Doug Noland’s review of what he calls: “Epic Monetary Disorder”.
posted by Doug Noland on the CreditBubbleBulletin:
Wednesday’s CPI release was telling. July consumer price inflation data were somewhat better than forecasts. Instead of increasing 0.2%, headline CPI was flat for the month. “Core” prices rose 0.3%, less than the expected 0.5%. From a fundamental perspective, a single month of marginally improved inflation data is not an earthshaking development. Fed officials were understandably cautious. Even dove Neel Kashkari showed restraint: “This is just the first hint that maybe inflation is starting to move in the right direction, but it doesn’t change my path.”
Meanwhile, the CPI report was a big deal for risk markets. The Nasdaq100 advanced 2.8% Wednesday, while the small cap Russell 2000 jumped 3.0%. Why such a spirited response? CPI hit during a key juncture for market Speculative Dynamics. A powerful short squeeze had developed across global markets. An upside inflation surprise would surely slam bond prices, pressuring stock prices lower and blunting the squeeze. Instead, a favorable inflation report provided an “all’s clear” for tightening the screws on those on the wrong side of the risk market rally.
The Goldman Sachs Short Index (GSSI) surged 5.1% Wednesday (up 7.5% for the week). In what is shaping up as a major Squeeze episode, the GSSI is already up 20.6% month-to-date – while rallying 47% off June lows.
It was the “Everything Bubble” and the everything bust – presently interrupted by the Everything Squeeze. After beginning the year at 295 bps, U.S. high-yield CDS surged to a June 16th high of 598 bps. HY CDS sank 43 this week to 421 bps – now down 177 bps from June highs. The iShares High Yield Corporate Bond ETF (HYG) has rallied 8.2% off June lows. Emerging Market CDS sank 37 this week to 280 bps – down 107 bps in four weeks. European high-yield (“Crossover”) CDS collapsed 56 bps this week to 463 bps – a four-week drop of 160 bps. Bank CDS prices have sunk back to April levels (i.e. JPM CDS down 30 from July highs to 73 bps).
Market Structure has been a longstanding CBB theme. It’s turning out to be a critical issue for the first substantive Federal Reserve tightening cycle in 25 years. Wednesday’s CPI report only makes the Fed’s job more difficult, as financial conditions have loosened dramatically over the past few weeks.
August 8 – Bloomberg (Jack Pitcher): “High-grade US companies are taking advantage of a broad markets rally on Monday by selling the largest number of bonds since early June. They’re capitalizing on falling costs and rising demand to refinance debt, pay for acquisitions and fund new projects. Credit Suisse Group AG is among 12 issuers of investment-grade bonds, continuing momentum for a primary market that roared back to life over the last few weeks… Investment-grade borrowers have raised money at an impressive clip, with $120 billion of new debt sold over the last three weeks.”
August 12 – Bloomberg (Yiqin Shen): “A surprise surge in deals is turning August into a memorable month for mergers and acquisitions, helped by rising stock prices and steadier US markets. Already $63 billion of transactions have been announced in North America, the most for a comparable monthly period since November and eclipsing the $52 billion in deals for all of July…”
Managing the monetary system with doctrine focused on market-based financial conditions and “neutral” interest-rate analysis is untenable. Financial conditions were notably tight a few weeks back. The shift back to loose has been abrupt and powerful. Thoughts that Fed policy rates were quickly approaching “neutral” are today little more than fanciful thinking.
U.S. and global systems have developed robust inflationary biases over the past year. In general, inflation promotes the necessary Credit growth to sustain price momentum. Higher prices, labor shortages, supply chain issues, and the like spur borrowing and investment spending. There are also these days unique climate change issues that drive major investment booms at home and abroad.
And there are the markets. A few short weeks ago, de-risking/deleveraging and the resulting major tightening of market financial conditions brought corporate debt markets to an abrupt halt. The prospect of the money spigot being turned off for scores of negative cash-flow and uneconomic enterprises was becoming a systemic issue. Venture capital and private equity Bubbles were bursting. Company layoff announcements were gathering momentum.
Moreover, collapsing securities prices and evaporating perceived wealth would surely add to downside pressures on spending and investment. It was reasonable to assume that tight financial conditions would mitigate some inflationary pressures percolating throughout the real economy. Focused on financial conditions, Powell signaled the Fed would quickly reach its “neutral rate” destination.
For 25 years, markets became progressively more confident in the central bank liquidity backstop. The so-called “Fed Put” became deeply embedded in Market Structure – in psychology, behavior, products, strategies and asset prices. It became instrumental to derivatives markets and hedging strategies more generally. If the Fed was managing the weather, why not sell flood insurance? And with readily available cheap market insurance, why would anyone liquidate risk asset portfolios? Stocks always end up moving higher. Just navigate through market pullbacks with some savvy derivative hedges. More than anything, don’t underperform the market. If you’re going to be wrong, you had better be wrong with the group.
Over time, the accommodative backdrop had a profound impact on Market Structure. Risk management was downgraded, while risk embracement was readily rewarded. Markets turned increasingly speculative. Greed trounces Fear. “FOMO” (fear of missing out) became the dominant force throughout the securities and derivatives markets. Those concerned with mounting risks were weeded out. Employing maximum risk became the go-to default strategy. Incorporate leverage to maximize returns, keeping one eye on derivatives markets for protection if the Bubble began to succumb.
Bubbles were succumbing. A Bloomberg headline from March 18th: “Stock Traders Brace For a $3.5 Trillion ‘Triple Witching’ Event.” A quarter later, June’s expiration was another monster $3.5 TN event. And it’s no coincidence that market trading lows were established June 16th – one day ahead of Q2 “Triple Witch.”
It’s worth noting that the Bloomberg Commodities Index sank 6.7% during June expiration week. The Dollar Index traded above 105 for the first time in almost two decades, as global Risk Off stoked a dollar melt-up. The dollar traded at a 24-year high versus the Japanese yen. Global currency markets were dislocating. Emerging Market currencies, stocks and bonds were all under intense liquidation. Periphery European bond markets were coming unglued, with Italian yields spiking (up 98bps in nine sessions) to 4.17%. The euro traded to a 20-year low. Trading across key markets was turning disorderly, as global derivatives markets began to dislocate (i.e. high yield CDS two-week spike of 103bps).
In short, global markets were “seizing up”. With multi-trillions of market risk offloaded to the derivatives markets, the system was at a critical juncture. If de-risking/deleveraging continued, the scope of derivatives-related selling pressure (“delta” or dynamic trading to hedge protection written) would overwhelm the marketplace.
In the past, such market episodes reliably triggered central bank dovish pivots and market recoveries. Christine Lagarde led the charge, calling an emergency ECB meeting to begin crafting an “anti-fragmentation” tool. “…Anybody who doubts that determination will be making a big mistake.” Beijing moved forward with a number of stimulus measures, while the Bank of Japan made it clear it was not about to back away from ultra-loose monetary policy or abandon JGB yield control. Testifying before Congress, Powell stated the Fed would have to be “nimble.” James Bullard was talking about 2023 rate cuts.
It may not have been the typical rate cut and QE announcements, but central bankers certainly communicated acute sensitivity to market fragilities. For now, central bank market backstops appeared intact. Financial markets reversed sharply higher, inciting what would be a major reversal of hedges and bearish bets – across global markets.
It’s worth underscoring that a serious global crisis of confidence was materializing around a big quarter-end U.S. derivatives expiration. The structure of U.S. and global derivatives hedging markets has created a weak link within the global financial system. Market participants have been conditioned to hedge in the derivatives markets, creating vulnerability for a self-reinforcing (1987 “portfolio insurance,” but so much bigger) crash dynamic. Such a collapse would destroy faith in the central bank “put,” essentially creating a crisis of confidence in Market Structure and central banking.
At least for this round, perceptions held that central bankers retain the capacity to stabilize markets. And now markets are weeks into a major unwind of hedges and short positions, a dynamic that unleashes smoldering speculative dynamics. Short squeezes are back; meme stocks have come back to life; and FOMO is forcing the under-invested to get their exposures right back up.
It’s also consistent with the “Fed hikes until something breaks.” The Bloomberg Commodities Index surged 4.5% this week, and after rallying 12% from July lows is up 24% y-t-d. Gasoline jumped 6.7% this week (up 37% y-t-d), with Natural Gas spiking 8.7% (up 135%). Rallying markets – in particular the unwind of hedges and the reemergence of speculative leveraging – create their own liquidity. Especially considering supply constraints and geopolitical instability, I see no reason why some of this liquidity won’t reinforce powerful inflationary forces throughout the commodities complex.
August 12 – MarketWatch (Barbara Kollmeyer): “Investors counting on a softer global economy to pull commodity prices lower may instead be faced with scarce supplies and inflation, as the market is awash in contradictions, Goldman Sachs has warned clients. ‘Today, commodity markets appear to hold irrational expectations, as prices and inventories fall together, demand beats expectations and supply disappoints,’ wrote Goldman’s head of commodities research Jeffrey Currie and his team… They note the commodity space has moved from hoarding to destocking, with consumers using up inventory at higher prices on the hopes that a broad softening of the economy will create extra supply. ‘Yet should this prove incorrect and excess supply does not materialize as we expect, the restocking scramble would exacerbate scarcity, pushing prices substantially higher this autumn, potentially forcing central banks to generate a more protracted contraction to balance commodities markets,’ Currie said.”
Market expectations currently have Fed funds peaking at 3.66% in March of next year. This seems reasonable enough in the context of China’s faltering Bubble, ongoing acute global fragilities, and U.S. market and economic vulnerabilities. But if U.S. securities markets regress to their speculative ways more sustainedly, there’s a scenario where loose financial conditions underpin both economic activity and inflationary pressures. A 5% Fed funds rate in 2023 is not unthinkable.
I’m assuming surging equities speculation, bustling debt markets, and booming commodities price inflation would alarm Fed officials. A precipitous loosening of financial conditions would catch them by surprise, hastening some serious “neutral rate” contemplation. Barring a market accident, inflationary pressures will not be contained by the level of Fed funds currently anticipated by the marketplace.
At 2.83%, 10-year Treasury yields show little concern for the risk market resurgence. It’s as if bonds become only more confident in Things Are Going to “Break.” There are certainly major risks associated with the marketplace turning bullish at this juncture – scrapping hedges while boosting exposures and leverage. It seems to ensure major liquidity challenges come the next bout of de-risking/deleveraging. And let’s not forget that the Fed ratchets up QT (quantitative tightening) next month.
I also worry about the hedge funds. This rally has caught many funds poorly positioned, only compounding performance challenges. As a whole, the industry is under intense performance pressure. Most funds have no choice but to plug noses and jump on the rally. They’ll also be the first to liquidate come the next leg of the bear market, selling right along with the derivatives players as a panicked marketplace rushes to reestablish hedges. And if the recent loosening of financial conditions has been spectacular, just wait until the next de-risking/deleveraging-induced tightening.
Originally posted by Doug Noland on the CreditBubbleBulletin.
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