Liquidity Risks
Doug Nolan
For the most part, things seem to look and feel as they did during the old cycle.
Loose financial conditions persist, and securities markets remain energized.
The latest hot technology innovation has succumbed to mania and Bubble Dynamics.
And, no matter what, central bankers have everything under control.
They might talk tough on inflation, but fragilities ensure they remain primed to do whatever it takes to keep markets liquid and buoyant.
Yet this week provided a timely reminder that things have indeed changed – that there are new cycle dynamics at work.
The UK is emblematic.
June 21 – Bloomberg (Tom Rees and Philip Aldrick):
“UK inflation remained higher than expected for a fourth month, leading to a flurry of bets that the Bank of England will raise interest rates to near 6% and drive up the cost of mortgages.
The Consumer Prices Index rose 8.7% in May, the same as the month before…
Core inflation, excluding food and energy, accelerated unexpectedly to a 31-year high of 7.1%.”
June 22 – Bloomberg (Andrew Atkinson and Reed Landberg):
“British businesses said staff shortages that are forcing them to drive up wages are adding to the cost of services, underlying pressures the Bank of England wants to choke off.
S&P Global Market Intelligence said its closely watched purchasing managers survey indicated that while manufacturers are cutting the cost of goods leaving factory gates, service companies reported a steep increase in the average prices they charge.
Higher costs to employ staff are being passed on to customers, S&P said...
The findings highlight the wage-price spiral that prompted the central bank to accelerate its fight against inflation on Thursday…”
June 22 – Bloomberg (Philip Aldrick):
“The Bank of England unexpectedly raised its benchmark interest rate by a half percentage point, stepping up its fight against the worst bout of inflation since the 1980s and warning it may have to hike again.
The nine-member Monetary Policy Committee voted 7-2 for an increase to 5%, the highest level in 15 years and the biggest move since February.”
“UK National Debt Breaches 100% of GDP for First Time Since 1961.”
“Stubborn UK Inflation Triggers Mortgage Crisis for Million.”
“London Home Asking Prices Slide as Rate Rises Stretch Buyers.”
“Persistent UK Inflation Should Worry Everyone.”
It has been a long time since a major developed economy faced such a confluence of inflation, economic stagnation, and financial fragility.
After peaking at 4.65% prior to the Bank of England’s September emergency intervention, two-year UK yields were back down to 3% by mid-November.
The view, shared by markets and BOE officials, was that crisis dynamics had placed a cap on the UK rate hiking cycle.
Tightened financial conditions and recession would surely crush inflation.
This view could not have been more wrong.
With its surprise 50 bps increase to 5.0%, the BOE policy rate has now more than doubled since October to the highest level since 2008.
And, importantly, despite weak growth dynamics and heightened fragilities, there is today little confidence that inflationary pressures will dissipate – certainly not anytime soon back down to the central bank target.
UK two-year yields closed the week up another 23 bps to 5.16%, with a three-week 81 bps yield spike.
Two-year U.S. Treasury yields traded to 4.81% in Thursday trading, up about 10 bps w-t-d to the high since March 9th.
The market is now pricing a peak Fed funds rate for the November 1st FOMC meeting at 5.32% - a major repricing from about 4% in March and 4.54% on May 10th.
Ten-year Treasuries traded to 3.80% in Thursday trading, near the high since March 9th, seemingly poised for an upside breakout.
But global yields reversed sharply lower Friday on the back of weak economic data out of the Eurozone.
After trading Thursday near eight-week highs, French yields sank 15 bps to 2.88%.
It was a similar story for bunds, with German yields dropping 14 bps to 2.35%.
Yields dropped 13 bps in Italy, Portugal and Spain.
June 23 – Bloomberg (Andrew Langley):
“Economic momentum in the euro area almost came to a halt in June, signaling an end to the revival the bloc demonstrated since its winter downturn.
A purchasing managers index compiled by S&P Global… fell to a five-month low of 50.3, missing analyst estimates for a slight decline from May to 52.5.
The slump was led by France, which has been battered by strikes, though Germany’s struggling factories also played a role…
Manufacturing remained the ‘principal area of weakness’ in June, though service-sector expansion ‘slowed sharply’ as the recent bounce-back in spending lost momentum.”
June 21 – Reuters (Maria Martinez):
“The German economy will contract more than previously expected this year as sticky inflation takes its toll on private consumption, the Ifo Institute said…
‘The German economy is only very slowly working its way out of the recession,’ Ifo's head of economic forecasts, Timo Wollmershaeuser, said. German gross domestic product is expected to fall by 0.4% this year, more than the 0.1% forecast by the Ifo Institute in March.”
The euro traded above 110 to the US dollar in Thursday trading, near 15-month highs.
The yen versus the euro was at the weakest level since August 2008, while the yen traded to a record low against the Swiss franc.
The yen fell to the weakest level versus the dollar since November.
With this week’s 0.73% loss boosting y-t-d declines to 3.91%, China’s renminbi ended the week at a seven-month low.
Currency markets, especially the yen and renminbi, appear vulnerable to disorderly trading.
Not a fear in the world for equities.
The VIX (equities volatility) Index traded Thursday down to 12.73, the low since January 2020.
Persistent inflation is forcing central bankers to tighten more forcefully, risking a surge in yields and associated market and economic instability.
So, what’s keeping the VIX so depressed?
I would argue that the pandemic period fundamentally changed market perceptions and structure.
Last week’s CBB mentioned the $6 TN increase in Household liquid assets (deposits, money funds, Treasuries and Agency Securities).
Unprecedented monetary inflation, spurred by massive central bank monetization and government deficit spending, created Trillions of liquidity that still sloshes about the system.
The historic scope of policy responses took perceptions of “whatever it takes” market guarantees to a whole new level.
While concerns grew that monetary policy tightening could jeopardize the central bank liquidity backstop, those fears were quickly allayed.
The BOE in September hastily restarted QE to thwart a bond market crash, and then the Fed in March expanded its balance sheet by almost $400 billion over a few weeks to thwart a systemic run on bank deposits.
With banking system stability in the crosshairs, markets understandably assume the “Fed put” is as big and even more reliable than ever.
It is not unreasonable for the stock market to see liquidity abundance and FOMO as far as eyes can see.
In a world with such prevailing financial and economic fragilities, along with extreme geopolitical risk, we are witnessing a formidable degree of complacency.
And this is all rather old cycle.
But there are new cycle realities that markets cannot disregard forever.
For one, pricing dynamics have been structurally altered.
This is not the idiosyncratic previous cycle dynamic, where loose financial conditions and related inflationary dynamics remained conveniently contained within the asset markets.
Inflationary pressures have decisively taken root throughout the economy.
Importantly, there’s (George Soro’s) “reflexivity” at work.
Markets’ perception of liquidity abundance creates the reality of ongoing over-liquefied markets.
The Fed and global central bank community repeatedly employed progressively intrusive interventions, to the point where markets now virtually disregard the risk of a destabilizing de-risking/deleveraging episode.
The FHLB joined Fed liquidity operations this year in a momentous liquidity injection. Acute fragilities revealed within the banking system solidified confidence that the Federal Reserve would not risk the consequences – including market instability - of tighter financial conditions.
The upshot is distorted pricing and availability of derivatives risk “insurance.”
This has worked to promote risk-taking and speculative leverage, both of which have exacerbated market liquidity excess.
In particular, the Fed/FHLB market liquidity bailout came after the risk markets rally had already attained momentum.
A speculative Bubble then took hold among the big technology stocks, pushing the “A.I.” Bubble into dangerous manic excess.
As they tend to do, the liquidity injection turned self-reinforcing.
A powerful short squeeze and unwind of risk hedges stoked FOMO and performance-chasing flows into the risk markets.
And with the big tech stocks favorite derivatives targets within a marketplace enamored with options trading, the market melt-up added Trillions of market capitalization - along with enormous amounts of speculative leverage.
As an analyst of Credit and Bubbles, the first sentence from a December 6, 2022, Reuters article (Marc Jones) is etched in my memory: “Pension funds and other ‘non-bank’ financial firms have more than $80 trillion of hidden, off-balance sheet dollar debt in FX swaps, the Bank for International Settlements (BIS) said.”
It has been my view that global speculative leverage began mounting shortly after the “great financial crisis.”
Back in 2014, BofA/Merrill Lynch analysts (Ajay Singh Kapur, Ritesh Samadhiya and Umesha de Silva) published a compressive report (“Pig in a Python”) on emerging market debt and “carry trade” speculative leverage, arguing that QE had inflated dangerous Bubbles.
Their report warned of the consequences of a multi-trillion increase in EM debt and speculative leverage.
This report is now more than nine years old.
Was the analysis flawed?
Or is it more a case of major excess evolving into historic global Bubbles without precedence – EM and developed economies?
Markets readily dismiss Bubble concerns so long as liquidity remains abundant.
But what could upset the apple cart?
Disorderly currency trading would be problematic for highly levered “carry trades.”
For years, I’ve pondered how much speculative leverage has accumulated in higher yielding Chinese debt instruments.
It’s reasonable to assume that a quasi-pegged renminbi, along with faith in Beijing’s capacity to ensure stability, incentivized a protracted cycle of leveraged speculation.
And there is no doubt that the yen – and negative-yielding Japanese debt – have been a major source of cheap finance for “carry trade” leverage around the globe.
The Bank of Japan’s refusal to begin reversing one of history’s most reckless monetary experiments has been a boon to leveraged speculation and global liquidity.
A spike in bond yields would also place the global liquidity Bubble at serious risk.
September revealed how contagion from UK bond de-risking/deleveraging can reverberate globally.
Friday’s weak European data and bond rally notwithstanding, global bonds today face the reality of sticky inflation and central banks struggling to get pricing pressures under control.
Meanwhile, Bubble excess in equities and other risk markets has fueled inflation-promoting liquidity excess – certainly including embedded speculative leverage in the derivatives marketplace.
Moreover, both global policy tightening and surging yields would place the yen and BOJ under intensifying pressure.
There are various possible scenarios for a de-risking/deleveraging episode.
I can envisage one where heightened currency instability triggers the paring of risk in leveraged global “carry trades.”
Rising global yields would then pressure more generalized deleveraging and hedging, certainly including in gilts and Treasuries.
U.S. yields would be further pressured by the impending massive issuance of Treasuries to finance huge deficit spending and rebuild the government’s cash balance.
A yield surge would particularly pressure the highly elevated growth stocks.
A sharp reversal in the big tech names (and related indices) would trigger deleveraging, margin debt, but, more significantly, the enormous derivative leverage that accumulated during the speculative melt-up.
Moreover, an equities reversal would trigger a flurry of risk hedging for a marketplace likely unhedged at this point.
And the hedge funds and global leveraged speculating community, which has increasingly leaned on the long exposures for performance over recent months, would quickly move to boost shorting to rebalance exposures.
There’s certainly the possibility that weakening global dynamics in China, Europe and elsewhere can help hold bond yields in check.
At least in China, more stimulus will be forthcoming.
A downside surprise with Chinese growth would raise the odds of accelerating crisis dynamics, unleashing instability that would not be contained within China.
It has the look of a long, hot summer.
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