“US Stocks Suffer Worst Year Since Financial Crisis.” “Stock and Bond Markets Shed More Than $30tn in ‘Brutal’ 2022.” “Nasdaq Closes Out its First Four-Quarter Slump Since Dot-Com Crash.” “Elon Musk Becomes First Person Ever to Lose $200 Billion.”

There are books and chapters to be written. This “Review” CBB can only scratch the surface. The year history’s greatest Bubble was pierced – with a most protracted period of monetary disorder coming home to roost. The “everything Bubble” morphing into the everything bust. And rarely has a Warren Buffett quip been as apropos: “Only when the tide goes out do you discover who’s been swimming naked.” A Revealing Year at Beach Nudist Colony.

It’s said that “bull markets create genius.” Brilliance vaporized in 2022 (in a mushroom cloud). Musk, Woods, Bankman-Fried, Xi Jinping come quickly to mind. So much boom-time BS belatedly recognized as such. More striking than the humbling of bull market icons was the specter of Crowds scurrying around in their birthday suits, befuddled that trading options and buying dips had turned into money losers. A confluence of FOMO (fear of missing out), TINA (there is no alternative), and bursting speculative Bubbles chastened tens of millions. The downside of manias.

The sad reality is that millions of unsuspecting Americans parted ways with a chunk of their financial security. They didn’t realize they were speculating rather than investing. For too long, our Federal Reserve ensured that disregarding risk became the go-to winning strategy. The undoubting had no idea they were about to be slammed by the double whammy of collapsing Bubbles and rampant consumer price inflation.

It had all been a grand illusion: the Fed and free “money” generating a permanent plateau of prosperity. The year saw inflationism’s inescapable scourge of wealth destruction and misery begin to be revealed.

Bitcoin dropped 64% in 2022. It was a cryptocurrency relative outperformer. Solana collapsed 94%, Cardano 81% and Ethereum 68%. Binance Coin fell 52%, XRP 59% and Dogecoin 60%. Initial industry bankruptcies included hedge fund Three Arrows Capital, Singapore-based 3AC, Voyager Digital, Celsius Network, BlockFi, Core Scientific and, of course, FTX. Wunderkind Sam Bankman-Fried (SBF), with peak Bubble “wealth” estimated at $26 billion, will start the new year under court-ordered detention at his parent’s California home on a $250 million bond (facing eight federal counts of “wire fraud, money laundering, and conspiracy, carrying a maximum of 115 years in federal prison”).

Tesla’s stock collapsed 65% this year, Meta/Facebook 64%, Zoom 63%, Rivian 82%, Netflix 51%, Nvidia 50%, Amazon 50%, Intel 49%, Micron 46%, Qualcomm 40%, Alphabet/Google 39%, Moderna 29%, Microsoft 29%, and Apple 27%. The Philadelphia Semiconductor Index dropped 35.8%, with the NYSE Arca Computer Technology Index sinking 32.4%. The colossal “tech” Bubble sprang myriad leaks – crypto, stocks, venture capital, SPACs, private equity…

Generac was the biggest decliner in the S&P500, losing 71% of its value. In the DJIA, Salesforce lost 47.8%, Disney 43.9%, 3M 32.5% and Nike 29.8%. The Bloomberg REIT Index dropped 29.2%.

The “Periphery to Core” analytical framework is helpful. Speculative Bubbles burst at the high-risk fringe – crypto, equities, corporate debt and EM.

The Argentine peso lost 42.0%, Turkish lira 28.9%, Colombian peso 15.9%, Hungarian forint 13.1%, Indian rupee 10.2%, Taiwanese dollar 9.9%, Indonesia rupiah 8.5%, Philippine peso 8.5%, Chinese renminbi 7.9%, Polish zloty 7.8%, and the South African rand 6.5%. On the positive side, the Brazilian real gained 5.6%, the Mexican peso 5.3%, and the Peruvian sol 5.1%.

At the global “core,” “king dollar” went on a moonshot. After beginning the year at 95.67, the Dollar Index almost hit 115 on September 28th – with the UK bond market at the cusp of collapse. Global de-risking/deleveraging was in a “doom loop” of forced bond liquidations, a surging dollar, EM central bank Treasury sales to support faltering currencies, heightened liquidity concerns, and only more deleveraging and hedging-related selling.

The bursting global bond Bubble came alarmingly close to dislocating. UK gilt yields spiked 146 bps in six sessions (September 16th to 27th) to a 16-year high 4.59%. The catalyst was the new Truss government’s “mini budget” heavy on tax cuts and spending. Markets for years (of loose financial conditions) welcomed reckless deficit spending. But with surging inflation, powerful global deleveraging, and waning liquidity, market reaction was swift and brutal.

While hedge funds and other speculative leverage were surely contributing, deleveraging in the UK pension system was in September the epicenter of bond market dislocation. So-called “liability-driven investing,” or LDI, had in the UK tripled in size over the past decade to $1.7 TN (from Bloomberg). These strategies accumulated huge amounts of leverage and derivatives, with surging market yields sparking self-reinforcing liquidations, higher yields and more forced liquidations. It was one massive, self-reinforcing margin call – most conspicuously in the UK, but global in nature.

Contagion effects were powerful. Greek yields surged 60 bps in six sessions to a five-year high 4.84%, with Italian yields up 62 bps to an almost decade-high 4.64%. Ten-year Treasury yields surged 57 bps in seven sessions to an intra-day high of 4.01% on Wednesday, September 28th – trading above 4% for the first time since 2008. The U.S. bond volatility MOVE index surged to about 160, just below the March 2020 crisis high. U.S. corporate CDS (investment-grade and high-yield) spiked to the highest prices since the 2020 pandemic crisis. During UK crisis week, 10-year yields surged 73 bps in Poland, 62 bps in Croatia, 52 bps in Hungary, 43 bps in the Czech Republic, and 41 bps in Peru.

China’s “big four” bank CDS surged to multi-year highs. China sovereign CDS posted a two-week 37 bps spike to 112 – the high back to January 2017. With developer bond prices collapsing, the yield on China’s high-yield dollar bond index jumped over 200 bps in a week to 25.25%. Asian high-yield bond yields rose 133 bps to 17.54%.

Global bank CDS spiked higher. U.S. bank CDS prices jumped to highs since the pandemic. EM CDS surged. Dollar-denominated EM bond yields spiked higher. In short, highly synchronized world markets were at the brink. Markets were “seizing up” – and doing so in an environment with newfound central bank liquidity backstop (i.e. “Fed put”) ambiguity.

It was a year of unprecedented global monetary tightening. There were scores of rate increases, including four extraordinary 75 bps Fed hikes, along with some central bank balance sheet shrinkage (“QT”). Yet the most consequential policy move of the year was the Bank of England’s September 28th emergency “pivot.” Just weeks ahead of its scheduled start to QT (quantitative tightening), the Bank of England abruptly resorted to another round of QE to stabilize the gilt market. BOE: “Were dysfunction in this market to continue or worsen, there would be a material risk to UK financial stability.”

The Bank of England bailout marked the year’s high in the Dollar Index (114.78), as well as highs for key risk indicators. Peak 2022 prices were set on September 28th for US investment-grade CDS (114bps), US high-yield CDS (640 bps), JPMorgan CDS (114bps), European (sub.) bank bond CDS (289bps), and European high-yield CDS (695bps).

Markets interpreted the BOE’s move as confirmation of the dependability of central bank market liquidity backstops. All the hawkish talk would vanish, with surefire central banks doing what they do when crisis dynamics take hold. Soon there were indications of a more general weakening in the knees for the central banker community. Fed vice chair Lael Brainard delivered a speech on October 10th laying out “a case for exercising caution as the central bank raises interest rates.” Hawk James Bullard suggested a 2023 policy shift, while Neel Kashkari contemplated a pause.

Markets could relax. The “Fed put” was alive and well. Talk of Volcker and inflation-fighting resolve was, at the end of the day, all talk.

A major global deleveraging episode had been subdued. Meanwhile, the U.S. economy showed notable resilience. It was a year of speculative Bubbles bursting everywhere. It’s reasonable to assert that the great Credit Bubble was pierced at the periphery. Importantly, however, rapid Credit growth was ongoing at home and abroad.

From the Fed’s Z.1, we know that historic U.S. Credit expansion ran unabated through the first three quarters of the year. Non-Financial Debt (NFD) expanded a seasonally-adjusted and annualized (SAAR) $5.438 TN during Q1, $4.318 TN for Q2, and $3.284 TN during Q3. For perspective, NFD expanded $2.439 TN during 2019, the strongest annual Credit expansion since 2007’s record $2.533 TN. NFD ballooned (without precedent) $6.791 TN during 2020, then somewhat came off the boil for 2021’s $3.869 TN.

Barring a sharp Q4 slowdown, 2022 Credit growth will be second only to 2020. First-half mortgage Credit growth was the strongest since 2007. Through three quarters, Consumer Credit expanded at the fastest pace since 2001.

The ongoing lending boom was 2022’s best kept secret. Bank Loans expanded (a nominal) $1.076 TN, or 11.4% annualized, during 2022’s first three quarters. Over four quarters, Bank Loans surged an unprecedented $1.504 TN, or 12.3%. For perspective, Bank Loans expanded $519 billion during 2021, above the past decade’s annual average of $467 billion (below 2005’s record $685bn).

Markets began the year pricing in an expected 0.82% Fed funds rate by the time of the December 14th FOMC meeting. Two-year Treasuries yielded 0.73%, with the 10-year at 1.51%.

As expected, the Fed was way too timid in reversing its ultra-loose, crisis-period monetary stimulus. A relatively hawkish Powell warned in January of impending hikes – yet waited until March for a little baby-step 25 bps nudge off the “zero bound.” The policy rate didn’t reach 1% until the June 15th meeting. Compounding the policy blunder, the Fed stuck with balance sheet expansion almost through the end of June (Fed Credit having expanded almost $150bn y-t-d).

M2 “money supply” surged $6.641 TN, or 42%, in the three years ended March 31, 2022, to a record $21.740 TN. Breaking down the extraordinary monetary expansion (from the Fed’s Z.1), Total (checking and time) Deposits (and currency) surged $6.642 TN, or 37%, to a record $24.382 TN over three years.

Household “liquidity” (cash, deposits and money market funds) surged an unprecedented $4.99 TN, or 37%, in the first two years of the pandemic (2020 and 2021) to $13.360 TN. Corporate liquidity (currency, deposits, money markets and “repo”) also inflated. Ending 2019 at $3.767 TN, Fed QE was instrumental in boosting corporate liquidity by $1.244 TN, or 33%, to end 2021 at $5.011 TN.

The Fed feared a disorderly market reaction to monetary tightening after a period of unprecedented monetary stimulus. Understandably, the fixation was on market fragility. This drew attention away from both non-market (i.e. bank and “private Credit”) lending booms and the phenomenal pools of “money” created during the Fed’s historic balance sheet expansion.

The Fed belatedly recognized that “transitory” was the wrong adjective. They nonetheless believed hawkish talk and the prospect of a tightening cycle would suffice in tightening financial conditions and quashing incipient inflationary pressures. Confirmation of this thesis was seen in tightened market financial conditions – more specifically with widening corporate bond spreads and the shuttering of the junk bond market.

Yet the larger story of 2022 was the ongoing lending boom thriving outside the markets. Moreover, with household and corporate spending bolstered by huge cash reserves, the greater U.S. economy – and inflation – remained surprisingly immune to Fed tightening measures.

FT headline: “Year in a Word: Inflation.” Too simplistic. This year’s key dynamic was a momentous shift in inflation dynamics, from years of asset market-centric price inflation to broad-based consumer, commodities and employment pricing pressures. Inflation dynamics are complex. But a confluence of developments conspired to alter the global inflation backdrop.

Trillions of pandemic monetary inflation were a tinderbox waiting to ignite. Russia’s March invasion of Ukraine dramatically shifted energy and grain supply/pricing dynamics. It also hastened “de-globalization.” Xi and Putin’s “partners without limits” agreement just weeks before the war was undeniable evidence that the world was in the throes of profound and alarming change.

Hopes for a timely return to pre-pandemic supply chains and resource availability conditions were crushed. The future was now murky. Meanwhile, drought, floods, fires, hurricanes, heat waves and deep freezes stirred climate change anxieties. The combination of climate-related food supply issues and a whirlwind of renewable investment also underpinned the new inflationary environment.

The U.S. officially surpassed one million Covid deaths in May. Many millions suffer some degree of “long-Covid” issues. The number of individuals “not in the labor force” remains about five million higher than pre-Covid levels. After beginning the year at a historically elevated 11.5 million, available job openings (JOLTS) peaked in March at a record 11.9 million. By October, the number had dipped to 10.3 million, still more than three million jobs ahead of pre-pandemic levels. After beginning the year at 3.9%, the unemployment rate was down to 3.7% near year-end.

Despite Fed tightening measures, the inflationary boom ran unabated – fueled by rapid Credit growth, huge cash balances, and a newfound inflationary mindset. Borrowing and spending is habitual, borrowing that spurs the Credit growth necessary to sustain rising prices. Inflated gas and food prices directly feed into huge growth in credit card balances.Why not buy now when prices are surely only going higher? Besides, jobs are plentiful and wages are growing.

Monetary tightening and bursting speculative Bubbles. War and troubling geopolitical developments. It was a year of drama. But the essence of why 2022 was historic is subtler. Momentous secular change. The year marked the end of a multi-decade cycle of ever-looser monetary policy, declining funding costs, inflating financial asset prices, expanding global integration and trade relationships (“globalization”), and associated scores of financial and speculative Bubbles.

Years of reckless monetary inflation, bypassing consumer prices as it stoked asset price inflation and Bubbles, had finally come to a conclusion. No longer could central bankers simply fixate on the financial markets and lean on unconventional monetary stimulus, while disregarding inflation risk.

Deteriorating U.S. and China relations are emblematic of unfolding new cycle dynamics. Xi Jinping has achieved absolute power, as confidence in Beijing policymaking hits lows. A mishandling of “zero-Covid,” and then a lack of preparation for today’s Covid free-for-all. This follows years of economic mismanagement. A historic apartment Bubble burst this year, while a deeply maladjusted “Bubble Economy” was beset by intense pressures.

Three percent 2022 GDP growth will uncharacteristically fall below Beijing’s 5% bogey. Most troubling, it required another year of double-digit system Credit growth to muster the weakest Chinese economic performance in decades. Annual growth in Aggregate Financing will likely surpass 2020’s record $4.6 TN. As of September 30th, Chinese Bank Assets had added another $5.0 TN y-o-y to a record $54.2 TN (3-yr growth 31%). Most recent data show China’s M2 “money supply” is expanding at a 12.4% rate.

Similar to the U.S., China’s Credit Bubble inflated in the face of collapsing speculative Bubbles. Massive Beijing stimulus and bank lending held financial crisis and economic depression at bay.

Tokyo also did its utmost to hold back crisis dynamics. It’s worth contemplating the extent to which Japan’s ongoing negative rates and Bank of Japan monetization bolstered global liquidity throughout 2022.

Arguably, Japan’s extremely loose monetary policy (negative rates/QE/YCC) has been integral to global leveraged speculation. Speculators have borrowed for free (or better) in Japan and used these funds to leverage in higher-yielding securities around the globe. The weak yen made many “carry trade” speculations profitable this year (offsetting losses on bond positions). And as Japanese institutional and retail accounts were forced overseas for positive yields, this liquidity surely provided critical support for vulnerable 2022 global markets. Market upheaval could have been worse had the BOJ joined the global tightening effort.

The Bank of Japan purchased a monthly record $128 billion of bonds in December to maintain the ceiling on its yield curve control (YCC) program. It’s unsustainable buying/monetization for a dangerously unsustainable policy. Ramifications for a reversal of Japanese monetary policy are global and major – though policy normalization will unfold over months. After getting over the initial shock of a doubling of the yield ceiling to 0.50%, markets were reassured by the prospect of additional BOJ QE necessary to support ongoing YCC. Japan avoided crisis in 2022, but at a cost of the most outlandish case of kicking the can down the road I’ve witnessed in my few decades of macro analysis.

“Pension funds and other ‘non-bank’ financial firms have more than $80 trillion of hidden, off-balance sheet dollar debt in FX swaps, the Bank for International Settlements (BIS) said,” read a December 4th Reuters article. It was an ominous revelation. I’ll assume this “hidden, off balance sheet dollar debt” played a role in the deleveraging episode that threatened global bond markets during the late-September UK gilts crisis. BOE crisis operations (with help from others) ended that phase of global de-risking/deleveraging.

Ten-year Italian yields ended the year at 4.70%, up 83 bps for the month of December to the high since October. Ten-year Treasury yields rose 27 bps this month to seven-week highs. Looking ahead, we’re justified for fearing that the next rounds of global de-risking/deleveraging now smolders. It was an extraordinary year and portentous start to the new cycle.

Original Post 31 December 2022

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Categories: Doug Noland