Doug Noland: Calm Before the Storm

Executive Summary:

Mr. Bullard is wishful thinking if he actually believes a lot of good things are going to happen – like the “stellar performance in the second half of the 1990s.” There are indeed strong associations between 1994 and 2022: the former was at the dawn of a historic up-cycle, the latter the conclusion. The late-nineties saw an extraordinary confluence of financial innovation, technological advancement, leveraged speculation, globalization, and monetary policy experimentation.

I’ve of late made several references to 1994 – the bookend to 2022 and pivotal year in financial history. It was the last true Fed tightening – and it did cause “some disruption.” There were big bond market and derivatives blowups that should have burst a fledgling bubble in hedge funds and leveraged speculation. Instead, the government-sponsored enterprises, or GSEs, (largely Fannie and Freddie), expanded their balance sheets by (an at the time unprecedented) $150 billion. Their massive purchases of an assortment of Credit instruments, essentially a QE operation, were pivotal in containing the crisis and bailing out the leveraged speculating community. A powerful liquidity backstop was established in 1994, and this “GSE put” would be integral to leveraged speculation in mortgage instruments and derivatives (financial markets generally) for the next decade (where GSE assets would balloon $2.25 TN through 2004).

If not for the 1994 GSE backstop and Mexican bailout, the “Asian Tiger” Bubbles would not have inflated to catastrophic extremes. There would have been no spectacular Russian and LTCM collapses in 1998, and hence no bailouts and stimulus that fueled perilous 1999 “dot.com” speculative Bubble blow-off dynamics. The “tech” bust then sparked Fed reflationary measures and the resulting mortgage finance Bubble. The subsequent “great financial crisis” saw the opening salvo of QE. The Fed’s balance sheet was at $400 billion in 1994, ended 2007 at about $900 billion, surpassed $2.0 TN in 2008, was up to $4.5 TN by 2014, and had ballooned to almost $9.0 TN earlier this week. A lot of troubling things got started in the second half of the nineties.

The pandemic ignited late-cycle climatic excesses in financial innovation, leveraged speculation and policy experimentation. The unfolding new cycle will now impose far-reaching restraint on all three. Already well past the cycle’s peak, 2022 will be recognized as a historic inflection point for “globalization.” The new Iron Curtain is only the most tangible evidence of unfolding changed dynamics. And while not my area of expertise, I suspect recent unprecedented monetary excess likely fueled peak technological innovation. Moreover, 1994 was early days for a most protracted and historic bond bull market, which was the foundation for epic equities and asset market inflation (not to mention unparalleled market-focused monetary accommodation). This year will commence what I expect to be a new cycle of major bear markets in bonds, stocks and financial assets more generally.Rather than the “good things” from the nineties second half, I fear more EM Bubble collapses, more LTCM and Russia-style implosions and associated acute instability. Global markets somewhat regained their composure this week. But I doubt the brush with the abyss will soon be forgotten. I’ll assume the leveraged speculating community is impaired. While I expect de-risking/deleveraging to continue, seeing the rally continue into quarter-end would not be surprising.


Calm Before the Storm

Is the market bottom in, or is this more a replay of the fleeting Q1 quarter-end bear market rally? Is the “fix in” for European bonds? Does Kuroda’s foolhardy cling to “whatever it takes” buy some additional time for the perilous Japanese bond Bubble? Does the sharp commodities market reversal and some weaker data take pressure off the Fed and global central bank community? Could all the global market ructions be evidence of an unfolding existential threat to the global leveraged speculating community?

Jumping 6.4%, the S&P500 more than recovered the previous week’s big loss. The Nasdaq Biotech Index surged 14.0%, while the Nasdaq Industrials rose 9.0%. The Nasdaq100 rallied 7.5%, the Utilities 7.4%, and the Biotechs 8.7%.

Meanwhile, commodities and related equities remained under pressure for the second straight week. The Bloomberg Commodities Index dropped another 4.3%, with a two-week loss of 10.4%. Natural Gas’s 10.4% drop boosted its two-week collapse to almost 30%. By the look of things, it appears that some long/short and momentum strategies saw their longs under pressure as their shorts rallied.

There is certainly a short squeeze element to the rally. The Goldman Sachs Most Short Index surged 11.2% this week. Okta spiked 22.5%, Etsy 16.0%, Norwegian Cruise Lines 15.7%, Lucid Group 15.5%, Docusign 13.5%, and Moderna 12.7%. The S&P Retail ETF jumped 7.3%. The S&P500 Automobile Manufacturing Index surged 14.4%.

In wild instability, U.S. high-yield CDS sank 47 bps this week, reversing the previous week’s 44 bps surge. Investment-grade CDS declined six bps after jumping eight. Huge bond fund outflows continue. While generally declining a couple basis points, bank CDS prices were notable for reversing only a fraction of the previous week’s surge.

Italian 10-year yields fell 14 bps this week to 3.46%, with yields now down 52 bps from June 14 intraday highs. Greek yields sank 25 bps to 3.77%, ending the week almost 100 bps lower than June 14 highs (4.74%). Portuguese yields are down 60 bps (to 2.52%) and Spanish yields 58 bps (to 2.55%) from highs of only eight sessions ago.

The ECB’s emergency meeting to address mounting “fragmentation” risk reversed the intense deleveraging dynamics that were overwhelming periphery European debt markets.

June 20 – Financial Times (Martin Arnold): “The European Central Bank is determined to nip ‘in the bud’ any fragmentation in borrowing costs between eurozone countries, its president Christine Lagarde said…, warning anyone doubting this was ‘making a big mistake’. Appearing before EU lawmakers in Brussels, Lagarde defended the ECB’s decision, made at an emergency meeting last week, to accelerate work on a new policy tool to counter a recent surge in the borrowing costs of more vulnerable countries. ‘You have to kill it in the bud,’ the ECB president said… ‘Fragmentation will be addressed if the risk of it arises; and it will be done so with the appropriate instruments, with the adequate flexibility; it will be effective; it will be proportionate; it will be within our mandate and anybody who doubts that determination will be making a big mistake.’”

Madame Lagarde is channeling her best Mario Draghi. A key passage from Draghi’s fateful 2012 “bumble bee” speech: “But there is another message I want to tell you. Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

The ECB’s balance sheet was less than $3 TN when Draghi unleashed “whatever it takes” inflationism. Numerous QE-style programs later, and assets are approaching $8 TN. Not surprisingly, massive monetary inflation failed to resolve deep structural issues at Europe’s troubled periphery.

While there will be short-term effects and copious volatility, I doubt markets are all that intimidated by the “anyone who doubts” will be “making a big mistake” tough guy bluster. “Madame inflation” faces quite a challenge convincing the Germans, financial markets and most interested parties that another bout of rank inflationism at this point will lead to anything other than higher inflation and only more instability. Lagarde will be playing a game of chicken – feigning Draghi’s overused, abused and depleted instrument – against battalions of emboldened market operators.

June 20 – Bloomberg (Chikako Mogi): “Tokyo’s bond market began the week on a much calmer footing as traders mulled unprecedented intervention by the Bank of Japan, which dragged benchmark yields back below their closely watched ceiling. Ten-year yields edged higher to 0.23% Monday in the aftermath of the BOJ’s 10.9 trillion yen ($81bn) of government bond purchases last week, the most on record… The central bank ramped up bond buying as benchmark yields breached its 0.25% tolerated limit amid a global debt selloff.”

I’m not opposed to a central bank using its balance sheet in “buyer of last resort” operations to thwart financial collapse. If such operations are anything but rare, there are serious stability issues that must be addressed. When employed, a central bank should begin reversing balance sheet crisis measures as soon as the system stabilizes. Central bankers must be on guard to ensure that their balance sheet operations never incentivize levered speculation.

What the Bank of Japan’s Haruhiko Kuroda has been doing is monetary policy insanity. Another $81 billion – just last week, in central bank inflationism running completely amuck – all to maintain a 25 bps ceiling on 10-year Japanese government bond (JGB) yields. This week’s additional small decline pushed the yen’s 2022 loss to almost 15% (trading this week at a 24-year low).

June 22 – Financial Times (Tommy Stubbington and Leo Lewis): “Investors are digging in for a battle with the Bank of Japan this summer, as they crank up bets that the global tide of rising inflation will goad the central bank into giving up its efforts to keep bond yields close to zero. Foreign fund managers’ renewed enthusiasm for wagers against Japanese government bonds — a trade that has backfired so frequently over the past two decades it earned the nickname ‘widow-maker’ — also puts them at odds with the majority of Japanese investors who think the BoJ will stick to its guns despite the collapse of the yen to a 24-year low. At last week’s policy meeting, the Japanese central bank renewed its pledge to buy as much government debt as it takes to keep 10-year borrowing costs below 0.25%. This commitment to so-called yield curve control, a long-standing feature of monetary policy in an economy that has for decades struggled to generate meaningful inflation, places Japan increasingly out of step with a headlong dash to higher interest rates around the world.”

I’m on record questioning whether the euro experiment survives coming global financial and economic crises. Recent cracks in European periphery bonds are sounding an early warning, something clearly not lost on ECB officials. Likely more pressing, the blowup in Kuroda’s JGB yield peg gamble might be only weeks away. At this point, market operators (i.e. the leveraged speculating community) smell blood. Shorting JGBs at a 25 basis point yield – in today’s backdrop of surging global inflation and bond yields – provides a rare risk vs. reward opportunity for speculating in a multi-trillion dollar market. I am reminded of last gasp, desperation policy measures – and final short squeeze in the Thai baht – back in the halcyon days of June 1997, just before all bloody hell broke loose.

And while on the subject of the mid-nineties…

It’s true we’ve moved a lot – but we’ve moved a lot from a very low level. I like to allude to the 1994 tightening in the U.S… The ’94 tightening was 300 bps in a year – including a 75 bps move in November of ’94. That tightening episode caused some disruption that year, in 1994. However, I’ve always felt that one set up the U.S. economy for a stellar performance in the second half of the 1990s. U.S. real GDP grew rapidly during that period; that’s when you got the very best labor markets that you’ve seen in the U.S. post-war era. And, so, a lot of good things happened in the second half of the nineties, and I hope we can get something like that again this time. But we are moving quickly, but we’re moving from a low level and from the very accommodative monetary policy that we put in place to try to combat the pandemic.” St. Louis Fed President James Bullard, June 20, 2022

I’m always interested in what’s on James Bullard’s mind. He’s a thoughtful economist and, depending on the outcome of the 2024 election, could be Powell’s successor. Bullard’s comments regarding 1994 and the late-nineties deserve a rebuttal.

I’ve of late made several references to 1994 – the bookend to 2022 and pivotal year in financial history. It was the last true Fed tightening – and it did cause “some disruption.” There were big bond market and derivatives blowups that should have burst a fledgling bubble in hedge funds and leveraged speculation. Instead, the government-sponsored enterprises, or GSEs, (largely Fannie and Freddie), expanded their balance sheets by (an at the time unprecedented) $150 billion. Their massive purchases of an assortment of Credit instruments, essentially a QE operation, were pivotal in containing the crisis and bailing out the leveraged speculating community. A powerful liquidity backstop was established in 1994, and this “GSE put” would be integral to leveraged speculation in mortgage instruments and derivatives (financial markets generally) for the next decade (where GSE assets would balloon $2.25 TN through 2004).

If not for the 1994 GSE backstop and Mexican bailout, the “Asian Tiger” Bubbles would not have inflated to catastrophic extremes. There would have been no spectacular Russian and LTCM collapses in 1998, and hence no bailouts and stimulus that fueled perilous 1999 “dot.com” speculative Bubble blow-off dynamics. The “tech” bust then sparked Fed reflationary measures and the resulting mortgage finance Bubble. The subsequent “great financial crisis” saw the opening salvo of QE. The Fed’s balance sheet was at $400 billion in 1994, ended 2007 at about $900 billion, surpassed $2.0 TN in 2008, was up to $4.5 TN by 2014, and had ballooned to almost $9.0 TN earlier this week. A lot of troubling things got started in the second half of the nineties.

Mr. Bullard is wishful thinking if he actually believes a lot of good things are going to happen – like the “stellar performance in the second half of the 1990s.” There are indeed strong associations between 1994 and 2022: the former was at the dawn of a historic up-cycle, the latter the conclusion. The late-nineties saw an extraordinary confluence of financial innovation, technological advancement, leveraged speculation, globalization, and monetary policy experimentation.

The pandemic ignited late-cycle climatic excesses in financial innovation, leveraged speculation and policy experimentation. The unfolding new cycle will now impose far-reaching restraint on all three. Already well past the cycle’s peak, 2022 will be recognized as a historic inflection point for “globalization.” The new Iron Curtain is only the most tangible evidence of unfolding changed dynamics. And while not my area of expertise, I suspect recent unprecedented monetary excess likely fueled peak technological innovation. Moreover, 1994 was early days for a most protracted and historic bond bull market, which was the foundation for epic equities and asset market inflation (not to mention unparalleled market-focused monetary accommodation). This year will commence what I expect to be a new cycle of major bear markets in bonds, stocks and financial assets more generally.

Rather than the “good things” from the nineties second half, I fear more EM Bubble collapses, more LTCM and Russia-style implosions and associated acute instability. Global markets somewhat regained their composure this week. But I doubt the brush with the abyss will soon be forgotten. I’ll assume the leveraged speculating community is impaired. While I expect de-risking/deleveraging to continue, seeing the rally continue into quarter-end would not be surprising.

Unfortunately, we’re early in Global Crisis Dynamics. There’s faltering U.S. “tech,” crypto and Credit Bubbles (to name a few), periphery European bonds, Kuroda’s Bubble, and EM Bubble fragilities. With Chinese equities rallying on prospects for Beijing stimulus measures, China’s developer crisis has fallen off the radar screen. I’d put it back on; things get worse by the week.

June 24 – Bloomberg (Lorretta Chen): “China high-yield dollar bonds fell 1-2 cents Friday, according to credit traders, with developers leading the declines as this month’s downslide continues. The market is on pace to complete a third full week without a daily price gain and post a record-tying eighth-straight losing week…”

June 21 – Bloomberg (Alice Huang and Lorretta Chen): “The ongoing bond plunge for resort chain Club Med’s Chinese owner shows that financial stress among the country’s property developers is shifting to other weaker borrowers. In a sign of contagion, prices slid Tuesday for some Chinese industrial firms’ offshore debt after a Monday selloff in Macau’s casino operators. Meanwhile, last week’s slump for conglomerate Fosun International Ltd.’s dollar bonds accelerated, with some on track for record declines… The steep losses in Fosun’s bonds spreading to non-property high-yield companies are pushing China’s junk dollar debt market into a new phase.”

Original Post 25 June 2022



Categories: Perspectives