The Greatest Threat
Doug Nolan
Let’s get started with domestic.
Ten-year Treasury yields traded this week at the lowest level since March.
Markets have taken this as confirmation of economic weakening.
The market closed Friday pricing a 4.85% policy rate at the Fed’s December meeting, implying two rate cuts (48 bps).
Mohamed El-Erian is emboldened, penning his “The Fed Needs to Cut Sooner Rather Than Later” piece this week for the Financial Times:
“The stronger argument for the importance of timing relates to the state of the economy. Mounting, though not yet universal, data signal economic weakening, including deteriorating forward-looking indicators.”
As for forward-looking indicators, I remain skeptical that the economy will meaningfully weaken so long as financial conditions remain extraordinarily loose.
Corporate debt issuance remains exceptional.
Meanwhile, state and local governments have joined the party.
June 20 – Bloomberg (Joe Mysak):
“The municipal bond market this week soaked up a record 27th deal of $1 billion or more, with overall borrowing accelerating at a torrid pace.
Debt sales are being driven in part by a decline in borrowing costs over the past few weeks…
Top-rated borrowers can borrow money for 10 years at about 2.80%...
That’s down from 3.09% at the end of May.
The previous annual record for so-called mega-deals was in 2020, when 26 were sold, totaling $46.49 billion…
Through Wednesday, 27 muni megadeals totaling $42.96 billion have been sold.
So far this year, states and localities have sold $221.4 billion in long-term debt, 42.8% ahead of last year’s pace.”
This “torrid pace” of borrowing will boost spending.
Markets disregarded the strong Services ISM report from a couple weeks back.
Strength was corroborated by Friday’s stronger-than-expected PMI data.
My analysis weights the much larger service sector above manufacturing activity, but it’s worth noting that the Manufacturing PMI rose to the highest level (51.7) since March.
The Employment component gained to the strongest reading since September 2022.
At 55.1, the Services PMI rose to the high since April 2022.
The PMI release included a notable quote from S&P Global Market Intelligence Chief Economist Chris Williamson (compliments of Bloomberg’s Vince Golle):
“The upturn is broad-based, as rising demand continues to filter through the economy.
Although led by the service sector, reflecting strong domestic spending, the expansion is being supported by an ongoing recovery in manufacturing.”
There are ample signs of economic weakness.
To be sure, the U.S. Bubble Economy is extraordinarily unbalanced.
Yet the overall economy maintains sufficient momentum to sustain inflationary pressures and keep the Fed on the sideline.
The Atlanta Fed GDPNow indicator remains above 3.0%.
The U.S. economy is incredibly vulnerable, though perpetuating “Terminal Phase” excess only exacerbates fragilities.
So far, trouble at the “periphery” (i.e., France) has supported loose conditions at the “core”.
Probabilities for a destabilizing global “risk off” deleveraging continue to rise.
With French elections (June 30th and July 7th) rapidly approaching, Wall Street remains summer-time free and easy.
They may talk reckless tax and spend and anti-reform policies, but France’s far-left and far-right parties surely wouldn’t risk a market crisis. Besides, Marine Le Pen has her sights on the 2027 presidential election prize.
As the thinking goes, she’ll keep one eye on the markets, as she dons her most engaging political moderate guise.
June 17 – Bloomberg (Alice Gledhill and Farah Elbahrawy):
“French stocks gained and bonds posted small moves as traders weighed assurances from far-right leader Marine Le Pen that she’d work with President Emmanuel Macron should she prevail in national elections…
Concern about political volatility after Macron called a snap vote for later this month spurred a flight to haven assets last week, wiping out $258 billion from the market capitalization of the country’s stocks.
On Monday, traders initially seized on Le Pen’s comments that she won’t try to push Macron out, but sentiment remains fragile before the first round of voting on June 30.”
Le Pen's comments comforted markets eager to believe the instability of the previous week was an overreaction.
German yields reversed as much as eight bps higher Monday, as the France/Germany 10-year yield spread narrowed.
By the end of the week, however, the spread had widened another three bps to a 12-year high of 80 bps.
French 10-year yields jumped eight bps this week - exceeding Portuguese yields by five bps and coming within eight bps of Spain.
Much of the early-week relief decline in European bank and high-yield (“crossover”) CDS had also faded by Friday.
Subordinated bank debt CDS declined six on the week, an unconvincing reversal following the previous week’s 31.5 bps spike.
High yield CDS reversed only seven of the 42 bps surge.
BNP Paribas CDS gained another two to 53 bps, the high since December 2023.
Societe Generale CDS rose three to 62 bps – also the high since December. Individual European bank (senior) CDS generally rose to multi-month highs.
June 21 – Bloomberg (Jenny Che):
“Marine Le Pen’s far-right National Rally would win first round of the French legislative election with 35%, according to latest Ifop-Fiducial poll of voting intentions...
National Rally gains 1 point since previous survey…
Alliance of left-wing parties would get 29%... President Emmanuel Macron’s group would get 21.5%...
National Rally would get 200-240 seats; left-wing alliance would get 180-210; Macron’s group would get 80-110.”
I don’t sense a fear of financial crisis is top of mind (outside of, perhaps, European debt markets).
It’s late in the speculative cycle, so U.S. market complacency is not surprising.
Markets have inflated so big, bold, and dominant that the notion of European politicians going rogue and triggering a crisis seems implausible to most.
But if France’s extremist party leaders are these days intimidated by the financial markets, they do a decent job of concealing it.
June 21 – Bloomberg (William Horobin):
“France’s leftist alliance unveiled plans to address the country’s economic challenges with a vast increase in taxation and public spending, and reaffirmed it would abolish several of Emmanuel Macron’s pro-business reforms.
By 2027, when the president’s mandate ends, the New Popular Front is budgeting €90 billion ($96.2bn) annually to boost purchasing power, €30 billion to protect the environment, and a further €30 billion to repair public services — totaling roughly 5.4% of last year’s gross domestic product.
That would be matched by extra revenue including from levies on multinationals and financial transactions, it said.
‘The Macron era is over,’ Socialist Party Senator Alexandre Ouizille told a news conference on Friday.
‘In a few days, there’ll be nothing left of it.’”
Under the headline, “Why Far Right Won’t Spark a Euro Crisis,” The Wall Street Journal’s Greg Ip wrote:
“Since a debt crisis beginning in Greece in 2009 almost destroyed the euro, investors have been alert to anything that threatens the survival of the European Union or the common currency shared by 20 of its 27 members.
But an RN [Pen’s National Rally Party] victory wouldn’t qualify.
As Europe’s far-right parties have crept closer to power, their stated goals have shifted from leaving the EU to reforming it from within.
The underappreciated story of Europe’s election season isn’t the fragility of the EU and euro, but their resilience.”
The European monetary union was arguably at greater risk during the 2011/12 (Italian-led) European debt crisis (compared to 2009) – a cataclysm that provoked Mario Draghi’s “bumblebee” speech and history-altering “whatever it takes” money printing.
The ECB’s balance sheet had doubled from 2011’s $2.0 TN to surpass $4.0 TN in early 2017 – only to almost reach $9.0 TN following egregious pandemic monetary inflation.
Massive central bank buying and market backstopping promoted government borrowing excess and material debt ratio deterioration since the previous crisis.
France’s debt at 111% of GDP is similar to Italy’s level when Italian bonds in 2011 suffered a crisis of confidence (yields spiking to 7%).
I’ll assume the extremist parties are not today hankering to blow apart the EU and the euro currency.
But how willing will a far-right and far-left-dominated French parliament be to work with the EU to shrink France’s deficit (currently 5.5% of GDP) back below the 3% limit?
June 19 – Bloomberg (Jorge Valero, William Horobin and Alessandra Migliaccio):
“France and Italy were reprimanded by the European Union for running big deficits, the first stage in a confrontation that will test the bloc’s resolve and could in theory prompt billions of euros in fines.
The announcement by the European Commission… is all the more consequential with French legislative elections looming that have rattled investors on the prospect that a winner from either the far-right or the left will only further bloat the country’s public finances.
In total, seven nations newly face censure by officials for running budget shortfalls above the bloc’s 3% limit, leaving them subject to the bloc’s so-called Excessive Deficit Procedure that requires remedial action and can lead to fines for non compliance.”
France is at the “core” of the EU and the euro – and it’s reasonable to assume that the new parliament will flout the deficit rules and remain in non-compliance indefinitely.
The ECB has its so-called “Transmission Protection Instrument”, or TPI, that was conceived as a mechanism to backstop periphery bond markets “to counter unwarranted, disorderly market developments if these pose a serious threat to the smooth transmission of monetary policy across the euro area.”
Basically, the ECB believed markets understood the central bank was ready to purchase bonds in the event of a significant widening of spreads (to cap peripheral yields), the marketplace wouldn’t panic and dump (Greek and Italian) bonds during periods of instability.
From QE to APP, OMT, LTRO, TLTRO, MRO, PEPP, and TPI – the “whatever it takes” ECB developed a liquidity facility to rectify seemingly any unfavorable market development.
And all these programs worked to bankroll a fabricated stability – relatively stable markets that accommodated borrowing excess and resulting deficit spending significantly in excess of EU rules.
Now what?
Austerity would inflict hardship on an already indignant population.
I won’t profess great insight into France’s election.
I certainly can’t claim expertise in the inner workings of the EU and ECB.
But I’ve analyzed my share of crises.
And this one has potential to surprise many folks – to shock manic markets that have pushed risk-taking to the limits.
Potentially, the first debt crisis in a “core” economy since 2008.
The EU’s second largest economy – with the largest ($2.6 TN) government debt market - is likely at the brink of political crisis.
Markets, having grown accustomed to not worrying about debt crises, could confront one that doesn’t fit within the parameters of ECB bailout mechanisms.
The TPI is structured specifically to “combat deteriorations in financing conditions not warranted by country-specific fundamentals…”
Benefitting nations “must pursue sound and sustainable fiscal and macroeconomic policies”.
“In particular, the criteria include: (1) compliance with the EU fiscal framework: not being subject to an excessive deficit procedure (EDP), or not being assessed as having failed to take effective action in response to an EU Council recommendation under Article 126(7) of the Treaty on the Functioning of the European Union (TFEU)… (2) absence of severe macroeconomic imbalances: not being subject to an excessive imbalance procedure (EIP)… (3) fiscal sustainability: in ascertaining that the trajectory of public debt is sustainable, the Governing Council will take into account, where available, the debt sustainability analyses by the European Commission… (4) sound and sustainable macroeconomic policies…”
The ECB must be praying it won’t have to get involved.
A huge bailout for France, especially with “Eurosceptics” and extremists effectively in control of the government, would be controversial to say the least.
And while markets imagine Le Pen playing nice (until ’27), all bets are off in a crisis environment.
Understandably, supporters on both the left and right will expect the ECB to immediately quell crisis dynamics.
Quick to point blame at the ECB and EU, an angry population will pressure political leaders to not cave to the demands of Frankfurt or Brussels.
The euro was little changed this week, failing to muster even a mild relief recovery.
As they say, crises unfold gradually and then suddenly.
If the first vote is inconclusive (i.e., no party wins a majority), some semblance of clarity may have to wait until July 7th.
And even post-election, it could take weeks or even months to gain a clear understanding of the direction of political leadership and policymaking.
But it’s difficult to see a scenario that doesn’t involve an unfolding (at best) political crisis.
And highly levered European debt markets ensure fragility.
The prospect of a political and debt crisis at Europe’s “core” doesn’t instill confidence in the euro currency.
In a more normal backdrop, markets at least in the near-term would afford the euro the benefit of the doubt.
But this is a global environment seemingly on the cusp of acute instability.
The Japanese yen dropped 1.5% versus the dollar to end Friday with the weakest closing price all the way back to April 1990.
China’s renminbi slipped to the weakest level since November.
It doesn’t take a wild imagination to envisage a scenario where weakness in the euro, yen and renminbi feeds on itself, propelling destabilizing dollar strength that slams the vulnerable emerging markets.
As I noted in last week’s CBB, instability at Europe’s “core” and attendant euro worries create a potential de-risking/deleveraging catalyst.
And “risk off” would catch extremely over-levered and complacent markets by surprise.
June 21 – MarketWatch (Joseph Adinolfi):
“Trading in bullish calls tied to megacap growth and tech stocks outnumber bearish puts by the widest margin on record…
Options traders piled into bullish bets on megacap growth stocks like Nvidia Corp. at a record pace this week, surpassing the previous pandemic-era peak.
On average, trading in bullish call contracts exceeded bearish puts by roughly 4.5 million contracts during the five days through Friday…
Calls tied to Nvidia were the most popular options ahead of Friday’s June ‘triple witching’ expiration, even surpassing activity in contracts tied to the S&P 500 and a popular ETF SPY that tracks the benchmark index…”
June 21 – Bloomberg (Rita Nazareth):
“Wall Street’s massive expiration of options not only left stock traders more cautious, it also drove one of the leaders of the bull market to a roller-coaster ride.
Volume soared at the close of trading.
It was estimated that $5.5 trillion expired during the quarterly event ominously known as triple witching’ in which derivatives contracts tied to equities, index options and futures mature.
Nearly 18 billion shares changed hands on US exchanges Friday.
That’s over 55% above the three-month average.”
Nothing to see in Europe.
Not with Nvidia/AI/big tech melting up into a $5.5 TN quarterly options expiration.
Reasonable odds of peak mania.
And what is the probability of full-scale war erupting between Israel and Hezbollah?
Rising.
Hadn’t heard much of the “basis trade” for a bit – that is until Thursday’s Bloomberg Intelligence (Brian Meehan) Report:
“Biggest Bond Market Threat: Massive Basis Trade.”
“Assessing the risk of the cash-futures basis market reveals near-record net short positions at the front end of the curve -- the two-, five- and 10-year contracts – while the rest is neutral.
At the same time, open interest in Treasury futures is at an all-time high of $2.5 trillion, up 40% from the last basis blowout in 2020, while the leveraged net short has more than doubled to $875 billion in 18 months.
The warning signal is loud and clear: Any stress in the repo market that leads to forced liquidations of those massive basis positions is the greatest threat the market has ever seen.”
Unfolding stress in Europe pressuring Treasury yields lower while bolstering the dollar.
Looser financial conditions buoying the U.S. Bubble Economy, holding Fed rate cuts at bay.
Higher yields and perceived safe haven U.S. financial markets acting as magnets for liquidity, as global risk aversion and de-leveraging gather momentum.
Leveraged speculation has never so dominated every nook and cranny of global finance.
Global de-risking/deleveraging “is the Greatest Threat markets have ever seen.”
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