Doug Noland: Market Messaging

Bull market expectations are deeply ingrained. The Crowd will buy the dips and commit more financial resources to the market all the way down – until the shock.

December 31. It’s just a day on the calendar. But what a difference a day makes. The final day of the tax year. And, especially after 2022 losses, there was surely atypically large year-end tax-related selling.

Probably even more significant, the 31st ended the quarter and year for fund performance purposes. There’s less focus on the “window dressing” phenomenon than in the past, but it’s almost human nature to do a little trading that might on the margin present returns in a more favorable light. It can help bonuses. And price tinkering can be more important for hedge funds and other players, where (up to billions of) “incentive compensation” is generated by taking a percentage (traditionally 20%) of fund investment returns.

The beginnings of years present analytical challenges. Attempting to read the tea leaves. Reassessment. Strategies in flux. Money on the move.

There is every reason to approach early 2023 with an intense analytical focus. December 31st concluded a historic Bubble year inflection point. It was certainly an extraordinary year in the markets – stocks, Treasuries, corporate bonds, commodities and currencies. Policy was remarkable, with global central banks orchestrating a concerted hawkish pivot. The launching of the most aggressive U.S. tightening cycle in decades. The bursting of China’s epic Bubble. Russia invades Ukraine. And in the face of myriad headwinds, historic U.S. and Chinese Credit booms were unrelenting.

It’s an intriguing first two weeks of the New Year, to say the least. The S&P500 gained 4.20% in the first nine trading sessions of the year, strong yet significantly lagging the broader market. The small cap Russell 2000 enjoys a y-t-d gain of 7.10%, and the S&P400 Midcap Index 6.20%. The “average stock” Value Line Arithmetic Index has surged a notable 7.50%. The Nasdaq100 is up 5.50%.

At the top of the sector leaderboard, the Philadelphia Gold & Silver Index has an early-2023 gain of 13.11%, the Philadelphia Semiconductor Index (SOX) 10.61%, the Philadelphia Oil Services Index 9.24%, the Nasdaq Transports 9.00%, the NYSE TMT Index 8.38%, and the Nasdaq Telcom Index 7.96%. The KBW Bank Index is up 6.72%, the NYSE Financial Index 6.75%, and the Bloomberg REIT Index 6.45%.

Despite all the talk of recession and rapidly waning inflation, Gold has gained a quick $96 (5.3%) to start the year. Copper has jumped 10.6%. Tin is up 16%, Zinc 12%, and Aluminum 9%.

After a timid start, the Goldman Sachs Most Short Index caught fire this week with a 15.7% surge (up 14.3% y-t-d) – the strongest weekly gain since April 2020.

Markets are in the throes of a major short squeeze. While the majority of hedge funds lost money last year, some large macro funds (i.e. Millennium, AQR, Rokos) enjoyed a banner year. Hedge Fund Research’s index of macro hedge funds posted a 14.2% 2022 return. Popular 2022 macro trades included shorts in bonds, U.S. Bubble stocks, European equities and the yen. Key markets have reversed abruptly and significantly, catching poorly positioned funds with quick losses to begin 2023.

The yen has a two-week gain versus the dollar of 2.54%. As a proxy, the U.S. iShares Treasury Bond ETF (TLT) has surged 7.22% to begin the year, with the iShares Investment-Grade Corporate ETF (LQD) up 4.78% (largest 2-wk gain since April 2020) and the iShares High Yield ETF (HYG) gaining 4.09%. What is surely a huge short in the bond market is suddenly inflicting painful losses. And after benefiting from Treasury bond underperformance in 2022, those leveraged long in corporate debt while hedged (short) with Treasuries are suffering an abrupt reversal of fortune.

In European equities, the Euro Stoxx 50 Index already sports a y-t-d gain of 9.42%. Germany’s DAX has jumped 8.35%, France’s CAC40 8.49%, Italy’s MIB 8.76% and Sweden’s OMX 8.50%. In Asia, Hong Kong’s Hang Seng Index has gained 9.89%, South Korea’s KOSPI 6.69%, China’s CSI300 5.24%, Taiwan’s TAIEX 4.86%, and Australia’s ASX200 4.11%.

Ten-year government yields are already down 69 bps in Italy, 46 bps in Greece, 36 bps in Portugal, and 35 bps in Spain. French yields are 35 bps lower, with German yields 28 bps lower. Ten-year yields are down 193 bps in Hungary, 90 bps in Colombia, 86 bps in Poland, 73 bps in Czech Republic, 66 bps in Romania, 57 bps in Mexico, 49 bps in South Africa, and 43 bps in South Korea.

It matters that some big macro funds are suffering early losses. When leveraged, losses dictate a risk management focus. Widening “leveraged speculating community” losses would boost the odds of problematic de-risking/deleveraging dynamic reemerging later in the year. But for now, this big, cross asset short squeeze (buying to unwind shorts and hedges) is a major liquidity-generating event.

Financial conditions indicators are flashing risk embracement and loose conditions. Investment-grade CDS traded this week to the low (70bps) since last April, with high yield CDS near lows (421bps) since April. JPMorgan, Bank of America, Citigroup, Goldman and Morgan Stanley CDS all traded Friday at nine-month lows. Investment-grade corporate spreads to Treasuries traded to the narrowest margin since April (high yield near lows since April).

“One has to be careful of false dawns. I would stick with my view that a recession this year is more likely than not,” commented Larry Summers Friday on Bloomberg television. “Bond king” Jeffrey Gundlach this week said the yield curve was “screaming recession” – “there’s so many recession indicators that are now flagging.” This follows last month’s, “I think the odds are probably greater than 75% that there’s a rate cut in 2023.”

Market optimism is likely a false dawn, and the big cross asset short squeeze could certainly prove one dazzling flash in the pan. Yet financial conditions this loose should not be ignored. I would expect recessionary forces to be held at bay.

Squeezes have long been a fixture of markets, and the more speculation, the more prominent squeeze dynamics become. Markets have been so speculative in recent years that squeezes have become commonplace. The current one is uncommon.

Importantly, this squeeze can act as the system’s major source of marginal liquidity at a critical juncture. There have been indications of tightening bank lending standards, with some waning momentum for the historic lending (bank, non-bank, “private Credit,” etc.) boom. Rallying securities markets and associated loosening hold the potential to spur market-based Credit growth while extending lending excess – working to essentially extend “Terminal Phase” Credit Bubble excess.

Gundlach: “My 40 plus years of experience in finance strongly recommends that investors should look at what the market says over what the Fed says.” And from a recent tweet: “There is no way the Fed is going to 5%. The Fed is not in control. The bond market is in control.”

A major loosening of market financial conditions creates a tailwind for inflation and the economy, significantly boosting the odds the Fed surpasses 5%. The Federal Reserve may not be in control, but they should be expected to push back. Fed officials surely recognize that celebratory Wall Street assertions of mission accomplished in the war on inflation are dangerously premature.

I’m always trying to discern messages from the markets, especially bonds. Bond messaging was notably amiss one year ago, with 10-year Treasury yields at 1.70% (2-yr 98bps). Yields almost reached 3.5% in June, were back down to about 2.58% in August, and were back up to 4.25% by October. Ten-year yields ended this week at 3.50%. A hefty dose of skepticism regarding bond messaging is appropriate.

Conventional thinking has the bond market – yields and the yield curve – signaling 2023 recession. Rate markets basically have Fed funds peaking at 4.91% at the Fed’s May 3rd meeting, only to reverse course, with rates reduced to 4.47% by the December 13th meeting.

Rates markets are clearly at odds with Fed messaging. Powell and other members have been unambiguous. Rates are going higher for longer – and expect hesitancy to pivot to looser monetary policy. Bond market messaging is fuzzy. If rates were reflective of recession expectations, then yields should be responding to loosened conditions. One would think bonds would view the equities squeeze and “risk on” dynamic with growing apprehension. Yet the expected Fed funds rate at the May 3rd meeting was down three bps this week and six bps year-to-date. Two-year yields were 19 bps lower over two weeks – in the face of “risk on.”

If, on the other hand, messaging from the bond market is more to prepare for some type of accident, things are making more sense. The gilt market accident spurred an abrupt Bank of England pivot. While I’m skeptical there’s sufficient recession risk over the next six months to induce a Fed pivot, some type of market accident forcing the Fed’s hand this year seems perfectly reasonable.

And from this “accident” perspective, the rate and bond markets’ disregard for squeezes and loosened conditions seems rational. After all, the instability and speculative dynamics unleashed only work to raise the odds of a subsequent accident: An everything squeeze and upside dislocation increases the likelihood of an eventual everything reversal and downside dislocation (“crash”). If everyone gets all bull up – boosting exposures and leverage while unwinding shorts and hedges – then everyone (on the same side of the boat) might later in the year simultaneously rush to sell and hedge in a destabilizing bout of de-risking/deleveraging/illiquidity.

The Federal Reserve faces a major dilemma. Markets are doing precisely what they didn’t want. Fed officials were hoping to tone down the aggressive rate hikes, while maintaining the pressure necessary to convince the markets not to loosen. It just didn’t work; market structure wouldn’t allow it.

And officials are now making a mistake by essentially pre-committing to small rate increases. Philadelphia Fed president Patrick Harker: “Hikes of 25 bps will be appropriate going forward.” Atlanta Fed President Raphael Bostic, Richmond Fed president Tom Barkin and others have suggested a 25 bps increase next month. Especially at the beginning of the year when market conditions are markedly loosening, Fed officials should be leaning hawkish and leaving the door wide open to more aggressive tightening measures.

And I understand why Chair Powell would choose to avoid discussing monetary policy in his Tuesday speech at the Riksbank. But he missed an opportunity to lean against loosening at what was potentially a critical market juncture.

January 8 – Financial Times (Steve Johnson): “Last year may have been one of the worst years ever for global markets, but sections of the exchange traded fund industry stormed to new records in a generally strong year… ETFs attracted net inflows of $867bn globally during the year, the second-highest on record after 2021’s $1.29tn peak, according to… BlackRock… But a number of asset classes went one better and chalked up their highest ever flows… Government bond ETFs saw net inflows of $181bn, more than in the three previous years combined…, with records broken across the curve, in short, intermediate, long and blended maturity funds. And while aggregate flows to equity ETFs slowed to $598bn from $1tn in 2021, emerging market equities set a fresh record, sucking in $110bn. Some defensive sectors also shattered their previous bests in 2022, such as healthcare ($20bn) and utilities ($6bn).”

2022 was a Bubble inflection point year. Things could have been a whole lot worse. Rather than destabilizing outflows, the ETF complex enjoyed another year of banner inflows. The hedge fund industry had some performance issues, but it was nothing close to panic deleveraging, mass redemptions, and industry crisis of confidence. The derivatives industry had a scare (September), but dislocation was saved for another day. And that hidden $65 TN of global speculative leverage that has the BIS worried remained snugly hidden.

After more than a decade of spectacular asset inflation, last year’s bear market was not enough to quash speculative impulses. The ETF complex, the leverage speculating community and derivatives markets inflated only larger.

There’s ample support for the thesis that we’re in the initial stage of what will be a most protracted and grueling bear market. From this perspective, it’s fitting to see a recovery in bullishness and speculative excess. Bull market expectations are deeply ingrained. The Crowd will buy the dips and commit more financial resources to the market all the way down – until the shock.

And while powerful squeezes captivate the marketplace, potential accident catalysts make steady headway.

January 13 – Reuters (Kevin Buckland and Junko Fujita): “The yield on Japan’s benchmark 10-year government bonds breached the central bank’s new ceiling on Friday in the market’s most direct challenge yet to decades of uber-easy monetary policy, before a wave of emergency bond buying reined it back in. Swirling speculation that the Bank of Japan’s policy of yield curve control (YCC) could be revised, or even abandoned, as early as next week had investors rushing for the exits. That catapulted 10-year Japanese government bond yields as much as 4 bps higher to 0.54%, the highest since mid-2015 and above a recently widened band of -0.5% to +0.5% set by the BOJ in a shock decision just three weeks ago. The stress was evident across the yield curve, forcing the BOJ to announce two separate rounds of emergency buying worth around 1.8 trillion yen ($13.9bn) combined. The central bank already holds 80% to 90% of some bond lines.”

January 11 – Associated Press (Fatima Hussein and Josh Boak): “The federal government is on track to max out on its $31.4 trillion borrowing authority as soon as this month, starting the clock on an expected standoff between President Joe Biden and the new House Republican majority that will test both parties’ ability to navigate a divided Washington… Once the government bumps up against the cap — it could happen any time in the next few weeks or longer — the Treasury Department will be unable to issue new debt without congressional action. The department plans to deploy what are known as ‘extraordinary measures’ to keep the government operating. But once those measures run out, probably mid-summer, the government could be at risk of defaulting unless lawmakers and the president agree to lift the limit on the U.S. government’s ability to borrow.”

January 13 – Bloomberg: “Revelations of a growing number of Chinese local government financing vehicles with overdue payments for a type of short-term debt are aggravating concerns about this group of risk-laden state borrowers. Over 100 LGFVs and their units across 22 provinces have left their maturing commercial bills unpaid since November 2021, indicating heavy debt pressure and tight cash flows, GF Securities analysts including Liu Yu wrote… The yuan-denominated local debt instrument typically carries tenors of less than one year. The financial health of LGFVs, which are mostly tasked to build infrastructure projects, has come under renewed scrutiny after one such borrower from an underdeveloped province recently extended its bank loans by two decades.”

Coincidentally, 10-year Treasury yields are today at about the same level as just before the 2008 crisis. Today’s inflation, policy, and global backdrops diverge significantly from ’08. What’s similar is bond messaging, which seems to suggest that market structure is untenable.

Original Post 13 January 2023

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