Melt-up Vs. Deleveraging

By Doug Noland on May 27, 2023

This is such a key Bubble Dynamic. Over time, Bubbles become increasingly vulnerable. Indeed, systemic fragilities stealthily grow exponentially over time – especially during culminating “Terminal Phase Excess”. And the bigger and increasingly vulnerable a Bubble becomes, the more cautious central bankers will be with tightening measures. Worse yet, acute fragility ensures policymakers will act quickly and forcefully to thwart Bubble deflation – ensuring a quick resurgence of speculative impulses.

We have no reason to expect markets to function normally. So many facets of today’s environment are unique. For one, a once-in-a-century global pandemic fundamentally altered so many things – including central bank, commercial bank, and household balance sheets. Unprecedented monetary and fiscal stimulus disrupted price dynamics throughout economies and markets. What’s more, major shortages forced a rethink of supply chain management, including inventory and outsourcing strategies.

Importantly, the pandemic hit during the waning period of a multi-decade global Bubble – a historic period of central bank experimentation, financial innovation, technological development, economic structural transformation, and globalization.

Over-liquefied markets had turned highly speculative and levered. Market structure evolved to become dominated by trend-following behavior, with derivatives, algorithmic trading and hedging strategies creating latent fragility. Recurring bouts of monetary instability and progressively activist central bank market intervention crystalized the perception that central bankers were guarantors of liquidity, stability, and buoyant financial markets.

If pandemic-related dislocations weren’t enough, Russia ruthlessly attacks Ukraine. This threw energy, grain, and other resources procurement into chaos. Shortly before the invasion, Russia and China announced their “no limits” partnership. The rise of the all-powerful Xi Jinping autocracy, China’s unwavering support for Russia, and increasingly aggressive threats directed at Taiwan, forced the “free world” to take a hard look at the risks of outsourcing from China.

There’s no reason to expect inflation to behave as it has in the past. Aberrantly too much “money” chasing goods of vacillating supply. For households, businesses, and governments, it became prudent to build stockpiles – with ample financial resources available for the task. Climate change only adds to the uncertain and inflationary backdrop.

Job openings (“JOLTS” data) ended 2019 at a historically elevated 6.709 million. The interplay of massive fiscal and monetary stimulus with severe employment market dislocation saw a spike in openings to an unprecedented 12.027 million by March 2022. So many businesses – from small operations to major corporations – had to significantly ramp up compensation to secure the workforce necessary to operate. The acute labor shortage, coupled with multi-decade high consumer price inflation, induced a fundamental shift in compensation expectations – by employee and employer alike.

After ending Q2 2019 at $4.009 TN, the Fed’s balance sheet peaked in 2022 at almost $9.00 TN. Federal Reserve Total Assets ($8.43 TN) remain today more than double the pre-pandemic level. During this period, Total Bank Deposits inflated as much as $6.3 TN, or 42%. Bank Deposits ended 2022 at $20.698 TN, $5.7 TN, or 38%, higher than June 30, 2019.

Pandemic period stimulus measures fundamentally reshaped the U.S. Household balance sheet. The surge in liquid assets (“money”) was unprecedented. Total Household Deposits surged $4.75 TN, or 45%, over just the past 13 quarters (ended Q4 ’22). During this period, total Household Financial Assets inflated $19.46 TN, or 21.3%, to $110.71 TN.

But it wasn’t just inflating Financial Assets that ballooned perceived wealth. Household Real Estate holdings inflated $14.63 TN, or 44%, to $47.89 TN. In just 13 quarters, Household Net Worth surged $33.08 TN, or 28.9%, to $147.71 TN. As a percentage of GDP, Household Net Worth jumped from 537% (Q4 ’19) to end 2022 at 565% – this even after ‘22’s stock market swoon (down from Q4 ‘21’s record 624%). For perspective, Net Worth-to-GDP peaked at 491% during Q1 2007 and 445% at Q1 2000.

That inflation proved anything but transitory should not surprise. It was nothing short of an epic loosening of financial conditions – following years and decades of generally loose conditions. Clearly, the Fed – and global central bank community – waited too long to begin removing stimulus and raising rates. But with the mighty inflation genie sprung loose from the bottle and running roughshod, only a destabilizing tightening of liquidity and Credit would break newfound inflationary psychology. No one was willing to go down that path.

The Bank of England restarted QE on September 28th to stem a crisis of confidence in the UK bond market – with 10-year yields at only 4.5% and weeks ahead of the scheduled start of quantitative tightening. This was soon followed by dovish comments from Fed officials, the ECB, Bank of Japan, and Bank of Canada. Speculative markets received the confirmation they demanded that central bank liquidity support was available as needed.

Federal Reserve assets surged $364 billion over three weeks during the March banking crisis. The FHLB provided several hundred billion of additional liquidity (Q1 asset growth $317bn). Indicative of the powerful boost to system liquidity, money market fund assets surged almost one-half Trillion over the past 11 weeks – a 48% annualized growth rate.

Market financial conditions loosened significantly, with the S&P500 jumping to a nine-month high. And in a key market dynamic dating back to the nineties, over-liquefied and speculative markets inherently fixate on the latest and greatest technological advancement. For the current mania, it’s all things A.I. (artificial intelligence).

May 25 – Bloomberg (David Marino): “Nvidia Corp.’s massive jump overnight flipped more than 500,000 bullish options from potentially worthless into winners, while turning one big trade from Wednesday into a loser. There were 549,483 outstanding contracts for call options allowing the owner to buy shares at levels ranging from $310 and $380, more than 150,000 of which — based on Wednesday’s $305.86 close — were set to expire worthless Friday. But the more than 25% surge has brought them ‘into the money’ in options parlance, meaning that near-term call owners are in line to own some 15 million shares below Thursday’s market value of about $388. On the other side, shareholders who sold calls as a way of collecting some extra premium would be forced to sell shares… And other traders short the options may have had to buy shares to cover their suddenly short positions.”

Don’t underestimate the liquidity impact of manic excess in big tech derivatives.

May 25 – Bloomberg (Lu Wang): “An end-of-week feeding frenzy in options of the world’s biggest companies has emerged as two of the hottest trends on Wall Street collide. Rampant demand for Big Tech exposure is combining with the boom in fast-expiring options to fuel an explosion in bullish bets in the first few minutes of Friday trading. That’s the day that weekly contracts on individual stocks like Apple Inc. and Microsoft Corp. expire, effectively turning them into the zero-day options that have become a trader obsession. Total call volume of the seven most-valuable tech firms — also including Alphabet Inc., Amazon.com Inc., Nvidia Corp., Meta Platforms Inc. and Tesla Inc. — last Friday spiked to 5 million contracts, doubling over the week… So frenzied is the late-week demand that some analysts see evidence it is moving the underlying stocks. ‘Friday should be known as megacap tech call option day,’ Brian Garrett, a managing director at Goldman Sachs…, wrote… ‘There have been days where hundreds of thousands of calls have traded in the first 10-15 minutes of the session.’”

When stocks and indexes with huge outstanding call options go into speculative melt-up mode, the sellers of those derivatives are forced to buy the underlying shares to mitigate/hedge losses. Many sell out-of-the-money call options – either to generate additional returns or to pay for put option protection. Large call option positions – especially out-of-the-money contracts – have the potential to create meaningful amounts of new liquidity when a big upward price move forces the purchase of the underlying stocks on margin.

The Nasdaq100 (NDX) is up almost 31% this year. The mania in A.I. and big tech has not only fueled huge gains in company market capitalization, but also powered significant moves in popular indexes including the NDX, SOX (semiconductors) and even the S&P500. This Bubble Dynamic is a powerful creator of marketplace liquidity. It also incites FOMO (fear of missing out). Between short covering and cajoling the under-invested, this speculation and derivatives-induced rally is pulling funds into the marketplace. The upshot is a further loosening of market financial conditions – irrespective of Fed tightening measures.

The bond market is turning nervous. Loose financial conditions have worked to bolster both the economy and pricing pressures. More data this week (PCE, GDP Price Index, Services PMI, Personal Income/Spending, Jobless Claims) point to resilient demand and inflation. And now market conditions are only loosening further.

Two-year Treasury yields surged 30 bps this week to 4.56% (high since March 10th). Benchmark MBS yields spiked 32 bps this week to a six-month high 5.79%. The rates market is now pricing a 69% probability of a 25 bps hike on June 14th – with peak Fed funds now at 5.33% for the July 26th meeting. The market expects a 5.00% policy rate at the December 13th meeting – up 36 bps this week and 70 bps in 11 sessions.

I certainly appreciate that when the stock market is luxuriating in a short squeeze/derivatives/FOMO “melt-up” dynamic, nothing else matters. But bond markets have their own dynamic percolating. UK 10-year yields surged 34 bps this week to 4.33%, trading this week to the highs since October. With world-beating UK inflation again surprising to the upside (8.7% y-o-y), two-year gilt yields spiked 54 bps this week to 4.48% – the high since the BOE was forced to intervene on September 28th. Trading action was certainly reminiscent of September’s deleveraging episode. I’ll assume the UK pension system remains highly levered and vulnerable.

It’s worth noting that China’s renminbi declined 0.74% this week, trading to the low versus the dollar since December 1st. Chinese developer bonds were bludgeoned, with number one Country Garden yields jumping to 61% (began the month at 35%). A disorderly Chinese currency risks serious de-risking/deleveraging.

The yen traded to the low versus the dollar since November. Tokyo core CPI was reported up 3.9% y-o-y, the strongest inflation reading since 1981. With the Japanese economy gaining a head of steam, new BOJ governor Kazuo Ueda is running out of excuses to stand pat on Kuroda’s ultra-loose monetary policy. Any shift in BOJ policy would have immediate ramifications for global leveraged speculation and marketplace liquidity.

Here at home, the banking system remains highly levered and vulnerable. There are scores of big securities portfolios that become immediately problematic in the event of a yield spike. And it wouldn’t take much to restart the deposit exodus from vulnerable institutions. The mortgage marketplace is vulnerable to self-reinforcing deleveraging and interest-rate hedging-related selling. And, generally, leverage permeating the entire system creates vulnerability to a surge in market yields.

The Fed is in a bad place. The resurgent stock market speculative Bubble is a major force for loosening financial conditions and stoking inflationary pressures, while risking a melt-up and crash scenario. But additional Fed tightening measures are problematic for the bond market and banking system.

We’re back to the Fed hikes until something breaks. At this point, financial conditions must tighten significantly to keep inflation from becoming only more deeply ingrained. And especially after this speculative stock market run, tighter conditions pierce Bubbles. For now, such loose conditions set the stage for the nightmare scenario – a surprising jump in inflation, a spike in market yields, and a repricing for tens of Trillions of fixed-income securities. Stocks can relish the fun and games. But look over your shoulder, and you might see inklings of de-risking/deleveraging.

Original Post 27 May 2023

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