On Fire
Doug Nolan
Could the backdrop going into next Wednesday’s Powell press conference be any more intriguing?
The economy has gained a head of steam since the FOMC’s December 13th meeting.
Additional stronger-than-expected data this week.
Q4 GDP was reported at 3.3%, down from Q3’s blistering 4.9%, but significantly above the 2.0% consensus estimate.
At 50.3 (estimate 47.6), the January Manufacturing PMI Index was the strongest since October ‘22’s 50.4.
New Orders rose to 52.2, the high since last June.
With a reading of 52.3, the Services PMI also surpassed forecasts (51.5) to a seven-month high.
Mortgage Purchase Applications popped another 8%, while December Pending Home Sales rose 8% to the highest level since July.
New Home Sales were stronger-than-expected (664k vs. 649k).
The rise (0.7%) in December Personal Spending hasn’t been stronger since last January, with Spending up 5.9% y-o-y.
Robust data had curiously little impact on rate cut expectations.
The market is still at about 50% likelihood of a cut at the March 20th meeting and is pricing 33 bps of cuts by the May 1st meeting.
Encouraging inflation reports have countered strong economic data.
Q4 Core PCE was reported at 2.0%, matching Q3’s level.
For perspective, Core PCE was at 4.7% during Q4 ’22 and 5.2% for Q4 ’21.
A key Fed inflation gauge, December’s monthly PCE, was reported at 0.2% (2.6% y-o-y), with Core PCE at 0.2% (2.9% y-o-y).
Financial conditions have loosened dramatically, and highly speculative financial markets have performed spectacularly, while key inflation measures confirm an easing of pricing pressures.
The backdrop would seem conducive to a return of “Balanced Powell.”
Having jumped on the dovish pivot bandwagon, markets anticipate the Fed Chair laying the groundwork for an imminent rate cut.
The thinking is that the FOMC will want to ensure it has rate cuts on the books well before November.
Seems the Fed is in a pickle of its own making.
It was a mistake to begin talking rate cuts with conditions so loose and markets booming.
The economy was administered a shot of adrenaline, pushing the timeline for economic weakness and resulting rate cuts out closer to election time.
If the Fed is determined to get cuts underway, it will have to lean hard on weaker inflation data, while disregarding the speculative market Bubble and notably loose financial conditions.
That would be a mistake.
Markets have fully embraced their beloved bullish narrative and are ready to impose their will.
Powell better focus on inflation and rate cuts, or markets might throw a little tantrum.
There’s all this talk that the Fed must respond to elevated real interest rates with rate cuts or risk economic recession.
But this analysis disregards the recent loosening of conditions and collapse of risk premiums.
Investment-grade corporate bond spreads (to Treasuries) ended Friday trading at 92 bps.
This spread hasn’t been narrower since October 2021.
High yield spreads (325bps) are lower today than when the Fed began raising rates in March 2022.
January 21 – Financial Times (Harriet Clarfelt):
“US corporate bond markets are ‘on fire’ as companies have sold a record $150bn of debt since the start of this month, the busiest opening to the year for more than three decades.
Investment-grade groups have issued $153bn worth of bonds this month…, the highest year-to-date figure for dollar-denominated debt in records going back to 1990.
Borrowers are rushing to lock in lower interest costs, while investors are keen to buy new bonds before policymakers start cutting US interest rates later this year.
‘The market is just on fire,’ said Richard Zogheb, head of global debt capital markets at Citi.”
Does the Fed really want to signal an imminent rate cut with equities and corporate debt markets On Fire and the economic boom smoldering?
On the other side of the world, panic has begun to take hold in Beijing.
A surprise cut in bank reserve requirements, talk of $278 billion stock market support, and the PBOC announcing a boost in targeted lending (it's worth looking through the “China Watch” items below).
The Shanghai Composite rallied 6% off Wednesday’s trading lows to finish the week up 2.8%.
Hong Kong’s Hang Seng Index rallied almost 10% off lows, before closing the week up 4.2%.
The Hang Seng China Financials Index rallied 11.5% to end the week up 6.8%.
The base metals rallied.
Copper gained 1.7%, Aluminum 2.6%, Lead 2.8%, Nickel 4.7%, Zinc 5.4%, and Tin 5.4%.
Iron Ore gained 2.6%.
EM equities rallied tepidly, while EM currencies and bonds were notably unimpressive.
Beijing has been in denial.
But they are likely coming to the recognition that to hold Bubble collapse at bay – let along maintain the growth trajectory necessary to achieve global superpower ambitions – will require massive government spending and PBOC printing.
More reports this week of currency support operations.
Beijing must by now understand that their fragile currency presents a major risk to system stability.
Chinese banks have been big players in using currency derivatives to support the renminbi.
This works to preserve valuable international reserves – but only for so long.
I expect more intense selling pressure will have the PBOC liquidating Treasuries to support its currency.
And if fear of renminbi and EM currency instability spurs U.S. dollar strength, we could see EM central banks also selling Treasuries to support local currencies.
It’s going to be an interesting few weeks.
An excerpt from Thursday’s Q4 Tactical Short conference call, “Prospects After a Market Melt-up.”
Fed officials hold great power to move markets.
But asset inflation and speculative bubbles require monetary fuel.
The Fed’s balance sheet contracted about $800 billion last year to $7.65 TN – and is today $1.25 TN smaller compared to its July ‘22 peak.
Moreover, the M2 monetary aggregate contracted $600 billion last year, as bank lending slowed markedly.
Which begs the question: What is the monetary source fueling historic asset inflation?
I believe the answer to this question is at the heart of likely post market melt-up prospects.
Was the source of the market fuel of the typical and sustainable variety?
Or is something more threatening going on, something abnormal and prone to a destabilizing reversal?
From the perspective of my analytical framework, speculative leverage is highly problematic.
When a trader uses a margin loan to purchase stock, this new credit adds liquidity into the market.
If large amounts of leverage and resulting liquidity enter the marketplace, this monetary fuel tends to be self-reinforcing.
Inflating stock prices induce only more margin-financed speculation.
And as the size of this speculative credit and liquidity grow, distortions to the markets, the financial system and the economy become more structural.
From my studies of the “Roaring Twenties” period, I became convinced that a historic expansion of speculative leverage created vulnerabilities to crash dynamics and economic depression.
The speculative melt-up that culminated in the summer of 1929 had left a fragile system acutely vulnerable to a market reversal, the self-reinforcing unwind of speculative credit, illiquidity, market dislocation, and panic.
The historical revisionists, with Ben Bernanke at the forefront, promote the view that the failure of the Federal Reserve to print sufficient money supply and recapitalize the banking system were the root causes of the Great Depression.
Contemporaneous analysis appreciated that loose money, credit excess, faith in the Fed backstop, and rank speculation had fueled a protracted bubble with deep structural maladjustment.
Speculative excess during our most prolonged bubble cycle has put “Roaring Twenties” excesses to shame.
Margin lending has inflated to record levels.
But in today’s world, margin debt accounts for only a sliver of speculative credit.
Especially with the proliferation of options trading by institutions and online traders - derivative-related leverage has surely exploded over recent years.
I suspect the “magnificent seven” phenomenon became a major source of late-cycle speculative leverage.
Call option buying in the major tech stocks and associated ETFs has been hugely market impactful.
And as these stocks and derivatives succumbed to speculative melt-up dynamics, traders and derivative dealers that had sold call options and upside derivatives were forced to aggressively establish leveraged long positions in the underlying instruments - to hedge their exposures.
This leveraging generated powerful system liquidity expansion.
But another source of leveraged speculation has likely been an even greater liquidity generator: the so-called “basis trade,” where hedge funds borrow to buy Treasury bonds while shorting corresponding Treasury futures contracts - capturing the tiny spread between the yields on the two instruments.
This trade has been around for years.
It had reached several hundred billion going into the pandemic.
A disorderly unwind of the “basis trade” was a factor that forced repeated Fed announcements of larger liquidity injections necessary to quell the March 2020 panic.
The Fed’s “basis trade” bailout ensured it would later inflate into one of history’s greatest levered speculations - in the world’s most important market.
Reports over the summer had the “basis trade” reaching $500 billion, surpassing the pre-pandemic level.
By the fall, it was up to $650 billion, with reports in December of a trillion-dollar “basis trade.”
And focus on the Treasury “basis trade” overlooks what is surely similar leverage in Agency securities and MBS.
Moreover, huge “carry trade” leverage has accumulated in U.S. corporate debt, along with bond markets around the world.
And the U.S. certainly doesn’t hold a monopoly on levered speculation.
With the Bank of Japan dragging its heels on policy normalization, a hugely advantageous yen “carry trade” financed massive speculative leverage in the U.S. and globally.
So, when we ponder sources of liquidity fueling market melt-ups in the face of a contracting Fed balance sheet and weakened bank lending, we can safely assume trillions of speculative leveraging – margin debt, derivatives-related leverage, “basis trades,” “carry trades,” and such.
Crazy end-of-cycle monetary disorder.
Money market fund assets expanded $1.17 TN last year, or almost 25%, to a record $5.9 TN.
This crushed the $729 billion annual growth record set in tumultuous 2007.
Moreover, 2023 was an acceleration of already historic ballooning that started pre-pandemic.
Since the Fed resumed QE back in September 2019, money fund assets have ballooned $2.56 TN, or 75%.
This historic monetary inflation flies under the radar.
Analysts simplistically assume that growth is driven by both flight from bank deposits and general risk aversion.
It goes unappreciated that the money fund complex has evolved into a critical funding source for levered speculation.
Wall Street firms and major banks tap the “repo” market to fund their securities finance operations.
When a hedge fund levers Treasuries as part of a “basis trade” strategy, this borrowing is done through the “repo” market.
And the money market fund complex has become the major source of lending into the “repo” marketplace.
This part of the analysis gets more complex.
Back during the mortgage finance bubble period, I was focused on the money markets as the key source of financing for ballooning GSE balance sheets.
The GSEs would issue new short-term debt instruments to the money funds in exchange for cash, and then use this money to buy debt securities in the open market.
This new liquidity would find its way back to the money fund complex, where the GSEs would simply issue more debt instruments and borrow more.
For those familiar with the workings of fractional reserve banking and the “deposit multiplier”, this was unfettered credit creation unconstrained by reserve requirements.
I refer to this dynamic as the “infinite multiplier effect.”
Basically, funds could be borrowed over and over again – creating the illusion of unlimited marketplace liquidity.
Funding “basis trade” speculation with “repo” borrowings - intermediated through the money fund complex - takes even mortgage finance bubble speculative leverage to dangerous new extremes.
For starters, this type of monetary inflation appears miraculous.
The Treasury can run $2 TN annual deficits, while the Fed shrinks its balance sheet.
Yet markets remain seductively liquid, while general financial conditions loosen.
The Citadel hedge fund group is a major “basis trade” operator.
Ken Griffin, Citadel’s founder and CEO, is fond of arguing that the “basis trade” is lowering government borrowing costs and supporting economic growth.
The problem today, as it has been for centuries, is that highly levered speculative bubbles neither last forever nor work in reverse.
When we ponder post-melt-up prospects, the plight of the “basis trade”, and levered speculation more generally, are at the top of our list of considerations.
In some respects, this Bubble Dynamic enjoys extraordinary stability.
At the heart of the financial system, the “basis trade” operators have full confidence that the Federal Reserve will do whatever it takes to maintain Treasury market liquidity.
The Fed would, as they’ve done in the past, also move aggressively and swiftly to ensure “repo” market and money fund stability.
And unlike risky mortgage debt, markets have no fear of credit issues – no matter the size of deficits or the ballooning amount of outstanding Treasury debt.
Recalling the great American economist Hyman Minsky, “stability can be destabilizing.”
Decades of Federal Reserve market backstops and bailouts – “coins in the fuse box” – have incentivized an unprecedented expansion of system leverage and speculative excess.
As a student of financial history who analyzed the mortgage finance bubble on a daily basis, I can state without a doubt that the current global government finance bubble has inflated momentously beyond previous bubbles.
Fallout from the so-called “great financial crisis” is not yet too distant of a memory.
And we know that it required trillions of Fed QE to thwart financial collapse in 2020.
The next serious bout of global de-risking/deleveraging will pose quite a challenge for the Fed and global central bank community.
The bigger bubbles inflate, the greater the amount of QE necessary to stabilize market liquidity.
To try to keep deleveraging from snowballing, the Fed will surely move quickly and aggressively.
And, importantly, the Fed has never faced such a policy challenge with inflation risk as elevated and the bond market as levered.
Market dynamics have been intriguing to start 2024.
Opening the year to the downside, weakness in the big Nasdaq stocks seemed to spur global market liquidity concerns.
Periphery markets – from the emerging markets to peripheral European bonds to U.S. small cap stocks – signal nascent de-risking/deleveraging concerns.
And while the Nasdaq100 reversed course and rallied to new all-time highs into options expiration, markets at the global periphery have been notable underperformers.
I vividly recall how big tech turned unstable to open year-2000, following 1999’s historic bubble year.
There was one final big rally into quarterly options expiration, right in the face of deteriorating industry fundamentals.
The March 2000 Nasdaq peak was not reached again for 15 years.
I am mindful of how a marketplace so conditioned to squeeze both shorts and hedges can extend “Terminal Phase” Bubble excess.
As I know better than most: call the demise of a bubble at your own peril.
Meanwhile, economic data to begin the new year are making the Goldilocks “soft landing” crowd nervous.
While downshifting from Q3’s blistering 4.9% growth, a strong holiday shopping season, surging consumer confidence, and ongoing labor tightness suggest upside economic risk. Q4 GDP was reported this morning (Thursday) at a much stronger-than-expected 3.3%.
After such a dramatic loosening of conditions, such data shouldn’t be surprising.
The Q4 “everything rally,” with market focus shifting to looming rate cuts, brought strong correlations between stocks and bonds.
The rates market ended ‘23 pricing at least six rate cuts this year.
Last week, bonds globally came under heavy selling pressure, as the market began dialing back rate cut expectations.
Two-year Treasury yields jumped 24 bps last week, while MBS yields surged 28.
At this point, ongoing big tech bubble inflation increases the likelihood of upside surprises to both economic growth and inflation.
Highly synchronized during the melt-up, bond and stock market performance could now part ways.
And I see the bond market especially vulnerable in today’s post-melt-up environment.
Market yields and rate expectations traded to levels not supported by underlying fundamentals.
And with sentiment turning so bullish, market players extended durations and let hedges expire.
This heightens the risk of a surprise bout of aggressive hedging and selling, with negative ramifications for marketplace liquidity.
It is today important to appreciate that melt-ups often conclude the speculative cycle.
Inflated prices become unsustainable.
Excesses – including speculative leveraging – turn untenable.
The underlying monetary disorder becomes increasingly destabilizing, for the markets as well as the real economy.
That said, there is an element of George Soros’ “reflexivity” – where perceptions tend to shape reality.
As we’ve witnessed again in recent months, news and analysis follow market direction.
Surging stock prices feed bullish narratives built on “soft landings,” falling inflation, and rate cuts.
Analysts will boost earnings estimates, and company management will do whatever they can to beat them.
Loose conditions will ensure easy corporate borrowing, along with more M&A and IPOs.
We see ongoing support for our thesis of a world transitioning to a new cycle.
Melt-up dynamics, however, have extended the current transition phase, emboldening those believing the previous cycle bullish market, inflation and economic dynamics will be sustained indefinitely.
The reality is one of a precarious widening gap between bullish perceptions and deteriorating prospects.
This discontinuity significantly raises the odds of a disorderly adjustment – both in the markets and within the economy.
Importantly, melt-up-induced price gains and liquidity excess mask mounting fragilities.
Having disregarded myriad risks, markets became acutely vulnerable to abrupt reversals, de-risking/deleveraging, illiquidity, and destabilizing shifts in market perceptions.
In general, the post melt-up backdrop is one of highly elevated liquidity and de-leveraging risks.
And, to begin 2024, there is support for this thesis right where we would expect to initially observe it - at the vulnerable global periphery - most sensitive to waning liquidity and tightened conditions.
In recent CBBs, I’ve noted the surge in global yields, especially in dollar-denominated emerging market debt.
If the sophisticated global players were beginning to position for an unfolding deleveraging dynamic, this is exactly where they would begin paring exposures.
The more vulnerable currencies are underperforming.
EM currencies have been sold aggressively to begin the year, while the yen has already lost 4.5%.
It is not atypical for nascent stress at the “periphery” to underpin excess at the “core.”
Even as the subprime implosion marked the beginning of the end to the mortgage finance bubble, a big rally in “core” AAA-rated Agency and MBS securities somewhat extended the boom.
These days at the troubled periphery, we have seen Chinese equities in free-fall.
Despite ongoing efforts to support stock prices, major Chinese indices have already suffered double-digit y-t-d declines.
Talk now is of an almost $300 billion market rescue package, a huge number that analysts view as insufficient.
This is a reminder of how incredibly China’s entire system inflated during this long cycle.
If $300 billion is inadequate to support Chinese stocks, how much will be required to rescue the nation’s real estate markets, local government debt, the “trust industry,” and their almost $60 TN banking system?
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