"Whatever They Want" Coming Home to Roost

Doug Nolan

Let's begin with global. China's yuan (CNY) traded to 6.9644 to the dollar in early-Friday trading, almost matching the low (vs. dollar) from December 2016 (6.9649). CNY is basically trading at lows going back to 2008 - and has neared the key psychological 7.0 level. CNY rallied late in Friday trading to close the week at 6.9435. From Bloomberg (Tian Chen): "Three traders said at least one big Chinese bank sold the dollar, triggering stop-losses." Earlier, a PBOC governor "told a briefing that the central bank would continue taking measures to stabilize sentiment. We have dealt with short-sellers of the yuan a few years ago, and we are very familiar with each other. I think we both have vivid memories of the past."

The PBOC eventually won that 2016 skirmish with the CNY "shorts". In general, however, you don't want your central bank feeling compelled to do battle against the markets. It's no sign of strength. For "developing" central banks, in particular, it has too often in the past proved a perilous proposition. Threats and actions are taken, and a lot can ride on the market's response. In a brewing confrontation, the market will test the central bank. If the central bank's response appears ineffective, markets will instinctively pounce.

Often unobtrusively, the stakes can grow incredibly large. There's a dynamic that has been replayed in the past throughout the emerging markets. Bubbles are pierced and "hot money" heads for the exits. Central banks and government officials then work aggressively to bolster their faltering currencies. These efforts appear to stabilize the situation for a period of time, although the relative calm masks assertive market efforts to hedge against future currency devaluation in the derivatives markets.

If policymakers then lose control - market pressures prevail - those on the wrong side of (now outsized) derivative hedges are forced to aggressively sell/short the underlying currency. This type of self-reinforcing selling can too easily foment illiquidity, dislocation and currency collapse. As I highlighted last week, for a list of reasons such a scenario would have devastating consequences for China - and the world.

As I've noted in previous CBBs, the current global environment has some critical differences compared to China's last currency instability episode in early-2016. Global QE was ramped up to about a $2.0 TN annual pace back then, versus today's QE that will soon be only marginally positive. Buoyed by zero rates, sinking bond yields and rising equities prices, global speculative leverage was expanding - versus today's problematic contraction. China's Credit system and economy were significantly more robust in 2016. EM, in general, was still enveloped in powerful financial and economic expansion dynamics. Moreover, the global trade and geopolitical backdrops have deteriorated dramatically since 2016.

October 26 - Bloomberg: "Investors are turning up the temperature on Chinese policy makers, who were already feeling the heat. That may cause the government to resort to even tighter controls on money flowing in and out of the country, according to Citi economists. Net foreign exchange settlement by banks in China on behalf of their clients -- a proxy for capital flows -- was negative in September for a third straight month, according to… the State Administration of Foreign Exchange. At -110.3 billion yuan, purchase of foreign currencies was the most since December 2016. An escalating trade war with the U.S. has contributed to souring investor sentiment and put downward pressure on China's currency, which Friday came within striking distance of a 10-year low against the dollar. It's fallen 9% over the last six months. Measures taken by the People's Bank of China this month to support the economy as the outlook has darkened… haven't helped the exchange rate."

October 26 - Bloomberg (Alfred Liu and Benjamin Robertson): "China's finance ministry has warned the country's state-owned financial assets need further protection from mismanagement, following the release of new data on the size of their balance sheets. Total assets of state-owned financial enterprises amounted to 241 trillion yuan ($34.6 trillion) in 2017, according to a report published by China's Ministry of Finance… Their liabilities were 217.3 trillion yuan last year… 'While we are gradually upgrading the management of state financial assets, we have to be aware that there are still institutional and structural contradictions and problems,' said Liu Kun, China's finance minister… 'The mission of preventing massive risks remains tough.'"

A disorderly breakdown of the Chinese currency has the potential to be one of the most destabilizing developments for global finance and the world economy in decades. I am not confident that Chinese officials have the situation under control. At the same time, there is no doubt that Chinese finance and financial institutions have inflated to previously unimaginable dimensions. And it appears Beijing is increasingly cognizant of unfolding risks. This likely explains why officials appear less inclined than in the past to push through aggressive fiscal and monetary stimulus. A key aspect of the bullish global thesis (Chinese stimulus on demand) is due for reassessment.

The Shanghai Composite rallied 1.9% this week. It was difficult for global markets to sense anything more than fleeting relief, suspecting the "national team" was hard at work. Markets throughout Asia were under pressure. Hong Kong's Hang Seng index fell 3.3%. Major indices were down 6.0% in South Korea, 6.0% in Vietnam, 4.3% in Taiwan, 3.2% in Thailand, 2.8% in Malaysia, 2.8% in India and 1.2% in Philippines. Japan's Nikkei 225 index sank 6.0%, with the TOPIX Bank Index's 4.7% drop boosting y-t-d declines to 17.1%.

Asian bank weakness is a primary Systemic Contagion Link globally. Europe's STOXX 600 bank index fell 3.5% this week, increasing 2018 losses to 24.0%. Italian banks were down another 3.9% this week (down 28.2% y-t-d). Deutsche Bank dropped 11.4% this week (to an all-time low). Deutsche Bank (senior) credit-default swap (CDS) prices rose 11 bps this week to 156 bps, the high since early July. Many of the big global banks saw CDS prices rise this week to near one-year highs. Curiously, Goldman Sachs CDS rose seven this week to 79 bps, an almost 19-month high. The U.S. bank equities index (BKX) sank 5.0% this week, and the Broker/Dealers dropped 4.8%.

In a further indication of heightened global systemic risk, German bund yields sank 11 bps this week to 0.35%, the low since September 4th. With Italian yields declining only four bps (to 3.45%), the spread to bunds widened seven bps to 310 bps. Portuguese yields dropped 11 bps to 1.96%, and Spanish yields fell 17 bps to 1.57%. UK 10-year yields sank 19 bps to 1.38%, the low since August.

It certainly has all the appearance of bond markets beginning to discount ramification of the bursting of the global Bubble. WTI crude declined another $1.52 to $67.62, a two-month low.

The dollar index increased 0.7% to 96.412, near a 16-month high. The British pound declined 1.9%, the Norwegian krone 1.6%, the Swedish krona 1.6%, the New Zealand dollar 1.4%, the South African ran 1.3% and the euro 1.0%.

October 26 - Bloomberg (Jacob Bourne): "Inflation expectations are tumbling in the U.S. bond market, suggesting traders are worried that the Federal Reserve's monetary policy is becoming too tight -- potentially by a quarter-point -- amid the slide in equities. The five-year breakeven rate, which represents bond investors' view on the annual inflation rate through 2023, dropped Friday to 1.88%, the lowest since January."

The headline for the above article was "Inflation Bets Are Tanking, Showing Bond Traders See a Tight Fed." Ten-year Treasury yields did drop 12 bps this week to 3.08%. But the overarching issue is escalating systemic risk associated with a faltering global Bubble - and not a "tight Fed." The Fed would prefer to remain "data dependent." The early read on Q3 GDP came in at 3.5%, with Personal Consumption growing at a 4.0% rate (strongest since Q4 '14). A number of Fed officials this week downplayed U.S. stock market weakness.

I'm not at all sure Fed officials appreciate their predicament. The global Bubble is bursting, yet the U.S. economy at this point maintains a decent head of steam. Bond markets are quickly adjusting to the changing global backdrop. Treasuries have had more of a domestic focus but that has begun to shift. And having shown resilience until recently, junk bonds (HYG) have now declined 1.1% over the past two weeks. With yields jumping this week to a two-year high, junk bond funds suffered net outflows of $2.364 billion.

October 26 - Bloomberg (Adam Tempkin): "One of Wall Street's go-to shelters in times of trouble is showing cracks as broad concerns pile up. Bouts of selling have hit bonds backed by mortgages, auto loans and credit card payments -- typically havens during periods of stress -- amid the carnage in financial markets this month. Certain sectors of so-called securitized loans are 'experiencing some headwinds,' said Neil Aggarwal, senior portfolio manager and head of trading at Semper Capital. 'A combination of rates, earnings, and global concerns are having an ongoing impact.' The debt class usually does better than corporate bonds during market turmoil because the securities are linked to consumer payments, rather than company performance, and typically have cash cushions to absorb initial losses. But recent weakness highlights how the sector may be unable to shrug off the chaos enveloping other assets."

Financial conditions have now begun to meaningfully tighten at the "Core." I suspect de-risking/de-leveraging dynamics have begun to unfold throughout U.S. corporate Credit. There are also indications of tightening liquidity conditions in securitized Credit. These are important developments.

October 26 - Bloomberg (Suzy Waite and Nishant Kumar): "Hedge funds using computer-driven models to follow big market trends have been whiplashed as volatility has spiked, among the biggest casualties of a stock rout that has accelerated worldwide. Funds known as commodity trading advisers, or CTAs, have traditionally shielded investors during market selloffs such as the global financial crisis, especially when mathematical models show a clear or pronounced trend. But this time, they've been unable to navigate sharp reversals in asset prices… 'It's a bloodbath out there across almost every strategy with very few exceptions,' said Vaqar Zuberi, head of hedge funds at Mirabaud Asset Management… 'CTAs have been caught by a double-whammy with rising rates and equities plummeting,' said Zuberi. 'There's only one exit and everyone is trying to exit now because the models are telling them to do so.' Computer-driven hedge funds were already headed for their worst year ever before this month's volatility…"

As an industry, hedge funds were already struggling for performance prior to the recent bout of "Risk Off." Many funds have seen 2018 gains quickly morph into losses. There is now the distinct risk of escalating losses into year-end spurring significant industry outflows. This dynamic elevates the odds of a destabilizing de-risking/deleveraging dynamic.

Treasuries provided somewhat of a hedge against equities losses this week. Yet, overall, markets have been particularly uncooperative to popular "risk parity" hedge fund strategies. Leveraged portfolios of stocks, government securities and fixed-income are not experiencing the diversification benefits they've enjoyed for most of the past decade (or two). Losses and general performance volatility will force these strategies to deleverage, with negative consequences for liquidity across various markets.

With de-risking/deleveraging gaining momentum globally - and some of the big global "banks" under pressure - it's reasonable to begin contemplating counter-party risk. And anytime markets start indicating waning liquidity and dislocation risk, my fears return to the derivatives markets. How much market "risk insurance" has been sold by strategies that plan on hedging this risk by selling into declining markets? Stated differently, what is the risk that derivatives "insurance" "dynamically (delta) hedged" by quant models could erupt into self-reinforcing sell programs, illiquidity and market dislocation?

October 26 - Financial Times (Alfred Liu and Benjamin Robertson): "Mario Draghi has pushed back against the wave of political attacks on the world's central banks, warning that the rising pressure could lead to lower growth and undermine a vital line of defence against future financial crises. Speaking just hours after he was criticised by Italy's deputy prime minister as 'poisoning the climate' against Rome, the European Central Bank president called on legislators around the world to instead 'protect the independence' of rate-setters. 'The central bank should not be subject to . . . political dominance and should be free to choose the instruments that are most appropriate to deliver its mandate,' Mr Draghi said in a thinly-veiled rebuke to his native country."

I see things similarly as the great statesman, the ailing Paul Volcker: "A hell of a mess in every direction." The stock market is only a few weeks past all-time highs, yet the finger-pointing has already begun in earnest. The Powell Fed cautiously raising rates just past 2.0% is certainly not responsible for the world's problems. A decade of central bank-induced monetary inflation, well that's a different story. More than a couple decades of central bank experimentation and inflationism, now you're on to something. It was always going to Come Home to Roost. That's the harsh reality that no one was willing to contemplate.

Draghi: "The central bank should not be subject to… political dominance and should be free to choose the instruments that are most appropriate to deliver its mandate."

It's ridiculous to bestow a small group of global central bankers the power to do Whatever They Want in the name of delivering on some arbitrary index level of consumer price inflation. To create $14 TN of "money" and unleash it upon global securities markets is undoubtedly history's most reckless monetary mismanagement.

Inevitable Blowback has commenced. "The dog ate my homework." "The inflation mandate made us do it." With a full year remaining in his term, Draghi won't be sharing Bernanke's good fortune. This whole historic monetary experiment will be unraveling while he's still on watch. But, then again, the Trump administration already has its scapegoat. Perhaps the whole world will blame Chairman Powell - or the man that appointed him.

Following a terrifying trajectory, things somehow turn more disturbing by the week. Political travesty has degenerated into a surreal quagmire. And to see this degree of division and hostility at this cycle's boom phase should have us all thinking carefully about what the future holds. As a nation, we are alarmingly unprepared. And it's back to this same issue that's troubled me for a number of years now.

Bubbles are always mechanisms of wealth redistribution and destruction. Akin to central banking, they can inflict immeasurable harm and somehow deflect culpability. As we've already witnessed as a society, they wreak subtle - and, later, more overt - havoc. And the current astounding Bubble has been on such an unprecedented global scale. Harsh geopolitical fallout is unavoidable. For me, it's been scary for a while. It's just more palpable now. We'll see if the midterms can provide an impetus for a market rally. If not, this has all the appearances of something that could turn sour quickly.

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