A Wolf in Panda’s Clothing

Good to see U.S./China tensions ease. It’s clearly in both countries’ interest. Especially with war raging in Gaza, President Biden could sure use a boost. And China’s faltering Bubble is in more desperate need of a boost than even the President’s poll numbers. The Xi Jinping charm offensive was a thing of beauty. “Planet Earth is big enough for the two countries to succeed.” “China is pursuing high-quality development, and the United States is revitalizing its economy. There is plenty of room for our cooperation.”

November 16 – Reuters (Trevor Hunnicutt, Jeff Mason and Steve Holland): “U.S. President Joe Biden and Chinese leader Xi Jinping agreed on Wednesday to open a presidential hotline, resume military-to-military communications and work to curb fentanyl production, showing tangible progress in their first face-to-face talks in a year. Biden and Xi met for about four hours on the outskirts of San Francisco to discuss issues that have strained U.S.-Chinese relations. Simmering differences remain, particularly over Taiwan.”

Sticking with Biden/Xi deliverables, how about the Panda news – “envoys of friendship between the Chinese and American peoples.” WSJ: “The business leaders applauded Xi’s speech several times, including when he indicated the possibility of China sending new Pandas to the U.S… ‘We are ready to continue our cooperation with the United States on panda conservation,’ Xi said.”

For a country these days held in such low regard by the American public, recalling all the beloved Pandas was a dim-witted move. China should fire its PR firm.

NYT on Xi’s dinner with American business leaders: “Mr. Xi spoke of pandas. He spoke of Ping-Pong. He spoke of Americans and Chinese working together during World War II to battle the Japanese.” It all sounds so warm and nice – and almost embarrassingly superficial. Bloomberg headline: “Xi Pledges ‘Heart-Warming’ Steps to Attract Foreign Capital.”

November 16 – Reuters (Trevor Hunnicutt, Jeff Mason and Steve Holland): “Chinese President Xi Jinping told U.S. President Joe Biden during their four-hour meeting on Wednesday that Taiwan was the biggest, most dangerous issue in U.S.-China ties, a senior U.S. official told reporters. The official quoted Xi as saying China’s preference was for peaceful ‘reunification’ with the Chinese-claimed island of Taiwan… ‘President Xi … underscored that this was the biggest, most potentially dangerous issue in U.S.-China relations, laid out clearly that, you know, their preference was for peaceful reunification but then moved immediately to conditions that the potential use of force could be utilized,’ the senior U.S. official told reporters… ‘President Biden responded very clearly that the long-standing position of the United States was … determination to maintain peace and stability,’ the official said. ‘President Xi responded: look, peace is… all well and good but at some point we need to move towards resolution more generally,’ the official said.”

While following Wednesday evening developments, my thoughts kept returning to a Monday NYT article (Chris Buckley): “Speeches by the Chinese leader show how he was bracing for an intensifying rivalry with the United States from early in his rule. When President Xi Jinping of China made his first state visit to the United States in 2015, he wrapped his demands for respect in reassurances. He courted tech executives, while defending China’s internet controls. He denied that China was militarizing the disputed South China Sea, while asserting its maritime claims there. He spoke hopefully of a ‘new model’ for great power relations, in which Beijing and Washington would coexist peacefully as equals. But back in China, in meetings with the military, Mr. Xi was warning in strikingly stark terms that intensifying competition between a rising China and a long-dominant United States was all but unavoidable, and that the People’s Liberation Army should be prepared for a potential conflict.”

“Despite his assurances to President Obama not to militarize the South China Sea, Mr. Xi told his senior commanders in February 2016 that China must bolster its presence there.” “In Mr. Xi’s worldview, the West has sought to subvert the Chinese Communist Party’s power at home and contain the country’s influence abroad. The Communist Party had to respond to these threats with iron-fisted rule and an ever-stronger People’s Liberation Army.”

Panda talk was a nice touch. But it seems obvious that Beijing has decided to play nice only because the nice guy act is today a necessary expedient for the tough guy to be in the most advantageous position to later impose his will. Wolf Warrior in Panda’s Clothing.

At least for a day, we could forget about Xi’s “no limits partnership” pact with Putin, a dictator brotherhood appearing only to have strengthened since Russia’s Ukraine invasion (and associated atrocities). And we can overlook Team Xi/Putin, these days burning the midnight oil assembling their anti-U.S. alliance with a motley crew of countries deserving of the “axis of evil” moniker. No reason to dwell on Hong Kong repression, the crazy Chinese surveillance state and eradication of basic freedoms, or the Uyghur tragedy. Sure will be fun to welcome the Pandas back.

I hope I’m wrong on Xi’s China; hope my views on lots of things are wrong. At lot has gone right for the markets of late. While the war in Gaza is horrendous, escalation has been limited so far. There is little to indicate that Hezbollah and Iran were initially prepared for a concerted war effort with Hamas. Crude prices declined $1.28, or 1.7%, this week, capping an almost 19% drop from October 20th highs ($90).

The release of better-than-expected October CPI data provoked a significant market response. Headline CPI was flat for the month, versus expectations of 0.1% (“core” 0.2% vs. 0.3%). Ten-year Treasury yields sank 19 bps on CPI Tuesday, with yields at that point down 45 bps in 11 sessions (55bps from the 10/19 high). MBS yields dropped 27 bps, with a 64 bps 11-session collapse (77bps from 10/19). The market immediately priced zero chance of an additional Fed rate hike (from Monday’s 28%).

Equities went a little nuts, with short squeeze dynamics playing an integral role. The Goldman Sachs most short index surged 7.2% in Tuesday trading, the largest one-day gain in a year (11/10/22). Indicative of squeeze dynamics, the year’s underperformers sprang to life. The KBW Bank Index jumped 7.5%, the biggest gain in almost six months (5/17). The Bloomberg REIT Index rose 5.4%, also the strongest in a year. The small cap Russell 2000 rallied 5.4%, the largest one-day gain in over a year (11/10/22). The “average stock” Value Line Arithmetic Index rose 4.1% Tuesday (also strongest in a year).

Market reaction recalled the June CPI report, with consumer inflation reported a tenth below expectations at 0.2% for the month. After trading at 4.07% on July 7th, yields were down 32 bps in eight sessions to 3.75%. June non-farm payrolls (209k) were reported weaker-than-expected, while yields dropped aggressively on the release of the tenth less-than-forecast increase in June CPI (reported on July 12th). That inflation “all’s clear” proved premature, with yields reversing sharply higher – to trade to 5.00% in mid-October.

History informs us that inflation is not easily contained once the Genie has escaped from the bottle. Inflation will ebb and flow, while retaining a powerful bias for upside surprises.

CPI (y-o-y) began 1968 at 3.6% and traded as high as 6.2% during December 1969. CPI had dropped back down to 2.7% by June 1972, only to shoot to 12.3% to end 1974. Inflation then reversed sharply lower, with a reading of 4.9% during November 1976. Despite market and policymaker optimism, the inflation fight was anything but mission accomplished. CPI reached 9.0% in 1978, 12.2% in 1979, and then peaked at 14.7% in April 1980.

The Fed funds rate began 1968 at 4.6%, only to reach 9.2% by August 1969. It was back down to 3.50% by February 1971, before reversing higher, with the policy rate surpassing 10% in July 1973. Fed funds began 1976 below 5%, jumped back to 10% in late-1978, and reached 15.5% in October 1979 – only to peak at 20% in Q1 1980. Fed officials are well aware of inflation’s resilient and cyclical nature – along with the dangers of “stop-start” policy tightening.

November 15 – Financial Times (Colby Smith): “The US Federal Reserve would put its credibility at risk if it prematurely declared victory in its fight against inflation and then had to raise interest rates again, one of the central bank’s top officials warned… Mary Daly, president of the Federal Reserve Bank of San Francisco, told the Financial Times that recent economic data showing a further deceleration in inflation was ‘very, very encouraging’ and indicated that the Fed’s policies are proving effective. But Daly refused to rule out another interest rate increase… ‘What I worry about is that without a sufficient amount of information about whether we’re really on that disinflationary process that brings us back to 2, we have to ‘stop-start’,’ she said… ‘People need to plan and if you’re in a ‘stop-start’ mentality, then that’s really disruptive. It also ultimately tears at credibility.’”

Deficit spending and bank lending were the key drivers of monetary inflation in the seventies and early eighties. I would argue that market structure these days adds a critical element to inflation risk. Market-based finance is the marginal source of monetary fuel that can either stoke inflation or spur disinflation. Since the March bank bailout, I have chronicled how “risk on” and resulting loosened financial conditions usurped the Fed’s tightening cycle.

Financial conditions have loosened meaningfully over recent weeks. High yield CDS prices collapsed 112 bps over three weeks, the largest three-week drop since coming out of the Covid pandemic crisis in July 2020. The 18 bps three-week fall in investment-grade CDS was the largest since October 2022. MBS yields collapsed 82 bps in a month (10/19 high). Treasury yields have sunk 55 bps over the past month, while corporate spreads (to Treasuries) have narrowed to September levels.

Unless it proves ephemeral, I would expect this latest loosening to underpin economic activity, while providing inflation only a greater opportunity to establish deeper roots. Tentative signs of somewhat looser labor market conditions bear watching. But at 9.55 million job openings, JOLTS data still point to extraordinary demands for labor.

A few snippets from the week: “Hyundai has joined Honda and Toyota in raising factory worker wages… said Monday it will raise factory worker pay 25% by 2028…” “California Highway Patrol officers are getting a 7.9% wage increase, marking their biggest raise in 20 years. Last year, they received a 6.2%…” “The National Defense Authorization Act (NDAA) for 2024 has been approved by the House of Representatives, allocating an impressive 5.2% pay increase to military members.” “Alaska’s minimum wage will increase on Jan. 1, 2024 from $10.85 to $11.73 an hour…” “Starbucks workers stage ‘Red Cup Day’ strike.”

The Nasdaq100 (NDX) ended the week with a y-t-d return of 45.9%, with the S&P500 returning 19.3%. The NDX is now only 4.4% from all-time highs, with the S&P500 less than 6% away. High yield bonds (the HYG ETF) have returned 6.74% y-t-d, with investment-grade bonds returning 2.46% (LQD).

I believe tighter financial conditions will be necessary to reduce inflation risk. And conditions were tightening throughout September and October. But, once again, when tighter conditions begin to translate into softer market and economic backdrops, markets become susceptible to powerful squeeze dynamics – the unwind of short positions and the reversal of hedges. And in this hyper-speculative marketplace, squeezes quickly entice aggressive “FOMO” performance-chasing buying.

This week provided further evidence of extraordinary correlations – across various markets and globally. Whether it’s “risk on” or “risk off” – it is a highly synchronized world. Major equities indices this week were up 4.5% in Germany, 4.2% in Spain, 3.5% in Italy, 3.5% in Brazil, 3.1% in Japan, and 2.8% in Mexico. Ten-year yields dropped 23 bps in the UK and 22 bps in Italy. EM (local currency) yields dropped 36 bps in Chile, 34 bps in South Africa, 30 bps in Colombia, 28 bps in Brazil, and 24 bps in Hungary. EM currencies were squeezed higher, as dollar bulls took one on the chin. In China, Asia, Europe and the U.S., bank CDS prices have moved sharply lower.

Stocks are always good for upside surprises. And with all the derivatives, hedging, speculating, and leveraging, we shouldn’t be surprised by wild CDS and currency market volatility. But it’s the bond market that I find most fascinating. There will be ebbs and flows. Treasuries and MBS were overdue for a “rip your face off” squeeze. But there will be a couple more Trillion of Treasuries to sell over the coming year, in the face of additional QT and waning international demand. And “risk on” only heightens the risk of upside surprises in economic growth and inflation.

The bottom line is that when the bond market approaches the point of imposing some desperately needed discipline (in the markets and Washington), a confluence of squeezes, unwind of hedges, speculative flows and leveraging spurs looser conditions. Enjoying the whole loosening experience, Gold jumped 2.1% this week and Silver surged 6.5%.

But I expect the bond market to push back against “risk on.” With $2 TN annual deficits as far as the eye can see, it’s either begin imposing discipline or watch inflation and supply eat away at system stability.

Original Post 18 November 2023

Categories: Doug Noland

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