Doug Noland: Trouble on the Horizon

Excerpt: But let’s return to the “Periphery vs. Core” analytical framework. It’s certainly not abnormal for trouble at the “Periphery” to initially bolster a booming “Core.” But it is extraordinary to observe the “Periphery” falter in the face of massive global QE and generally very low bond yields. The perceived bulletproof “Core” is oblivious to this ominous development.


November 19 – Reuters (Francois Murphy and Paul Carrel): “Austria will become the first country in western Europe to reimpose a full COVID-19 lockdown, it said on Friday as neighbouring Germany warned it may follow suit, sending shivers through financial markets worried about the economic fallout. Europe has again become the epicentre of the pandemic, accounting for half of global cases and deaths. A fourth wave of infections has plunged Germany, Europe’s largest economy, into a national emergency, Health Minister Jens Spahn said, warning that vaccinations alone will not cut case numbers.”

As desperately as we want to put Covid behind us, the irrepressible virus refuses to succumb. Germany reported a record 65,000 new infections Thursday. And, according to Bloomberg (Chris Reiter and Tim Loh), infections are now doubling every 12 days – a trajectory that if continued will overwhelm hospitals within weeks. “In Berlin, there were 79 intensive-care beds available for the city’s 3.8 million people on Friday, while in the northern port city of Bremen, there were just five beds for its 680,000 residents.”

Here at home, infections are on the rise again, as we head into colder weather and the holiday season. Friday from CNBC: “The U.S. reported a seven-day average of nearly 95,000 new Covid infections Thursday, up 31% over the past two weeks…” Outbreaks were up about 50% in two weeks in the Midwest and Northeast. My concern is elevated by fear of somewhat waning vaccine efficacy associated with the early vaccination push. I also suspect there will be less enthusiasm for booster shots. Reasons for optimism include natural immunities, Pfizer’s new antiviral pill, and a list of other encouraging treatments.

Meanwhile, I am not optimistic about the impact Europe’s Covid outbreak will have on the unfolding global financial crisis. Once again, Covid brandishes nefarious timing. China-related contagion had already created vulnerability. Now, fledgling global “risk off” has de-risking/deleveraging increasingly impairing liquidity at the “Periphery.”

The euro dropped 1.3% this week to 1.13, the low versus the dollar since July 2020. Euro weakness (stoked by ECB dovishness) comes at a particularly inopportune time for the emerging markets. The dollar, having already gained momentum on the back of heightened EM risk aversion, traded above 96 for the first time in 16 months. Dollar strength is pressuring leveraged EM “carry trades,” a key dynamic in unfolding “Periphery” vs. “Core” Crisis Dynamics.

In general, crisis dynamics unfold initially at the “Periphery” and then begin gravitating toward the “Core.” It’s the weakest players at the fringe that get in trouble first – the highly levered with liquidity constraints and vulnerability to any tightening of financial conditions. Simply stated, if the weak lose access to new borrowings, they quickly confront serious trouble. It’s worth adding that the global “Periphery” had been on the receiving end of massive yield-chasing speculative flows since the start of pandemic stimulus, leaving it acutely vulnerable to a shift to “risk off” de-risking/deleveraging.

November 18 – Bloomberg (Burhan Yuksekkas and Tugce Ozsoy): “The Turkish lira tumbled to a record low after the central bank cut borrowing costs for a third straight month, a move that risks further undermining price stability while eroding what little confidence investors had in the nation’s policy makers. The lira fell as much as 6% to 11.3118 against the dollar, the biggest decline in eight months. Officials cut the one-week repo rate by 100 bps to 15%…, and said they would consider ending the easing cycle next month. It comes as consumer inflation accelerated to almost 20% in October…”

This week’s 11.3% drop pushed Turkish lira year-to-date losses to 34%. Turkish inflation, already above 20%, will surely accelerate. Turkey runs large trade and current account deficits. It carries a significant debt load, too much of it denominated in the U.S. dollar and other foreign currencies. Turkey has $125 billion of foreign-denominated debt due over the next year, about 43% denominated in dollars. Between persistent trade deficits and debt maturities, Turkey faces quite challenging external financing requirements. The country has $87 billion of international reserves, although the central bank (and banking system) has accumulated offsetting currency forward positions. Turkish banks have significant foreign liabilities and derivatives exposures.

Turkish local-currency bond yields jumped 60 bps this week to 19.31%, up about 300 bps in two months. Dollar-denominated yields rose 34 bps this week to 6.94%. Turkey’s sovereign CDS jumped 38 to 446 bps, up from about 300 bps to start the year.

Is it even possible for a crisis to develop with Trillions of liquidity sloshing about the global system? With ongoing QE from the Fed, ECB, BOE, BOJ and others, few have contemplated waning liquidity or the possibility of a liquidity shock. But with Turkey now succumbing to Crisis Dynamics, “risk off” de-risking/deleveraging and contagion have become a clear and present risk.

Brazil’s real declined 2.5% this week, boosting 2021 losses to 7.1%. Brazil’s local-currency bond yields rose 22 bps this week to 11.69%. Brazil’s sovereign CDS gained two to 238 bps, up 60 bps in two months and almost 100 bps from the start of the year. At 10.7%, Brazil’s y-o-y inflation hasn’t been higher since the dark days of 2003. While Brazil’s external financing requirements don’t appear as precarious as Turkey, it has a limited international reserve position, extensive central bank currency derivative positions, and a banking system vulnerable to a surge of “hot money” outflows.

Analysts will cite “idiosyncratic risks.” With a pivotal presidential election Sunday, the Chilean peso dropped another 3.5% this week (down 14.2% y-t-d). Chile CDS jumped 22 this week to 90 bps (highs since May 2020). Despite raising rates to 3.75%, South Africa’s rand fell 2.7% (down 6.6% y-t-d). South African yields jumped 15 bps to 9.97%.

Eastern Europe was this week in “risk off” crosshairs. Hit by Covid and a crisis at its border with Belarus, Poland’s zloty slumped another 2.6% this week (down 10.3% y-t-d). At 6.8%, y-o-y inflation is the highest since 2000. Poland’s local-currency bond yields surged 33 bps this week to 3.23% (after ending Sept. at 2.21%).

Russia’s ruble declined 0.8%, with 10-year yields jumping 18 bps to 8.34% – a two-month rise of 130 bps, as yields surpass the March 2020 spike to reach the highest level since April 2019. Ukrainian CDS surged 39 (two-week gain of 76) to 488 bps, the high since 2019. Hungary’s yields jumped 23 bps to a seven-year high of 4.08%. The Romanian leu declined 1.4%, with yields up five bps to 5.14% – the high since March 2020. The Czech koruna fell 2.1%, and the Bulgarian lev lost 1.4%.

In the “Periphery of the Periphery,” Tunisia CDS surged 98 to 934 bps, Ghana 74 to 1,115 bps, Iraq 52 to 631 bps, and Kenya 32 to 444 bps.

The Shanghai Composite gained 0.6%, posting modest back-to-back weekly gains. It was another wild week for developer stocks and bonds, with prices towards the end of the week supported by indications Beijing would loosen real estate Credit. Basically, things are spiraling out of control, leaving Beijing with no alternative than to attempt to stabilize the situation.

November 15 – Reuters (Liangping Gao and Ryan Woo): “China’s property woes worsened on all fronts last month, as price falls in both new and resale homes amid deeper contractions in construction starts and investment by developers piled pressure on the sector in a rare confluence of declines. The Chinese property market… has slowed sharply since May, with sentiment increasingly shaken by stress in the sector in the wake of a growing liquidity crisis that has engulfed some of the country’s biggest and most indebted developers… Prices of new homes dropped 0.2% on average last month from September…, the first decline since March 2015. In the resale market, prices slumped in all but six of the 70 major cities tracked by the bureau… During the month, homes sales tumbled 22.65% on year to 1.24 trillion yuan…, the fourth straight decline and the lowest this year.”

And from Bloomberg: “Property firms refrained from expenditure, resulting in a widening 5.4% year-on-year contraction in real estate development investments, according to Bloomberg calculations. New starts by developers, a leading indicator of investments, plunged 33% from a year earlier, and their land purchases shrank 24% from September. Projects completed by developers also dwindled 21% from a year prior likely due to hoarding of cash.”

November 15 – Bloomberg (Tom Hancock and Enda Curran): “China’s economy is slowing to the lows seen way back in 1990 — a price President Xi Jinping seems willing to pay to reduce its dependence on the property sector. Beijing’s squeeze on the real estate sector will linger into next year and beyond, a development many hadn’t seen coming that has now prompted banks like Goldman Sachs…, Nomura… and Barclays Plc to cut their growth forecasts in 2022 to below 5%. Bar last year’s pandemic year, that would be the weakest in more than three decades. Analysts at Societe Generale SA even attach a 30% probability of a hard landing in 2022.”

November 19 – Bloomberg: “China’s economy is slowing more than people think and the outlook is for weaker growth going forward as the government is unlikely to step in with significant stimulus, according to Leland Miller, chief executive officer of China Beige Book. ‘The third quarter was particularly brutal’ for China’s economy, Miller said… In addition, ‘we’re going to be looking at much lower growth going forward and it’s going to be because the Party is OK with that.’”

It’s so early in the process. Yet China’s historic apartment Bubble is indeed bursting, with air beginning to seep out of the Chinese Bubble economy. Moreover, it’s all unfolding despite huge ongoing Credit growth and low interest rates.

Beijing will direct its banking system to lend, while state-owned companies will borrow, buy and invest. I’ll assume these measures will for now keep the wheels from falling off – at least work to slow the pace of Bubble deflation. I empathize with the Chinese people, who must suddenly question whether things are as they had thought – and what the future might hold. I would not be surprised to see gloomy sentiment envelop both apartment buyers and shoppers. A population that saw expectations inflate as never before is now susceptible to sliding into a deep funk.

But let’s return to the “Periphery vs. Core” analytical framework. It’s certainly not abnormal for trouble at the “Periphery” to initially bolster a booming “Core.” But it is extraordinary to observe the “Periphery” falter in the face of massive global QE and generally very low bond yields. The perceived bulletproof “Core” is oblivious to this ominous development.

Here in the U.S., stocks are six weeks from wrapping up a historic year. Virtually all assets have enjoyed spectacular price inflation, while manic markets remain all too willing to disregard risk. Attention is focused on Powell or Brainard. Will the Fed adjust its taper schedule at its December meeting? The first rate increase in the second half of 2022 or not until ’23?

Inflation garners considerable attention. Yet so long as the Fed and bond market are okay with it, there’s little to worry about. China problems are old news. Why worry about a Chinese slowdown when our economy is over-heated? Besides, if things somehow turn bad enough – in China or with global contagion – the Federal Reserve will surely slow/curtail tapering and indefinitely postpone rate increases. Inflation will subside, bond yields will drop – and The Forever Bubble Lives On.

Meanwhile, the “Periphery” is in serious trouble. As attention fixates weekly on U.S. stock market record highs, global contagion quietly gathers momentum. “Risk off” de-risking/deleveraging is broadening and strengthening by the week. Importantly, liquidity issues are spreading among “Periphery” markets. Moreover, the manic “Core” draws precious liquidity from the “Periphery,” in the process toppling “Periphery” Bubbles, while fueling precarious “Terminal Phase” “Core” excess.

Speculative blow-offs ensure liquidity shocks. On the upside, speculative leverage – certainly including option and derivatives-related – fuels self-reinforcing liquidity over-abundance. But when manic markets inevitably reverse course, it’s selling and deleveraging that becomes self-reinforcing. Incredible liquidity abundance can rather abruptly shift to fragility, illiquidity and dislocation.

Prior to QE, market analysts used to fret speculative melt-ups. Fretting is appropriate. Unparalleled speculative excess today masks a deteriorating global liquidity backdrop. Global Crisis Dynamics and contagion are advancing, and they will land at a manic “Core” that I cannot imagine in a more unstable and vulnerable state.

It’s worth noting that U.S. investment-grade and high-yield CDS prices rose this week. Corporate Credit spreads jumped to eight-month highs. Bank CDS prices increased, while U.S. banks stocks sank 2.7%. European bank stocks dropped 2.8%, with Italian banks down 3.9%. European CDS prices moved sharply higher. Japanese banks fell 2.0%.

Curiously, after trading to a record 3.25% during Tuesday trading, the five-year Treasury “breakeven” inflation rate reversed sharply lower to end the week at 3.04%. Crude sank 6%, as economically-sensitive commodities showed some vulnerability. And after trading up to 1.65% earlier in the week, safe haven 10-year Treasury yields were back down to 1.52% during Friday trading. Even in “Core” markets, there were hints of Trouble on the Horizon.

Original Post 20 November 2021


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