TSP Smart: Bear Market Rally Top?

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Inaugural Squeeze

by Doug Noland

It was in ways business as usual. “Risk off” had powerful momentum globally back in July. De-risking/deleveraging dynamics were increasingly fomenting illiquidity, contagion and instability across global markets. Bubbles were bursting. Derivatives-related selling was starting to overwhelm. In short, global markets were at the cusp of serious dislocation – of “seizing up”. And, as they’ve done on numerous occasions over the years, markets peered over the edge, grimaced and abruptly recoiled.

This dynamic has become all too familiar: when instability turns sufficiently serious, markets instinctively anticipate dovish central bank policy responses. The ECB (“Doubting our commitment would be a serious mistake”) was right on cue with its new “anti-fragmentation” tool. The Bank of Japan did its part, assuring global markets that the BOJ was anything but contemplating stepping back from ultra-easy monetary policy or its yield curve ceiling. In Beijing, it was a veritable laundry list of stimulus measures. Meanwhile, Fed officials were providing enough mixed messages that it was reasonable to interpret waffling as a precursor to a dovish pivot. After all, Powell had been adamant that “financial conditions” would be a FOMC focal point.

Without a doubt, financial conditions had tightened dramatically. Using July 14th for a snapshot: The S&P500 ended the session with a year-to-date loss of 20%. The Nasdaq100 was down 28%, while the Banks (BKX) ended the session with a 2022 loss of 25%. High yield CDS traded as high as 560 bps, after beginning the year at 293 bps. The junk bond market had gone weeks without a new issue. Commodities markets were under major pressure, with the Bloomberg Commodities Index sinking 20% from early-June highs.

And then the “Everything Squeeze”: From July lows, the S&P500 rallied as much as 19%. The Nasdaq100 recovered 24%, and Bank stocks rallied 20%. The Goldman Sachs Short Index surged 43% off lows. High yield CDS collapsed 180 to 405 bps. After trading to 3.48% on June 14th, 10-year Treasury yields were down to 2.58% on August 1st.

And as is typical, rallying markets then enjoyed confirmation of the bullish narrative from positive economic data. There was the booming June jobs report, the ISM Services Index, Factory Orders, Durable Goods, Consumer Credit and, of course, July CPI data. Everything seemed to be falling into place. Sentiment – that had shifted to bearish extremes – quickly returned home to comfy bullishness.

But the more things stay the same, the more they change. I’ll posit that we’ve now experienced the first Squeeze of the New Cycle. In the previous cycle, major short Squeezes invariably launched new legs higher for the perpetual bull market. Squeezes and resurgent leveraged speculation would ensure a major loosening of financial conditions. And, importantly, looser monetary policy (i.e. “dovish pivots”) would validate already loosening market conditions. Dynamics created the appearance of endless liquidity.

These days, bullish markets, luxuriating in newfound liquidity abundance, face an unfamiliar policy backdrop. Rather than a “dovish pivot,” the Fed is poised to plow ahead with its first real tightening cycle in 28 years. Moreover, the Squeeze rally and attendant loosening of financial conditions only places more pressure on the Fed.

August 18 – Reuters (Howard Schneider): “The recent easing of U.S. financial conditions, including a surge in stock prices, may have been based on an overly optimistic sense that inflation was peaking and the pace of interest rate increases was likely to slow, Kansas City Federal Reserve President Esther George said… George said the pace and ultimate level of future rate hikes remained a matter of debate. ‘To know where that stopping point is … we are going to have to be completely convinced that (inflation) number is coming down,’ she said.”

It’s worth pondering how extraordinary this all is: The Federal Reserve is actually pushing back against a loosening of financial conditions. Talk about the polar opposite of Bernanke’s momentous proclamation back in 2013 that the Fed would “push back” against a market tightening of financial conditions – basically signaling to the markets that the Fed wouldn’t tolerate sinking stock prices or rising risk premiums. Today, rallying risk markets counteract Fed tightening measures, compounding the Fed’s challenge of fighting inflation without inevitably crashing the markets and economy.

Yet the Squeeze rally has much more to be anxious about than just higher Fed policy rates. The global backdrop is fraught with extreme risk. The Squeeze erupted with the global “Periphery” at the brink of acute instability. Not surprisingly, fringe companies, countries and markets saw some of the most spectacular Squeeze-induced gains (i.e. U.S. meme stocks and the “frontier” emerging markets). And it is now the vulnerable “Periphery” that we would expect in the crosshairs as Squeeze Dynamics dissipate and “Risk Off” reemerges. We saw exactly this dynamic unfold this week.

EM CDS surged 42 this week to 322 bps, the largest weekly increase since war erupted in Ukraine back in March. Sovereign CDS prices jumped 117 bps in Turkey, 44 bps in South Africa, 33 bps in Colombia, and 20 bps in Brazil. “Frontier” markets were pummeled, with CDS up 555 bps in Pakistan, 136 bps in Ghana, 94 bps in Angola, and 79 bps in Tunisia. EM currencies were under heavy pressure this week. The Chilean peso dropped 7.3%, the Colombian peso 5.0%, the South African rand 4.9%, the Hungarian forint 4.9%, the Polish zloty 4.0%, and the Czech koruna 3.4%.

EM bonds were hammered. Yields surged 71 bps in Hungary (8.26%), 61 bps in Poland (5.95%), 53 bps in the Czech Republic (4.15%), 39 bps in Mexico (8.23%), 38 bps in Brazil (12.23%), and 27 bps in South Africa (10.71%). Dollar-denominated EM debt was not spared. Turkey dollar yields surged 113 bps (10.52%), Mexico 53 bps (5.18%), Chile 38 bps (4.64%), Indonesia 36 bps (4.05%), Brazil 31 bps (5.75%), and Panama 30 bps (4.86%).

In short, de-risking/deleveraging was this week back with a vengeance at the “Periphery”. And the eerie calm that had enveloped European debt markets has begun to dissolve. Italian yields surged 43 bps this week to a one-month high 3.50%. Greek yields jumped 46 bps to 3.69%. Yields were up 29 bps in both Spain and Portugal. European high yield (“crossover”) CDS surged 62 to 525 bps – the largest gain since the tumultuous week of June 17th.

The Big Squeeze emerged as the situation in China took a turn for the worse. A Monday Bloomberg headline: “China Shocks With Rate Cut as Data Show ‘Alarming’ Slowdown.”

August 16 – Bloomberg: “China’s surprise interest-rate cut has done little to allay concern over the property and Covid Zero-led slowdown, with economists and state media calling for additional stimulus. In a front-page report…, the central-bank backed Financial News said Beijing should introduce new pro-growth policies at the appropriate time to keep growth within a reasonable range, citing Wen Bin, chief economist at China Minsheng Bank. The Securities Times said in a separate report the People’s Bank of China’s surprise rate cut may be the first in a series of policies to stabilize growth.”

August 15 – Bloomberg: “China’s economic slowdown deepened in July due to a worsening property slump and continued coronavirus lockdowns, with an unexpected cut in interest rates unlikely to turn things around while those twin drags remain. Retail sales, industrial output and investment all slowed and missed economists estimates in July. The surveyed jobless rate for those aged 16-24 climbed to 19.9%, a record high and headache for the Communist Party as it gears up for a major congress in coming months that’s expected to give President Xi Jinping a precedent-defying third term in power.”

Add to the list of disappointing Chinese data July’s atrocious Credit numbers. Aggregate Financing (China’s metric of system credit) increased only $112 billion during the month, down huge from June’s strong (quarter-end lending push) $767 billion and almost a third lower than July 2021. Both Aggregate Financing and New Bank Loans were only about half the expected level. Consumer (chiefly mortgages) Loans shriveled to only $18 billion, down from June’s $126 billion and July 2021’s $60 billion. At 7.7%, one-year Consumer Loan growth was the weakest in decades, down from 11.6% to start the year.

Developer bonds rallied this week on talk of aggressive Beijing support (including bond guarantees). Still, the Shanghai Composite declined 0.6%. Ominously, the renminbi dropped 1.1% versus the dollar to a near two-year low. Inflation and the global tightening cycle are doing no favors for Beijing’s easing measures or its currency.

I’ve been around long enough to know that calling the end of major Squeezes is risky business. But, then again, this is a unique backdrop. I believe the de-risking/deleveraging hiatus has run its course, at least at the global “Periphery”. Ominously, this week was reminiscent of June, where pressure on EM currencies and bonds negatively impacted “developed” bond markets (including bunds and Treasuries). It’s a problematic cycle: De-risking/deleveraging, faltering EM currencies, EM central bank Treasury/developed bond liquidations to fund currency support, higher yields forcing “developed” market deleveraging, and resulting evaporating global liquidity.

Bund yields surged 24 bps this week to 1.23%, while 10-year Treasury yields rose 14 bps to 2.98%. Perhaps a harbinger of de-risking/deleveraging contagion gravitating from the “Periphery” to the “Core,” benchmark U.S. MBS yields jumped 32 bps to a six-week high 4.36%.

I don’t want to read too much into a single week. But as I’ve written previously, contemporary finance does not function well in a backdrop of rising yields, widening Credit spreads (increasing risk premiums) and surging CDS prices. Summer fun and games will be winding down soon. September will bring cooler temperatures, another Fed rate hike, and a ratcheting up of quantitative tightening. This Squeeze has only heightened fragilities – at home and abroad. I expect The Mirage of Liquidity Abundance to prove a summer phenomenon.

Original Post 20 August 2022


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Categories: Doug Noland, Perspectives