SUMMER 2020 / CREDIT BUBBLE BULLETIN

Summer of 2020

Doug Nolan


QE fundamentally changed finance.

What commenced at the Federal Reserve with a post-mortgage finance Bubble, $1 TN Treasury buying operation morphed into open-ended purchases of Treasuries, MBS, corporate bonds and even corporate ETFs holding high-yield “junk” bonds.

Markets assume it’s only a matter of time before the Federal Reserve adds equities to its buy list.

For years now, Treasury bonds (and agency securities) have traded at elevated prices – low yields – in anticipation of an inevitable resumption of QE operations/Treasury purchases.

Conventional analysis has focused on persistent disinflationary pressures as the primary explanation for historically depressed bond yields. While not unreasonable, such analysis downplays the prevailing role played by exceptionally low Federal Reserve interest-rates coupled with latent (and escalating) financial fragility.

Meanwhile, near zero short-term rates and historically low Treasury and agency securities yields have spurred a desperate search for yields, significantly inflating the demand and pricing for corporate Credit.

The Fed’s COVID crisis leap into corporate debt has wielded further profound impacts on corporate Credit – yields, prices and issuance.

September 2 – Financial Times (Joe Rennison): “Companies have raised more debt in the US bond market this year than ever before… A $2bn bond from Japanese bank Mizuho and a $2.5bn deal from junk-rated hospital operator Tenet Healthcare helped nudge overall US corporate bond issuance to $1.919tn so far this year, surpassing the previous annual record of $1.916tn set in 2017, according to… Refinitiv. The surge marks a dramatic revival for the market since the coronavirus-induced rout in March, when prices slumped and yields soared… ‘There has been a phenomenal amount of issuance,’ said Peter Tchir, chief macro strategist at Academy Securities… ‘It’s been the busiest summer I have ever seen. It’s felt like we have been setting issuance records month after month.’”

Future historians will view The Summer of 2020 as a Critical Juncture for the financial markets, with parallels to the Q1 2000 “blow off” top in Nasdaq (highs not exceeded for 16 years).

From March 23rd trading lows to Wednesday’s highs, the NDX rallied an incredible 84%.

At the close of Wednesday trading, the Nasdaq100 (NDX) enjoyed a year-to-date gain of 42.2%.

But an abrupt reversal saw the NDX sink 5.2% on Thursday and another 5% at Friday’s trading lows (before ending the session down 1.3%).

The Fed’s crisis operations unleashed a historic speculative Bubble, most conspicuously with the big technology stocks. FOMO (fear of missing out) forced professional asset managers into rapidly inflating tech stocks and tech-heavy indices – with nothing more than lip service paid to fundamentals and valuation.

Meanwhile, the online trading community (further energized by government stimulus payments) went into speculative overdrive. The Robinhood, E-trade, Schwab and Fidelity platforms posted unprecedented surges in trading volumes as retail “investors” fully embraced technology stocks, the mantra stocks always go up, and the unfailing Fed “put.”

Less obvious - but likely at least as consequential in fueling the destabilizing speculative melt-up – has been the system-wide proliferation of derivatives trading.

From the Wall Street Journal: “Data by the Cboe Options Exchange show that U.S. equity call-options volume has risen 68% this year. That compares with 32% for put options…”

Purchasing call options has been a highly lucrative endeavor over recent months. Owning call options on some of the big tech stocks has been nothing short of a once-in-a-lifetime bonanza.

The retail trading community has adopted options trading like never before. And I can only assume institutional derivatives trading (listed and over-the-counter) has exploded.

In a speculative market melt-up backdrop in the face of readily apparent downside risk, playing the wild market upside with call options (or comparable derivatives) has been a reasonable institutional strategy. Selling call options also seemed to have made sense, both to boost returns and as a mechanism to offset the cost of purchasing put option downside protection.

I’ll assume an unprecedented quantity of upside “call” options (trading on the exchanges or “OTC” derivatives purchased from brokerages) are currently outstanding. And when the market rally gained momentum, the writers/sellers of these derivatives were forced to buy the underlying stocks (or ETF shares, futures contracts) to hedge their rapidly increasing exposures to a rising market environment. A confluence of FOMO, manic retail speculation, and derivatives-related hedging fueled a historic speculative melt-up.

The equities market blow-off has been a key Monetary Disorder manifestation. To this point celebrated as one of the great bull market advances, surging prices are nonetheless indicative of acute market instability. Was this week’s dramatic technology stock reversal a signal of a change in trend – a historic market top with euphoria succumbing to a much less appealing reality?

Thursday trading saw the VIX (equities volatility) index jump 10 to 36, only to then trade at a 10-week high 38 during Friday’s session (before ending the week at 30.75). The Treasury market was similarly instructive. Ten-year Treasury yields traded to 0.78% last Friday – and were as high as 0.73% in late-Wednesday trading (with equities at record highs). Yields then sank as low as 0.60% as technology stocks reversed sharply lower.

Why might Treasury bonds respond so keenly to an overdue pull back in the big technology stocks? I view this dynamic as confirmation of the pivotal role the tech stock speculative melt-up has been playing in the market Bubble. If as much leverage has accumulated in technology stocks (derivatives, in particular) as I suspect, then a reversal in Nasdaq holds the clear potential to spark an unwind of derivatives-related leverage.

Those that have written/sold call options - previously aggressive buyers to hedge exposures – would reverse course to become forceful sellers into a declining market. Moreover, deleveraging in derivatives markets might then provide a catalyst for a more systemic de-risking/deleveraging dynamic.

Treasuries (and the VIX) are these days fixated on the big tech stocks because they are the marginal source of speculative leverage and, as such, marketplace liquidity.

Curiously, this week's equities market drama had little impact on corporate Credit.

Investment-grade CDS prices ended the week little changed, with high-yield CDS prices actually declining slightly. Both ended the week at or near March lows. The iShares Investment-Grade Corporate Bond ETF (LQD) was little changed in price, with the iShares High-Yield ETF (HYG) declining only about 0.5%.

And why would corporate Credit fret a Nasdaq reversal?

A faltering stock market Bubble, after all, will ensure more aggressive Fed balance sheet expansion, certainly including corporate bonds and ETF shares. Besides, sinking Treasury yields only adds to the appeal of relatively higher-yielding corporate Credit.

And while a faltering stock market Bubble will have major negative ramifications for corporate Credit quality, corporate bonds are priced these days relative to Treasuries with little regard for default risk. Both investment-grade and high-yield CDS prices trade below average prices over the past decade, despite today’s highly elevated risk of widespread defaults.

Let's return to that $1.9 TN of y-t-d corporate debt issuance (already a new annual record), Credit perceived to be underpinned by extraordinary Federal Reserve liquidity, market and economic support. I would argue this gross mispricing of Credit risk is a major Monetary Disorder manifestation with momentous ramifications.

I don’t buy into the notion that central bankers have everything under control – or that aggressive Federal Reserve stimulus measures will support financial markets indefinitely.

I see instead aggressive stimulus having been administered to a system already suffering from years of powerful Bubble Dynamics. And I’ve pointed to two key Monetary Disorder ramifications – egregious equities market Bubble speculative excess (with tech stock derivatives at its epicenter) and massive issuance of mispriced corporate Credit.

In both cases, I believe strongly that aggressive Fed stimulus exacerbates dangerous financial excess and economic maladjustment – fomenting precarious “Terminal Phase” Bubble excess.

Fueling a spectacular equities speculative melt-up comes with great risk. Spurring the issuance of Trillions of mispriced corporate Credit will haunt the system for years to come.

In particular, the notion of “insurance” monetary stimulus is dangerously ill-conceived. It has resulted in the Fed aggressively employing stimulus upon a system already under the command of powerful Bubble Dynamics. In the case of equities, it rather quickly fueled a destabilizing historic speculative melt-up – the type that traditionally ends with dislocations and crashes. For corporate Credit, it almost immediately spurred massive bond fund inflows and record debt issuance.

Both Bubble Dynamics are self-defeating.

Markets have become well-conditioned to assume aggressive monetary stimulus will launch a new speculative cycle. That unprecedented stimulus measures were employed only days after record stock prices made this cycle unique. Stimulus hit a system already overcome by speculative impulses, helping explain both how Bubble excess could so quickly attain powerful momentum along with why markets so easily detached from troubling economic fundamentals.

Especially over recent weeks, the view that the global Bubble has been pierced hasn’t seemed credible. Yet I do see support for the analysis that we’re witnessing the degree of excess and speculative blow-offs consistent with a major top. I wouldn’t be surprised if the Nasdaq top is in.

It wouldn’t be surprising to see equities unravel from here. But the risk of a serious de-risking/deleveraging episode rises significantly when we begin to see risk aversion return to the corporate Credit market.

QE may have changed finance, but it didn’t abolish market or business cycles. It made them more perilous.

Mainly, we’re seeing latent risks now beginning to surface. After this week, it’s more easily discerned why Treasury yields have remained so low - and the VIX elevated - in the face of record stock prices. As an analyst of Bubbles, I see compelling support for the Bubble thesis.

I see fragility. And we’re now less than two months from the most pivotal of elections.

Can financial markets remain attractive as politics turns ugly, repulsive and problematic?