More W than V

Doug Nolan


The much vaunted “V” recovery is improbable. To simplify, a somewhat “w”-looking scenario is a higher probability. After such an abrupt and extraordinary collapse in economic activity, a decent bounce was virtually assured.

Millions would be returning to work after temporary shutdowns to a substantial chunk of the U.S. services economy. There would be pent-up demand, especially for big ticket home and automobile purchases. A massive effort to develop vaccines would ensure promising headlines.

With incredible amounts of liquidity sloshing around, constructive data supporting the “V” premise was all the markets needed. The enormous scope of hedging and shorting activities back in the March and April timeframe ensured the availability of more than ample firepower to fuel a rally. An equities revival would then spur a general restoration of confidence and spending – in a self-reinforcing “V” dynamic.

Inevitably, highly speculative Bubble Markets inflated way beyond anything even remotely justified by the fundamental backdrop – actually coming to believe the “V” hype. The rapid recovery phase, however, will prove dreadfully short-lived. Scores of companies won’t survive, and millions of job losses will prove permanent.

Fearful consumers have made lasting changes in spending patterns, with many retrenching.

Tons of fiscal stimulus will be burned through with astonishing rapidity. And a raving Credit market luxuriating in Fed monetary inflation will confront Credit losses at a breadth and scale much beyond the last crisis.

My concern has been the COVID dislocation would be with us for a while. It’s surprising we haven’t seen at least some relief as summer unfolds. I was not expecting major outbreaks in Arizona, Florida, Texas and Southern California this time of year.

At this point, it’s clear that as a nation we haven’t approached pandemic risks with sufficient urgency and resolve. We all watched the crisis play out in New York and the northeast. We witnessed their “curves” brought down dramatically.

We convinced ourselves it was more of a major city issue. We watched the European “curves” drop precipitously as well. We extrapolated to the entire U.S. Human nature took over. Too many of us became impatient and dismissive.

Total U.S. new COVID infections surpassed 44,000 Friday – handily smashing Thursday’s record. From CNN: “So far, 32 states are reporting an increase in new coronavirus cases this week as compared to the prior week. Eleven of them report a 50% increase or greater.

They include Montana, Idaho, Vermont, Nevada, Arizona, Texas, Florida, Georgia, Michigan, Missouri and Mississippi” and “at least nine other states have announced they are not moving ahead to the next phase of reopening.”

According to the Washington Post, six states set record new cases Friday, with 12 posting highs for seven-day average new infections. A record 8,942 new cases were reported in Florida, 62% ahead of Wednesday’s previous daily record and a 170% rise from last Friday. Average cases are up 526% since Memorial Day (from Washington Post). The rate of new positive tests surged to an alarming 13.1%. Florida banned the sale of alcohol at bars.

Texas reported 18,000 new COVID cases in three days, with a record 6,584 suffered on Wednesday. Texas paused reopening on Thursday, and then closed bars and limited restaurant capacity to 50% on Friday. Texas’s positive test rate jumped to a worrying 11%.

Seeing a record 879 cases in one day and fearing an overwhelmed hospital system, Houston declared its highest level one emergency. Houston Mayor Sylvester Turner: “The community’s infection rate is three times higher today than it was three months ago.” There are increasing calls for a return to a statewide lockdown.

California reported 5,812 new cases Friday, with total infections surpassing 200,000. The state’s positive rate has increased to 5.3%. California governor Gavin Newsom warned his government was prepared to reinstate a state-wide lockdown. He called for counties with rising infections to consider adjusting reopening plans. San Francisco Friday delayed the next phase of reopening.

New daily records were set Friday as well in Arizona (3,428), Tennessee (1,410), Arkansas (669), Georgia (1,900), and Utah (676). The New York Times quoted Ohio Governor Mike DeWine: “This is a very dangerous time. I think what is happening in Texas and Florida and several other states should be a warning to everyone. We have to be very careful.”

June 26 – CNBC: “A JPMorgan study found that increased restaurant spending in a state predicted a rise in new infections there three weeks later. Analyst Jesse Edgerton analyzed data from 30 million Chase credit and debit card holders and from Johns Hopkins University’s case tracker. He said in-person restaurant spending was ‘particularly predictive.’”

M2 money supply surged an unprecedented $2.821 TN over the past 16 weeks - to $18.329 TN. For perspective, M2 expanded on average $641 billion annually over the past decade. For the entire decade of the nineties, M2 gained $1.484 TN. Over the past 16 weeks, Federal Reserve Assets jumped $2.841 TN. During this crisis period, M2 and Fed Assets inflated notably similar amounts.

Between September 3rd and December 10th, 2008, Federal Reserve Assets jumped $1.344 TN (to $2.25 TN). Over this period, M2 money supply expanded $466 billion to $8.217 TN – gaining about a third of the growth in Fed Assets. Moreover, Institutional Money Fund Assets (not included in M2) rose $200 billion during Q4 2008’s QE adoption – versus about a $1.0 TN surge over the past few months.

There are various factors that might explain why M2 growth (along with Institutional Money Fund assets) corresponded much more closely to the Fed’s balance sheet recently, in contrast to the 2008 crisis period. Unparalleled fiscal spending has surely played a major role in expanding bank deposits. It’s not as apparent how Washington spending has impacted Institutional Money Funds.

Analysis points to crucial differences between QE1 and the latest evolution of Fed QE operations. For starters, it was over a year between the 2007 subprime blowup and the Fed resorting to a $1.0 TN experiment QE. Stocks and corporate Credit had been correcting - speculative impulses and Bubble Dynamics had been deflating - for months prior to QE1. The maladjusted U.S. Bubble economy had already commenced restructuring.

This cycle’s dynamics are in stark contrast. The crisis – and Fed response – hit with stocks and corporate Credit just days beyond record highs. Rates were almost immediately slashed to zero - and Fed Credit was expanded almost $2.5 TN in a couple months. Speculative dynamics were quickly reenergized - speculators were further emboldened. Dysfunctional Market Structures – including the massive ETF and derivatives complexes – were reinforced.

Importantly, QE1 in 2008 worked to accommodate speculative de-leveraging. In short, holdings were shifted from various levered players (i.e. hedge funds, Lehman, Wall Street firms, banks, insurance cos., etc.) onto the Fed’s balance sheet. The Fed’s balance sheet was used to ease the deflation of a market Bubble.

There was an enormous increase in Fed Credit that offset the contraction of securities Credit used in leveraged speculation (as levered positions were unwound). As such, Fed “money printing” was not significantly boosting general liquidity in the securities markets or real economy.

This cycle has experienced profoundly different dynamics. For one, it is important to appreciate that the Fed’s recent QE program actually commenced back in September. Late-cycle “repo” market instability – an indication of problematic excess in leveraged speculation – provoked so-called “insurance” monetary inflation from the Fed. This only exacerbated speculative excess – leverage and manic trading activity – in stocks and corporate Credit, in particular.

Markets were demonstrating acute speculative excess when Wuhan went into lockdown. As the global pandemic was unleashed, U.S. stock and corporate Credit traded to all-time highs on February 19th. Crisis unfolded quickly. Marketplace illiquidity and then the Fed’s rapid adoption of massive QE ensured only modest speculative deleveraging. Instead, Trillions of QE incited a massive short squeeze, unwind of bearish hedges and a manic period of speculative excess – all in the face of an unfolding global pandemic. Incredible.

The “V” was more crazy market rationalization and speculation than reality. And with COVID cases again rising rapidly, the harsh reality of a prolonged period of economic depression is coming into clearer view. And again I’m focused on the risk of a bursting speculative Bubble – a Bubble that appears even more dangerous today than in February.

I ponder ramifications for the Fed’s latest $3 TN of QE. Rather than accommodating de-risking/deleveraging it inflated bank and money fund deposits. It exacerbated Bubbles in equities and corporate Credit. It spurred a rally that basically invalidated market hedges. It wreaked bloody havoc for all types of strategies. And as economic prospects continue to deflate, the divergence to inflated securities prices becomes only more perilous.

As we’ve witnessed, these Trillions of Fed “money” sure can get the speculative juices flowing. I’m just not so sure this “money” will support the markets during the next serious bout of de-risking/deleveraging.

The way I see it, the Fed has significantly boosted the odds of a replay of serious market illiquidity and dislocation. It’s worth noting a record $1.1 TN increase in M2 over the preceding 12 months didn’t stop markets from collapsing into illiquidity in March. Did it contribute?

Global markets remain haunted by the specter of an unwind of unprecedented speculative leverage. When markets break to the downside, there is clear potential for another episode of derivative-related selling to panic buyers.

There will be an additional bout of aggressive hedging and shorting. And Market Structure will ensure an avalanche of selling that will again completely overwhelm marketplace liquidity. And all the “money” on the sidelines will be content to remain sidelined.

A serious bout of de-risking/deleveraging will require another few Trillions of Fed liquidity support. And it’s not obvious to me which would be the more destabilizing Fed response: The Federal Reserve precipitously “printing” Trillions more “money” to pacify the markets - or their reticence to engage in another historic round of monetary inflation only months from their previous historic engagement.

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