Recalling 1994

 
Doug Nolan
 
 
Equities rallied to begin the week. With Syrian missile strikes more limited than feared and no military response from Russia, there was immediate impetus to unwind hedges. That it was option expiration week ensured plenty of firepower. The S&P500 had rallied 2.3% at Wednesday's trading high, before a resumption of selling cut the gain for the week to 0.5%.

WTI crude dropped $1.17 in Monday's trading, though selling was short-lived. Crude gained $1.01 for the week to $68.40, trading to the high since December 2014. WTI is now up a rather inflationary 13% y-t-d. The President's Friday morning tweet - "Looks like OPEC is at it again. With record amounts of Oil all over the place, including the fully loaded ships at sea, Oil prices are artificially Very High! No good and will not be accepted!" - generated media attention but only brief selling pressure. The market seems to think it knows more about crude supply dynamics than the Commander and Chief.

The GSCI Commodities Index rose another 1.2% this week (up 7.1% y-t-d), also to the high since December 2014. It wasn't only energy driving commodity gains. Silver rose 3.0% this week, with Palladium up 4.2%, Aluminum 8.1%, Zinc 3.7%, Nickel 6.4%, Tin 3.2% and Copper 2.8%.

Trade frictions, Middle East instability and general geopolitical uncertainty add up to mounting inflation concerns. The 10-year TIPS breakeven rate (implied inflation rate calculated by subtracting the 10-year TIP yield from the 10-year Treasury yield) rose four bps this week to 2.18%, the high since August 2014. It's worth noting that the breakeven rate bottomed at 1.26% in February 2016. It rallied to 2.07% by early-2017 before settling back to 1.68% near mid-year - and has been on a reasonably steady ascent now for nine months.

Ten-year Treasury yields rose 13 bps this week to 2.96%, surpassing the February 21st level to the high going back to January 2014. If 10-year Treasuries surpass 3.0% next week, it will mark the highest yield since July 2011. Two-year yields jumped nine bps to 2.45%, the high going back to August 2008. Generating surprisingly little attention, Benchmark MBS yields surged 14 bps this week to 3.66% (up 66bps y-t-d!), the high all the way back to September 2013. Expect more discussion about mortgage convexity.

Notably, 10-year Treasury yields rose eight bps during Thursday and Friday trading, despite a 1.4% fall in the S&P500. The safe haven status of Treasuries is anything but iron clad these days. Treasuries did, however, outperform investment-grade corporates. The iShares investment-grade ETF (LQD) fell 1.27% this week - most of the decline coming Wednesday through Friday - to trade below March lows. Sell Treasuries to hedge mortgage and corporate interest-rate risk. Between new issuance and hedging related selling, that's a supply glut that risks a bout of market indigestion.

Yet this week's jump in yields was not isolated to U.S. fixed-income. Key emerging bond markets were under pressure, particularly during Friday's session. Mexico saw its 10-year (dollar) yields jump 17 bps this week to 4.31%. Mexican bond yields are now up 70bps y-t-d and close to breaking out to highs going back to 2011. Brazilian bond (dollar) yields rose seven bps (to 4.99%), Peru's 15 bps, Colombia's nine bps, and Indonesia's 12 bps. Indonesia saw its local currency 10-year yields jump 20 bps to 6.74%, and India's local bond yields surged 21 bps to 7.74%.

Friday EM trading was notable. Currencies came under pressure, as the South African rand dropped 1.15%, the Colombian peso 1.0%, the Turkish lira 0.85%, the Russian ruble 0.8% and the Brazilian real 0.7%. For the week, the Mexican peso dropped 2.6%, the Colombian peso 1.8% and the Indian rupee 1.4%. Combining currency and bond losses, there was some pain this week in key emerging markets. In equities, the Shanghai Composite dropped 1.5% Friday, increasing losses for the week to 2.8% (down 7.1% y-t-d). EM inflows have been unrelenting in the face of a lengthening list of issues. Why do I sense these flows are about to reverse?

April 18 - Financial Times (Peter Wells): "The chances of the Federal Reserve delivering four interest rates in 2018 have ballooned in recent days. There is a 35.3% chance the US central bank will deliver three more rate rises this year, following its 0.25 percentage lift in March…, which is the highest probability in the history of the contract. As such, the chance of the Fed delivering at least three interest rate rises this year is sitting at 82%, also a contract-era high."

It's a far cry from "slamming on the brakes," yet the Fed is finally feeling some heat to get short-term rates up to a more reasonable level. A novel idea was offered by Dallas Federal Reserve Bank President Robert Kaplan: "I don't have a problem with being restrictive." As notably, the doves have really come around. Federal Reserve Bank of Minneapolis President Neel Kashkari: "I think it's likely that the fiscal actions that have been taken are going to on the margin help us achieve our inflation target. I was much more skeptical… It now seems much more likely that we are going to actually achieve our inflation target in the near future…" And from Governor Lael Brainard: "My anticipation is that the outlook is for continued, solid growth. The outlook looks consistent to me for continued gradual increases in the federal funds rate."

Imagining a murkier inflation outlook doesn't come easily. The global boom has decent momentum, although lurking financial fragilities could rather abruptly haunt economic prospects. Tariffs, protectionism and trade wars have the potential for consequential pricing impacts. There is, as well, significant ramifications for the global economy in the event trade disputes really heat up. And let us not forget an extraordinarily uncertain geopolitical backdrop, with myriad potential consequences for inflation and growth. Last but not least, there's the great uncertainty associated with myriad interdependent global Bubbles.

One thing we know with certainty: the world has added tremendous amounts of debt since the last debt crisis. And debt is poised to continue rising rapidly until sober markets impose some discipline on profligate borrowers. This is a momentous festering issue that will come to a head at some point. Ten-years of ultra-loose global finance destroyed discipline - by borrowers and lenders alike. "Deficits don't matter." In the markets, the view holds that central banks won't tolerate a problematic backup in market yields. So, as central bankers gaze submissively from the sidelines, governments just keep issuing debt and markets keep buying it.

April 18 - Bloomberg (Andrew Mayeda): "The world's debt load has ballooned to a record $164 trillion, a trend that could make it harder for countries to respond to the next recession and pay off debts if financing conditions tighten, the International Monetary Fund said. Global public and private debt swelled to 225% of global gross domestic product in 2016, the last year for which the IMF provided figures, the fund said… in its semi-annual Fiscal Monitor report. The previous peak was in 2009, according to the… fund. 'One hundred and sixty-four trillion is a huge number,' Vitor Gaspar, head of the IMF's fiscal affairs department, said… 'When we talk about the risks looming on the horizon, one of the risks has to do with the high level of public and private debt.'"

For posterity, I've pulled a few paragraphs from the IMF's most recent Fiscal Monitor report:

"At $164 trillion-equivalent to 225% of global GDP-global debt continues to hit new record highs almost a decade after the collapse of Lehman Brothers. Compared with the previous peak in 2009, the world is now 12% of GDP deeper in debt, reflecting a pickup in both public and nonfinancial private sector debt after a short hiatus. All income groups have experienced increases in total debt but, by far, emerging market economies are in the lead. Only three countries (China, Japan, United States) account for more than half of global debt -significantly greater than their share of global output...

"A large number of countries currently have a high debt-to-GDP ratio, as suggested by critical thresholds identified in the IMF's debt sustainability analysis. In 2017, more than one-third of advanced economies had debt above 85% of GDP, three times more countries than in 2000. One-fifth of emerging market and middle-income economies had debt above 70% of GDP in 2017, similar to levels in the early 2000s in the aftermath of the Asian financial crisis. One-fifth of low-income developing countries now have debt above 60% of GDP, compared with almost none in 2012."

"From a longer-term perspective, global indebtedness has been driven by private sector debt-which has almost tripled since 1950. For almost six decades, advanced economies spearheaded the global leverage cycle, with the debt of the nonfinancial private sector reaching a peak of 170% of GDP in 2009, with little deleveraging since. Emerging market economies, in contrast, are relative newcomers. Their nonfinancial private debt started to accelerate in 2005, overtaking advanced economies as the main force behind global trends by 2009. Private debt ratios doubled in a decade, reaching 120% of GDP by 2016."

"The ongoing recovery presents a golden opportunity to focus fiscal policy on rebuilding buffers and raising potential growth. Forecasts indicate that economic activity will continue to accelerate, which implies that fiscal stimulus to support demand is no longer a priority in most countries. Governments should avoid the temptation of spending the revenue windfalls during good times. Starting to rebuild buffers now will ensure that policymakers have sufficient fiscal ammunition to respond in case of a downturn and prevent fiscal vulnerabilities themselves from hurting the economy."


Wishful thinking with respect to "a golden opportunity." The global government finance Bubble has been fueled by almost a decade of near zero rates, massive central bank monetization and unprecedented amounts of government borrowing. My view holds that myriad global Bubbles have become only more vulnerable to any meaningful tightening of financial conditions. And there are pressing issues that increasingly put the loose financial landscape in jeopardy.

China has belatedly moved to slow system Credit growth. On the surface, it appears they are having some success. Overall Credit expansion has decelerated, mainly on the back of significant regulator pressures over shadow banking. At the same time, mortgage and household lending has accelerated. One can make a case that the overall ongoing expansion of non-productive Credit growth remains highly problematic. Underlying financial fragility continues to worsen. Along with sinking stock prices, China's interbank lending market this week indicated tightened liquidity conditions. The People's Bank of China announced Tuesday that it would support lending with lower bank reserve requirements.

April 17 - Wall Street Journal (William A. Galston): "I know that worrying about the deficit and debt is hopelessly retro, but please indulge me for a few minutes. Last week the Congressional Budget Office issued its outlook for the next 10 years. The news was not good. Over the next decade, the annual federal deficit averages $1.2 trillion. It rises from 3.5% of gross domestic product in 2017 to 5.1% in 2027. The national debt, which is driven by annual deficits, rises from $15.7 trillion to $28.7 trillion over the same period, and surges from 78.0% to 96.2% as a share of GDP-the highest mark since just after World War II. These projections have worsened significantly since the CBO's report last June, and public-policy decisions are the culprit."

April 18 - Bloomberg (Vincent Del Giudice and Alexandre Tanzi): "Mamma Mia! In five years, the U.S. government is forecast to have a bleaker debt profile than Italy, the perennial poor man of the Group of Seven industrial nations. The U.S. debt-to-GDP ratio is projected widen to 116.9% by 2023 while Italy's is seen narrowing to 116.6%, according to the latest data from the International Monetary Fund. The U.S. will also place ahead of both Mozambique and Burundi in terms of the weight of its fiscal burden."

If China's Bubble doesn't pose enough risk for global finance, there's the unfolding fiscal fiasco in Washington. Put on so much debt and you sacrifice flexibility - that's the case for the U.S., China and globally. Especially for the behemoth importer U.S. economy, tariffs and trade wars risk stronger inflation. There is as well the risk that our foreign creditors might find less appetite for additional bonds and other U.S. financial assets. Then there's the pressure such egregious late-cycle fiscal stimulus places on the Federal Reserve. For a Fed that is already far behind the curve, the prospect of stimulus-induced economic expansion with heightened inflationary pressures must be unsettling. Long convinced that inflation was dead and buried, doubt is now making some headway.

It's hard for me to believe there's not massive leverage throughout U.S. and global fixed-income markets. This historic speculative Bubble was at risk of being pierced back in late-2016. 2017, however, proved to be a year with still enormous ongoing global QE (chiefly BOJ and ECB), rampant Chinese Credit expansion and global inflation dynamics that just didn't quite attain momentum. Along the way, financial conditions remained extraordinarily loose and markets ever more complacent.

With the bond vigilantes long extinct, an overindulgent Washington embarked on massive tax cut fiscal stimulus. Mission Accomplished. Next on the agenda, trade and China. This week saw 10-year Treasury yields a mere four bps away from the 3.00% bogey. U.S. and emerging bond markets would appear unusually poised for a negative surprise. Things get interesting if the Fed ever ponders whether monetary tightening might be necessary to calm a frazzled bond market. Thinking back, I've always been intrigued by how the bond (and derivatives!) market was so caught by surprise in 1994. IO's and PO's and such and, of course, ghastly amount of speculative leverage.

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