Issues 2024
Doug Nolan
As my thoughts turned this week to “Issues 2024,” my mind returned to the great American economist Hyman Minsky (1919-1996).
The dynamic evolution of Capitalistic systems, innovation and financial structures, the “Financial Instability Hypothesis,” “Ponzi finance”, “stability is destabilizing”…
No economist’s work is more germane to Issues 2024 than the brilliant Minsky.
Minsky theorized that U.S. Capitalism had evolved through four distinct stages:
“Commercial Capitalism,” “Finance Capitalism”, “Managerial Capitalism”, and “Money Manager Capitalism.”
“The financial structure of the American economy has undergone significant evolution over the history of the republic.
In the initial era of commercial capitalism, external finance was used primarily to facilitate commerce by financing goods in process or in transit.
The present period, in contrast, is one of money-manager capitalism, where financial markets and arrangements are dominated by institutional investors.”
Hyman Minsky, “Economic Insecurity and the Institutional Prerequisites for Successful Capitalism,” Journal of Post Keynesian Economics, Winter 1996/97
Five years after Minsky’s 1996 passing, I humbly “updated” Minskian analysis to incorporate a fifth stage, “Financial Arbitrage Capitalism”.
The rapid rise of the levered speculator community had superseded more traditional money management – for its impact on market function, policymaking, and economic development.
In short, financial and economic systems had become more levered and fragile, provoking an even greater interventionist and inflationist policy regime.
The hedge fund industry had surpassed $500 billion by 2001, up from about $35 billion to begin the nineties.
Speculative leverage had become both a major force in market behavior and a powerful source of liquidity for U.S. economic development.
In particular, the leveraging of mortgage Credit was instrumental in the fledgling mortgage finance Bubble and associated real estate boom.
Speculative leverage/financial arbitrage had become a major force in shaping both U.S. financial and economic structure.
After ending 2001 at $7.45 TN, total mortgage Credit would almost double in six years to close 2007 at $14.61 TN.
More pertinent to Issues 2024, Treasury Securities expanded 45% in six years to $8.028 TN – only then to balloon another $22.22 TN, or 276%, to end Q3 2023 at $30.27 TN.
“It should be noted that the stabilizing effect of big government has destabilizing implications in that once borrowers and lenders recognize that the downside instability of profits has decreased there will be an increase in the willingness and ability of business and bankers to debt-finance.
If the cash flows to validate debt are virtually guaranteed by the profit implications of big government, then debt-financing of positions in capital assets is encouraged.”
- Minsky, “Inflation Recession and Economic Policy,” 1982.
“Big government” today includes $2 TN annual fiscal deficits and a central bank with a now long history of market bailouts and open-ended “money” printing (including $5 TN covid stimulus) and liquidity backstopping operations.
As for profits, we can think of real economic profits, as well as speculative profits in the asset markets.
Big government’s unprecedented measures to inflate both types of profits have for years incentivized risk-taking and leveraging.
A paramount Issue 2024 could be presented simplistically: History’s greatest Bubble either inflates or bursts.
As I wrote one year ago, “last year’s Bubble inflation went to perilous extremes.
This significantly raised the odds for a destabilizing 2022 bursting episode.”
The bottom line: Bubble excess went from “perilous extremes” to precarious “terminal phase” blow-off excess.
Highly speculative markets suffered upside dislocations, the type of end-of-cycle dysfunction that has preceded major market collapses (i.e., 1929).
Simplistic analysis does not suffice in today’s extraordinarily complex environment.
Not after a spectacular “everything short squeeze” and such systemic market dysfunction.
Not in the 16th year of a historic global government finance Bubble.
Not after two decades of Financial Arbitrage Capitalism severely disfiguring financial and economic structures.
Not with a multi-decade super cycle in transition.
That finance and financial structures evolve from robustness to progressively more fragility is the foundation of Minsky’s Financial Instability Hypothesis.
“Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified.
Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows…
Speculative finance units are units that can meet their payment commitments on ‘income account’ on their liabilities, even as they cannot repay the principle out of income cash flows.
Such units need to "roll over" their liabilities…
For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations.
Such units can sell assets or borrow.”
Minsky, The Financial Instability Hypothesis, 1992
“Ponzi financing units cannot carry on too long.
Feedbacks from revealed financial weakness of some units affect the willingness of bankers and businessmen to debt finance a wide variety of organizations.”
Speculative leverage by its nature resides in the domain of Minsky’s Ponzi finance.
Liabilities are extinguished through the sale of levered holdings, with inherent liquidity risk and fragility.
To be sure, from such a prolonged period of Financial Arbitrage Capitalism and speculative leveraging, we have witnessed the most atypically enduring Ponzi financing.
Minsky surely never contemplated a $1 TN “basis trade,” a $4 TN hedge fund industry, a $9 TN Fed balance sheet, or $34 TN of Treasury debt obligations.
It is critical to appreciate the forces perpetuating what in any other backdrop would have been unsustainable Ponzi dynamics and acute fragility.
This is where we must focus on anomalous government finance Bubble dynamics.
Government debt and central bank Credit, the core of money and Credit and finance more generally, enjoy unique attributes of moneyness.
Perceived safety and liquidity attributes ensure uniquely insatiable demand for these liabilities.
Melding with Minsky’s framework, governments and central banks evolved over this long cycle into “Ponzi financing units”.
Importantly, the latest phase of Financial Arbitrage Capitalism has been dominating by levered speculation in perceived risk-free obligations of Ponzi units.
And the wild inflation of Ponzi central bank “money”/liabilities – along with interest-rate/market manipulation – has been fundamental to sustaining system Credit expansion dominated by Ponzi government debts (along with the levered speculation of these obligations).
In short, the Fed (and global central community) has repeatedly inserted “Coins in the Fuse Box,” sustaining government Ponzi finance and history’s greatest Bubble.
Issue 2024: Systemic fragility is at the most extreme level since 1929.
This fragility has its roots in three decades of Credit and financial excess, along with attendant economic maladjustment.
Fragilities were exacerbated by the multi-decade expansion of speculative finance, a historic Bubble that succumbed to late-cycle parabolic excess exemplified by last year’s $1 TN “basis trade” (levered 50 to 1).
Moreover, 2023's Everything Squeeze only intensified acute fragilities, derivatives melt-up, and frenetic FOMO buying.
Last year showcased super cycle transition period indecision and volatility, along with end-of-cycle crazy speculative blow-off excess.
Such artificial buying is not only unsustainable, it increases the likelihood of abrupt reversals and destabilizing selling and dislocations.
Such intense short squeezes are prone to destabilizing reversals, and never have squeeze dynamics simultaneously overpowered markets in equities, Treasuries, corporate Credit, currencies, EM, and derivatives (including options and CDS).
It's incredible to witness speculative market Bubbles work their (black) magic.
Inflating market prices definitely spawn their own news and analyses.
Bull market moves create genius – along with seductive bullish narratives.
“Stocks for the long-term” has been further crystallized.
Risks should be ignored.
Selling is for losers.
And, considering the backdrop, the intensity of market optimism is nothing short of phenomenal.
Talk is of “soft landings,” disinflation, and the start of a Fed easing cycle – while a multi-decade Bubble teeters on the precipice.
The everything squeeze rally only extended the chasm between bullish perceptions and the reality of acute vulnerability.
The marketplace enters 2024 remarkably distracted and unprepared.
Issue 2024: Liquidity – or the potential lack of it.
It’s difficult to envisage an environment more susceptible to market illiquidity and dislocation.
Markets – at home and abroad – have likely never been as levered.
Fifty to one leverage equates to unprecedented leverage in a tens of Trillions Treasury and agency marketplace.
That said, the “basis trade” is surely only a fraction of fixed-income levered speculation.
And there are yen and other “carry trades” globally.
The Q4 melt-up in the big Nasdaq stocks and indices generated enormous derivatives-related leverage, especially in the bustling options marketplace.
And as historic levered speculation generated hundreds of billions (Trillions?) of new marketplace liquidity, Fed securities sales (QT) last year went off without a hitch.
As always, speculative leveraging, squeezes, and derivatives-related buying feed the illusion of liquidity abundance.
Meanwhile, risks of a destabilizing de-risking/deleveraging episode stealthily soar.
As we ponder 2024 market dynamics, a brief “periphery and core” analytical framework diversion.
The more financially challenged “periphery” is inherently susceptible to shifts in financial conditions.
Tighter liquidity conditions immediately place the “periphery” at risk of higher funding costs, waning availability of finance, financial outflows, and even a complete loss of access to new Credit.
At the same time, the “periphery” is viewed as a major beneficiary of a “risk on” shift to looser conditions – as we saw in the second half (especially Q4).
Short squeezes boost liquidity and recovering markets spur inflows, with relatively higher market yields a magnet for levered speculation in “risk on” backdrops.
Resulting optimism and speculative leverage create vulnerability to the next bout of “risk off.”
Global markets wasted no time signaling 2024 liquidity concerns.
Emerging bond markets began the year on the back foot.
Dollar bond yields surged 42 bps in Columbia, 42 bps in Turkey, 41 bps in Panama, 33 bps in Indonesia, 32 bps in Peru, 31 bps in Saudi Arabia, 27 bps in Chile, 27 bps in Brazil, and 22 bps in Mexico.
EM CDS jumped 14.5 this week to 182 bps, the largest one-week move since mid-August.
After trading at a five-month high of 245 bps in October, EM CDS collapsed 78 bps to end the year at 167 bps.
“Periphery” currency losers to begin the year: the South Korean won declined 2.1%, the South African rand 1.7%, the Thai baht 1.7%, the Russian ruble 1.6%, the Malaysian ringgit 1.3%, the Chilean peso 1.3%, the Turkish lira 1.1%, the Polish zloty 1.1%, and the Taiwanese dollar 1.0%.
Bloomberg: “Traders Wrong-Footed by Dollar’s Best Start to Year Since 2011.”
With vulnerability quickly emerging at the “periphery,” the dollar index gained 1.1% to start the new year.
And within the major currency universe, the Japanese yen has evolved into a susceptible peripheral currency.
Through much of 2023, the yen was pressured lower by a confluence of rising policy rates and market yields globally, along with ongoing negative rates and BOJ yield curve control bond purchases.
But then the yen rallied almost 8% in the final weeks of 2023, as perceptions of looser global conditions took hold.
Bloomberg: “Yen Closes Worst Week Since 2022 as Earthquake Shifts BOJ Calls.”
The yen was hammered 2.5% to start 2024 trading.
China’s renminbi similarly enjoyed a Q4 rally, only to drop 0.66% this week - the largest decline since early-September.
European bank (subordinated) CDS jumped 11.5 this week to 134 bps, the largest weekly rise in 13 weeks.
After rising to a five-month high of 190 bps in late October, European bank CDS collapsed 67 to end 2023 at 123 bps.
European high yield (crossover) CDS surged 28.5 this week to 339 bps, the largest gain since the week of September 22nd (29bps).
After trading to a seven-month high 473 bps in October, European crossover CDS ended the year 163 lower at 310 bps.
Peripheral European bonds were also under pressure this week. Greek yields surged 26 bps (to 3.31%), Italian yields 15 bps (3.85%), Portuguese yields 15 bps (2.81%), and Spanish yields 16 bps (3.15%).
The UK bond market has evolved into a susceptible periphery market.
Ten-year gilt yields surged 25 bps this week to 3.88%.
UK two-year yields jumped a notable 27 bps to 4.23%.
Here at home, MBS yields surged 24 bps for the first week of the year.
MBS can be viewed at the “periphery of the core,” susceptible to shifts in market yield and liquidity expectations.
MBS is also a bastion of leveraged speculation, hedging and derivatives trading.
High yield CDS rose 15 to 371 bps, the largest move since October.
Bank America CDS jumped six this week to 75 bps, the largest weekly move since October.
Citigroup CDS rose seven to 70.5 bps, also the biggest increase since October.
In general, this week’s rise in U.S. and European bank CDS was the largest since October.
Bloomberg: “Wall Street Euphoria Ends in Worst New Year Kick-Off Since 2003.”
The Semiconductors dropped 5.8% this week, as the Nasdaq100 fell 3.1%.
We can assume enormous leverage has accumulated in the big tech stocks and related indices.
This week’s sharp reversal portends 2024 market liquidity issues.
And bullish traders waiting for “magnificent seven” weakness to provide a broader market buy signal are missing the general market liquidity impact from big tech de-risking/deleveraging.
Susceptible to a shift in the liquidity backdrop, the small cap Russell 2000 reversed 3.8% lower.
At the top of this week’s leaderboard, the defensive NYSE Healthcare Index rose 2.2%, and the Utilities advanced 2.0%.
Friday closing prices had the market expecting a 73% probability of a rate cut by the March 20th FOMC meeting.
This was down from last Friday’s 100%.
The market is pricing a 3.95% policy rate at the December 18th meeting, implying 138 bps of rate cuts this year.
This is up from last week’s 3.75% (158bps of cuts).
Add Friday’s stronger-than-expected 216,000 gain in December Non-Farm Payrolls (3.7% Unemployment Rate) to data suggesting Q4 loose conditions and market gains have underpinned economic activity.
And at 0.4% (4.1% y-o-y), Average Hourly Earnings was stronger-than-expected and suggestive of ongoing labor tightness and wage inflation.
At 164,000, the ADP employment change also meaningfully beat forecasts (125k).
Weekly Jobless Claims (202k) declined to the lowest level since October – and remain not much above historic lows.
Issues 2024: Economic instability.
“Soft landing” talk misses the key point.
The U.S. economy today is remarkably impacted by financial conditions and asset market performance.
Q4 loosening and asset inflation should underpin relatively strong Q1 spending and growth.
Holiday spending and travel were generally robust.
“Risk on” and liquidity abundance continue to support Credit Availability, both for households and businesses.
But with markets acutely vulnerable to “risk off” deleveraging and resulting liquidity issues, the deeply maladjusted U.S. economy enters 2024, only more susceptible to abrupt tightening conditions (following 2023 excesses).
Last year’s AI mania was critical in sustaining speculative flows into the general technology sector, in the process extending the lives of scores of uneconomic enterprises.
While AI will undoubtedly continue its rapid development, any waning enthusiasm – including stock market risk aversion – risks triggering a major shift in industry financial conditions.
But AI wasn’t the only major Bubble manifestation to gain momentum in 2023.
“Private Credit” became an only bigger force.
In consumer finance, Credit Availability generally remained loose, as “Buy Now, Pay Later” became a greater driver of retail spending.
In general, “De-Fi” (decentralized finance) was largely immune to Fed rate increases.
With loose conditions continuing to underpin consumers, businesses, and the overall economy, for the most part Credit fears remained limited to commercial real estate.
Issue 2024: market illiquidity and dislocation risk a problematic tightening of non-bank Credit.
And a tightening of Credit would spur a major reassessment of prospects for both consumer and business Credit.
Such a development would mark a critical Credit cycle inflection point, with tightening conditions bolstering fears of mounting loan losses.
Today’s “soft landing” crowd fails to contemplate the potential for tightened market-based Credit - and the profound ramifications such a tightening would have at this stage of the cycle.
The Fed’s December “dot plot” indicated a median forecast of three rate cuts this year, while the market is pricing almost six.
Like last year, I tend to see market rate cut expectations incorporating odds of the Fed being forced to respond to crisis dynamics.
I expect the Fed to be on hold so long as financial conditions remain loose.
Yet odds of a 2024 market accident and Fed response are not low.
Sometimes there are clear catalysts for deflating Bubbles.
Not always.
Nasdaq peaked during March 2000 (a high not broken for 15 years), reversing lower after a major short squeeze and derivatives-related melt-up.
That squeeze was made all the more powerful because of the backdrop of deteriorating industry fundamentals.
There was no major catalyst.
Selling gathered momentum following an upside dislocation, and the market simply lost its capacity to disregard fundamentals.
I can see this week as the starting point for closing the wide gap between inflated market prices and deteriorating prospects.
But there is no shortage of potential catalysts.
If you haven’t noticed, it’s an election year.
I’m not alone struggling with foreboding feelings.
Most Americans would prefer neither Biden nor Trump.
And no matter the winner, a majority will see the President as unfit for office.
With a backdrop so inviting for third party candidates, it’s not difficult to envisage a scenario where the leading candidate does not secure the necessary 270 electoral college votes.
This election cycle could easily turn into a huge mess.
Just getting to November is problematic.
Legal battles will engulf the Supreme Court in ugly political partisanship.
And a felony conviction before November would only add to the chaos.
Our nation is so deeply and irreparably divided.
I believe this social tinderbox has remained somewhat stifled in an environment of robust markets and a strong economy.
All bets are off when the Bubble bursts.
We begin an unprecedented election year deeply divided, and I fear by year-end our nation could test the limits of divisiveness.
I wish I could feel more optimistic about the geopolitical environment.
Taiwanese elections are next weekend (13th).
January 1 – Bloomberg (Betty Hou):
“Taiwan’s final election polls put the ruling party on track to win a record third straight term in power, a setback to President Xi Jinping’s efforts to bring the island closer to Beijing.
The Democratic Progressive Party’s Vice President Lai Ching-te was the frontrunner in three surveys in recent days, with his lead over main opposition rival, Hou Yu-ih of the Kuomintang, ranging from 3 to 11 percentage points.”
Lai Ching-te is a staunch proponent of Taiwan independence.
“On so-called Taiwan independence, Taiwan’s basic position is that Taiwan's sovereignty and independence belong to its 23 million people not the People’s Republic of China.”
To Beijing, he’s a dangerous separatist.
December 31 – Financial Times (Edward White):
“Chinese President Xi Jinping has used his annual new year address to the nation to sound a warning to Taiwan’s voters days ahead of the island’s presidential election, while highlighting his country’s technological prowess and economic strength.
In the televised speech on Sunday evening, Xi said the ‘reunification’ of Taiwan and China was a ‘historical inevitability’.
He added that ‘compatriots’ on both sides of the Taiwan Strait must share in the glory of ‘national rejuvenation’.”
If the DPP retains the presidency, I would expect China to begin tightening the screws.
I have been concerned that China has an unspoken “plan B.”
In the event of worsening financial and economic crisis, Beijing would use Taiwan “reunification” to distract the Chinese people from domestic policy failures.
I’m assuming various measures (i.e., sanctions, trade embargos, blockades, cyber-attacks, etc.) would be employed prior to direct military confrontation.
I see no reason not to expect this process to commence early this year.
Chinese hostilities would garner a U.S. response.
China’s deflating apartment Bubble took a decisive turn for the worse in 2023.
I expect broadening Chinese financial instability to be a key Issue 2024.
January 5 – Bloomberg (Lisa Du and Zheng Li):
“Chinese regulators have sought for years to get to grips with the $2.9 trillion trust industry, a corner of the country’s shadow-banking sector that offers bigger returns than regular bank deposits but can be fraught with risk.
A reckoning arrived on Jan. 5, when one of the sector’s biggest players, Zhongzhi Enterprise Group Co., filed for bankruptcy, victim of a property crisis that’s bedeviled the world’s second-largest economy.
China’s banking regulator had vowed in November to use ‘strong medicine’ to tackle major risks in the country’s financial sector.
But the collapse of Zhongzhi in one of China’s biggest ever bankruptcies still came as a shock to investors, given the government’s past willingness to throw an occasional lifeline to struggling firms.”
The domino collapse of Chinese developers is increasingly spilling into the $3 TN trust industry and the $12 TN local government debt market.
Just this week, Fitch downgraded the four huge national asset management companies (AMCs).
These “bad banks” were created to absorb problem loans after late-nineties lending excesses.
Also this week, Reuters reported that China’s big banks are increasingly working to limit exposures to the troubled “small” banking sector, a potentially significant tightening of Credit and liquidity.
It’s only a matter of time until the financial rot makes its way to China’s major banks.
A crisis of confidence in China would not be a surprising 2024 development.
November’s rally pulled the renminbi back from the ledge.
I expect currency market instability to be a major Issue 2024, and the renminbi will likely be right in the thick of it.
I could see a crisis of confidence in the renminbi and China’s banking system as a catalyst for a more globalized crisis of confidence.
Cracks are widening in South Korean Credit, with highly levered Asian economies vulnerable to Chinese contagion and tightened global conditions.
Last year, we saw how Chinese and global instability can underpin the U.S. dollar.
All the major currencies are hopelessly unsound.
Huge trade deficits and massive government deficits create dollar vulnerability to crisis of confidence dynamics.
For now, the U.S. dollar remains the “core” currency expected to benefit somewhat from instability at the “periphery.”
But a Fed move to slash rates and/or restart QE could easily unleash dollar weakness that might prove difficult to control.
As part of the transition to a new cycle, I expect currency and global financial asset fragility to underpin the value of hard assets.
And geopolitical instability is fundamental to unfolding new cycle dynamics.
Deepening global conflict is a key Issue 2024.
Expanding hostilities in the Middle East seem a forgone conclusion.
How long do the IDF and Hezbollah maintain restraint?
Does Israel directly confront Iran?
When might Iran acquire a nuclear weapon?
Russia has a new supply of North Korean missiles to terrorize Kiev and other Ukrainian cities.
The Ukraine military has acquired more capabilities to retaliate deeper inside Russia.
But there are myriad geopolitical flashpoints, including in the South China Sea (China v. Philippines), the Korea peninsula, and Eastern Europe.
Cyber and terrorism risks are rising.
And the trajectory of climate instability is troubling, with ramifications for inflation and social stability.
Sure, history’s greatest Bubble could inflate for yet another year.
But all the elements are present for things to turn sour.
Issue 2024: a confluence of acute Bubble fragility, social instability, and geopolitical hostilities creates a high-risk backdrop without precedence.
Key Issue 2024: Hope and pray for the best, while diligently preparing for the worst.
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