Kaufman Knows Inflation
Doug Nolan
“U.S. Inflation Hits 39-Year High of 7%, Sets Stage for Fed Hike.”
“Powell Makes Case for Fed Curbing Inflation While Doing No Harm.”
“Federal Reserve Is on Top of Inflation, Powell Tells Congress.”
“Powell Assures Americans That Fed Will Tackle High Inflation.”
“China Home Market Slump Deepens as Prices Fall for Fourth Month.”
“The ‘Mother of All’ Supply Shocks Lurks in China’s Covid Crackdowns.”
“Cyberattack Hits Ukraine as U.S. Warns Russia Could be Prepping for War.”
In a week of notable headlines, I’ll start with the Bloomberg headline, “Mester Says Shrink Fed Balance Sheet Fast But Don’t Roil Markets.”
Notions of “Doing No Harm” and “Don’t Roil Markets” are wishful thinking.
There’s the long-established principle that central banks must move early to quash inflationary impulses - to ensure a central bank doesn’t fall “behind the curve.”
History teaches that to allow inflation to gain a foothold ensures the containment challenge rises exponentially over time.
Unleash inflation dynamics - in the markets and/or the real economy – and getting it back under control will invariably inflict magnitudes of harm, pain and market “roil” necessary to alter behavior and quell inflation psychology.
But don’t take my word for it.
We have the good fortune of having one of the great Credit and macro thinkers of our age still with us – and providing astute analysis - at the age of 94.
For those unfamiliar with the esteemed Henry Kaufman, he was a Fed economist before becoming a Wall Street legend in the seventies as chief economist and head of bond market research at Salomon Brothers (my analytical framework owes a great debt to Dr. Kaufman).
Kaufman Knows Inflation.
Dr. Kaufman was interviewed this week for an article by Bloomberg’s Erik Schatzker:
“I don’t think this Federal Reserve and this leadership has the stamina to act decisively.
They’ll act incrementally.
In order to turn the market around to a more non-inflationary attitude, you have to shock the market.
You can’t raise interest rates bit-by-bit.”
“The longer the Fed takes to tackle a high rate of inflation, the more inflationary psychology is embedded in the private sector -- and the more it will have to shock the system.”
“‘It’s dangerous to use the word transitory,’ Kaufman said.
‘The minute you say transitory, it means you’re willing to tolerate some inflation.’
That, he said, undermines the Fed’s role of maintaining economic and financial stability to achieve ‘reasonable non-inflationary growth.’”
“If he were advising Powell, Kaufman said he’d urge the Fed chair to be ‘draconian,’ starting with an immediate 50-bps increase in short-term rates and explicitly signaling more to come.
Plus, the central bank would have to commit in writing to doing whatever is necessary to stop prices from spiraling higher.”
There’s no “draconian” in our central bank’s playbook.
Markets were heartened by Powell’s suggestion that inflation will likely be coming down on its own by mid-year, as well as by the general reassuring tone (echoed by Brainard) that the Fed is focused on doing no harm.
To the ears of acutely vulnerable Bubble markets, “no harm” implies no Fed appetite for risks associated with a meaningful tightening of financial conditions.
In last week’s “Issues 2022” piece, I attempted to put the new year into some historical context.
Inflation is running the hottest in four decades.
Commenting on Volcker’s decisive move to crush inflation, Kaufman stated: “It required a lot of fortitude in 1979 to do what the Fed did.”
In Volcker’s day, the Fed would impact system financial conditions through the banking system, for the most part with subtle adjustments to bank reserves (that would impact bank short-term funding costs - and lending and financial conditions generally).
Under Alan Greenspan, the Fed transitioned to the securities markets as the primary mechanism for system stimulation.
It was both seductive and powerful.
Greenspan realized he could stoke speculation, leverage, higher market prices and overall looser financial conditions, uttering not many syllables.
But this approach was ominously “asymmetrical” – maximum stimulus to sustain booms, but minimal effort to rein in excess.
And the larger Bubbles inflated, the more aggressive the requisite rate cuts to hold Bubble deflation at bay.
Out of rate cuts, Bernanke resorted to massive “money” creation.
Massive degenerated into monumental.
The Fed’s balance sheet has inflated $5.0 TN in 121 weeks, now having inflated 10-fold since 2007.
Decades of mismanagement are coming home to roost in 2022.
The risk of collapsing “Everything Bubbles” precludes aggressive tightening measures.
The Fed surely grasps that it will not be forcefully hiking rates, though officials hope that through a concerted effort to talk tough, the markets will get the message and moderately tighten for them.
The Bloomberg Commodities Index gained 2.2% this week, increasing early-2022 gains to 4.4%.
WTI crude surged $4.92 for the week to $83.82, quickly back within striking distance of October’s $85.40 high.
Gasoline jumped 5.2% this week, with Natural Gas surging 8.8%.
There are powerful inflationary biases percolating throughout energy and commodities markets.
Faltering speculative Bubbles (i.e. equities, crypto, corporate Credit, etc.) and associated de-risking/deleveraging would spark a problematic tightening of financial conditions.
My sense, however, is that today’s environment has important differences to previous backdrops, where market “risk off” was immediately perceived as bearish for energy and commodities prices (and inflation generally).
Inflationary forces have made decisive headway throughout the global economy (including energy and commodities).
There is more than ample monetary tinder available, and investment interest in the commodities markets could actually grow as the appeal of financial assets wanes.
Besides, 2022 appears poised for another year of enormous growth in government indebtedness globally.
While all bets are off in a crash environment, I would expect inflationary pressures to prove resilient even in the face of weak securities markets.
Indeed, a crisis of confidence in financial assets could exacerbate the unfolding shift to commodities and real things as more secure stores of wealth/value.
As for the stock market, there was a dynamic this week that was reminiscent of the bursting “tech” Bubble back in 2000.
In trading Monday (and again on Thursday), there were notable correlations between sinking technology stocks and the cryptocurrencies - and some key financial conditions indicators (including various CDS prices).
It was as if fear was starting to take hold - the market was beginning to connect the dots between a collapsing crypto Bubble, the desperately overheated technology industry, and latent systemic risk.
In short, we started to see some of the correlations I would expect at the incipient stage of market panic.
At the late stage of the nineties’ tech Bubble, there was recognition that the big technology companies were extraordinarily overvalued.
Yet the bulls were undeterred.
After all, revenues and profits were growing so rapidly that overvaluation was viewed as short-lived.
Not appreciated was that inflated stock prices were but one facet of industry Bubble Excess.
Speculation, speculative leverage, and the attendant loosest financial conditions (at the time) imaginable were spurring massive spending (over- and mal-investment) by fledging Internet, technology and media companies.
When the speculative market Bubble burst and financial conditions tightened suddenly and dramatically, scores of companies were left without access to new finance.
Investment in technology and communications equipment and services collapsed.
Even for many established companies and industry bellwethers, revenues and earnings dropped significantly.
It is this dynamic that helps explain how stock prices tend to collapse up to 80 to 90% in major bear markets.
Price-to-earnings ratios sink, while earnings collapse.
And speaking of Bubbles and bear markets, Chinese stocks were again under pressure this week.
In particular, many developer stocks and bonds are well on their way to losses unimaginable just a few short months ago.
China crisis dynamics gained important momentum this week.
While this is a significant global development, market focus is elsewhere.
And that’s how things tend to play out.
The initial phase of instability garners much attention.
But then policy responses and a semblance of stability nurture the perception that the situation has been largely resolved.
Meanwhile, Credit stress builds and broadens, methodically gravitating from the “Periphery” toward the systemic “Core.”
January 14 – Bloomberg (Alice Huang and Rebecca Choong Wilkins):
“Concerns about China’s largest builder by contracted sales are weighing on the nation’s other higher-rated developers, triggering worries that contagion risks may be rising.
Country Garden Holdings Co. saw its shares and dollar bonds plunge Thursday following a report that it was unable to generate sufficient interest in a potential convertible bond deal.
China’s stronger builders have so far been relatively immune to a credit crisis sweeping the sector.
If those firms’ capacity to raise debt offshore is seen to be under threat, the industry may see further defaults -- increasing the stress on China’s struggling housing market.”
Country Garden, China’s largest developer by sales, saw its share price sink almost 10% this week, while yields surged 460 bps to a record 12.77%.
Yields began the year at 6.43% and traded at only 3.30% in September.
Developer crisis dynamics have accelerated, making their way to what was recently considered the bluest of blue chips.
Other top-ten developer bonds were slaughtered this week.
Sunac’s bond yields surged 1,310 bps to a record 38.44% (traded at 7.6% in September).
Longfor yields jumped 850 bps to a record 18.19% (4.75% in September).
Seazen Group bond yields spiked 2,000 bps (20 percentage points) to 60.00%.
Seazen yields began the year at 20.8%, after trading at 3.85% in September.
Somewhat smaller, Shimao yields ended the week above 100%.
Kaisa Group yields surpassed 72%, China Aoyuan Group 65%, Yuzhou Group 66%, and Agile Group 48% - to name but a few.
January 14 – Bloomberg (Jan Dahinten):
“Chinese property developer Guangzhou R&F Properties Co. was downgraded to restricted default by Fitch Ratings following its successful delay in repaying most of a $725 million dollar bond due Thursday.
The debt move, completed Thursday, was necessary for the builder to avoid default given its limited liquidity…”
R&F Group yields were up another 800 bps this week to 135.0%, boosting the two-week yield spike to almost 45 percentage points.
An index of Chinese dollar high-yield bonds sank to a record low, with yields surging 230 bps to 20.60% (largest weekly increase since November).
The Shanghai Stock Exchange Property Index was down 4.3% this week
Suggestive of the developer crisis turning more systemic, Friday saw a notable rise in Chinese bank CDS prices.
For the week, China Development Bank CDS increased four to a one-month high 62 bps.
Bank of China rose four to a one-month high 63 bps.
Industrial & Commercial Bank gained three to a one-month high 64 bps, and China Construction Bank rose two to a one-month high 62 bps.
Furthermore, China sovereign CDS rose four to a five-week high 47 bps (began 2020 at 30 bps).
And let’s not forget about Huarong and the highly levered “asset management companies,” or AMCs.
They are in Crisis Dynamics Crosshairs.
January 14 – Bloomberg (Crystal Chui and Zheng Li):
“China Cinda Asset Management Co. tumbled in Hong Kong trading after the state-owned firm unexpectedly backed out of a plan to take a major stake in Ant Group Co.’s consumer finance unit which aims to boost its registered capital as part of a regulatory-driven overhaul.
Cinda is withdrawing from a share subscription agreement that the company announced Dec. 24, the Beijing-based bad-loan manager said… Shares of Cinda fell as much as 13%, the biggest decline since its debut in 2013.”
January 14 – Bloomberg (Alice Huang):
“Dollar bonds issued by China’s major state-controlled distressed debt managers continued to decline Friday, with some on pace for their biggest-ever drops.
Spread on China Cinda’s 4.4% perpetual note has widened 39bps this week to 332bps, including 28bps on Friday…
It’s poised for its biggest-ever daily and weekly widenings since November’s issuance.
Huarong’s 3.75% 2024 note widened 47bps to 349bps, on track for the biggest daily increase since November.
Spread has widened 106bps this week, set for the most since July.”
January 13 – Bloomberg:
“Several of China’s largest banks have become more selective about funding real estate projects by local government financing vehicles, concerned that some are taking on too much risk after they replaced private developers as key buyers of land, people familiar with the matter said.
At least five state-run banks have imposed new restrictions this year on loans to weaker LGFVs seeking to buy land and develop new real estate projects, said the people…
Banks are being more stringent in assessing the financial strength of the local economy and the sales prospects of the projects, the people said.
China’s biggest lenders are walking a fine line over the property sector…”
China developers, the “AMCs,” and LGFVs – we’re literally talking about Trillions of suspect liabilities.
China’s December Credit data was reported this week.
Aggregate Financing, China’s metric of system Credit, expanded a near-forecast $373 billion during December to a record $49.47 TN.
This was down from November, but up significantly (44%) from December 2020.
For the year, Aggregate Financing surged $4.938 TN, or 10.3%.
While down 23% from 2020’s off-the-charts Credit splurge, 2021 growth was up 23% from 2019 and 39% from 2018.
Total Bank Loans were about 10% below forecast at $178 billion - to a record $30.345 TN.
This was down from November’s $201 billion and 10% below December 2020.
Q4 Bank Loan growth was down 4.4% vs. Q4 2020.
Bank Loans were up 11.5% y-o-y, 25.8% over two years and 80.8% over five years.
Notably, Consumer Loans dropped by almost half from November’s $116 billion to only $59 billion, and were down a third from December 2020.
Indicating a rapid slowdown in mortgage lending, it was the weakest Consumer loan growth since February 2021.
It’s worth noting that Q4 consumer loan growth was about 10% below Q4 2020.
At $104 billion, Corporate Loan growth was up from November and 13% above December 2020.
Corporate loans expanded 11.1% over the past year, 25.1% over two years and 67.6% over the past five years.
And while down slightly from 2020, total 2021 loan growth was up 27.3% from 2019 and 45.2% above 2018.
Explaining how Aggregate Financing held up so well in the face of such weak consumer lending, Government Bonds surged $183 billion in December, up from November’s $129 billion and December 2020’s $112 billion – growth second only to August 2020’s $217 billion.
Government bonds expanded $1.050 TN during 2021, or 15.2%, with two-year growth of 40.6% and three-year growth of 60.8%.
While down slightly from 2020’s record $1.164 TN, last year’s annual expansion of Government bonds was 62% higher than 2019.
It is ominous to say the least that such severe Credit issues have erupted in the face of ongoing enormous system Credit growth.
January 14 – Reuters (Aamer Madhani, Nomaan Merchant and Vladimir Isachenkov):
“U.S. intelligence officials have determined a Russian effort is underway to create a pretext for its troops to further invade Ukraine, and Moscow has already prepositioned operatives to conduct ‘a false-flag operation’ in eastern Ukraine, according to the White House.
White House press secretary Jen Psaki said on Friday the intelligence findings show Russia is also laying the groundwork through a social media disinformation campaign that frames Ukraine as an aggressor that has been preparing an imminent attack against Russian-backed forces in eastern Ukraine.”
War Drums.
Russian stocks sank 4.6% this week.
Russia’s 10-year ruble yields surged 100 bps to an almost six-year high 9.46%.
Russia’s sovereign CDS jumped 53 to 178 bps, the high since the March 2020 crisis spike.
Ukraine dollar yields jumped 126 bps to 10.44% (high since April 2020).
Ukraine sovereign CDS surged 227 to 858 bps, the high since the 2014 Russian invasion period.
We’re only two weeks into 2022, yet there are already threatening convulsions at key fault lines: the mighty U.S. tech and crypto Bubbles; China’s collapsing apartment Bubble turning more systemic; and a geopolitical backdrop fraught with risk.
If things start to unravel, how reliable is the Fed (and global central bank) liquidity backstop?
For years now, dependable and predictable Fed responses to market instability have been fundamental to (cheap) pricing for risk protection derivatives.
There’s still a solid argument for the dependability of the Fed’s liquidity backstop.
But surging inflation has significantly clouded the predictability of both the timing and scope of Fed QE responses to market instability.
I expect this to increasingly be a key factor in higher pricing and waning liquidity throughout the derivatives universe.
This will become a pressing issue as market Bubbles falter.
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