Monetary Inflation Run Amok

There was further evidence this week that loose financial conditions are working their magic. University of Michigan Consumer Sentiment added a stronger-than-expected 1.5 points to January’s strong gain to reach 66.4, the highest reading since January 2022. Current Conditions popped four points higher to a 14-month high 72.6.

The Consumer Expectations component was down slightly to 62.3. The dispersion of expectations between the political parties is noteworthy. The UofM reading of Consumer Expectations rose to 76.3 for Democrats, 48.5 for Republicans and 61.7 for Independents. Interestingly, the survey of One-Year Price Inflation Expectations increased three-tenths to 4.2%.

February 7 – Reuters (Lindsay Dunsmuir and Howard Schneider): “Friday’s blockbuster jobs report showed why the battle against inflation will ‘take quite a bit of time,’ Federal Reserve Chair Jerome Powell said…, acknowledging that interest rates may need to move higher than expected if that sort of economic strength threatens the Fed’s progress in lowering inflation. In a question-and-answer session before the Economic Club of Washington, Powell declined several times to say explicitly that the surprising addition of 517,000 new jobs in January would necessarily force the Fed’s benchmark interest rate higher than the 5% to 5.25% range currently anticipated…”

It was an interesting interview, though David Rubenstein missed the opportunity to have Powell clarify how he and his committee define financial conditions. Bond yields moved little on Powell’s Tuesday appearance at the Economics Club of Washington, D.C. Yields surged Monday ahead of Powell, as markets prepared for Fed pushback. Atlanta Fed president Raphael Bostic got things started. “If a stronger-than-expected economy persists, ‘It’ll probably mean we have to do a little more work,’ Bostic told Bloomberg… ‘And I would expect that that would translate into us raising interest rates more than I have projected right now.” Yet the bond retreat preceded Bostic, with rising yields from Asia to Europe.

Ten-year Treasury yields jumped 21 bps this week to 3.73%. Following the blockbuster jobs report, markets are not as dismissive of Fed hawkishness. By the end of the trading week, analysts pointed to the closer alignment of market and Federal Reserve rate expectations. Rate markets now have peak Fed funds at 5.19% for the July 26th FOMC meeting, compared to the previous week’s 5.03% at the June 14th meeting.

The big cross asset squeeze (that pushed stock and bond prices higher) explains part of the recent divergence between Fed and market expectations. It was interesting to see benchmark MBS yields surge 42 bps this week, reversing notable early-2023 MBS outperformance (yields having dropped 50 bps over the previous five weeks). Short squeeze dynamics and the unwind of hedges tend to have exaggerated impact on mortgage securities. And after yields were squeezed 62 bps lower over five weeks, UK gilt yields abruptly reversed 34 bps higher this week. The equities short squeeze, as they tend to do, also reversed sharply this week. The Goldman Sachs Short Index sank 9.7%, reducing y-t-d gains to 15%.

For now, Fed and market expectations for peak Fed funds are in closer alignment. The same cannot be said for the anticipated timing of the pivot back to rate cuts. Markets may now be buying the “higher,” but they continue to push back against the Fed’s “for longer.” Market pricing has Fed funds declining 26 bps between July’s peak and the December 13th meeting – with expectations for almost two cuts (46bps) between July and the January 31st 2024 FOMC meeting.

Analysts early in the new year asserted that recession expectations were behind the market’s 2023 pivot expectations. In his post-meeting press conference, Powell claimed markets were discounting a more rapid drop in inflation, which would have the Fed reversing course. With the markets now more aligned with the Fed on peak rates, pivot analysis becomes only more intriguing.

The case that rate markets are discounting the probability of an “accident” seems only more compelling. Evidence of impending recession is today weaker than at the start of the year. At this point, the flurry of tech layoffs is handily absorbed by the incredible 11 million job openings. Weakness in manufacturing is offset by resilience in services. And while there are early indications of consumer debt issues and tightened lending standards, lending has likely only somewhat moderated from last year’s exceptional level. Importantly, market financial conditions have loosened meaningfully. Surging markets have spurred debt issuance, as well as general confidence.

But the big short squeeze, unwind of hedges, and the reemergence of bullish optimism raise the odds of trouble later in the year. The risk of upside surprises for economic growth and inflation is higher today. And I would argue that risks associated with a problematic de-risking/deleveraging episode grow by the week. For one, the Fed continues to shrink its balance sheet, a pullback in liquidity these days easily offset by squeeze-related buying and speculative leveraging. Moreover, strong flows into the risk markets, on the belief that the storm has passed, only add to the scope of potential outflows poised to overwhelm the marketplace in the event of acute instability and crisis dynamics. In the recent whirlpool of abundance, illiquidity festers.

But for “accident watch,” the radar is set internationally.

February 10 – UK Telegraph (Joe Barnes): “Russia on Friday launched its heaviest bombardment on southern Ukraine since the start of the war, as officials warned Moscow’s major offensive had ‘definitely’ started. Ukraine’s Air Force said Russian forces had fired multiple missiles from TU-95 strategic bombers and Iranian-built kamikaze drones at multiple targets across the country. Moscow also launched 35 S-300 missiles, usually used for air defence, at ground targets… The missile attack on Ukraine was the fourteenth mass strike, which has mainly been focused on the country’s energy network, since October.”

February 10 – Bloomberg (Toru Fujioka): “Kazuo Ueda, the surprise pick to become the Bank of Japan’s next governor, will be tasked with keeping confidence in the BOJ’s policy path without jarring global markets and heaping strain on the finances of a government that just can’t stop spending. Given the tricky mission ahead, Prime Minister Fumio Kishida was widely expected to opt for the safest pair of hands he could find: Masayoshi Amamiya… But instead Ueda, a university professor and MIT PhD, is now set for the top slot… ‘The Bank of Japan’s current policy is appropriate and monetary easing needs to be continued at this point,’ he told reporters Friday… There will be precious little patience awaiting Ueda when he takes the helm in April as market players wait for another opportunity to bombard the central bank’s stimulus program with the kind of attacks that toppled a similar yield-based framework in Australia. ‘It’s hard to overstate the challenge,’ said Takahiro Sekido, chief Japan strategist at MUFG Bank Ltd. in Tokyo and a former BOJ official. ‘Saying it’s a rough ride isn’t even close. The BOJ has done so much in the past decade and the policy got so complicated — so many markets will be affected by even a slight policy change’… ‘It is absolutely inevitable that the BOJ will have to dismantle its quantitative easing fairly quickly,’ says Amir Anvarzadeh, a strategist at Asymmetric Advisors…, who has tracked Japanese markets for three decades. ‘It’s coming’… In an illustration of just how costly the battle is proving, the BOJ shelled out in January more than three times the amount the government earmarked for additional defense spending in the coming fiscal year. With inflation at a four-decade high, a bond market showing signs of dysfunction and indications that wages are finally going up, the BOJ is running out of reasons to keep adding to a mountain of bond purchases that already outsizes the world’s third-largest economy.”

Markets Friday didn’t quite know how to react to the stunning news. Masayoshi Amamiya, governor Kuroda’s right-hand man and heir apparent, is said to have turned down the job. Can you blame him? Professor Kazuo Ueda, a BOJ board member back some 17 years ago, will be the first academic to lead the Bank of Japan. I understand the circumstances that led to Bernanke’s rise from star academic theorist to head of the world’s most powerful central bank: he had crafted sophisticated inflationist theories appealing in an environment of bursting Bubble anxiety. I find it ironic that an academic will now be responsible for trying to rescue Japan (and the world?) from crazy inflationist ideology that ran completely amok.

I’ve read nothing that suggests Ueda is a monetary fanatic. In contrast with Kuroda, he is not a crazy inflationist trapped in a policy quagmire of his own making. I’ll assume come April he will begin a cautious path toward some degree of normalization. I expect markets to pounce, perhaps even before Professor Ueda finishes grading that stack of term papers on his desk.

Speaking of Monetary Inflation Run Amok…

February 10 – Bloomberg (Chester Yung): “China’s cash squeeze eased, with a gauge of overnight funding costs dropping the most in a week, after the central bank injected some $150 billion into the financial system over three sessions. The overnight repurchase rate, an indicator of short-term borrowing costs in the interbank market, slumped more than 40 bps to 1.86%.”

Aggregate Financing (China’s key metric of system Credit growth) surged $878 billion during January to a record $51.52 TN, a traditionally huge month for Chinese lending. Growth was almost 11% ahead of estimates, and only 3% below (all-time record) January 2022. This placed 12-month growth at $4.670 TN, or 9.7%. For perspective, one-year growth as of January 2020 was $2.922 TN. In the three years since the pandemic’s onset, Aggregate Financing has expanded a staggering $13.888 TN, or 36.9%. Aggregate Financing surged 68% in five years.

Loan growth during January was nothing short of spectacular. At $846 billion, the growth in total Financial Institutions Loans was 46% higher than January 2022 and well ahead of expectations (Bank loans up $720bn). This pushed one-year growth to $3.391 TN, or 11.7%. This was the strongest one-year growth rate since October 2021. Total Loans expanded 24.6% ($6.376 TN) over two years, 40.5% ($9.294 TN) since the start of the pandemic (3 years), and 78.6% ($14.200 TN) in five years. While Q4 data is not yet available, it’s worth noting that Chinese Bank Assets expanded $4.276 TN through three quarters, a 10.9% growth rate.

Corporate Bank Loans expanded a blistering $687 billion during January, surpassing the previous record (Jan. 2022) by 40%. This pushed one-year growth to $2.703 TN, or 14.9%, the highest one-year growth rate in over a decade. For perspective, one-year growth was 44% higher than comparable 2022 growth and 90% above comparable pre-Covid 2020. Outstanding Corporate Loans have surged 28% over two years, 43% since the start of the pandemic (3 years), and 77% over five years.

From a financial stability perspective, the last thing you want is runaway late-cycle loan growth. As part of a desperate Beijing’s efforts to thwart a downward economic spiral, the banking system is being called upon to provide a lifeline to China’s troubled developer sector, while pushing corporate and household loan growth to bolster the general economy. And while the corporate sector borrows aggressively, the household sector is remaining much more cautious.

Consumer (chiefly mortgage) Loans expanded only $38 billion during January, down 69% from January 2022 growth. This lowered one-year growth to $477 billion, or 4.5%, by far the lowest growth rate in data back to 2008. Consumer Loans were expanding at 16% plus to begin 2021. Three-month growth of $101 billion is down 64% and 73% from comparable 2022 ($286bn) and 2021 ($379bn).

Government bonds expanded $60 billion during January, with one-year growth of $1.017 TN, or 12.9%. Government bonds have expanded 30.9% over two years, 57.4% since the start of the pandemic (3 years), and 83% over five years. Government bonds have increased to $8.9 TN from January 2017’s $3.3 TN.

Chinese money supply growth has accelerated markedly. At $1.083 TN, China’s M2 aggregate expanded in January a third more than the previous record from last June ($799bn). This pushed one-year growth to $4.508 TN, or 12.6%, the strongest growth rate since 2016. Three-month M2 growth of $1.838 TN significantly exceeded comparable $1.393 TN from 2022 and $1.137 TN from comparable 2020. China’s M2 has now inflated $10.5 TN, or 35.3%, in three years, and has doubled since November 2015, in one of history’s spectacular inflations of money and Credit.

Plenty to monitor. Tuesday’s U.S. January CPI report will be interesting. I’ll assume meaningful amounts of hedging going into the release. A stronger-than-expected inflation reading could spur a decent pop in yields. But a weak inflation report would see an unwind of hedges and a resurgent squeeze dynamic. Place your bets. It’s all one gigantic speculation.

Original Post 11 February 2023

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Categories: Doug Noland

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