A Most Critical Stage

I prefer not to refer to old Credit Bubble Bulletins. I’m making an exception this week, extracting from the February 6, 2009, edition. In “Government Finance Bubble,” I offered my first warning of dangerous unfolding Bubble dynamics.

“The Government Finance Bubble is enormous and powerful – and should be anything but underestimated. Akin to the previous Bubble in Wall Street finance, the epicenter of this Bubble is here in the U.S. But I would argue that this unfolding Bubble dynamic has greater potential to engulf the entire world than even U.S.-style mortgages and derivatives did starting back around 2002. Welcome to the new world of synchronized stimulus, deficits, and reflationary policymaking.”

“It is imperative for policymakers to ensure that the Government Finance Bubble does not follow in the footsteps of the runaway excess associated with Wall Street/mortgage finance. Yet it’s clear that policymaking (monetary and fiscal) is setting a course to guarantee just such an outcome. And, as has been the case for some time now, markets are keen to fall in love with – and aggressively accommodate – whatever might be the Bubble of the Day.”

Chart added by Michael Bond

I never imagined in February 2009 that the Fed’s balance sheet (less than $900bn to begin ‘08) would inflate from that February’s $2.2 TN to $9.0 TN, or that Treasury liabilities would more than triple from $9.5 TN to $30.4 TN – as Agency Securities ballooned another 50% to $12.0 TN. I expected rapid growth from China’s banking system, but to inflate from $9.0 TN to $56 TN was not something I thought possible. The same can be said for Bank of Japan assets that inflated six-fold to surpassed $6.8 TN, or the ECB’s balance sheet that inflated five times to almost $9.0 TN.

I’ve referred to the “global government finance Bubble” as the “granddaddy of Bubbles.” It originated from aggressive reflationary policymaking following the collapse of the mortgage/Wall Street finance Bubble, a historic Bubble that itself had inflated from post-“tech” Bubble reflationary measures.

I’m repeating this analytical framework to reinforce a critical point: We’ve reached the end of the line. There’s no bigger Bubble waiting in the wings for post-government finance Bubble reflation. This ensures that Bubble collapse comes with momentous consequences. And these risks today place tremendous pressure on fiscal and monetary policymakers to perpetuate the excess necessary to hold Bubble collapse at bay.

Further core Bubble theory bears rehashing. A Bubble financed by an expansion of high-risk credit (i.e., junk bonds) poses minimal systemic risk. Why? Because such a bubble will be relatively short-lived. When things start to get crazy, the holders of junk debt will invariably reach their risk tolerance threshold. “I’ve got enough. No more junk!” And this will bring the bubble to its conclusion before it has had years to inflict deep structural damage.

Bubbles fueled by money-like instruments function altogether differently. Money is something we trust for its attributes of safety and liquidity. Unlike junk debt, there’s no point where we say “No thanks. I’ve got enough money.” And it’s this insatiable demand that creates the ultimate fuel for protracted Bubbles and deep structural maladjustment. Incredibly, this historic Bubble – inflating at the heart of system finance – is now into its 15th year.

From a purely analytical standpoint, it’s all fascinating. Bubble analysis was some years ago completely discredited. Stock market “investors” are convinced nothing can get in the way of equities prices invariably marching ever higher. There’s been some bond market pain, but fears of runaway deficits and a crisis of confidence have not materialized.

Peering beyond the financial markets to the real world, something clearly has gone terribly wrong. To those of us who believe sound money and Credit are the bedrock for healthy households, communities, societies, governments and global relations, there is powerful evidence of deleterious effects from decades of inflationism and Monetary Disorder.

The global government finance Bubble is at A Most Critical Stage. Bubbles are faltering, though with diverse symptoms and dynamics.

November 6 – Reuters (Tom Westbrook): “China’s attempts to keep the yuan from falling contributed to last week’s chaos in money markets, sources involved say… Routine month-end demand for cash in China’s banking system snowballed into a scramble on Oct. 31 that pushed short-term funding rates as high as 50% in some cases, an incident that authorities are now investigating… The contributing factors were the usual month-end demand for liquidity, cash hoarding in the lead up to a big government bond sale and a market where the biggest banks were already reticent to lend because of a mandate to counter pressure on the yuan. ‘It was an accident,’ said Xia Chun, chief economist at wealth manager Yintech Investment Holdings, calling it an unforeseen consequence of the government’s heavy hand in financial markets.”

It’s at the stage where ongoing double-digit Chinese Credit growth is required to hold Bubble collapse at bay. Apartment Bubble deflation continues to gain momentum, with contagion increasingly impacting the vulnerable local government sector. The outlets for sufficient (to perpetuate Bubbles) system Credit expansion have narrowed. This backdrop has Beijing placing tremendous pressure on an already bloated banking system to expand lending and bond purchases, including for troubled housing and government sectors.

Breakneck growth of unsound late-cycle Credit is the kiss of death for a vulnerable currency. Aggressive People’s Bank of China (PBOC) liquidity injections further undermine currency stability. Today, Beijing faces the perilous challenge of holding the forces of Bubble collapse in check without undermining confidence in China’s banking system and currency. Moreover, China’s dire predicament is compounded by Xi Jinping’s zealous global superpower ambitions. The weight of the entire Chinese Credit system rests on the assumption that Beijing can continue to circumvent Bubble collapse.

November 9 – Financial Times (Martin Wolf and Kana Inagaki): “The Bank of Japan will proceed carefully with raising interest rates to avoid bond market volatility and any adverse impact on financial institutions, its governor has said, warning that unwinding the central bank’s ultra-loose monetary policy will be a ‘serious challenge’. Kazuo Ueda told the Financial Times Global Boardroom conference that the central bank was making progress towards hitting its 2% inflation target but cautioned that it was still ‘too early’ to determine the sequence of its policy normalisation. ‘When we normalise short-term interest rates, we will have to be careful about what will happen to financial institutions, what will happen to borrowers of money in general and what will happen to aggregate demand,’ Ueda said. ‘It is going to be a serious challenge for us.’”

Bank of Japan (BOJ) Governor Kazuo Ueda has no coherent strategy for exiting Japan’s historic inflationary experiment. A negative policy rate in today’s world of significant inflation and central bank tightening undermine Japan’s currency. Meanwhile, artificially low yields and BOJ bond purchases (forecast to reach $860bn this year!) associated with an untenable YCC (yield curve control) policy further subvert yen stability.

How great are the excesses that have accumulated in the most recent eight years of misguided BOJ inflationary policies? How much has been borrowed in Japan to finance global leveraged speculation? How much Japanese investor and institutional funds have flowed to higher yielding global instruments and markets? Importantly, BOJ policies, instrumental in global government finance Bubble inflation, have turned untenable.

Chinese and Japanese government-dominated Credit systems today still retain moneyness. But ongoing egregious government finance Bubble excess increasingly risks crises of confidence in the renminbi and yen. Both governments are trapped in Bubble Dynamics, unwilling to face the consequences of retreating from precariously flawed inflationary policy regimes. Further delays guarantee only greater imbalances and maladjustment, along with highly destabilizing adjustment periods. Disorderly currency devaluation can unleash global de-risking/deleveraging.

The U.S. predicament is different, but similarly perilous. One key difference, the dollar is for now underpinned by the serious fragilities in China, Japan, and EM, along with latent euro frailty.

It is important to appreciate the ramifications for a U.S. Credit system so dominated by government finance (i.e., Treasuries, Agency Securities, and Fed Credit). There have been profound changes in system function compared to previous mortgage finance and “tech” Bubble periods. Previous Bubbles saw Credit risk accumulate over years, only to go to parabolic extremes during “Terminal Phase” excess. Inevitable risk aversion and resulting Credit tightening triggered Bubble deflation and problematic Credit, market and economic down cycles.

The ongoing government finance Bubble inherently enjoys significant immunity to risk aversion and traditional Credit dynamics. Insatiable demand accommodated $2 TN of federal deficit spending the past year. Unlike late-stage mortgage Bubble excess, government Credit doesn’t require heavy financial intermediation through the banking system, Wall Street securitizations or derivatives markets. And such massive government debt growth underpins incomes and corporate earnings, bolstering system-wide Credit. What’s more, years of government sector liability expansion (Treasury and Federal Reserve) created unprecedented gains in household and corporate sectors cash and bond holdings (along with inflated equities and real estate).

That government finance Bubble dynamics work to minimize Credit and intermediation risks is a major factor in what appears robust and resilient market and economic dynamics. Stated differently, the certainty and relative stability of system Credit growth underpins confidence, risk-taking, asset prices, and economic activity.

Yet this aberrant financial structure suffers from a crucial weak link: These dynamics come with momentous liquidity risk. For one, moneyness attributes associated with the largest and perceived safest and most liquid securities (Treasuries and Agencies) market in the world become a magnet for leveraged speculation. For example, why speculate in wild and woolly high-yielding subprime mortgage derivatives when leveraging Treasury and Agency securities is so lucrative? And the more perilously this market inflates, the more confident the marketplace becomes in the Federal Reserve liquidity backstop.

Clearly, the leveraged speculating community was emboldened by the September 2019 QE restart. Any doubts as to how far the Fed would be willing to go to backstop marketplace liquidity were allayed with measures taken in March 2020 – that would see the Fed’s balance sheet inflate an unprecedented $5.0 TN. And fear that inflation and the Fed’s tightening cycle might inhibit Federal Reserve backstop measures were allayed with the hasty $700 billion (Fed and FHLB) liquidity injection in response to the outbreak of bank runs this past March.

Importantly, liquidity backstop distortions for a marketplace in the throes of historic Bubble inflation come with momentous ramifications. Ponder a few data points. Outstanding Treasury Securities have ballooned $21.7 TN, or 360%, since the end of 2007. Over the past four years, combined Treasury and Agency securities have ballooned $12.6 TN, or 47%, to almost $40 TN. Such phenomenal Credit expansion is possible only with the perception of a “whatever it takes” liquidity backstop.

I would further argue that this liquidity backstop and resulting boom of perceived safe Credit have been instrumental in bolstering – and now sustaining – inflationary pressures. While the Fed sought to tighten with rate policy, the liquidity backstop thwarted a general tightening of financial conditions.

Importantly, with Fed rate hikes ensuring higher market yields (lower bond prices), leveraged speculation simply shifted to “basis trades,” “carry trades,” and various Credit spreads. Playing the small spread between the Treasury/Agency cash markets and futures contracts was pretty much free money. And why not short Treasuries and use those proceeds to speculate in higher-yielding corporate debt, CDOs (collateralized debt obligations), leveraged loans and such.

Why not borrow for free in a devaluing Japanese yen, using proceeds to leverage in higher-yielding instruments in the U.S. and elsewhere. And with the Fed certain to respond quickly to system liquidity issues, why not leverage in size (“basis trades” 50-100 times levered)?

The upshot of all this leveraging has been a massively inflating pool of speculative finance. This powerful fuel for sustaining Bubbles has also fomented volatility and general instability. On the one hand, the near certainty of ongoing enormous growth of money-like Credit – underpinned by the Fed’s open-ended liquidity backstop – creates an extraordinarily robust financial structure. On the other hand, such incredible inflation of perceived safe Credit coupled with unprecedented leveraged speculation is one historic accident in the making.

Why would the VIX (equities volatility) Index trade at only 14 in the face of such an unstable and risky world? Because of the massive pool of speculative finance, and the view that short-term risks are low for de-risking/deleveraging to spark an accident.

The Nasdaq100 jumped 2.8% this week, increasing y-t-d gains to 42.0%. It’s worth noting that high yield CDS prices dropped a further 28 bps this week, with the two-week 91 bps collapse the largest in over a year. The 13 bps two-week decline in investment-grade CDS was also the biggest in a year. And while the bond market indicated ongoing vulnerability this week (two-year Treasury yields up 22 bps and MBS yields 19 bps higher), the risk of a loosening of financial conditions is significant. An easing of conditions will only allow inflation to take even deeper root.

Surely cognizant of his role in promoting looser conditions last week, the Fed Chair tried to make amends.

November 8 – Financial Times (Colby Smith): “Federal Reserve chair Jay Powell has warned the US central bank against the risk of being ‘misled’ by good data on prices, saying the mission to return inflation to its 2% target had a ‘long way to go’. Speaking at an IMF event…, the Fed chair said officials were ‘gratified’ by the retreat in price pressures, but stopped short of sounding the all-clear on an inflation problem that has proved more persistent than policymakers expected. ‘We know that ongoing progress toward our 2% goal is not assured: inflation has given us a few head fakes… If it becomes appropriate to tighten policy further, we will not hesitate to do so.’”

At this point, the markets are confident that the Fed will not press rate increases to the point of sparking tightened conditions. I believe it will require significantly tighter conditions to crush what is now a new cycle of deeply rooted inflationary pressures.

November 8 – Bloomberg (Lulu Yilun Chen and Low De Wei): “Citadel founder Ken Griffin said the world is facing unrest and structural changes that are pushing it toward de-globalization and causing higher baseline inflation that may last ‘for decades.’ ‘The peace dividend is clearly at the end of the road,’ Griffin said… ‘We are likely to see higher real rates and we’re likely to see higher nominal rates.’ The billionaire said that will have implications on the cost of funding the US deficit, saying the government hadn’t counted on higher rates ‘when we went on the spending spree that created a $33 trillion deficit.’”

November 7 – Bloomberg (Austin Weinstein): “US officials will seek to limit access to Federal Home Loan Banks after failing lenders turned to the $1.3 trillion system in desperate bids to survive March’s banking crisis. The Federal Housing Finance Agency will try to push FHLBs back to their roots in housing finance, and away from serving as lenders of last resort to troubled banks, according to a report… The plans would ratchet up federal oversight, and seek to direct banks toward the Federal Reserve’s discount window in times of extreme stress. Banks borrow hundreds of billions of dollars from the government-chartered FHLBs each year to fulfill short-term funding needs. The practice came under scrutiny after the FHLBs, which have implied backing from the government, lent heavily to Silicon Valley Bank, Signature Bank and First Republic Bank as they careened toward failure.”

A pivotal government finance Bubble player is being reined in. While this may not have immediate consequences, the FHLB’s role as a quasi-central bank crisis liquidity provider could be in jeopardy. I am reminded of how accounting scandals at Fannie Mae and Freddie Mac disabled the powerful GSEs, though the full impact was not revealed until they were unable to provide their crucial liquidity functions during the 2008 crisis.

Original Post 11 Nov 2023

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