Doug Noland: China Bubble Deflation Watch

Two-year Treasury yields traded at 4.06% Wednesday, just ahead of the CPI data release. Yields sank to 3.87% intraday Wednesday and were as low as 3.81% Thursday – before reversing sharply higher to close the week at 3.99%.

Wednesday’s much anticipated CPI report had something for everyone. At 4.9%, y-o-y inflation was below 5% for the first time since May 2021 – and slightly less than expected. So-called (Powell favorite) “supercore” inflation slowed to only 0.1% for the month. Yet the 0.4% monthly gain in both headline and core inflation indicates persistent inflationary pressures.

Bonds and stocks rallied immediately on the release of CPI data, with television analysts scurrying to try to explain the spirited bullish market reaction. The explanation was in market positioning, rather than in data minutia. There has been significant hedging around key economic releases, certainly including CPI and non-farm payroll reports. And with markets remaining resilient over recent months, Greed is on the side of those writing derivative “insurance” – with Fear weighing on buyers. Holders of hedges have “weak hands,” meaning they have limited tolerance for additional losses. So, the basically in line CPI report spurred an immediate unwind of hedges and squeeze dynamics in both Treasuries and stocks. Rallies, however, were relatively short-lived.

There is a decent list of things that should keep markets on edge. The so-called “X-date” is rapidly approaching, with no movement yet toward a debt ceiling compromise. U.S. sovereign CDS prices traded to 78 bps in Thursday trading, surpassing Iceland, to the high since 2009. The KBW Regional Banking Index (KRX) sank 6.2% this week, to the low since November 2020. The big banks were not spared, with the KBW Bank Index down 3.5%. Pacwest lost 21% this week, with the Bank of Hawaii down 23.2%. Comerica dropped 12.3% and Keycorp lost 8.6%. Gaining three, Bank of America’s CDS price was back above 120 bps (near the high since March 2020)

Monday’s Senior Loan Officer Survey confirmed a meaningful tightening of lending standards over recent months. Banks reporting they’ve “tightened considerably” doubled from January’s reading to 3.2%. Those that have “tightened somewhat” were down marginally to 42.9% (from 43.3%) – but up from 37.7% in October, 25.8% in July, and 6.1% last April. Perhaps the key number didn’t receive the attention it deserves. A full 54% reported “basically unchanged.” Standards have tightened and loan growth has surely slowed. Yet, if over half of the banking industry continues to operate at the recent boom level, this likely in the near-term equates to what normally would be considered solid loan growth.

With the VIX trading down to 16.5 this week, equities seem to be basking in liquidity abundance and the prospect of a dovish Fed pivot. Indicative of the extraordinary monetary backdrop, money market fund assets swelled an incredible $434 billion over the past nine weeks.

Fed governor Michelle Bowman was out Friday: “The most recent inflation and employment reports have not provided consistent evidence that inflation is on a downward path… Should inflation remain high and labor market remain tight, additional monetary policy tightening will likely be appropriate…”

Markets dismiss calls for additional rate increases, though the rates market did end the week with a 13% probability of a 25-bps hike at the FOMC’s June 14th meeting – pricing in a 5.10% implied rate. Yet markets are not backtracking whatsoever on pricing in a dovish pivot. Markets ended the week pricing a 95-bps rate reduction by the January 31, 2024 meeting (over about seven months).

It’s intriguing. Inflation proving stickier than expected had no impact on expectations for a dovish pivot. The same for persistently tight labor markets and general economic resilience. In this I see corroboration of the thesis that the rates market is pricing probabilities of some type of accident forcing the Fed’s hand. The banking crisis is a potential accident. The “X-date” fiasco could blow up. In general, speculative markets are an accident in the making.  But I’ve been positing over recent years that the vulnerable Chinese Bubble was likely a factor in persistently low Treasury and global sovereign yields.

This week’s 1.4% dollar rally is worth exploring. There’s a big short on the dollar, so short covering could explain this week’s gain. China’s renminbi declined 0.71% this week to a near 2023 low versus the dollar. The Shanghai Composite dropped 1.9%. Chinese stock weakness was broad-based. Number one developer Country Garden’s bond yields surged almost nine percentage points to 49% (in Thursday trading), up from 26% to begin April – to the highest level since last November. And with confidence in China’s recovery fading, April’s putrid Credit data raised eyebrows.

Growth in China’s metric of system Credit growth, Aggregate Financing, dropped to $175 billion, down significantly from March’s $773 billion and only 61% of estimates. It was also the weakest monthly growth since last October. But with a booming Q1 (over $2 TN), year-to-date growth of $2.45 TN, or 13.7% annualized, ran 28% ahead of comparable 2022. Aggregate Financing expanded $4.81 TN, or 10.3%, over the past year, $9.167 TN, or 21.5%, over two years, $13.611 TN, or 35.7%, over three years, and a staggering $21.01 TN, or 68.4%, over five years.

April’s $103 billion growth in New Loans was down from March’s blistering $559 billion – and only about half of expectations. At $1.627 TN, y-t-d loan growth was 26% ahead of comparable 2022.  New Loans expanded $3.52 TN, or 12.2%, over the past year, $6.362 TN, or 24.3%, over two years, $9.232 TN, or 39.7%, over three years, and $14.368 TN, or 79.3%, over five years.

Corporate Loan growth dropped to $98 billion from March’s $389 billion – and was the weakest expansion since October ($66.5bn). Still, record y-t-d growth of $1.571 TN ran 32% ahead of comparable 2022. Corporate Loans expanded $2.744 TN, or 14.9%, over the past year, $4.691 TN, or 28.5%, over two years, $6.310 TN, or 42.5%, over three years, and $9.340 TN, or 79.1%, over five years.

Consumer Loans contracted $35 billion in April, a turnaround from March’s $179 billion expansion (strongest since Jan. 2021). At $331 billion, y-t-d growth was double comparable 2022. Consumer Loans expanded $732 billion, or 7.1%, over the past year, $1.575 TN, or 17%, over two years, $2.879 TN, or 35%, over three years, and $4.947 TN, or 80%, over five years.

I don’t want to overstate the importance of a dramatic one-month collapse in Chinese Credit growth. Lending tends to slow the first month of new quarters, especially following huge end of quarter surges. The expansion of Aggregate Financing slowed sharply last October, July and April. Consumer Loans contracted during October and April of last year. Meanwhile, Chinese M2 Money Supply contracted $87 billion during April, the first contraction since last October (M2 contracted $48bn in July).

Weak April lending and money supply are consistent with other data pointing to a fading recovery in key segments of the Chinese economy. There was the surprising April manufacturing contraction (PMI below 50), with a significant drop in export orders. While still expanding, service sector growth slowed. The April drop in imports (7.9%) raises questions about the durability of consumer demand. And at 0.1%, April consumer inflation was also weak. Yet China’s colossal housing sector appears poised to provide the biggest disappointment.

May 11 – Bloomberg: “China’s housing market sales is regressing after a brief recovery, underscoring the challenges the world’s second-largest economy is facing. Signs of weakness are emerging after housing sales and prices recovered briefly following a historical slump of about 18 months. China’s property sector is key for the economic growth outlook this year, as it accounts for about 20% of the country’s gross domestic product after including related industries. High-frequency indicators in recent weeks show momentum in home purchases has fizzled. Property investment also continues to contract, and consumers are reluctant to take out mortgages. That’s despite Beijing rolling out a slew of measures to prop up the market… ‘After a short-lived recovery in February-March, the release of pent-up demand for home purchases has come to an end,’ said Lu Ting, Nomura Holdings Inc.’s chief China economist. ‘The property recovery this year will be only moderate.’”

Iron ore prices this week fell to a five-month low. Shanghai Steel Rebar futures prices dropped 3.3% this week, trading near the low since November. Most industrial commodities were under pressure this week. Copper dropped 4.0%, Nickel 7.4%, Tin 3.0%, Zinc 2.8%, and Aluminum 2.4%. Silver sank 6.6%. Energy prices continue to weaken. Crude’s (WTI) $1.30 decline pushed y-t-d losses to 13%.

May 11 – Bloomberg (Lorretta Chen and Ailing Tan): “China’s high-yield dollar bonds are falling in their longest losing streak this year, adding to strains in a junk debt market shaken by a property firm’s default and another’s liquidation. The securities have lost 3.6% in May, with average prices dropping to 69 cents… The notes already shed 3.8% last month, the third straight monthly decline and the worst streak since one through July 2022. Recent woes include a default on yuan borrowings by KWG Group Holdings Ltd., which develops high-rise apartments, office buildings and shopping malls. There was also a wake-up call when Jiayuan International Group Ltd…, slapped with a court-ordered liquidation, making it the first builder during the nation’s property crisis to face such a fate despite public efforts to restructure debt.”

From the above Bloomberg “China’s housing market…” article:

“Home sales were dismal over the five-day Labor Day break in May, the first long holiday since China abandoned pandemic restrictions and infection waves eased.”

“In the existing-home market — which is less distorted by seasonal factors linked to the launch of developers’ projects — sales were even worse. In the first four days in May, second-hand residence sales plunged 44% by area from a month earlier…”

“Slower property sales have led to a glut of inventory. Unsold houses have climbed 43% from a recent low in November 2021, around the time home prices began their downward spiral.”

China’s protracted apartment boom inflated into one of history’s greatest speculative Bubbles. Japan still suffers from its eighties Bubble period. China’s Bubble deflation is in the nascent stage. Keep in mind that Chinese apartment owners, speculators, bankers, regulators, and government officials have no experience with bursting real estate Bubbles. So far, the priority seems to be maintaining inflated apartment prices to hold panic at bay. This only delays the day of reckoning. If reports of tens of millions of unoccupied units are in the ballpark, clearing prices will have to be found.

May 10 – South China Morning Post (Elise Mak): “Regulators in Jiangsu province have chided two developers for their ‘bad behaviour’ after they offered discounts on new homes in excess of 25%. Housing authorities in Kunshan…, said that Kunshan Jiabao Wangshang Properties and Kunshan Changtai Properties had ‘slashed prices significantly and arbitrarily that could disturb the normal order of the real estate market and cause social instability’. Both companies were pulled up for their ‘bad behaviour’ and ordered to rectify the issue immediately… The regulators stepped in after previously capping discounts at up to 15%. ‘We hope all developers will learn a lesson and comply with the law and industry regulations seriously,’ regulators in Kunshan said…, adding that they would strengthen oversight and punish developers for resorting to ‘wrongful sales tactics’. The two developers launched campaigns to boost sales during the May Day holiday. While one of them offered buyers discounts of up to 26%, the other dangled free parking spaces.”

See “China Watch” below:

“Xi Jinping’s crackdown on perceived threats to national security is roiling the vast industry of consultants and researchers who help global investors understand China, threatening the government’s attempts to lure foreign capital into an economy showing increasing signs of strain. The latest and most prominent target is Capvision Pro Corp.”

“China’s crackdown on data access to overseas firms is adding to concerns about how Beijing controls the flow of information in the country, making it difficult for investors to assess the state of the economy.”

“China is warning domestic brokerages not to spread information that compromises national security, reinforcing a campaign that has roiled consulting firms and providers of financial data.”

Preparing for trouble, Beijing is now moving aggressively to control the information flow – about the economy, markets and finance – in the name of national security. It wreaks of growing desperation. Beijing tactics are not confidence inspiring.

The complexity of the Chinese economy and Credit system grew exponentially over this protracted Bubble period. I appreciate the conventional view that Beijing officials have everything under control. From my perspective, odds are rising for China’s Bubble deflation to spiral out of control. How long can confidence in the gargantuan Chinese banking system be sustained?

Original Post 12 May 2023

Categories: Doug Noland

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