Monetary disorder played prominently throughout 2023, though most acutely with the fourth quarter upside market dislocation. Speculative leverage went to extremes, exemplified by a $1 TN hedge fund “basis trade.” Derivatives-related leverage was also pivotal in exacerbating liquidity excesses. Options trading boomed, while hedging in-the-money call options provided a key source of marketplace liquidity generation. The proliferation of derivatives strategies coupled with the “magnificent seven” phenomenon evolved into a powerful source of speculative leverage and self-reinforcing market liquidity excess.
I believe odds favor an evolving de-risking/deleveraging dynamic taking hold in 2024. Inherently problematic, unsustainable market melt-ups hasten their own demise. And I would expect the leveraged speculator community, which profited greatly from last year’s parabolic gains in the big tech stocks and indices, to turn more defensive. That said, players can be expected to stick with squeezing both shorts and derivatives traders until that highly rewarding game stops working. And the FOMO and “buy every dip” crowds are now well-conditioned to ignore risk while seeking buying opportunities.
Today’s late-speculative cycle backdrop ensures a highly uncertain and unstable market environment. We should anticipate erratic interplay between mounting caution and deeply ingrained risk embracement. We likely haven’t seen the last of late-cycle crazy, with enterprising Wall Street primed for all kinds of nutty stuff (i.e., spot bitcoin ETFs).
And, sure enough, the “risk off” tenor of 2024’s first week of trading was quickly reversed during week two. The Nasdaq100 rallied 3.2%, fully reversing the previous week’s decline. This allayed fears of impending de-risking/deleveraging in a key (highly levered and vulnerable) segment of the marketplace. With January options expiration next Friday, this week’s Nasdaq recovery spurred reversals in derivative hedges and bearish option bets. And the unwind of hedges again was instrumental in a general loosening of market conditions.
Global markets remain closely correlated. The first week of trading pointed to fledgling risk aversion and liquidity concerns. Yields jumped, CDS prices rose, spreads widened, and risk premiums generally increased. This week provided the opposite.
Investment-grade CDS declined five bps, more than reversing the previous week’s three bps increase. High-yield CDS dropped 18 bps, after jumping 15 bps. U.S. bank CDS reversed much of the previous week’s rise. Reversals were notably weaker in Europe and the emerging markets. Pounded the first week of the new year, this week’s EM bond rally was only a partial reversal.
Treasuries rallied this week, with some curious curve gyrations. Ten-year yields reversed 11 of the previous week’s 17 bps jump, while MBS yields reversed all the 24 bps surge. Meanwhile, two-year Treasury yields sank 24 basis points this week, with yields 11 bps lower over two weeks. Market expectations for the policy rate at the December FOMC dropped a notable 30 bps this week to 3.65%, implying 168 bps (six plus) of rate cuts between now and December 18th.
The reasons behind the market’s pricing of an additional rate cut this week are worthy of contemplation. It certainly wasn’t weak data. December CPI was reported stronger-than-expected. Headline CPI increased 0.3% (0.2% expected) and 3.4% y-o-y (3.2%), with “core” up 0.3% (0.3%) and 3.9% y-o-y (3.8%). Last month’s Small Business Optimism survey hasn’t been stronger since September 2022. November Consumer Credit blew away estimates ($23.8bn vs. $8.6bn). Weekly jobless claims (202k) were the lowest since October. Mortgage applications jumped, while the December federal deficit was a much-stronger-than-expected $129 billion.
Fed officials didn’t offer the market justification for pricing an additional cut. Dallas Fed President Lorie Logan doesn’t want to take another rate hike off the table. New York Fed President John Williams reiterated “higher for longer.” Cleveland Fed President Loretta Mester pushed back against market expectations of a cut by March. And even dovish Chicago Fed President Austan Goolsbee strongly pushed back against the market’s aggressive rate cut outlook.
I view market rate cut expectations as corroborating the acute fragility thesis. There’s something(s) out there that has the market betting the Fed will be forced into aggressive cuts. It could certainly be a market structure issue. A market reversal, unwind of “basis trade” and other speculative leverage, and a surge in hedging/derivatives-related selling could swiftly erupt into illiquidity, market dislocation and panic.
Perhaps the market is pricing odds of a geopolitical crisis forcing aggressive policy easing. The strike on Houthi military assets in Yemen raises the stakes. A scenario where a surge in Hezbollah and Iranian aggression pulls the U.S. further into the conflict cannot be discounted. And I can’t shake the notion that global bond markets are fixated on Chinese developments – financial and geopolitical.
New Credit data this week. China’s Aggregate Financing (system Credit growth) expanded $271 billion during December, about 50% ahead of December ’22, but 10% below estimates – to $52.74 TN. This pushed 2023 growth to a record $4.964 TN, or 9.8%. This was 11.2% above 2022 and narrowly (2.3%) ahead of prior record 2020 growth. Q4 growth of $870 billion was 48% above ‘22’s fourth quarter.
At $163 billion, Bank Loans were 13% below forecasts and down 16% from December ’22 – to a record $33.14 TN. Q4 Loans of $418 billion compare to the year ago $450 billion. Bank Loans expanded $3.293 TN, or 11.0%, over the past year – 10.8% ahead of ’22’s growth of $2.971 TN. Bank Loans grew 23.3% over two, 37.5% over three, and 74.3% over five years.
Consumer (chiefly mortgage) Loans increased only $30 billion, with one-year growth of 6.9%. Q4 Consumer Loans expanded $67 billion, up from Q4 ‘22’s $58 billion – but down 70% from Q4 ’21. Corporate Loans increased $125 billion during December, down from the year ago $177 billion. Q4 growth of $311 billion was 15% below Q4 ’22. Yet Corporate Loans still expanded $2.497 TN, or 13.0%, in 2023 (5% ahead of ’22 growth).
The Beijing boom gathered pace. Government Bonds increased $130 billion to a record $9.736 TN. Record one-year growth of $1.282 TN, or 15.9%, was 41% ahead of ’22 growth – and a third higher than 2020’s previous record expansion. The $509 billion Q4 increase in Government Bonds compares with Q4 ‘22’s $188 billion.
Indicative of mounting stress in the non-bank sector, the “Shadow Banking” category contracted $22 billion during December and $57 billion for Q4.
How does record annual Credit growth of almost $5 TN square with the headlines, “China’s Loan Growth Falls to Record Low as Demand Struggles,” “Deflation Worries Deepen in China,” and “China’s Worst Deflation Streak in 14 Years Puts Pressure on PBOC”?
China’s Bubble is engulfed in a most perilous phase. A deflating apartment Bubble has led to a collapse of developer Credit and a major slowing in consumer mortgage borrowings. Meanwhile, Beijing is aggressively pushing lending and growth in non-real estate sectors to meet its 5% growth target (i.e., EV and auto manufacturing, renewable energy, semiconductors and technology…). Corporate lending continues at a breakneck pace, while government borrowing and spending ramp up dramatically.
China’s economic imbalances are turning only more precarious. For example, there are an estimated 300 EV manufacturers in China. Talk of “deflation” misses the point. The maladjusted Chinese system now requires upwards of $5 TN annually to hold systemic Bubble collapse at bay. At Beijing’s direction, “Terminal Phase” Credit excesses continue to promote rapid expansion of increasingly suspect loans. Enormous amounts of new Credit are being allocated to uneconomic enterprises, either funding the investment spending necessary to meet growth goals or extending additional Credit to loss-making enterprises to keep them afloat. Importantly, this is prolonging the parabolic rise in system risk, the type of late-cycle dynamics that risks a crisis of confidence in a system’s banking system and currency.
January 12 – AFP: “China’s military on Friday vowed to ‘crush’ any efforts to promote Taiwan’s independence, a day before a crucial election on the self-ruled island which Beijing claims is part of its territory. ‘The Chinese People’s Liberation Army maintains high vigilance at all times and will take all necessary measures to firmly crush ‘Taiwan independence’ attempts of all forms,’ defence ministry spokesperson Zhang Xiaogang said… Zhang accused Taiwan’s ruling Democratic Progressive Party of pushing the island ‘toward the dangerous conditions of war’ by purchasing arms from the United States.”
January 9 – Financial Times (Kathrin Hille): “Lai Ching-te’s voice cracked as he hailed a crowd of tens of thousands in southern Taiwan on Sunday night. In the home stretch ahead of the presidential elections, Lai, the candidate for the ruling Democratic Progressive party, was hoarse from weeks of campaigning, but he implored supporters to keep his party in power. ‘We must embrace the world instead of relying on China,’ he said. ‘Your sacred ballot will decide not only the future of Taiwan but the fate of the world!’ The race has unfolded under unprecedented pressure from China, which… threatens to annex it by force if Taipei refuses to submit to its control indefinitely. Beijing has described the vote on Saturday as a choice between war and peace, between prosperity and decline — an indication that China could step up its campaign of military intimidation and economic pressure if Lai, the current vice-president, wins.”
The Thursday night strike on the Houthis likely marks a significant escalation of Middle East tensions. Saturday’s election in Taiwan is potentially a major geopolitical development. Victory by the Democratic Progressive Party (DPP) would mark a third straight term for a party Beijing detests.
When it comes to Taiwan, talk always seems to be of the critical importance of maintaining the status quo. It is becoming increasingly clear that Beijing is tiring of the status quo. And just as Xi Jinping tired of Hong Kong developments, he’s likely about had his fill of Taiwan’s increasingly fraternal relationship with the U.S. The People’s Liberation Army’s pre-election threat was ominously direct.
Assuming a DPP win, I expect Beijing to begin tightening the noose. The Biden administration and Congress stepped up military support last year. Ongoing support appears likely. A November BBC headline: “The US is Quietly Arming Taiwan to the Teeth.” I’ll assume Beijing’s intense efforts to thwart DPP at the polls were merely its first line of defense. Things get tougher now.
China’s deflating Bubble and its more belligerent approach with Taiwan are surely no coincidence. I’ll assume Beijing has crafted a plan that includes a threatening response to a DPP victory. I would expect much more aggressive push back against Taiwan’s relationship with Washington, with a focus on military assistance and transfers. Beijing will significantly ratchet up financial and economic pressure, with more intimidating military operations around the island. And, over time, I would not be surprised by threats to blockade the Island to halt the import of military supplies and other strategic resources.
With no end in sight for the Ukraine war and the Middle East at the brink, it wouldn’t be an inopportune time for China to begin executing its Taiwan plans. Such a development would pose a major challenge to the U.S., with risks even today’s markets couldn’t ignore. Perhaps the rates market is pricing probabilities of a detonation of one of these geopolitical catalysts bursting vulnerable global market Bubbles.
January 12 – Bloomberg (Sam Dagher and Mohammed Hatem): “The airstrikes meant to cow Yemen’s Houthi militants are pitting the US and its allies against an Iran-backed movement that senses its moment has arrived after seizing on the Israel-Hamas war three months ago. It’s also a confrontation that Iran has been scripting in the decades spent assembling what’s been called its ‘axis of resistance’ to Israel and the US. But never before did members of Tehran’s arc of influence — stretching from the Houthis to Hamas and Islamic Jihad in Gaza, Hezbollah in Lebanon to militias in Iraq and Syria — coordinate so well and on such scale. What happens next rests not just on Iran but also in large part with Houthi leader Abdul Malik Al-Houthi, whose relish for staring down the US leaves little hope the escalation will end here. Taking on the world’s superpower is a step toward fulfilling what the 44-year-old and his followers believe is his fate to become a pan-Islamic ruler…”
January 12 – Telegraph (Benedict Smith): “Abandoning Ukraine to Vladimir Putin will embolden Iran, Rishi Sunak has warned as he met Volodymyr Zelensky in Kyiv. The prime minister’s comments come after Britain and the US launched airstrikes against Iranian-backed Houthis who have brought chaos to the Red Sea by attacking merchant ships. ‘For the free nations of the world, aid to Ukraine is also an investment in our own collective security,’ Mr Sunak said. ‘Because if Putin wins in Ukraine he will not stop there and our opponents around the world believe we have neither the patience nor resources for long wars. ‘So waver now and we embolden not just Putin but his allies in North Korea, Iran and elsewhere.’”
Original Post 12 January 2024
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Categories: Doug Noland