Putin & The Vigilantes
Doug Nolan
It really got going Tuesday.
Chinese “big four” bank CDS each surged about 10 bps, the largest single-session gains since the July 15th peak “risk off.”
Heightened risk aversion was not limited to Chinese banks.
European bank CDS shot higher, with (subordinate) bank debt CDS jumping 19 bps (largest move since July).
UK banks Barclays (123bps) and Natwest (115bps) saw CDS prices jump 16 bps.
Credit Suisse CDS rose 10 bps, Commerzbank eight (118bps), Deutsche Bank eight (137bps) and UBS eight (89bps).
US banks were certainly not immune.
JPMorgan CDS rose five (92bps) Tuesday, Citigroup six (108bps), Goldman five (113bps) and Morgan Stanley five (106bps)
The dollar index gained 0.6% Tuesday, trading back above 110.
EM currencies were under pressure, with the Polish zloty, Chilean peso, Hungarian forint and Czech koruna all down about 1%.
More notably, currency markets were on edge for central bank intervention.
The Bank of Korea had moved to prop up the won, while Japanese officials’ intervention warnings had reached a fever’s pitch.
Meanwhile, the People’s Bank of China was clearly struggling with its own efforts to maintain currency stability.
September 19 – Bloomberg:
“The yuan fell, an indication that China’s latest attempts to beef up the currency with a record pushback in the reference rate and verbal warnings is barely holding back a selling wave.
The People’s Bank of China fixed the yuan at 6.9396 per dollar, 647 pips stronger than the average estimate in a Bloomberg survey of analysts and traders, the widest difference on record since Bloomberg started the survey in 2018.
The onshore yuan dropped as much as 0.6% Monday even after state media cited the regulator as saying last week companies shouldn’t bet on the direction and extent of currency moves.”
Global bond markets also showed heightened instability.
Ten-year yields shot up 10 or 11 bps Tuesday in Italy and throughout European peripheral bond markets, with bund yields up 12 bps to a nine-year high (1.92%).
Treasury yields also traded up Tuesday to multi-year highs.
Such big moves, especially in bank CDS, usually have a relatively clear catalyst.
It was unclear what was behind market instability.
Sweden’s Riksbank surprised markets with a 100 bps hike – “its most aggressive tightening in almost three decades” (Bloomberg), following the largest y-o-y inflation (9%) in 30 years.
Importantly, the Swedish krona sank 1.1% for the session (4.9% for the week!) despite the forceful hike.
It was another indication of acute currency market vulnerability and waning central bank control.
A crucial week for global central bankers got off to an ominous start.
Also Tuesday, Japan reported its strongest CPI reading (2.8%) since 2014, with goods prices up 5.7% y-o-y.
In an escalating battle with the markets, the Bank of Japan moved forward with “more aggressive and unscheduled” bond buying.
Adding to the chorus of hawkish central banks, the Bank of Canada stated it would take “whatever actions” necessary to curb inflation.
I tend to separate market-related analysis from geopolitical, often placing the latter nearer the end.
But when searching for catalysts for Tuesday’s market moves, the most consequential news of the day was out of Russia.
September 20 – Wall Street Journal (van Gershkovich, Matthew Luxmoore and Mauro Orru):
“Officials in Russian-occupied parts of Ukraine announced plans for Russia to annex four regions in the country's east and south, while Moscow moved to clear the way for a broader mobilization as an increasingly pressured Kremlin seeks a firm response to counter Kyiv's offensive.
Russian-controlled parts of the Donetsk, Luhansk, Kherson and Zaporizhzhia regions of Ukraine said they would hold three-day votes on joining Russia starting this Friday, Moscow's latest effort to consolidate its hold on territory it took months to capture but now risks losing to Ukraine's forces.
A Kyiv offensive in the annexed areas would allow Russia to claim an attack against its own territory, raising the threat of an escalation in the conflict.
Russia's lower house of parliament also approved legislation that could help address its shortage of troops on the battlefield, raising fears that it could announce a full-scale mobilization possibly within days.”
Russia media were prepared for a Tuesday evening Putin speech, though what was assumed would be a major announcement did not materialize.
A Russian commentator was quoted: “The longer the announced appearance of President Putin is delayed, the more serious the announcements in it will be.”
And from the New York Times (Anton Troianovski):
“The Kremlin signaled that if Russia were to go forward with annexation — even if no other countries recognized it — any further military action by Ukraine in those regions could be seen as an attack on Russia itself, justifying any military response by the nation with the world’s largest nuclear arsenal.
‘Encroaching on the territory of Russia is a crime, the commission of which allows you to use all the forces of self-defense,’ Dmitri A. Medvedev, the former Russian president and the vice chairman of Mr. Putin’s Security Council, wrote…Tuesday, describing the referendums as having ‘huge significance.’”
Putin’s address to Russia and the world came Wednesday.
September 21 – Financial Times (Max Seddon and Polina Ivanova):
“As he addressed the nation on Wednesday morning to announce a ‘partial mobilisation’ of 300,000 reservists, president Vladimir Putin framed Russia’s war in Ukraine in stark, existential terms.
The nation was defending itself against a west that wanted to ‘weaken, divide and destroy Russia’ and it was prepared to use nuclear weapons in response.
The apocalyptic threats are intended to coerce Ukraine and its western allies to accept Russia’s gains in the conflict.
The hasty staging of ‘referendums’ in occupied areas this weekend is supposed to set a line that Ukraine and the west must not cross.
By in effect annexing large parts of southern and eastern Ukraine, Putin wants to dissuade Kyiv and its western allies from attacking what the Kremlin now considers ‘Russian territory’ — laying the groundwork for full mobilisation or even nuclear conflict if they persist.
Putin’s escalation is a gamble that underscores his shrinking room for manoeuvre on the battlefield in Ukraine and domestically in Russia.
‘The whole world should be praying for Russia’s victory, because there are only two ways this can end: either Russia wins, or a nuclear apocalypse,’ Konstantin Malofeyev, a nationalist Russian tycoon, said…
‘If we don’t win, we will have to use nuclear weapons, because we can’t lose…
Does anyone really think Russia will accept defeat and not use its nuclear arsenal?’”
Understandably, the main focus for the week was on a slew of central bank tightening measures.
But Putin’s speech marked an alarming ratcheting up of geopolitical risk.
It essentially guarantees months of Putin hardball and associated uncertainty.
Russia appears poised to further tighten the screws on European gas supplies into the winter.
And while it has become easy to dismiss Putin’s nuclear bluster, I’ll assume he’s prepared to make things more difficult.
After sham referendums, Russia will annex the four Ukrainian regions.
Putin could then threaten the use of tactical nukes to counter Ukrainian attacks (with U.S. weaponry) on the newly enlarged mother Russia.
The Ukrainian military has momentum on its side and has every reason to refuse conceding territory to Putin.
Putin has the potential to significantly boost his forces and firepower.
He has nuclear weapons, both tactical and conventional. Is the world witnessing an unfolding nuclear standoff?
And will Putin set his sights back on Kiev?
The likelihood of this terrible war taking another terrible turn increased this week.
Might a major Russian escalation spur even more onerous Western sanctions?
Could Putin shut all gas flowing into Europe?
Would Ukrainian wheat exports be in jeopardy (wheat up 2.4% this week in the face of a commodities tailspin).
And in such a scenario, would Russia’s “partner without limits” be called upon for financial, economic and even military support?
The bottom line: an unhinged Putin comes with the highest risks imaginable.
Irrespective of a cornered Putin, global market risks are about the most extreme one could imagine.
And I’m not even sure Jerome Powell would make my top ten list of reasons behind this week’s global market rout.
Powell’s press conference was firm but measured, even mentioning the Fed’s focus on financial conditions and the possibility of smaller rate increases and even a pause.
The S&P500 popped to an almost 1% gain during his press conference, before selling resumed into the close.
Meanwhile, global currency markets have dislocated, creating a huge predicament for the global leveraged speculating community.
Despite repeated Beijing efforts to bolster the sagging renminbi, China’s currency declined another 2% this week (down 10.8% y-t-d).
Everything points to rapidly escalating systemic risks in China.
China Construction Bank CDS surged a notable 32 this week to 127 bps, the high in data back to 2019 (and up from 37bps in early-2021) and more than 50% above the March 2020 peak.
Industrial & Commercial Bank of China (ICBC) CDS jumped 25 to 116 bps – the high in data back to 2017.
For perspective, ICBC CDS traded at 33 bps in early 2021, after spiking to a high of 72 bps during the 2020 pandemic panic.
Bank of China CDS rose 26 to 120 bps, the high since 2014.
And China Development Bank CDS jumped 24 to a five-year high 110 bps.
China sovereign CDS surged an ominous 27 this week to surpass 100 bps (101.3) for the first time since 2017.
Underscoring the degree of current instability, it was the largest weekly advance in China CDS since the global crisis backdrop in September 2011.
Especially with global markets dislocating, a run on the renminbi and crisis of confidence in the $53 TN Chinese banking system is no longer far-fetched.
Meanwhile, an accident in Japan seems inevitable.
September 22 – Financial Times (Kana Inagaki and Leo Lewis): “Japan intervened to strengthen the yen for the first time since the late 1990s on Thursday, after the currency tumbled to a 24-year low on pledges by the central bank to stick with its ultra-loose policy.
Masato Kanda, the country’s top currency official, said the government had ‘taken decisive action’ to address what it warned was a ‘rapid and one-sided’ move in the foreign exchange market…
Shunichi Suzuki, finance minister, declined to comment on the scale of the intervention…
‘It’s the next logical step of the psychological game the Japanese are trying to play here.
The yen was heading very steeply to 146, and the [Japanese authorities] had to get a message out quickly.
I think the idea is to plant the idea in the market that this is their line in the sand,’ said one Tokyo-based trader.”
Despite the first currency intervention since 1998, the Japanese yen posted another weekly loss (0.3%).
Why can’t I shake this nagging feeling their weak currency is not Japan’s greatest risk?
Each passing week of spiking global yields finds the BOJ’s 25 bps bond yield ceiling more untenable.
All the components of a major market dislocation are evident and seemingly poised to erupt.
And erupt they did in the UK this week.
At least from a financial markets standpoint, the sudden appearance of the Bond Vigilantes in the gilts markets (after all these years) was the most portentous market development in a week of portentous developments.
September 23 – Financial Times (Tommy Stubbington and Nikou Asgari):
“UK government bonds sold off sharply, and the pound hit a new 37-year low against the dollar as investors worried that Kwasi Kwarteng’s tax cuts and energy subsidies would place Britain on an ‘unstable’ fiscal trajectory.
Long-term borrowing costs surged in one of the biggest weekly increases on record, with one investor describing Kwarteng’s plan as a ‘radical economic gamble’.
Sterling fell on Friday below $1.10 for the first time since 1985, while the FTSE 100 share index slid 2.3%.”
“Sold off sharply” does not do justice to what transpired in the UK government debt market.
Ten-year UK “gilt” yields jumped 33 bps Friday and an alarming 69 bps for the week – to the highest yields since 2010.
Amazingly, two-year UK yields spiked 44 bps Friday and 81 bps for the week (to 3.93%).
UK government officials must be asking, “what the hell was that all about?”
After all, didn’t markets relish tax cuts and additional deficit spending?
The arrival of the Vigilantes confirms New Cycle Dynamics.
Deficits now matter, Current Account Deficits now matter – traditional fundamentals matter, and governments had better get used to it.
Two-year Treasury yields surged 34 bps this week to 4.21%.
German two-year yields spiked 38 bps to 1.90%, the high back to December 2008.
Keep in mind that the German two-year traded at negative 0.74% as recently as six months ago.
They traded at 26 bps to end July.
Two-year yields surged 38 bps this week in France (1.84%), 38 bps in Spain (2.14%), 43 bps in Italy (3.04%), 50 bps in Portugal (1.94%), and 27 bps in Switzerland (1.33%).
Seeing spiking developed sovereign yields in the face of “risk off” market instability – especially at the front-end (shorter maturities) of the yield curve – is taking some getting used to.
And I suspect it has more to do with de-risking/deleveraging than expectations for more aggressive rate hike cycles.
Huge amounts of leverage likely accumulated in short-dated sovereign debt.
After all, in a world of fragile Bubble markets, central bankers wouldn’t actually aggressively raise rates and risk financial meltdown, would they?
I wouldn’t be surprised if we’re in the throes of major speculator losses and derivatives blow-ups.
And this is where things turn messy.
September 23 – Bloomberg (David Goodman):
“The Bank of England needs to unleash a sizable interest rate hike outside of its normal decision-making cycle in the wake of ‘historical drops’ in the pound and gilts, according to George Saravelos, global head of foreign exchange research at Deutsche Bank AG… Saravelos said the extraordinary step is needed to calm the markets.
The view is his own, rather than the view of Deutsche Bank economists.
‘The market is giving very strong signals that it is no longer willing to fund the UK’s external deficit position at the current configuration of UK real yields and exchange rate,’ Saravelos wrote.
‘The policy response required to what is going on is clear: a large, inter meeting rate hike from the Bank of England as soon as next week to regain credibility with the market.’”
For almost three decades, the policy response to market instability was unambiguous and predictable: lower rates, or at least a signal looser “money” was available as needed.
Conceptually, I understand the impetus to aggressively hike rates to stabilize a nation’s currency and keep inflation expectations in check.
Huge hikes in the face of acute debt market de-leveraging would be a novel approach - with a clear risk of sparking panic and market collapse.
Is it feed a cold and starve a fever – or vice versa?
We’ll assume a full-fledged bout of de-risking/deleveraging has been unleashed.
And analysts will debate whether more aggressive tightening is required to calm currency markets and inflation fears, or rather how central bankers have overdone it and will soon shift to dovish pivots.
Importantly, we’ve reached a critical juncture with respect to the New Cycle Thesis: It’s unclear to central bankers what the best course of action is to counter acute market instability.
Continue with the inflation fight to ensure price pressures are reined in.
Or must they immediately turn their attention to rapidly escalating financial crisis risks and illiquid markets?
The Bank of England is today surely not contemplating another big QE program to hold crisis dynamics at bay.
And it’s unclear whether the Fed, ECB, or other central banks are prepared to abruptly shift course and orchestrate another concerted QE program to reliquefy liquidity-challenged global markets.
And this is a huge issue.
The world could now be in the early stage of history’s greatest globalized de-risking/deleveraging cycle - and a global central bank liquidity backstop is not a policy focus.
Global markets were back to the precipice this week.
While scary, the alarm bells aren’t blaring yet.
After all, the precipice provided nice short-term buying opportunities both in June and July.
It’s Pavlovian: The precipice is time for a short squeeze and to force the unwind of risk hedges.
And that game works until it doesn’t.
It certainly doesn’t work as well as it used to, back when the precipice ensured central bank dovish pivots.
Global markets are to the point where I don’t know how many more treks there are to the precipice – without tumbling off the cliff.
The UK is certainly not the only country with exorbitant debt and fiscal deficits.
When it comes to spendthrift governments in desperate need of market discipline, the world is the Vigilantes’ oyster.
Not sure why they’d stop with the UK. More likely, we should be prepared for Vigilante contagion.
And these Vigilantes could change everything.
They certainly make life more difficult for the leveraged speculators, which implies persistence market liquidity challenges.
Does leverage even work in fixed-income these days?
If not, what is the scope of de-leveraging necessary to adjust to new market and policymaking realities?
JPMorgan CDS surged 17 this week to 105 bps, the high since the March 2020 panic, and the largest weekly move since June 2020.
Citigroup CDS surged 21 to 123 bps, Goldman 21 to 130 bps, and Morgan Stanley 21 to 123 bps – all three the largest weekly moves since March 2020.
It was curious to see the big U.S. banks at the top of this week’s CDS leaderboard.
I suspect we might be at the initial phase of serious derivatives market issues.
The mighty global derivatives complex operates on the assumption of liquid and continuous market.
So last cycle.
These days, it doesn’t take a crystal ball to see an illiquid and discontinuous world.
And it’s a challenge to imagine a combination more potentially destabilizing than Putin and the Vigilantes.
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