The Typical and Atypical
Doug Nolan
“Risk off” gains sufficient momentum to spark destabilizing deleveraging.
Markets approach the abyss, before well-timed policy responses trigger a powerful market recoil.
Huge bearish derivatives positions – for hedging and downside bets – foment instability.
On the market’s downside, the sellers of put options and other market “insurance” must dynamically hedge their exposures, with selling begetting market weakness and additional sales.
A policy response then forces these sellers to immediately reverse course and become urgent buyers.
Especially in high-risk speculative market environments, the specter of a big short squeeze and unwind of hedges captivates the marketplace, from day traders to the sophisticated levered players.
The greater system risk and fragility, the greater the potential for an disorderly upside unwind of shorts and hedges.
To that end, when it comes to quick trading profits, no market dynamic can compete with being on the right side of a squeeze.
And what begins as a short squeeze tends to take on a life of its own.
Typically, the confluence of policy responses, squeezes, unwinds, and dip buying revitalizes speculative impulses – ensuring another leg higher for an irrepressible bull market.
Market dynamics have been pretty much business as usual thus far.
But this is too much of a uniquely abnormal environment to extrapolate typical market dynamics.
There’s so much at stake.
The administration and global policymakers have settled into crisis management mode.
Fragile markets require a steady drumbeat of positive headlines.
Tensions must be ratcheted down.
Even in the face of what will be heated negotiations, tones need to be more conciliatory.
“Trump says he has 'potential deals' with India, South Korea, Japan.”
“Lutnick: ‘I have a deal done, done, done, done’ as China, Japan and India warm to trade talks.”
“Trade deal with India soon: Vance.”
“Japan Seeks US Trade Deal in June Amid Report of Standoff.”
“China ‘evaluating’ US offer to negotiate tariffs; Beijing’s door is ‘open.’”
“China says it’s evaluating the possibility of trade talks with the U.S.”
“China Hints at Possible Thaw with US in Weighing Trade Talks.”
May 2 – New York Times (David Pierson and Joy Dong):
“Despite mounting financial pressure, China says it won’t negotiate until the Trump administration shows ‘sincerity’ by canceling tariffs on its goods.
In a potential softening of the bruising trade war between China and the United States, Beijing said on Friday that it was considering holding talks with the Trump administration after repeated attempts by senior U.S. officials to start negotiations. China’s Commerce Ministry said… China was ‘evaluating’ the U.S. offer to talk, but it said Beijing’s position remained consistent: It will only engage in negotiations if Washington cancels its tariffs on Chinese goods first.
‘If the United States does not correct its wrong unilateral tariff measures, it means that the United States has no sincerity at all and will further damage the mutual trust between the two sides,’ the ministry said.”
It's imperative that the U.S. and China begin talks.
Both economies face major risks, and clocks are ticking.
But I doubt China is softening its position.
From the look of China’s Ministry of Affairs Tuesday “Never Kneel Down” video, I’ll assume they’re dug in for tough and protracted negotiations.
But these 145% tariffs are essentially an embargo.
Stating an openness to commence talks puts pressure on the administration to back down on clearly unworkable tariff levels.
The tariff rate is so egregious that there’s ample room for a mutually beneficial “compromise” that would be well received in the markets – a somewhat lower (non-embargo) tariff starting point that would get the two belligerents to the negotiating table.
Still, this would be superficial.
Risks to both economies would remain highly elevated in what will certainly be extraordinarily fraught and protracted negotiations.
April 29 – Financial Times (Joe Leahy, Ryan McMorrow, and Kathrin Hille):
“China has stepped up an international propaganda campaign against the US trade war, unleashing slick videos portraying itself as standing up against American ‘bullying’ on behalf of the rest of the world, especially the ‘weak’ in developing countries.
Posted by the ministry of foreign affairs…, the videos represent a dramatic hardening of Beijing’s diplomatic stance in the trade war and are part of a charm offensive designed to portray China as championing free commerce while Washington ‘slaps its allies in the face’.
The propaganda videos contrast dark scenes of Wall Street chaos and angry American protesters with a bright and futuristic China…
The latest video, titled ‘Never Kneel Down’, was released on Tuesday and warns countries not to make deals with the US…
‘Bowing to a bully is like drinking poison to quench a thirst,’ the video said.
‘China won’t back down so the voices of the weak will be heard’…
‘Bullying will be stopped… when the rest of the world stands together in solidarity, the US is just a small stranded boat.’”
“Open for talks” notwithstanding, Beijing is likely comfortable with its position and fixated on an arduous process necessary for the achievement of strategic objectives.
China, seeing the Trump administration under heightened pressure, is content to delay the start of serious negotiations.
Meanwhile, speculative markets are notoriously shortsighted.
The Trump administration is seemingly past the belligerent and disrespectful phase, lowering the risk of negative headlines and Chinese counterattacks.
In the throes of a formidable squeeze, markets are happy to postpone trade war concerns for another day.
At some point, today’s “typical” market recovery will have to contend with a list of quite atypical risks.
Ten-year Treasury yields rose seven bps this week to 4.31%.
Yields traded down to 4.00% on April 4th, only to then spike 49 bps the following week.
Another upside yield surprise is a reasonable bet.
A continuing stock market rally would become a growing bond market worry.
Meanwhile, tariff-related price increases and supply chain issues loom large.
The environment is certainly conducive to inflation.
Q1’s GDP Price Index jumped to 3.7% (from Q4’s 2.3%), while Core PCE rose to 3.5% (from 2.6%) during the quarter.
I also ponder festering liquidity issues.
Bloomberg: “Fear of Next Market Jolt Drives Rush to Sell Corporate Bonds.”
If I were a borrower, I would certainly use this rally as a window of opportunity to build cash reserves.
These types of squeeze markets create the illusion of liquidity abundance.
But the start of deleveraging, with associated liquidity destruction, ensures ongoing latent liquidity risks and market fragilities.
April 28 – Politico (Jordain Carney):
“If Speaker Mike Johnson has his way, the ‘big, beautiful’ domestic policy bill that President Donald Trump wants passed post-haste would be through the House no later than Memorial Day…
To that end, House Republicans will launch a legislative sprint when they return to Washington Monday, with key committees set to finally put GOP pledges on taxes, energy, defense and border security into legislative text.
The problem: There are rampant doubts that Johnson’s ambitious timeline is feasible.
While Republicans believe they’ve made some progress over the two-week break, including smoothing over some of their trickiest tax problems, they’re still far from an agreement on the key disputes… most notably, the size of spending cuts needed to pay for their plans and how dramatically to reshape Medicaid and other safety-net programs.”
Before long, all the secret closed door meetings will end, finally allowing actual budget legislation to see the light of day.
The administration’s proposed budget is thin on detail and thick on unspecified spending cuts.
There’s little to indicate the President is backing away from his list of aggressive tax cuts – tips, social security, SALT, overtime…
What’s more, substantial tariff revenues are expected to help fill the gap – risking the fanning of inflation.
We should expect a healthy dose of bond market skepticism as budget details emerge.
The market closed Friday pricing a 3.53% Fed funds rate (implying 80bps of rate reduction) for the December 10th FOMC meeting (up from 3.27% on April 8th), up 10 bps for the week to a near four-week high.
For some time now, market rate cut expectations have consistently proved overly optimistic.
With big tariffs coming, the Fed is appropriately attentive to inflationary risks.
And while the President is unrelenting, the rallying stock market does reduce pressure to cut rates.
There will come a time when markets fret that Fed policymakers have been conditioned to dismiss market instability.
Economic momentum has weakened, though the stock market recovery and reopening of debt markets reduce immediate recession risk.
But I’ll push back on the narrative that a robust economy going into trade war uncertainties connotes resilience.
The ostensible robustness of our “Bubble economy” can be traced to massive fiscal deficits, a boom in risky lending, extraordinary asset inflation and speculative Bubbles.
It would be unwise to extrapolate such unsustainable factors.
Years of reckless fiscal spending appear to be coming home to roost.
Ten-year Treasury yields are 75 bps higher since the Fed began its 100 bps of rate cuts.
There is rationale to expect market yields to be less likely than in the past to collapse on first thoughts of market instability, recession, and Fed QE.
To say that market, policy, economic, and geopolitical backdrops are “fluid” is today an understatement.
But a more stagflationary environment is a reasonable scenario.
And a recession with sticky market yields would pose a serious issue, especially for the faltering Bubble in “private Credit” and leveraged lending.
May 2 – Bloomberg (Sonali Basak):
“Private credit fund investors are offloading stakes at significant discounts ahead of more potential pain for the US economy, Oaktree Capital Management Co-Chief Executive Officer Robert O’Leary said.
Oaktree sees more chances to buy marked-down assets…, where private asset holders sell stakes in relatively illiquid funds to bring returns to their own investors.
That activity has been building in private equity for some time, but credit investors are now putting up bigger trades…
Discounts are starting at about 90 cents on the dollar and going as low as the ‘50 cent range,’ he said…
Limited partners are taking matters into their own hands given a desire ‘to get out of this before a fall.’
He said the current discounts don’t include a lot of deterioration in credit quality, and as the economic outlook worsens, those discounts will get bigger.
‘To date, we haven’t seen forced selling, there haven’t been really dire liquidity situations that people need to address…
I think we’re going to get into more sort of anxious points in time where LPs will want to trade...’
Private credit has grown rapidly in recent years to become a $1.6 trillion industry…
High-yield debt markets could see high-single-digit default rates, he said.
Other markets are even more vulnerable.
‘If loans are going to see double-digit defaults, I see no reason why ultimately private credit couldn’t end up there,’ he said.
‘It’s poorly underwritten, in the main.
I’m not saying everybody is’…
Many companies with too much debt are simply limping along…
O’Leary said this week that investors have not opened up to idea that we might be facing a recession or are already in one.
O’Leary said a downturn could be as serious as the dot-com bubble.
‘That was traumatic, that was pretty V-shaped, so we came out of it pretty quickly…
The problem here is you’re starting to put in place barriers that will shape the behavior of our counterparties.’”
The leveraged loan market showed a pulse this week, with prices up and some deals getting completed.
After trading below 94.50 at April 9th lows, leveraged loan prices were up 27 cents this week to 95.89 – though still below the 96.51 that began April and 97.70 at January highs.
Stock and Credit market recoveries don’t alter my view that history’s greatest Bubble has been pierced.
This is a process that will unfold over months and even years.
O’Leary’s important comments from the above Bloomberg article support the thesis of a momentous inflection point in the Credit cycle.
I believe the reversal of speculative flows in “private Credit” marks the beginning of the problematic down cycle.
Moreover, the manic boom in “private Credit” and high-risk lending more generally was fundamental to late-cycle “blow-off” excess (along with stocks, AI, crypto, etc.) for history’s greatest multi-decade Bubble.
The Dollar Index recovered 0.6% this week to 100.03.
From a January high of 110 and a February close at 107.61, the dollar traded down to a 97.92 low on April 21st.
The dollar’s pathetic “recovery” suggests a fundamental shift in market perceptions consistent with the burst Bubble thesis.
April 28 – Bloomberg (Ye Xie):
“Despite the market recovery of the past week, foreign investors ‘remain on a buyers’ strike on US assets,’ according to Deutsche Bank AG.
To gain an almost ‘real-time’ window into how overseas investors have been behaving in recent weeks, Deutsche Bank’s head of FX strategy, George Saravelos, looked at the flows into a variety of funds that take money from overseas and channel it into US stocks and bonds.
The data shows a ‘sharp stop’ in the purchases of US assets by overseas buyers over the past two months, with no sign of a turnaround last week…, Saravelos wrote…
‘Our broad takeaway is that the flow evidence so far points to an, at best, very rapid slowing in US capital inflows and, at worst, continued active disinvestment from US assets…
Either interpretation poses a challenge to the USD as a twin deficit currency.’”
International “recycling” of decades of massive U.S. trade/current account deficits into our securities markets has been fundamental to the great Bubble.
This vital mechanism is today under threat from all sides.
The administration’s new tariff regime will surely lead to shrinking trade deficits.
Meanwhile, the dollar increasingly suffers from crisis of confidence dynamics.
And this extraordinary backdrop puts the Treasury market at significant risk.
Massive over-issuance, elevated inflation risk, and now a trade war.
Is a Liz Truss market dynamic a ridiculous thought?
And it’s not just the Chinese with a horde of Treasuries available as a negotiation lever.
May 1 – Reuters (Ben Berkowitz and Ben Geman):
“Japan’s huge U.S. Treasury holdings are among tools available for Tokyo in trade negotiations with the United States, Japanese Finance Minister Katsunobu Kato said…
Kato said the primary purpose of Japan’s huge U.S. Treasury holdings is to ensure it has sufficient liquidity to conduct yen intervention when necessary.
‘But we obviously need to put all cards on the table in negotiations.
It could be among such cards,’ Kato said… when asked whether Japan, in trade talks with the U.S., could reassure Washington it will not sell its Treasury holdings in the market.
‘Whether we actually use that card, however, is a different question,’ Kato added.
Japan holds roughly $1.27 trillion in foreign reserves.”
I’m not sure why nations would just roll over during trade negotiations.
The U.S. is in a weakened position, especially with the Chinese keen to play hardball.
Our economy is only weeks away from product availability and supply chain issues.
In a replay of pandemic dynamics, might consumers begin hoarding items perceived as vulnerable to shortages?
Do we see price spikes for some Chinese products?
Does consumer and business confidence take another hit?
In the current backdrop, I view market rallies as exacerbating both instability and systemic vulnerabilities.
The next phase of deleveraging risks turning highly destabilizing.
And the more stocks rally, the greater the shock that will be created come the next leg of the bear market.
This wild market volatility is the proverbial demolition ball chipping away at market structure.
Indeed, it’s regressed into one monumental market and economy confidence game.
I have a difficult time believing the administration can bolster confidence – not with markets unstable and fragile, with a weakening economy, unfolding trade wars, and a leery population rapidly losing patience.
It will be fascinating to see if President Trump has the fortitude to sustain his China trade war brinkmanship.
I suspect Beijing is determined to find out.
April 29 – Bloomberg (Hadriana Lowenkron):
“President Donald Trump said China deserved the steep tariffs he imposed on their exports and predicted Beijing could find a way to reduce their impact on American consumers.
‘You don’t know whether or not China’s going to eat it.
China probably will eat those tariffs,’ Trump said… in an interview with ABC News.
‘China was making $1 trillion dollars a year.
They were ripping us off like nobody has ever ripped us off.
Almost every country in the world was ripping us off.
They’re not doing that anymore.’
Trump said he did not believe hard times were ahead for US consumers, while acknowledging that his 145% tariffs on many Chinese goods amounted to a near-embargo.
‘That’s good,’ Trump said.
‘They deserve it.’”
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