The Red Line

Doug Nolan
April 25 – Financial Times (Jennifer Hughes): “Stand easy — or easier, at least. Ten basis points might not be the biggest one-day change for borrowing costs in China’s vast $7tn bond markets, but it was enough on Monday to push the country’s closely watched onshore repo rate back from an eight-month high. That offers a little breathing space for investors to ponder what next for the rising tensions in onshore bond markets. One point to look at is their own leverage as well as their fears for companies… Amid all the furore about the pain of rising rates, one so-far overlooked factor is that investors, as well as companies, appear precariously balanced. The market for pledge-style repos — short-term, bond-backed loans — is currently bigger than the stock of outstanding debt, according to Wind Info. A sharp worsening in market sentiment could force those borrowers into fire sales if their loans are called or cannot be rolled over.”

I recall an early-1998 Financial Times article highlighting the explosive growth in Russian ruble and bond derivatives. Not only had the “insurance” market for risk protection grown phenomenally, Russian banks had become become major operators in what had evolved into a major speculative Bubble in Russian debt exposures. That was never going to end well.

There was ample evidence suggesting Russia was a house of cards. Yet underpinning this Bubble was the market perception that the West would not allow a Russian collapse. With such faith and the accompanying explosion in speculative trading, leverage and a resulting massive derivatives overhang, any break in confidence was to ensure illiquidity, panic and a devastating bust. Just such an outcome unfolded in August/September 1998.

“The market for pledge-style repos — short-term, bond-backed loans — is currently bigger than the stock of outstanding debt” (from FT above). With this undramatic sentence exists the potential for a rather dramatic global financial crisis. And, to be sure, seemingly the entire world has operated under the assumption that Chinese officials (and global policymakers in general) have zero tolerance for crisis – let alone a collapse. So Credit, speculation and leverage have been accommodated – and they combined to run absolute roughshod.

Jennifer Hughes’ FT article (noted above) included a chart worthy of color printing and thumbtacking to the wall: “China’s Use of Bonds as Loan Collateral Rises Sharply”. The pink line shows “Onshore Market Bonds” having almost doubled since mid-2011 to about 40 TN rmb ($6.17 TN). The Red Line – “Pledge-Style Repos” – has ballooned four-fold since just early 2014 to surpass 40 TN rmb. So basically, in this popular market for inter-bank borrowings, borrowing banks have pledged bond positions larger than the entire market as collateral for their (perceived safe) short-term borrowing needs.

China has an historic Credit problem. It as well suffers from an unfolding “money” fiasco of epic proportions. My analytical framework attempts to differentiate the two, as each comes with its own set of (related) issues. A Credit Bubble is a self-reinforcing but inevitably unsustainable expansion of debt. Money (the contemporary variety) is a financial claim perceived as a safe and liquid “store of nominal value.” Importantly, systemic risk expands exponentially when risky borrowings are financed by an expansion of “money-like” instruments/financial claims. This typically occurs late (“terminal phase”) in the Credit Bubble Cycle.

During the U.S.’s mortgage finance Bubble period, “Wall Street Alchemy” worked to transform increasingly risky mortgage debt into perceived safe “AAA” securities and instruments. And so long as the rapid expansion of mortgage Credit propelled home prices and economic activity, the Fallacy of Moneyness prevailed. But at some point Bubble risk intermediation processes invariably turn perilous. The disconnect becomes increasingly untenable: enormous risk has accumulated – and continues to swell – backed by a rapid expansion of perceived safe “money.” After months of festering Credit deterioration, it was the breakdown in confidence in the repo market that precipitated the devastating 2008 financial crisis.

How sound is China’s multi-Trillion repo market? In general, lending in short-term, collateralized, inter-bank markets is perceived to be very low risk. Confidence is based on the soundness of the individual institutions in the market; in the quality and liquidity of the debt collateral; and the capacity and determination of official institutions to backstop the marketplace during periods of tumult.

As for China, underpinnings are vulnerable. The banking sector has enjoyed years of explosive growth, which by definition virtually ensures latent fragilities. There are as well major cracks surfacing in China’s corporate bond market, portending serious issues with the collateral backing China’s “pledged-style repos.” And how has corruption and incompetence (not to mention state-directed lending) impacted the quality of banking system assets? At this point, faith that Beijing will backstop system Credit while ensuring uninterrupted economic expansion is fundamental to repo market confidence.

After the incredible $1.0 TN Q1 Chinese Credit expansion, there were indications this week that excess went too far and officials now seek to slow things down (see “China Bubble Watch”). Officials also moved this week to rein in commodities speculation. Efforts were made as well to tighten mortgage Credit, at least in some of the more overheated markets.

I often refer to the “global pool of speculative finance.” Well, after years of rampant Credit excess, China these days has its own unwieldy pool of speculative finance fomenting boom/bust dynamics throughout equities, housing and, more recently, in debt and commodities. And I believe it is a safe assumption that the explosive growth in short-term (“repo”) borrowings has been instrumental in financing myriad asset and speculative Bubbles. Chinese officials, of course, have been keen to avoid bursting Bubbles and all the associated negative economic, social and geopolitical consequences. Regrettably, these efforts have nurtured only greater distortions, risk misperceptions and stupendous Bubble excess.

Returning to the “China as marginal source of global Credit” theme, one can these days make clearer delineations. Today, Bubble markets and an extraordinarily maladjusted and imbalanced global economy are highly dependent upon ongoing Chinese financial and economic booms. The Chinese Bubble depends upon ongoing speculative excess and asset inflation. And Chinese asset and speculative Bubbles are sustained by cheap “repo” and other short-term “money-like” finance.

With various Bubbles either already faltering or indicating acute fragility, confidence in China’s “repo” finance has turned quite vulnerable. And as goes the Chinese “repo” market so goes China’s asset Bubbles, Credit Bubble and economic Bubble, with ominous portents for global markets and the overall global economy.

Markets were turning keen to this risk earlier in the year. More recently, with Chinese officials having seemingly stabilized their financial and economic systems, global market attention returned to anxious central bankers, zero/negative rates and a couple Trillion additional QE. 
There was a huge policy-induced short squeeze that bolstered bullishness and sucked in a significant amount of buying power. The leveraged speculating community got turned upside down, with trades going haywire throughout global markets. The return of “risk on” turned into a real pain trade for many. And just when it appeared markets had stabilized and positioning had normalized…

There were indications this week that the “risk on” spell may have been broken. Thursday saw Japan’s Nikkei sink 3.6%, while the yen jumped 2.6%, the “most since 2010.” It was a somewhat histrionic market reaction to the Bank of Japan’s decision not to immediately expand stimulus. For me, it indicated market “risk off” susceptibility. Japanese equities and the yen have been important markets for the leveraged speculating community. Both the Japanese equities rally and the yen pullback were “counter-trend” moves susceptible to hasty market reassessment.

The yen surged 4.7% this week to an 18-month high versus the dollar. Japan’s Topix Bank Index sank 8.6%, increasing 2016 losses to 29.3%. It’s worth noting that financial stocks were under pressure globally again this week. Hong Kong’s Hang Seng Financials were down 2.8% (down 11.3% y-t-d), and European bank stocks fell 2.7% (down 16.7%). The major European equity markets – having been major squeeze and “risk on” beneficiaries over recent weeks – also showed their vulnerability. Germany’s DAX index sank 3.2%, and French stocks were down 3.1%. Rallies dominated by short-squeeze dynamics often have a propensity for abrupt reversals.

Here at home, the Securities Broker/Dealer index was (ominously) slammed 5.5%. Worries, however, were not limited to financials. Having notably benefited from squeeze dynamics, an abrupt reversal saw biotech stocks slammed 5.9%. More prophetic for the general markets – and the economy overall – were further indications this week of a faltering technology Bubble. In a period of general earnings deterioration, it is worth recalling how quickly technology earnings can evaporate (recall 2000 to 2002).

Wall Street darling Apple sank 11% this week on weak earnings. Fear of a rapid slowdown in smart phones also saw the semiconductors (SOX) slide 3.5%. On the back of declines in Apple, Microsoft (down 3.7%) and Netflix (down 6.1%), the Nasdaq100 dropped 3.0%. Tech indices – and the general market - benefited from players crowding further into the big winners (Amazon and Facebook up 6.3%). It’s worth noting that the VIX ended the week at 15.70, up from the week ago 13.95.
Commodities are on fire. The GSCI Commodities index jumped 3.6% this week to a six-month high (up 15.6% y-t-d). Crude gained another $2.27 to $46.01. More interestingly, Gold surged $61 (4.9%) to 14-month highs (HUI up 15.4%!). Silver jumped 5.4% to a 15-month high. Curiously, the dollar index fell 2.2% this week to a one-year low.

From my vantage point, global market vulnerability has reemerged. Sentiment has begun to shift back in the direction of central banks having largely expended their ammunition. This becomes a more pressing issue when market players sense heighted deleveraging risk. Dan Loeb’s (Third Point Capital) comment, “There is no doubt that we are in the first innings of a washout in hedge funds,” provided a timely reminder that the market recovery did little to erase levered player woes. Indeed, market convulsions over recent months have only compounded problems.

It’s during bouts of “risk off” that the true underlying liquidity backdrop is illuminated. Combine short squeezes and the unwind of hedges with QE - and global markets seemingly luxuriate in liquidity abundance. “Risk off” exposes the liquidity illusion. Risk aversion would see longs liquidated and leverage unwound, with a rush to reestablish shorts and risk hedges. 
And rather quickly de-risking/de-leveraging would overwhelm QE. And if “risk off” is accompanied by Chinese Credit, banking and “repo” problems, well, global crisis dynamics would gather momentum in a hurry.

It’s almost as if gold, silver and crude prices are now shouting they win either way. If the China Bubble perseveres along with global QE, inflation has a decent shot of taking root (an ugly scenario for global bond Bubbles). But if the ominous China “repo” Red Line foretells a harsh Chinese and global crisis - crude and the precious metals, in particular, offer rather enticing wealth preservation potential. It’s time again to be especially vigilant.

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