, essentially bulletproof. In this context, markets view Archegos and its de-leveraging as inconsequential.

According to CNBC, Morgan Stanley (with the permission of Archegos) liquidated $5bn of Archegos positions on Thursday, March 25th, a day ahead of Goldman Sachs’ block trade fire-sale, “to a small group of hedge funds.” Morgan Stanley and Goldman’s quick move to dump shares left others, including Credit Suisse and Nomura, holding the bag (full of big losses). Once word got out, the entangled stocks tanked. The hedge funds that bought shares were none too pleased Morgan Stanley had offloaded positions they surely knew would soon be hit by large forced sales from Archegos’ other prime brokers. As CNBC (Hugh Son) put it, “…Morgan Stanley isn’t likely to lose them [hedge funds clients] over the Archegos episode… That’s because the funds want access to shares of hot initial public offerings that Morgan Stanley, as the top banker to the U.S. tech industry, can dole out.”

And while Morgan Stanley’s hedge fund clients may recover (Archegos-related) trading losses through some choice IPO allocations, Credit Suisse and Nomura won’t enjoy such a luxury. Prime brokerage risks that were easily dismissed can no longer be ignored.

April 9 – Bloomberg (Ambereen Choudhury and Patrick Winters): “Credit Suisse Group AG is planning a sweeping overhaul of the hedge fund business at the center of the Archegos Capital blow up, as the drama forces Wall Street banks to reconsider how they finance some of their most lucrative clients. The Swiss bank is weighing significant cuts to its prime brokerage arm in coming months, people familiar with the plan said. The lender has already moved to tighten financing terms with some funds, and hopes changes to the unit can allow it to forgo major cuts to other parts of the investment bank, which just had a banner quarter…”

It may not be immediately discernible, especially with markets towering new heights, but conditions will be tightening in leveraged securities and derivatives finance. Rising asset markets essentially create their own self-reinforcing liquidity. Yet Illiquidity Lies in Wait. It’s when markets are in retreat that liquidity issues come to the fore. It’s worth noting, however, recent underperformance of the small cap stocks, a sector especially susceptible to shifting liquidity dynamics. It also appears the game has changed for the SPAC Bubble, a sector directly financed by the leveraged speculator/prime brokerage nexus.

April 9 – Financial Times (Ortenca Aliaj and Aziza Kasumov): “A crucial source of funding for blank-cheque company deals is drying up, pointing to a slowdown for one of Wall Street’s hottest products after a record-breaking quarter. Advisers to special purpose acquisition companies… say they are struggling to find so-called Pipe financing to complete their planned acquisitions. Pipe is short for private investment in public equity. Institutional investors such as Fidelity and Wellington Management have ploughed billions of dollars into Pipe deals since the Spac boom emerged last year, providing a route to the public markets for businesses ranging from established software and entertainment companies to speculative developers of flying taxis and electric vehicle technology.”

Yet “global government finance Bubble” vulnerability goes much beyond a tightening of conditions in leveraged speculation.

April 6 – Bloomberg: “China’s central bank asked the nation’s major lenders to curtail loan growth for the rest of this year after a surge in the first two months stoked bubble risks, according to people familiar with the matter. At a meeting with the People’s Bank of China on March 22, banks were told to keep new advances in 2021 at roughly the same level as last year… Some foreign banks were also urged to rein in additional lending through so-called window guidance recently after ramping up their balance sheets in 2020… The comments give further detail to what the central bank stated publicly after the meeting, when it said it asked representatives of 24 major banks to keep loan growth stable and reasonable. In 2020, banks doled out a record 19.6 trillion yuan ($3 trillion) of credit…”

Markets, at this point, have a difficult time taking Beijing “tightening” talk seriously. After all, they’ve talked tough too many times – only to timidly backtrack. But I believe Chinese leadership is today more determined – and markets too complacent. Especially after last year’s Credit melee, the entire Chinese system is acutely fragile. And it’s this fragility that has markets so convinced Beijing won’t dare risk bursting the Chinese Bubble. Still, I believe Chinese officials have come to recognize the risk of not reining in the Bubble has grown too great not to act.

April 9 – Bloomberg: “China’s producer prices climbed in March by the most since July 2018 on surging commodity costs, adding to worries over rising global inflation as the pandemic recedes. The producer price index rose 4.4% from a year earlier after gaining 1.7% in February…, higher than the 3.6% median estimate… ‘Our research has found that China’s PPI has a high positive correlation with CPI in the U.S.,’ said Raymond Yeung, chief economist for Greater China at Australia and New Zealand Banking Group Ltd. ‘The higher-than-expected PPI data could impact people’s judgment of inflation pressure in the U.S. and globally, and this impact shouldn’t be underestimated.’”

U.S. Producer Prices surged a full 1.0% in March, double estimates. This pushed y-o-y Producer Price Inflation to 4.2%, the strongest advance since 2011. The ISM Non-Manufacturing (services) Index surged to a record high 63.7, with all 18 industry groups reporting they’re paying higher prices (up from 67% in December). The ISM Non-Manufacturing Price Index jumped to 74, the high going back to July 2008.

Mounting inflationary pressures are a global phenomenon. While the Fed has been dismissive, the prospect of an overheating U.S. economy seems clearer by the week. The Federal Reserve should begin contemplating when to signal an approaching QE tapering. Such unparalleled government monetary inflation has stoked myriad inflated price levels and distortions throughout the asset markets and real economy. Accordingly, we should expect any attempt to ween the system from QE will at this point prove highly destabilizing.

April 9 – Reuters (Thyagaraju Adinarayan, Sujata Rao and Julien Ponthus): “Equity funds have attracted more than half a trillion dollars in the past five months, exceeding inflows recorded over the previous 12 years, according to data from BofA, which has likened the stampede to a ‘melt-up’ in markets. The flows are also raising fears of a pullback from record highs, given valuations are at the highest since the dotcom bubble of the late 1990s, with the S&P 500 trading at nearly 22 times forward earnings.”

“Melt-up,” indeed. It all reeks of a historic market topping process. A tightening of conditions throughout speculative finance has commenced. Global bond yields have been rising. China has begun a tightening cycle fraught with extreme risk. Vulnerable emerging markets have sustained the first round of de-risking/deleveraging. And the global central bank community is facing a confluence of runaway speculative manias and mounting inflationary pressures.

The risk of market liquidity accidents is highly elevated – and rising. Those that dispute this analysis should ponder the scenario where the leveraged speculating community and public race to the exits simultaneously: panicked speculator deleveraging and a run on the ETF complex (kind of like March 2020 but bigger). It’s not farfetched. At this point, with the Bubble inflating so late-cycle crazily, it’s not clear how such a scenario is to be avoided. And while Archegos has started the clock ticking, inebriated markets are hell-bent on Keeping the Dance Party Rolling.

Original Post 10 April 2021


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Categories: Perspectives