Sovereign Market Dislocation and Derivatives Turmoil

Doug Nolan

Seven UK mutual funds thus far have halted withdrawals and/or taken significant write-downs on fund asset values. Combined fund assets are about 20 billion pounds. Back in June 2007, it was the implosion of funds managed by Bear Stearns with about $20 billion of assets that set in motion the collapse of the mortgage finance Bubble. To be sure, bursting Bubble dislocations would have been less destructive had “Terminal Phase” excess not run roughshod throughout 2007 and well into 2008.

When I criticized the Fed’s reflationary policies back in 2009 – and initially warned about the emergence of the “global government finance Bubble” – the focus of my concerns was not hyperinflation or a dollar collapse. My worry was the likelihood for massive global fiscal and monetary stimulus to foster a systemic mispricing of “finance” – securities prices and Credit more generally. From this global macro perspective, the outcome has been my worst-case-scenario. Actually, policy measures and attendant pricing distortions have been far more extreme than I could have imagined.

Japanese 10-year JGB yields ended the week at negative 0.29%. German 10-year bund yields closed the week at a record low negative 0.19%, and Swiss yields were a record low negative 0.69%. French 10-year yields ended Friday’s session at an all-time low 10 bps. The Netherlands saw yields drop to zero. Despite stronger-than-expected job gains, Treasury yields closed the week at a record low 1.36%.

Italy, with three Trillion of sovereign debt measured at a problematic 135% of GDP (and growing), ended the week with 10-year yields at a record low 1.19%. Draghi’s “whatever it takes” has had a most profound impact on Italian yield (down about 500bps since the summer of 2012). Yet despite collapsing borrowing costs, Italy nonetheless runs persistent budget deficits. And while the ECB has thus far succeeded in keeping Italy solvent, the same cannot necessarily be said for Italy’s troubled banking industry (see “Italy Watch” below).

From the Wall Street Journal (Giovanni Legorano): “In Italy, 17% of banks’ loans are sour. That is nearly 10 times the level in the U.S., where, even at the worst of the 2008-09 financial crisis, it was only 5%. Among publicly traded banks in the eurozone, Italian lenders account for nearly half of total bad loans.”
In a more normal market backdrop, Italy’s finances would today be in crisis. Surging sovereign yields and failing banks would have forced harsh but needed financial, fiscal and economic structural reform. This should have transpired years ago. These days there is perhaps some tension, but there’s no burning crisis in Rome. Prime Minister Renzi, while politically weakened at home, can use his government’s vulnerability to wield impressive power in Brussels and Frankfurt, especially post Brexit. After all, Italy could rather easily bring down the European banking system. Indeed, the Italians today hold sway over the euro currency, and Renzi knows he’s playing a strong hand.

July 6 – Reuters (Isla Binnie): “The difficulties facing Italian banks over their bad loans are miniscule by comparison with the problems some European banks face over their derivatives, Italian Prime Minister Matteo Renzi said… Speaking at a joint news conference with Swedish Prime Minister Stefan Lofven, Renzi said other European banks had much bigger problems than their Italian counterparts. ‘If this non-performing loan problem is worth one, the question of derivatives at other banks, at big banks, is worth one hundred. This is the ratio: one to one hundred,’ Renzi said.”
On the back of talk of EU concessions (further flouting of rules) on a bank bailout, Italian banks rallied 9.7% Friday (w-o-w plus 2%, y-t-d down 53%). Despite Friday’s 3% rally, Germany’s behemoth Deutsche Bank ended the week down another 4.4%. Deutsche Bank has now lost almost half its value this year. And I’ll assume Renzi had his mind on DB and a few other major German and French banks with his claim that derivative issues are 100 times larger than Italian loan troubles. Italy’s problem loans pile is gargantuan, yet I reckon the Prime Minister could be onto something.

By this point, there’s a prevailing numbness that has enveloped the markets. The extraordinary passes almost as the typical and familiar. One can only say “incredible” and “amazing” so many times - and for so long. The naysayers, well, they’ve been bloodied into submission. And while tired debates remain fixated on “bull vs bear”, “expansion vs recession” and “inflation vs deflation”, global markets are in the midst of a phenomenal development with momentous ramifications.

Global sovereign debt markets have wildly dislocated, with a concerted yield collapse unparalleled in history. At the same time, there are literally hundreds of Trillions of interest rate swaps, swaptions and myriad sophisticated derivatives and derivative trading strategies – comprising by far the largest market in the world. Hands down it’s the murkiest. Still, extraordinary moves in yields, various spreads and yield curve structure ensure that there are enormous (and rapidly growing) embedded gains and losses lurking throughout the derivatives marketplace. Wonder where?

It’s also worth noting that the Japanese yen, another heavy-weight in the derivatives universe, gained almost 2% this week, pushing y-t-d gains versus the dollar to 16.6%. Ominously, Japan’s TOPIX Bank index was clobbered 6.4% this week, boosting 2016 losses to 41%.

Market dynamics may appear virtuous, but there’s a strong case to be made for an especially vicious cycle. The labyrinth interest-rate derivatives complex operates with near-zero transparency. But we can posit some educated top-down assumptions: As we’ve witnessed repeatedly, especially since 2012, heightened systemic risks spurs additional QE. This additional QE fosters more “front-running” speculative buying in sovereign debt markets (cash and derivatives) backstopped by aggressive central banks.

QE, meanwhile, completely fails to contain expanding systemic risks. “Whatever it takes” instead exacerbates market speculation, volatility and uncertainty. And having painted themselves into a corner, central banks effectively cling to one weapon to counteract instability: More QE. So it reaches the point - the point we’re at today - where acute fragility incites a vicious combination of more QE, short covering, speculative front-running and safe haven buying. There’s simply a rapidly expanding quantity of “money” chasing a hastily declining supply bonds.

Prospects of aggressive rate cuts (and perhaps even “helicopter money”) from the Bernanke Fed were instrumental in fueling a spectacular energy market speculative blow-off right into the 2008 crisis. Commodities surged generally, with WTI hitting its all-time high $145 in July 2008. Treasury bond prices made a similar parabolic move, while the huge rally in GSE debt and MBS was instrumental in extending “Terminal Phase” mortgage excesses. Importantly, the risk markets turned tightly correlated. It all became one precarious liquidity-induced speculative Bubble poised to burst.

World markets are in the midst of something on a frighteningly grander scale than 2007-2008. 
Tens of Trillions of sovereign debt have become trapped in speculative melt-up dynamics, as central bankers, derivative traders, speculators and safe haven buyers all battle to procure precious bonds. And I don’t believe it’s coincidence that the world’s largest derivative players are seeing their stock prices suffer under intense selling pressure. Meanwhile, sinking bank shares heighten market fears, which only feeds the dislocation and reinforces the dynamic imperiling the big derivative operators.

Brexit hit as market dislocation had already attained powerful momentum. A crisis of confidence then engulfed the UK lenders. Moreover, major Brexit-related uncertainties weakened already waning confidence in Italian banks, and European banking (and currencies) more generally. European worries exacerbated Asian worries. And the worse things look for Italy and European banks the more convinced the markets are of additional concerted “whatever it takes” – in Europe, the UK, Japan and elsewhere including even the U.S.

I guess it might have gone either way. Brexit could easily have spurred a problematic “risk off.” 
 Instead, a globally super-charged sovereign debt dislocation/melt-up has completely overwhelmed the markets. The disappearing supply of sovereigns and resulting evaporation of yields - coupled with the prospect of endless QE - have led to a generalized risk market short-squeeze and unwind of hedges. This worked to solidify the notion that corporates and EM would now provide the primary source of yield for a freakishly yield-desperate world. And with visions of over-abundant liquidity and ultra-low corporate borrowing costs as far as the eye can see – replete with M&A boom and buybacks forever - it has become possible to overlook a lengthening list of fundamental factors overhanging equities markets.

A couple of notable Friday (WSJ) headlines: “Market Extra: S&P 500 near record highs? Treasury Yields at Lows? Something's Gotta Give” and “Sovereigns Face Record Year for Downgrades.” In the face of mounting risk, “money” now floods into the risk markets. Curiously, at least for the week, economically-sensitive commodities, including energy (crude down 7.9%) and copper (down 4.6%), were hammered, especially in comparison to the precious metals.

July 6 – Bloomberg (Taylor Hall and Charles Stein): “It’s another record for Vanguard Group Inc. The firm, which has grown to become the world’s largest mutual fund manager by offering low-cost investments, attracted $148 billion in new client money during the first six months of 2016, surpassing its previous first-half record of $140 billion set last year… In June alone, about $30 billion flooded into the firm’s mutual funds and exchange-traded products.”
The Flood goes way beyond equities index products. I suspect flows into perceived low-risk dividend and yield plays have gone from enormous to more enormous. After having been on the receiving end of robust flows for some time, it appears Brexit actually incited greater inflows into corporate debt.

July 7 – Bloomberg (Joe Rennison): “Investors poured money into corporate bond funds over the past week, as demand for fixed rate returns accelerated against the backdrop of global government debt yields hitting record lows. Bond funds had inflows of $14.4bn, with the US receiving the lion’s share of $7.8bn.”
The Fed’s 2007 reflationary policies spurred strong flows into the risk markets - in the face of a horrible risk vs reward calculus. Washington had seemingly transformed the entire mortgage finance complex into a low-risk proposition: “The Moneyness of Credit.” When confidence inevitably waned there was an uncomfortably sudden appreciation that safety and liquidity had become major issues. The halting of redemptions in Bear Stearns’ mutual fund shares was a major inflection point. Confidence was shaken. It was the beginning of the end. It was, as well, the kickoff for a bout of destabilizing wild and crazy.

Throughout history real estate has provided a convenient bastion for financial innovation and speculation. Why not let retail investors in on the strong returns available in booming London and UK real estate markets, especially with decent yields unavailable elsewhere. Why not transform inflating illiquid assets into perceived safe and liquid shares for the masses - especially with central banks destroying yields for tens of Trillions of debt securities?

The “Moneyness of Risk Assets” has been a centerpiece of my global government finance Bubble analysis. It was an epic misconception to print “money” by the Trillions, incentivize massive flows (and speculative leverage) into risk markets in order to reflate the U.S. and the world – and then respond to inevitable instability with “whatever it takes” activism and further market manipulation. The Fed and global central bankers have nurtured the illusion that risk markets are safe and liquid (money-like). They have spurred “contemporary finance” and the transformation of increasingly risky assets into perceived safe and liquid securities. Ironically, as the liquidity myth is illuminated in UK real estate funds, a sovereign debt market dislocation ensures “money” floods into potential liquidity traps in risk markets around the world.

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