TSP Smart: Pondering Modern-Day Runs

By Doug Noland on July 2, 2022

Excerpts from Doug Noland’s post

The nineties ushered in unfettered Credit in a scope never previously experienced. History teaches that Credit is inherently unstable. I became convinced this new Credit mechanism was instability on steroids. The 1994 bond market/derivatives blowup, Mexico, the spectacular Asian Tiger boom and bust, Russia, LTCM, the tech Bubble…

Habitual central bank-induced market recoveries (spurred by rate cuts, bailouts and later, QE) ensured this new financial structure and associated monetary doctrine enveloped the world. A Federal Reserve liquidity backstop (“Fed put”) took root and would grow to become deeply embedded in market perceptions, prices and structure for securities and derivatives markets (Market Structure).

What was to unfold over three decades was nothing short of history’s greatest period of Credit and speculative excess. Now the dreadful downside. Virtually everyone seems unaware of the extraordinary challenges ahead.

Global de-risking/deleveraging has attained important momentum. I suspect the global leveraged speculating community is increasingly impaired – and this impairment will manifest into heightened risk aversion interrupted by occasional bear market rallies. Importantly, the ongoing unwind of speculative leverage is methodically destroying liquidity. Segments of the markets are turning increasingly illiquid, raising the likelihood of contagion, panic and dislocation.

New ballgame. The world is now in a serious de-risking/deleveraging episode, without the prospect of timely central bank liquidity injections. This, for one, profoundly alters the risk vs. return calculus for leveraged speculation, and I believe we are witnessing global players moving to reduce risk. And with the timing and scope of central bank liquidity support very much an open issue, this significantly raises the odds of self-reinforcing de-risking/deleveraging spurring contagion and illiquidity.

As I have repeatedly posited, contemporary finance does not function well in reverse. The confluence of rising market yields, widening spreads, and surging CDS/derivatives prices is problematic for highly levered global securities markets.

I believe global “safe haven” sovereign yields have reversed sharply lower in response to rapidly rising market illiquidity and dislocation risk. This may offer a temporary reprieve to “risk off.” But the prospect of Crisis Dynamics and resulting global economic disruption is now fueling the liquidation of commodities and related sectors that had been performing well in the face of the general market bloodbath.

Market upheaval has turned systemic. No place is safe. And the Runs have commenced.

Pondering Modern-Day Runs

by Doug Noland

“In 1939, a brief proposal auspiciously titled ‘A Program for Monetary Reform’ was circulated among economists in the United States. Written in the wake of The Great Depression by a group of prominent American economists which included Irving Fisher and Paul Douglas, it included a stark criticism of the fractional reserve banking system in the United States, referring to it as ‘a chief loose screw in our present American money and banking system’ (Fisher et al., 1939). Despite this, the fractional reserve system remained then, and continues to remain status quo for all developed banking systems in the world. It has gathered many more critics over the years that attribute to it many disadvantages, such as a tendency for bank runs and moral hazard on behalf of lending institutions, among other negative externalities.” Sergey Alifanov, “On the Dangers Inherent in a Fractional Reserve Banking System”, Trinity College Dublin, 2015

Bank panics and Runs certainly predate the Great Depression. Notable examples in more distant history include the Dutch Tulip Bulb Mania (1637), Britain’s South Sea Bubble (1719), and France’s (John Law’s) spectacular Mississippi Bubble (1720). And Runs preceded banks as we think of them today, with panicked efforts to redeem goldsmith-issued notes. Carmen Reinhart and Kenneth Rogoff, in “This Time Is Different,” noted a panic and Run in Sicily, fourth century B.C.

Credit and economic crises invariably drew attention to the inherent fragility of fractional-reserve banking. Here a deposit into a bank would fund a loan that would become a new deposit at another bank, where it could then be lent again (and again). “Fractional reserve” denotes a requirement to hold a portion of a new deposit in reserve (not available for lending). For example, a 20% reserve requirement would mean that of a $100 deposit $80 would be available for funding a new loan. And when this new $80 financial claim became a deposit at another institution, a $64 loan could be made, and so on – a process referred to as the “money multiplier.”

Reserve requirements imposed to restrain Credit growth would invariably prove ineffective during periods of manic excess. Post-bust analysis would then target unhinged bank lending and resulting Credit and speculative excess as chiefly responsible for boom and bust dynamics. There was no pot of money available to satisfy throngs of panicked depositors rushing to pull their cash from troubled banks. There’s no pot of money in today’s troubled global markets.

“S&P 500 Closes the Book on its Steepest First-Half Slide Since 1970.” “Markets Post Worst First Half of a Year in Decades.” “Biggest Forex Rout Since ‘97 Puts Asia Central Banks in Bind.” “This was the Worst First Half for the Market in 50 Years and It’s All Because of One Thing — Inflation.”

Surging consumer inflation may have been the catalyst, but the unfolding crisis has been decades in the making. I’ll take exception with just a snippet from the opening quote from Sergey Alifanov: “The fractional reserve system… continues to remain status quo.” In the late-nineties, I began referring to the “infinite multiplier effect.” Market-based Credit had started proliferating outside the banking system, completely free from reserve and capital requirement constraints. Subtly, key systemic risk was shifting from banking system impairment to assets Bubbles and inevitable runs on market-based instruments. This risk has been masked for years by central bank inflationism.

Rather than recognizing and addressing this dangerous new financial innovation and evolving Market Structure, the Fed pivoted in the opposite direction: it commenced a transformative era of monetary management doctrine that specifically underpinned non-bank Credit and market-based finance. Habitual central bank-induced market recoveries (spurred by rate cuts, bailouts and later, QE) ensured this new financial structure and associated monetary doctrine enveloped the world. A Federal Reserve liquidity backstop (“Fed put”) took root and would grow to become deeply embedded in market perceptions, prices and structure for securities and derivatives markets (Market Structure).

What was to unfold over three decades was nothing short of history’s greatest period of Credit and speculative excess. Now the dreadful downside. Virtually everyone seems unaware of the extraordinary challenges ahead.

The establishment of the Federal Deposit Insurance Corporation’s (FDIC) (part of the Banking Act of 1933) essentially relegated bank Runs as a systemic issue to the history books. Meanwhile, Runs on a plethora of non-deposit financial instruments have been a recurring issue. For the most part, however, the Fed’s propensity to swiftly respond to heightened market stress with (progressively aggressive) stimulus measures ensured that bouts of “risk off” were reversed before panic gained perilous momentum. The Fed’s QE, zero rates and other bailout measures unleashed in late-2008 proved sufficient to sustain confidence in money market and mutual fund shares, along with financial assets generally.

The situation had turned significantly more alarming by March 2020. Over the preceding decade, Trillions had flowed into perceived safe and liquid financial instruments, certainly including ETF shares. Witnessing Bernanke’s policies of coercing savers into the risk markets (as a key mechanism for system reflation), I began warning of a “Moneyness of Risk Assets” dynamic (an offshoot of the mortgage finance Bubble period’s “Moneyness of Credit” fiasco).

The pandemic blindsided Bubble markets. There were dislocations and swift 20% losses for some popular ETF products, most notably for funds holding corporate debt and small cap equities. While investors assume their ETF shares are highly liquid “stores of value” (markets invariably move higher), underlying assets in many funds are liquidity-challenged. In the event of market panic, as was experienced in March 2020, entire assets classes face acute illiquidity. The Fed resorted to plans for aggressive purchases of shares of ETFs holding equities and corporate Credit. Confidence was again restored, and $5 TN of Fed QE then ensured that the flood of “money” into the ETF complex became a tsunami.

June 29 – Bloomberg (Steve Matthews): “Federal Reserve Chair Jerome Powell said the US economy is in ‘strong shape’ and the central bank can reduce inflation to 2% while maintaining a solid labor market, even though that task has become more challenging in recent months. He also vowed to ensure rapid price increases don’t become entrenched, saying that ‘we will not allow a transition from a low inflation environment to a high inflation environment.’ ‘We hope that growth will remain positive,’ Powell said… ‘Household and business finances are also in solid shape, and ‘overall the US economy is well positioned to withstand tighter monetary policy.’”

With institutional credibility on the line, Powell and Fed officials are displaying newfound resolve in their belated inflation fight. Understandably, markets fret the status of the beloved – the venerated “Fed put.” I can only assume the Fed recognizes the acute fragility that today permeates global markets, though there is little so far to indicate as much. New York Fed president John Williams, responsible for overseeing the Fed’s market operations and market-monitoring function, stated Tuesday on CNBC: “I’m not seeing any signs of a taper tantrum. The markets are functioning well.”

Markets are unwell, at home and abroad. Global markets a couple weeks back began to dislocate, before a rally took some pressure off. It was another rally with a short half-life, with pressure returning this week.

Global de-risking/deleveraging has attained important momentum. I suspect the global leveraged speculating community is increasingly impaired – and this impairment will manifest into heightened risk aversion interrupted by occasional bear market rallies. Importantly, the ongoing unwind of speculative leverage is methodically destroying liquidity. Segments of the markets are turning increasingly illiquid, raising the likelihood of contagion, panic and dislocation.

Ten-year Treasury yields sank 25 bps this week, and are now down 62 bps from the June 14th 3.50% intraday high. It’s a global phenomenon. German bund yields have dropped 65 bps in 13 sessions (June 16 intraday highs), with yields down a notable 21 bps this week. Swiss 10-year yields slumped 43 bps this week to a one-month low 0.81%. UK yields dropped 22 bps.

European periphery yields have collapsed since June 14th. Italian yields sank another 37 bps this week, and are down 110 bps from June 14th highs. Greek yields fell 27 bps this week (down 124 bps from June 14th highs), with yields this week sinking 25 bps in Portugal (down 85bps) and 28 bps in Spain (down 93bps).

Commodities markets remain under heavy selling pressure. The Bloomberg Commodities Index fell another 3.4% this week, with the index down 14% from June 9th highs. Copper is down 19% in four weeks, tin 24%, nickel 22%, zinc 14%, lead 13%, and aluminum 12%. The precious metals have not been immune to selling, with silver and platinum down 6.2% and 2.1% this week. Highfliers natural gas, wheat and corn have suffered the kind of brutal reversals that inflict a lot of speculator pain.

The simple explanation has markets responding to heightened recession risk. Yet I tend to see markets increasingly discounting the scenario of intensifying de-risking/deleveraging and attendant risks of illiquidity and dislocation.

Two-year Treasury yields traded at 3.13% intraday Wednesday, before sinking 40 bps to a Friday intraday low of 2.73% (ended week at 2.835%). The market’s implied rate for the Fed funds rate at the December 14th FOMC meeting traded up to 3.50% in Wednesday’s session, before sinking to a Friday low of 3.17% (ended week at 3.32%). The sharp reversal in yields and market rates coincided with Wednesday’s meeting of the world’s top central bankers at the ECB’s annual conference in Sintra, Portugal.

June 30 – Bloomberg (Craig Torres and Carolynn Look): “Risks are mounting that the world is shifting to a regime of higher inflation, forcing central bankers to tear up their playbook of the last 20 years. That was a key message from Federal Reserve Chair Jerome Powell and his European counterparts on Wednesday as they debated how to tackle persistent price pressures and slower growth. ‘I don’t think we are going to go back to that environment of low inflation’ European Central Bank President Christine Lagarde told the ECB’s annual forum in Sintra, Portugal. ‘There are forces that have been unleashed as a result of the pandemic, as a result of this massive geopolitical shock we are facing now that are going to change the picture and the landscape within which we operate,’ she said… Her comments, alongside those of Powell and Bank of England Governor Andrew Bailey, mean a potential upheaval of monetary policy practice.”

Leaders of the central bank community were all together and addressing, for the first time as a group, fundamental secular change. More from the above Bloomberg article: “The Fed chief warned of a ‘re-division of the world into competing geopolitical and economic camps, and a reversal of globalization’ that could result in lower productivity and growth. The risk of longer-lasting scarcity as the world reorders can already be seen.”

From the BOE’s Andrew Bailey: “It’s how you deal with a series of large supply shocks with no air gap between them, which of course feeds through into expectations. Put them all together, they’re not transitory in the traditional sense of the term.”

From Bundesbank President Jens Weidmann (earlier in the week): “The more persistent the shock proves to be, the more the delay in monetary tightening increases the risk that companies, households and workers will start to expect that high inflation is here to stay. In order to prevent de-anchoring, the persistence of inflation should be overstated rather than understated, and a forceful monetary policy response is advisable precisely when uncertainty about it is particularly high.”

And more from Powell: “The last ten years were so far the height of the disinflationary forces that we faced. That world seems to be gone now at least for the time being. We are living with different forces now and have to think about monetary policy in a very different way… If you want to know the lessons to be learned of the last ten years, look at our framework. Those were all based on a low inflation environment that we had. And now we are in this new world where it is quite different with higher inflation and many supply shocks and strong inflationary forces around the world.”

A “new world,” indeed. And the status of the “Fed put” – after three decades of becoming ever more explicit – is now officially indeterminate. Federal Reserve officials are these days focused on their inflation fight rather than how they might respond to market crisis. Of course, the Fed would surely muster a policy response. But these days markets must assume it will be a delayed response. Moreover, it’s reasonable to assume that the Fed would not initially come with the type of massive QE liquidity injections that faltering markets would require for stabilization.

The “Periphery to Core Dynamic” has gained momentum globally. It’s worth noting June losses for EM currencies. The Chilean peso dropped 10.3%, the Brazilian real 10.0%, the Colombian peso 9.2%, the Polish zloty 4.8%, the South Korean won 4.7%, the Philippine peso 4.7%, the Argentine peso 4.0%, and the South African rand 3.9%. EM bonds have been clobbered, while key EM CDS prices jumped this week to highs since 2020.

Federal Reserve holdings for foreign owners (largely global central banks) of Treasury and Agency Debt last week dropped another $12.4 billion to the low back to 2020 ($3.391TN). The Run on EM markets is unleashing a dangerous dynamic. When global liquidity flows abundantly, financial flows originating from U.S. trade deficits and leveraged speculation often find their way into higher-yielding EM securities. These flows end up at EM central banks, where they are conveniently “recycled” back into U.S. markets through (chiefly) purchases of Treasuries, agencies and other debt securities.

This “infinite multiplier” dynamic works miraculously so long as liquidity remains abundant, asset prices are inflating, and leveraged speculation is expanding. But this dynamic breaks down in reverse. “Hot money” outflows are now forcing EM central banks to sell Treasuries to generate purchasing power to support their flagging currencies. This is taking an increasing toll on liquidity and the stability of global financial flows.

EM tightening cycle fragility (aka “taper tantrum”) is not a new phenomenon. This is, however, the first episode of highly levered (securities markets and real economies) EM systems facing global de-risking/deleveraging without a clear Fed and central banking community “put.” With the global liquidity backstop now nebulous, there is every reason for the leveraged speculators to move more aggressively in exiting levered EM “carry trades.” And resulting outflows lead to only weaker currencies, more EM central bank Treasury (and sovereign debt) sales, and greater stress on global financial stability.

Ominously, CDS prices surged this week in the Philippines (53bps), Indonesia (38bps), Malaysia (38bps), and India (19bps) – trading to highs since 2020. So-called “frontier” markets are at great risk. This week’s CDS spikes included Ethiopia (588bps), Angola (136bps), Pakistan (125bps), Mongolia (96bps), El Salvador (264bps), Iraq (90bps) and Senegal (80bps) – to name a few.

The risk of serious breakdown – a “seizing up” – of global financial flows appears to be rising rapidly. This risk is increasingly being reflected at the “Periphery of the Core.” At Thursday’s intraday high, U.S. high-yield CDS was up a blistering 62 bps w-t-d, back near the spike high from two weeks ago (and the high since May 2020). High-yield corporate spreads to Treasuries (Bloomberg Index) surged a notable 71 bps this week to 578 bps, with an alarming three-week gain of 140 bps – to highs since July 2020. Investment-grade CDS jumped seven this week to 101 bps, back near highs since May 2020, with investment-grade spreads 10 bps wider to 158 bps (high since June 2020). Posing clear systemic risk, the corporate debt market remains largely closed to new issuance.

Market upheaval has turned systemic. No place is safe. And the Runs have commenced.

The Run on crypto assets is said not to pose general financial system risk. Perhaps that’s true, but it is likely a harbinger of what’s to come throughout the risk markets. Emerging markets appear vulnerable to a brutal contagion dynamic that could engulf the world. The relative stability of recent flows into U.S. equities is ominous. March 2020-style panic outflows and market dislocation pose significant systemic risk. How would the Fed respond today to a Run on the ETF complex?

Modern day Runs appear to have the potential to be every bit as destabilizing as the old bank Run. Keep in mind that contemporary financial crises have typically turned systemic in the money markets (i.e. Lehman “repos”). Crisis tends to erupt when perceived safe and liquid holdings (“money”) are suddenly recognized as at heightened risk. It’s this “moneyness” perception for all these financial instruments (i.e. ETF and mutual fund shares, derivatives and “structured finance”) that has me on edge. Myriad acutely vulnerable Bubbles and a Fed liquidity backstop blurred by newfound ambiguity. The New Cycle is off to a very troubling start.

Original Post 2 July 2022

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