Doug Noland: A Changing World

The global central bank community has been wrong on inflation. Their analysis lacked objectivity and analytical vigor. Groupthink. Flatfooted. That policymakers would so misjudge on something fundamental to monetary management is a major blow to credibility. And not to be on guard after unleashing trillions of new “money” is inexcusable. The inevitable serious fallout seemed to begin this week.

The global inflation problem has been obvious for months, though central bankers were loath to upset the markets. They were hoping it would resolve itself. In the pinnacle of “asymmetric” monetary policy, central bankers have been eager to move immediately with previously unimaginable monetary stimulus. Yet fear of market disruption compelled the most gradual approach to the unwinding of stimulus measures (i.e. the Fed and ECB continue today with QE programs).

Monetary inflation went much too far – then ran amuck. Over the past two years, unprecedented monetary stimulus pushed speculative asset Bubbles into historic manias. It also stoked inflationary dynamics that had already attained significant momentum from years of loose finance. Focused on market fragilities, central bankers were willing to dismiss inflation risk and stick with their newfound gradualist doctrine. And gradualism played an integral role in promoting only greater market excess, while ensuring dangerously deep-rooted inflation.

Following the ECB’s December 16th meeting, Christine Lagarde stated that “monetary accommodation is still needed for inflation to stabilize at our 2% inflation target over the medium term,” adding that it was “highly unlikely” the ECB would begin raising rates until at least 2023.

February 2 – Reuters (Balazs Koranyi and Francesco Canepa): “Euro zone inflation rose to a new record high last month, defying expectations for a big drop and piling pressure on the European Central Bank to finally admit that price growth is not as temporary and benign as it has long predicted. Inflation across the 19 countries that share the euro picked up to 5.1% in January from 5% in December, far outpacing expectations… for a drop to 4.4%… The reading reflected soaring energy prices as expected but unprocessed food inflation also jumped more than 5%, a potential source of political pressure on the ECB as fuel and food prices impact ordinary voters quickly. Inflation is now more than twice the ECB’s 2% target.”

It’s worth noting that German inflation was a stronger-than-expected 5.1% annualized during January. Spain reported CPI of 6.1%, Italy 5.3%, Austria 5.1%, and France 3.3%. They were left with no alternative. Christine Lagarde and the ECB had to pivot from an embarrassingly indefensible position.

February 3 – Financial Times (Martin Arnold and Tommy Stubbington): “Christine Lagarde refused to rule out raising interest rates this year in response to the European Central Bank’s ‘unanimous concern’ about soaring prices, fuelling increased investor bets that it will raise borrowing costs several times in 2022. The ECB president said inflation risks were ‘tilted to the upside’… She backed away from earlier comments playing down the chances of the bank raising rates in 2022 because of ‘the situation having changed’ and said it was ‘getting much closer’ to hitting its target on inflation. Lagarde said there was ‘consensus’ among ECB policymakers on its decision to keep rates unchanged and to pursue a ‘step-by-step” reduction in bond purchases this year. But a person familiar with the council said ‘one or two’ of its members had called for an immediate tightening of policy.”

In our age of levered global speculative finance, there are outsize costs associated with policy mistakes: too much excess-fueling leverage leads eventually to destabilizing de-risking/deleveraging dynamics. For a while now, periphery European debt markets have been at the epicenter of epic policy-induced market distortions. It was a bloody week.

Italian 10-year yields surged 46 bps this week to 1.75%, the high since May 2020. Greek yields jumped 40 bps to 2.25%, the highest level since April 2020, with yields already up 94 bps y-t-d. Yields surged 35 bps in Portugal (0.97%) and 34 bps in Spain (1.04%). French yields jumped 28 bps to 0.64% – the highest yield since January 2019. German yields rose 25 bps to a positive 0.21%, also the high since January 2019.

“Periphery” European debt (Italian and Greek in particular) have arguably been among the most mispriced sovereign bonds in the world. With Italy’s debt-to-GDP above 155% and Greece’s surpassing 200%, market repricing risk is extreme.

While markets are far from 2012, it’s worth recalling Europe’s “doom loop” dynamic of vulnerable European banks exposed to large “periphery” bond holdings. Curiously, European banks stocks were higher this week, with the STOXX 600 Bank Index’s 2.4% advance boosting y-t-d gains to 9.8%. Alarm, however, was apparent in European Credit. Not surprisingly, the major European banks jumped to the top of the CDS leaderboard for the week (i.e. UniCredit up 7 to 82bps). An index of European subordinated bank CDS jumped 10 to a 15-month high of 138 bps (traded as high as 144bps intraday Friday). An index of European high-yield bond CDS jumped 29 to a 15-month high 315 bps.

It wasn’t only the ECB and European bond yields that shook the world of finance this week. The Bank of England raised rates 25 bps in consecutive meetings, with four of nine committee members (apparently more concerned with inflation risk and BOE credibility than market reaction) pressing for a 50 bps hike. Markets are now pricing in short rates of 1.50% by September. UK 10-year yields jumped 17 bps this week to a 26-month high 1.41%. Europe this week became a full-fledged active participant of Global Crisis Dynamics.

February 4 – Reuters (Marc Jones): “The world’s top central banks are about to embark on ‘the largest quantitative tightening in history’, analysts at Morgan Stanley said…, estimating that $2.2 trillion worth of support would disappear over the next 12 months. A surge in global inflation is forcing the U.S. Federal Reserve, European Central Bank, Bank of Japan and Bank of England to reel in the support measures used during the coronavirus pandemic.”

Markets occasionally offer subtle hints. Of late, they’re coming persistently and not so subtly. Thursday trading is a case in point. Besides Lagarde’s awkward pivot and the Bank of England’s urgency, Facebook (“Meta Platforms”) dropped an earnings mega bombshell. Priced for endless growth, investors were slammed by the reality of a hyper-competitive environment with major threats to the company’s business model. Welcome to the technology mania aftermath, where speculative Bubbles and resulting ultra-loose finance ensured massive over-investment and “arms race” dynamics.

February 3 – Bloomberg (Thyagaraju Adinarayan and Jan-Patrick Barnert): “Meta Platforms Inc.’s one-day crash now ranks as the worst in stock-market history. The Facebook parent plunged 26% Thursday on the back of woeful earnings results, and erased about $251.3 billion in market value. That’s the biggest wipeout in market value for any U.S. company ever.”

That was Thursday. What about Friday?

February 3 – Bloomberg (Jeran Wittenstein and Tom Contiliano): “ Inc. gave the market back what Meta Platforms Inc. took away — or at least a big chunk of it. The e-commerce giant’s shares surged 14% on Friday, adding about $191 billion in market value, after investors cheered its fourth-quarter earnings report. The advance was the biggest single-day gain in U.S. stock market history…”

Markets these days couldn’t be more unstable or, seemingly, accident prone. That $251 billion of perceived wealth in one company’s stock can instantly evaporate into thin air should give pause to market participants of all stripes. And it should be unnerving that perceived wealth in stocks and bonds now shows a tendency toward simultaneous spontaneous combustion.

Meanwhile, major U.S. stock indices all posted solid gains for the week. Between the rally and the retreating VIX, the market is working its magic to destroy the value of put options purchased recently to hedge market risk. It’s now only two weeks until February options expiration.

And while stocks reversed higher, I doubt many sophisticated market operators will enjoy a relaxing weekend. Things seem to turn more ominous by the week. In particular, the nexus between surging bond yields, tightening financial conditions, and the faltering tech Bubble was on full display Thursday. Investment-grade CDS closed the week up three bps to a 15-month high 64 bps – with the majority of the gain coming on Thursday. High-yields CDS rose 13 this week to a 15-month high 356 bps – gaining 11 bps during Thursday trading.

Financial conditions have begun to tighten. They’re not, however, tightening quickly enough to restrain surging commodities prices. WTI crude jumped another $5.49 this week to $92.31, increasing early-2022 gains to 23%. The Bloomberg Commodity Index’s 2.3% advance boosted y-t-d gains to 10.5%.

Markets are now confronting the problematic dynamic of surging Treasury and sovereign yields, along with widening corporate Credit spreads and rising CDS prices. Ten-year Treasury yields jumped 14 bps this week to a more than two-year high 1.91% (2-yr yields up 15bps to 1.31%). The Bloomberg Long Corporate spread index gained three bps this week to a 14-month high 1.49%. Benchmark MBS yields surged another 19 bps (up 67bps y-t-d!) to 2.73%, the high since the March 2020 crisis spike. All indications point toward mounting pressures on levered players to rein in some risk and leverage.

The market environment has changed – A Changing World. Unfolding deleveraging will place mounting pressure on various faltering Bubbles. And no sector today appears more vulnerable than the expansive technology super-industry. For years, a tsunami of speculative finance fueled the loosest financial conditions ever, replete with record corporate debt sales, stock issuance, IPOs, SPACs, M&A, private-equity, venture capital and such.

The vast technology universe – the usual computer and communication technologies joined by big data and the cloud, AI, quantum computing, blockchain, robotic automation, EV and autonomous vehicles, solar and green energy, Internet of Things, 5G, virtual reality, wearable tech, 3D printing, cybersecurity, drones, biomedical and telehealth, and on and on. It’s been such an extended period of overabundance of cheap finance available for just about anything.

The underlying economics of an enterprise have been virtually inconsequential. The upshot has been a proliferation of tens of thousands of loss-making ventures whose existence depends on easily accessible finance. In Austrian economic terms, it’s a “Bubble economy” structure that has been feasting on ever larger amounts of cheap and indiscriminate money and Credit.

The significantly tighter financial conditions necessary to contain inflationary dynamics place the aged “tech” Bubble in peril. And the rapidly rising risk of faltering market and industry Bubbles will pressure a vulnerable corporate debt market. High-yield bond funds suffered outflows of $4.0 billion this past week. At $6.5 billion, January was a record month for high-yield fund outflows. Resilient throughout 2021, the junk bond market appears increasingly susceptible. We’ve witnessed the first crack in the equities Bubble. Things turn more serious when the next leg of instability includes the interplay of a faltering corporate debt market.

And within the “A Changing World” theme, I would be remiss for not highlighting this era’s Olympic spirit.

There is no limit to what we can achieve when we work together – for peace, for human rights, and for healthy lives and wellbeing for everyone.” UN Secretary António Guterres, February 4th, 2022

February 4 – Reuters (Andrew Osborn and Mark Trevelyan): “China and Russia proclaimed a deep strategic partnership on Friday to balance what they portrayed as the malign global influence of the United States as China’s President Xi Jinping hosted Russia’s Vladimir Putin on the opening day of the Beijing Winter Olympics. In a joint statement, the two countries affirmed that their new relationship was superior to any political or military alliance of the Cold War era. ‘Friendship between the two States has no limits, there are no ‘forbidden’ areas of cooperation,’ they declared, announcing plans to collaborate in a host of areas including space, climate change, artificial intelligence and control of the Internet. The agreement marked the most detailed and assertive statement of Russian and Chinese resolve to work together – and against the United States – to build a new international order based on their own interpretations of human rights and democracy.”

Original Post 5 February 2022

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