Heels Dislodged
Doug Nolan
It was a fascinating set up.
A pivotal FOMC meeting two days ahead of quarterly “quadruple witch” expiration of options and other derivatives.
Option expiration-related volatility used to be largely confined to the equities market.
But with ETFs taking the financial speculation world – certainly including the derivatives universe – by storm, volatility around option expirations now reverberates across markets – equities as well as Treasuries, fixed-income, commodities, currencies and EM.
Moreover, there were only a couple weeks until quarter-end for a Q2 that had been nicely rewarding for various reflation trades, including commodities and cyclical stocks (i.e. materials, industrials, precious metals).
Toss into the mix that there had been a bout of risk hedging in May, followed by an unwind of hedges and the reemergence of short squeeze dynamics.
There were scores of stocks and instruments up on air, vulnerable to sharp reversals.
And if there wasn’t enough market unease after the Fed’s somewhat surprising meeting outcome, St. Louis Fed president Bullard had to rattle the cages Friday morning with hawkish commentary.
Let’s take a glance at the equities market week, then circle back to the Fed.
The week offered hints of how swiftly bull market returns can go up in flames.
The Banks came into the week with a y-t-d return of 33.5%.
This week’s 7.8% drop abruptly slashed y-t-d returns by about a third to 23.1%.
Broker/Dealer 2021 returns dropped from 26.5% to 21.2% in five sessions.
The Midcap Index saw its y-t-d return drop from 19.9% to 13.9%, and small cap Russell 2000 returns fell from 18.7% to 13.8%.
By S&P sector, the Materials Index sank 6.3% this week, Energy 5.2% and the Industrials 3.8%.
The NYSE Arca Gold BUGS Index sank 11.8%.
The Philadelphia Oil Services Index fell 6.3%.
Those betting on a steeper yield curve – a seemingly attractive bet in the current backdrop of mounting inflationary pressures and a Fed “behind the curve” - took one on the chin.
The spread between two and 30-year Treasury yields closed (pre-meeting) Tuesday’s session at 202 bps.
In a mad scramble to unwind “curve steepeners,” this spread had contracted 26 bps to 176 bps by Friday’s close.
The five to 30-year spread sank from 140 to 113 bps.
The dollar shorts were also left bloodied.
The Dollar Index jumped 1.8% to a two-month high, with technical analysts shouting, “double bottom!”
Most hot EM currencies reversed sharply lower, with surging EM bond yields inflicting some “carry trade” pain.
The high-flying commodities market was pummeled.
Lumber collapsed 15.2% - and is now down almost 50% from May 10th highs (up only 3% y-t-d).
Dr. Copper was slammed 8.2%, with Zinc down 7.3%, Nickel 5.9% and Tin 5.4%.
Silver was wacked 7.6%, with Platinum down 9.3%, Palladium 10.9%, and Gold 6.0%.
The soft commodities were not spared.
Soybeans were down 7.5%, Sugar 6.3%, Corn 7.1%, and Wheat 2.9%.
It’s being called a “hawkish tilt.”
In the post-meeting policy statement, the most significant change was replacing “running” with “having run” in describing inflation persistently below target.
Markets, though, had their attention elsewhere: the shifting FOMC “dot plot”.
As a group, individual forecasts on average now signal an expectation to raise rates twice by the end of 2023, versus previous forecasts for increases likely not to commence until 2024.
This shift caught most analysts by surprise.
Expectations had been that members would continue to low-ball their rate forecasts, at least until the FOMC had communicated tapering plans.
Powell suggested taking the dot plot “with a grain of salt.”
Salty markets weren’t buying it.
Expectations are now for a taper announcement in September, with the first installment of reduced asset purchases commencing late this year.
The Fed’s median GDP forecast rose to 7% for the year.
The Unemployment Rate is expected to fall to 3.8%. Core CPI will temporarily rise to 3.0% this year, before (conveniently) returning to just above its 2.0% target level for the next two years.
In a rather dramatic pivot, the Fed now sees a hot economy.
The Fed “blinked,” suggested Cornerstone Macro’s Roberto Perli.
I also concur with another analyst’s comment, “The Fed took a step in the direction of reality.”
In a sign of just how low the bar has dropped, the headline from the Financial Times editorial board’s praise piece read, “The Federal Reserve Deftly Changes Tack.”
The U.S. economy is booming, inflationary pressures are mounting, and labor markets are rapidly tightening.
It was past time for our central bank to blink.
It was certainly a rather pronounced change in tone from Powell:
“If you look at the labor market and you look at the demand for workers and the level of job creation and think ahead, I think it’s clear, and I am confident, that we are on a path to a very strong labor market, a labor market that shows low unemployment, high participation, rising wages for people across the spectrum.
And as you look through the current time frame and think one and two years out, we’re going to be looking at a very, very strong labor market.”
While it was an initial step toward reality, it’s destined to be a treacherous journey.
“I think we learned during the course of the last very long expansion, the longest in our history, that labor supply during a long expansion can exceed expectations, can move above its estimated trend.
And I have no reason to think that won’t happen again.”
It’s worth remembering that we’re now 92 weeks (and $4.23 TN!) into the latest bout of QE, liquidity injections that commenced in the pre-pandemic backdrop of near record stock prices and a multi-decade low unemployment rate.
Throw unfathomable quantities of liquidity at a system already showing strong inflationary biases in stocks and labor, and one should be prepared for a mania and anomalous wage inflation.
Powell:
“We’re all going to be informed by what we saw in the last cycle, which was labor supply outperforming expectations over a long period of time.”
And I’d like to inform Chair Powell that the Fed will be “fighting the last war.”
Powell somewhat came clean on extraordinarily uncertain economic, inflation and policy backdrops.
“I think we have to be humble about our ability to understand the data. It’s not a time to try to reach hard conclusions about the labor market, about inflation, about the path of policy.” “The problem now is that demand is very, very strong. Incomes are high.
People have money on their—in the bank accounts.
Demand for goods is extremely high and it hasn’t come down.
We’re seeing the service sector reopening, and so you’re seeing prices are moving back up off their lows there.”
Understandably, markets studied the dots and Powell and concluded a period of policy clarity has been supplanted by significant uncertainty.
It was as if Powell intimated his heels had been dislodged, and he could no longer guarantee there’d be no surprises.
And then Bullard beams onto CNBC Friday morning to proclaim surprises start right now.
“I put us starting in late 2022,” the St. Louis Fed President stated in reference to the “lift off” rate increase.
Markets came into Wednesday’s session thinking, believing, hoping for 2024.
The world changed this week: Markets can no longer fixate singularly on the salve of massive Federal Reserve stimulus.
There are major developments in China, for example, that have been easily disregarded in the halcyon environment of $120 billion monthly QE and luminous Fed policy clarity.
Suddenly, it will matter that Beijing is determined to slow system Credit growth, putting China’s Bubbles in serious jeopardy.
Chinese Credit stress matters.
It matters that some of the major apartment developers are facing liquidity challenges.
Huarong and the other huge asset managers matter.
The possibility that Beijing may allow a major financial institution to fail matters tremendously.
Ten-year Treasury yields slipped a basis point this week, not necessarily the reaction one would expect from a “hawkish” Fed pivot.
Last month’s 5% y-o-y CPI gain was the strongest since June ‘08.
There are parallels to that pivotal bubble year.
Recall that crude and commodities went on a speculative moonshot – bolstered by a late-cycle confluence of strong global demand and Fed stimulus measures.
After peaking at 5.30% in June ‘07, 10-year yields were down to 4% by June ‘08.
There was this extraordinary dynamic: Year-over-year CPI rose from 2% in August ‘07 to a cycle peak 5.6% about a year later – yet yields sank more than 100 bps.
Why were Treasuries in ‘08 dismissive of the inflationary backdrop?
Bond market focus was elsewhere - on the faltering credit bubble.
Treasuries sensed that an unfolding crisis would see the Fed deploy extreme stimulus.
So why did 10-year yields end the week at 1.44% in the face of powerful inflationary pressures, historic Treasury issuance and a less dovish Fed?
Once again, the bond market is focused on bubble dynamics and the certainty of even greater future stimulus.
June 10 – Reuters (Lusha Zhang and Kevin Yao):
“China’s new bank loans unexpectedly rose in May from the previous month but broader credit growth continued to slow, as the central bank seeks to contain rising debt in the world’s second-largest economy…
Growth of outstanding total social financing (TSF), a broad measure of credit and liquidity in the economy, slowed to 11% in May, the weakest pace since February 2020, and compared with 11.7% in April.
Analysts attributed to the weaker TSF growth to slowing issuance of corporate and government bonds, and a contraction in shadow credit, which could hamper economic growth in the future.
‘The slowdown in credit growth is happening even faster than we had been anticipating a couple of months ago,’ Julian Evans-Pritchard at Capital Economics said…”
June 16 – Bloomberg (Sofia Horta e Costa):
“China is resorting to increasingly forceful measures to contain risks to the financial system, in moves that threaten to undermine President Xi Jinping’s pledge to give markets greater freedom.
Authorities have in recent weeks ordered state firms to curb their overseas commodities exposure, forced domestic banks to hold more foreign currencies, considered a cap on thermal coal prices, censored searches for crypto exchanges and effectively banned brokers from publishing bullish equity-index targets.
A new rule will bar cash management products from holding riskier securities and limit their use of leverage.
On Thursday, an official said China plans to sell metals from state reserves.
While the measures fall short of direct intervention, they risk reinforcing the notion of moral hazard.”
June 18 – Bloomberg:
“Chinese property developers are poised for their worst week since January, on concerns that more bad news could follow the central bank’s announcement last week that wealth-management products have been banned from investing in junk bonds, according to brokerage Zhongtai International.
A Bloomberg equity gauge tracking the property sector falls as much as 5.7% this week, and is set for its worst performance since the week of January 29.”
The bottom line: global Bubbles are fragile and increasingly vulnerable.
In particular, China is a Credit accident in the making.
Fed policy certainty has been the glue holding things together – keeping the mania raging, keeping the leveraged players playing, keeping all the options and derivatives speculators betting on the long side, and keeping the weak dollar supportive of levered “carry trades” the world over.
Ten-year Treasury yields below 1.50% are sending a signal: there are Bubble fragilities that will impede any effort of policy normalization.
QE is here to stay.
And after a week of big commodity price drops, it will be easy for some to now dismiss inflation risk – or even assert yields indicate prospective deflation.
And while bursting Bubbles would surely exert disparate disinflationary pressures, thinking one step ahead, I ponder the consequences of the Fed’s policy response to the next crisis.
I actually doubt it will be that far out into the future.
And there are decent odds Trillions of additional liquidity will hit a system already demonstrating powerful inflationary dynamics.
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