Doug Noland: Ebb and Flow

The U.S. economy created 943,000 jobs in July. With upward revisions, there were 938,000 positions added in June and 614,000 in May – for a notable three-month employment surge of almost 2.5 million. The Unemployment Rate dropped five-tenths to 5.4%, the low since March 2020. For the two-decade period 2000 through 2019, Unemployment averaged 5.9%. Average Hourly Earnings were up 4.0% y-o-y in July, the strongest rise of the pandemic. And from Thursday’s Challenger data, July job cuts were the smallest since June 2000 (y-t-d cuts lowest on record). Throw in reports of acute labor shortages across industry groups and seemingly the entire economy, and it’s clear job markets are turning tighter by the week.

August 5 – Associated Press (Martin Crutsinger): “The U.S. trade deficit increased to a record $75.7 billion in June as a rebounding American economy sent demand for imports surging. The… deficit rose 6.7% from a revised May deficit of $71 billion. The June deficit set a record, topping the old mark of $75 billion set in March… In June, exports edged up a modest 0.5% to $207.7 billion while imports surged 2.1% to $283.4 billion. The politically sensitive goods deficit with China rose to $27.8 billion in June, up 5.8% from the May level. So far this year, the goods deficit with China, the largest that the United States runs with any country, totals $158.5 billion, an increase of 19.2% compared to the same period in 2020.”

Traditionally, Trade and Current Account deficits provided important indications of excessively loose monetary policy. These days, no one – including the Fed – couldn’t care less. Our Credit system and economy flood the world with dollar balances conveniently recycled back into U.S. securities markets. Instead of waning confidence in the world’s reserve currency, there is jubilation for liquidity abundance the world over. For now.

August 4 – Bloomberg (Reade Pickert): “U.S. service providers expanded in July at the fastest pace in records dating back to 1997 as measures of business activity, new orders and employment all improved. The Institute for Supply Management’s services index jumped to 64.1 last month from 60.1 in June, topping all estimates… ‘Materials shortages, inflation and logistics continue to negatively impact the continuity of supply,’ Anthony Nieves, chair of the ISM’s Services Business Survey Committee, said… Prices paid by service providers jumped to 82.3 last month, the highest level since September 2005. Meantime, delivery times lengthened, with a gauge of supplier deliveries rising to its second-highest reading on record.”

August 3 – Bloomberg (Alex Tanzi and Katia Dmitrieva): “U.S. household debt rose at the fastest pace since 2013 in the second quarter, driven by a mortgage boom as Americans took advantage of low borrowing costs and sought more space to work from home. Household liabilities climbed $313 billion to $14.96 trillion as of the end of June, a 2.1% rise from three months earlier, the Federal Reserve Bank of New York said… Most of the increase came in mortgage balances. With the average 30-year rate declining in the period, millions of Americans with good credit took the opportunity to refinance and cut their monthly payments.”

August 6 – Bloomberg (Reade Pickert): “U.S. consumer borrowing surged in June by the most on record, reflecting large increases in credit-card balances and non-revolving loans. Total credit jumped $37.7 billion from the prior month after an upwardly revised $36.7 billion gain in May, Federal Reserve figures showed… On an annualized basis, borrowing increased 10.6%.”

Recall that CPI jumped 0.9% in June, with a y-o-y gain of 5.4%. Producer Prices surged 1.0%, as y-o-y inflation rose to 7.3%. The most recent data showed the national FHFA House Price Index up 18.0% y-o-y, with the S&P CoreLogic Index rising 16.99%.

Federal Reserve Credit has inflated $4.462 TN, or 120%, over the past 99 weeks. During this period, M2 “money supply” ballooned $5.450 TN, or 36%, to $20.4 TN. Of course, such unparalleled monetary inflation has consequences, immediate as well as longer-term. To believe the Fed can simply accommodate the financial markets with the most gradual and transparent “taper” and everything will magically normalize is more than wishful thinking.

Wall Street won’t admit it. The Fed clearly has its heels dug in. Risks are escalating for the overheated U.S. economy. Chair Powell and the FOMC have come under mounting pressure from Republican fiscal conservatives. And there was this week an astute letter from influential moderate Democrat Senator Joe Manchin:

“With the recession over and our strong economic recovery well underway, I am increasingly alarmed that the Fed continues to inject record amounts of stimulus into our economy by continuing an emergency level of quantitative easing (QE) with asset purchases of $120 billion per month of Treasury securities and mortgage backed securities. The Fed has sustained $120 billion per month in asset purchases since June 2020, despite increasing vaccination rates to combat the virus and additional fiscal stimulus from Congress in the ARP. The record amount of stimulus in the economy has led to the most inflation momentum in 30 years, and our economy has not even fully reopened yet. I am deeply concerned that the continuing stimulus put forth by the Fed, and proposal for additional fiscal stimulus, will lead to our economy overheating and to unavoidable inflation taxes that hard working Americans cannot afford.

Simply put, our monetary and fiscal stimulus response met the moment of crisis when our economy suffered the medical equivalent of a heart attack. But, now it’s time to ensure we don’t over prescribe the patient by further stimulating an already strong recovery and therefore risk our ability to respond to future crises we are sure to face. I urge you and the other members of the Federal Open Market Committee to immediately reassess our nation’s stance of monetary policy and begin to taper your emergency stimulus response. While I appreciate your commitment to maximum employment and stable prices, it is imperative we begin to understand that long term policy responses tailored for an economic depression, like the Great Depression and Great Recession of 2008, may not be what is required for today’s economy and could result in higher than desired inflation if not removed in time.”

My own view holds that QE should be employed only in dire emergencies. To safeguard system stability, when used it must be limited in scope and duration. There’s a strong case that QE thwarted financial collapse in 2008, although I believe $1 TN was excessive. It was critical for the Fed to have followed through with their 2011 “exit strategy” policy normalization. Reinstating QE in 2012 in a non-crisis environment – where the Fed’s balance sheet doubled the 2011 level to $4.5 TN – was foolhardy inflationism that opened the monetary inflation floodgates. Restarting QE again in September 2019 in the face of increasingly manic securities markets and multi-decade low unemployment – was reckless.

It’s difficult to comprehend the $4.0 TN QE pandemic response. The Fed confronted a faltering Bubble of its own making. There’s a case for limited QE liquidity injections to accommodate a de-risking/deleveraging crisis dynamic. The Federal Reserve instead employed massive open-ended QE, first to thwart deleveraging and then to stoke Bubble excess. Never should the Fed and global central banks have allowed markets to believe QE was readily available to circumvent market adjustments and corrections. Prolonged QE has fomented market dysfunction and deep structural maladjustment.

July 31 – Bloomberg (Sam Potter and Elaine Chen): “Record inflows. Record fund launches. Record assets. If active money management is in decline, someone forgot to tell the ETF industry. Amped up by a meme-crazed market and emboldened by the success of Cathie Wood’s Ark Investment Management, stock pickers are storming the $6.6 trillion U.S. exchange-traded fund universe like never before — adding a new twist in the 50-year invasion from passive investing. Passive funds still dominate the industry, but actively managed products have cut into that lead, scooping up three-times their share of the unprecedented $500 billion plowed into ETFs in 2021… New active funds are arriving at double the rate of passive rivals, and the cohort has boosted its market share by a third in a year.”

August 5 – Financial Times (Robin Wigglesworth, Kate Duguid, Colby Smith and Joe Rennison): “Hedge funds that exploit bond market dislocations, such as those blamed for exacerbating the US Treasury ructions of March 2020, have swelled to more than $1tn of assets for the first time. The strategy, known as ‘fixed income relative-value arbitrage’, — which typically involves using big dollops of leverage to profit from small but persistent anomalies — attracted another $5.5bn of investor money in the second quarter, according to HFR. That, coupled with buoyant markets, lifted total assets under management above the $1tn milestone.”

Manic securities market excess is conspicuous – equities, corporate Credit, ETFs, cryptocurrencies, “meme stocks,” IPOs, M&A, structured finance, etc. The precarious nature of housing market inflation and excess is similarly obvious. How it somehow became reasonable to stick with $120 billion monthly QE in the face of such momentous asset market inflation and speculation is difficult to understand.

The Fed dismisses Bubble and inflation risks. One has only to look at charts of the Fed’s balance sheet, system Credit growth, M2, and Treasury debt to appreciate that we’ve transitioned into uncharted waters with regard to monetary inflation. And it is not credible to simply assert that the associated jump in inflation will be transitory. Inflation psychology has evolved quickly – in commodities pricing, labor markets, and corporate pricing of goods and services.

The Fed is delusional if it actually believes it has anchored inflationary expectations. The University of Michigan’s survey of one-year inflation expectations jumped to 4.7% in July, the high since 2008. And with the economy overheated, we should assume onerous fallout from another year of zero rates along with an additional Trillion of QE. There is no precedent for such massive monetary stimulus in these circumstances.

Ten-year Treasury yields jumped seven bps Friday to 1.30%, a rather dramatic reversal from Wednesday’s intraday 1.13% low. Treasury bonds have been pulled lower over recent months by Chinese Credit deterioration and myriad global Bubble fragilities. There’s always an Ebb and Flow associated with financial instability, and this week there was a Beijing-directed hiatus in the evolving Credit crisis. With a relatively tranquil week for China (and Asia & EM), Treasuries turned more attentive to U.S. overheating.

The Shanghai Composite rallied 1.8%, and the growth-oriented ChiNext Index recovered 1.5%. An index of high-yield Chinese bonds saw yields drop a modest 41 bps to 12.38% – though yields remain 269 bps higher over three weeks. Huarong CDS dropped 140 bps to 1,088, but there was little relief from elevated CDS prices for the other “AMCs” and developers. Meanwhile, crisis dynamics for behemoth developer Evergrande attained crucial momentum.

August 6 – Bloomberg: “China Evergrande Group bonds dropped to record lows after reports that creditor lawsuits against the world’s most indebted developer will be consolidated, a step that has preceded several high-profile defaults by Chinese borrowers. Cases related to Evergrande and its affiliates will be centralized in a Guangzhou court, Caixin reported… Speculation about the move triggered a slump in the developer’s bonds late Thursday, with losses deepening after the city of Beijing tightened property curbs and S&P Global Ratings cut its assessment of Evergrande for the second time in as many weeks. ‘Evergrande’s liquidity position is eroding more quickly and by more than we previously expected,’ S&P analysts led by Matthew Chow wrote… ‘The company’s nonpayment risk is escalating, not only for the substantial public bond maturities in 2022 but also for its bank and trust loans and other debt liabilities over the next 12 months.’”

Evergrande yields (8¾ ’25) traded to almost 40% in Friday trading, as the market prepares for imminent default. The company’s woes pulled down developer bond prices, reversing part of what had been a decent rally earlier in the week.

Between Beijing’s recent bareknuckle reform measures and acute Credit market stress (Huarong, Evergrande, developers, high-yield, etc.), investor/speculator confidence has been shaken. For the most part, markets still view Beijing as having things under control. But there are widening fissures in market confidence.

A Friday Financial Times opinion piece (Simon Edelsten) pondered perhaps the crucial question confronting global markets: “What happens when investors lose faith in Beijing? It could take China years to win back confidence after recent state intervention in tech.” The article’s conclusion: “It has taken China decades to stimulate homegrown entrepreneurship. Undermining the most successful businesses so publicly will have a rapid and lasting impact across the economy. Nearly two decades ago, when I first visited China, the government was keen to demonstrate its care for shareholders and their rights. It is deeply troubling if that policy is being abandoned. As the Asian crisis demonstrated, it takes years to win back investors’ confidence.”

Chinese Credit instability Ebbed somewhat this week. I have my doubts “the fix is in.” Beijing still commands formidable market power. Yet I expect they’ll intervene only when they feel it’s necessary to restore stability. Unlike the Fed, they are not content to fan speculative excess. Especially if Evergrande collapses, I would expect the Flow of Credit instability to gain velocity. Moreover, expect each round of Ebb and Flow to beget ascending levels of systemic stress. And if the marketplace is beginning to lose faith in the almighty Beijing meritocracy, I see the “small” banking and local government finance sectors susceptible to “risk off” contagion.

Meanwhile, more record highs this week for the S&P500 and major equities indices. Yet there remains an underlying instability that indicates heightened vulnerability. Commodity markets were notably unstable this week, with major declines in crude, copper and the precious metals. While the VIX closed the week at about 16, it again traded above 20 earlier in the week (Tuesday). And, importantly, volatility has increased for a vulnerable bond market. Corporate bond fund flows have slowed markedly, with outflows this week. “Investors” should enjoy the summer doldrums while they last.

Original Post 7 August 2021


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