Losing Capacity to Stabilize
Doug Nolan
It was an important week – perhaps critical.
There was additional support for my macro thesis.
The bottom line: increasingly unstable global markets today face extreme uncertainty, arguably the greatest array of uncertainties in decades.
By Friday, developments left me with an uneasy, foreboding feeling.
We’re all aware of the serious global inflation problem.
A few recognize the perilous global Bubble quandary, with China’s deflating Bubble becoming difficult to dismiss.
The interaction of these powerful – and potentially countervailing - forces has become a source of acute market uncertainty and instability.
There’s also the war in Ukraine, along with the developing global economic war.
There’s an FOMC compelled to clamorous hawkishness.
But before we turn to the Fed, let’s discuss the fraught global backdrop.
It appears the war in Ukraine may take a further turn for the worse.
There has been discussion of Russia regrouping for a blitzkrieg in the eastern Donbas region, providing for a swift land grab and claims of triumph in time for Russia’s May 9th “Victory Day” celebration.
It appears, however, that Putin has not given up on his designs for a major chunk of Ukrainian territory.
April 22 – Bloomberg:
“A Russian general said the Kremlin’s war in Ukraine aims to secure control of the entire south of the country as well as the eastern Donbas region, according to state news services, as he also suggested the campaign could extend into neighboring Moldova.
The push in southeastern Ukraine aims ‘to establish full control over Donbas and southern Ukraine,’ Major General Rustam Minnekayev, acting commander of Russia’s Central Military District, said Friday at a defense industry meeting in Ekaterinburg…
‘This will allow us to ensure a land bridge to Crimea as well as influence key aspects of the Ukrainian economy, Black Sea ports through which agricultural and metallurgical exports go to other countries,’ he said.”
If Putin indeed has his sights on Ukraine’s entire southern territory along the Black Sea, ramifications are huge and potentially momentous.
Losing its key ports (becoming landlocked) is viewed as an existential threat to the Ukrainian nation.
The prospect of months of horrendous fighting – and limited scope for constructive negotiations – increases greatly in that scenario.
Moreover, the U.S. and NATO would only harden their resolve to see a defeated Russia.
Despite the Kremlin’s warnings, the West will continue to dramatically expand the scope of military support for Kyiv.
It appears tanks, artillery, sophisticated drones and advanced weaponry, air defense systems, helicopters, and even fighter aircraft are now flooding into Ukraine.
And the longer the conflict rages, the further it will materialize into a proxy war between bitter adversaries the U.S. and Russia.
The world fundamentally changed on February 24th - and there’s no turning back.
April 20 – Bloomberg:
“Russia’s Defense Ministry released video of a Sarmat intercontinental ballistic missile being test-fired from the Plesetsk cosmodrome in the northern Arkhangelsk region, Tass said.
The ministry previously showed videos of the missile in 2018.
‘This unique weapon will strengthen the military potential of our armed forces, will reliably guarantee Russia’s security against outside threats and force those who in the heat of frenzied aggressive rhetoric try to menace our country to think again,’ Putin said on state TV.”
I’ll assume that a protracted war scenario boosts prospects for overt economic and financial support from Russia’s close ally China.
April 20 – Bloomberg (Daniel Ten Kate):
“China will continue strengthening strategic ties with Russia, a senior diplomat said, showing the relationship remains solid despite growing concerns over war crimes in Vladimir Putin’s war in Ukraine.
Vice Foreign Minister Le Yucheng called for deepening ties in a range of fields during a meeting on Monday in Beijing with Russian envoy Andrey Ivanovich Denisov…
He said that a nearly 30% jump in trade between the nations during the first three months of 2022 demonstrate ‘the great resilience and internal dynamism of bilateral cooperation.’
While bilateral trade did grow…
‘No matter how the international landscape may change, China will continue to strengthen strategic coordination with Russia for win-win cooperation, jointly safeguard the common interests of the two countries and promote the building of a new type of international relations and a community with a shared future for mankind,’ Le said…
Denisov said Russia regards relations with China as a ‘diplomatic priority,’ the statement said.”
The administration is actively preparing for China’s circumvention of Russia sanctions.
April 22 – Bloomberg (Iain Marlow):
“A senior U.S. diplomat again warned China of sanctions if it offers ‘material support’ for Vladimir Putin’s war in Ukraine, while also pledging to help India end its dependence on Russian weapons.
China wasn’t helping the situation in Ukraine by doing things like amplifying Russian disinformation campaigns, U.S. Deputy Secretary of State Wendy Sherman said…
She said she hoped Beijing will learn the ‘right lessons’ from Russia’s war, including that it can’t separate the U.S. from its allies.
‘They have seen what we have done in terms of sanctions, export controls, designations, vis-a-vis Russia, so it should give them some idea of the menu from which we could choose if indeed China were to provide material support,’ Sherman told a crowd at an event hosted by the group Friends of Europe…”
The specter of the U.S. and its allies imposing sanctions couldn’t come at a worse juncture for the faltering Chinese Bubble.
But, then again, such a scenario would play into the groundswell of Chinese anti-U.S. propaganda.
Beijing would be given the opportunity to blame the United States, while deflecting responsibility for gross mismanagement of its housing market, credit system and economy.
Moreover, Beijing could divert attention away from its “Covid zero” fiasco.
April 22 – Bloomberg (David Qu):
“Lockdowns in Shanghai and other cities are taking a heavy toll on activity, high-frequency indicators show.
Restrictions are helping contain the virus, but at a steep cost.
Mobility and consumption continue to drop, and job worry remains elevated.
Subway travel was 43% below the pre-pandemic level in 11 large cities, worsening by 6.5 percentage points from a week earlier.
Home sales in major cities were less than half year-earlier levels for a third straight week.
Car sales dropped for a second consecutive week by more than 50% versus pre-pandemic numbers…
The number of provinces with at-risk areas fell to 14 from 17.
Affected provinces now account for about 59% of GDP, down from 73%.”
It was an especially ominous week for China.
The Shanghai Composite dropped 3.9% this week (near lows since July 2020), boosting y-t-d losses to 15.2%.
The growth-oriented ChiNext Index sank 6.7% (down 30.9% y-t-d), trading to lows since June 2020. Chinese developer bonds were under pressure.
Evergrande yields surged 183 bps (to 109.62%), Sunac 319 bps (76.75%), Lonfor 844 bps (71.88%) and Kaisa 230 bps (76.17%).
Country Garden, China’s largest developer, saw yields jump 266 bps this week to an almost one-month high 15.51% (began 2020 at 6.6%).
An index of Chinese high-yield dollar bonds jumped over 100 bps to an April high 21.43%.
April 17 – Bloomberg:
“The Chinese Communist Party’s flagship newspaper called on the nation to support President Xi Jinping’s Covid Zero strategy, showing any shift in policy is unlikely even as lockdowns in Shanghai and elsewhere threaten to hurt the economy.
In a front-page commentary Monday, the People’s Daily said Xi’s strategy to snuff out the virus has proven ‘correct and effective’ and China should be ‘uniting more closely around the party’s leadership with Xi Jinping as the core.’
Citizens should follow the strategy ‘unswervingly and unrelentingly’ with ‘earlier, faster, stricter and more practical’ measures, it said.
‘At present, it is the most difficult critical period for epidemic prevention and control,’ the People’s Daily commentary said.
China can ‘never let the hard-earned achievements of epidemic prevention and control be wasted,’ it added.”
A Thursday Bloomberg headline: “China Stocks Plunge as Xi Offers No Respite From Covid Lockdowns.”
It increasingly appears that “Covid zero” has pushed China’s Bubble deflation past the point of no return.
And as irrational as it may appear to stick with such draconian measures even as economic activity collapses, Beijing is so deep into this policy stance that it is loath to backtrack and risk losing face.
While the Omicron wave will pass, confidence has been badly shaken – confidence in government policy, the apartment and securities markets, the jobs market and the economy more generally.
April 21 – Bloomberg:
“China’s central bank governor stressed the importance of keeping inflation under control in two separate speeches released Friday and pledged more targeted support for small businesses, reinforcing policy makers’ cautious approach to monetary stimulus.
The People’s Bank of China’s ‘policy is to maintain price stability,’ Governor Yi Gang said on a panel at the Boao Forum for Asia.
In separate comments delivered at a meeting of the International Monetary and Financial Committee, he emphasized that ‘China’s monetary policy’s primary objectives are stable prices and stable employment.’”
China’s markets had been unimpressed by all Beijing’s talk of stimulus measures.
Dismay then set in this week after the People’s Bank of China refrained from lowering rates and commencing meaningful stimulus.
Officials have every reason to worry about inflation taking hold.
Beijing now also has reason to fear for the stability of its currency, despite the Friday Bloomberg headline: “China Downplays Currency Concerns Amid Record Outflows.”
International investors have been dumping Chinese stocks and bonds.
And seeing trouble ahead, throngs of wealthy Chinese will be exploring their options.
China’s renminbi dropped a notable 2.00% against the dollar this week to an eight-month low, while the offshore renminbi lost 2.22% - the “biggest weekly depreciation since August 2015.”
Meanwhile, Chinese major bank CDS rose to - either at or near - multi-year highs. Ominously, China’s sovereign CDS jumped five to 75 bps – the high since the March 2020 pandemic spike.
The renminbi is not alone in this week’s breaking of the currency volatility dam.
The South African rand sank 6.3%, with the Colombian peso down 3.5%, the Chilean peso 2.4%, the Malaysia ringgit 2.1%, the Brazilian real 2.0%, and the Mexican peso 1.3%.
In general, the commodity currencies were under pressure.
The Australian dollar dropped 2.0%, the New Zealand dollar 1.9%, the Norwegian krone 1.6%, and the Canadian dollar 0.8%.
While we don’t want to make too much of one week’s action, the Bloomberg Commodities Index reversed 2.6% lower this week, with notable weakness in some of the more industrial-based commodities (focus shifting to China and vulnerable global Bubbles?).
Meanwhile, the global bond rout runs unabated.
EM bonds joined weak currencies, equities and CDS for what appeared a portentous week for the developing markets.
Yields were up 36 bps in Poland, 35 bps in Peru, 29 bps in the Czech Republic, 26 bps in Colombia, 24 bps in Hungary, 21 bps in Thailand and 17 bps in Brazil.
Dollar-denominated EM bonds were also under pressure.
Mexican dollar bond yields surged 33 bps (3-wk gain of 87bps) to 4.90%, the high since the March 2020 pandemic spike.
Italian 10-year yields spiked 19 bps higher to a three-year high 2.67% (up 56bps in 3wks).
Portugal yields rose 15 bps (1.99%), Spain 16 bps (1.94%), and Greece seven bps (2.98%) – all to multi-year highs.
German bund yields surged another 13 bps this week to 0.97%, the high back to September 2014.
Yields were up 16 bps (to 2.97%) in Australia, 17 bps (3.56%) in New Zealand and eight bps in Canada (2.88%).
China has its “Covid zero” fiasco.
For Japan, it’s BOJ Governor Haruhiko Kuroda’s “JGB zero.”
He’s apparently determined to just keep printing as much “money” as necessary to keep Japanese government bond yields near (25bps) zero – while global inflation and bond yields spike higher.
April 22 – Bloomberg (Toru Fujioka and Matthew Boesler):
“Governor Haruhiko Kuroda said the Bank of Japan must keep applying monetary stimulus given the more subdued inflation dynamics in the country compared with the U.S., in remarks Friday that omitted any reference to the yen’s depreciation.
‘The Bank of Japan should persistently continue with the current aggressive money easing toward achieving the price-stability target of 2% in a stable manner,” Kuroda said…
‘There is still a long way to go to achieve the 2% target in a stable manner.’”
BOJ policymaking is not confidence inspiring.
And in another facet of global market instability, the yen declined another 1.6% this week.
The yen is now down 6% over the past month and 10.4% year-to-date – to a 20-year low.
Here in the U.S., benchmark MBS yields jumped another 18 bps this week to 4.16%, the high since April 2011.
MBS yields are now up a stunning 209 bps in less than four months.
And the more hawkish the Fed’s rhetoric, the more intense the spike in market yields.
Meanwhile, conventional 30-year mortgage rates are now up 214 basis points y-t-d to the high (5.11%) since December 2009.
Each week, Credit markets are more reminiscent of 1994.
April 22 – Financial Times (Tommy Stubbington):
“Investors’ expectations for US inflation have shot to their highest level in decades even as the Federal Reserve signals an aggressive tightening of monetary policy is imminent…
A historic bond rout has intensified this week as officials from both the Fed and the European Central Bank stepped up their inflation-fighting rhetoric.
But the hawkish message has done little to arrest a rise in long-term inflation expectations, which are watched closely by central bankers concerned that they can become self-fulfilling.
The US 10-year break-even — a closely watched gauge of market inflation expectations over the next decade — climbed to 3.08% on Friday, the highest level in at least two decades.”
Are bonds more worried by inflation or the Federal Reserve’s policy shift?
The Fed is being forced to at least talk of “slamming on the brakes.”
This is anathema to highly levered speculative Bubbles and Bubble financial and economic structures.
There is increasing recognition of what a mess the Fed has made of things.
The cover of the new Economist magazine: “Why the Federal Reserve Has Made a Historic Mistake on Inflation.”
How big of a mistake are we talking about?
The Fed being slow to react to inflation over the past year?
The historic pandemic monetary response?
Or might the blunder go back further – perhaps much further?
Again, my thoughts return to pivotal year 1994 – the last real tightening cycle.
That was the year Fed rate increases unleashed powerful de-risking/deleveraging dynamics.
If not for the GSE’s $150 billion quasi-central bank “buyers of last resort” liquidity operations, there would have been major systemic issues in fledgling markets for securitizations, derivatives and “Wall Street finance,” more generally.
Instead, the GSE liquidity backstop, along with an implicit Fed promise to avoid destabilizing rate increases going forward, validated the financial system’s move to market-based finance (and away from a traditional bank-dominated Credit system).
Credit is inherently unstable.
History is unequivocal.
The nineties commenced a historic experiment in financial and monetary management.
A couple decades ago, I first posited that global finance never had operated without restraints on the quantity or quality of new Credit instruments.
There had been gold standard periods, the Bretton Woods monetary regime, and the more ad hoc dollar reserve system.
And, importantly, a history of runs and calamitous collapses ensured banks adhered to reserve and capital requirements.
This at least placed some restraint on system Credit growth.
All of this began to change during the nineties, as the Greenspan Fed accommodated a transition to Wall Street-based Credit.
Mortgage-backed securities, asset-backed securities, money market funds, and repurchase agreements all expanded rapidly outside the confines of the banking system.
Powerful non-bank Credit operators emerged – the GSEs, the Wall Street firms, and the leveraged speculating community.
These credit instruments, along with the non-bank players, created a New Financial Infrastructure that aggressively expanded Credit unrestrained by traditional reserve and capital requirements.
Historical literature examining Credit debacles often highlights the risks of “fractional reserve banking” and the bank deposit/money multiplier.
In the nineties, I began referring to the “infinite multiplier effect.”
There was effectively a new financial structure taking root – one I was convinced was highly unstable and a disaster in the making.
Several major boom and bust cycles later, there is no doubt in my mind of the magnitude of the disaster created.
From my analytical perspective, it has been the worst-case scenario to this day.
Others, living through the same booms and busts, became more confident than ever that central bankers would always do whatever it takes to ensure the cycle continued indefinitely.
At its core, a belief galvanized that the Fed was willing and able to do whatever was necessary to ensure Credit system stability – regardless of the quantity or quality of Credit creation.
It has been my view – especially after the reckless $5 TN pandemic response – that desperate policymakers were precariously exacerbating unwieldy Bubbles.
They were losing control.
And “losing control” is a proper framework for analyzing today’s extraordinary backdrop.
The Fed clearly doesn’t have control over inflation dynamics.
And being forced to shift to surging consumer and producer inflation fundamentally changes the focus of monetary management.
This effectively concludes a cycle of prioritizing loose financial conditions and a liquidity backstop that has underpinned booming markets back to the 1994 tightening experience.
The big debate today is whether the surge in yields has created buying opportunities throughout fixed-income markets.
In particular, have risk premiums widened sufficiently in MBS, ABS, and corporate debt markets?
Not with the Fed’s newfound preoccupation with inflation and the attendant fundamental shift in the risk profile of Credit.
With the Fed about to commence “QT” - and the future of QE in question - no longer can markets take liquidity for granted.
Indeed, the timing and scope of the beloved “Fed put” liquidity backstop is now uncertain.
This implies significantly higher Credit, market and economic risks.
New realities will require a major risk premium/valuation adjustment for a broad swath of Credit instruments – from MBS and consumer securitizations to corporate Credit and structured finance to municipal securities.
This adjustment has commenced, though it’s still early in the process.
That Trillions of vulnerable instruments are held in ETF and mutual fund structures adds another dimension to latent fragilities.
I can’t see how this adjustment proceeds smoothly.
A panicked run – similar to what was materializing in March 2020 – is a distinct possibility.
Credit is inherently unstable.
This has been a multi-decade experiment.
For years, markets have taken stability and the Fed’s liquidity backstop for granted.
Now the Federal Reserve - and central banks around the globe - are Losing Their Capacity to Stabilize securities and derivatives markets.
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