Doug Noland: Accident-Prone End-Game Dynamic

Bloomberg Television’s Jonathan Ferro (November 12, 2021): “You wrote a scathing piece in the Financial Times this week. I want to start with a quote from it: ‘Failure to act promptly would turn the Fed’s increasingly discredited ‘transitory’ characterization from one of the worst inflation calls in decades to also a big policy mistake with widespread and unnecessary damage.’ Mohamed, I want to start with that single piece there: ‘One of the worst inflation calls in decades.’ Why do you think it’s this bad?”

Mohamed El-Erian: “Because they didn’t show humility at the beginning of the process… There are lots of structural changes going on in the post-pandemic economy… post immediate shock. You can’t simply dismiss them as transitory. You’ve got to respect the fact that behaviors change. And they just didn’t have the open mindset enough to see that. So, they got stuck in this narrative and they held on to it for too long, and the result of which is they’re looking at inflation that is much higher than they ever expected; they’re looking at inflation that is much broader than they expected; and they’re looking at inflation that is going to last even longer than they expect even now. So, it’s going to go down in history as one of the worst inflation calls by the Federal Reserve.

The Consumer Price Index (CPI) was reported up a stronger-than-expected 0.9% for the month of October, pushing the year-over-year increase to a distressing 6.2% – the strongest gain since November 1990. Up 0.4% for the month, Core CPI rose 4.6% y-o-y (high since July 1991). It’s worth noting that heightened inflationary pressures in 1990 were fueled by a fleeting spike in crude prices ahead of the first Persian Gulf War. Crude prices spiked from $16.50 in early-July to above $40 by November, only to trade back below $20 by February 1991. CPI jumped from July’s 4.8% y-o-y to 6.3% in November. Saddam’s military promptly crumbled, with the crude oil and inflationary spikes proving transitory. CPI was below 3.0% y-o-y within a year.

The New York Fed’s November survey of one-year Household Inflation Expectations jumped 0.4% for the month to 5.7%. Ignoring the summer of 2008’s ($140 crude-induced) spike to 5.1%, this month’s 4.9% reading of University of Michigan Consumer One-Year Inflation Expectations was the highest since 1981. Weighed down by inflation concerns, Consumer Expectations sank five points (21 points in 5 months!) to 62.8, the low since 2011. Producer Prices (PPI) gained 0.6% during October, with PPI up 8.6% y-o-y.

November 12 – Associated Press (Christopher Rugaber): “Americans quit their jobs at a record pace for the second straight month in September, while businesses and other employers posted a near-record number of available jobs. The Labor Department said… 4.4 million people quit their jobs that month, or about 3% of the nation’s workforce. That’s up from 4.3 million in August. There were 10.4 million job openings, down from 10.6 million in August… The figures point to a historic level of turmoil in the job market as newly-empowered workers quit jobs to take higher pay that is being dangled by increasingly-desperate employers in need of help. Incomes are rising, Americans are spending more and the economy is growing, and employers have ramped up hiring to keep the pace. Rising inflation, however, is offsetting much of the pay gains for workers.”

Chinese Producer Prices were reported up a stronger-than-expected 13.5% y-o-y, their hottest inflation in 26 years. Germany posted y-o-y consumer inflation of 4.6%, the highest in decades, with aggregate euro zone inflation at 4.1%. Brazil’s inflation rose stronger than expected, while Mexico reported a 6.24% y-o-y CPI increase. Surging inflation is a global phenomenon.

The week had the feel of an inflection point in terms of market perceptions of both inflation risk and central bank inflation neglect. Global bond markets had rallied last week on concerted central bank dovishness. There was heightened concern this week that inflationary pressures will run unchecked. The Treasury five-year “breakeven rate” of market inflation expectations spiked 29 bps to a Friday intraday high 3.18% (before ending the week at 3.12%). Friday’s rate was the highest in data from 2001. The Treasury 10-year “breakeven rate” jumped 17 bps to 2.72% (Friday’s 2.76% intraday high was a record in data back to 1997).

November 11 – Bloomberg (Alexandra Harris): “The U.S. Treasury market has become a minefield over the past month. As bond traders around the world try to force central banks to respond to elevated inflation rates, unusually large price swings have taken their toll. Signs have emerged of a vicious cycle in which reluctance to participate in the market impairs liquidity, making large price swings even more likely. As measured by Bloomberg’s U.S. Government Securities Liquidity Index, trading conditions in Treasuries are the worst since March 2020, when the pandemic spurred massive central-bank intervention around the world. The index measures deviations in yields from a fair-value model. As for expected volatility, the ICE BofA MOVE Index for U.S. bonds is near the highest since April 2020.”

Two-year Treasury yields began October at 0.27% and ended the month at 0.50%. Dovish central banks sparked a short squeeze, with two-year yields closing last Friday at 0.40%. Inflation angst had yields back to 0.51% to close this week, as wild volatility engulfs short-term rate markets. Five-year Treasury yields jumped 17 bps this week – after sinking 13 bps last week. In what must be quite a hedging challenge, benchmark MBS yields surged 16 bps this week, following the previous week’s 11 bps drop.

The rates market ended the week pricing in 2.5 Fed hikes by the end of 2022, up from last Friday’s 1.79. Importantly, markets have begun to deemphasize the dovish policy stance, focusing instead on deteriorating inflation dynamics. This problematic loss of central bank control bodes poorly for market stability, with elevated risk of a disorderly market adjustment.

And speaking of disorderly market adjustments… The Shanghai Composite rallied 1.4%, with the growth-oriented ChiNext Index up 2.3% this week. Chinese developer bonds recovered, as “Chinese Property Stocks Soar Most in Six Years…”

November 11 – Bloomberg: “China’s efforts to limit fallout from China Evergrande Group’s crisis are gathering steam. A series of articles published in state media in the past few days signal support measures are on the way to help developers tap debt markets, potentially easing a liquidity crunch that began with Evergrande’s meltdown five months ago. Stocks and bonds of property firms jumped for a second day on reports that regulators may adjust rules so that real estate firms can sell debt in the domestic interbank market. Another report showed state-owned enterprises are pushing for the right to increase borrowing for mergers, which could make it easier for them to scoop up struggling developers. State-run banks meanwhile boosted lending to the sector last month, state media reported.”

There’s no conundrum surrounding the market’s disregard for the ongoing historic Chinese developer bond collapse. Beijing has been expected to intervene when the situation gets bad enough. They certainly wouldn’t tolerate things spiraling out of control. Well, things were looking really bad earlier in the week.

In a major ratcheting up of crisis dynamics, instability jumped from the developer “Periphery” to the “Core,” engulfing what had been perceived as the most financially sound and stable developers. Friday’s closing prices (and yields) are not indicative of the week’s chaotic trading.

Country Garden, China’s largest developer, saw its bond (2025) yield close Friday at 5.43%, down from the previous week’s 7.80% close. This yield began September at 3.25%, largely ignoring the Evergrande implosion. In a spectacular market dislocation, Country Garden yields spiked to 9.5% in Monday trading and to as high as 10.74% in Tuesday mayhem.

Vanke (#4 developer) bonds (2029) traded Wednesday to 4.56%, up over 100 bps in four sessions. This yield was just above 3% in mid-September. Vanke CDS, having traded below 100 bps in September, surged 152 bps this week to a record 252 bps. Longfor (#6) yields surged almost 100 bps to 4.70%, with its CDS this week spiking 188 to a record 285 bps. Interestingly, the marketplace even turned on government-backed Poly Real Estate (#2). After trading below 2% in mid-September, (2024) yields surged 60 bps this week to 2.94%. Perhaps the wildest move of the week was achieved by government-backed Sino Ocean, whose yields, after closing the previous week at 7.79%, traded as high as 32% on Tuesday before ending the week at 9.62%.

Fears again this week pointed to mounting systemic risks, manifesting in higher CDS prices for China’s major banks. Bank of China CDS jumped as much as seven to 70 bps, matching highs from the mid-October systemic scare. Trading at four-week highs, Construction Bank of China CDS rose as much as seven to 71.5 bps. Industrial and Commercial Bank of China CDS was up eight mid-week to 72 bps, and China Development Bank CDS rose four to 66.5 bps.

There was also this week a noteworthy jump in China’s sovereign CDS prices. After closing last Friday at 49 bps, China CDS jumped to almost 57 bps during Wednesday trading. This was the high since the mid-October spike, when China CDS traded as high as 60 bps – and up from about 32 bps on September 16th.

November 8 – Bloomberg (Richard Frost): “Kaisa is showing that Evergrande was just the tip of the iceberg when it comes to the challenges facing China’s real estate industry. Kaisa is putting up 18 projects in Shenzhen for sale, with a total value estimated at about 82 billion yuan ($13bn), according to reports… That’s after the company said it was facing ‘unprecedented pressure on its liquidity’ and missed payments on high-yield consumer products it had guaranteed. With more than $11 billion of dollar bonds outstanding, Kaisa is the nation’s third-largest dollar debt borrower among developers.”

November 11 – Financial Times (Thomas Hale and Hudson Lockett): “A bout of selling this week in junk bonds issued by riskier Chinese property developers has sent their borrowing costs soaring to the highest level in a decade and imperilled companies’ ability to access an important funding source… ‘The downward spiral for Chinese developers is the result of a massive liquidity squeeze,’ said Paul Lukaszewski, head of corporate debt for Asia-Pacific at Abrdn. ‘Few companies can survive for long in environments where they cannot access their internal cash or external financing.’”

Beijing is no doubt becoming increasingly nervous. The developer bond collapse turned disorderly, eliciting supportive comments from China’s state media and PBOC officials. There was a spectacular short squeeze in developer shares and bonds, but it’s difficult to believe the situation won’t continue to deteriorate. China is very early in its real estate bust. I doubt Chinese citizens understand the seriousness of the situation. Published apartment prices have remained stable, despite the acute liquidity squeeze, which will force heavy discounting of unsold units.

China’s October Credit data were out this week. At $250 billion, the growth in Aggregate Financing was about 7% below estimates and down sharply from September’s $455 billion. October (1st month of the quarter) is typically a seasonally weak period for lending, with the month’s growth up 14% from October 2020. Aggregate Finance expanded $4.72 TN over the past year, or 10.0%.

At $129 billion, New Loans were less than half September’s $260 billon, but were above estimates. Over the past three months, New Loans were 4% below comparable 2020. Corporate Bank Loans dropped to $49 billion (from Sept’s $154bn), yet were ahead of the year ago $37 billion. Corporate lending over the past three months was 13% ahead of 2020, with six-month growth 23% above comparable 2020. Corporate Bank Loans were up 11.4% y-o-y, 25.3% over two years, 39% over three and 68% over five years.

Consumer Loans dropped to $73 billion, down from September’s $123 billion – but ahead of the year ago $68 billion. Over the past three months, Consumer Loan growth was 19% below comparable 2020. Six-month growth was down 21% from comparable 2020. Even with the slowdown, Consumer Loans were up 13.1% y-o-y, 30% over two years, 50% over three years and 117% over five years – in mortgage lending excess that will come back to bite.

Beijing faces a precarious balancing act. A historic Bubble collapse has commenced, with producer price inflation running at a 26-year high. It’s unclear that cutting rates and bank reserve requirement, while showering the system with liquidity, would significantly alter the trajectory of China’s bursting apartment Bubble. Excess liquidity, however, will surely find its way into inflating producer and consumer prices.

It’s been my view that the prospect of a faltering Chinese Bubble has provided crucial underpinning to global bond markets confronting accelerating inflation. It’s always the case that liquidity will seek out inflation. Inject enormous liquidity when securities prices have attained a strong inflationary bias, and you’ll fuel a mania. Adding liquidity when price levels throughout the economy have gained strong momentum will propel an inflationary cycle.

I believe it matters that China’s Bubble is faltering in a backdrop of powerful global inflationary dynamics. At least in the near-term, the likelihood of the bond-pleasing deflationary scenario appears much reduced compared to a year or even six months ago. Perhaps that’s part of what has lately lit a fire under the “breakeven rates.” Up another $46 dollars this week, gold prices have also heated up. It appears global central bankers have begun to lose control of bond yields. And if yields begin reflecting inflation realities, bond markets have an arduous adjustment period ahead.

Returning to the Fed’s worst inflation call in decades. The developing global financial crisis has been decades in the making. Contemporary central bank doctrine is fundamentally flawed. Using the securities markets as the primary mechanism for system stimulus – for Credit growth and financial conditions more generally – ensures speculative excess, over-leveraging and Bubbles. Coddle speculative markets at the system’s peril.

The Fed is trapped. They’ve been trapped for a while, but it essentially didn’t matter (in the age of open-ended QE) so long as consumer price inflation remained well-contained. That era has run its course. Speculative market Bubbles are these days dependent on persistently low rates, liquidity abundance and extremely loose financial conditions – a backdrop that is now quite problematic in terms of stoking the perilous confluence of manic blow-off Bubble excess and surging inflation. It was always going to end badly. Markets are exhibiting an erratic, Accident-Prone End-Game Dynamic.

Original Post 12 November 2021

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Categories: Doug Noland