Doug Noland: Losing Control

Tesla’s market capitalization surpassed $1.1 TN this week, the first junk-rated company with a trillion-dollar valuation. Now the richest individual in the world, Elon Musk’s wealth this week reached a staggering $300 billion. The S&P500, Dow, Nasdaq100, and Nasdaq Composite ended the week at all-time highs. Microsoft retook the top spot as the world’s most valuable company.

October 29 – Reuters (Gaurav Dogra and Patturaja Murugaboopathy): “U.S. equity funds attracted large inflows in the week to Oct. 27… According to Lipper data, U.S. equities funds attracted investments worth a net $12.99 billion, which were the largest since the week to Aug. 18.”

Plenty to divert attention away from critical global market developments. Ominous Bond Market Convulsions.

October 28 – Reuters (Wayne Cole): “Australia’s central bank on Friday lost all control of the yield target key to its stimulus policy as bonds suffered their biggest shellacking in decades and markets howled for rate hikes as soon as April. An already torrid week for debt got even worse when the Reserve Bank of Australia (RBA) again declined to defend its 0.1% target for the key April 2024 bond, even though its yield was all the way up at 0.58%. Scenting capitulation, speculators sent the yield sky-rocketing to 0.75% while yields on three-year bonds recorded their biggest monthly increase since 1994. All eyes were now on the RBA’s policy meeting on Nov. 2 where investors were wagering it would call time on yield curve control (YCC) and its guidance of no rate rises until 2024.”

October 29 – Financial Times (Hudson Lockett and Tabby Kinder): “The Reserve Bank of Australia declined to defend its bond-yield target, a pillar of its quantitative easing programme, unleashing what one trader described as ‘carnage’ in the country’s sovereign bond market. The yield on the government bond maturing in April 2024 jumped as high as 0.8% on Friday in a dramatic rise that began after a round of stronger than expected inflation data released on Wednesday. The bank had said as recently as October 5 that it was targeting a 0.1% yield on the security. This week’s sharp rise in yield… signalled to many traders and investors that the RBA was abandoning its so-called yield curve control…”

The Australian bond market this week provided further evidence of an unfolding disorderly global bond market (and yield curve!) adjustment process, as raging global inflation forces central banks to retreat from ultra-loose and intrusive monetary policies. Australian two-year yields surged 33 bps Thursday and another 24 bps Friday, with an extraordinary 66 bps spike for the week to 0.775% – the high since January 2020. After trading as low at 0.53% in August, five-year yields jumped 38 bps this week to 1.57%, the high since March 2019. Ten-year Australian yields surged 29 bps this week to 2.09% – the high since March 2019. As noted above: “carnage.”

October 27 – Financial Times (Matthew Rocco, Kate Duguid and Tommy Stubbington): “The Bank of Canada surprised investors by abruptly ending its bond-buying programme on Wednesday and pulling forward its expected timeline for interest rate rises, triggering a heavy sell-off in Canadian government debt. The announcement puts the BoC at the head of a growing number of central banks that have responded to surging inflation by signalling a shift towards tighter monetary policy… The main forces pushing up prices — higher energy prices and pandemic-related supply bottlenecks — now appear to be stronger and more persistent than expected,’ the bank said… ‘Higher-than-expected inflation prints and the expected rise in prices from consumers and businesses has put the fear of God into them,’ said Karl Schamotta, chief market strategist at Cambridge Global Payments. ‘I don’t think anyone was expecting this.’”

Canadian two-year yields jumped 22 bps this week to 1.09%, the high since March 2020. Two-year yields were at 0.40% on September 14th. Five-year yields jumped 17 bps this week to 1.51% – having gained 68 bps in just seven weeks to the high back to January 2020. Ten-year yields were up seven bps to 1.72%, the high since May 2019.

October 29 – Financial Times (Tommy Stubbington and Kate Duguid): “A violent shake-up in bond markets has intensified as fund managers are wrongfooted by a global drop in short-term debt, say analysts and investors. Stubbornly high inflation around the world and a hawkish response by some central banks have fuelled a rapid rise in short-dated government bond yields. At the same time, concerns about growth prospects in the coming years have kept a lid on long-term bond yields, resulting in a dramatic ‘flattening’ of yield curves. Short-term bond markets have ‘experienced unprecedented volatility’ this week, said George Saravelos, Deutsche Bank’s global head of currency research. He said a sell-off in Australia’s market was the most severe since 1996, while Canada had been hit with its worst decline since 2009. Saravelos said the moves have been exacerbated by investors being forced to abandon soured bets as markets move against them. ‘What is happening now runs beyond macro,’ he said… ‘This is the closest we can get to a distressed market.’”

FT (Hudson Lockett and Tabby Kinder): “‘The RBA [Reserve Bank of Australia] simply doesn’t show up to defend their yield target, the bonds are slaughtered,’ one fixed income trader said, also describing the latest moves for Australian, New Zealand and Canadian bond yields as ‘massive carnage’.”

New Zealand two-year yields jumped 28 bps this week (84bps in four weeks!) to a four-year high 2.06%. Five-year yields rose 25 bps – 54 bps in two weeks – to 2.36%, the high since April 2018. Ten-year yields rose 14 bps to 2.64%, the high back to November 2018 (up 50bps in four weeks).

October 28 – Financial Times (Martin Arnold and Tommy Stubbington): “Christine Lagarde rebuffed investor expectations that the European Central Bank could raise rates next year to quell fast-rising prices, even as she acknowledged that its latest governing council meeting was dominated by a discussion of ‘inflation, inflation, inflation’. The ECB president said the council had done ‘a lot of soul-searching’ to test its assumption that inflation would fade next year, and its analysis did ‘not support’ market expectations for a rate rise before the end of 2022. Nevertheless, even as Lagarde spoke…, investors ramped up their bets of an ECB rate rise. Markets are currently pricing in a 0.1 percentage point rise by September next year. ‘The view in the market is that central banks are behind the curve,’ said ING rates strategist Antoine Bouvet. ‘The ECB is no exception.’”

“Yield curve control” blew up in the Reserve Bank of Australia’s face. Perhaps not as explosive, but Christine Lagarde’s effort to talk down European yields and rate expectations elicited a rather thunderous backfire. Italian 10-year yields jumped 23 bps Thursday and Friday to 1.17%, the high since July 2020. After rising six bps Thursday, Greek 10-year yields surged 25 bps during Friday’s session to 1.31%, the high back to June 2020. Portuguese yields jumped 10 bps Friday to 0.52% (high since May), and Spanish yields rose nine bps Friday to 0.61% (near high from June 2020).

Meanwhile, EM bond market carnage continues. Brazilian 10-year yields traded Thursday to a near five-year high 12.43% (ended the week at 12.20%). Brazil dollar 10-year yields rose nine bps this week to 4.82% (high since July 2020). South African yields rose 28 bps to an 18-month high 10.18%. Russian yields surged 37 bps to 8.22% – up 73 bps in two weeks to the high back to March 2020.

EM currencies remain under pressure. The South African rand dropped another 2.7% this week, with the Mexican peso down 1.9%. Eastern Europe’s bonds and currencies weakened further. The Polish zloty declined 1.0%, the Russian ruble 0.9%, the Romanian leu 0.8%, the Bulgarian lev 0.7% and the Czech koruna 0.7%.

October 29 – Bloomberg (Hema Parmar and Nishant Kumar): “A rapid convergence in key global bond yields is behind losses for some of the biggest macro hedge funds. Chris Rokos’s hedge fund has sunk 11% in October, in part because of wagers that the difference between short- and long-term U.K. and U.S. government bond yields would widen, according to people familiar with the matter. Instead, they’ve tightened. The market’s shift to expecting Bank of England rate hikes sooner caused most of the harm at Rokos Capital Management… The fund, down 20% for the year, is on track to post its worst annual loss ever. The firm isn’t alone as traders bet central banks will curtail stimulus measures much faster than had been expected, roiling so-called steepener trades.”

Speculative yield curve trades are blowing around the world, inflecting painful losses upon a segment of the leveraged speculating community. The UK’s two-year to 10-year spread dropped 32 bps this week to 44 bps. In Canada, this spread declined 12 bps to 51 bps – with a three-week drop of 25 bps. In chaotic Wednesday trading, Canada’s 2yr-10yr spread sank 18 bps to 44 bps (narrowest since January). The 2yr-10yr spread dropped 31 bps in Australia to 93 bps. In the U.S., it fell 12 bps to 105 bps.

October 28 – Reuters (Karen Pierog and Gertrude Chavez-Dreyfuss): “Investors are gauging what a furious flattening of the U.S. yield curve suggests about expectations for growth and how aggressively the Federal Reserve may tighten monetary policy in the face of surging inflation. Yields on 20-year Treasuries rose above those on 30-year bonds several times on Thursday, a move analysts pinned on technical factors, including higher demand for much more liquid 30-year bonds as well as expectations of a more hawkish Fed.”

October 28 – Reuters (Clare Jim and Andrew Galbraith): “Chinese developers took a drubbing on Thursday, with shares and bonds falling, creditors seizing assets and rating agencies distributing more downgrades, ahead of a final debt payment deadline for China Evergrande Group on Friday. Shares of Kaisa Group were hardest-hit… after rating agency downgrades that highlighted the company’s limited access to funding and significant U.S. dollar debt obligations.”

It’s also worth adding that global bank stocks were under pressure this week. The Hang Seng China Financials Index sank 3.2%, with Japan’s TOPIX Bank Index falling 3.3%. Even high-flying U.S. financial stocks lost a little altitude, with the KBW Bank Index falling 2.8%. But for the most part, U.S. equities completely disregarded U.S. and global bond market spasms. Persistent squeeze dynamics and the unwind of hedges – not to mention strong fund inflows – sustained momentum for the week.

Every cycle is different – each with its individual nuance. There are, however, recurring speculative dynamics. For me, the current backdrop is increasingly reminiscent of the summer of 1998. At July 20th, 1998 highs, the S&P500 enjoyed a y-t-d return of 23%. Financial stocks were outperforming, with the Broker/Dealer index up 31%. I was convinced Russia was on the cusp of financial crisis. How could markets disregard the risks associated with such a major development? The answer in the summer of 1998 was a rather simple mantra: “The West will never allow Russia to collapse.”

I knew the hedge fund community had huge levered positions in Russia’s debt. I was also focused on a big increase in derivatives activity to hedge against declines in the ruble and Russian bonds. It was clear to me that Russia was in trouble, and if their markets faltered there was a high probability of illiquidity, dislocation, and a financial collapse that would rock the leveraged speculating community and global markets.

In the six weeks between July 20th highs and September 1st lows, the S&P500 sank 21%. And between July highs and October lows, the Broker/Dealer index collapsed 56%. I was familiar with Long-term Capital Management going into the crisis. I was as shocked as anyone to learn of their egregious leveraging and $1 TN notional value derivatives portfolio. It’s not an exaggeration to say the global financial system was pushed to the brink. The Fed orchestrated a bailout, there was the so-called “Committee to Save the World” – Greenspan, Rubin and Summers – along with rate cuts – that reversed crisis dynamics and unleashed the 1999 mania.

Today’s risks so greatly dwarf 1998 that they’re hardly comparable. In key respects, China’s bubble is without precedent. Its global financial and economic impact today rivals, if not exceeds, the U.S. The amount of global leveraged speculation today makes ‘98 excess seem trivial. And while I presume there are no global funds as recklessly positioned as LTCM, there are reasons to fear that scores of funds have pushed the risk and leverage envelope. A seasoned hedge fund operator ran Archegos with more than 10 to 1 leverage in concentrated stock holdings. We also witnessed in March 2020 the chaos unleashed when de-risking/deleveraging gained momentum. Now global “carry trades” and yield curve bets have started blowing up.

There’s another big difference between now and 1998: open-ended QE, and now unshakable confidence that central banks will do “whatever it takes” to sustain the boom. 1998’s “the West will never allow a Russia collapse” has evolved to today’s “Beijing and global central bankers have everything under control.” And such market perceptions are fundamental to the type of egregious speculative leverage and excess that ensure future crises. And, clearly, the world has never witnessed the scope of excess that has accumulated over the past decade – and especially over the last 19 months.

The shifting winds of global liquidity are palpable. Chinese contagion has ratcheted up general risk aversion. De-risking/deleveraging dynamics have gained important momentum in the emerging markets. And this week there were forced unwinds of levered yield curve trades. Global liquidity has begun to wane, and financial conditions have started tightening, which is now impacting the more vulnerable markets and economies. Ominously, talk returned this week of liquidity concerns in sovereign debt markets, including Treasuries.

Meanwhile, inflation has become a pressing issue around the globe, unsettling central bankers and bond markets alike. This comes with major policy and market ramifications. Chinese contagion has already manifested into weakening EM currency markets, compounding inflation risk in key EM economies. There is now heightened pressure on central banks – EM in particular – to raise rates to bolster sinking currencies and counter mounting inflationary pressures.

The world today confronts a unique confluence of synchronized fragile bubbles and surging inflation. And, importantly, the worsening inflationary backdrop is reducing central bank flexibility to use monetary stimulus in response to market instability. This is poised to become a key issue, with major ramifications for vulnerable market bubbles.

For some time now, markets have assumed that central bank liquidity would put a floor under market prices, while ensuring rapid market recovery in the event of a bout of instability. But central banks pushed things much too far. Especially after the pandemic response, unprecedented monetary stimulus further inflated historic bubbles, stoking the most powerful inflationary dynamics in decades.

This creates a critical dilemma: When bubbles falter, central bankers will confront dislocated markets demanding Trillions of additional liquidity, in a backdrop of already powerful inflationary pressures. This is poised to be a real nightmare for central bankers that supposedly have everything under control.

Next week will be the Fed’s turn to operate in the new environment. The FOMC will be pondering whether leaning “dovish” or “hawkish” would be best received by an unsettled bond market. From Friday’s WSJ: “Consumer prices rose at the fastest pace in 30 years in September while workers saw their biggest compensation boosts in at least 20 years…” With inflation raging and the Fed so far “behind the curve,” expect the bond market to lose patience with the idea of waiting months to get rate “normalization” started. But then there’s the faltering Chinese Bubble, along with global de-risking/deleveraging gaining momentum.

Today’s unparalleled degree of uncertainty is anathema to leveraged speculation. There was evidence this week that central banks are Losing Control, a precarious dynamic that will spur a ratcheting down of risk throughout the global leveraged speculating community.

Original Post 30 October 2021


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Categories: Perspectives