Vigilantism and Deleveraging
Doug Nolan
Hanging on by the skin of its teeth?
Year ends are invariably interesting – on occasion intriguing.
There’s money at stake, especially this year with huge 2024 market gains.
End of year mark-ups in thin holiday trading (aka “Santa Claus rally”) are expected to lift Wall Street bonuses and, more importantly, hedge fund payouts (typically 20% of the year’s returns).
Sometimes there are sellers standing by to capitalize on year end buying.
Occasionally, markets are susceptible to pent up selling pressure.
There are managers anxious to make portfolio adjustments, yet they prefer to avoid year-end sales that would impact annual performance numbers.
The hope is for a peaceful holiday market price mark-up that pushes out portfolio adjustments early into the new year.
It’s a tenuous peace.
A surprise market downdraft forces players off the fence, sparking an earlier-than-expected start to portfolio changes.
The Nasdaq100 was hit 1.4% in Friday trading.
At least for a session, “magnificent” was a misnomer, with the tech darlings down 2 to 3% at intraday lows.
By the close, Nvidia had dropped 2.1%, Microsoft 1.7%, Netflix 1.8%, Alphabet 1.6%, Amazon 1.5%, Apple 1.3%, and Meta Platforms 0.6%.
Wall Street favorite MicroStrategy fell 3.2%, reducing y-t-d gains to 422%.
Tesla sank 5.0% during the session, reducing Q4 gains to 65.0% (lagging only United Airlines in the S&P500).
I’ll double-down on last week’s CBB thesis that instability has made its initial leap from the “Periphery” to the “Core” – a rather inconvenient development for an exuberant marketplace primed for a year-end rally, followed by an even more pleasurable “January effect.”
Festering instability – “periphery” and “core” – risks upsetting a lot of strategies, plans and dreams.
Russia’s ruble was slammed 4.5% in volatile Friday trading.
For the week, South Africa’s rand dropped 2.0%, Brazil’s real 1.7%, South Korea’s won 1.6%, Russia’s ruble 1.2%, and the Mexican peso 1.3%.
Chunky month-to-date losses include South Korea (5.0%), South Africa (3.3%), Indonesia (2.4%), Chile (2.0%) and Argentina (1.8%).
Brazil’s real has dropped 3.6% so far this month, boosting 2024 losses to 21.6%.
No waning of crisis dynamics in Brazil.
The country’s 10-year (local currency) yields jumped another 27 bps Friday to 15.16%.
Yields surged 96 bps this week, boosting the month-to-date rise to 165 bps – while trading above 15% for the first time since February 2016.
Ten-year Brazilian dollar bond yields rose eight bps this week to 7.09%, up 75 bps month-to-date to the high since October 2023 (approaching highs since 2006).
Brazil’s Ibovespa Equities Index fell 1.5% (down 10.4% y-t-d) to a six-month low.
Brazil’s sovereign CDS jumped five Friday and 14 for the week to 211 bps (began the year at 132 and December at 163bps).
December 24 – Bloomberg (Oscar Medina):
“Colombia and Brazil are both run by leftist presidents with ambitious social agendas.
Now the neighboring Latin American nations have something else in common: growing investor fears about government finance.
In the first two years of their mandates, Gustavo Petro and Luiz Inacio Lula da Silva have taken similar tacks to boost their economies.
They each relied on deficit spending to deliver on campaign pledges just as inflation became a global problem.
And they each lashed out at their independent central banks for raising interest rates…
Faced with the need to balance their budgets, both Petro and Lula unveiled plans to increase government revenue without cutting spending.
Neither announced austerity measures until everything else failed — and in Brazil’s case, it was too little too late.”
Colombia’s 10-year (local currency) yields surged 56 bps this week (up 192bps m-t-d) to 11.87%, the high since October 2023.
Dollar-yields rose another seven bps to 7.69%, with a two-week jump of 33 bps.
Colombia CDS gained four to 209 bps, after beginning 2024 at 157 bps.
Colombia’s peso has declined 12.6% versus the dollar this year.
The Mexican peso’s 1.3% weekly decline pushed 2024 losses against the dollar to 16.5%.
Mexico’s 10-year (local currency) yields rose another seven bps this week to 10.45%, the highest yield since 2002.
Mexico CDS gained 4.5 to 133 bps, the highest close since October 2023.
It’s two straight weeks with heightened instability at the “periphery” failing to engender “safe haven” benefits for the “core.”
Ten-year Treasury yields jumped another 10 bps to 4.63%, the highest close since May 1st.
It’s tempting to suggest that the revitalized bond vigilantes are now active globally – enveloping the “periphery” while penetrating “core” defenses.
UK gilt yields rose 12 bps this week to 4.63%, exceeding the highest close from the October 2022 bond crisis – and within 11 bps of the highest yield back to October 2008.
Japan’s JGB yields gained six bps to 1.11%, the high since July 2011.
French yields jumped 13 bps to 3.21%, the highest close since July.
Yields this week were up 10 or 11 bps in Italy, Spain, Portugal, and Germany.
Deleveraging continues to gain momentum in key EM markets.
Friday’s volatility is a reminder of latent fragility in over-owned and uber-loved technology and AI stocks, along with mounting risk of a de-risking/deleveraging event in a sector rife with leverage and speculation.
There’s a strong argument that the “core” is today extraordinarily vulnerable to strengthening contagion (i.e., risk aversion and illiquidity) from the “periphery.”
The 2-year/10-year Treasury yield spread widened another 7.5 this week to 29 bps, the widest since June 2022.
The curve has steepened 21 bps since the Fed slashed rates on September 18th, with 10-year yields having now spiked 97 bps.
December 26 – Bloomberg (Alexandra Harris):
“Key rates tied to the US overnight funding market are rising, even after the Federal Reserve adjusted some of its tools in an effort to rein in volatility.
The Secured Overnight Financing Rate — an important one-day lending benchmark linked to activity in the repurchase agreement market — jumped to 4.40% as of Dec. 24 from 4.31%...
Other reference rates tied to the repo market — the Tri-Party General Collateral Rate and Broad General Collateral Rate — jumped to 4.39% from 4.29%...
The increased rates come at a critical end-of-year moment as Wall Street watches for signs that volatility in funding markets is extending beyond the typical surges during month- and quarter-ends, when banks shore up their balance sheets for regulatory purposes by curbing repo activity.”
December 27 – Bloomberg (Alexandra Harris):
“Elevated rates in the US funding market suggest primary dealer balance sheets are constrained as year-end approaches.
The Secured Overnight Financing Rate rose to 4.53% on Dec. 26 from 4.40%...
That leaves it higher than the interest on reserve balances rate of 4.40%.”
As deleveraging gains momentum, we’ll be closely monitoring for “repo” market instability.
While the levered Treasury “basis trade” garners little attention these days, it’s worthy of plenty.
Especially if the big tech stocks surprise to the downside, I would expect significant hedge fund deleveraging and attendant liquidity issues.
Fear of unfolding systemic instability and illiquidity would pressure the egregiously levered “basis trade” players to begin paring back.
Any disorderly unwind of “basis trade” leverage would trigger a destabilizing tightening of financial conditions.
December 27 – Financial Times (Harriet Clarfelt):
“Global corporate debt sales soared to a record $8tn this year, as companies took advantage of red-hot demand from investors to accelerate their borrowing plans.
Issuance of corporate bonds and leveraged loans climbed by more than a third from 2023 to $7.93tn, according to LSEG data, as big companies… took advantage of borrowing costs falling to their lowest level in decades relative to government debt.
The surge in activity passed a previous peak in 2021, as strong investor demand drove down costs for corporate borrowers even before the Federal Reserve and other central banks started cutting interest rates from their multi-decade highs.”
While the reality of a hostile new environment has begun to sink in at the “periphery,” the exuberant “core” continues to extrapolate “terminal phase excess.”
December 26 – Axios (Michael Flaherty):
“Big Tech is spending at a rate that's never been seen, sparking boom times for companies scrambling to facilitate the AI build-out.
AI is changing the economy, but not in the way most people assume.
AI needs facilities and machines and power, and all of that has, in turn, fueled its own new spending involving real estate, building materials, semiconductors and energy.
Energy providers have seen a huge boost in particular, because data centers require as much power as a small city.
‘Some of the greatest shifts in history are happening in certain industries,’ Stephan Feldgoise, co-head of M&A for Goldman Sachs, tells Axios.
‘You have this whole convergence of tech, semiconductors, data centers, hyperscalers and power producers’…
The fortunes being spent today on data centers for AI are jaw-dropping, but tech leaders are actually worrying about spending too little.
‘When you go through a curve like this, the risk of underinvesting is dramatically greater than the risk of overinvesting for us here,’ Google CEO Sundar Pichai told analysts...
Tech CEOs view their investments in data centers as all-purpose bets on the future.
If the AI bubble pops, a data center can easily be put to work fueling whatever the next big wave in tech turns out to be.”
Perhaps history’s greatest spending boom, the runaway AI/tech Bubble is fueled by late-cycle extraordinarily loose conditions coupled with blind faith.
I’m reminded of the “Roaring Twenties” post-crash “over-investment” versus “malinvestment” debate (seemed to be monstrous amounts of both).
An incredible arms race mentality has the world today poised to spend Trillions with little clarity on future revenues and profits.
It’s party on so long as financial conditions remain loose and market Bubbles inflate.
It’s difficult for me to envisage systems (financial and economic at home and abroad) more vulnerable to a destabilizing market-induced tightening and forced reassessment of future prospects.
I believe global deleveraging has attained sufficient momentum to be self-reinforcing.
And it’s unclear what might reignite “risk on” speculative leveraging, especially at the “periphery.”
Contrary to early-August instability, today’s deleveraging is not fueled by a strong yen susceptible to dovish Bank of Japan pronouncements.
And with yields up almost 100 bps since the Fed began its rate cuts, the incredible magic powers of Fed monetary easing appear to have finally dissipated.
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