Doug Noland: Market Structure in the Crosshairs

Markets will on occasion reveal subtle hints, clues that can be critical when nearing inflection points. Last week’s CBB discussed the elevated correlations between the cryptocurrencies, technology stocks, and some financial conditions indicators. This suggested heightened risk of a bout of “risk off” selling that could presage illiquidity, panic and bursting speculative Bubbles. Not subtly, this dynamic gained important momentum this week.

Bitcoin’s 11% Friday drop boosted losses for the week to 15.6%. Etherium dropped 28% this week, Litecoin 27%, and Binance 28%. It was a technology bloodbath, with the Semiconductors sinking 11.9%. There was an element of panic in many of the online trading community’s favorite stocks. A Friday afternoon Bloomberg headline: “Nasdaq 100’s Unrelenting Declines Ring a Dot-Com Bust Alarm Bell.” While there are notable similarities, the nineties was a rather petite Bubble in comparison to today’s gross obesity.

Markets this week provided inklings of a potentially far-reaching Critical Juncture. Wednesday trading deserves special attention. Stocks opened the session higher, only to reverse sharply lower. “Risk off” was gaining momentum, with technology stocks and the cryptocurrencies appearing particularly vulnerable. But even in the face of faltering risk market Bubbles, Treasury yields were marching higher – trading Wednesday to 1.90%, the high since year-end 2019.

Meanwhile, Gold surged $27 during the session. Buying went beyond the “shiny metal”. Silver jumped 67 cents, or 2.8%, Platinum $41, or 4.2%, and Palladium $104, or 5.4%. And gains were not limited to the precious metals. Nickel jumped 4.9%, Copper 1.7%, Tin 1.4%, and Aluminum 1.0%. In the soft commodities, Cotton rose 2.4%, Sugar 2.2%, Coffee 2.0%, and Cattle 1.1%. In hot energy markets, Crude added another 94 cents to close at the high since 2014 ($85.80).

The Bloomberg Commodities Index advanced 1.3% Wednesday, while the Nasdaq100 fell 1.1%. The dynamic was new and not all that subtle, though barely a peep was uttered from the punditry on such a potentially momentous development: The emergence of Bubble vulnerability in Financial Assets spurring heightened demand for Hard Assets.

The Bloomberg Commodities Index’s 1.8% gain for the week boosted early-2022 gains to 6.2%. Meanwhile, the Nasdaq100 dropped 7.5%, pushing y-t-d losses to 11.5%. So-called “safe haven” Treasury bonds (the TLT ETF) ended Wednesday’s session with y-t-d losses already approaching 5% (after losing 4.6% in 2021).

Elsewhere, Bitcoin and the cryptocurrencies suddenly looked a rather tarnished “new (digital) gold.” They certainly weren’t performing as an inflation hedge or providing portfolio diversification. A Friday Bloomberg headline: “Crypto Meltdown Erases More Than $1 Trillion in Market Value.”

It was one of those weeks that left an unsettled feeling in the pit of my stomach. A lot of money was lost in the cryptocurrencies and high-flying tech stocks. Before this is over, astonishing amounts of perceived wealth will have vanished into thin air. Tens of millions of unsuspecting “investors” will lose meaningful amounts of their savings. They bought into the mania, threw caution to the wind, and will suffer the consequences. Blindsided.

Sure, individuals made their own decisions. But who could blame them? With Trillions of liquidity inflating financial asset prices, zero rates on savings, and the Fed having repeatedly proved they would backstop the markets, it became perfectly rational to buy into the bullish Wall Street propaganda. Stocks always go up. There are few sure things in life, but stocks are one of them.

Wednesday from Bloomberg: “The Next Big Treasuries Shock Could Come From a Huge Option Position.” The article highlighted a note from Nomura’s Charlie McElligott, who was focused on a “monster” put option positioned (slightly “out of the money” 127 strike for the 10-year Treasury contract): “This level should continue to be monitored as a potential ‘acceleration point’ on a break lower.”

While appearing miraculous on the upside, I have long argued contemporary finance doesn’t function well in reverse. So long as Credit and speculative leverage are expanding, markets will appear highly liquid, financial conditions will remain loose, and asset price inflation will maintain self-reinforcing momentum. But fragility lies in wait – just below the surface. Derivatives – they lurk as an accident waiting to happen. And the lying and lurking can persist for years, long forgotten but ready to pounce.

“Portfolio insurance” played an instrumental role in the 1987 stock market crash. Derivatives were fundamental to market dislocations in 1994, 1998, and 2000. Hedging and leveraging strategies – through listed and over-the-counter derivative products – were integral to the mortgage finance Bubble and its fateful collapse. Derivatives and the gargantuan ETF complex were central to March 2020’s scary market dislocation.

We’re heading toward a historic test of market function. I recognize that conventional thinking has it that markets have faced various challenges over the years/decades and inevitably passed every test. It’s different this time. Past performance is not indicative of future results.

Bond yields collapsed during the 1987 stock market crash, providing key reinflationary stimulus for late-eighties (“decade of greed”) excess. And since ’87, sinking bond yields repeatedly provided key post-crisis stimulus. After beginning 1990 at 8%, a historic bond bull market saw yields trend lower for three decades, trading down to 0.50% following the Fed’s March 2020 market bailout.

The Fed for three decades enjoyed incredible latitude to employ increasingly aggressive stimulus measures. Greenspan’s cryptic utterances and “baby step” rate increases, to aggressive rate slashing, to Bernanke’s Trillion dollar QE, to Powell’s $5 Trillion. And the contemporary bond market had absolutely no issue with ever more outlandish monetary inflation. After surpassing 6.0% in 1990, y-o-y inflation was as low as 1.1% by 2002. And after running negative in 2009, CPI bounced back to trade as high as 3.9% in 2011. But between 2012 and 2021, CPI spent much of the time below 2%. The Fed responded with momentous monetary stimulus in March 2020 – with zero fear of inflationary consequences.

There’s a strong case that the approaching market test will prove monumental. Total Debt Securities increased $9.1 TN, or 20%, over the past nine quarters. Covertly, systemic risk to higher market yields has been rising exponentially. Then inflation surged to a 40-year high 7.0%. Treasury yields have been moving higher, with mounting losses and attendant fund outflows. There is ample evidence supporting the view of secular shifts in inflation and bond market dynamics.

Charlie McElligott’s focus this week was on a particularly chunky Treasury options strike, and how those who wrote/sold this interest-rate protection might be forced to aggressively sell Treasuries to hedge their derivatives exposure. Yet the bigger question is who will be on the other side of trades if a spike in yields forces massive derivatives-related selling. What will be the source of liquidity if “the market” attempts to offload interest-rate risk into an impaired and illiquid marketplace?

After trading Wednesday to 1.90%, 10-year Treasury yields reversed lower into expiration, closing the week at 1.76%. The Treasury market was let off the hook by some panic selling of stocks (tech in particular) and cryptocurrencies. And while “risk off” may leave a Treasury market test for another day, that in no way allays the seriousness of the unfolding test of contemporary finance more generally.

January 21 – Reuters (Gaurav Dogra): “Global exchange-traded funds (ETFs) drew record inflows last year as investors plowed their growing cash balances into the low-cost, transparent investment products. According to Refinitiv Lipper data, global exchange-traded funds received a record $1.22 trillion in inflows last year, which was about 71% higher than the previous year. Their net assets swelled to a record $9.94 trillion. U.S. ETFs were the biggest recipients, receiving $901 billion, while European and Asian ETFs drew about $190 billion and $88 billion respectively.”

ETF industry assets have inflated tremendously since the cataclysmic March 2020 market dislocation (that saw quick 20% losses for key bond and equities funds). Who will take the other side of trades when panicked ETF holders rush for the exits (with the leverage speculating community keen to profit from retail’s misfortune)? The “Moneyness of Risk Assets” has been a prevailing concern of mine since Bernanke unleashed QE. I’ve had particular unease with the perception of safety and liquidity afforded to ETF shares in funds that purchase less than liquid securities (i.e. small cap stocks and junk bonds). A new breed of ETFs (i.e. ARK Funds) took risk to a whole new level, loading up on highly volatile speculative stocks in a mania. Miraculous money-making – and self-reinforcing fund flows – on the upside is now collapsing with a big thud.

Who takes the other side of the trade if the public panics out of equity funds? And I’m not referring to some of these high-flying specialty funds. The largest stock losers in the S&P500 so far this year included Moderna, Netflix, Etsy, Enphase Energy, EPAM Systems, Align Technology, and Bio-Techne. It’s been quite a mania.  The greater the speculation and the higher the price, the more likely a stock will make its way into the S&P500 index. Tesla began 2020 at $86. It was included in the S&P500 on December 21, 2020, after its stock price had surged to $650.

The small cap ETFs have been under intense pressure to begin the year. When hit with outflows, these funds face the challenge of raising cash by selling often liquidity-challenged securities. As the big tech stocks came under heavy selling pressure to start 2022, the S&P500 was supported by a (convenient) melt-up in the big financial shares. The Banks (BKX) surged 11.7% in 2022’s first nine sessions.

While attention was focused this week on collapsing cryptocurrencies and tech shares, it’s worth noting the ominous reversal in financial stocks. Sinking 10.0%, the Bank Index actually suffered larger losses this week than the Nasdaq100 (down 7.5%). Goldman Sachs fell 9.7%, JPMorgan 8.1%, Bank of America 6.2% and Citigroup 5.5%. Robinhood sank 14.3%, Wisdom Tree 9.7%, Interactive Brokers 7.3%, and Charles Schwab 6.6%.

It’s worth noting this week’s jump in Bank CDS prices, especially on Friday. Notable Friday moves included a five-point jump in Morgan Stanley CDS (to 65bps), four points for Bank of America (to 57bps), and three points for JPMorgan (to 55bps). For the week, Citigroup CDS jumped five to a one-month high 64 bps; Morgan Stanley five to (high since July 2020) 65 bps, Goldman Sachs five to 70 bps; JPMorgan five to (one-month high) 55 bps; and Bank America five to (near 18-month high) 57 bps.

Bank stocks were under pressure globally this week, though nowhere suffered the bludgeoning the big U.S. financial institutions did. U.S. banks also led the CDS leaderboard. It was as if there was a sudden awakening to U.S. fragility. U.S. Market Structure in the Crosshairs?

Let’s return to the unfolding U.S. “test.” It was notable that the S&P500 was clobbered 5.7%, yet 10-year Treasury yields were unchanged. Two-year yields actually rose another four bps this week. Curiously, despite clear indications of faltering Bubbles, market expectations held steady with four rate increases this year.

Not only is the consensus expecting multiple rate hikes, forecasts have the Fed commencing balance sheet contraction, or quantitative tightening, as early as the Spring. I can’t see it. Market Structure can’t take it. The Fed is still at least a couple months from its first little baby step rate increase – yet speculative Bubbles are already coming unglued. Talk is that the Fed will use its balance sheet (QT) to impose tightening in lieu of a more aggressive rate hike cycle. Today’s fragile Market Structure – including unprecedented speculation and leverage, problematic derivative structures, an ETF time-bomb, and myriad fragile market Bubbles – would not withstand QT.

I don’t see the Fed’s tightening cycle getting far. And while faltering risk market Bubbles would be expected to temper inflationary momentum, the surprise could be inflation’s resilience. And this week’s Hard Asset over Financial Assets Dynamic is definitely worthy of contemplation. There are today Trillions of available cash balances. Risk aversion towards Financial Assets might just bolster flows into perceived superior stores of value in real things. And this dynamic could underpin inflationary pressures in many things – including food, energy, commodities and such – that will combine with acute wage pressures to feed persistently elevated inflation.

Meanwhile, persistently elevated inflation creates a momentous challenge both for Fed policymaking and U.S. Market Structure. “Risk off” without an aggressive Fed response? De-risking/deleveraging not automatically triggering massive QE liquidity injections? I cannot overstate how this would radically alter the risk profile of key aspects of Market Structure and contemporary finance more generally. The risk of runs on the fund industry turning disorderly. The risk of derivative accidents. Self-reinforcing asset deflation and deleveraging. Risk aversion in corporate Credit.

Market Structure is becoming a huge issue. Contemporary Finance Doesn’t Function Well in Reverse – and that’s an understatement. Illiquidity and mayhem. Rather than “Ring a Dot-Com Bust Alarm Bell,” it was the systemic risk bells that began chiming this week.

Original Post 22 January 2022


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