Junctures and New Cycles
Doug Nolan
The lazy days of such a sweltering summer are not when Wall Street would typically be on the lookout for market junctures.
Bonds might be at a one: the so-called “year of the bond” or, instead, another year of a transformative bond bear market?
August 11 – Bloomberg (Farah Elbahrawy and Greg Ritchie):
“US Treasuries are on course for a record year of inflows as investors chasing some of the highest yields in months pile into cash and bonds, according to Bank of America…
Cash funds attracted $20.5 billion and investors poured $6.9 billion into bonds in the week through August 9…
Meanwhile, US stocks had their first outflow in three weeks at $1.6 billion.
Flows into Treasuries have reached $127 billion this year, set for an annualized record of $206 billion, BofA said.”
There were good reasons for bonds to rally, including huge investment flows.
And at 3.2%, Thursday’s July headline CPI (y-o-y) was a tick better-than-expected – “smallest back-to-back gains in more than two years” – to near the lowest level since March 2021.
Ten-year Treasury yields traded at 3.97% on pleasing CPI data, the low yield for August trading.
Yields then reversed and ground higher for the remainder of the session, closing Thursday up 9.5 bps at 4.11%.
Benchmark MBS yields traded as low as 5.65% in early-Thursday trading, only to end the session up 13 bps on the day to 5.88%.
And while Friday’s July PPI came in a tenth higher-than-expected at 0.3% (up 0.8% y-o-y), the bond market should have taken some comfort from the University of Michigan’s one-year consumer inflation expectations component, reported two-tenths below the consensus estimate of 3.3% - equaling a more than two-year low.
Beyond favorable U.S. inflation data, Treasuries would have typically responded positively to heightened financial stress and weak markets in China.
In what would have been a good week for bonds turned into an uncomfortably lousy one.
Ten-year Treasury yields rose another five bps Friday, pushing the week’s gain to 12 bps (to 4.15%).
Ten-year yields are again knocking on the door of the 4.24% spike high from last October.
Things are looking even rougher in mortgage land.
Benchmark MBS’s 11 bps Friday jump boosted the week’s yield gain to a notable 23 bps.
MBS yields traded above 6% intraday Friday (closed at 5.97%), again within striking distance of the 6.10% October high.
The market’s impulse to sell the good CPI news is not confounding.
The Pollyanna “immaculate disinflation” case gets tougher going forward.
Energy prices have bounced back, with the Ukraine war and inhospitable climate elevating food price risks.
But mainly, some prices that spiked (i.e., used cars and airline tickets) have come off the boil.
Now the focus will shift to more structural issues.
For one, ongoing tight labor markets virtually ensure strong wage growth and second-round inflationary pressures.
August 9 – CNBC (Leslie Josephs):
“UPS’ CEO said drivers will average $170,000 in pay and benefits such as health care and pensions at the end of a five-year contract that the delivery giant struck with the Teamsters Union last month, averting a strike.
The tentative agreement covers some 340,000 workers at the package carrier…
‘We expect our new labor contract to be ratified in 2 weeks,” UPS CEO Carol Tomé said…
The company cut its full-year revenue and margin forecasts ‘primarily to reflect the volume impact from labor negotiations and the costs associated with the tentative agreement.’”
August 9 – Bloomberg (Michael Mackenzie):
“A closely watched bond-market gauge of expected US inflation is rising back toward a nine-year high, signaling concern the Federal Reserve may continue to wrestle with elevated price pressures for years.
Ahead of the latest monthly consumer-price index data…, a key long-term measure of where the market sees inflation heading has risen to around 2.5%, just shy of the peak in April 2022, when it reached the highest since 2014.
The upward shift in the gauge — the so-called US five-year inflation breakeven that begins in 2028 — stands in contrast to broader speculation that the Fed’s steep interest-rate hikes are set to keep reining in the biggest consumer-price surge since the 1980s.”
Meanwhile, Crisis Dynamics have gained momentum in China.
Country Garden – the former largest and “model developer” – now has a “penny stock” that traded Friday at an all-time low.
The company missed a $25 million bond payment due Monday, which starts the clock ticking on a 30-day grace period before official default.
Bond yields (2025) that were at 17% in February – after beginning 2022 below 7% - spiked Friday to a record 187% (trading at seven cents on the dollar).
With an apology, the company announced a larger-than-expected $7.6 billion first-half loss – followed soon by a three-notch Moody’s downgrade to Caa1.
From Bloomberg:
“Once considered relatively immune to the credit crunch, the Foshan-based developer has become a proxy for financial contagion in an industry that accounts for about a quarter of the country’s gross domestic product.”
With China’s system not buckling under the stress of Evergrande’s 2022 default, there is today an element of complacency in global markets.
Country Garden ended 2022 with liabilities just under $200 billion.
It is a household name in China, with more than 3000 complexes spread across the country (over half in smaller so-called “tier 3” and “tier 4” cities).
A New York Times article referenced a disparaging online conversation that attracted 100 million views.
Reuters (Alun John):
“Credit distress at Chinese private developer Country Garden is likely to spill over to the country's property and financial markets, weakening sentiment and delaying the recovery of the property sector, Moody's… said.”
To better appreciate unfolding China risks, it’s important to recognize the Ponzi Finance elements to the Chinese housing market.
Buyers of new apartments typically must provide large down payments prior to the start of construction – funds often used to complete previously sold units.
The Evergrande default sent shock-waves through housing markets, with project delays/cancelations leading to widespread public outrage and protests.
Potential buyers have backed away from the more troubled developers and the entire group of private developers, more generally, choosing instead to purchase from public and quasi-public builders.
Country Garden’s July sales were down 60% from July 2022 (75% from July 2021).
This week’s news will have a further chilling effect on company sales and housing sentiment.
So far, apartment price deflation has been relatively moderate compared to the scope of deteriorating fundamentals.
Country Garden and other private developers will increasingly resort to aggressive discounting to drive sales.
Analysts expect Country Garden to make bond payments over the next month to avoid imminent default.
But absent a Beijing bailout, prospects for recovery appear dim.
Moody’s:
“These developments would likely drive potential homebuyers away from privately owned developers to state-owned developers—if not from the property markets—in the near term.”
For years, land sales have been a major source of local government revenues, ballooning cash flows that spurred unending borrowing and spending on infrastructure and pet projects.
The apartment bust has weakened this critical revenue stream.
It appears (Ponzi-like) purchases by local government financing vehicles (LGFV) sustained this game over the past year, with LGFVs piling on more debt for land purchases that funneled cash into local government coffers.
The Country Garden solvency crisis risks accelerating the jump of Crisis Dynamics from housing to local government finance.
August 11 – Bloomberg:
“China will allow provincial-level governments to raise about 1 trillion yuan ($139bn) via bond sales to repay the debt of local-government financing vehicles and other off-balance sheet issuers, a small step toward addressing one of the biggest threats to the nation’s economy and financial stability…
The program will in effect bail out weaker issuers including LGFVs, shifting the debt burden to provincial governments instead.”
August 10 – Financial Times (Cheng Leng, Qianer Liu and Sun Yu):
“Beijing is making one of its biggest top-down efforts in years to tackle the debts racked up by local governments in a sign of authorities’ mounting concern over the risk to financial stability...
China’s State Council, the country’s cabinet, is sending teams of officials to more than 10 of the financially weakest provinces to scrutinise their books — including the liabilities of opaque off-balance sheet entities — and find ways to cut their debts…
The enormous debts accumulated by China’s provinces have become an urgent problem for policymakers as they try to end the country’s long reliance on a debt-fuelled infrastructure binge to drive economic growth.
One Goldman Sachs estimate puts the total local government debt pile at Rmb94tn ($13tn), including the liabilities of the off-balance sheet entities known as local government financing vehicles.”
Some might ponder why Beijing doesn’t just bite the bullet and commit to a $1 TN developer bailout.
Perhaps it’s because they confront a much bigger festering crisis, with $13 TN of local government debt spread across hundreds of entities – some accounted for, but much of the hidden variety.
Like the scores of stimulus measures announced over recent months, this week’s plan to transfer $139 billion of LGFV debts to the books of provincial governments is understandably viewed in the markets as a drop in the bucket.
It’s interesting to contemplate the massive $600 billion response to the “great financial crisis.”
With China’s banking system having inflated to $60 TN, even a 10-fold increase of 2009 stimulus would today provide little more than a jug of water in the bucket.
Ponzi: developer trouble curtails big consumer down payments, which spurs developer industry insolvency that ends a key source of finance for highly over-levered local governments - that places an egregiously bloated banking system in harm’s way.
The commonly cited statistic of real estate accounting for 25% of Chinese GDP surely understates the role history’s greatest apartment Bubble has played in fueling China’s Bubble Economy structure.
August 9 – Reuters (Liangping Gao and Ryan Woo):
“China's consumer sector fell into deflation and factory-gate prices extended declines in July, as the world's second-largest economy struggled to revive demand and pressure mounted on Beijing to release more direct policy stimulus.
Anxiety is rising that China is entering an era of much slower economic growth akin to the period of Japan's ‘lost decades’, which saw consumer prices and wages stagnate for a generation, a stark contrast to the rapid inflation seen elsewhere.
The consumer price index (CPI) dropped 0.3% year-on-year in July…
It was the first decline since February 2021.”
I proceed cautiously when using the “deflation” label.
After all, I’ve listened to its recurring use throughout three decades of history’s greatest Credit Bubble.
It’s a challenge analytically to suggest China is in deflation, with Aggregate Financing (China’s metric of system Credit) having expanded almost $4.5 TN, or 9.2%, over the past year – and with the M2 monetary aggregate having inflated $3.8 TN, or 10.7%, to $39.42 TN.
There’s some nuance in analyzing Chinese inflation data.
For one, some sectors (including energy) are carefully regulated when it comes to raising prices.
The rapid deterioration in Chinese corporate profits is at least partially explained by the inability to pass along rising costs.
But China clearly has massive overcapacity in some sectors, with a confluence of waning demand from an increasingly disillusioned consumer sector, collapsing investment, and waning exports depressing economic activity.
What makes China’s current predicament all the more ominous is that Bubble collapse has been proceeding despite ongoing rapid Credit growth.
Data suggest a destabilizing Chinese Credit slowdown could now be unfolding.
August Credit growth was abysmal.
The $48 billion increase in Bank Loans was the weakest since November 2009.
Aggregate Financing rose $73 billion, the smallest increase in data back to 2017.
With Consumer Loans contracting $27 billion, total Bank Loans ($48bn) were down sharply from June’s $421 billion and less than half of expectations.
The lending slowdown was broad-based.
The $33 billion gain in Corporate Loans was down from June’s $315 billion to the weakest level since October 2020.
Corporate Bond Issuance of $118 billion slowed markedly from June’s $222 billion.
We don’t want to overreact to one month of data, especially for typically weak first months of new quarters.
And while we need to be mindful of a period that includes two first months, we now have a notable four-month period of weak Credit expansion.
At $1.04 TN, four-month growth in Aggregate Financing was 23% below comparable 2022 – and was the weakest since 2019.
A 5.6% growth rate over four months reduced the one-year expansion to 9.2%, the weakest in data back to 2017.
The Shanghai Composite dropped 3.0% this week, the largest weekly drop since December.
The CSI 300 fell 3.4%.
The Hang Seng China Financials Index’s 2.1% Friday drop pushed losses for the week to 4.4%.
The renminbi lost 0.92% against the dollar (down 4.66% y-t-d) to within 0.2% of a nine-month low.
The week had a New Cycle feel.
Beijing just doesn’t have things under control as before, with the so-called “great meritocracy” struggling to come up with a comprehensive strategy to hold Bubble collapse at bay.
Patience in this piecemeal, reactionary, finger in the dyke approach seems to be wearing thin.
I have to assume the default strategy of burdening their overburdened banking system with more high-risk late-cycle loans will suffice until Xi Jinping has an epiphany (that it ain’t gonna work).
At that point, the PBOC cranks up the electronic printing press.
China sovereign CDS jumped seven this week to 62 bps, the largest weekly gain since March.
Returning to the U.S. bond market, it also felt New Cycle.
Markets are pricing in only a 12% probability of a rate increase during the Fed’s September 20th meeting, with a 36% probability of a hike by the November 1st meeting.
Fed tightening has likely concluded, according to the market.
Yet bond yields are on a commanding march higher.
Market focus has shifted from Fed policy to more fundamental concerns, including persistent inflation and endless supply.
It has all the makings of a paradigm shift after three decades, when inflation and supply could essentially be disregarded.
And it goes without saying: the previous bond market paradigm had a momentous effect on equities valuations and global asset prices generally.
The world has changed.
Covid – and the incredible monetary and fiscal pandemic responses – changed the world.
Russia’s invasion of Ukraine changed the world.
China’s pursuit of global superpower status, along with its partnership with Putin to establish a new world order, has changed the world.
Years of runaway debt growth and inflationism forever altered the world.
And now climate change is in the process of reshaping economies and societies.
And the world grew so accustomed to indiscriminately inflating the quantity of financial claims year after year – with central banks ensuring ever increasing financial asset market values.
It was never going to be sustainable.
The world is in the process of rapid and momentous change, and these changes are not constructive for financial assets.
Perhaps the bond market is signaling a new paradigm, an unfolding New Cycle and long-overdue revaluation.
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