BREAKING / CREDIT BUBBLE BULLETIN

Breaking

Doug Nolan 

Monthly non-farm payroll reports tend to be market moving. 

Released on the first Friday of the month, the data hits two weeks ahead of options expiration.

Friday’s volatility and upside reversal were not unusual. 

Especially when market instability has fueled significant hedging and bearish speculative trading, payroll data can be key. 

With large amounts of outstanding put options, bearish data can spark major selling. 

But if data is not sufficiently bearish, positioning often leads to a reversal of hedges and bearish positions. 

And with only two weeks before maturity of front-month options contracts, reversals have the potential to quickly gain momentum as traders rush to liquidate positions quickly losing market value.

I’ll assume the October 20th expiration will again see huge notional value option maturities. 

With the bond market under major selling pressure and “risk off” gaining momentum, there has surely been huge hedging activity. 

I would tend to see Friday’s reversal as a short-term technical countertrend move. 

The stronger-than-expected 336,000 gain in September payrolls was undoubtedly market bearish – though the weaker-than-expected 0.2% gain in Average Hourly Earnings provided a window for a reversal and squeeze dynamics.

Friday’s reversals don’t alter the reality that bond markets are in some serious trouble. 

Global markets were provided some relief at a critical juncture, but the reversal didn’t erase a week of losses that had traders fearing things were beginning to “break.”

October 4 – Bloomberg (Ye Xie): 

“Losses on longer-dated Treasuries are beginning to rival some of the most notorious market meltdowns in US history. 

Bonds maturing in 10 years or more have slumped 46% since peaking in March 2020… 

That’s just shy of the 49% plunge in US stocks in the aftermath of the dot-com bust at the turn of the century. 

The rout in 30-year bonds has been even worse, tumbling 53%, nearing the 57% slump in equities during the depths of the financial crisis.”

Ten-year Treasury yields traded Friday at an intraday peak of 4.89% (ended the week at 4.80%), the high since August 2007. 

The 30-year long-bond traded as high as 5.05%, breaching the 5% level for the first time since August 2007 (before closing the session at 4.97%). 

Thirty-year fixed mortgage rates jumped 18 bps last week to a 23-year high 7.53%, with a four-week gain of 39 bps.

Market probabilities for a Fed rate increase at the November 1st FOMC meeting jumped to 31% from the previous week’s 19%. 

But the probability of a hike at the December 13th meeting declined to 17% from 21%. 

So, odds for one additional rate increased only marginally, remaining near 50%.

October 6 – Bloomberg (Tracy Alloway): 

“For much of this year, credit investors have largely appeared to shrug off the sell-off in government bonds. 

While yields in the $10.6 trillion market for corporate debt have been rising alongside those on benchmark US Treasuries, spreads (or risk premiums) had remained relatively sanguine — suggesting credit investors weren’t too worried about the impact of higher rates on this supposedly rate-sensitive asset class. 

Now, as the yield on the 30-year Treasury reaches heights not seen for decades, that dynamic is changing and a major crack is beginning to emerge in the market’s facade. 

The correlation between government bond yields and credit spreads on junk-rated debt has turned positive, meaning risk premiums in corporate credit are now moving higher alongside benchmark rates.”

High-yield CDS traded Friday to 516 bps, the high since March, before reversing a notable 24 bps to end the week at 492 bps. 

High yield CDS had surged 70 bps in 13 sessions. Investment-grade CDS traded up to a four-month high of 82 bps in Friday morning trading, before ending the session at 75 bps.

October 5 – Financial Times (Owen Walker, Ian Smith, Will Louch, Josephine Cumbo, Stephen Gandel, Antoine Gara and Harriet Clarfelt): 

“A sell-off in global bond markets has pushed borrowing costs to their highest levels in a decade or more. 

That means potentially heavy losses for banks, insurers, pension funds and asset managers that own trillions of dollars of sovereign and corporate debt after loading up in recent years. 

Policymakers and investors are wary that the latest round of sharp moves could inflict severe damage on various parts of the financial system. 

‘We are watching this . . . very carefully to see if something breaks,’ said Salman Ahmed, global head of macro at Fidelity International.”

Emerging Market CDS traded Friday to a five-month high of 246 bps, before reversing sharply lower to end the week at 232 bps. 

Mexico CDS traded Wednesday to 140 bps (up from 100bps to begin September), the high since March. 

After trading as high as 137 bps in early Friday trading, Mexico CDS ended the week at 131 bps. 

Brazil CDS traded at a four-month high, with prices rising to 201 bps early Friday, only to reverse nine lower to end the week at 192 bps.

De-risking/deleveraging is hammering EM currencies. 

For the week, the Colombian peso sank 6.3%, the Mexican peso 4.1%, the Russian ruble 3.3%, the Chilean peso 3.3%, the Brazilian real 2.2%, the South African rand 2.0%, the Thai baht 1.7%, and the Indonesia rupia 1.0%.

EM bonds remain under pressure. 

Colombia yields surged 41bps (12.26%), Romania 28bps (7.16%), Peru 23bps (7.56%), and Hungary 22bps (7.63%).

The spike in EM dollar-denominated bonds runs unabated. 

Yield surges included Colombia 32 bps (8.70%), Panama 26 bps (7.13%), Saudi Arabia 20 bps (5.76%), Chile 19 bps (6.00%), Turkey 17 bps (8.87%), Indonesia 17 bps (6.02%), Brazil 16 bps (7.00%), Philippines 14 bps (5.62%), Peru 13 bps (6.20%) and Mexico 11 bps (6.56%).

One-month yield spikes include Colombia’s 90 bps, Panama’s 87bps, Chile’s 67bps, Mexico’s 66bps, Peru’s 65bps, Saudi Arabia’s 60bps, Indonesia’s 56 bps, Turkey’s 56 bps, Philippines’ 52 bps and Brazil’s 50 bps.

Global bank CDS prices also confirm escalating “risk off.” 

Goldman Sachs CDS surged 10 bps to a five-month high 104 bps, Bank of America eight to a four-month high 104 bps, Citigroup five to a five-month high 92 bps, and JPMorgan four to a four-month high 69 bps.

European banks led the global leaderboard for the week. 

Credit Suisse CDS jumped 11 bps (83bps), Dexia CDS 10 (110bps) and Banco Santander 10 CDS (110bps). 

The European (subordinated) bank debt CDS index traded up to a five-month high of 196 bps in Friday trading, before reversing sharply to close the week at 182 bps.

“Risk off” continues to pressure European peripheral bonds. 

Italian 10-year yields traded above 5% last week for the first time since 2012, with yields trading to 5.01% in Friday trading, before reversing 10 bps lower to close the week at 4.91%. 

Spanish 10-year yields traded above 4% for the first time since 2013, with Portuguese yields rising to a six-year high.

Ominously, Japanese yen trading briefly turned disorderly in Tuesday trading. 

The dollar/yen pierced the key 150 level, only to reverse violently lower to trade down to 147.43 minutes later. 

Japanese 10-year JGB yields jumped above 80 bps last week for the first time in a decade.

October 4 – Financial Times (Leo Lewis, Hudson Lockett and William Langley): 

“Japan’s central bank made unscheduled purchases of government debt on Wednesday as yields on benchmark bonds hit their highest mark in a decade, while a global market sell-off also continued to drive US Treasury yields to 16-year highs. 

The Bank of Japan offered to buy ¥675bn worth of Japanese government bonds… 

The BoJ’s offer was part of a total ¥1.9tn ($12.7bn) of JGB purchases across various maturities on Wednesday. 

The unscheduled part of the offer greatly exceeded market expectations, traders said.”

There was no trading in the onshore renminbi during the Golden Week holiday. 

The offshore renminbi declined 0.23% versus the dollar, with the Chinese currency less than 1% below multiyear lows.

Notably, China sovereign CDS surged nine to 91 bps, the high since last November. 

China bank CDS jumped to at least four-month highs.

China Construction Bank CDS rose seven to 106 bps, China Development Bank gained seven to 101 bps, Industrial and Commercial Bank rose seven to 106 bps, and Bank of China gained seven to 106 bps.

October 6 – Reuters (Albee Zhang and Zhang Yan and Kevin Yao): 

“China's foreign exchange reserves fell more than expected in September…, as the U.S. dollar rose against other major currencies. 

China's reserves - the world's largest - fell $45 billion to $3.115 trillion last month, compared with $3.13 trillion tipped by analysts in a Reuters poll, from $3.16 trillion in August.”

China’s international reserves hoard underpins key market assumptions. 

Chinese system Credit, bank loans, and M2 money supply have continued to expand at double-digit rates, despite GDP growth slowing to 5% (or less). 

Moreover, it’s classic late cycle “terminal phase” dynamics, with the runaway expansion of non-productive debt of poor and deteriorating quality.

How can Beijing direct so much risky lending and Credit growth without drawing market angst over the soundness of its Credit and banking systems, the Chinese currency, and financial stability more generally? 

Because of the perception that China’s massive international holdings provide the resources necessary in the event of a major bank recapitalization and/or problematic capital flight.

Analysts have been much too complacent. 

The exact numbers are unknown, but China has lent in size to scores of high-risk borrowers around the world (including Sri Lanka, Pakistan, Kenya, and Mongolia to name a few). 

Beijing has used reserves to capitalize and fund lending institutions that promote China’s global superpower ambitions. 

How much of their international reserves is available today is an important mystery.

Even assuming most of the $3.115 TN is available, reserve holdings have shrunk significantly compared to overall Credit and the size of China’s economy. 

For example, in 2014 – with reserves at a peak $4 TN – holdings equated to 39% of GDP and 17% of bank assets. 

Today, these ratios are down to 16% and about 5%. 

Or think of it this way: bank loans increased $1.3 TN in 2014, about a third of the $4.0 TN reserve positions. 

Bank loans expanded $3.3 TN over the past year, somewhat more than the current international holdings.

Unfolding global de-risking/deleveraging clearly has the potential to “break” things. 

Indeed, an alarming number of dominoes are today aligned. 

In currency markets, China’s renminbi, Japan’s yen, and EM currencies are vulnerable to disorderly trading. 

At Wednesday’s intraday highs, 10-year Treasury yields had spiked 30 bps from the previous Friday’s close. 

At home and abroad, bond trading is turning increasingly disorderly.

It was an ominous week - with the destabilizing trifecta of spiking Treasury (and sovereign) yields, widening Credit spreads (risk premiums), and surging CDS prices. 

The potential for an escalating war in the Middle East could further darken sentiment. 

Friday’s 3% intraday rally in the Nasdaq100 came just as the S&P500 was about to penetrate a key technical level. 

A lot is resting on the shoulders of the big technology stocks, with two weeks to go until October options expiration.

October 4 – Bloomberg (Tatiana Darie): 

“As the yen continued to weaken over the past week, hitting 150 on Tuesday, hedging costs have soared too. 

That makes US debt increasingly less attractive, posing yet another threat to plunging bonds. 

Commonly-used three-month USDJPY hedge cost for yen-based investors have now climbed to ~6%, hovering at the highest in 23 years. 

That leaves US debt from Treasuries to corporate bonds and CLOs — markets where Japanese investors have typically been big buyers — less attractive.”