Overheated
Doug Nolan
“Periphery and core” and global government finance Bubble analytical frameworks continue to offer a fruitful perspective for better understanding today’s extraordinary backdrop.
At the “periphery,” China’s Bubble deflation has reached another critical stage.
Here at the “core,” “Terminal Phase Excess” is also at a critical juncture.
Bloomberg’s Jonathan Ferro:
“You think the biggest risk here is they hold too long, not too soon?”
Mohamed El-Erian:
“Correct.
If they don’t cut in June, you will hear me say, ‘oh no.’
We’re now making the opposite policy mistake that we made back in ‘20/’21.”
“Terminal Phase Excess” dynamics create great analytical and policy dilemmas.
It's likely that the Fed will be viewed as having waited too long to begin easing policy.
I fully expect the course of 2024 monetary policy to be debated for years and even decades.
The ECB is still pilloried for a final rate hike in early-July 2008, just weeks ahead of all hell breaking loose.
The Fed, on the other hand, began aggressive easing in September 2007, having slashed rates 325 bps by April 30th, 2008.
Extending the duration of “Terminal Phase Excess” only exacerbated systemic fragilities, though I’ve not come across analysis exploring this issue.
Elevated system Credit growth was sustained, with Q3 2008’s $728 billion Non-Financial Debt expansion second only to Q1 2004.
Importantly, the “Repo” market jumped $319 billion during Q1 2008 to a then record $5.167 TN.
Money Fund Assets surged $356 billion during Q1 (to a record $3.443 TN), capping off unprecedented one-year growth of $1.025 TN, or 42%.
Agency Securities expanded $1.100 TN in four quarters ended Q2 2008 - to a record $7.886 TN.
In short, post-Bubble economic adjustment was postponed, while historic financial imbalances expanded parabolically (and fatefully)
Today’s excesses (including “repo”, money market funds and Agency securities) dwarf those from the mortgage finance Bubble period.
Indeed, one must look back to the “Roaring Twenties” for anything comparable. December’s “dovish pivot” signaling to acutely speculative markets was quite a policy blunder.
Current Fed talk of impending rate cuts (i.e., Williams, Waller and Goolsbee) is Bubble complicity.
And so long as the current environment persists, actual rate cuts would be reckless.
Chair Powell’s assertion of a “policy rate well into restrictive territory, meaning that tight policy is putting downward pressure on economic activity and inflation” is even more lacking in credibility today.
There’s a decent case to make that financial conditions haven’t been looser since the mortgage finance Bubble period.
For sure, stock prices have never been higher.
Investment-grade spreads (to Treasuries) traded down to 89 bps on Thursday, the low back to November 12, 2021.
Excluding 2021’s QE-depressed risk premiums, investment-grade spreads haven’t been this narrow since March 2007.
And, for further perspective, investment-grade spreads averaged 138 bps over the past three decades.
High yield spreads narrowed to 306 bps this week, the low since January 20, 2022.
It’s worth adding that 2021’s QE-depressed high yield spreads were the narrowest since (pre-subprime eruption) June 2007.
High yield spreads averaged 497 bps over the past thirty years.
Investment-grade CDS traded down to 51 bps Thursday, the low back to December 31, 2021.
High yield CDS sank to 336 bps, the low since February 1, 2022.
Bank CDS this week plumbed further into multiyear lows.
JPMorgan CDS traded down to 36.8 bps in Friday trading, the low back to pre-pandemic February 24, 2020.
At 56 bps, Bank of America CDS has fallen to the low since January 25, 2022.
Goldman Sachs CDS dropped to 59 bps this week, the low back to November 19, 2021.
Citigroup CDS declined to 58 bps, the low since January 17, 2022.
Loose conditions are a global phenomenon.
European Bank (subordinated) CDS fell to 115 bps, the low since January 13, 2022.
European high yield (crossover) CDS dropped to 301 bps, the low since February 3, 2022.
Emerging Market CDS sank 11 this week to 167 bps, the low back to September 17th, 2021.
With everyone bewitched by the likes of Nvidia, AI and a phenomenal stock market melt-up, equally significant (but less recognized) excess unfolds in Credit.
It appears record January corporate debt issuance ($190bn) will be followed by a record February ($170bn).
Bloomberg headlines:
“US High-Grade Sales Top $60 Billion in Busiest Week Since 2022.”
“High Grade Bond Spreads Are Tightest in Years.”
“Wave of Cash Seen Washing Into Credit as Investors Seek Duration.”
February 23 – Bloomberg (Tasos Vossos):
“Cash may still be king for the moment, but after more than $1 trillion flowed into money-market funds last year as short-term rates rose, investors are trying to figure out where it goes next.
Bank of America Corp. projects a record $500 billion of flows to high-grade corporate debt in 2024, based on the current pace of inflows.
Barclays Plc strategists expect $400 billion to $600 billion could move into risk assets from money-market funds over the next year, with investors likely to favor credit over equities in that shift…
Annuities — an insurance product that consumers use to help fund their retirements — are another source of potential demand for credit.
Sales of annuities reached an all-time record high of $385 billion last year, up 23% from the year before.
Money raised by annuities often goes toward investment-grade debt.”
February 19 – Bloomberg (Alex Harris and Nina Trentmann):
“Investors are plowing billions into money-market funds by the day.
Corporate treasurers are hoarding record amounts of cash.
The market is digesting a glut of Treasury bills without a hiccup.
For an asset class that many market prognosticators all but left for dead to start the year, there’s still plenty of life left in cash.
Investors have added $128 billion to US money-market funds since the start of the year…
Companies were sitting on a record $4.4 trillion of cash at the end of the third quarter, and after a flood of more than $1 trillion of T-bills since mid-2023, the market has room for more.”
February 23 – Bloomberg (Stephan Kahl):
“Pacific Investment Management Co. attracted about $21.6 billion in third-party money in the first six weeks of 2024, approaching the level for the entire year before.
The bond giant had an ‘absolutely stunning’ development this year, Oliver Baete, chief executive officer of Pimco parent Allianz SE, said…”
February 20 – Bloomberg (Fareed Sahloul):
“The US is leading a revival in global mergers and acquisitions that many dealmakers didn’t think would emerge until later in the year.
The latest big transactions in the country are led by Capital One Financial Corp.’s $35 billion offer to buy Discover Financial Services.
Elsewhere, Truist Financial Corp. is selling its insurance brokerage business… and Walmart Inc. has agreed to acquire smart-TV maker Vizio Holding…
These take the value of deals announced globally this year to roughly $425 billion… — a figure that’s up 55% on this point in 2023.”
February 20 – Bloomberg (Simon White):
“It’s been a tough time for pessimists.
From a bear market that was historically mild to a recession that has gone missing in transit, the markets and the US economy keep surprising to the upside.
To add to that, the credit cycle is showing clear signs of re-accelerating - with spreads expected to tighten further - after a downturn looked inevitable last year…
The beneficial thing about trying to be process-driven and data-led is that no matter how resolute your view, it must be jettisoned if the contrary evidence becomes impossible to ignore.
When it comes to credit, it’s becoming undeniable that it’s in the midst of an upturn.”
“The credit cycle is showing clear signs of re-accelerating… it’s becoming undeniable that it’s in the midst of an upturn.”
“Overheated” is apt.
The Credit market is Overheated.
So-called “private Credit” is Overheated.
Equities are desperately Overheated.
And there are strong arguments that Overheated finance is increasingly fueling economic overheating.
The Atlanta Fed GDPNow Forecast is currently at 2.9%, after beginning the year at 1.9%.
And this growth follows Q4 and Q3 GDP of 3.3% and 4.9%.
The Fed’s failure to tighten market financial conditions has historic consequences.
The backdrop has degenerated into a full-fledged financial mania.
Fed officials were out in force this week, pushing back against rate cut expectations.
Markets scoff.
There is no fear today that the Federal Reserve will actually tighten conditions.
They will be on the sidelines with the rest of us watching the interplay of loose finance, speculative excess, market liquidity abundance, and a historic AI mania.
Today’s Super Bubble shares little in common with the late nineties “tech” (“dot.com”) bubble, financed by the likes of WorldCom, Global Crossing, 360networks and an aggressive band of junky telecom borrowers.
Mortgage finance Bubble excesses eventually hit a wall.
There were only so many subprime homebuyers, with inflated price Bubbles in Phoenix, Las Vegas and around the country unsustainable.
Today’s Bubble has evolved at the “core” of “money” and Credit, fueled largely by massive deficit spending from a borrower who enjoys insatiable market demand for its securities (despite $30 TN of debt).
Private sector Bubble dynamics are these days also driven by excesses at “core” industry heavyweights.
Over this protracted Bubble cycle, the so-called “magnificent seven” have accumulated extraordinary market dominance along with incredible financial resources (cash and borrowing capacity).
It’s a group incredibly enriched for an arms race.
February 21 - Bloomberg Intelligence (Mandeep Singh):
“Generative AI, a market we project could reach $1.3 trillion in 2032, remains this year’s dominant catalyst of positive estimate revisions and multiple expansion for most tech segments, including hardware, software and internet.
Cloud and semiconductor suppliers offering GPU capacity for training large language models (LLMs) continue to reap some of the most notable sales gains…
Generative AI also should accelerate the shift toward digital ads, while adding incremental revenue to established markets like cybersecurity and gaming.”
February 1 - Bloomberg Intelligence (Nishant Chintala):
“Generative AI may expand to about 10-12% of the total IT hardware, software, services, ad spending and gaming markets by 2032 from less than 1%, based on our calculations.
Additions to generative-AI revenue will likely come from infrastructure-as-a-service (about $309bn by 2032) used for training large language models (LLMs), along with digital advertisements ($207bn) and specialized assistant software ($95bn).
Other contributors in hardware include AI servers ($105bn), AI storage ($57bn), computer-vision products ($58 billion) and conversational devices ($110bn).”
February 21 - The Motley Fool (Danny Vena):
“A much more bullish take comes courtesy of Cathie Wood's Ark Investment Management, which estimates that AI software alone could drive incremental spending of $13 trillion by the end of the decade.
With the market still in its infancy, nobody really knows for sure.
What is clear is that an opportunity of this magnitude can't be ignored.”
Massive data centers can’t be built fast enough.
This historic boom will also require massive investment in cooling and energy infrastructure, for a global arms race evolving into a spending black hole.
Combining the AI arms race with myriad other spending booms (i.e., renewable energy, climate change-related, supply chain management and national defense) and loose Credit heightens economic overheating risks.
Nvidia added $155 billion of market capitalization (reaching $2 TN) as stocks surged further into record territory.
Yet 10-year Treasury yields slipped a few bps this week.
Why is the bond market not more alarmed by Overheating?
For one, the Fed has already signaled that interest rates are coming down.
Not oblivious to Bubble Dynamics, bonds see in AI and equities (and elsewhere) an unsustainable boom that will end with quite a bust.
Moreover, there are already significant cracks globally, with Bubble deflation gathering momentum in China.
February 22 – Bloomberg (Ye Xie):
“China’s equity rout a few weeks ago was exacerbated by quantitative funds stampeding to exit positions, akin to a 2007 episode in the US when such investors suffered an abrupt meltdown that roiled markets.
That’s the analysis of Man Group’s Ziang Fang, who said… the unwinding of these funds’ positions was so massive that it spurred small-cap stocks to underperform by a historic margin.
China’s intervention to stem the turmoil also caused significant market dislocations, compounding the losses for these funds…
Crowded positioning and high leverage contributed to the Chinese quants’ woes, resembling the events of August 2007 when a number of US model-driven hedge funds saw similarly sudden losses, he said.
‘China’s recent ‘quant quake’ has revealed systemic financial risks as a series of interconnected events and highlights the perils of crowding and leverage,’ according to Fang…”
February 21 – Reuters (Samuel Shen and Vidya Ranganathan):
“Chinese hedge fund managers are scrambling to soothe investors after a rout in small-value stocks, even as regulators step up scrutiny of major market players’ activities as they try to revive the country’s ailing stock markets…
Chinese quant funds… are highly exposed to small-cap stocks which started plunging in early February, triggering panic-selling.
Many quant products lost more than 15% of their value in just a week…
‘Onshore quant funds are facing severe losses and liquidation pressure, apart from stricter regulatory scrutiny,’ UBS said in note.
‘If they reduce fund size and decrease trading activities, it may affect market liquidity, especially for small caps.’”
February 22 – Bloomberg:
“China’s quantitative hedge funds are admitting to unprecedented failures by their stock-trading models during one of the wildest two-week stretches in the market’s history.
One manager described it as the industry’s ‘biggest black swan event.’
Another said its models ‘switched from doing it right to getting it wrong repeatedly.’
While historical data on China quant returns is limited, all signs point to record underperformance for such funds…
‘That was the first ever liquidity crisis triggered by a stampede from crowded quant strategies in China,’ said Li Minghong, a fund-of hedge-funds manager at Beijing Yikun Asset Management LP. While such risks were anticipated, ‘I didn’t know it would come so early, so abruptly.’”
February 22 – Bloomberg:
“Some of China’s largest quantitative hedge funds, including High-Flyer Quant Investment, have denied rumors of them nearing bankruptcy or forced liquidation following recent market decline, the 21st Century Business Herald reported, citing the firms.”
Significant de-risking/deleveraging hit the Chinese stock market.
A domestic hedge fund industry that expanded rapidly over recent years is now reeling.
And while Beijing had no issue when the levered players were long the market, they today have little tolerance for selling or shorting.
The impaired “quants” and hedge funds will now face the specter of investor redemptions and forced liquidations.
The Shanghai Composite rallied 4.8% this week.
The “national team” was hard at work, along with the view that near market meltdown was enough to get Beijing’s attention.
Volatility and bear market rallies notwithstanding, contagion is becoming a more pressing issue.
Crisis of confidence dynamics inch closer.
February 23 – Wall Street Journal (Cao Li):
“China’s real-estate downturn is getting worse.
The latest bad news: A sharp drop in the average price of a home in 70 big cities in mainland China, a proxy for the national market.
New home prices fell 1.24% from a year earlier, accelerating from December’s 0.89% decline, according to… China’s National Bureau of Statistics.
Secondhand home prices did even worse, falling by 4.4% in January compared with a year earlier.
It was the steepest such decline in almost nine years.”
Mounting China fragility might explain this week’s downward pressure on global yields in the face of bubbling equities markets.
It has taken awhile, but Japan’s Nikkei 225 Index this week finally surpassed its 1989 Bubble peak.
The late-eighties Japanese Bubble was part of my introduction to macro analysis.
I remember the period clearly.
Japanese manufactures and banks were going to take over the world.
I used to think we had learned important lessons.
Major speculative asset Bubbles inflate during periods of low consumer price inflation.
Protracted Bubbles leave a legacy of deep structural maladjustment.
Chinese officials carefully studied the Japanese experience and forgot everything.
And I guess if the Federal Reserve can’t even recall lessons from the mortgage finance Bubble experience, we can’t expect much was gleaned from Japan’s eighties fiasco.
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