The Calm Before the Storm

Doug writes: So, why would risk premiums and indicators remain sanguine in the face of a yield spike and hawkish reassessment of Fed rate policy? Phrased differently, what is holding back “risk off” dynamics? A Friday evening Bloomberg headline: “Blaring Bond Alarms Are Falling on Deaf Ears in the Stock Market.”

Michael Bond ponders: “The secret to stocks’ success so far in 2023? An unexpected $1 trillion liquidity boost by central banks” in Market Watch 2 March 2023

The Calm Before the Storm

by Doug Noland

Ten-year Treasury yields traded as high as 4.09% this week, the high since November 9th. Benchmark MBS yields rose to 5.67%, up 100 bps over the past month, also to the high since the ninth of November. The week ended with market expectations for peak Fed funds at 5.44% for the Fed’s September 20th meeting. This is around 40 bps higher than expectations in November.

German bund yields are currently about 40 bps higher than November levels. UK 10-year yields ended the week at 3.85%, up 85 bps over the past month to the high since the October crisis period. Spanish and Portuguese bond yields this week surpassed November peaks to trade at new multiyear highs (Spain back to 2014 and Portugal to 2017).

The VIX (equities volatility) Index closed Friday down 3.2 for the week to 18.49. The VIX was at 29 on November 9th, down from the October high of almost 35. Investment-grade Credit default swap (CDS) prices dropped six this week to 71 bps (2023 low 66bps), compared to 92 bps on November 9th (September high 114bps). High-yield CDS sank 33 this week to 433 bps (2023 low 408bps). This compares to 540 bps on November 9th (September high 640bps).

Investment-grade corporate yield spreads to Treasuries closed the week 32 bps lower than November 9th at 120 bps (2023 low 115bps). JPMorgan CDS ended Friday at 65 bps, Goldman at 83 bps, and Bank of America at 69 bps, down significantly from November 9th levels of 90, 120, and 97 bps, respectively.

European high-yield (“crossover”) CDS fell 22 this week to 397 bps, down from 523 bps on November 9th (September high 695bps). Emerging Market (EM) CDS dropped 15 this week to 229 bps. This compares to 276 bps on November 9th (September high 346bps).

So, why would risk premiums and indicators remain sanguine in the face of a yield spike and hawkish reassessment of Fed rate policy? Phrased differently, what is holding back “risk off” dynamics? A Friday evening Bloomberg headline: “Blaring Bond Alarms Are Falling on Deaf Ears in the Stock Market.”

For one thing, it’s the nature of markets to tend not to get so worked up by a development the second time around. There was major concern back in November that the global yield spike could spiral out of control. The UK gilt market in late-September illuminated the risk of highly levered bond and derivatives strategies – forced deleveraging sparking panic and market meltdown. Bank of England emergency QE operations allayed fears.

Interestingly, the Dollar Index traded to 113 during the first week of November, after beginning 2022 at 96. The dollar melt-up was a major factor stoking global de-risking/deleveraging. The emerging markets, in general – and Chinese developers, in particular – had issued enormous amounts of dollar-denominated debt. A significant amount of this debt was likely purchased on leverage, so-called “carry trades.”

The surging dollar was problematic for leveraged speculation, but also for the EM central bank community. A “doom loop” dynamic had gained momentum, where surging yields (sinking bond prices) and currency weakness were inciting self-reinforcing “hot money” outflows and associated liquidity issues. To stabilize their currencies, EM central banks sold Treasuries and other developed market debt, selling that pushed global yields higher yet.

A confluence of factors supported a multi-month fading of this key global de-risking/deleveraging dynamic. The Dollar Index peaked on September 28th, not coincidently the day of the Bank of England’s dramatic market intervention. There was also a notable shift to less hawkish central bank commentary. In late October, the Bank of Canada (prematurely) signaled it was winding down its tightening cycle. Haruhiko Kuroda reassured markets – “We don’t plan to raise interest rates or head for an exit (from easy policy) any time soon,” as Japan executed massive currency support operations. And it wasn’t long before Powell and Fed officials adopted a less hawkish tone. Powell (Nov. 30th): “So, we have a risk management balance to strike, and we think that slowing down at this point is a good way to balance the risks of over tightening.” Meanwhile, Beijing hit the crisis-management panic button.

The confluence of shifts spurred short covering and a reversal of interest-rate hedges. After peaking at 4.24% on October 24th, 10-year Treasury yields were down to 3.37% by January 18th. It’s also worth noting the unusually mild European winter. The stage had been set for spiking energy prices, shortages, economic disruption, huge utility company losses, financial turmoil, and bailouts. At least for the winter, fragile European bonds and the euro dodged a bullet.

The moon and stars had aligned. A huge cross-asset short squeeze developed, fueling powerful global rallies in sovereign bonds, corporate Credit, equities and crypto. The bond market rally spawned a bullish market narrative of “immaculate disinflation”, an economic soft-landing, and a Federal Reserve that would soon pivot dovish. The big squeeze, unwind of hedges, and “risk on” speculation combined for a major loosening of financial conditions.

Such a significant loosening of financial conditions at this stage of policy tightening and market cycles unleashed strange dynamics. The more markets imagined disinflation, the greater loose financial conditions worked to sustain elevated price inflation. And while bond yields have reversed sharply higher over the past few weeks, loose financial conditions continue to buoy equities and risk markets more generally.

A couple of this week’s headlines illustrate peculiar market dynamics.

Bloomberg: “The Best Credit Had the Worst February on Record as Traders Capitulate on Rates.”

Reuters: “US Companies Rush to Issue Corporate Debt, Busiest February Ever.”

February 28 – Reuters (Matt Tracy): “U.S. companies with the highest credit ratings sold a record $144 billion of debt securities so far in February to get ahead of further potential interest rate hikes, meeting strong demand from investors… Investment-grade rated corporate bond issuance in February has been the busiest ever for the month with the tally as of Monday already some $20 billion ahead of the now second-heaviest February in 2021, said BMO Capital Markets’ fixed income strategy director Dan Krieter… February’s bonds were oversubscribed by 3.64 times on average, data from Informa Global Markets said… Analysts expect $160-165 billion of new bond supply in March.”

According to Bloomberg, January and February combined for record two-month investment-grade issuance of $294 billion. Decent March issuance would ensure near-record Q1 debt issuance, in what will likely be yet another quarter of sustained strong system Credit expansion. That economic and inflation data have recently surprised to the upside is no coincidence.

February 28 – Bloomberg (Catarina Saraiva): “Central bankers must augment what they learn from incoming data with clues gleaned from the real economy and avoid putting too much weight on financial markets, said Federal Reserve Bank of Chicago President Austan Goolsbee. In his first public speech since taking office last month, Goolsbee acknowledged it was tempting to lean on the instant reaction of investors to incoming news, because economic data arrives with a delay. ‘But it is a danger and a mistake for policymakers to rely too heavily on market reactions,’ he said… ‘Our job is ultimately judged by what happens in the real economy.’”

Markets have been resilient. They’re really complicating the Fed’s inflation fight. I can imagine many Fed officials quietly share the sentiments expressed by the Chicago Fed’s new president. The Federal Reserve needs to deemphasize its fixation on – and worries for – the financial markets. Just focus on the real economy, and the markets will sort things out.

I can’t help but see things falling into place for the “hike until something breaks” accident scenario. The big squeeze of ’23 and resulting loosening of financial conditions prolong the “Terminal Phase” of Credit Bubble excess. Risk markets are enjoying an echo Bubble, with the bulls today operating on the gratifying side of Greed and Fear. Short squeezes will continue until they quit working. Climbing the proverbial wall of worry – for a Wile E. Coyote moment.

Don’t mistake this phase of “risk on” for healthy market resilience. A dreadful “risk off” lurks on the horizon. And the reality of contemporary financial markets is one of a hopelessly destabilizing cycle of recurring “risk on”/“risk off.” Periods of de-risking/deleveraging ensure enormous amounts of derivatives hedging, shorting, and bearish derivatives speculation, positioning that promotes destabilizing squeezes. And at this stage in the cycle, “risk off” dynamics spur illiquidity and elevated risk for spiraling margin calls, runs, and panics. Central bank intervention (i.e. BOE QE or dovish pivots) then unleashes short squeezes, the unwind of hedges, and bouts of powerful speculative excess.  This is no market backdrop for a reasonably smooth tightening cycle.

Speculative market “risk on” dynamics and attendant loose financial conditions today pose a serious predicament for the Fed (and global central bank community). I can imagine Austan Goolsbee will not be quick to embrace massive QE the next time de-risking/deleveraging unleashes acute market instability. And the longer “risk on” supports elevated Credit growth, economic demand, tight labor markets, and speculative excess, the more markets will bank on the “Fed put” come the next bout of market turmoil.

It doesn’t matter today. It will matter greatly at some point in the future: instability associated with a serious de-risking/deleveraging episode will require massive QE – a market bailout likely to come later, in smaller scope, and with more Fed dissension than markets have grown accustomed.

It’s an interesting setup for next week. Powell testifies Tuesday and Wednesday. ADP and JOLTS (job vacancies) employment data on Wednesday. And then the big February payrolls report on Friday. The calendar – with jobs data this month delivered on the second Friday – shortens to one week the time-span between key payrolls data and a “quadruple witch” quarterly options expiration.

Interestingly, the MOVE (bond market volatility) Index closed Friday only slightly below the elevated level from November 9th. With all the hedging that has surely taken place over recent weeks, bonds are poised for a gap move in the event of surprising payroll data. A repeat of January’s big upside surprise (517k) could see huge derivatives-related selling. On the other hand, unexpectedly weak jobs and earnings gains would likely spark a short squeeze and unwind of hedges ahead of options expiration. And I doubt it would take much of a bond rally to incite another round of squeezes in our highly speculative stock market.

I can’t shake the feeling that currency markets will play prominently in this year’s clash of “risk on” vs. “risk off”. And if there’s one key aspect of the current backdrop that supports “risk on,” I’d point to relative currency stability. Last year’s yen train-wreck, dovish ECB euro weakness, and China bust renminbi vulnerability combined to power the destabilizing dollar melt-up. After a couple months of the new year, the Dollar Index has gained about 1%. The yen has somewhat stabilized ahead of a new BOJ governor, while newfound ECB hawkishness appears poised to narrow interest-rate differentials. Meanwhile, Beijing is throwing the kitchen sink at its faltering Bubbles.

Not sure how long this semblance of stability holds. Japan – its bond market and currency – is an accident in the making. Surging inflation in Germany, France, Spain and elsewhere ensure tighter ECB policy that could bankrupt Italy. In China, perilous late-cycle non-productive Credit expansion is incompatible with currency stability, while geopolitical risks loom large. On various levels, the current “risk on” backdrop seems much the calm before the storm.

Original Post 4 March 2023

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