Doug Noland: The High-Wire Act Has Commenced

Excerpts:

Powell’s in a really tough spot. I still believe he wanted to commence the process of letting Wall Street stand on its own when he was appointed Fed Chair in 2018. The Street put a quick kibosh to that: Powell Pivot #1. Unless he’s today overcome by deep denial, he appreciates that the Fed has nurtured a real monster. And it was only 22 months ago that the FOMC was throwing the kitchen sink (overflowing with liquidity) at Wall Street to thwart collapse. He can’t be oblivious to latent fragilities at this point, right? Perhaps he’s reluctant now to feed the beast. And having the markets tighten before the Fed even gets going in a way provides an element of plausible deniability (for when the wheels come off).

Powell had a couple opportunities to provide traders a little empathy. They received none, which could be the best explanation for the market consternation his press conference generated. Powell: “Communications… are working.”

So, we feel like the communications we have with market participants and with the general public are working and that financial conditions are reflecting in advance the decisions that we make. And monetary policy works significantly through expectations. So that in and of itself is appropriate.”

I believe Powell is a “good man.” I’ve sympathized with his predicament from day one. This runaway Bubble was not of his making – though he’s definitely made it significantly more difficult to make this case today. Moreover, history will not be kind to this week’s downplay of systemic risk.

In reality, asset prices themselves represent a significant threat to financial stability. Households have never been so exposed to securities market bubbles. Corporate credit is extraordinarily vulnerable to a tightening of financial conditions. The banking system is heavily exposed to potential asset market instability and a deeply maladjusted economic structure.

It’s wishful thinking not to believe the banks have over this long cycle found all kinds of clever ways to get themselves into trouble. And when it comes to the “non-bank financial sector,” money market funds should be the least of the Fed’s worries. I would start with derivatives markets, the ETF complex and the leveraged speculating community, all having grown tremendously since the near financial meltdown they played integral roles in a mere 22 months ago. I guess it’s easier to just pound away at the money funds.

And let’s be clear: It was years of an ultra-dovish Fed – as opposed a hawkishy Wednesday Powell – responsible for the unfolding market accident – one that made some impressive headway this week.

I’m not so sure actual investors have much to do with this extreme volatility. It’s about speculative dynamics, and this week there were indications of rising probabilities for a dislocation/crash scenario. And this development unleashes some panic selling, huge amounts of hedging, erratic sell and buy programs from derivatives-related algorithmic “dynamic trading,” destabilizing flows within the ETF complex, along with aggressive speculative trading (some betting on a “crash,” but with hair-triggers to reverse bearish wagers on rallies).


The High-Wire Act Has Commenced

Wednesday’s FOMC meeting made for a hawkish week, at least within the headlines. “Banks Scramble to Change Fed Rate Calls After Hawkish Shift.” “Rate Traders See Risk of More Than Four U.S. Fed Hikes This Year After Hawkish Powell.” “US Stocks Drop in Wake of Hawkish Federal Reserve.” “Hawkish Fed Shakes Investors” And from Reuters: “’I do not think Fed Chair Powell could have been more hawkish during his press conference than if he raised rates today,’ said Tom di Galoma, managing director at Seaport Global Holdings…”

Geez. I guess it’s been a long time since we’ve experienced a hawkish central banker. Powell, of course, needed to talk tough on inflation. Yet he seemed determined to occupy the middle ground. There was no suggestion of the possibility of a 50 bps rate hike in March. There was no announcement of an immediate end to QE purchases. No rush to begin reducing the size of the Fed’s balance sheet. A dove in hawk’s clothing and no surprises.

From Mohamed El-Erian’s Bloomberg piece: “The Fed delivered what I expected but not what I think is needed for sustainable economic well-being. It should have stopped purchasing assets immediately and given a clearer signal on rate increases. Instead, the central bank doubled down on its 2021 trade-off of trying to please financial markets at the cost of increasing the challenges ahead for the economy, sound policy making and its own credibility.”

In a sign of changing times – and the Federal Reserve’s newfound predicament – it was as if Powell provided something for everyone – not to like.

Powell quotes from the “hawkish” side: “Economic activity expanded at a robust pace last year.” “The economy has shown great strength and resilience.” “There’s a risk that the high inflation we’re seeing will be prolonged, and there’s a risk that it will move even higher.” “We understand that high inflation imposes significant hardship.” “While the drivers of higher inflation have been predominantly connected to the dislocations caused by the pandemic, price increases have now spread to a broader range of goods and services.” “We’re not making progress” on relieving supply-chain pressures. “Things like the semiconductor issue… they’re going to be [around] quite a long time.”

Compensating for the Fed’s belated recognition of labor tightness, Powell repeatedly highlighted job market strength: “A tremendously strong labor market.” “The labor market has made remarkable progress and by many measures is very strong.” “Labor demand remains historically strong.” “Employers are having difficulties filling job openings, and wages are rising at their fastest pace in many years.” “Most FOMC participants agree that labor market conditions are consistent with maximum employment.”

“Monetary policy will be becoming significantly less accommodative.” “This is going to be a year in which we move steadily away from the very highly accommodative monetary policy…” “The best thing we can do to support continued labor market gains is to promote a long expansion, and that will require price stability.”

“The balance sheet is substantially larger than it needs to be… So, there’s a substantial amount of shrinkage in the balance sheet to be done. That’s going to take some time. We want that process to be orderly and predictable.”

“We fully appreciate that this is a different situation. If you look back to where we were in 2015 ’16, ’17, ’18 when we were raising rates, inflation was very close to 2%, even below 2%.”

But Powell’s press conference was not without shout-outs to the jittery doves. “…There are other forces at work this year, which should also help bring down inflation… including improvement on the supply side… fiscal policy is going to be less supportive of growth this year… So, there are multiple forces which should be working over the course of the year for inflation to come down.”

“I think the path is highly uncertain, in that we’re committed to using our tools to make sure that inflation, high inflation that we’re seeing does not become entrenched… A number of factors are supporting a decline in inflation…”

The Powell Fed surely recognizes it has commenced a tricky High-Wire Act. Inflation vs. Market Fragility. Powell mentioned “nimble” four times and “adaptable” and “humble” twice each.

“It is not possible to predict with much confidence exactly what path for our policy rate is going to prove appropriate. And so, at this time, we haven’t made any decisions about the path of policy. And I stress again that we’ll be humble and nimble.”

“And we’re going to need to be, as I’ve mentioned, nimble about this. And the economy is quite different this time. I’ve said this several times now. The economy is quite different, it’s stronger. Inflation is higher. The labor market is much, much stronger than it was. And growth is above trend.”

“There’s a case that, for whatever reason, the economy slows more and inflation slows more than expected, we’ll react to that. If, instead, we see inflation at a higher level or a more persistent level, then we’ll react to that.”

“We need to be quite adaptable.” “We have our eyes on the risks, particularly around the world.”

The Fed Chair was notably cautious in his comments regarding the market hot-button issue of balance sheet reduction: “Balance sheet is still a relatively new thing for the markets and for us, so we’re less certain about that.” “Our decisions to reduce our balance sheet will be guided by our maximum employment and price stability goals.” “Building up and then shrinking the balance sheet is a complicated one, and it involves inevitably surprises. And, so, during the years there in the prior cycle, we amended our balance sheet principles a number of times.”

Two-year Treasury yields surged 13 bps Wednesday to 1.15%, the largest one-day jump in 22 months. Five-year yields rose 13 bps to 1.68%, the high since January 2020. The market came into the Fed meeting expecting 3.91 rate increases by the FOMC’s December 14th meeting. It ended Wednesday at 4.62 rate increases and closed the week at 4.75.

Bloomberg quoted a factual statement from JPMorgan chief U.S. economist Mike Feroli: “Powell’s remarks after the meeting were arguably the most hawkish he’s made as Fed Chair.”

While it was more middle ground than hammering home hawkishness, there was a lot for Wall Street not to like from the Fed Chair. But everyone knew Powell would be determined to present a hard line on inflation. Wall Street is also comfortable that Powell is willing to “pivot” in the event of serious market trouble. “Nimble” is code for readiness to doff the hawk outfit.

Other headlines for the week: “Where’s the ‘Fed Put’?” “Markets Wonder if the Fed Put is Dead, or Just Resting?” “The Fed Put is Dead.”

No one can seriously believe the ‘Fed Put’ has met its maker. It’s this murky new strike price that will create restless nights. What will it take in the markets to force another big pivot from the Fed Chair? And what are the consequences if he drags his pivot foot?

There’s a narrative that seemed to gather some momentum as a wild market week came to an end (10-yr yields ended the week 11bps below Wednesday’s highs): “Peak hawkishness and policy mistake fear.” I can make sense of part of this. With BofA calling for seven rate hikes this year, it won’t be easy to turn much more hawkish on rates. Yet I don’t believe policy mistake fears will revolve around the course of interest-rates. It’s when the Fed fails to quickly come to the markets’ defense, as de-risking/deleveraging dynamics gather momentum, that will provoke shrieks of “policy mistake!”

I’ve been closely following the Fed for a few decades. I have similar questions today as I’ve had more than a few times over the years, all the way back to 1990. Are they attuned to heightened systemic risks – and just putting on brave faces? Or are they less informed than they should be – sometimes bordering on oblivious? Inquiring minds want to know.

Powell’s in a really tough spot. I still believe he wanted to commence the process of letting Wall Street stand on its own when he was appointed Fed Chair in 2018. The Street put a quick kibosh to that: Powell Pivot #1. Unless he’s today overcome by deep denial, he appreciates that the Fed has nurtured a real monster. And it was only 22 months ago that the FOMC was throwing the kitchen sink (overflowing with liquidity) at Wall Street to thwart collapse. He can’t be oblivious to latent fragilities at this point, right? Perhaps he’s reluctant now to feed the beast. And having the markets tighten before the Fed even gets going in a way provides an element of plausible deniability (for when the wheels come off).

Powell had a couple opportunities to provide traders a little empathy. They received none, which could be the best explanation for the market consternation his press conference generated. Powell: “Communications… are working.”

Axios’ Neil Irwin: “I was wondering if the volatility we’ve seen in the financial markets in the last few weeks strikes you as anything alarming or that might affect the trajectory of policy. Conversely, to the degree that financial conditions have tightened some, might that be desirable in some ways in achieving your tightening goals?”

Powell: “So… the ultimate focus that we have is on the real economy, maximum employment, and price stability. And financial conditions matter to the extent that they have implications for achieving the dual mandate… Markets are now pricing in a number of rate increases. Surveys show that market participants are expecting a balance sheet runoff to begin… at the appropriate time sometime later this year perhaps… So, we feel like the communications we have with market participants and with the general public are working and that financial conditions are reflecting in advance the decisions that we make. And monetary policy works significantly through expectations. So that in and of itself is appropriate.”

Yahoo Finance’s Brian Cheung: “Within the context of other hiking cycles, it seems like worries about asset bubbles emerging as a result of easing rates has been part of that. I didn’t know if that was part of the discussion today.”

Chair Powell: “I would just say this. We, of course, have a financial stability framework. And what it shows is a number of positive aspects of financial stability. But you mentioned really asset prices is one of the four. So, asset prices are somewhat elevated, and they reflect a high-risk appetite and that sort of thing. I don’t really think asset prices themselves represent a significant threat to financial stability, and that’s because households are in good shape financially than they have been. Businesses are in good shape financially. Defaults on business loans are low and that kind of thing. The banks are highly capitalized with high liquidity and quite resilient and strong. There are some concerns in the non-bank financial sector around — still around money market funds, although the SEC has made some very positive proposals there. And we also saw some things in the Treasury market during the acute phase of the crisis which we’re looking at ways to address. But, overall, the financial stability vulnerabilities are manageable, I would say.”

I believe Powell is a “good man.” I’ve sympathized with his predicament from day one. This runaway Bubble was not of his making – though he’s definitely made it significantly more difficult to make this case today. Moreover, history will not be kind to this week’s downplay of systemic risk.

In reality, asset prices themselves represent a significant threat to financial stability. Households have never been so exposed to securities market bubbles. Corporate credit is extraordinarily vulnerable to a tightening of financial conditions. The banking system is heavily exposed to potential asset market instability and a deeply maladjusted economic structure. It’s wishful thinking not to believe the banks have over this long cycle found all kinds of clever ways to get themselves into trouble. And when it comes to the “non-bank financial sector,” money market funds should be the least of the Fed’s worries. I would start with derivatives markets, the ETF complex and the leveraged speculating community, all having grown tremendously since the near financial meltdown they played integral roles in a mere 22 months ago. I guess it’s easier to just pound away at the money funds.

January 25 – Bloomberg (Emily Graffeo): “The stock market’s dramatic turns are fueling record trading in ETFs, the highly liquid investment vehicles that traders are using to keep pace with surging volatility. That jump in activity lifted the entire U.S. ETF market’s dollar value of shares traded… to a record high, with more than $478 billion trading on Monday… That surpassed the previous record $404 billion from Feb. 28, 2020.”

January 25 – Financial Times (Eric Platt): “Investors are racing to protect their portfolios from damage as volatility sweeps across Wall Street… Put options contracts, which can shield against losses from declines in share prices, were in heavy demand at the start of the week, when the S&P 500 benchmark index of US stocks registered a 10% drop from recent highs. Traders bought 31.3m equity put options contracts that day…, just shy of the all-time high set on Friday, when 32.3m of the contracts were bought. Both days far surpassed the previous record of 26.7m contracts set in February 2020 when the coronavirus pandemic began to rattle US financial markets.”

January 28 – Bloomberg (Michael Msika): “The brutal selloff this week isn’t scaring investors from putting their money in the stock market. In the week that pushed the S&P 500 Index to the verge of a correction, stock funds absorbed billions of cash. There’s ‘zero capitulation in equity positioning,’ Bank of America Corp. strategists led by Michael Hartnett wrote… The strategists, who track EPFR Global data, said equity mutual funds and exchange-traded products took in $17.1 billion in the week to Jan. 26.”

And let’s be clear: It was years of an ultra-dovish Fed – as opposed a hawkishy Wednesday Powell – responsible for the unfolding market accident – one that made some impressive headway this week.

January 24 – Bloomberg (Lu Wang): “That was some ride U.S. stocks just took. The Nasdaq 100, along with the rest of the market, turned on a dime in the middle of its worst selloff in two years and vaulted back into the green, erasing a loss of nearly 5%. The move was the latest in a series of heart-stopping turnarounds that have dogged markets amid rising tensions around Federal Reserve policy. Days like Monday are not unprecedented… Today’s move was the biggest of its kind since Jan. 8, 2001, in the middle of the come-down from the dot-com bubble. Most of the other similar moves occurred in the three years that crash took to play out, with a few others coming in the heart of the 2008 financial crisis.”

January 28 – Bloomberg (Lu Wang and Jessica Menton): “In another week of severe equity turbulence, the S&P 500 saw three of the biggest intraday reversals of the decade, Microsoft Corp. swung 15% in 15 hours, and stock volatility doubled. In the end, for one last twist, the index rallied Friday, erasing losses for the week to post one of its smallest wire-to-wire moves in months. It was the final irony for a week in which investors just couldn’t make up their minds, amid a panoply of warring narratives.”

I’m not so sure actual investors have much to do with this extreme volatility. It’s about speculative dynamics, and this week there were indications of rising probabilities for a dislocation/crash scenario. And this development unleashes some panic selling, huge amounts of hedging, erratic sell and buy programs from derivatives-related algorithmic “dynamic trading,” destabilizing flows within the ETF complex, along with aggressive speculative trading (some betting on a “crash,” but with hair-triggers to reverse bearish wagers on rallies).

The VIX Index traded Monday to almost 39, the high since October 2020. It was five sessions of unrelenting volatility. Monday trading saw the gap between intraday lows and highs in the S&P500 of 4.6%. Tuesday it was 2.9%, Wednesday 3.3%, Thursday 2.7%, and Friday 3.25%.

Importantly, risk aversion began seeping more steadily into the Credit market. Investment-grade CDS traded as high as 65 bps Friday morning, the high since November 2020 (ending the week up 3 to 61bps). High-yield CDS jumped to 358 early Friday (high since November 2020), before closing the week up 13 to 343 bps. Bloomberg: “Junk Sees Biggest Loss in 15 months as Risk Cut.” Junk bond funds saw outflows jump to a chunky $2.81 billion, making three straight weeks of negative flows.

Bank CDS were under notable pressure. JPMorgan CDS jumped six this week to 60 bps, the high since July 2020. BofA CDS rose seven to 62 bps (high since July 2020), and Citi seven to 68 bps (July 2020). Goldman Sachs CDS gained four to 79 bps. It was curious to see the major U.S. financial institutions on top of this week’s global bank CDS leaderboard (and, for the most part, year-to-date).

“Munis Post Biggest Weekly Slump in 11 Months as Rate Hikes Loom.” After all the hullabaloo about the hawkish Fed, 10-year Treasury yields this week added one basis point (to 1.77%). WTI crude jumped another $1.68 to $86.82, with the Bloomberg Commodities Index’s January gain rising to 8.0%.

Heightened instability is a global phenomenon. European high-yield CDS surged 16 to 285 bps, trading Friday to a 15-month high. Bloomberg: “Global Junk-Bond Markets Wobble, Spelling Risk for M&A Financing.” Asian equities were under heavy selling pressure. Major indices sank 6.0% in South Korea, 5.6% in Hong Kong, 4.8% in Australia, 3.1% in India, 3.0% in Taiwan and 2.9% in Japan. “Risk off” saw the Dollar Index jump 1.7%, with a lot of EM and “carry trade” currencies taken out to the woodshed.

While global markets are generally synchronized to the downside, it’s notable that China joins the U.S. for some of the heftier losses. The Shanghai Composite sank 4.6% this week, with a 2022 decline of 7.6%. The growth-oriented ChiNext Index dropped 4.1%, boosting y-t-d losses to 12.5%. This week’s self-off is notable for rebuffing recent rate cuts and measures to loosen real estate finance.

January 28 – Bloomberg: “Chinese stocks extended their nearly $1.2 trillion rout this month even as mutual funds, state media and companies all intensified efforts to support the market. At least 15 mutual funds have committed to buying their own equity-focused products in the past couple of days, a move that may have been coordinated. A series of recent articles in state media have touted the attractiveness of Chinese stocks on valuation and policy support, with the Securities Times calling the act of the funds ‘setting a good example.’”

January 28 – Bloomberg (Rebecca Choong Wilkins): “Fresh signs of contagion are rippling through China’s property industry, with a spate of auditor resignations deepening concerns about developers’ financial health in the run-up to earnings season. Investors moved to pare risk exposure on Friday after Hopson Development Holdings Ltd. said its auditor PricewaterhouseCoopers resigned after receiving insufficient information to complete auditing procedures. Hopson Development’s dollar bonds were on pace for record declines, while its shares fell the most since 2009. China’s high-yield dollar bonds dropped at least 3 cents on the dollar…”

Developer shares were slammed 7.5% this week, reversing almost all the sector’s recent rally. Industry leader Country Garden saw its bond yields surge 170 bps this week to 9.07%. And while developer bonds were generally mixed for the week, the impact of recent policy measures meant to boost the sector appear short-lived.

January 26 – Bloomberg: “On the surface, the recent land auction by the Chinese city of Rizhao appeared routine. There were four bids, pushing the price up 11% to $170 million. A closer look reveals something curious: The offers were reportedly made by a finance entity owned by the Rizhao government, meaning the city effectively sold land to itself. Across China, local government financing vehicles have replaced cash-strapped property developers as the biggest buyers of land…, stoking fresh concerns over the ability of these off-balance sheet borrowers to repay a debt pile that tops $8.4 trillion by some estimates. In nine of 21 large Chinese cities that packed in land sales over the last two months of 2021, at least half of the plots were bought by these so-called LGFVs… Some of these purchases were worth billions of dollars.”

Worries about off-balance sheet liabilities. Fear auditors could flee the developer sector. Concerns as to who is behind land purchases. It all has the inklings of incipient systemic confidence issues. It’s worth noting that the big Chinese banks are seeing CDS prices quietly drift higher. This week saw China Construction Bank CDS rise two to 64 bps; China Development Bank rose three to 61 bps; Industrial & Commercial Bank of China added two to 64 bps; and Bank of China CDS increased two to 63 bps. China sovereign CDS was back above 50 bps (up 2.5 this week), after beginning the month at 40 bps (early-September at 32 bps).

For a while now, my analytical framework has focused on the interplay of two separate yet interdependent Chinese and U.S. Bubbles. That China’s Bubble is faltering significantly elevates U.S. Bubble risk – and vice versa – which essentially places a world of Bubbles in jeopardy.

Global markets have entered a highly uncertain and volatile backdrop. The White House warns that a Russian invasion of Ukraine could be “imminent.” The Beijing Winter Olympics opening ceremony is next Friday, with closing ceremonies on the 20th. Putin is expected to attend opening festivities and meet directly with Xi in Beijing. While Russia has orchestrated a couple invasions during recent Olympics, I doubt Putin would risk displeasing Xi, while it’s difficult to believe Xi would embrace a highly destabilizing development as his nation showcases such a prestigious global occasion. Yet mobilizations – Russian and NATO – will continue, and the standoff will surely intensify.

There have been record put option purchases over recent sessions. February options expiration is on the 18th. I’d be prepared for a volatile few weeks.

Original Post: 29 January 2022


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