TSP Smart: Inverted Tail Spin

Michael Bond: Forgive my analogies. As I read Doug’s post this week, it came to me that the Fed’s abrupt maneuver of reversing from buying assets to selling assets while the markets are peaking at very high altitude is exactly what would induce a fighter into a tail spin. We already had one in the March of 2020. And just like running our emergency checklist in fighters to regain control, the Fed performed their emergency response with 11 money printing operations.

Except the markets managed to turn up again to break record altitude records. And here we are with the Fed performing a more aggressive maneuver and I fear we will end up in an inverted tail spin. Inverted tail spins require much more altitude loss to recover. In my first fighter, the emergency procedure had only one step – eject. There was no way to fly out of an inverted tail spin in a F-111.

All the conditions are ripe for that inverted tail spin in the markets. Historic levels of debt, stock valuations 50% higher than 1929 and 2000 levels, China’s apartment bubble imploding as they go into a losing COVID lockdown leading to triple global supply constraints: China, the war, and the past shutdown. Then there is raging inflation which negates the procedures from a normal spin. Inflation is our inversion.

Excerpts:

A $95 billion monthly reduction of assets (removal of monetary stimulus) would be a case of the Fed Playing with Fire. If markets remain stable, the Fed can surely proceed to extract some of these funds. Market stability, however, is today “a big if”. Risk of a destabilizing bout of de-risking/deleveraging remains elevated. And as yields have spiked higher, talk has returned to liquidity issues in Treasuries, MBS and interest-rate hedging markets. 

With inflation breathing down their necks, the Fed has commenced what markets now anticipate will be the most aggressive tightening cycle since 1994. Additional context is helpful. From my analytical perspective, if Fed hikes meet current market expectations, it would be the FIRST actual tightening cycle since 1994.

That cycle’s acute bond and derivatives market instability spurred a major shift in the execution of Fed interest-rate policymaking. Going forward, the Fed would be compelled to signal well in advance its rate intentions and, when implementing higher rates, would proceed with caution so as to not upset the markets. It was the dawn of New Age Pain-Free “Tightening.” And this evolution in monetary doctrine did absolute wonders for the financial markets, and, in particular, leveraged market speculation. Nice and gradual rate moves could now unfold without inducing a tightening of Credit or financial conditions more generally.

It was a miracle. Permanently loose financial conditions were left unchecked to fuel market and economic booms. Of course, runaway excess would put system stability at great risk. But bursting Bubbles would see the Fed respond with whatever monetary stimulus necessary to resuscitate Bubble excess. It wasn’t that inflation was not a problem. It was that the inflationary fuel continued to gravitate to the markets, with resulting asset inflation and Bubble Dynamics. The Federal Reserve could just focus on ensuring robust asset markets, while basically disregarding consumer price inflation.

The previous cycle enjoyed incredible staying power, and it will be difficult for most to accept that such a rewarding era has run its course.

Playing with Fire

by Doug Noland

Rate markets are now pricing in a 2.54% Fed funds rate by the FOMC’s December 14th meeting. This is up from 33 bps in October, 82 bps to begin 2022, and 1.30% on March 1st. For the most part, the stock market took this major ratcheting up of tightening expectations in stride.

Curiously, the bond market had seemed determined to remain sanguine. Ten-year yields were at 1.73% on March 4th, with yields only 113 bps above the three-month T-bill rate (25bps over 2-yr Treasuries). Bonds largely dismissed talk of a hawkish rate cycle, not to mention billowing inflationary pressures.

Ten-year Treasury yields surged 32 bps this week to a three-year high 2.71%, with the spread versus three-month T-bills up to 182 bps. It’s worth noting that 10-year yields were trading at 2.45% Tuesday morning when the headline hit, “Brainard: Fed to Shrink Balance Sheet at Rapid Pace as Soon as May.” Yields immediately surged 10 bps and didn’t look back. The Nasdaq100 Index sank 2.2% in Tuesday trading, and was down another 2.2% Wednesday. The Semiconductors dropped almost 7% in two sessions, while the Broker/Dealers were down almost 7.5% at Thursday’s intraday lows.

Markets have generally been okay with even the prospect of an aggressive rate hike cycle. But when talk shifts to the Fed’s balance sheet, things instantly turn dicey. Brainard was front-running the markets’ anxiously awaited – and Powell promised – QT (“quantitative tightening”) details in Wednesday’s release of the minutes from the FOMC’s March 16th meeting: “Participants generally agreed that monthly caps of about $60 billion for Treasury securities and about $35 billion for agency MBS would likely be appropriate. Participants also generally agreed that the caps could be phased in over a period of three months or modestly longer if market conditions warrant.”

A $95 billion monthly reduction of assets (removal of monetary stimulus) would be a case of the Fed Playing with Fire. Granted, there is currently a buffer of excess funds (remnants of the latest $5TN QE program) in the system. If markets remain stable, the Fed can surely proceed to extract some of these funds. Market stability, however, is today “a big if”. Risk of a destabilizing bout of de-risking/deleveraging remains elevated. And as yields have spiked higher, talk has returned to liquidity issues in Treasuries, MBS and interest-rate hedging markets. 


I am reminded of how abruptly the Fed shifted in September 2019 from gradual balance sheet reduction to another round of QE.  Liquidity is the weak spot for highly levered market Bubbles.

This week was notable for the rout in EM bonds. Local currency yields were up 76 bps in Hungary (6.80%), Poland 66 bps (6.03%), Brazil 58 bps (11.89%), Mexico 39 bps (8.70%), Czech Republic 27 bps (4.04%), and Romania 29 bps (6.47%). Dollar-denominated EM bonds were also pounded. Turkey’s dollar-denominated bond yields surged 43 bps (8.71%), Chile 38 bps (3.67%), Indonesia 27 bps (3.44%) and Saudi Arabia 23 bps (3.39%). Ten-year yields were up 20 bps in Canada (2.63%), 14 bps in the UK (1.75%), and 13 bps in Australia (2.96%)

For now, global bond yields are in the throes of a sharp upward adjustment. German bund yields jumped 15 bps this week to a more than four-year high 0.70%, with two-year German yields up 11 bps to the high (0.05%) all the way back to June 2014. With a big election Sunday, French yields spiked 24 bps to highs (1.25%) since July 2015 (spread to bunds widest since March 2020). Italian yields surged 30 bps to an almost three-year high 2.40%. Greek yields jumped 22 bps (2.88%), Portugal 26 bps (1.64%), and Spain 23 bps (1.70%), all multi-year highs that are stirring memories of the European “doom loop.” European bank stocks dropped 2% this week, with the euro sinking 1.5% (near May 2020 lows).

With inflation breathing down their necks, the Fed has commenced what markets now anticipate will be the most aggressive tightening cycle since 1994. Additional context is helpful. From my analytical perspective, if Fed hikes meet current market expectations, it would be the FIRST actual tightening cycle since 1994. 


That cycle’s acute bond and derivatives market instability spurred a major shift in the execution of Fed interest-rate policymaking. Going forward, the Fed would be compelled to signal well in advance its rate intentions and, when implementing higher rates, would proceed with caution so as to not upset the markets. It was the dawn of New Age Pain-Free “Tightening.” And this evolution in monetary doctrine did absolute wonders for the financial markets, and, in particular, leveraged market speculation. Nice and gradual rate moves could now unfold without inducing a tightening of Credit or financial conditions more generally.


It was a miracle. Permanently loose financial conditions were left unchecked to fuel market and economic booms. Of course, runaway excess would put system stability at great risk. But bursting Bubbles would see the Fed respond with whatever monetary stimulus necessary to resuscitate Bubble excess. It wasn’t that inflation was not a problem. It was that the inflationary fuel continued to gravitate to the markets, with resulting asset inflation and Bubble Dynamics. The Federal Reserve could just focus on ensuring robust asset markets, while basically disregarding consumer price inflation.

The previous cycle enjoyed incredible staying power, and it will be difficult for most to accept that such a rewarding era has run its course. Consumer price inflation has returned with a vengeance to become a critical problem. And it’s amazing to witness the transformation of the Fed “doves”: Inflation actually hurts the least fortunate the most. Centuries of history; Monetary Management 101.

Federal Reserve governor Lael Brainard, from her speech “Variation in the Inflation Experiences of Households,” April 5, 2022: “Today, inflation is very high, particularly for food and gasoline. All Americans are confronting higher prices, but the burden is particularly great for households with more limited resources. That is why getting inflation down is our most important task, while sustaining a recovery that includes everyone.”

It is of paramount importance to get inflation down. Accordingly, the Committee will continue tightening monetary policy methodically through a series of interest rate increases and by starting to reduce the balance sheet at a rapid pace as soon as our May meeting. Given that the recovery has been considerably stronger and faster than in the previous cycle, I expect the balance sheet to shrink considerably more rapidly than in the previous recovery, with significantly larger caps and a much shorter period to phase in the maximum caps compared with 2017–19. The reduction in the balance sheet will contribute to monetary policy tightening over and above the expected increases in the policy rate reflected in market pricing and the Committee’s Summary of Economic Projections. I expect the combined effect of rate increases and balance sheet reduction to bring the stance of policy to a more neutral position later this year, with the full extent of additional tightening over time dependent on how the outlook for inflation and employment evolves.

April 5 – CNBC (Jeff Cox): “San Francisco Fed President Mary Daly is worried about inflation, telling an audience… that the high cost of living is causing a heavy burden on society. ‘I understand that inflation is as harmful as not having a job,’ she said, ‘that if you have a job and you can’t pay your bills, or I feel like I can’t save for what I need to do, then that’s keeping you up at night.’ ‘And our goal is to make sure that people don’t stay up worrying about whether their dollar today will be the same and worth a dollar tomorrow,’ she said…”

Heads shaking, market professionals these days must be questioning who on the FOMC has their interests at heart. Still, markets believe the Fed has their backs. The Fed has no choice, unless they are willing to risk seeing everything come crashing down.

After a few decades of drifting ever deeper into the muck of inflationism, it’s at least encouraging to see the Fed commence the return to a more traditional inflation focus. I remain skeptical of this tightening cycle’s staying power. It’s also worth noting the unity around the concept of a “neutral rate” – “the rate that neither restricts nor spurs economic growth.” While an interesting theoretical concept, the “neutral rate” does not exist in reality, and thus is a dead end as a guide for policymaking.

Markets these days dictate system Credit Availability and financial conditions more than ever before. And there is certainly no “neutral” Federal Reserve rate that will magically return even a semblance of equilibrium to Bubble markets. There is no “neutral rate” as this point to smooth the boom and bust cycle that has haunted our system for the past 30 years.

The thought that the Fed can raise rates to the right level to orchestrate a coveted “soft landing” is no more than wishful thinking. Instead, the tightening cycle appears poised to proceed until “something breaks.” And when exactly that occurs has much more to do today with speculative market dynamics and geopolitics than with a particular interest-rate.

It is also important to appreciate that this is the first tightening cycle since the adoption of QE. This significantly complicates both the market environment and the Fed’s tightening challenge. The Fed has too many times in the past responded to market stress with pampering rate cuts and QE liquidity support. Bonds, today seeing Bubble fragility everywhere, price in the likelihood of future rate cuts and additional aggressive Fed purchases. And the resulting artificially low (negative real) bond yields work to sustain loose financial conditions and attendant inflationary pressures. This dynamic is forcing even the Fed doves to speak hawkishly of an aggressive tightening cycle.

I have posited for a while now that China Bubble fragility was a significant factor in the U.S. and global bond markets’ propensity to disregard inflation risk. The Chinese economy and financial system these days face a litany of serious risks.

April 8 – Reuters (Brenda Goh, Roxanne Liu, David Stanway and David Kirton): “Shanghai on Friday announced a record 21,000 new cases and a third consecutive day of COVID testing as a lockdown of its 26 million people showed no sign of easing and other Chinese cities tightened curbs – even in places with no recent infections… Shanghai’s outbreak has surpassed 130,000 cases in total, far exceeding the approximately 50,000 symptomatic cases recorded in the original outbreak in the central city of Wuhan… Nomura this week estimated that 23 Chinese cities have implemented either full or partial lockdowns. The cities collectively are home to an estimated 193 million people and contribute 22% of China’s GDP. These include Changchun, a major manufacturing hub that has been locked down for 28 days.”

Beijing has a real mess on its hands. “Zero tolerance” has failed to contain highly transmissible Omicron. Major financial and trade hub Shanghai, with its 25 million citizens, suffers 20,000 new daily cases and is locked down indefinitely.

Adopting draconian lockdown restrictions for a chunk of an economy to contain a virus that, in the vast majority of cases, is associated with only mild symptoms (or asymptomatic) sure appears irrational. But China has over-invested in apartments, commercial buildings and manufacturing capacity at the expense of its healthcare system. It lacks the capacity in most cities to manage even a moderate surge in Covid infections, while available services in the countryside are limited in the best of circumstances. While China has high vaccination rates, its older population is less vaccinated and more vulnerable. There are also questions as to the effectiveness of Chinese vaccines, though large numbers of recent asymptomatic cases are encouraging.

From Friday’s Wall Street Journal (Lingling Wei, Stella Yifan Xie and Natasha Khan): “Yet Covid-19 has since become more infectious, the Chinese economy more fragile and the stakes for Mr. Xi higher. He seeks a third five-year term as China’s leader later this year. ‘Xi is boxed in,’ said Minxin Pei, a professor of political science at Claremont McKenna College and editor of China Leadership Monitor, a quarterly journal on Chinese politics. ‘Changing the zero-Covid policy now would raise more questions about his leadership. It’s politically untenable.’”

China’s Omicron wave will pass. They could be in for some rough months, especially if Beijing doesn’t ease up on “zero tolerance.” China’s economy was faltering prior to Omicron. Meanwhile, risk to already strained global supply chains appears significant. But when it comes to Covid, analysts and markets have grown comfortable “looking over the valley.” I would warn against complacency.

Covid’s timing continues to utterly amaze. Beijing’s Covid management gloating is coming back to slap them right across in the face. And Omicron is having its day after Chinese developers have suffered a crisis of confidence and apartment sales have collapsed. These onerous – borderline inhumane – lockdown measures come with Chinese citizens’ heads already spinning. Apartments were supposed to be a guaranteed path to wealth accumulation. Robust economic growth was virtually guaranteed. Adept management by the great Beijing meritocracy was to ensure ever increasing wealth and prosperity. Moreover, stability and security were the communist party’s overarching mandate.

The headline for the above WSJ article: “Shanghai’s Omicron Outbreak Corners Chinese Leader.” From the FT: “Shanghai Lockdown Tests the Limits of Xi Jinping’s Zero-Covid Policy.” Bloomberg: “Shanghai’s Covid Lockdown Risks Becoming Biggest Crisis of Xi’s Tenure.” And from the New York Times: “The ‘China Model’ is Being Tested by Covid, Russia and the Economy. And It’s Coming Up Short.”

I don’t see signs of imminent unrest, but the Chinese people are clearly growing increasingly frustrated. Waning confidence in government management has only accelerated with the lockdowns. That Beijing was not better prepared to deal with Omicron outbreaks is not a confidence builder for a population already feeling the ground trembling beneath their feet. And how could many Chinese today not have serious questions about Beijing’s judgment now that its partner “without limits” is fighting a war with barbaric tactics and unrelenting criminal attacks on innocent civilians?

The situation in China has deteriorated so quickly that Beijing is being forced to implement aggressive stimulus measures. Rate cuts could come as early as next week. I expect stimulus measures to be even less effective than the Fed’s series of 2007 and early-2008 rate cuts. Such measures work like magic when speculative impulses remain energized – when Bubbles are inflating. Their potency diminishes rapidly as confidence wanes – when Bubbles are deflating and Greed has shifted to Fear. I doubt general confidence recovers much post-Omicron.

The various impacts the war in Ukraine will have on China are unknown. Revelations of atrocities in Bucha, Mariupol, Borodianka, the missile attack on the train station in Kramatorsk, and brutality against civilians in scores of cities and villages throughout Ukraine, have changed the trajectory of the conflict. The West is more unified and determined that Russian aggression cannot succeed. The likelihood of a negotiated settlement anytime soon seems remote.

Reuters: “The battle for Donbas will remind of World War Two with large operations maneuvers and thousands of tanks, planes and armored vehicles, Ukrainian Foreign Minister Dmytro Kuleba warned on Thursday at NATO.”

NATO will now significantly step up the flow of military assistance into Ukraine, including sophisticated S-300 air defense systems, tanks, heavy weaponry and armored vehicles, along with additional Javelin anti-tank missiles, Stingers, drones and other weaponry. With each passing week, the war in Ukraine appears less a proxy war and more a direct conflict between Russia and the U.S./NATO coalition. It’s difficult to see Russian sanctions dissolved so long as Putin is in power.

The ruble was up 6.3% this week, with Russia’s currency having now recovered the entire huge loss suffered at the start of the war. I couldn’t help but ponder China’s possible stabilizing role. Secretary of State Blinken stated the ruble’s recovery is “not sustainable.”

China a few weeks back called the West’s sanctions “outrageous.” The sanction noose now tightens by the week. Beijing was likely banking on the war being resolved quickly. But it now appears increasingly likely that Russia will require major financial, economic and military support from its partner “without limits.”

April 6 – Bloomberg: “The European Union’s foreign policy chief described a summit with Chinese President Xi Jinping as a ‘deaf dialog,’ casting doubt on how much cooperation the Asian nation will offer to end the war in Ukraine. ‘China wanted to set aside our difference on Ukraine,’ said Josep Borrell, who accompanied European leaders in talks with Xi last week. ‘They didn’t want to talk about Ukraine. They didn’t want to talk about human rights and other issues, and instead focused on the positive things.’ Borrell told the European Parliament… that ‘the European side made clear that this compartmentalization is not feasible, not acceptable,’ adding: ‘For us the war in Ukraine is a defining moment for whether we live in a world governed by rules or by force.’”

Does China pursue clandestine support for as long as it can get away with it? Or might Beijing see the writing on the wall – and make the decision to openly buttress Russia with concurrent efforts to placate the West, while scurrying to erect its side of the new economic “iron curtain”?

Everything points to Russia’s invasion of Ukraine as a history-changing development. Let’s hope it doesn’t prove the early onset of WWIII. It does, however, have the appearance of the beginning of a major global economic and financial showdown – a so-called “new world order.” That this is now unfolding with China’s economy and financial system acutely vulnerable adds complexity and great risk. It’s been my long-standing fear that Beijing would somehow blame the U.S. (and Japan) for its post-Bubble hardship. That alarming path is today more palpable than I ever could have imagined.

April 4 – New York Times (Chris Buckley): “While Russian troops have battered Ukraine, officials in China have been meeting behind closed doors to study a Communist Party-produced documentary that extols President Vladimir V. Putin of Russia as a hero. The humiliating collapse of the Soviet Union, the video says, was the result of efforts by the United States to destroy its legitimacy. With swelling music and sunny scenes of present-day Moscow, the documentary praises Mr. Putin for restoring Stalin’s standing as a great wartime leader and for renewing patriotic pride in Russia’s past. To the world, China casts itself as a principled onlooker of the war in Ukraine, not picking sides, simply seeking peace. At home, though, the Chinese Communist Party is pushing a campaign that paints Russia as a long-suffering victim rather than an aggressor and defends China’s strong ties with Moscow as vital. Chinese universities have organized classes to give students a ‘correct understanding’ of the war, often highlighting Russia’s grievances with the West. Party newspapers have run series of commentaries blaming the United States for the conflict.”

Original Post 9 April 2022


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Categories: Doug Noland, Perspectives