Instability
Doug Nolan
The Japanese yen (dollar/yen) traded Monday to 160.17, the first time above 160 since April 1990.
The yen rallied to 154.54 after purported intervention.
The Japanese currency had weakened back to 157.94 by Wednesday, before a second round of intervention pushed the dollar/yen down to 153.
It was back above 156 on Thursday, before reversing lower to end the week at 153.05.
From high to low, it was a range of 5%.
The Nasdaq100 (NDX) traded up to 17,800 in Monday trading – then dropped 2.9% to Wednesday morning lows.
The index spiked 2% on dovish Powell, only to sink 2% into Wednesday’s close.
And from Thursday lows (17,291), the NDX rallied 3.7% to 17,927 – and closed the week at 17,891.
Two-year Treasury yields traded to a high of 5.04% on Tuesday afternoon.
The intraday low of 4.71% occurred immediately upon Friday morning’s release of weaker-than-expected payrolls data (2-yr yields down 18bps for the week to 4.82%).
Ten-year Treasury yields traded in a range of 4.69% to 4.45% - ending the week down 16 bps to 4.51%.
MBS yields traded in a 34 bps range (6.23% - 5.89%) – closing the week down 22 bps to 5.93%.
At Tuesday’s close, the market was pricing a 5.05% Fed funds rate for the December 18th meeting (28 bps of rate reduction).
By Friday’s close, this rate was down to 4.87% (46bps of reduction).
Basically, the market shifted from one cut in December to two starting by November.
Powell is a dove.
That was likely settled for good Wednesday.
There was justification for market expectations of a more hawkish FOMC and Chair.
Inflation has been sticky, and the current trajectory unclear.
It’s a leap of faith today to believe inflation is moving to the Fed’s 2% target.
Powell should not have surprised us.
He may play dumb when financial conditions loosen, but his November 1st press conference made it clear that he is astutely aware when conditions are tightening.
It would have been out of character for Powell to pivot hawkish Wednesday, not with global yields rising, the yen in trouble, currencies unstable, and stock Bubbles wobbly.
Any pushback to fledgling tightening these days ensures excessively loose financial conditions.
The Goldman Sachs short index surged 8.6% this week.
The yen jumped 3.5%.
Two-year Treasury yields dropped 18 bps, and MBS yields sank 22 bps.
A mini “everything squeeze” certainly helps loosen things up.
Investment-grade spreads to Treasuries declined one this week to 86 bps, the narrowest spread since November 2021.
Difficult to see inflation cooperating so long as financial conditions remain this loose.
Loose reinforces tight labor.
And I worry that loose conditions will continue to fuel bubbles (i.e., stocks, tech, AI) until a disorderly tightening has things all crashing down.
Stocks appear incapable of an orderly correction, as is expected from a speculative Bubble.
We won’t know until the end of the month how much intervention has set back Japan’s Ministry of Finance.
I see Japan as a good test case for the scope of intervention required to corral (post-Covid stimulus) super-sized speculative market Bubbles.
It took decades of hard work for Japan to accumulate its $1.15 TN international reserve position.
There’s going to be understandable angst watching national wealth frittered away buying yen.
And things are turning fascinating in the bond market.
The Fed has turned a blind eye to mounting inflation risk.
Beijing appears ready to crank up stimulus, with potential to give the global economy – and inflation – a shot in the arm.
Washington has gotten too used to its blank checkbook, ensuring massive issuance until that fateful day the market imposes some discipline.
Another interesting week supports the heightened Instability thesis.
Below is an excerpt from Thursday’s McAlvany Wealth Management Tactical Short Q1 recap conference call (Doug Noland and David McAlvany), “Dovish Pivot to Melt-Up to Instability.”
We’ve been hearing a lot lately about “American exceptionalism.”
Unfortunately, I fear future historians will view this catchphrase in a similar light to Irving Fisher’s pre-crash 1929 “permanent plateau of prosperity.”
To subscribe to the bullish narrative today is to believe that unprecedented money and credit creation, interest-rate manipulation, and repeated market bailouts are healthy promoters of true economic wealth and system stability.
If our system were sound, why then have we been running unprecedented peace-time federal deficits - and why is the Fed’s balance sheet still at $7 TN?
Why is there so much stress within society and enmity in geopolitics?
Does a sound system embolden unprecedented leveraged speculation – massive “repo” borrowings, “carry trades,” “basis trades,” margin debt and hundreds of trillions of derivatives?
Is it healthy to have tens of millions actively gambling on stocks and options?
Answers to these questions seem rather obvious.
Is this how Capitalism is supposed to operate, or has something gone horribly astray?
The bottom line is that the U.S. – and, really, the world – has been suffering from acute and prolonged monetary disorder.
The runaway expansions of central bank balance sheets and speculative leverage have created tens of trillions of pernicious “money” – liquidity fueling historic asset bubbles, inequality, inflation, and all sorts of maladies.
There’s been nothing similar for almost a century.
There are indeed many alarming parallels between the current cycle and the “Roaring Twenties.”
Both were spectacular boom cycles fueled by a confluence of transformative new technologies and financial excess – bubbles repeatedly resuscitated by central bank stimulus measures.
After all, recurring government interventions and bailouts emboldened speculators, bankers, corporate executives, consumers, and risk-takers more generally.
Perverted incentives and distorted risk perceptions set the stage for what I refer to as “Terminal Phase” excesses, which conclude the cycle.
New York Fed president Benjamin Strong administered a fateful “coup de whiskey” in 1927 that unleashed catastrophic speculative leveraging - culminating in 1929’s melt-up and subsequent panic and crash.
Similar dynamics were unleashed from egregious pandemic stimulus - excess provided an additional shot of adrenaline from March 2023 banking crisis stimulus, including $700 billion of Fed and FHLB liquidity injections, along with what amounted to blanket deposit guarantees.
Financial conditions loosened following bank bailout measures, even as the Fed raised rates.
At mid-month last September, most of my financial conditions indicators signaled that the so-called Fed “tightening” cycle had thus far imposed little system tightening.
Conditions, however, began to tighten meaningfully in October, with a booming economy and heightened geopolitical risks weighing on market sentiment.
Importantly, with global yields spiking, there were indications that a de-risking/deleveraging dynamic was starting to take hold.
And right on cue, an abruptly less hawkish Powell at his November 1st press conference asked rhetorically:
“The question we’re asking is: Should we hike more?”
The Fed Chair triggered nothing less than a historic short squeeze – in stocks, Treasuries, fixed income, currencies and EM – the global so-called “everything squeeze.”
Market sentiment had turned bearish, with considerable shorting and derivatives hedging.
Powell lit the “melt-up” match.
The Nasdaq100 jumped almost 11% in November.
Between November 1st and December 12th, the day before the next FOMC meeting, the Nasdaq100 returned almost 14%, and the Goldman Sachs Short Index 18%.
The Semiconductor Index spiked 22%. Nvidia and Micron rose 17%, while AMD was up 40%.
Financial conditions had loosened dramatically.
For example, high yield corporate bond spreads versus Treasuries closed December 12th at 363 bps – down from 438 bps on November 1st – to the low back to April 2022 – shortly after the Fed’s initial rate increase.
I believe the FOMC’s December 13th meeting will be debated for decades.
Following a conspicuously speculative market rally, a major loosening of financial conditions, and a 4.9% Q3 GDP print, the Fed nonetheless telegraphed a “dovish pivot.”
So much for traditional “lean against the wind” policy caution.
And never mind William McChesney Martin’s celebrated insight that the job of the Fed is “to take away the punch bowl just as the party gets going.”
Well, the crowd was intoxicated and increasingly irrational.
The Fed spiked the punch anyway.
From my analytical framework, which heavily leans on financial conditions and bubble dynamics, it was reckless monetary mismanagement.
It certainly stoked a market melt-up for the history books.
From October 26th lows to March highs, the Semiconductors rallied 65%, the KBW Bank Index 47%, the NYSE Computer Technology Index 39%, the small cap Russell 2000 31%, the Nasdaq100 30%, and the S&P500 28%.
Bitcoin ended March up 159% from October lows, trading at a record high of $73,798 on March 14th.
Loose conditions turned much looser.
From an October high of 5.00%, 10-year Treasury yields were down to 3.8% in late-December.
By mid-January, the market was pricing more than six 2024 rate cuts.
Investment-grade spreads to Treasuries traded down to 88 bps late in the first quarter, the narrowest risk premium since November 2021 – and within only seven bps of the low back to 2005.
Corporate debt issuance was phenomenal, with Q1’s $530 billion of investment-grade sales 11% ahead of 2020’s first quarter record.
M&A volumes were up 59% y-o-y to $432 billion.
Such “terminal phase excess” has major consequences.
For one, the period of late-cycle credit excess was further extended.
From Federal Reserve data, we know that Non-Financial Debt – or NFD - expanded at an annualized rate of $3.5 TN during the fourth quarter.
This put 2023 NFD growth at $3.63 TN, down only slightly from 2022.
To put this enormous credit expansion into perspective, 2023 NFD growth was almost 50% higher than pre-pandemic 2019’s $2.47 TN – with 2019’s expansion the strongest since 2007’s then record $2.53 TN.
Federal borrowings last year increased $2.62 TN.
But it’s not just the Federal government, which partakes in late-cycle borrowing excess.
So-called “private credit” – which is essentially subprime corporate lending – continues its phenomenal boom.
Subprime lending has also become a fixture in consumer finance, driven by “buy now pay later,” soaring credit card balances, and myriad new age lending platforms.
We’re sure hearing a lot of “soft landing” rhetoric.
But our economy is today in a credit and asset inflation-induced boom.
It’s a bubble economy acutely vulnerable to any tightening of financial conditions.
The situation is highly unstable, instability made only more acute by market speculative melt-ups.
It will have a “soft landing” appearance only while credit, market and economic booms continue.
But don’t for a minute believe that credit, business and market cycles have been relegated to history.
When bubbles inevitably start bursting, a hard landing will be unavoidable.
You might have heard some talk about the so-called “neutral rate” – referred to as “r-star” by the economics community.
It is a hypothetical rate at which monetary policy is neither contractionary nor expansionary – an equilibrium rate, if you will.
Most economists believe this rate is between two and three percent, with the latest Fed “dot plot” placing the longer-term rate at 2.5%.
But with a current policy rate double that level failing to restrain the boom, some analysts now argue the neutral rate must be higher.
By neglecting bubble analysis, the entire neutral rate debate is flawed.
After all, an identical policy rate in an environment where bubble inflation maintains momentum will have different impacts compared to during a bubble deflation.
The primary analytical focus should be on the effects rate policy are having on system financial conditions.
And keep in mind that bubbles are creatures of loose conditions.
Moreover, bubbles possess incredible capacity to sustain easy conditions.
Bubble dynamics perpetuate credit and speculative excess, processes that generate self-reinforcing liquidity abundance.
The Fed “tightening” cycle failed to contain bubble excess specifically because policy rates didn’t impose tighter conditions.
This is such a critical point.
Powell and Fed officials have repeatedly spoken of significantly restrictive policy, when a litany of indicators – including credit availability and expansion, spending and GDP growth, equities and asset prices, and the precious metals – all provide evidence of quite loose conditions.
An important question: Why is the system proving so immune to policy tightening – to rate increases and QT?
Let’s start, as sound analysis dictates, with credit.
Our federal government has been impervious to rising market yields.
Politicians certainly haven’t tempered borrowing and spending plans in response to higher policy rates.
Washington borrowed more last year than what the entire economy – government, business, and household sectors - borrowed in the pre-pandemic years.
Importantly, there remains insatiable demand for government securities.
In my nomenclature, government debt retains the critical attribute of “moneyness” despite now uncontrolled over-issuance.
The legacy of Fed QE and market intervention is fundamental to bullish perceptions of enduring liquid and safe securities markets.
Indeed, the view holds stronger than ever that the Fed will guarantee Treasury market liquidity.
It has become fundamental to contemporary monetary policy doctrine that central banks are committed to open-ended government bond buying necessary to safeguard robust markets.
The Fed liquidity backstop has been instrumental in the ballooning of levered speculation, including a massive “basis trade.”
Here, hedge funds borrow in the “repo” market to establish highly levered Treasury positions, while offsetting interest-rate risk by shorting Treasury futures.
This enormous securities leveraging operation has generated critical bubble-sustaining liquidity.
It was back in February 2009 that I began warning of an unfolding global government finance bubble.
Over the years, I’ve referred to this as the “granddaddy of all bubbles.”
The adoption of QE and massive deficit spending were fundamental to fanatical reflationary policymaking.
This marked the full abandonment of traditional restraints and guardrails.
Washington and governments around the globe unleashed virulent bubble dynamics that would prove impossible to control.
The sordid history of inflationary policymaking is replete with examples of stopgap money printing sliding into deeply entrenched and eventually out-of-control monetary inflation.
And with contemporary “money” and credit merely debit and credit entries in this colossal globalized electronic general ledger, there is today no need for wheelbarrows.
All the “American exceptionalism” and AI hype - and irrepressible market bubble excess – corroborate out-of-control bubble blow-off phase dynamics.
I’ll highlight a few recent examples.
A headline from last week: “Micron Clinches Up to $13.6 Billion in US Grants, Loans.”
This was part of Micron’s commitment to investing $125 billion in four new U.S. semiconductor fab plants.
This money was provided by the 2022 Chips and Science Act.
Intel will receive $8.5 billion, and Samsung $6.5 billion.
Investment in new semiconductor manufacturing is part of the massive unfolding spending boom in all things AI-related.
This is a case study in late-cycle craziness – powered by perceptions of unlimited finance, perpetual bull markets, and permanent prosperity.
Things have regressed into a perilous global government-driven arms race.
The Financial Times ran an interesting article last week reporting on South Korea’s incredible semiconductor spending boom, described by the country’s President as a “semiconductor war.”
I’ll quote from the article:
“The 1,000-acre site, a $91bn investment by chipmaker SK Hynix, will itself only be one part of a $471bn ‘mega cluster’ at Yongin that will include an investment of $220bn by Samsung Electronics.
The development is being overseen by the government amid growing anxiety that the country’s leading export industry will be usurped by rivals across Asia and the west.”
As astounding as tech arms race spending is in the U.S., South Korea, and many countries, it is surely paltry compared to what has been unfolding with government-directed investment in China.
The accelerating deflation of China’s historic apartment bubble has Beijing doubling down on state-directed spending in semiconductors, AI, EVs, renewable energy, and myriad cutting-edge technologies - for domestic consumption and export.
And last week, China’s Ministry of Finance vowed support for People’s Bank of China government bond purchases, a policy shift endorsed in a recent book compiling Xi Jinping’s pronouncements on finance and economics.
Well, it wasn’t long ago that Beijing was denouncing Western QE policies.
Perhaps Beijing has realized there are limits to how far it can push its bloated state-directed banking sector.
It’s worth adding that China’s sovereign wealth fund bought $43 billion of ETFs during Q1, part of huge “national team” government stock market support.
China is today demonstrating ultimate “terminal phase” government finance bubble dynamics.
Things have turned only crazier in China, as a somewhat different strain of crazy afflicts Japan.
At last Friday’s meeting, the Bank of Japan upgraded its inflation forecast from 2.4% to 2.8%, for an economy with a 2.6% unemployment rate.
Yet the BOJ held firmly with its near-zero rate policy, while reaffirming its bond buying program.
The yen was slammed 1.7%, sinking to the low versus the dollar all the way back to May 1990.
Reports have Japan spending upwards of $30 to $40 billion Monday to defend its currency, and perhaps more in Wednesday evening’s second round.
The BOJ is predictably trapped by its misguided experiment with hyper-monetary stimulus.
Years of negative rates and bond market manipulation have left a legacy of epic market distortions and deep financial structural maladjustment.
Amazingly, the BOJ now owns over half of the Japanese government bond market.
Backing away from bond-buying risks a destabilizing spike in yields and massive losses – in the marketplace and within its own balance sheet.
Meanwhile, the yen suffers the effects of zero rates and ongoing outflows – outflows from yield-seeking domestic sources, as well as from levered speculators capitalizing on free funding from a weak currency - cheap financing used to lever higher-yielding securities around the globe.
Yen trading has turned disorderly.
The Ministry of Finance was understandably reluctant to start a fight with the markets that will be quite expensive and challenging to win.
I believe global markets have commenced a period of heightened instability, with the currencies increasingly at the epicenter of destabilizing volatility.
And unstable currencies create a predicament for levered “carry trades” and leveraged speculation more generally.
It is today reasonable to contemplate the unsustainability and deepening fragility associated with global government finance bubble “terminal phase” excesses.
For starters, ongoing global credit and spending excess ensure persistent inflationary pressures.
I’m fond of repeating the quip, “that which does not destroy a bubble only makes it stronger.”
The Fed’s failure to tighten conditions further energized bubble dynamics.
We’ve watched commodity prices gain momentum, while global yields have surged back to highs since last November.
“Higher for longer” applies to central banks around the world.
And elevated borrowing costs are a major problem for a highly over-indebted world.
They’re a pressing issue for vulnerable debt markets and increasingly fragile currency markets.
In a notable development, Indonesia’s central bank last week surprised the markets by raising rates to support the weak rupiah.
Who’s next?
What countries lack the wherewithal to stabilize their currencies?
Where is the “hot money” most exposed?
This is an environment where contagion can become an urgent issue.
Today’s backdrop is particularly precarious for heavyweights Japan and China.
A rapidly devaluing currency risks unleashing inflation and a bond market crash in Japan.
A BOJ forced to accelerate policy “normalization” risks unmasking epic financial imbalances at home and abroad.
I’m assuming so-called yen “carry trade” levered speculation mushroomed into the trillions, while creating demand and liquidity abundance in about every nook and cranny of global debt markets – certainly including the U.S., peripheral Europe, China, and the emerging markets.
Leveraged speculation has profited handsomely from zero rates, yen devaluation, and telegraphed assurances of ongoing accommodation.
All bets are off when Japan belatedly recognizes the imperative of major policy tightening to stabilize the yen.
I believe China’s predicament is even more precarious.
The renminbi currency trading band has essentially turned into a hard peg to the U.S. dollar, as an apprehensive Beijing is compelled to tighten control.
But “higher for longer” and booming U.S. markets, along with a sickly yen, have propelled dollar gains.
China’s currency appreciated 10% versus the yen over the past year, with more moderate gains versus other Asian currencies.
This has placed China’s export sector at a competitive disadvantage, right as Beijing presses its bet on booming exports to counter their housing depression.
Beijing needs a weaker currency, and they recently attempted a couple tweaks in the currency band - hoping to orchestrate measured devaluation.
But markets reckon band tweaks are only a prelude.
Instability immediately forced Beijing to retreat to its hard peg.
For evidence of currency peg danger, one can look back to the 1995 Mexican “tequila crisis”, the devastating 1997 Asian Tiger domino collapses, the 1998 Russia/LTCM debacle, and the 2002 fiasco in Argentina.
China rapidly expanded to become the second largest global economy.
Since 2008, the Chinese banking system has inflated from $8 TN to $58 TN – with bank assets surging a record $5.2 TN last year.
Superpower ambitions and bitter rivalry with the U.S. ensure Beijing will work furiously to sustain credit and economic booms.
Beijing is also determined to promote the renminbi as a leading global currency.
Increasingly, China’s credit and growth objectives are in direct conflict with a stable currency.
Despite its collapsing apartment bubble, China expanded credit a record $5.0 TN last year.
We can assume that much of this credit was non-productive, financing uneconomic zombie enterprises and epic malinvestment – not to mention the impact of compounding debt service costs for risky borrowers.
There is also the nation’s deepening relationship with the Russia, Iran, and North Korea anti-U.S. axis – along with Western business exodus from China.
Add the intensifying global backlash against Chinese trade policies, and China is left with troubling currency prospects.
The renminbi has been underpinned by China’s $3.2 TN of international reserves, ongoing trade surpluses, and, importantly, the perception that Beijing would never tolerate a disorderly currency devaluation.
The marketplace has good reason today to question both the true size of liquid international holdings and China’s trade prospects.
Estimates have China suffering monthly outflows of $40 to $50 billion dollars.
Beijing now regularly calls upon its major state-directed banks to sell dollars and establish derivatives positions to support China’s currency peg.
There are indications that Beijing is leaning heavily on derivatives, rather than burning through international holdings.
I’ve in the past repeatedly witnessed how such measures and subterfuge promote mounting fragilities.
In the case of currency pegs, increasingly desperate measures to sustain the peg ensure banking system and derivatives vulnerability to market dislocation and crisis dynamics.
Meanwhile, the growing perception of an unsustainable peg encourages only more aggressive capital outflows, speculative bets, and one-sided derivatives exposures, along with a shrinking reserve position.
At some point, it becomes clear that the cost of maintaining the peg is too heavy.
There comes a fateful moment when confidence that a disorderly devaluation will never be tolerated turns to fear that it is likely unavoidable.
I fear we’re approaching such a critical juncture with China’s currency peg.
Devaluation seems inescapable.
Of course, Beijing would prefer a nice and gradual process.
But any small devaluation will spur outflows keen to avoid further depreciation.
But a big devaluation risks unleashing major instability, as banks, derivatives operators, and leveraged speculators recoil from losses.
Any meaningful devaluation would trigger a wave of derivatives-related selling and disorderly trading.
Typically, a central bank is forced to respond to currency dislocation with higher policy rates and tighter credit policies.
Surging bond yields and faltering financial markets then induce abrupt system tightening and economic turmoil.
Gold and silver have recently made powerful upside moves.
Commodities generally show signs of life.
Having taken a backseat during the financial asset melt-up, hard assets are beginning to show their safe haven mettle.
And analysts are increasingly pondering whether these markets are portending currency crisis.
To conclude, let me offer a brief summary.
The world’s most powerful central bank signaled a shift to rate cuts despite exceptionally loose financial conditions, quite strong credit growth, and an acutely speculative stock market.
Already vulnerable global bubbles became only more inflated and fragile.
The second largest global economy, suffering the collapse of its historic apartment bubble, is pushing only harder with enormous government-directed lending and investment to meet GDP targets.
And the central bank of the fourth largest economy maintains zero rates and government debt purchases despite a sinking currency and rising inflation.
No one has been willing to make the tough decisions necessary to rein in precarious excess.
All are at heightened risk of losing control.
According to the Institute of International Finance, global debt last year rose to a record $313 TN – a gain of over $100 TN since the start of the pandemic.
There is no doubt that we’re witnessing the greatest bubble ever.
As a bubble fueled by government finance, guarantees and market liquidity backstops, this super bubble has inflated much greater and for much longer than previous bubbles.
This global bubble – at the very foundation of money and credit – has been uniquely powerful, unpredictable, and perilous.
And bubbles inevitably burst.
This global bubble will burst with momentous consequences.
Ongoing “terminal phase” excess ensures global systemic risk continues its parabolic rise until the bubble falters.
I believe inflationary policies from all the major central banks – and governments more generally – have unleashed a period of acute instability.
Unfolding currency volatility foreshadows global market instability.
The stage is set for a highly disruptive global de-risking/deleveraging episode.
Myriad bubbles, certainly including the AI phenomenon, are acutely vulnerable to tightening conditions.
And with elevated inflation risk and rising global yields, central banks are rapidly losing room to maneuver.
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