Global Quagmire
Doug Nolan
The Global Bubble, several decades in the making, is in the process of bursting.
A new cycle is emerging, replete with extraordinary uncertainties.
Acute instability has become a permanent feature, at least through the cycle transition phase.
These are not statements made to be provocative, but rather to offer an analytical framework that might help us better comprehend such a complex and increasingly alarming world.
CNBC’s Steve Liesman:
“You talked about using 50 basis point rate hikes or the possibility of them in coming meetings.
Might there be something larger than 50? Is 75 or a percentage point possible?
And perhaps you could walk us through your calibration?”
Chair Powell:
“So, 75 basis point increase is not something the committee is actively considering…
Assuming that economic and financial conditions evolve in ways that are consistent with our expectations, there’s a broad sense on the committee that additional 50 bps increases should be on the table for the next couple of meetings…
We’ll be paying close attention to the incoming data and the evolving outlook, as well as to financial conditions…
So the test is really just as I laid it out, economic and financial conditions evolving broadly in line with expectations.”
The Financial Times’ Colby Smith:
“Given the expectation that inflation will remain well above the Fed's target at year end, what constitutes a neutral policy setting in terms of the Fed funds rate?
And to what extent is it appropriate for policy to move beyond that level at some point this year?”
Powell:
“So, neutral.
When we talk about the neutral rate, we’re really talking about the rate that neither pushes economic activity higher, nor slows it down.
So, it’s a concept really.
It’s not something we can identify with any precision.
So, we estimate it within broad bands of uncertainty.
And the current estimates on the Committee are sort of 2 to 3%.
And also, that’s a longer-run estimate.
That’s an estimate for an economy that’s at full employment and 2% inflation.
So really what we’re doing is we are raising rates expeditiously to the -- what we see as the broad range of plausible levels of neutral.
But we know that there’s not a bright line drawn on the road that tells us when we get there.
We’re going to be looking at financial conditions, right.
Our policy affects financial conditions and financial conditions affect the economy.
So, we’re going to be looking at the effect of our policy moves on financial conditions.
Are they tightening appropriately?”
Powell referred to “financial conditions” 17 times during his relatively short press conference.
“Nimble” made it only once, in the Chair’s opening statement.
The S&P500 rallied 3.5% during and immediately following Powell’s press conference, with the Nasdaq100 surging 4.5%.
Taking 75 bps hikes off the table was the spark, but the general tenor of the press conference was much less hawkish than markets had feared.
A Financial Times headline succinctly captured its essence: “Investors Detect Dovish Undertones to Powell’s Campaign Against Inflation.”
Powell’s neutral rate comments (“current estimates on the Committee are sort of 2 to 3%”), while open to interpretation, suggest a more measured tightening cycle than markets anticipate.
There was reference to inflation-restraining reductions in fiscal and monetary stimulus, along with continued focus on eventual supply chain normalization.
Mainly, nervous markets were comforted by the focus on “financial conditions.”
The Fed’s hawkish tightening cycle is on a Collision Course with faltering Bubbles, De-risking/Deleveraging Dynamics and serious liquidity issues.
Powell faced an extraordinary challenge in conveying to the public and Washington politicians the Fed’s focus and commitment to reining in inflation, while signaling to the markets that he is appropriately focused on unfolding market instability.
From this perspective, Powell’s preparation and performance were masterful.
Powell:
“Before I go into the details of today’s meeting, I’d like to take this opportunity to speak directly to the American people.
Inflation is much too high, and we understand the hardship it is causing, and we’re moving expeditiously to bring it back down.
We have both the tools we need and the resolve it will take to restore price stability on behalf of American families and businesses.”
With his overt opening display of hawkishness out of the way, he subtly turned his attention to vulnerable markets.
“Going to raise rates, and you’re going to be kind of inquiring how that is affecting the economy through financial conditions…”
“We need to look around and keep going if we don’t see that financial conditions have tightened adequately…”
“We just would be looking at very broad measures of financial conditions—all the different financial conditions indexes, for example—which include equity, but they also include debt and other—many other things; credit spreads, things like that too.”
As for balance sheet reduction, Powell noted this tool’s high degree of uncertainty, implying flexibility and, again, a focus on financial conditions.
Powell spurred a big equities market reversal.
Bonds mustered a gain, though the unenthusiastic four bps decline (to 2.94%) in 10-year Treasury yields was portentous.
Yields were up 16 bps to 3.10% by mid-day Thursday.
It was Bloomberg with the day’s apt headline: “Stocks Stumble as Traders Fret About Fed’s Quagmire.”
After rallying 3.0% Wednesday, the S&P500 fell 3.6% in Thursday’s rout.
With big tech in the crosshairs, the Nasdaq100 sank 5.0% Thursday, more than reversing Wednesday’s 3.4% recovery.
It was the type of volatility one might expect prior to an accident.
Importantly, De-risking/Deleveraging Dynamics attained critical momentum.
Investment-grade CDS rose five bps (largest one-day gain since June 2020) Thursday to 83 bps, the high since May 2020.
High-yields CDS surged 30 to 460 bps, the largest one-day increase in almost two years and the high since July 2020.
Bank CDS jumped to the highest levels since April 2020 pandemic instability.
JPMorgan CDS gained three to 90 bps, BofA five to 93 bps, Citigroup four to 109 bps, and Goldman Sachs four to 108 bps.
Thursday’s instability was a global phenomenon.
European Bank (subordinate debt) CDS traded above 200 bps for the first time since May 2020.
European high-yield (“crossover”) CDS surged 19 bps, the first session trading above 450 bps, also back to May 2020.
May 6 – Bloomberg (Steven Arons and Nicholas Comfort):
“European banks are counting the rising costs of Russia’s invasion of Ukraine as the war pushes up commodity prices and disrupts corporate supply chains.
Led by Societe Generale SA and UniCredit SpA, the region’s lenders have so far flagged a hit of about $9.6 billion, mostly from writing down the value of their operations in the region and setting aside money as a shield against the expected economic ramifications.”
European bank stocks (STOXX 600) dropped 3.8% this week (down 12.3% y-t-d), with Italian banks slammed 5.3% (23.2%).
Ominously, European bonds are being crushed, even while the ECB has yet to lift rates above zero.
Moreover, the prospect for Europe’s dreaded bond/bank “doom loop” (vulnerable banks levered in sinking bond portfolios) has become only more troubling with the war in Ukraine taking a chunk out of precious European bank capital (while elevating stagflation and geopolitical risks).
Highly levered European “periphery” bond markets were hit by major liquidations this week.
Italian yields spiked 36 bps (6-wk gain 104bps) to 3.14%, the high since December 2018.
Greek 10-year bond yields surged another 23 bps (6-wk gain 90bps) to a (excluding the March 2020 spike to 3.67%) three-year high 3.56%.
Moreover, susceptible Spain and Portugal joined the bond rout.
Spanish yields jumped 26 bps (2.24%) and Portuguese yields surged 25 bps (2.27%) – both ending the week with yields near seven-year highs.
I can’t recall a serious global “risk off” session of equities, corporate Credit, CDS, European periphery bonds, and “developing” market stress that didn’t spur at least a modicum of a safe haven Treasury market bid.
Corroborating the New Cycle Thesis, 10-year Treasury yields surged 12 bps on “risk off” Thursday, trading above 3.10% for the first time since November 2018 (ending the week at 3.13%).
Symptomatic of deleveraging and resulting systemic global market stress, “developing” markets were under pressure this week.
Local currency yields were up 59 bps in Romania (decade high 7.65%), 39 bps in Poland (7-yr high 6.88%), 38 bps in Peru (13-yr high 8.27%), 36 bps in Hungary (9-yr high 7.21%), 33 bps in India (3-yr high 7.45%), 31 bps in the Czech Republic (12-yr high 4.41%), 25 bps in Colombia (12-yr high 10.65%), 23 bps in Brazil (6-yr high 12.69%), and 22 bps in Slovakia (8-yr high 1.93%).
Dollar-denominated EM bonds were anything but immune to intensifying de-leveraging contagion.
Yields were up 51 bps in Turkey (9.01%), 27 bps in Saudi Arabia (3.97%), 22 bps in Indonesia (4.02%), and 12 bps in the Philippines (4.00%).
EM CDS rose 15 bps this week to a seven-week high 285 bps (began 2022 at 187bps).
There was an additional noteworthy dynamic from Thursday’s session.
As “risk off” gathered momentum across markets during the U.S. session, selling accelerated in the offshore renminbi (CNH).
CNH had gained on Powell’s relief rally, but then sank about 1% Thursday.
Selling continued into Friday’s session, with the dollar/CNH trading above 7.72 for the first time since November 2020.
The CNH’s 1.2% decline for the week pushed y-t-d loss to 5.4%.
To observe CNH selling so directly correlated with U.S. “risk off” supports the analysis of global market vulnerability to the unwind of speculative leverage in Chinese securities.
Ominously, China sovereign CDS jumped 6.5 this week to 83 bps.
Outside the multi-day March 2020 pandemic spike to 91 bps, China sovereign CDS has not been higher since February 2017.
Despite a chorus of Beijing assurances, the erstwhile Pavlovian Chinese market recovery has gone MIA.
The Shanghai Composite’s 1.5% decline boosted y-t-d losses to 17.5%.
Down another 3.2%, the growth-oriented ChiNext Index has a 2022 loss of 32.4%.
Chinese developer and other high-yield bonds remain under pressure.
May 5 – Bloomberg:
“China’s top leaders warned against questioning Xi Jinping’s Covid Zero strategy, as pressure builds to relax virus curbs and protect the economic growth that has long been a source of Communist Party strength.
The Politburo’s supreme Standing Committee pledged… during a meeting led by Xi to ‘fight against any speech that distorts, questions or rejects our country’s Covid-control policy,’ state broadcaster China Central Television said.
The body reaffirmed its support for the lockdown-dependent approach, saying China had made progress toward overcoming its worst outbreak since the first wave in Wuhan two years ago.
‘Our pandemic prevention-and-control strategy is determined by the party’s nature and principles,’ the seven-member committee said, according to CCTV.
‘Our policy can stand the test of history, and our measures are scientific and effective.’”
China’s historic apartment Bubble is bursting, the Chinese Bubble Economy is faltering, and “Covid zero” is right there nudging things over the cliff.
Beijing’s response is anything but confidence inspiring.
Kooky.
And with the confluence of a deflating Bubble and the villainous Putin/Xi bromance, expect more discussion of whether China is at this point even “investible.”
For now, it was another week where it was rational to question whether Beijing can maintain currency stability.
If there is anywhere near the amount of speculative leverage (including levered “carry trades”) in China as I suspect, we’re now officially on Chinese Dislocation Watch.
The Fed’s “US Marketable Securities Held in Custody for Foreign Official & International Accounts” sank $36.1 billion this past week, the biggest decline since the market panic in late March 2020.
There’s a crucial global “doom loop” dynamic to ponder.
When global de-risking/deleveraging gains momentum, currency weakness motivates EM central bankers to liquidate Treasury holdings for funds to support their local currencies (accommodating “hot money” outflows).
And as this selling contributes to higher Treasury and, accordingly, global yields, there is further pressure on “carry trades” and other levered speculations.
It’s a bad cycle of broad-based market weakness, currency instability, Treasury selling and illiquidity.
The tightening of global financial conditions has accelerated.
May 3 – Reuters (Selcuk Gokoluk):
“Emerging-market debt sales slumped to their lowest level for the month of April in a decade…
Developing-nation governments and companies raised $30.6 billion of bonds in dollars or euros in April, a 48% decline from the same month a year ago…
Issuance for the period dropped to its lowest level since 2012…
The average yield on dollar debt exceeded 6.3% on May 2 to hit the highest level in two years, making borrowing prohibitively expensive for junk-rated issuers from emerging markets…
Meanwhile, global emerging-market debt funds suffered their largest outflow since April 2020 in the week ending April 27, with investors pulling almost $4 billion, according to a Bank of America Merrill Lynch report…
Outflows in the year to date reached $18.7 billion…”
May 2 – Bloomberg (Michael MacKenzie and Chikako Mogi):
“In times of Treasury turmoil, the biggest investor outside American soil has historically lent a helping hand.
Not this time round. Japanese institutional managers -- known for their legendary U.S. debt buying sprees in recent decades -- are now fueling the great bond selloff, just as the Federal Reserve pares its $9 trillion balance sheet.
Estimates from BMO Capital Markets based on the most recent data show the largest overseas holder of Treasuries has offloaded almost $60 billion over the past three months.
While that may be small change relative to the Japan’s $1.3 trillion stockpile, the divestment threatens to grow.”
There are dynamics at play that have fundamentally altered global demand for Treasuries.
My confidence that we’re witnessing a fundamental secular shift will be further solidified with confirmation that the Chinese have begun shaving Treasury holdings.
April 30 – Financial Times (Sun Yu):
“Chinese regulators have held an emergency meeting with domestic and foreign banks to discuss how they could protect the country’s overseas assets from US-led sanctions similar to those imposed on Russia for its invasion of Ukraine, according to people familiar...
Officials are worried the same measures could be taken against Beijing in the event of a regional military conflict or other crisis.
President Xi Jinping’s administration has maintained staunch support for Vladimir Putin throughout the crisis but Chinese banks and companies remain wary of transacting any business with Russian entities that could trigger US sanctions.
The internal conference, held on April 22, included officials from China’s central bank and finance ministry, as well as executives from dozens of local and international lenders such as HSBC...
Senior regulators including Yi Huiman, chairman of the China Securities Regulatory Commission, and Xiao Gang, who headed the CSRC from 2013 to 2016, asked bankers in attendance what could be done to protect the nation’s overseas assets, especially its $3.2tn in foreign reserves.
China’s vast dollar-denominated holdings range from more than $1tn US Treasury bonds to New York office buildings.”
For decades, the U.S. financial system could expand Credit without constraint or worry.
Massive trade and Current Account deficits would flood the world with dollar balances that would simply be recycled back into Treasuries and U.S. securities.
For the most part, the greatest inflationary manifestations remained comfortably within the confines of the securities and asset markets.
Finance would run absolutely wild, while the Fed monkey with conventional central bank doctrine.
Somehow, the Federal Reserve became fixated on inflating CPI up to its 2% target, even as central bank balance sheets and Monetary Disorder ran completely out of control – leveraged speculation, manias and shenanigans aplenty.
Arguably, no sector lavished in monetary excess with such flagrance as the indomitable tech sector.
More evidence this week of serious leakage from a historic Bubble.
Get ready for one brutal and protracted bear market.
Losses will be unprecedented.
May 4 – Financial Times (Robin Wigglesworth):
“Back in the halcyon days of… early 2021, it looked like venture capital was the hottest game in town.
Hedge funds were piling in.
Even private equity firms were getting involved in early-stage company investing.
Investors loved the combination of fat returns and the lack of volatility in private markets.
But the VC cycle now looks like it has hit a sudden stop.
Refinitiv’s venture capital index, which uses the performance of individual VC portfolios and listed stocks to mimic the performance of the broader industry, tanked another 24.2% in April, taking its 2022 loss to a comically bad 45.8% (NB, the Nasdaq is ‘only’ down 19.7% YTD).
That is comfortably its worst monthly performance since worst of the dotcom bust two decades ago.
Of course, a lot of venture capital funds are unlikely to be marking down their books to anywhere near these levels.”
The short half-life of Powell’s Wednesday rally speaks volumes.
Equities players (especially those loaded with tech stocks) were relieved by Powell’s subtle lean dovish.
Meanwhile, bonds want nothing to do with it – not with inflation dynamics now deeply entrenched.
And there have already been Fed officials (current and former) pushing back against Wednesday’s Powell Show (i.e. “Fed’s Barkin Declines to Take 75 bps off the Table”).
A divided Fed will only exacerbate uncertainties.
Our system faces a serious inflation problem.
At the same time, Market Structure and systemic fragilities simply will not tolerate a significant tightening cycle.
It is a Quagmire.
The writing’s on the wall: faltering markets will spur a major tightening of financial conditions, while consumer inflation remains elevated.
Back to the faltering global Bubble.
It is in reality myriad interrelated Bubbles, conjoined through global networks of financial institutions, leveraged speculation, market structures and derivatives.
China, U.S. securities and assets, European periphery bonds, global tech, and EM.
Basically, it all ripened into One Big Crowded Trade.
And as the Crowd heads for the exits, there’s no one with sufficient liquidity outside of global central bank balance sheets.
There are today similarities to previous serious “risk off” episodes that almost brought down the global financial system.
There are key differences: Global Bubbles are today much grander and interconnected; the world’s financial and economic structures are splintering; inflation has become a serious global issue; and the Fed and global central bank community’s liquidity backstop is problematic like never before.
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