Historic Q1 2022
Doug Nolan
Historic Q1 2022.
Inflation, a Hawkish Fed, Spiking Bond Yields, War, China and Acute Instability.
Where to begin?
“Inflation Hits a New 40-year High.”
“Bond Market Suffers Worst Quarter in Decades.”
“Commodities Finish Best Quarter in 32 Years.”
Greatest divergence between financial assets and Hard Assets ever?
“China Home Sales Slump Worsens Despite Vows to Support Market.”
“China Growth Outlook Worsens as Manufacturing, Home Sales Slump.”
“Recession Warning Sign Flashes as Yield Curve Inverts.”
It is only a matter of how profound Q1 developments will shape the future.
In the final week of a historic quarter, there was optimism that negotiations were about to bear fruit.
Russia stated it was taking steps to “de-escalate.”
An understandably skeptical President Zelensky warned Russia was determined to split Ukraine.
Obvious enough.
But is Putin’s overarching goal to divide the world?
Putin has over the years railed against a U.S.-dominated world.
He abhors the dollar-based global financial apparatus.
Russia’s dictator repudiates the U.S. as “global cop”, replete with power to dictate the terms of trade and financial relationships, and security alliances, while unilaterally imposing financial and economic sanctions at its discretion.
Putin’s tight relationship with fellow autocrat Xi – master of newfound superpower China - provided the backing for his gambit of breaking violently from the existing world order.
March 30 – CBS:
“Beijing and Moscow advanced a vision of a new world order… as Russian Foreign Minister Sergey Lavrov made his first visit to key ally China since his country launched its invasion of Ukraine.
Moscow’s top diplomat landed in the eastern city of Huangshan early Wednesday for a series of meetings…
U.S. officials have accused China of signaling ‘willingness’ to provide military and economic aid to Russia…
Lavrov painted a picture of a new ‘world order,’ saying the world was ‘living through a very serious stage in the history of international relations.’
‘We, together with you, and with our sympathizers will move towards a multipolar, just, democratic world order,’ Lavrov said…
A readout from the Chinese foreign ministry quoted Wang Yi as saying ‘China-Russia relations have withstood the new test of the changing international situation, maintained the correct direction of progress and shown tenacious development momentum.’”
I anxiously awaited the narrative from Russian Foreign Minister Lavrov’s trip this week to China.
Chinese officials have been guarded with its public remarks, refusing to condemn Russia’s invasion while attempting to present a middle ground position as aspiring peacemaker.
Would there be a bit of chill in the reception for Lavrov, a fitting signal of at least a modicum of dissatisfaction with the state of affairs – even if only publicly for a wary international audience?
For a government and society that prioritizes stability, would China indicate some apprehension at the prospect of an insecure and rapidly changing global environment?
Or might Beijing instead display support and solidarity, shedding the thin veil of neutrality to reveal China’s acquiescence to its partner’s designs for reshaping global power dynamics?
China was notably – and surprisingly - unsubtle.
Until proven otherwise, the Chinese clubby homecoming this week for its “partner with no limits” supports the thesis that China is fully on board with a reformulation of the “world order”.
From Newsweek: “Chinese Foreign Minister Wang Yi praised Russia for its efforts to ‘prevent a large-scale humanitarian crisis’ in Ukraine.”
AFP: “Beijing and Moscow advanced a vision of a new world order… Lavrov painted a picture of a new world order, saying the world was ‘living through a very serious stage in the history of international relations.’
‘We, together with you, and with our sympathizers will move towards a multipolar, just, democratic world order…”
Press Trust India quoted Foreign Minster Wang: “There is no ceiling for China-Russia cooperation, no ceiling for us to strive for peace, no ceiling for us to safeguard security and no ceiling for us to oppose hegemony.”
March 30 – Financial Times (Kathrin Hille):
“China has reaffirmed its partnership with Russia and said it wanted to push bilateral relations ‘to a higher level’ as Moscow faces international sanctions and widespread criticism over its invasion of Ukraine.
In the first meeting between the countries since Russia started the war a month ago, China’s foreign minister Wang Yi told his Russian counterpart, Sergei Lavrov, that ‘the two sides’ will to develop bilateral ties is even firmer, our confidence in advancing co-operation in various areas even stronger…’
The Chinese readout of the Lavrov-Wang meeting also repeated support for the Russian security concerns that Moscow claims drove it to attack Ukraine.
‘The Ukrainian issue… is not only the outbreak of the long-term accumulation of security conflicts in Europe, but also the result of the cold war mentality and group confrontation,’ Wang said.”
Equities markets, especially when they turn acutely speculative, become fixated on short-term trading dynamics.
How bearish is sentiment?
How aggressive has short positioning become?
What is the scope of outstanding put options and bearish derivatives that would need to be unwound (aka “gamma squeeze”) in the event of a market rally?
What is the speculative landscape heading into option expiration?
Equities will move on incremental news.
When it appeared less likely the War was spiraling out of control, it was time to squeeze the shorts and force an unwind of bearish derivative positions.
Longer-term developments – including a momentous reshaping of the “world order” – are essentially irrelevant to stocks.
Meanwhile, bonds tend to have a longer-term horizon.
Why are long-term real (adjusted for inflation) yields remaining so deeply negative – 10-year yields at only 2.39% - with almost 8% y-o-y consumer price inflation and the Fed commencing what is expected to be the most hawkish tightening cycle since 1994?
And with the 2-yr/10-yr Treasury yield spread trading negative this week, some interpret this as a signal of looming recession.
I would approach the analysis somewhat differently.
I have posited that long-term yields have remained depressed in the face of surging inflation largely because of today’s world of extraordinary Bubble Fragility.
China’s historic Bubble is clearly faltering, and the prospect of weakening Chinese demand was cited this week as a factor behind sinking crude and materials prices.
In general, global financial markets are at heightened risk of de-risking/deleveraging, and a crisis of confidence that would likely stop global central bank “tightening” in its tracks.
It has been my long-held concern that a bursting Chinese Bubble would be associated with heightened geopolitical risk.
This thesis is coming to fruition.
I don’t see the timing of Russia’s invasion as coincidence.
China and the world are transitioning from a historic boom and Bubble period.
Animosity and conflict are inescapable cycle shift fallout.
March 30 – Bloomberg:
“Borrowing by Chinese businesses plunged in the first quarter and interest rates on loans surged to a record despite the central bank’s efforts to encourage more lending, according to China Beige Book International.
Only 16% of the companies surveyed by CBBI… applied for loans in the first three months of 2022, the lowest since the quarterly poll began in 2012…
The firms also paid for the most costly loans since 2012 even though the People’s Bank of China cut its policy rates early in the year.
The average interest rate for bank loans climbed to 8.5% from 6.1% in the fourth quarter of 2021, while those for shadow financing loans surged to 15.1% from 10.7%, according to… CBBI.
The survey paints a grimmer picture of credit demand in the corporate sector than the slowdown reflected in the official data.”
Results from the private China Beige Book survey signal a broad-based tightening of financial conditions that should not be disregarded.
March 31 – Bloomberg:
“China’s home sales slump deepened in March, keeping pressure on cash-strapped developers even as policy makers vow to support the property market.
The 100 biggest companies in China’s debt-ridden property industry saw a 53% drop in sales from a year earlier, according to… China Real Estate Information Corp.
That’s the steepest decline this year.”
Beijing’s “Covid zero” policy has pushed a teetering economy over the ledge.
Many supportive comments from government officials over recent weeks have done little to bolster general confidence.
The rapidly deteriorating backdrop this week elicited the strongest indications yet of imminent stimulus measures.
I expect Beijing will face the harsh reality that customary reflationary tactics will prove much less effective in today’s post-Bubble environment.
March 30 – Bloomberg:
“China’s central bank vowed to boost confidence and provide more effective support to the economy, amid mounting growth pressure from the country’s worst Covid outbreak since Wuhan.
The People’s Bank of China reaffirmed it will step up the magnitude of monetary policy and make it more forward-looking, targeted and autonomous...
The central bank will ‘further unclog the transmission mechanism of monetary policy’ and expand the relending program for small and rural businesses, a meeting by the monetary policy committee chaired by Governor Yi Gang concluded…”
April 1 – Bloomberg (Dorothy Ma):
“Declines accelerated in the first quarter for China’s high-yield dollar bond market, which is dominated by the country’s developers, as a record pace of defaults persists.
Junk-rated notes lost 19% to start this year, the most in at least a decade…”
The Shanghai Composite sank 10.6% during Q1, with the growth-oriented ChiNext Index sinking 19.9%.
An index of dollar-denominated high-yield Chinese corporate bonds saw its yield surge to 22.5% (traded as high as 27.9% on 3/16) from 16.8% to begin the year.
China’s big four banks posted notable increases in Credit default swap (CDS) prices.
China Construction Bank CDS jumped 17 during Q1 to 74 bps, China Development Bank 18 to 72 bps, Industrial & Commercial Bank of China 18 to 76 bps, and Bank of China 17 to 72 bps.
China sovereign CDS prices posted an ominous jump during Q1, rising 21 to 62 bps.
Here in home, it was a quarter of extreme volatility.
From early-January highs to February 24th lows, the S&P500 dropped 14.6%.
The S&P500 had then rallied 12.7% at March 29th trading highs.
Over this period, the Nasdaq100 dropped 20.9%, only then to rally 16.8%.
The end of quarter equities rally pressured a fragile bond market.
After beginning March at 1.73%, 10-year Treasury yields surged 75 bps to peak at 2.48% on March 25th.
The Treasury five-year “breakeven” rate of inflation expectations began March at 3.15%, only to trade up to 3.73% on March 25th.
On March 1st, the Treasury market was pricing 4.82 25-basis point rate hikes by the FOMC’s December 14th meeting.
By March 28th, expectations had spiked to 8.42 hikes.
Surging yields were a global phenomenon.
Greek yields spiked 134 bps during the quarter to 2.65%.
Italian yields surged 80 bps (2.04%), Portugal 89 bps (1.35%), and Spain 80 bps (1.36%). German 10-year bund yields rose 73 bps to 0.55%.
With one day left in the quarter, German 2-year yields had surged 65 bps to trade, with a positive yield for the first time since 2014.
Canadian 10-year yields gained almost 100 bps during the quarter to 2.40%, while Australian yields surged about 120 bps to 2.86%.
March 31 – Wall Street Journal (Sam Goldfarb):
“U.S. bonds’ worst quarter in more than 40 years has come to a close…
The Bloomberg U.S. Aggregate bond index—largely U.S. Treasurys, highly rated corporate bonds and mortgage-backed securities—returned minus 6% in 2022 through Wednesday, on track for the biggest quarterly loss since 1980.
Yields on short to medium-term Treasurys… have logged their biggest quarterly gains in decades, with the two-year yield rising the most since 1984 and the five-year yield the most since 1987.”
The iShares Treasury Bond ETF (TLT) returned negative 10.63% for the quarter.
The iShares Investment Grade Corporate Bond ETF (LQD) returned negative 8.38%, and the iShares High Yield Corporate Bond ETF (HYG) returned negative 4.73%.
It was a rough quarter generally for fixed-income, but those hedging corporate debt holdings with Treasury short positions successfully mitigated rate risk.
Meanwhile, MBS turned bloody.
Benchmark MBS yields surged 143 bps during the quarter to 3.49%, trading late in the quarter at the highest yields (3.71%) since December 2018.
MBS yields were up another nine bps during Q2’s first session.
“The ‘Yield Curve Inversion’ Is Signaling Something Important.”
After beginning the year at 78 bps, the 2-yr/10-yr Treasury yield spread ended the week at negative eight bps.
I’ll leave a deeper yield curve discussion for another day.
But this week, in particular, had the look of levered yield curve trades blowing up.
That would help explain how two-year Treasury yields could spike 19 bps this week to 2.46%, as 10-year yields dropped nine bps to 2.38%.
There are increasing discussions of Treasury market liquidity issues.
April 1 – Bloomberg (Paula Seligson and Josyana Joshua):
“The U.S. investment-grade loan market saw a slow start to the year after 2021 volumes hit a record high.
Companies raised $238.6 billion of the syndicated corporate loans in the first quarter of 2022, down 21% year-over-year…
That compares to $300.2 billion in the first quarter of 2021.
The drop-off occurred due to a significant decrease in M&A volume, which fell to only $31.6 billion in the first quarter, a sharp 51% drop year-over-year compared to $64.7 billion in 2021.”
March 31 – Wall Street Journal (Hardika Singh):
“Commodities wrapped up their best quarter in more than 30 years after Russia’s invasion of Ukraine supercharged a rally in markets from oil to wheat and nickel…
The S&P GSCI, a benchmark tracking the prices of commodities futures from precious metals to livestock, has climbed 29% in the first quarter, notching its biggest gain since 1990.”
WTI Crude traded to $126 (March 7th), before ending the quarter up 33% at $100.28.
Gasoline jumped 41% during Q1, and Natural Gas surged 51%.
Nickel spiked spectacularly and held some of those gains to end Q1 up 55%.
Aluminum rose 24%, Iron Ore 39%, and Zinc 18%.
The soft commodities were also hot.
Wheat was up 77% y-t-d early in the War, before ending the quarter up 34%.
Corn jumped 26%, and Soybeans rose 20%.
Cotton jumped 23%.
Gold gained 6.9%, and Silver rose 6.4%.
The new global Iron Curtain virtually ensures shortages and bouts of panic buying of key commodities over the foreseeable future, perhaps somewhat offset by deteriorating Chinese economic prospects.
It’s difficult to envisage a backdrop with greater uncertainties.
For starters, how does the War unfold?
Would the West be willing to loosen sanctions as part of a peace deal after Russia so brutally pulverized Ukrainian cities?
How long might China escape U.S. and European animus for its Russian brotherhood?
How significantly does the unfolding new world order hinder financial and economic flows?
Moreover, how might central bankers respond to faltering markets in an economic war backdrop where the performance of securities markets will be viewed as indicating relative success or failure?
It was a wild and deeply troubling Q1.
Little reason to expect much different for Q2.
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