Monstrous Chinese banks stuffed with dung. Little wonder Treasuries are rallying, with inklings of the first safe haven bid in a while. And I would tend to somewhat dismiss the view that Treasury yields are discounting typical recession risk.
Market yields are instead pricing in rising probabilities of systemic instability forcing the Federal Reserve into emergency rate cuts and likely more QE.
Fed officials are not prepared for such a scenario.
Bubble inflection points are typically marked by a reversal of speculative flows out of an asset class. After being inundated by flows during the pandemic (especially this year’s first nine months), the “private Credit” boom is suddenly jeopardized by (deferred) redemption requests.
And with Blackstone and others limiting monthly/quarterly redemptions, remaining holders will fear being left holding the bag. Fund outflows require asset liquidations (i.e. commercial buildings and corporate loans), which is tantamount to tightening lending and financial conditions. Factor in tightening bank lending standards, and there’s reason to fear an accelerating downside to both the real estate Bubble and corporate lending boom.
Credit Downturn Acceleration
by Doug Noland
Interesting week. The FOMC statement and “dot plot” were viewed as somewhat more hawkish than expected. In his press conference, it was a solid “Balanced Powell” performance.
Powell stuck with his now familiar hawkish points. “We have more work to do.” “Where we’re missing is on the inflation side. And we’re missing by a lot.” “We do see a very, very strong labor market, one where we haven’t seen much softening; where job growth is very high; where wages are very high.” “I would say it’s our judgment today that we’re not at a sufficiently restrictive level yet…”
He has, however, definitely toned it down – now pulling some punches. Questioned about his previous warning of pain from the Fed’s inflation fight, Powell deflected: “So the largest amount of pain would come from a failure to raise rates high enough and from us allowing inflation becoming entrenched in the economy.”
“Balanced Powell:” “We’re restrictive, and I think we’re getting close to the level we think sufficiently restrictive.” But one of the more interesting exchanges was Powell responding to whether the Fed might re-evaluate and adjust its 2% inflation target.
Powell: “Changing our inflation goal is not something we’re thinking about, and it’s something we’re not going to think about… I think this isn’t the time to be thinking about that. I mean, there may be a longer-term project at some point.”
“Longer-term project”? Commentators on Bloomberg were quick to question why the Chair would today even broach the subject of adjusting the target. “Balanced Powell.”
FT headline: “‘Emphasize the Pain’: Jay Powell Keeps Hawkish Tone Even as Inflation Eases.” Most pundits and analysts saw the FOMC and Fed as more hawkish. Curiously, however, two-year Treasury yields declined a couple basis points during Powell’s press conference to end the session slightly lower.
For the week, two-year Treasury yields dropped a notable 17 basis points to a more than two-month low 4.18% (down from Nov. 7 high of 4.72%). Bloomberg: “Bond Traders Dismiss Fed’s Hawkish Tone, Bet on 2023 Rate Cuts.”
Even more intriguing, Treasury yields declined this week in the face of a surge in European yields. German bund yields jumped 22 bps to 2.15%, with the spread to Treasuries narrowing a notable 31 to a two-year low 135 bps. French 10-year yields jumped 28 bps (2.68%), Spanish yields 29 bps (3.25%), and Portuguese yields 31 bps (3.17%). Italian yields surged 46 bps (up 69bps in six sessions) to a six-week high 4.30%. Reuters: “Debt-Laden Italy Lashes Out at ‘Crazy’ ECB After Rate Hike.” A harbinger of monetary union instability.
The Treasury market is behaving peculiarly. On the margin and versus market expectations, the ECB was somewhat more hawkish than the Fed. My sense is that Treasury market focus has subtly shifted more to fundamental developments and away from monetary policy. The entire yield curve is now inverted. The 2yr/10yr spread closed Friday’s session at negative 70 basis points, after trading at a multi-decade low negative 84 bps last week. And even the three-month/two-year spread traded this week to negative 16 bps (ended week at negative 13) – the low since crisis period March 2020. Something(s) has the markets anticipating a dovish pivot in the not too distant future. The expected Fed funds rate at the FOMC’s March 16th meeting dropped 10 bps this week to a seven-week low 4.78%. The expected rate for the June 15th meeting fell 15 bps to a nine-week low 4.76% (December down 18bps to 4.35%).
The Street.com: “Bond Markets Call BS on Hawkish Fed Chair As Recession Risks Mount.” What might the bond market see that Fed officials are missing?
Stocks enjoyed a nice late-year rally. 2022 economic resilience has bolstered bullish sentiment in the face of stock market losses. The Fed should wrap up rate increases within the next few months. Meanwhile, global economic prospects have brightened with China jettisoning zero-Covid.
Yet there is a compelling bear case gathering momentum. Importantly, system Credit growth has slowed – and the risk of a precipitous lending slowdown is rising.
December 12 – Wall Street Journal (James Mackintosh): “Top executives at Blackstone Inc. declared themselves baffled that so many retail investors want their money back from its giant private property fund, given its strong performance. They shouldn’t be surprised. The very design of the fund encourages investors to withdraw when they see others doing so. My worry is, those same incentives could hit other parts of the financial system as central banks pull back from easy money… Most harmed will be those who piled into private assets without thinking about how much cash they might need. The basic principle of the Blackstone Real Estate Income Trust, or BREIT, is that it took $46 billion from ordinary investors, added debt and bought a bunch of property, mostly Sunbelt housing and warehouses. It was good at it, or perhaps lucky, and the value of the fund went up a lot, so it was very popular. But this year mortgage rates soared and recession fears rose, and house prices began to come down. They have dropped only a bit so far, and not everywhere, but enough to make it less obvious to investors that they ought to be piling cash into a leveraged bet on property prices.”
Bubble inflection points are typically marked by a reversal of speculative flows out of an asset class. After being inundated by flows during the pandemic (especially this year’s first nine months), the “private Credit” boom is suddenly jeopardized by (deferred) redemption requests. And with Blackstone and others limiting monthly/quarterly redemptions, remaining holders will fear being left holding the bag. Fund outflows require asset liquidations (i.e. commercial buildings and corporate loans), which is tantamount to tightening lending and financial conditions. Factor in tightening bank lending standards, and there’s reason to fear an accelerating downside to both the real estate Bubble and corporate lending boom.
December 11 – Wall Street Journal (Matt Wirz, Ben Eisen and Tom McGinty): “Consumer spending in the U.S. is going strong. Consumer lending, not so much. The financial squeeze that started about six months ago for companies that lend to ordinary Americans is getting worse, contrasting sharply with recent rallies in stocks and corporate bonds. The main reason: These finance companies have lost access to easy money. Widespread economic uncertainty has made debt investors less willing to buy the bonds these nontraditional lenders issue… Now, these finance companies are paying as much as four times what they paid in January to borrow in bond markets the cash they lend to customers… Once-highflying consumer-finance companies such as Pagaya Technologies have flipped from profit to loss. Some smaller outfits are shutting down altogether. Many of the nontraditional lenders launched within the past decade, which means they have never weathered a sustained period of high interest rates. ‘All of these fintech firms talk about their data science and machine learning capabilities, but the truth is, their models have not been battle tested through a recession yet,’ said Reggie Smith, JPMorgan… lead fintech stock analyst.”
The ongoing crypto Bubble collapse should have us all fearing the underbelly of “fintech,” “De-Fi” and BNPL (buy now, pay later). Carvana has imploded. NPR: “In a Year Marked by Inflation, ‘Buy Now, Pay Later’ is the Hottest Holiday Trend.” Hangover.
December 14 – Bloomberg (Paige Smith): “US credit-card and personal-loan delinquencies are likely to rise in 2023 to the highest in a dozen years, with lenders cutting back on originations as a potential recession looms. Serious card delinquencies are expected to climb to 2.6% at the end of next year from 2.1% at the close of 2022, according to a forecast… by credit-reporting firm TransUnion. Delinquency rates for unsecured personal loans are also expected to gain, to 4.3% from 4.1%. ‘The liquidity people had is going away,’ Michele Raneri, vice president of US research and consulting at the…company, said… ‘Inflation is a huge contributor.’”
December 16 – Bloomberg (Finbarr Flynn): “Moody’s… raised its forecast for speculative-grade corporate defaults in 2023, warning they could more than quadruple under its most pessimistic scenario. The agency predicts the default rate will climb to 4.9% by November of next year under its baseline scenario, from a forecast of 2.9% for the end of 2022. Last month’s year-ahead projection was 4.5%.”
It took some time. The Credit cycle downturn has accelerated. There is ample justification for joining Moody’s in contemplating the “most pessimistic scenario”. Credit conditions are tightening after historic Credit and speculative Bubbles. Losses – stocks, crypto, options and other speculative trading – continue to mount, as households and businesses burn through their pandemic stimulus cash hoards. Rising rates and market yields are pressuring asset prices. The cost and Availability of Credit are increasingly contractionary. In short, the backdrop is set for a powerful reversal of speculative flows coupled with lender angst to usher in a most painful and destabilizing Credit down-cycle.
Is another crypto shoe about to drop?
December 16 – Financial Times (Scott Chipolina, Michael O’Dwyer, Martha Muir, Joshua Oliver, and Stephen Foley i): “Outflows from Binance accelerated to $6bn in the first half of this week, while accounting firm Mazars has halted its work on crucial ‘proof of reserves’ reporting, as the crypto exchange battles to avert a crisis of confidence. Binance… is battling to reassure investors of its financial strength following the collapse of rival crypto exchange FTX. The exchange said on Friday that it had been hit by roughly $6bn in net withdrawls between Monday and Wednesday.”
December 16 – CNBC (Ari Levy): “Over a month after the collapse of FTX, investor concern over crypto exchange Binance isn’t fading. Binance’s native token, BNB, has fallen 15% in the past week, including a drop of over 6% in the past 24 hours. BNB, first minted in 2017, is the world’s fifth most valuable cryptocurrency, with a market cap of about $39 billion, according to CoinMarketCap. It’s behind only bitcoin, ethereum, tether and USD Coin.”
December 16 – CNBC (MacKenzie Sigalos and Kate Rooney): “Accounting firm Mazars Group has suspended all work with its crypto clients. The decision to cut ties with Binance, KuCoin and Crypto.com comes just after the global accounting firm released ‘proof of reserve’ reports for several digital asset exchanges. The move comes as major cryptocurrency exchanges look to prove their solvency, and show they have enough money to cover customer withdrawals.”
And the biggest shoe… Market and media focus have been on the loosening of zero-Covid, myriad Beijing stimulus measures, and rallying Chinese stocks and developer bonds. Meanwhile, new leaks are springing up in history’s greatest Bubble. Two key sources of acute vulnerability – “wealth management products” and local government financing vehicles (LGFV) – indicate heightened stress.
December 14 – Bloomberg (Wei Zhou): “Concerns are growing about the $1.6 trillion of debt from Chinese local government financing vehicles amid one of the fastest declines in the onshore credit market. Wealth-management products, investment pools that have been selling corporate bonds to meet investor redemptions, are one of the major buyers of LGFV yuan notes. Surging yields and widening credit spreads have prompted firms, including many LGFVs, to pull a cumulative 84 billion yuan ($12.1bn) of planned bond sales since the start of November… Yields on some notes from nonfinancial firms including LGFVs rose more than 10 bps Wednesday… Redemptions of WMPs had already resulted in yield premiums for three-year AAA-rated corporate bonds reaching the highest level since August 2020… The deepening selloff in corporate notes is poised to exacerbate refinancing pressure on LGFVs and lead to higher credit risk in the sector.”
December 14 – Financial Times (Sun Yu): “Beijing’s retreat from its zero-Covid policy is causing chaos in the country’s Rmb29tn ($4.1tn) market for wealth management products, with some fund managers having to freeze withdrawals or sell down their holdings as they struggle to cope with a rush of redemptions by investors. Half of the country’s 31,000 outstanding fixed-income WMPs have reported a decline in value since the government first signalled that it would relax its strict approach to Covid-19 on November 11… Wind, a financial data provider, reported that 1,837 fixed-income WMPs, a major source of funding for China’s bond market, were trading below par value as of December 12, compared with 256 at the beginning of November.”
China’s economy is in serious trouble – the most peril of the pandemic period. And I believe it was more fear of an unfolding downward economic spiral than public protests that was behind Beijing’s abrupt abandonment of zero-Covid. If, as I suspect, Beijing officials are panicked, we can expect a steady drumbeat of fiscal and monetary stimulus. Unlike in the past, markets can no longer take for granted that Beijing has things under control.
They certainly don’t have Covid under control, as a historic wave of infections gathers momentum. China faces a few extremely grim months. Unprecedented uncertainty. How does China’s inadequate healthcare system hold up? The frail economy? Housing pushed over the cliff? Can Chinese society hold together through additional challenging months, smothered by such extraordinary insecurity and deflated prospects? The Chinese will persevere, but can they regain the necessary confidence to thwart economic depression? How long will it take to restore trust in policymaking? And, finally, will confidence be sustained in China’s currency and bloated banking system in the face of massive Beijing stimulus measures?
December 14 – Bloomberg: “China asked some of the nation’s biggest banks to help stabilize the domestic bond market after a wave of fund redemptions by retail investors fueled the biggest credit selloff since 2015, according to people familiar… Regulators asked lenders to buy bonds via their proprietary trading desks… The goal is to absorb the selling pressure caused by retail withdrawals from some of those same banks’ wealth management products, the people said. The so-called window guidance on bond purchases includes notes issued by Chinese local government financing vehicles, one of the people said… The guidance underscores regulators’ concern that a downward spiral of fund redemptions and falling bond prices may stoke financial instability.”
Monstrous Chinese banks stuffed with dung. Little wonder Treasuries are rallying, with inklings of the first safe haven bid in a while. And I would tend to somewhat dismiss the view that Treasury yields are discounting typical recession risk. The inflation-fighting Fed is, after all, prepared to hold its ground in the event of some economic weakness. Market yields are instead pricing in rising probabilities of systemic instability forcing the Federal Reserve into emergency rate cuts and likely more QE. Fed officials are not prepared for such a scenario.
Original Post 17 December 2022
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Categories: Doug Noland