Esther George could not have been much clearer. Inflation is too high and must come down. Financial conditions must tighten, and securities markets are a key monetary policy transmission mechanism. And the Fed today has little clarity on how far this tightening process will need to go.
The “world” – certainly including Market Structure – has gone through monumental change since the last real tightening cycle back in 1994. The Fed has lost control.
Michael Bond: I can not imagine a worse policy mistake than the Fed’s using the “wealth effect” from asset bubbles to attempt to boost economic spending. First in housing, then in everything. It does more damage in two ways: 1) It allowed unproductive debt to pile up globally, and 2) it caused misallocation of wealth away from economic growth and into the easy money speculative bets. And as we have repeatedly learned, the casino skims profits on the way up and leaves massive losses hidden in derivatives and balance sheets.
Or as Doug says, “Ponzi’s do not work in reverse”. The Fed did not lose control recently. They lost control long ago when they decided to continue emergency monetary policy after the emergency ended in 2010. In other words, the only way to prevent a bust is to avoid the boom. Avoid the bubbles. Too late.
More on the New Cycle
By Doug Noland
The thesis is one of secular change – an extraordinary multi-decade Bubble period transitioning (in a highly destabilizing manner) to a most uncertain New Cycle. Historical perspective is crucial.
May 19 – Bloomberg (Steve Matthews): “Federal Reserve Bank of Kansas City President Esther George said the ‘rough week in the equity markets’ was not surprising, partially reflecting the central bank’s policy tightening, and doesn’t alter her support for half-point interest-rate hikes to cool inflation. ‘I think what we are looking for is the transmission of our policy through markets’ understanding that tightening should be expected,’ George said… ‘It is one of the avenues through which tighter financial conditions will emerge… Right now, inflation is too high and we will need to make a series of rate adjustments to bring that down… We do see financial conditions beginning to tighten so I think that’s something we’ll have to watch carefully. It’s hard to know how much will be needed.’”
Esther George could not have been much clearer. Inflation is too high and must come down. Financial conditions must tighten, and securities markets are a key monetary policy transmission mechanism. And the Fed today has little clarity on how far this tightening process will need to go.
The “world” – certainly including Market Structure – has gone through monumental change since the last real tightening cycle back in 1994. The Fed has lost control.
It was only during the early-nineties Greenspan era that financial conditions came to play such a prominent role in policymaking. He aggressively manipulated the yield curve (slashed short rates 5 percentage points in less than two years to a three-decade low 3% as of Sept. 1992), creating an extraordinarily profitable (borrow short/lend long) “carry trade” for the severely impaired U.S. banking system. Financial history was fundamentally altered, as Fed policy created enormous easy profits for the fledgling leveraged speculating community. The 1994 bond bust would have posed an existential threat to the hedge fund industry, if not for the powerful GSE liquidity backstop.
Greenspan came to relish the incredible power he could wield over system Credit, market liquidity, financial conditions and economic development. Moreover, the Federal Reserve system emerged from 1994’s acute speculative deleveraging and market instability with a new doctrine of avoiding policy measures that could unleash a “risk off” tightening of financial conditions.
Since 1994, so-called “tightening” cycles have been gradual and timid affairs, with the clear intention of avoiding bouts of de-risking/deleveraging. Indeed, Washington would move aggressively to thwart stress building on the leveraged speculating community. Bouts of late-nineties instability were met by rate cuts, massive GSE liquidity injections, and Fed-orchestrated bailouts. Between 1994 and 2003, GSE assets inflated $2.254 TN or 360%. With accounting fraud curbing the GSE’s capacity for market liquidity backstops, it was then left to the Fed and QE to deal with 2008’s de-risking/deleveraging mayhem.
I often ponder analysis of the traditional gold standard monetary regime. Pegging Credit expansion to the supply of gold reserves proved a powerful restraint on monetary excess and inflation. Equally influential but less appreciated, assurance that policymakers were committed to the stability of the regime was fundamental to its success. Market operators well understood the nature of policy responses if the system began to diverge from general stability. Importantly, mounting excess would be predictably countered with effective tightening measures. Wise to the process, speculators would bet on a return to stability – trading activity that would tend to support system stabilization. Importantly, a stable monetary regime operated with inherent self-correcting and adjusting mechanisms. Indeed, the interplay of policymaking and speculation worked as an inherent stabilizing mechanism.
To more clearly grasp the current predicament, a key is to appreciate that the policymaking and speculation nexus has worked as a destabilizing mechanism inherently reinforcing excess for decades. Central banks repeatedly responded to financial excess and resulting market instability with measures that only more aggressively accommodated leveraged speculation.
The egregious leverage and speculative excess that precipitated the 1994, 1998, 2000-2002 and 2008 crises each time engendered monetary policy measures only more advantageous to leveraged speculation (i.e. rate cuts, bailouts, liquidity injections, broadening securities purchases, and only more telegraphed and gradual rate increases). Decades of this deeply flawed monetary regime promoted a gargantuan leveraged speculating community that bet only more aggressively on increasingly egregious monetary inflation.
Stealthily, leveraged speculation evolved into the marginal source of system Credit and liquidity, with limitless finance fueling historic Bubbles. And, importantly, this inherently highly unstable finance maintained a semblance of stability only so long as aggressively accommodated by loose monetary policy and conditions
For more than 25 years, the Fed operated with little concern for a rapid rise in consumer prices. Over time, the primary policy focus shifted to ensuring that booming asset market inflation sustained loose financial conditions and attendant robust economic expansion. The cycle has now clearly shifted. Consumer inflation has become a serious issue and monetary policy priority. Securities market price deflation is apparently viewed by Fed officials as a necessary facet of tighter financial conditions and inflation containment.
May 16 – CNBC (Jeff Cox): “Former Federal Reserve Chair Ben Bernanke said the central bank erred in waiting to address an inflation problem that has turned into the worst episode in U.S. financial history since the early 1980s. Bernanke, who guided the Fed through the financial crisis that exploded in 2008 and presided over unprecedented monetary policy expansion, told CNBC that the issue of when action should have been taken to tame inflation is ‘complicated.’ ‘The question is why did they delay that. … Why did they delay their response? I think in retrospect, yes, it was a mistake,’ he told CNBC’s Andrew Ross Sorkin… ‘And I think they agree it was a mistake.’”
Why did the Fed delay? Because they preferred to gamble on transitory inflation, rather than risk the certainty of market and economic instability unleashed by tightening financial conditions and bursting market Bubbles. Ironically, it was chairman Bernanke that advanced the policy of overtly backstopping financial markets back in July 2013.
July 10, 2013 (Reuters): “Federal Reserve Chairman Ben Bernanke said… that the U.S. central bank might have to ‘push back’ if financial conditions tightened so much as to threaten the economy’s progress. ‘If financial conditions were to tighten to the extent that they jeopardized the achievement of our inflation and employment objectives, then we would have to push back against that,’ Bernanke said…”
Coming in the throes of fledgling global “taper tantrum” de-risking/deleveraging, Bernanke’s comment was interpreted as a signal that the Fed would not tolerate much market weakness. Markets rallied strongly on Bernanke’s comment and didn’t look back. De-risking/deleveraging and Crisis Dynamics quickly gained momentum when the new Fed Chair expressed willingness to tolerate tighter financial conditions (to begin having the markets stand on their own). “Risk on” then made a brisk return on the “Powell pivot,” though a bout of repo market instability in the summer of 2019 spurred a hasty revival of Fed QE. Markets were at the brink of collapse in March 2020, when the monetary floodgates were opened in historic – cycle culmination – fashion.
Not only did massive QE thwart de-risking/deleveraging, it also triggered blow-off excess throughout leveraged speculation, along with myriad manias (stocks, crypto, ETFs, options, derivatives, etc.). Not surprisingly, it also stoked already heightened price pressures into dangerous inflation dynamics. Raging leveraged speculation, runaway manias, and surging inflation were a central banker’s nightmare.
The Nasdaq100 sank 4.5% this week, boosting 2022 losses to 27.5%. Many popular hedge fund long positions have suffered huge losses.
May 17 – Bloomberg (Hema Parmar and Alex Wittenberg): “Tiger Global Management was already off to a ‘very disappointing’ first quarter, when it cut some of the biggest tech losers of 2022 from its portfolio and added others. But things went from bad to worse for Chase Coleman’s firm. It added to its stake in beleaguered online used-vehicle dealer Carvana Co., which has lost more than two-thirds of its value since the end of the quarter. It exited 83 stocks, including Netflix Inc. and Adobe Inc., while paring its holding of pandemic darling DoorDash… Meanwhile, it added just two new positions. One of them, digital banking-services provider Dave Inc., has plunged 64% since March 31. That helped fuel a 15% April decline for Tiger Global’s flagship hedge fund, extending its loss for the year to 44%.”
When things turn sour for leveraged speculation, they tend to really turn sour. Losses beget de-risking/deleveraging that begets lower prices, waning liquidity, fear, and intensifying de-risking. As 2022 unfolded, many hedge funds (and “family offices”) were holding their own despite pockets of equity market weakness. It appears that much of the industry has taken a fateful turn for the worse over recent weeks.
May 18 – Reuters (Svea Herbst-Bayliss): “Melvin Capital, once one of Wall Street’s most successful hedge funds which then lost billions in the meme stock saga, will shut down after it was hit again by this year’s market slump. Gabe Plotkin, widely regarded as one of the industry’s best traders after posting years of double digit returns, told investors that the last 17 months have been ‘an incredibly trying time.’ Plotkin had been trying to turn around the firm after being caught out in early 2021 betting against retail favorite GameStop and after being wrong footed again by tumbling markets this year. ‘The appropriate next step is to wind down the Funds by fully liquidating the Funds’ assets and accounts and returning cash to all investors,’ Plotkin wrote…”
May 15 – Financial Times (Eric Platt, Ortenca Aliaj and Nicholas Megaw): “Hedge funds focused on US equities are pulling back sharply on their bets after the longest stretch of sustained selling in more than a decade left many managers nursing stiff losses. The S&P 500 index has fallen for six weeks in a row in a tumultuous stretch that on Thursday left Wall Street’s benchmark share barometer down by almost a fifth from the peak it reached at the start of 2022… Long-short equity funds, which pitch themselves on the ability to protect client money in down markets, have lost 18.3% for the year up to and including Wednesday, according to Goldman Sachs…”
As mounting losses are reported to investors, expect a flurry of redemption requests. This will spur more selling and only steeper losses. Many will choose to sell ahead of others that will be forced to sell. It appears a particularly precarious cycle is now unfolding. And long-term readers will remember that this is not my first warning of serious unfolding issues for the global leveraged speculating community. Previous industry crises, however, were rather quickly mollified by Fed and global central bank easing measures – policies that turned increasingly reckless. With seemingly no massive market bailout in the cards, a serious de-risking/deleveraging episode will now pose an existential threat.
High-yield Credit default swap (CDS) prices surged 39 this week to 523 bps, trading intraday Friday above 530 bps for the first time since June 2020. After beginning the year at 2.78, high yield spreads to Treasuries have widened over 100 bps in three weeks to an 18-month high 4.82 percentage points. The iShares High Yield Corporate Bond ETF (HYG) has declined 2.3% this month (down 10.8% y-t-d), underperforming both the iShares Investment Grade ETF (LQD) (positive 0.1%) and the iShares Treasury Bond ETF (TLT) (negative 0.6%).
May 20 – Bloomberg (Jeannine Amodeo): “Leveraged loans remain under pressure as volatility across credit seeps into the market. What looked like a promising start to the week with five deals launching, and then a heavily oversubscribed deal for Peloton Interactive Inc., didn’t last long. Average loan prices have sunk below 95 cents on the dollar as investors flee the asset class on concerns that inflation and a potential recession will hurt heavily-indebted companies. The sell-off has brought the market for new loan and bond sales to a virtual halt, as investors just aren’t stepping in to buy deals amid concerns that prices will go even lower.”
Leveraged Loan prices dropped 3.5% over the past month, in the steepest decline since March 2020. It’s worth noting that after trading at 96.75 on February 23rd 2020, leveraged loan prices collapsed to 78.36 over the following month. And recall also that High Yield (HYG ETF) sank 22% between February 23 and March 23, 2020, while Investment Grade (LQD) dropped 12.8%.
There is surely enormous speculative leverage in high-yield bonds, leveraged loans, and throughout Wall Street “structured finance”. And at this point, high-yield finance is basically closed for new issuance. This dramatic tightening of financial conditions puts scores of negative cash-flow companies in jeopardy. And the rapidly deteriorating Credit backdrop ensures even more intense speculator de-risking/deleveraging. The likely scenario is liquidation, illiquidity and market dislocation. A run on corporate bond ETFs is a growing risk.
Barely off the ground, the Fed’s first tightening cycle in 28 years is nonetheless about to strangle high-yield finance and leveraged speculation. And this dramatic tightening of one important segment of finance has begun to deflate Wall Street’s historic Bubble in the financing of uneconomic enterprises. This will negatively impact scores of start-ups and Wall Street creations, but also Arms Race over-investment by scores of our nation’s largest companies. This dynamic surely supported this week’s 14 bps decline in 10-year Treasury yields (2.78%), along with the notable 17 bps drop in the Treasury five-year “breakeven” inflation rate (down 44 bps in three weeks to a three-month low 2.90%).
May 20 – Bloomberg (Jeannine Amodeo and Natalie Harrison): “A group of banks led by Bank of America Corp. has been forced to self-fund a $615 million loan supporting Bain Capital’s buyout of VXI Global Solutions after failing to place the debt with institutional investors, according to people with knowledge of the matter. The move allows Bain, which agreed to buy the outsourcing company from Carlyle Group Inc. earlier this year, to close the acquisition while the banks work out a solution to offload the debt, said the people…”
Bank of America CDS jumped eight this week to 104 bps, the high since April 2020. JPMorgan CDS rose eight to 99 bps (high since March 2020) and Citigroup nine to 119 bps (April 2020). Morgan Stanley (116bps) and Goldman Sachs (118bps) CDS both rose eight this week to highs since early-April 2020.
It was curious to see U.S. banks on the top of this week’s global bank CDS leaderboard. But, then again, U.S. stocks were huge underperformers. Most EM equities indices posted decent gains and European stocks were relatively stable, while the Nasdaq100 sank 4.5% and the S&P500 fell 3.0%. Meanwhile, the high-flying U.S. dollar reversed lower. Call trend reversals at your own peril. Yet it is becoming increasingly clear that a historic financial Bubble has begun to deflate in the U.S.
I have held that the Fed’s ability to sustain U.S. securities market price inflation has for decades provided key unappreciated support to our currency – offsetting unending massive Current Account Deficits and general monetary inflation (currency debasement). From this perspective, I’m increasingly on guard for a consequential shift in dollar sentiment that would catch a vulnerable market by surprise. And a weakening dollar would support precious metals and commodities prices, in the process solidifying the secular transition of Hard Asset outperformance relative to financial assets.
The renminbi rallied 1.44% versus the dollar this week. Finally, the People’s Bank of China cut benchmark interest rates (15 bps to 4.45%). This follows marginal cuts in mortgage rates. The Shanghai Composite rallied 2.0%, though reaction in the troubled developer bond universe was at best muted.
May 19 – Bloomberg: “China’s plans to bolster growth as Covid outbreaks and lockdowns crush activity will see a whopping $5.3 trillion pumped into its economy this year. The figure — based on Bloomberg’s calculation of monetary and fiscal measures announced so far — equates to roughly a third of China’s $17 trillion economy, but is actually smaller than the stimulus in 2020 when the pandemic first hit. That suggests even more could be spent if the economy fails to pick up from its current funk — a possibility raised by Premier Li Keqiang earlier this week.”
China – its citizens, bankers, corporate management teams, investment professionals, and policymakers – has no experience with collapsing apartment and financial Bubbles. They also have minimal experience managing through a major de-risking/deleveraging episode. Levered speculation has flourished over recent years. My thesis holds that colossal speculative leverage has accumulated throughout Chinese securities and derivatives markets – both from domestic and international operators. More support this week for the thesis of China finance at high-risk of dislocation.
May 20 – Bloomberg: “China’s almost-trillion dollar hedge fund industry risks worsening the turmoil in its stock market as deepening portfolio losses trigger forced selling by some managers. About 2,350 stock-related hedge funds last month dropped below a threshold that typically activates clauses requiring them to slash exposures, with many headed toward a level that mandates liquidation, according to an industry data provider. Such signs of stress were ‘close to the historical high,’ China Merchants Securities Co. analysts said in a report this month. Unusual elsewhere, the selling rules are common in China, where they were introduced to protect hedge fund investors from outsized losses. They can, however, backfire in a falling market when many funds are forced to pare their stock holdings.”
That both major pillars of the great global Bubble – the U.S. and China – face such serious de-risking/deleveraging risk is troubling, to say the least. Bottom line: The New Cycle of heightened inflation, tighter financial conditions, and great uncertainty is inhospitable to leveraged speculation. Today’s backdrop has troubling parallels to pre-Lehman 2008, with unsustainable highly leveraged holdings of mispriced securities and derivatives.
Rather than subprime mortgages as the system’s weak link, today it’s “subprime” corporate Credit. History suggests today’s festering issues in Credit derivatives and “structured finance” will prove woefully worse than anyone today appreciates. And there is little policymakers can do to remedy the situation. The cycle has changed. The amount of stimulus necessary to one more time resuscitate Bubble Dynamics would risk hyperinflation.
May 17 – Financial Times (Laurence Fletcher, Akila Quinio, Miles Kruppa and Antoine Gara): “Early last year Chase Coleman wrote to investors to celebrate the 20-year record of Tiger Global, one of the biggest winners from a technology bull market that had run since the financial crisis. Now the best-known of the so-called Tiger cub firms has become the highest-profile hedge fund casualty of the tech stock hammering as interest rates have started to rise. Tiger’s hedge fund has lost about $17bn this year…, erasing about two-thirds of the dollar gains made for investors since its 2001 launch. Coupled with losses suffered late last year, that puts the fund well below the point at which it charges investors its lucrative 20% performance fees. ‘A fall of this magnitude is rare’ in the hedge fund industry, said Amin Rajan, chief executive of consultancy Create Research. ‘Getting back to its glory days will be an Everest of a task, if the rate-hiking cycle is prolonged and severe.’”
Original Post 21 May 2022
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Categories: Doug Noland