Risk Off, the BOJ and China

Doug Nolan

Is a meaningful de-risking/de-leveraging episode possible with global central banks injecting liquidity at the current almost $2.0 TN annualized pace?

Thus far, central bankers have successfully quashed every incipient Risk Off. Market tumult has repeatedly been reversed by central bank assurances of even more aggressive monetary stimulus. The flood gates were opened with 2012’s global concerted “whatever it takes.” Massive QE did not, however, prevent 2013’s “taper tantrum.” Previously unimaginable ECB and BOJ QE coupled with ultra-loose monetary policy from the Fed were barely enough to keep global markets from seizing up earlier in the year.

It’s my long-held view that market interventions and liquidity backstops work primarily to promote speculative excess and resulting Bubbles. While celebrated as “enlightened policymaking” throughout the markets, an “activist” governmental role (fiscal, central bank, GSE, etc.) is inevitably destabilizing. The upshot of now two decades of activism is a global marketplace dominated by speculation and leveraging.

I’ll posit that a given size of “liquidity backstop” fosters a commensurate speculative response in the marketplace, ensuring that a larger future backstop/intervention will be required come the next serious de-risking/de-leveraging episode. The essence of the current (global government finance) Bubble is that central banks have committed to doing “whatever it takes” – and this moving target “whatever it will take” has kept inflating right along with speculative market and asset Bubbles across the globe. This scheme has gone on for years. A Day of Reckoning cannot be postponed indefinitely.

This is clearly a more pressing issue for me than for other analysts. Speculative Bubbles tend to climax with a terminal furry of exuberance, excess and dislocation. A final destabilizing tsunami of financial flows and attendant price spikes ensure that grossly inflated market confidence and price levels turn untenable. Then comes the painful Reversal.

Global sovereign debt and bond markets this year were overwhelmed by “blow-off” excess. The biggest cash markets in the world along with the biggest derivative markets in the world dislocated in historic “melt-up.” Effects became systemic. Price impacts were extreme – historic. Virtually all asset classes were significantly disrupted by Bubble Dynamics. To be sure, there was newfound exuberance in the power and sustainability of “whatever it takes.”

From my analytical perspective, it appears we’re again nearing another “critical juncture,” yet another potential major inflection point. And the probability that such prognostication ends up looking foolhardy is not small. After all, central bankers have repeatedly had their way – imposed their will upon the markets. On the other hand, if we have indeed reached a critical point for acutely vulnerable markets, few are prepared. Of course, almost everyone is convinced they have the answer to the opening question: “No, and this was proved earlier in the year.”

Let’s take a different tack. Would $167bn ($2TN/12), a month of global QE, be sufficient to hold Risk Off at bay? How about $38 billion during a week of intense market tumult? The proverbial drop in the bucket. I actually believe that the global Bubble has inflated to such precarious extremes that even $2.0 TN of central bank purchases would in rather short order be overwhelmed in the event of a major bout of speculative de-leveraging. Let me suggest that the almighty central banker liquidity backstop arsenal would wither in the face of a synchronized global liquidation across various asset classes. What’s more, the possibility of just such an outcome has greatly increased after the recent global bout of synchronized central bank-induced speculative excess.

By the look of markets over the past week or two, the six-month central bank-induced respite appears to be winding down. The ghosts of January and February have reawakened: Europe, global banks, energy, EM and China (to name a few). Some Friday headlines: “Oil Falls to 1-Month Low…” “Mexican Peso Slides to Record Low…”; ‘Cost of Insuring Deutsche Bank’s debt Rises 8 percent…”; “U.S. Stock Funds Post Largest Weekly Outflows in a Year…” “Monte Paschi Bonds Slide to Two-Month Low…” “China H Shares Go From Best to Worst…”; “Low-Volatility Funds Face Rougher Ride”. “Volatility Puts Some Funds at Risk.”

Europe suffered a rough week, especially at The Fragile Periphery. In general, unimpressive rallies gave way to serious selling. Greek 10-year yields surged 33 bps to 8.45%, the high going back to April. Portugal’s 10-year spread (to bunds) widened 26 bps this week to 339 bps, the widest level since February. Italian spreads widened 10 bps to a four-month wide 134 bps. Major equities indices dropped 2.8% in Germany and 3.5% in France. Stocks were slammed 4.3% in Spain and 5.6% in Italy.

September 16 – Wall Street Journal (Jenny Strasburg): “A legal settlement half the size of the U.S. Justice Department’s $14 billion opening bid in a mortgage-securities case would exceed Deutsche Bank AG’s litigation provisions and strain its already thin capital cushion. Even a $4 billion settlement ‘would put questions around capital position,’ J.P. Morgan… analyst Kian Abouhossein said in a research note this week.”
Ominously, European banks were back in the markets’ crosshairs. Deutsche Bank was hammered 12.3% this week, boosting y-t-d losses to 45%. Europe’s STOXX 600 Bank Index sank 5.6% (down 24% y-t-d). Italian banks were slammed 9.4% (down 50% y-t-d). Italy’s Monte dei Paschi was clobbered 9% Friday, while UniCredit sank 5.8%. It was not only European banks under pressure. Japan’s Topix Bank index dropped 4.3% this week (down 29% y-t-d), while Hong Kong’s Hang Seng Financials fell 4.2% (down 1.7% y-t-d). U.S. Banks dropped 1.6% (down 3.7% y-t-d).

Also reminiscent of January/February, EM selling pressure intensified. The Mexican peso sank 3.8% this week to a record low. It’s easy to blame Trump, but clearly the markets are increasingly concerned with Mexico’s large current account deficit (3% of GDP), economic vulnerability and susceptibility to “hot money” outflows. Mexico – along with indebted energy companies and countries around the world - were not helped by crude’s $2.85 drop to $43.03, a one-month low. Russian stocks dropped 2.3%, with the ruble down 0.7%. No help from geopolitical either. The South Korean won dropped 2.1%, with Korean stocks down 1.9%. Mexico’s stocks lost 1.2%, and Brazil’s Bovespa fell 1.7%.

September 11 – Reuters (Silvio Cascione): “Brazilian prosecutors launched a preliminary investigation into an alleged corruption scheme at the national development bank BNDES, weekly magazine Veja reported… The prosecutors have been gathering documents for at least two months and are in talks with a former BNDES executive about a potential collaboration… BNDES is the largest source of long-term corporate credit in Brazil and is one of the world's largest development banks. The bank ramped up lending under the administrations of the Workers' Party between 2003 and 2015 as part of government efforts to boost economic growth, offering subsidized credit to several of Brazil's largest firms across sectors.”
It was another interesting week in the currencies. The dollar caught a bid, especially versus EM and Europe. And as the marketplace turns its focus back to risk and liquidity, it’s notable that the British pound was hit 2.0% against the dollar this week. The Japanese yen gained 0.4% versus the dollar.

The much anticipated Fed and BOJ meetings are now just days away (Sept. 20/21). Market odds for the FOMC raising rates next week have dropped down to about 10%. Significantly more uncertainty surrounds the Bank of Japan’s meeting.

September 15 – Wall Street Journal (Takashi Nakamichi): “The world’s leading experiment in monetary easing is floundering, and its engineers are divided over how to get it on track. The Bank of Japan has tried radical measures for 3½ years to reflate the country’s sagging economy, resorting this year to negative interest rates. Growth and inflation remain elusive. Now the bank’s board, while still in favor of easing, has some members wanting to revise the methods for doing so—likely sparking uncertainty for economy-watchers and worries for investors. Japan’s financial regulator, big banks, insurers and advisers to Prime Minister Shinzo Abe have all piled into the fray with policy prescriptions, in a ferment that comes less than a week before the BOJ meets to decide its next move. ‘The BOJ’s policy has become a ‘cloudy cocktail’—nontransparent and difficult to understand,’ said Nobuyuki Nakahara, a former BOJ board member who advises Mr. Abe… The suspicion that central-bank firepower is reaching its limits finds support in Japan, where the BOJ has yet to generate steady inflation despite buying nearly $800 billion of bonds annually since late 2014, plus billions of dollars worth of exchange-traded funds.”
One could surmise that there’s been sufficient pre-meetings market volatility to hold hesitant central bankers at bay – in Washington and Tokyo. The now typical modus operandi finds central bankers attempting to muster some courage (“trial balloons” floated along the way) ensuring market conniption fits leading up to policy decision time. Unsettled markets needle dovish central bankers to “beat expectations” – and markets rally. Clockwork.

The problem is that it’s no longer easy for central bankers to placate an increasingly disordered market backdrop. BOJ stimulus was already unprecedented, even before QE was again supersized earlier in the year. Interest rates are already negative. There are heightened fears that negative rates are harming the banks, insurance companies and pension funds, and that the BOJ risks running short of bonds to purchase. As for the FOMC, the markets are already confident the diffident Fed will again stand pat.

All eyes will be fixated on the Bank of Japan. Indication of a loss of nerve would have an immediate impact on global yields and currencies. More likely, policy measures will be convoluted. At this point, efforts to manipulate a steeper yield curve could prove too cute by half. Markets are somewhat indifferent to negative rates, but would look quite unkindly to any uncertainty with respect to future “whatever it will take” QE.

The markets have grown so accustomed to Kuroda’s game of dovish surprises. These days there’s recognition that going on four years of BOJ stimulus have failed to bear fruit – while risk proliferates like weeds (tall with nettles). One more round of mindlessly “beating expectations” could very well propel a reflex rally. It also risks an alarming – policy at the “end of the rope”! - market seizure.

A few months back I wrote that the latest round of central bank reflationary measures would prove unsuccessful. I’m sticking with this view, notwithstanding the strong rallies experienced almost across the board. A policy-induced short squeeze took on a life of its own. Sovereign bonds dislocated spectacularly, unleashing a liquidity outburst. “Money” flooded into EM and anything with a yield. “Melt-up.” “Money” flooded into perceived low-risk equity products. “Money” flooded into the indexes – equities and corporate debt. Within the hedge fund community, “money” flooded into the hot strategies – risk-parity and “managed futures”/CTA. “Money” flooded into instruments profiting from a collapse in market volatility.

Central banks ensured that enormous amounts of “money” simultaneously flowed across various – now highly correlated - asset classes. “Funny” how things work. Just when it was becoming apparent that monetary stimulus was losing its punch, desperate policy measures spurred one final destabilizing “whatever it will take” speculative whirlwind. This has created an extraordinary backdrop of markets set up for disappointment and dislocation.

My view holds that Global Risk Off has likely commenced. It’s reemerging in Europe, in EM, in energy and in global financials. China remains a major unknown. The economy stumbles along on record Credit expansion, Credit that turns more problematic by the month. A mortgage lending Bubble is increasingly dominating Credit growth, creating serious issues for regulators, the financial sector and the overall maladjusted Chinese economy. And Global Risk Off risks triggering another bout of destabilizing outflows and China currency angst, which would be an even bigger problem for the world today than it was at the beginning of the year.

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