Inklings of Secular Change
Doug Nolan
The S&P500 was about unchanged Wednesday at 2:36 ET, six minutes into Chair Powell’s press conference opening statement.
“We will need to be nimble in responding to incoming data and the evolving outlook.”
A market surge over the final 84 minutes of trading saw the S&P500 end the session 2.2% higher.
The Goldman Sachs Most Short index spiked 5.6% (finishing the week up a blistering 10.5%).
March 18 – Bloomberg (Jeran Wittenstein):
“No earnings?
No problem.
That was the message from investors this week who stormed back into the shares of faster-growing companies with little in the way of profits after months of chasing value stocks.
While major benchmarks rallied, a Goldman Sachs index of unprofitable tech companies was up 18% over the five sessions.”
Wednesday marked the first Fed rate increase since November 2018.
Recall that Powell had assumed the Chairmanship earlier that year (February 5th).
Under Powell, rates were raised 25 bps in June and again in September.
Wall Street excoriated him in October for his “rookie mistake” comment, “we’re a long way from neutral.”
There was near marketplace revolt when the Powell Fed hiked rates in the midst of market instability in December 2018.
March 16 – Financial Times (Colby Smith):
“Testifying before Congress earlier this month, Jay Powell was asked if the US Federal Reserve was prepared to ‘do what it takes’ to get inflation back under control — and if necessary, follow in the footsteps of his venerated predecessor, Paul Volcker, who regained price stability ‘at all costs’.
Calling the late Volcker ‘the greatest economic public servant of the era’, Powell responded: ‘I hope history will record that the answer to your question is yes.’
The chair of the central bank on Wednesday sought to drive home that point, framing the first interest rate rise since 2018 as the start of a series of increases and emphasising that the Federal Open Market Committee (FOMC) was ‘acutely aware of the need to return the economy to price stability and determined to use our tools to do exactly that’.”
The Fed’s balance sheet and 7.9% inflation ensure history will not mistake Powell for Volcker incarnate.
I had hope for Chair Powell.
He was neither an avowed inflationist nor a proponent of QE as Federal Reserve governor.
I still believe one of his early objectives as Fed leader was to have the markets begin standing on their own.
Powell’s fate – all of our fates – was altered on January 4, 2019, when, on a panel discussion with Janet Yellen and Ben Bernanke, he pulled out some prepared comments: “…Policy is very much about risk management.” “We will be patient as we watch to see how the economy evolves…” “We will be prepared to adjust policy quickly and flexibly and to use all of our tools to support the economy…” A Bloomberg headline: “Powell Shows He Cares About Markets.”
It was a dramatic “dovish pivot,” coming unexpectedly only about two weeks after a rate increase.
Markets had been under pressure following the hike, as “risk off” gathered momentum.
It would prove the last rate increase for 39 months.
The Fed’s balance sheet was about $4 TN at the time.
But by that summer, the Fed announced a new QE program in the face of increasingly speculative markets and the lowest unemployment in decades.
Then in March 2020, with markets in crisis, the Fed unleashed historic liquidity injections that would see the Fed’s balance sheet more than double to almost $9.0 TN.
Unprecedented monetary inflation stoked late-cycle Bubble excess, including myriad precarious manias.
Markets understandably interpret “nimble” as code for “readily available Fed market liquidity backstop”.
No one believes Powell can now abandon the “Fed put” he has exercised like no other – surging inflation notwithstanding.
For now, markets are okay with a monetary policy contradiction: a determined fight against inflation – with a generous market liquidity backstop.
Having so incredibly mismanaged the monetary backdrop, the Fed was compelled to craft a plan for meaningful monetary tightening.
Basically, it’s a rate increase for each remaining meeting this year and a few more next year, while commencing measured balance sheet reduction as early as the May meeting.
The committee’s median “dot plot” projections have rates at 1.9% by the end of the year and 2.8% to conclude 2023.
It’s a rational and reasonable strategy, commencing what would be the most aggressive tightening cycle since 2005.
There are, of course, worries about how this might impact economic growth and employment.
The more pressing risk is what an assertive tightening cycle means for faltering market Bubbles.
The spread between two- and 10-year Treasury yields dropped to 21 bps this week, down from 77 bps to begin the year - to the narrowest spread since February 2020.
There is essentially no spread between five and 10-year yields.
Understandably, two-year yields (at 1.94%) price in the Fed’s near-term tightening plan.
Why, though, with inflation surging and the Fed anticipating raising rates to almost 3.0% by the end of next year, do 10-year yields remain at only 2.15%?
The market must anticipate an abrupt reversal of inflation dynamics and/or an eventual about-face from the FOMC.
My bet would be on the latter.
Markets have every reason to question the sustainability of the Fed’s tightening cycle.
Larry Summers is calling for a 5% Fed funds rate, but odds of that seem about zero.
Fragile Bubble markets will badly malfunction in a backdrop of tightening financial conditions.
The Ukraine and global economic wars greatly exacerbate vulnerabilities.
Myriad risks burden markets, while the Fed and global central bank community are burdened by even more forceful inflation dynamics.
Powell is no Volcker.
Besides, in today’s backdrop, even the great statesman Paul Volcker would be hamstrung by a confluence of fragile Market Structures, global inflationary dynamics and acute geopolitical risk.
Truth be told, the Fed can plan and talk boldly, but faces limited flexibility.
This week’s 6.2% S&P500 rally (Nasdaq100 8.4%, Semiconductors 9.2% and Broker/Dealers 9.1%) helped mollify fears of impending market breakdown.
Notably, the VIX rose to almost 34 in early-Tuesday trading.
JPMorgan Credit default swap (CDS) prices traded above 85 bps (began the year at 48), the high since crisis period April 2020.
Goldman, BofA, Citigroup, and Morgan Stanley CDS all spiked to the highs since 2020.
Investment-grade corporate Credit spreads (to Treasuries) surged to the widest level since July 2020.
At Monday’s close, investment-grade corporate debt (the LQD ETF) had posted a six-session return of negative 6.7% - boosting y-t-d losses to 11.9%.
It was reminiscent of market dynamics heading into the pandemic dislocation.
Today’s backdrop is more troubling than March 2020.
For one, it could be the riskiest geopolitical environment in a couple generations.
Historic Bubbles have inflated tremendously in two years.
Furthermore, China’s historic Bubble is faltering.
March 18 – Bloomberg (Sofia Horta e Costa):
“China is changing direction on a number of key policies all at once as President Xi Jinping seeks to stabilize the country’s economy and financial markets in a politically crucial year.
On Thursday, Xi vowed to minimize the cost of China’s longstanding Covid-Zero policy, signaling a shift in priority.
His comments came hours after Hong Kong’s leader said she would soon unveil a sweeping review of the city’s approach toward the virus.
Earlier in the week, China’s finance ministry said it wasn’t expanding its property tax trial any time soon.
The same day, the State Council said it would complete its crackdown on Big Tech ‘as soon as possible,’ and resolve risks around property developers (previously authorities had insisted the crisis among builders such as Evergrande would be left to the market to deal with).”
Beijing hit the panic button.
China’s real estate developer crisis was spiraling out of control.
Country Garden, China’s largest developer, saw bond yields spike Wednesday to 31.6%, having doubled in only seven sessions (yields began 2022 at 6.7%).
Yields spiked to 120.6% for Evergrande, 120.5% for Kaisa, 124.6% for Lonfor and 98% for Sunac.
Developer bonds were virtually collapsing across the board.
An index of Chinese high-yield dollar bonds jumped to a record 27.1% yield (began the year at 16.8%).
Chinese bank CDS were spiking higher.
Industrial Bank of China CDS surged to 88.5 bps, China Construction Bank 84.6 bps, China Development Bank 83.4 bps, and Bank of China 84.5 bps – all highs since crisis period 2020.
Ominously, China sovereign CDS surpassed 70 bps (began 2022 at 40) for the first time since the March 2020 spike.
At Wednesday’s lows, the Shanghai Composite had sunk 13% in less than eight sessions to the low back to July 2020.
Over eight sessions, China’s CSI Financials Index collapsed almost 14%.
Hong Kong’s Hang Seng Index dropped 5.0% Monday and another 5.7% Tuesday, boosting y-t-d losses to 21.0%.
The Hang Seng China Financials Index dropped 7.7% in two sessions.
China’s about-face on about everything ignited a spectacular short squeeze and market rally.
March 17 – Bloomberg (Abhishek Vishnoi and Jeanny Yu):
“Chinese stocks had their biggest two-day advance since 1998 as Beijing’s strong push to stabilize financial markets and stimulate the economy lured buyers back after a relentless selloff.
The Hang Seng China Enterprises Index rallied 7.5%...
That followed an almost 13% jump in the previous session for the gauge of Chinese firms listed in Hong Kong.”
After collapsing as much as 31% in three sessions, the Nasdaq Golden Dragon China Index rallied as much as 54% and ended the week up 26.4%.
Equities were wild, but rather tame compared to the commodities.
March 14 – Bloomberg (Jack Farchy, Alfred Cang and Mark Burton):
“It was 5:42 a.m. on March 8 in London when the nickel market broke.
At that time of day, bleary-eyed traders are typically just glancing at prices as they swig coffee on their way to the office.
On this day, however, metal traders across the city were glued to a screen…
Nickel prices usually move a few hundred dollars per ton in a day.
For most of the past decade, they’d traded between $10,000 and $20,000.
Yet the day before, the market had started to unravel, with prices rising by a stunning 66% to $48,078.
Now, the traders watched with a mixture of horror and grim fascination as the price went vertical.
Already at an all-time high by 5:42 a.m., it lurched higher in stomach-churning leaps, soaring $30,000 in a matter of minutes.
Just after 6 a.m., the price of nickel passed $100,000 a ton.”
While not as crazy as nickel, WTI Crude traded at almost $110 early Monday, sank to $93.70 in Tuesday trading, before rallying as much as 13% off lows to end the week down $4.63, or 4.2%, at $104.70.
Aluminum dropped 8% and then rallied 5.5%.
Copper dropped 5% from Monday’s highs, and then rallied 4.7%.
Silver slumped 5.6%, rallied 4.4%, then declined Friday to end the week down 3.5%.
Palladium sank as much as 17% in wild Monday trading, before ending the week down 11%.
Platinum was down as much as 10% at Tuesday’s lows, before ending the week with a loss of 5%.
Gold opened the week at $1,989, traded down to $1,895 in Wednesday trading, before closing Friday at $1,922 (down 3.4% for the week).
The Treasury five-year “breakeven” rate of market inflation expectations jumped to a record 3.68% in early Friday trading, only to reverse lower to end the week at 3.59%.
For perspective, this rate was below 1% when the Fed responded to the March 2020 market dislocation.
Crude prices ended February 2020 at $45.
CPI was up 2.3% y-o-y in February 2020.
Whether it’s the Fed, Beijing, the ECB or other officials from around the globe, policymakers now face extraordinary financial, economic and geopolitical risks in an inflationary backdrop not experienced in decades.
The thesis holds that a secular shift to a new regime is now unfolding.
Going back three decades to the reign of Alan Greenspan, the Fed held sway over system stability.
The Greenspan Fed accommodated a transformational shift to market-based finance.
The Fed could then control financial conditions, Credit Availability, asset inflation, perceived wealth creation, investment, and economic growth with measures that evolved from Greenspan’s cryptic utterances, to aggressive rate slashing, to Bernanke’s Trillion to Powell’s $5 TN.
No matter what the crisis – early nineties bank impairment, 1994 bond bust, LTCM, the bursting tech Bubble, 9/11, the mortgage finance Bubble collapse to the pandemic – the solution was one version or another of increasingly reckless monetary inflation.
And for three decades, the bond market enjoyed one of history’s great bull markets.
Ten-year Treasury yields traded above 9% in early 1990.
In the face of runaway Credit growth, transitory spikes in crude prices and inflation rates, and unprecedented monetary stimulus, bond yields trended lower – all the way down to 0.53% in July 2020.
For thirty years, the Fed operated with minimal concern for bond market instability or inflation.
This prolonged and historic cycle is drawing to a close.
The cycle of repeated reflationary measures and only bigger and more unwieldy Bubbles has come to a head.
As global Bubbles falter, it would require yet another round of massive monetary inflation to again hold collapse at bay.
But with powerful inflationary forces unleashed – certainly including supply-challenged commodities markets – there is the distinct risk of inflation becoming completely unhinged.
This risk places the bond market in peril.
Derivative markets have begun to adjust to the troubling new backdrop.
Central bankers can supply additional liquidity, but they can’t mint more crude, nickel, wheat, or commodities generally.
At least in commodities, central bankers are incapable of ensuring liquid and continuous markets.
And as energy, food and commodities prices surge higher, central bankers are kidding themselves if they actually believe they can control the general inflationary backdrop.
I wish the Fed today possessed the “tools” to manage inflation.
Ten-year yields at 2.14% will not do the trick.
At this point, the Fed would have to dramatically tighten financial conditions to reset inflation expectations.
But such a move would collapse fragile Bubbles.
March 18 – Bloomberg (Lu Wang):
“Wall Street traders are enduring fresh equity-market fireworks Friday after another week of global turbulence…
Roughly $3.5 trillion of single-stock and index-level options were estimated to expire Friday, according to Goldman Sachs…
At the same time, more near-the-money options were expected to mature than at any time since 2019…
The S&P 500 climbed almost 6% over previous three sessions in the best rally since 2020…”
It's worth repeating:
“Roughly $3.5 trillion of single-stock and index-level options were estimated to expire Friday.”
It was yet another rally into expiration, where the reversal of hedges fueled panic-buying and melt-up dynamics.
Imagine, however, the scenario where derivatives dealers - on the wrong side of Trillions (notional) of put options and other bearish hedges - are forced to aggressively hedge their rapidly increasing exposures (by selling securities) into cascading markets.
This is an accident in the making.
In the event of a major “risk off” market dynamic, literally Trillions of market exposures will be offloaded to the derivatives markets, where the dealer community will be left with the task of trying to hedge market protection they have provided (i.e. listed put options sold or over-the-counter derivatives written).
Granted, this dynamic is not unfamiliar in the marketplace.
What has changed is the scope of both speculative excess and derivatives trading, along with an inflation backdrop unlike anything experienced during the entire era of contemporary derivatives trading (going back to late-eighties “portfolio insurance”).
As recently as two years ago, the Fed responded to “de-risking/deleveraging” and resulting market dislocation with unprecedented liquidity injections.
Such a monetary response today would risk further commodities market speculation and dislocation, while stoking a perilous inflationary spike.
Markets are an erratic mess: commodities, equities, bonds, currencies and, certainly, derivatives.
The game has fundamentally changed.
Whether it is nickel, crude, wheat or commodities more generally, producers will now approach hedging programs more cautiously (fearful of getting caught in squeezes and margin calls).
Especially after the War and unfolding “economic iron curtain,” supply constraints create a high-risk backdrop for getting caught in short squeezes and market dislocations.
To be sure, the derivatives dealer community active in commodities can no longer assume liquid and continuous markets.
It would today be misguided to operate with the expectation of being able to readily (“dynamically”) hedge derivative exposures in the markets.
Wild price volatility and illiquidity dictate that those still willing to sell protection in these markets will demand highly elevated prices.
Market dynamics suggest a fundamental secular change in commodities derivative markets, with fewer players, less liquidity and significantly higher risk premiums.
This points to powerful inflationary biases throughout the commodities universe.
Moreover, central banks risk throwing gas on an inflationary fire when they respond to financial market illiquidity with additional QE/monetary inflation.
A key question is whether this secular shift in commodities markets portends a secular cycle downturn for financial assets?
I believe it does.
Financial markets – stocks, bonds, derivatives – confront risks not faced in decades.
Inflation is high, while risks are tilted strongly to the upside.
Meanwhile, the combination of surging inflation and unprecedented indebtedness creates the highest risk in generations for a disorderly spike in market yields.
Importantly, there’s also the key issue of the Fed’s (and global central banks’) market liquidity backstop.
Markets cannot today rest assured that “whatever it takes” still applies.
At the minimum, the necessary focus on inflation risk will dictate that the Fed’s response to “de-risking/deleveraging” and resulting market illiquidity will be more tentative and limited in scope than in the past.
The backdrop points to a sea change in the risk/reward profile of financial assets generally.
Geopolitical risks are today of extreme nature and will likely remain highly elevated.
Liquidity risks have fundamentally shifted.
Wildly speculative markets confront a less certain and likely diminished central bank liquidity backstop.
Importantly, writing market protection has become a much riskier proposition, a reality that will manifest into higher priced derivatives and market protection.
And a shift away from readily available inexpensive market “insurance” will translate into less leveraging and risk-taking.
Going forward, de-risking will require more selling of securities holdings, rather than simply buying cheap hedges.
It was a week of extraordinary contradictions.
Constructive comments on negotiations from both the Ukrainian and Russian sides.
The Wednesday Financial Times article, “Ukraine and Russia Explore Neutrality Plan in Peace Talks:” “Ukraine and Russia have made significant progress on a tentative peace plan…”
By late in the week, the Ukrainian side said talks could last at least “several weeks,” while Putin stated Kyiv was “putting forward more and more unrealistic proposals.”
If anything, the bombing and destruction became only more intense and brutal.
The U.S. and China appeared on a collision course, although the Biden/Xi meeting offered reason for cautious optimism.
Chinese markets were at the brink, before a Beijing-induced rally elicited cries of “the bottom’s in!”
Here at home, another spectacular short squeeze suspended crisis dynamics.
The bottom line: the world has commenced an alarming period of uncertainty and instability.
And the more comfortable markets become in disregarding geopolitical risk, the more leash the Fed will have to tighten policy.
A well-known market pundit said the Fed was in “fantasyland.”
The same can be said for the markets.
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