Doug Noland: Derivatives, Squeezes and Fiascos Aplenty

How does one chronicle a week like this one?

“Sam Bankman-Fried’s $32bn FTX Crypto Empire Files for Bankruptcy.” “What’s Next for Crypto as FTX Collapse Triggers ‘Lehman Moment’?” “Stocks Skyrocket in Best Post-CPI Day on Record.” “Apple’s $191 Billion Single-Day Surge Sets Stock-Market Record.” “Big Tech Job Cull May be the Start of Things to Come.” “Credit Market Rallies Most in Two Years as Inflation Abates.” “Dollar Suffers Biggest Plunge Since 2009 as CPI Smacks Fed Bets.” “Yen Set for Best Week Since 2008 as Fed Stance Seen Softening.” “Beaten-Down Chinese Developer Stocks Set for Best Week on Record.” “Asia Stocks Jump Most Since 2020 as China Covid Zero Pivot Seen.” “Biggest Junk-Bond ETFs Post Record Inflow in Dash Back to Risk.” “Control of U.S. Congress Hangs in Balance as States Labor to Count Ballots.” “How Young Voters Became the Wall for the ‘Red Wave’.”

We’ll start with Thursday’s incredible trading session. October CPI was reported up 0.4%, versus estimates of 0.6%. Core prices gained 0.3% versus 0.5%. All Hell Broke Loose.

From Bloomberg: “Thursday’s shock CPI print was a positive surprise after a week of worry and risk aversion. It set off one of the biggest cross-asset rallies in decades. The Bloomberg US Treasury index has only had three better days this century. Two were during the pandemic volatility of March 2020 and one was March 18, 2009 – the day the Fed announced plans to expand its QE program… The S&P500 and Nasdaq 100 both also had their best day since 2020. The dollar fell by the most since March 18, 2009. Investment-grade bonds, which are even more yield-sensitive than Treasuries, had their best single day in more than 30 years.”

The Semiconductors (SOX) jumped 10.2% during Thursday’s session, the Nasdaq Computer Index 9.0%, the Nasdaq100 8.4%, and the Bloomberg REIT Index 7.1%. The “average stock” Value Line Arithmetic Index gained 6.2%. The small cap Russell 2000 rose 6.1%, with the S&P400 Midcaps jumping 5.8%. The Banks (KBW) rose 5.8%. The S&P500 gained 5.5%.

The Goldman Sachs Short Index surged 10.9% Thursday, with a two-day 17.5% spike. Zerohedge referred to “the biggest short squeeze on record.” When it comes to ferocious short squeezes, I’ll never forget early 1991. Jim Grant’s Interest Rate Observer aptly captured the market environment with a humorous cartoon. It has mamma and papa bear in bed. In obvious distress, papa bear had awoken from what must have been a horrifying nightmare. The caption: “I dreamt the market was open.”

I’ve lived (sleep deprived) through more than my share of short squeezes. The Thursday/Friday squeeze episode was epic for how spontaneous combustion erupted simultaneously across global markets. International markets again demonstrated the characteristics of one big Crowded Speculative Bubble. Stock bears crushed – in the U.S., Europe, China and Asia. Hong Kong’s Hang Seng Index rallied 7.7% Friday.

Currency bears – crushed. The Japanese yen surged 3.9% Thursday, the biggest one-day gain since March 2020. For the week, the yen gained 5.6%, the South Korean won 7.6%, the Swiss franc 5.7%, the Swedish krona 5.1%, the British pound 4.0% and the euro 3.9%. The Colombian peso surged 6.5%, the Thai Baht 4.5%, the Czech Koruna 4.4%, and the Bulgarian lev 4.1%.

Treasury and bond bears – crushed. Ten-year Treasury yields sank 28 bps Thursday, with the iShares Treasury Bond ETF (TLT) surging 3.8%. Benchmark MBS yields sank a ridiculous 54 bps in Thursday trading. Hedging run amuck. High-yield CDS prices collapsed 53 bps, the largest one-day drop since April 9th, 2020. Investment-grade CDS fell nine to a two-month low 83 bps, the biggest decline since September 2020. Italian yields sank 28 bps Thursday. Yields dropped 109 bps over two sessions in Hungary. Indonesian yields dropped 40 bps this week. Yields were down 36 bps this week in Canada and 37 bps in Mexico. Dollar bond yields were down 38 bps in Chile and Peru, and 37 bps in Panama.

The sound of hedges blowing up everywhere. 2022 has been a year of massive hedging across global markets. Especially in Treasuries and global fixed-income, derivatives have surely been a major factor in exacerbating the yield melt-up. Meanwhile, derivative hedges and speculations have been instrumental in the dollar melt-up – and the corresponding yen melt-down, in particular.

Things were turning serious a few weeks back. The UK bond market was at the brink of collapse, with contagion effects weighing on bond markets around the globe. The yen was dislocating to the downside, while it appeared a break of the BOJ’s yield peg could unleash mayhem. European markets were fragile. EM bond yields were spiking higher. Asian bond markets were dislocating, with particular worry for South Korea. Eastern European bonds and currencies were under intense pressure.

Chinese developer and housing collapses were gaining momentum. China’s weak recovery was faltering, while a new Covid wave was unfolding. Adding to the gloom, China’s national congress was alarming on multiple levels. There was every reason to hedge risk just about everywhere.

It started with the Bank of England’s bond market rescue. The Bank of Canada then raised rates less aggressively than expected and appeared to pivot dovish. The Bank of Japan held firm with the loosest monetary policy imaginable in an inflationary world. Some Fed officials indicated a less hawkish policy course was approaching, as concerns grew for housing and layoffs. And then Beijing began to tinker with Covid zero.

Powell’s press conference provided a final ingredient for this week’s squeeze. Unequivocally hawkish, it’s fair to assume that the 5% post-meeting stock market drop (along with big moves in bond yields and the currencies) was at least partially fueled by aggressive hedging-related selling.

On the one hand, there was ample evidence that global central bankers and Beijing had shifted focus to crisis management. Markets pondering that the “fix” could be in. On the other hand, an ugly CPI print would ensure Fed hawkish resolve and another potentially highly destabilizing surge in yields and the dollar. Derivative hedging markets around the world were keying off the possibility of a bad Thursday’s CPI report. It was good, and a simultaneous reversal of hedges unleashed panic buying and an epic short squeeze across markets. And, for good measure, throw in FOMO (fear of missing out).

Was it a ridiculous market reaction to one month’s data? Absolutely. But these are dysfunctional markets. Way too much market risk is being offloaded to derivatives markets. Derivatives-related selling has the clear potential to spark cascading sell orders, market dislocation and crashes. For now, however, markets remain confident that central bankers retain the capacity to thwart the crash scenario. This ensures Crowded Hedging Markets are especially susceptible to abrupt upside reversals, panic buying, squeezes, melt-ups and mayhem.

Crowded Hedging Markets are certainly a primary source of today’s acute market instability. Moreover, they ensure that hedges don’t work as advertised. For many, hedges have been a drag on performance in 2022 – a year when they should have helped mitigate risk. I’ll assume that scores of managers and investors will throw in the towel on hedging risk for 2023. Just assume the bear market is over. Besides, hedging doesn’t work well anyway.

I understand why most want to see this week’s big rally in a positive light. And I wish I wasn’t negative so much of the time. But it all looks like an accident in the making to me.

Wall Street asks, is October’s positive inflation surprise enough to move the needle for the Fed? It might be for Jay Powell, though not in the markets’ desired direction. I suspect this is exactly the dynamic Powell frets – a major loosening of market financial conditions. And he also faces the prospect of markets turning giddy for a year-end rally.

With Crowded Derivatives Hedging, markets virtually become binary. They either falter in de-risking/deleveraging, illiquidity, dislocation and crisis, or markets do an abrupt about-face, in your face “risk on” panic buying and speculative excess. And “risk on” loose financial conditions undermine the Fed’s inflation fight, increasing the odds for a longer and more challenging tightening cycle.

A chronicle of this week’s developments would be incomplete without noting some major cost cutting announcements. Mark Zuckerberg confronted the reality that the halcyon free “money” days are over. As a former employee stated: “The Bubble has burst.” It’s worth noting that Meta’s stock rallied on the aggressive cost-cutting news, the same reaction stocks had to cost cutting announcements from Netflix, Amazon, Intel, Microsoft, Google and others. CEOs will continue to cut jobs and expenses so long as they’re rewarded for it. Can Twitter slash costs fast enough? And what debt holders are on the hook for Musk’s Twitter fiasco?

November 10 – Financial Times (Cristina Criddle and Hannah Murphy): “After 18 years of bumper growth, a new reality dawned on Meta… as chief executive Mark Zuckerberg announced a drastic retrenchment of his company’s workforce. The deep job cuts — equal to about 13% of its workforce, or 11,000 employees — speak to the competitive threats that Meta, which owns Facebook, Instagram and WhatsApp, is facing from deep-pocketed Chinese rival TikTok. They are also the first sign that Zuckerberg has been forced to moderate, at least partly, his costly bet on building a digital avatar-filled metaverse amid heightened scrutiny from investors over his spending. ‘The bubble has burst,’ one former Meta staffer said.”

November 9 – Reuters (Aditya Soni and Nivedita Balu): “Meta Platforms Inc said… it would cut more than 11,000 jobs, or 13% of its workforce, as the Facebook parent doubled down on its risky metaverse bet amid a crumbling advertising market and decades-high inflation. The mass layoffs, among the biggest this year and the first in Meta’s 18-year history, follow thousands of job cuts at other tech companies including Elon Musk-owned Twitter Inc, Microsoft Corp and Snap Inc .”

November 10 – Reuters (Chavi Mehta and Nivedita Balu): “ Inc is undertaking a review of its unprofitable businesses, including the devices unit that houses voice assistant Alexa, to cut costs…, sending its shares up 11%. Following a months-long review, Amazon has told employees in some unprofitable units to look for jobs elsewhere in the company, while moving to redeploy staff from certain teams to more profitable areas and closing teams in areas such as robotics and retail…”

November 11 – Reuters (Katie Paul and Paresh Dave): “Twitter Inc’s new owner Elon Musk on Thursday raised the possibility of the social media platform going bankrupt, capping a chaotic day that included a warning from a U.S. privacy regulator and the exit of the company’s trust and safety leader. The billionaire on his first mass call with employees said that he could not rule out bankruptcy…, two weeks after buying it for $44 billion – a deal that credit experts say has left Twitter’s finances in a precarious position.”

November 7 – Reuters (Matt Tracy): “Elon Musk’s revelation that Twitter has suffered a ‘massive’ revenue drop since he took over 10 days ago underscores the precarious nature of the social media company’s finances after he saddled it with $13 billion in debt, credit experts say. Musk tweeted… that Twitter was losing more than $4 million a day, largely because advertisers started fleeing once he took over. He has blamed civil rights activists pressuring advertisers, though many in the advertising industry say his tweets spreading conspiracy theories have contributed.”

Elon Musk was said to have warned of the risk of bankruptcy only two weeks after his leveraged buyout. FTX went from glorious riches to bankruptcy in a few days. The crypto space is turning into one historic debacle. Unfortunately, millions of unsuspecting “investors” were lured into one of history’s spectacular speculative Bubbles. Things like this are invariably much worse than we ever could have imagined. Panic. Runs and collapses.

November 11 – Financial Times (Joshua Oliver, Scott Chipolina and Nikou Asgari): “Bankman-Fried, who one week ago was among the most respected figures in the crypto industry, with a $24bn fortune and close links with US lawmakers, Wall Street and celebrities, on Friday resigned as FTX’s chief executive. John R Ray, a restructuring specialist who oversaw the Enron and Nortel Networks bankruptcy cases, will take the reins… In just over three years, FTX had secured a $32bn valuation and had wooed a roster of blue-chip investors, including Paradigm, SoftBank, Sequoia Capital and Singapore’s Temasek. Venture capital firms Sequoia and Paradigm have in recent days marked their investment down to zero. The sprawling business empire run by a tight-knit group of longtime associates around Bankman-Fried, many of whom lived together in a Nassau, Bahamas, penthouse, has around 100,000 creditors and $10-50bn of assets and liabilities, according to the filing.”

November 11 – Wall Street Journal (Vicky Ge Huang): “Stephen Gibbs got spooked this week when he heard about problems brewing at FTX and he decided it was time to take his money out of the crypto exchange. Mr. Gibbs, a musician in Thailand, said he tried to withdraw his money Tuesday. But FTX that day halted both crypto and fiat withdrawals from its international unit. As of Thursday, Mr. Gibbs said, his transaction was still listed as ‘requested.’ On Friday, FTX filed for bankruptcy protection. ‘If you couldn’t trust an exchange like FTX, you can’t trust any exchange,’ Mr. Gibbs said before the bankruptcy filing. ‘And then if you can’t trust exchanges, the whole premise of cryptocurrency doesn’t work.’”

Little wonder Beijing is moving aggressively on all fronts. October Credit growth was alarmingly weak. China’s broad measure of Credit growth, Aggregate Financing (AG), expanded only $128 billion in October, down from September’s almost $500 billion and just over half of estimates. At $4.04 TN, y-t-d growth is almost 9% above 2021 (and down 8% from 2020, while up 34% from 2019).

New Bank Loans expanded only $86 billion (20% below estimates), down from September’s $350 billion and the weakest month of lending since December 2017. At $2.63 TN, y-t-d New Loan growth is running 6.5% ahead of 2021 (up 10.7% compared to 2020 and 31% ahead of 2019). Corporate Bank Loans dropped to $65 billion, down from September’s $270 billon (up from October 2021’s $44bn).

Consumer (chiefly mortgage) Loans were slightly negative, the first contraction since April. At $478 billion, y-t-d Consumer Loans are half of last year’s pace. What’s more, 2022 Consumer Loan growth is down 44% from comparable 2019. At 6.4%, one-year growth is down from the 12.5% rate to start the year – to the weakest pace in decades.

Corporate Bonds expanded a reasonably solid $33 billion, with y-t-d growth ($262bn) down 19% and 53% from comparable 2021 and 2020. Government Bonds gained $38 billion, with y-t-d growth of $872 billion 23% ahead of 2021 (down 14% from comparable 2020). “Shadow Banking” contracted about $25 during October. M2 “money supply” was up 11.8% y-o-y, near the strongest growth since 2016.

Beijing Friday released a list of “20 key parameters to guide officials on the ground as it eases… Covid Zero…” They look reasonable enough. There’s one worth noting: “React quickly to outbreaks to reduce size and duration needed for pandemic control.” This is the essence of Covid Zero, and there’s seemingly no easing of the pressure on local officials to take draconian measures to try to halt the transmission of a highly contagious virus.

Original Post 12 November 2022

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