We’re striving for context and perspective. In this incredible environment, feelings of insecurity and apprehension are inescapable. But we can work hard to minimize confusion.
A Bubble: “A self-reinforcing but inevitably unsustainable inflation.” An Experiment: “A test; trial; a tentative procedure or policy; an operation or procedure carried out under controlled conditions in order to discover an unknown effect or law.” The former definition is Noland’s and the latter Webster’s.
We are witness to momentous secular change unfolding in real time. The FOMC hiked rates 75 bps Wednesday, the largest rate boost since Greenspan’s lone 75 bps move more than 27 years ago (November 1994). For anything bigger, it’s back to the Volcker era.
The 1994 tightening cycle and attendant acute bond/derivatives market upheaval fundamentally altered Federal Reserve doctrine. It’s been gradualism ever since. All policy moves had to be well telegraphed to the markets. In effect, rates would be cautiously raised to ensure little market impact, hence no actual tightening of financial conditions.
The previous fateful cycle has run its course. Gradualism is out. Importantly, the Fed’s current objective is to meaningfully tighten financial conditions specifically to control runaway inflation. While the Fed remains as committed as ever to transparency, this comes with a major caveat: the FOMC can now be forced into changing its mind in a blink of an eye. Powell and the committee’s recently telegraphed 50 bps June hike was abruptly scrapped for 75. Fed guidance, the bedrock of bond market expectations and pricing in recent decades, has been turned to sand.
June 15 – Bloomberg (Mohamed A. El-Erian): “For its sake and that of both the domestic and global economy, the central bank desperately needs to regain control of the inflation narrative. The persistent failure to do so in the past 12 months is turning the perception of the Fed from the world’s most powerful central bank — long respected for its ability to anchor global financial stability — to an institution that too closely resembles an emerging-market bank that lacks credibility and inadvertently contributes to undue financial volatility. Regaining control of the inflation narrative is critical to the Fed’s policy effectiveness, its reputation and its political independence.”
It’s easy to agree with Mr. El-Erian: go out and regain the inflation narrative! But for the Fed to accomplish such a feat would basically require jettisoning policy doctrine that has evolved over the past three decades – the very doctrine underpinning the great Experiment in unfettered contemporary market-based finance.
Former ECB President Jean-Claude Trichet (2003-2011) was fond of saying “we never pre-commit.” The critical role of a central bank is to resolutely promote stable money and Credit. Committing to a set course only incentivizes market operators to exploit a predictable path of policy measures. Examples would include leveraged speculation to profit from future rate moves, the structure of the yield curve, currency devaluation and asset inflation more generally. In its most dangerous form, market participants push risk and speculative leverage envelopes in response to foolproof central bank liquidity and market backstops. I’m reminded of the Hyman Minsky insight, “stability is de-stabilizing.” Manipulating a false sense of stability in financial markets is ensuring trouble.
A cycle that commenced in the early nineties has run its course, and the Fed has no alternative than to adapt to new inflation realities. Tinkering with the markets proved a most slippery slope, from Greenspan to Bernanke to Yellen and Powell. Somehow, manipulating market expectations evolved to become a centerpiece of contemporary monetary management. The entire doctrine was developed with bolstering financial markets the focal point.
Trillions of liquidity were injected into the markets as the primary mechanism for inflating securities prices, loosening system finance and stimulating wealth-effect household and business spending. When resulting highly speculative markets wavered, Bernanke was there to “push back against a tightening of financial conditions.” A market downdraft early in his term had Powell executing a dizzying pivot. When cracks emerged in the summer of 2019, the Fed restarted QE. In response to collapsing Bubbles, the Fed desperately unleashed $5 TN (as global CBs added Trillions more).
The Fed is wishful thinking if it actually believes it will stabilize inflation back down near its 2% target. For a few decades, the Fed has had the luxury of directing its policy focus to the financial markets. Consumer price inflation was relatively contained and stable. It was also aberrational.
The inflating global Bubble backdrop created the perception of an expanding economic pie. The forces of cooperation and integration were powerful. Importantly, China, benefiting from a confluence of unlimited cheap finance and globalization, unleashed a historic investment boom. The resulting massive increase in the supply of low-cost manufactured goods (from China and EM more generally) was fundamental to subdued consumer price inflation in the face of historic Credit excess.
This anomalous inflationary dynamic, with asset prices rising more forcefully than consumer prices, proved powerfully self-reinforcing. Global liquidity excess fueled the ongoing investment boom, stoking both growth dynamics and insistent asset inflation. Downward pressures on goods prices, a key inflationary dynamic, were misinterpreted as manifestations of deep-seated disinflationary forces. Then, as asset Bubbles inevitably faltered, the battle cry quickly turned to a whatever it takes fight against the scourge of deflation. Increasingly fanatical monetary inflation repeatedly revived Credit, asset and economic Bubbles.
A historic cycle has, finally, come to its conclusion. Multiple Interconnected Historic Experiments are failing concurrently – unfettered global finance, inflationist central bank doctrine, market and economic structure.
History – distant and recent – teaches that Credit is Inherently Unstable. Market-based Credit, within a backdrop of central bank inflationism and resulting speculative excess, is acutely unstable. A retrograde multi-decade Experiment in central bank market manipulation and egregious monetary excess fed the misperception of financial stability and soundness – for Credit, Credit markets, stocks, derivatives and “structured finance.”
Over time, the entire global financial structure was underpinned by new paradigm central bank policy doctrine. How could governments endlessly create Trillions of new liabilities (i.e. bonds), while prices of these (increasingly unsound) securities only inflated higher? Central bank policies. Defaults – or even market illiquidity – would never be tolerated. In a world of such great uncertainty, how could the perception take hold that stocks were a sure bet to always increase in price? Central banks and their “whatever it takes” liquidity backdrop. Why is there such little concern for booms in about every type of risky lending, leveraged speculation and crazy manias? Central Banks. Better yet, how could derivatives markets willfully disregard past debacles and expand to hundreds of Trillions on the specious assumption of liquid and continuous markets?
The life of a central banker has turned incredibly more complicated. A new cycle of significantly higher and unstable inflation has taken hold. It’s the downside of global Bubble Dynamics – a shrinking pie, insecurity, angst, and disintegrating relationships and alliances – along with conflict. The Ukrainian war, tit for tat sanctions, and the new Iron Curtain. Meanwhile, cost structures over the years have inflated tremendously in previously low-cost economies China and EM more generally. And with new Inflation Dynamics now favoring energy, commodities and hard assets over suspect financial assets, central bank liquidity injections will increasingly gravitate to real things and away from securities (reinforcing consumer price inflation and imperiling the central bank market liquidity backstop).
The week’s good news – that should not be easily dismissed – was that markets made it through quarterly options/derivatives expiration without a serious accident. It was anything but a sure thing. Things were looking dicey.
Still, Crisis Dynamics have attained important momentum.
June 17 – Bloomberg (Michael P. Regan): “It was one of the most dramatic weeks in the short history of the cryptocurrency market, bookended by the type of announcements investors fear the most from a counterparty: We’re sorry, but we just can’t return your money right now. In between, a nascent technocratic industry with grand ambitions to reinvent the financial system was rocked repeatedly by echoes of past crises in the old system. It was a week of margin calls, forced selling and important collateral being exposed as way too illiquid in a time of crisis. There were rumblings of hedge-fund blowups, tales of opportunistic predatory trading, job cuts and loud denials of problems from key players proven wrong almost immediately. Amid it all, the myth was shattered once and for all that this new crypto financial system was somehow immune to – or even able to benefit from — the economic fundamentals currently punishing the old system.”
A modern day bank run, with an unsettling semblance of a collapsing Ponzi Scheme. And as spectacular as this imploding speculative Bubble has become – with millions of unsuspecting “investors” suffering painful losses – from a systemic perspective, it pales in comparison to the unfolding collapse of the Everything Bubble.
It was an especially bloody week in the equities market. In what was the week’s theme across markets, there was No Place to Hide. Indeed, the equities marketplace has mutated into a perilous minefield. The week was notable for the year’s outperforming sectors being taken to the woodshed. The Philadelphia Oil Services Index collapsed 19.8%. The “defensive” Dow Jones Utilities Index was hammered 9.5%. The materials and metals stocks, relative bright spots in bear market darkness, succumbed to the gloom. The S&P500 Materials Index fell 8.3%, and the Philadelphia Gold & Silver Index (XAU) sank 8.7%
And on the subject of “No Place to Hide,” heightened currency market instability deserves comment. After trading below 1.00 late in Wednesday trading, the Swiss franc (vs. $) approached 1.04 in Thursday’s and Friday’s sessions (following the SNB’s surprise rate hike). Reaching a 105.79 intraday high late in Wednesday trading, the Dollar Index then suffered a quick 2.2% downdraft into Thursday afternoon – before recovering. The dollar/yen traded at a 24-year high 135.5 in Wednesday trading, sank to 131.5 Thursday, only to almost rally back to 135.5 in Friday action. The euro (vs. $) traded down to 1.036 Wednesday, rallied to 1.060 Thursday and fell back to 1.045 in Friday trading.
Wild currency instability is consistent with the unfolding market accident thesis. Everything points to an especially brutal week for the leveraged speculating community. As losses mount, hands weaken (waning loss tolerance). During the initial phase of de-risking/deleveraging, players tend to liquidate fringe positions causing performance pain – expecting/hoping a market rally will make paring chunky core positions (with big hits to performance) unnecessary. Hope morphed into fear this week, with favored hedge fund stocks and sectors under intense selling pressure. No Place to Hide means no choice but to de-risk/deleverage.
With huge systemic ramifications, the corporate Credit market has swiftly approached the point of major dislocation. Market Structure begins to malfunction when market yields spike concurrently with widening Credit spreads and surging CDS prices.
June 14 – Bloomberg (Katie Greifeld): “Rare market stresses are emerging in the world of bond ETFs as volatility grips Wall Street ahead of the crucial Federal Reserve meeting. Cash prices in two of the largest high-yield exchange-traded funds closed at steep discounts to the value of their underlying assets on Monday, as bonds posted historic losses in the hawkish aftermath of last week’s shock inflation print. The $13.4 billion iShares iBoxx High Yield Corporate Bond ETF (ticker HYG) ended Monday 1.2% below its net asset value — the largest dislocation since March 2020. The $6.8 billion SPDR Bloomberg High Yield Bond ETF (JNK) closed at a 1.8% discount, in the biggest divergence since 2016. Such price inconsistencies are normally repaired by specialized traders known as authorized participants… But heightened volatility can complicate that process, particularly with fixed-income ETFs, which trade much more frequently than the debt securities they hold.”
June 16 – Bloomberg (Natalie Harrison): “Spreads on US junk-rated corporate bonds, an important gauge of risk that signals higher defaults when it increases, surpassed 500 bps for the first time since November 2020. The figure, which measures the extra yield investors demand to hold the debt instead of US Treasuries, increased 31 bps on Thursday to 508 bps, according to the Bloomberg US Corporate High Yield index. Junk spreads have surged 100 bps the past two weeks…”
“Stock Markets Plunge Again as Flurry of Interest Rate Hikes Fuels Recession Fears.” “Investors Brace for Recession, More Market Turmoil After Fed’s Supersized Hike.” “Stock Slump Worsens as Recession Worries Grow.”
I would posit that the stock market this week responded foremost to heightened stress, illiquidity, and the risk of serious dislocation in corporate Credit. How does an economy slide from a 3.6% unemployment rate and 11 million available jobs to recession? Dislocation in the Credit market.
The reversal of speculative finance appears unalterable. De-risking/deleveraging Dynamics have attained powerful momentum that I doubt will be subdued. High-Yield CDS prices jumped 44 this week to 576 bps (high since May 2020), with a stunning two-week surge of 103 bps (largest 2-wk gain since April 2020). Perhaps even more noteworthy, Investment-Grade CDS rose eight this week to trade above 100 bps for the first time since April 2020 – with the 18 bps two-week surge the largest since March 2020. Bank CDS rocketed higher, with double-digit surges – and highs since March 2020 – for the most powerful U.S. financial institutions (JPMorgan, Goldman, Morgan Stanley, Citigroup, and Bank of America).
June 17 – Bloomberg (Brian Smith): “After the market pitched the first full-week (non-seasonal) primary supply shutout since the onset of the pandemic, underwriters lack confidence in the near-term deal calendar… After rising to nearly 5% this week – a level not seen since the global financial crisis – the Bloomberg US Agg Corporate YTW index dwarfs the 3.60% average coupon on the US IG Corporate Investment Grade index. Investors are becoming more selective… US investment-grade bond funds have now seen 12 straight weeks of cash withdrawals, the longest outflow streak on record… with a massive $8.7bn outflow for the week ended June 15.”
June 17 – Bloomberg (Carmen Arroyo and Jill R. Shah): “The safest portion of the $1 trillion collateralized loan obligation market is falling into lockstep with its structured product peers as spreads widen, causing money managers to change tack. The bonds, which are backed by bundles of business loans, have held fast as the rest of the market priced in looming recession risks and widespread volatility. While most structured products cheapened in the span of a few weeks, CLO pricing remained tight, especially as their floating-rate coupons cushioned investors from the Federal Reserve’s intense campaign of interest rate hikes. But this is no longer the case.”
The week was notable for Crisis Dynamics making a decisive thrust from the Periphery toward the Core. From booming to no deals this week in investment-grade corporate Credit. Waning resilience for top-rated “structured finance” securitizations. This points to a major tightening of corporate Credit. Pertinent questions: What role has structured finance played in this year’s booming demand for top-tier corporate Credit? How much speculative leverage has accumulated in perceived safe fixed-income securities, and how will a surprising tightening within the investment-grade debt market impact perceptions of creditworthiness?
Powell did his best to calm the markets following the Fed’s extraordinary 75 bps rate hike. Likely done with 75 bps moves. Basically, front-loading what the committee anticipates will be a modest tightening cycle.
Powell: “On QT, we’ve communicated really clearly to the markets about what we’re going to do there. Markets seem to be okay with it. We’re phasing it in. Treasury issuance is down quite a lot, quite a lot from where it’s been. So, I have no reason to think – markets are forward looking and they see this coming. I have no reason to think it will lead to illiquidity and problems. It seems to be kind of understood and accepted at this point.”
It was briefly addressed almost in passing; such a critical and increasingly pressing issue – the Fed’s balance sheet. There has been complacency both in the markets and within the Fed regarding QT, which, best I can tell, centers around the couple Trillion in “repos” held at the Fed, perceived as part of excess system liquidity. Especially with this week’s intensifying de-risking/deleveraging dynamic, I believe the unwind of speculative leverage is in the process of triggering acute liquidity crisis.
There’s a lot of market grumbling. The Fed is failing to communicate effectively. They don’t seem to have a cohesive plan. It is monetary management on the fly.
And this brings us back to Bubbles and Experiments – to Bursting Bubbles and Failed Monetary Experiments. Market Structure developed over decades on a foundation of low interest rates and the security of the Fed’s liquidity backstop. The focus of monetary policy doctrine evolved to prioritize asset inflation and sustaining securities markets Bubbles. Today, myriad historic Bubbles are deflating, with unparalleled risk of illiquidity, panic, runs and collapses. Meanwhile, runaway inflation has forced a shift in Fed focus away from the financial markets.
Only the Fed’s liquidity backstop will thwart financial collapse. Meanwhile, the timing and scope of Federal Reserve support are up in the air. It’s crisis management time, at home and abroad. You know the global financial environment is perilous when China’s collapsing Bubble backdrop suddenly appears a pillar of relative stability. EM dominoes starting to fall. Kuroda’s crazy JGB (Japanese government bond) Bubble about to blow. The ECB’s European bond Bubble blowup this week spurring an emergency meeting and yet another round of high-risk desperate measures.
June 16 – Bloomberg (Jorge Valero): “European Central Bank President Christine Lagarde told euro-area finance ministers that the ECB’s new anti-crisis tool will kick in if the borrowing costs for weaker nation rise too far or too fast, according to people briefed… At a meeting in Luxembourg Thursday, Lagarde explained to ministers that the new mechanism that central bank officials are devising is intended to prevent irrational market movements from putting pressure on individual euro nations as ECB embarks on its first interest-rate hikes in more than a decade, the people said… She said the instrument may be triggered if bond spreads widen beyond certain thresholds or if market movements exceed a certain speed.”
June 17 – Financial Times (Sam Fleming and Martin Arnold): “Germany’s finance minister has challenged the European Central Bank over the spectre of bond market fragmentation in the eurozone, saying he did not see particular hazards in current market conditions. Christian Lindner told the ECB’s president in a closed-door session that he was not worried by recent moves in spreads between bond yields in the euro area… His words came after the ECB held an emergency meeting… in which its governing council pledged to accelerate plans to create a ‘new anti-fragmentation instrument’ — a reference to the widening gap in the cost of borrowing between more stable sovereigns such as Germany and more vulnerable member states such as Italy.”
Original Post 18 June 2022
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Categories: Doug Noland