Battle Lines are Drawn
Doug Nolan
I might have titled this week’s CBB “Wednesday.”
But even I will (on occasion) draw a line on quirkiness.
Wednesday was another extraordinary market session - and a dramatic antithesis to the previous Thursday.
Battle Lines are Drawn.
The gains in headline and “core” CPI came in a tick below estimates at 0.2%.
CPI (y-o-y) was reported at 3.1% (estimate 3.0%), with “core” at 4.8% (vs. 5.0%).
It was like Déjà vu all over again.
Two-year Treasury yields sank as much as 16 bps to 4.71%, a full 40 bps below the intraday highs from the previous Thursday.
Ten-year Treasury yields fell 11 bps Wednesday and were down 31 bps for the week at Friday morning lows.
Yet Treasury volatility has been child’s play compared to the wild and woolly MBS marketplace.
MBS yields collapsed as much as 44 bps in Wednesday trading, and were as much as 67 bps lower than the previous Thursday’s intraday high.
MBS yields ended Wednesday’s session down 25 bps, the largest decline since the 33 bps collapse on the FOMC’s March 22nd meeting date (with the Fed focused on the banking crisis and markets interpreting Powell’s comments as suggesting a likely pause).
Friday’s 12 bps jump reduced the week’s yield decline to 38 bps, the largest drop since the banking crisis week March 17th.
Chalk one up for the “immaculate disinflation” crowd.
July 14 – Bloomberg (Anchalee Worrachate):
“The bond rally that erupted after this week’s US inflation report was the moment Wall Street veteran Bob Michele has been waiting for.
The J.P. Morgan Asset Management chief investment officer for fixed income has been gearing up for a bond rally since late last year…
He has long believed the US economy will enter a recession as the Federal Reserve went too far in raising interest rates.
So when he saw inflation in the world’s biggest economy cooled more than economists had forecast, he was convinced this was the start of a prolonged rally.
Michele… says the deeply inverted US yield curve spells trouble and the Fed will be forced to cut rates by the end of this year.
‘More and more indicators are at levels you only see in recession.
We are buying every backup in yields…
The considerable central bank tightening is starting to bite hard in the real economy.’”
I’m challenged to find significant evidence Fed policy is “starting to bite hard.”
My analytical framework prioritizes financial conditions.
Generally, tighter market liquidity conditions presage tighter lending, slower Credit growth and weakened demand.
Markets generally lead economic performance – not vice versa.
Booming markets generate self-reinforcing liquidity, loose conditions, and asset inflation, which work to bolster confidence and boost spending.
Investment-grade corporate spreads traded Thursday at the narrowest level versus Treasuries since March.
High-yield spreads traded to the lows since April 2022.
Investment-grade CDS dropped to 63 bps, the low since February 2022.
High-yield CDS sank to 410 bps Thursday, the low since pre-bank crisis February 3rd.
JPMorgan CDS traded Friday at lows since February 2022, with BofA CDS at lows since March.
Leveraged Loan prices (Morningstar Index) surged this week to highs since August 2022.
The VIX (equities volatility) traded Thursday (13.12) near the lows since pre-pandemic January 2020 (closed Friday at 13.34).
Market financial conditions have become extraordinarily loose.
The unwind of short positions continues to bolster liquidity.
Friday’s reversal halted a major run in the Goldman Sachs Short Index, with a blistering 19% gain over 13 sessions (index up 31% y-t-d).
And I’ll assume the reversal of short positions and hedges provided powerful liquidity support this week throughout Treasury and fixed-income markets (MBS!).
So, back to “Battle Lines.”
The “immaculate disinflation” crowd sees inflation on a solid trajectory to the Fed’s 2% target.
It’s back to normal after persevering through the aberrational Covid spike.
Fed policy is working it magic, as it always does.
At this point, the softest of landings is virtually assured.
And lower bond yields will underpin another leg higher for the perpetual equities bull market.
I see inflation ebbing and flowing – with much more flow than ebb over time.
But what conventional analysis sees as the previous inflation normal I view as aberrational. Inflation risk remains highly elevated in New Cycle Dynamics.
This exceptionally hot weekend will remind us of newfound climate hostilities.
And there is deglobalization, with heightened China tensions adding to trade, supply-chain and pricing uncertainties.
The bottom line is I don’t see inflation risks subsiding until financial conditions tighten.
Labor market conditions remain extraordinarily tight, which implies ongoing upward compensation pressures.
Meanwhile, American households are enjoying a windfall on returns from Trillions of cash holdings that ballooned during the pandemic.
Moreover, a decent percentage of the population is benefiting (directly or indirectly) from this year’s booming stock market.
July 14 - MarketWatch (Greg Robb):
“The University of Michigan's gauge of consumer sentiment rose to a preliminary July reading of 72.6 from a June reading of 64.4.
It is the largest gain since December 2005. Sentiment is at its highest level since September 2021.”
Inflation data notwithstanding, recent data supports the view of loose conditions and bubbling markets bolstering confidence and economic activity.
There was last week’s strong employment and services data. Tuesday’s report on NFIB Small Business Confidence was stronger-than-expected, rising to the highest level (91) since November.
The Current Economic Conditions component of the Univ. of Michigan survey posted a June/July surge of 12.6 points (to a 21-month high 77.5), the largest two-month gain since the 12.8 May/June 2020 recovery from the Covid panic (which was the largest two-month gain since 2005).
Moreover, consumer inflation expectations surprised to the upside, with one-year expectations up a tick to 3.4% and five-to-10-year expectations up a tick to 3.0%.
The rates market still prices peak fed funds for the November meeting, with the expected yield down three bps to 5.40%.
The market is pricing a 92% probability of a hike on the 26th, while the odds of an increase on September 20th dropped to 17% from last week’s 28%.
The expected policy rate at the March 2024 meeting fell 15 bps to 5.08%.
Fed officials’ (Waller, Barr, Mester, and Daly) tough talk on inflation was drowned out this week by the sound of an equities breakout.
Markets basically have the tightening cycle wrapping up this month, an assumption that finds the Fed again in a tough spot.
The Nasdaq100 enjoys a y-t-d gain of 42.3%.
The S&P500 has returned 18.4% and is only about 6% below all-time highs.
The “average stock” Value Line Arithmetic Index is up 12.2% - and less than 6% from record highs.
The iShares High Yield Corporate ETF (HYG) has returned 5.1% this year, with the iShares Investment-grade ETF (LQD) returning 3.9%.
Treasuries (TLT) have returned 3.3%.
I get it.
Stocks and bonds rally near the end of tightening cycles.
Markets would, however, traditionally commence recovery out of recession angst and debilitating bear market losses, as the system responds to nascent loosening.
The current cycle has little in common with the past.
Five hundred basis points of rate increases have neither tightened conditions nor inflicted significant pain in the markets or real economy.
Arguably, “animal spirits” are today as spirited as ever.
Inflation is a risk, though I believe it is overshadowed by myriad risks associated with ongoing Bubble excess.
The way I see it, there is way too much debt, liquidity, “money,” derivatives, hedging and speculative excess.
In short, global financial markets have become one big “Crowded Trade.”
This ensures that dysfunctional markets are incapable of orderly adjustment.
In particular, short positions (in stocks, Treasuries, MBS, ETFs, futures, etc.) are established in anticipation of weaker markets, only to be run over by an over-liquefied and highly speculative marketplace.
MBS yields spiked last week as derivatives-related selling pressured the market.
A big reversal of hedges and derivative-related short positions this week sparked a yield collapse.
There was nothing in the data the past week suggestive of economic weakening (quite the contrary).
But a tick better-than-expected CPI and vulnerable market positioning were enough to trigger a tumultuous market reversal.
I have my doubt bonds are out of the woods.
Equities have dislocated to the upside, with panic short covering, the unwind of hedges, and a flurry of FOMO speculation (stocks, ETFs and options) working to inundate the marketplace with excess liquidity.
Until proven otherwise, this should lend a vulnerable economy meaningful support.
It will extend labor market tightness, providing more time for expectations of higher compensation to become more deeply rooted.
Ironically, market expectations for slower growth and waning inflation exacerbate the loose conditions underpinning inflationary pressures.
Contemporary market structure is at the root of the problem.
This is not Paul Volcker’s financial system.
For one, Washington can run ongoing massive deficits ($1.39 TN over nine months!) with little impact on Treasury yields.
There are hundreds of Trillions of derivatives, along with a multi-trillion “leveraged speculative community.”
There is the $130 TN U.S. “Financial Sector” (from the Fed’s Z.1) – including an $8.3 TN Fed balance sheet, $9.5 TN of GSE Assets, $6.1 TN of “Fed Funds and Securities Repo,” $5.5 TN of Money Market Fund Assets, $2.7 TN of GSE MBS, and $4.8 TN of Security Broker/Dealer Assets.
Back in the nineties, as this new financial structure took hold, the Federal Reserve was blind to ramifications.
They were caught by complete surprise by the 1994 bond/derivative rout, the 1995 Mexican crisis, the 1997 SE Asia debacle, and the 1998 Russia/LTCM collapse.
The Fed's complacency shocked me throughout the 2002-2007 mortgage finance Bubble period.
At this point, the Fed and global central banking community are well-versed in the risks associated with market-based finance.
The Bank of England this week released their semi-annual Financial Stability Report.
It’s a comprehensive and analytically robust document.
And while the report focuses on UK issues, it also touches on key international risks to financial stability.
July 12 – Bloomberg (Greg Ritchie):
“A leveraged trade in US Treasury futures that has regained popularity with hedge funds poses a risk to global financial stability, according to the Bank of England.
Known as the basis trade, the strategy typically involves exploiting small price differences between cash bonds and futures, and is attracting scrutiny from US regulators…
The BOE added its voice, saying the risks associated with these trades have mostly not been tackled by regulators.
The trade is particularly risky because returns are bolstered by borrowing money in the repo market.
That tends to work well in a low volatility environment but can backfire if the market moves fast, and can even disrupt the smooth functioning of the financial system.
At the onset of the coronavirus pandemic in early 2020, as fund rushed to unwind their basis trades, liquidity dried up in Treasuries and other money markets.”
Other key risks noted in the BOE report include:
“Vulnerabilities in certain parts of market-based finance (MBF) remain.
These could crystallise in the context of the current interest rate volatility, amplifying any tightening in financial conditions.”
“Although the business models of some non-bank financial institutions (NBFIs), such as pension funds and insurance companies, mean that they can benefit from the impact of higher interest rates, the use of derivatives to hedge their interest rate exposures can create material liquidity risk.
Liquidity risks also arise when NBFIs use derivatives and repo to create leverage.
These liquidity risks must be managed, as evidenced by the LDI stress seen in September 2022.”
“The risks from higher interest rates can also be amplified by NBFIs deleveraging and rebalancing their portfolios.”
“There continues to be an urgent need to increase resilience in MBF globally.”
“The underlying vulnerabilities in the system of MBF, identified by the FPC and financial stability authorities globally, remain largely unaddressed and, absent actions to mitigate them, could rapidly resurface.”
“The FSB published Policy Proposals to Enhance Money Market Fund Resilience to address the structural vulnerabilities and ‘run risks’ associated with MMFs.
As sterling and dollar denominated MMFs are also domiciled in Luxembourg and Ireland, there is a need to ensure that MMFs globally are resilient.”
Bubbling markets readily disregard myriad stability risks.
Inflation is seen in full retreat, with policy tightening having about run its course.
Recession risks have dissipated.
It’s difficult for me to imagine a backdrop of greater stability risk.
Inflation risk remains highly elevated.
The risk of bursting financial Bubbles is extreme.
Fed rate increases have failed to tighten market conditions, with speculation and speculative leverage becoming only more acute.
And fearless markets are confident that underlying fragilities ensure central bankers won’t risk bursting Bubbles.
The Swedish krona and Norwegian krone were up 5.7% this week, the Hungarian forint 5.3%, the South African rand 4.2%, the Swiss franc 3.1%, the Malaysian ringgit 3.1%, the South Korean won 3.1%, the New Zealand dollar 2.6%, and the Japanese yen 2.5%.
It’s worth repeating that U.S. MBS yields sank 38 bps this week, after surging 31 bps the previous week.
UK 10-year yields dropped 21 bps after surging 26 bps.
Italian yields dropped 19 bps following the previous week’s 28 bps spike.
Two-year Treasury yields experienced a 50 bps swing in six sessions.
With the Dollar Index sinking 2.3%, the Bloomberg Commodities Index rallied 2.6%.
Silver surged 8.1%, and Copper rose 4.0%.
Indications of heightened instability are being masked by the upside equities market dislocation.
A monumental head fake.
Despite all the bullish enthusiasm, it appears to be an increasingly challenging environment for leveraged speculation.
Battle Lines are Drawn.
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