Lacking a Good Scenario
Doug Nolan
The problem, as I see it, is that fragile markets have more to lose with each passing day.
And with each day of intense bombing, there is seemingly less to lose for the IRGC.
As go the markets, so go global economic prospects.
Four weeks in, the likelihood of precarious escalation remains on a steady upward trajectory.
Markets Friday began to accept the seriousness of an unfolding predicament not readily amenable to Trump and Fed “puts.”
With reliable backstops uncertain, markets must begin contemplating precarious scenarios for the first time in a while.
The Bloomberg MAG7 Index slumped 2.8% Friday, boosting the week’s loss to 4.9% - with the index closing the week at the lowest level since August 1st (down 15.7% y-t-d).
Friday’s losses included Meta Platforms down 4.0%, Amazon 4.0%, Tesla 2.8%, and Microsoft 2.5%.
For the week, Meta sank 11.4%, Alphabet 8.9%, Microsoft 6.6%, Nvidia 3.0% and Amazon 2.9%.
Meta ended the week at the lowest close since April 23rd, Microsoft April 8th, Nvidia September 5th, and Alphabet November 28th.
Amazon closed the week within 55 cents of the low back to May 9th.
Air is leaking from the AI Bubble.
March 24 – New York Times (Maureen Farrell):
“The private credit industry, a once-booming corner of the lending markets, is facing an investor exodus and heightened scrutiny of its risky practices.
The bad news seems to keep coming.
On Tuesday, Ares Management, an investment firm with more than $600 billion in assets, said it would block roughly half of the redemption requests from one of its private credit funds.
A day earlier, the private equity giant Apollo Global Management said the same of one of its funds…
Also on Monday, the debt-ratings agency Moody’s downgraded a private credit fund run by KKR to junk status, warning investors that a growing number of the fund’s outstanding loans were not being repaid and that its profitability is at risk.”
March 26 – Bloomberg (Olivia Fishlow and Ellen DiMauro):
“A wave of redemption requests across the private credit industry has left more than $4.6 billion of investor capital trapped behind withdrawal limits, with more asset managers expected to impose curbs in the coming weeks.
Investors have looked to pull roughly $13 billion from over a dozen funds so far this quarter…
But since the vehicles can cap withdrawals at 5% of net assets per quarter, investors have only been able to access about two-thirds of the cash they’ve sought…
How much investors seek to cash out, and whether the firm again opts to avoid imposing limits, will be a key to gauging pressure on the sector, market participants say.”
The crisis of confidence and run on “private Credit” continue to gain momentum.
The Iran War certainly accelerated the process.
At this point, however, even a rapid end to the conflict would likely not reverse the exodus.
The reversal of flows has already revealed fundamental flaws and serious weaknesses in “private” high-risk lending.
Historic lending and speculative cycles have largely run their courses.
Importantly, the thesis of a major tightening of risky lending obstructing the AI arms race buildout is increasingly difficult to rebut.
Wall Street analysts have been playing down parallels between “private Credit” and the 2008 crisis.
Many cite the lack of leverage; today’s well-capitalized banking system with limited “private Credit” exposures; sounder liquidity mechanics (i.e., fund “gates”); and manageable scale ($1.8 to $2.0TN).
Fair enough.
Former New York Fed President Bill Dudley wrote a thoughtful piece last week:
“Private Credit Is Bad, But Not 2008 Bad.”
“Will the growing troubles in private credit precipitate a broader financial crisis?
As a veteran of the 2008 subprime lending meltdown, I’m extremely hesitant to say no.
Nonetheless, I don’t think it’s likely.”
And Friday evening from Barron’s Randall Forsyth:
“Serious but not systemic.
That is how to think of the impact on the economy of the ructions in the private-credit market.”
“Private Credit” is emerging as a major issue, especially in terms of financing the AI arms race Bubble.
That said, my argument is not that high-risk lending is today a paramount systemic risk.
Subprime mortgages were certainly not the critical force during 2008’s near financial collapse.
Today’s risk, as it was during the 2008 crisis, is a major unwind of speculative leverage, marketplace illiquidity, money market instability, derivatives chaos, panic, and market dislocation.
A crisis of confidence that commenced at the “periphery” (subprime mortgages) over time penetrated the heart (“core”) of perceived safe and liquid (money-like) financial instruments, certainly including Lehman Brothers and Wall Street “repo” and money market obligations.
Repeating a fundamental point, it is sudden fear for perceived safe “money” – as opposed to risky loans/instruments – that is the domain of panics and financial crises.
The MOVE (bond volatility) Index, while down marginally Friday (to 112), traded Thursday at 115, the high since April 25th.
The MOVE spiked 30 bps in seven sessions, comparable to the “liberation day” period move.
The Investment-grade (VIXIG) Volatility Index surged almost five Friday to 61.8, the highest since April 11th.
Investment-grade CDS jumped 2 to 67.4, the high back to April 23rd.
The VIX (equities volatility) Index jumped 3.5 Friday to 31.05, the highest close since April 21st.
High yield CDS spiked 31 bps Friday, the largest upside move since April 10th – to the high since May 1st.
High yield spreads blew out 23 Friday to 334 bps - to the widest level since early May.
Major bank CDS rose (2 to 3bps) Friday, with BofA (75bps), Morgan Stanley (80bps), Citigroup (75bps), Goldman Sachs (75bps), Wells Fargo (69bps) and JPMorgan (55bps) all now at or near highs since April.
Interestingly, BofA’s Global Financial Stress Index (GFSI) (“a gauge that tracks anxiety and stress levels across global financial markets”) surpassed “liberation day” levels and traded just below the March 2023 banking mini-crisis peak.
The preponderance of indicators points to a major unfolding de-risking/deleveraging dynamic.
Bitcoin was slammed 4.3% in Friday trading to 66,000, near a one-month low.
Bitcoin was down 6.5% for the week, 25% y-t-d, and 47% from October highs.
Bitcoin’s inability to muster a rally is ominous.
The cryptocurrencies, at the speculative risk asset “periphery,” set deleveraging in motion.
“Risk off” then gravitated to leveraged loans and high yield instruments, certainly including “private Credit.”
Strengthening contagion effects began to work their way to big tech, a particularly crowded sector (retail, hedge funds, institutions) where major leverage has accumulated over recent years.
The precious metals, favored by the levered crowd, also abruptly reversed sharply lower.
The Iran War stoked fledgling risk aversion, though markets were willing to assume a quick end to the conflict.
President Trump’s repeated declarations of rapid resolution certainly fostered complacency.
Another TACO moment came Monday, spurring big, though fleeting, market reversals.
Brent crude traded Monday in a 15% intraday range (114.43 to 96.77), only to end the week at 114.57.
Brent crude surged 4.2% in Friday trading.
March 25 – Financial Times (Editorial Board):
“The damage that could be done to global energy markets by closing the Strait of Hormuz was long anticipated (except, perhaps, in the Oval Office).
Less well understood was the fact that the waterway is a vital artery, too, for chemicals, metals and fertilisers.
Disruption to shipping is affecting sectors from AI and semiconductors to mining and food production, compounding the energy shock.
And, as with energy supplies, upheavals could persist beyond the end of US and Israeli strikes on Iran.
Take helium.
Qatar accounts for about one-third of global supplies of the gas, a byproduct of natural gas production at the vast Ras Laffan field.
Not only are exports blocked through the strait but Ras Laffan’s infrastructure has suffered long-lasting damage from Iranian retaliatory strikes.
This is bad news for the semiconductor industry, which uses helium to cool wafers during manufacturing; Taiwan and South Korea get the majority of their supplies from Qatar, whose high-purity helium is not easily substituted.
Helium is also important for fibre optics, defence manufacturing and medical imaging (the gas cools MRI scanners).”
On many levels, the President’s Thursday cabinet meeting was a disturbing spectacle.
For a war-time gathering, the President and his team seemed to lack the serious focus deserving of an unfolding national crisis.
Many, including global political and business leaders, surely question the President’s mental fitness.
If we took his comments at face value, we’d conclude the commander and chief is delusional:
“We don’t need Hormuz at all… We have so much oil.
Our country is not affected by this.”
Industry experts are lining up to pronounce “the worst energy disruption in history.”
Unprecedented production losses for crude and myriad refined products risk devastating supply chain crises – oil and energy, fertilizer and agriculture, petrochemical and plastics, shipping and logistics – and on and on.
A significant global inflationary event is now unfolding, hitting a world where inflation has been running on the hotter side for over five years.
It’s slamming a highly indebted world.
It threatens to destabilize global financial markets exposed to historically unparalleled levels of speculative leverage.
Deleveraging continues to gain momentum in “core” sovereign debt markets, a bastion of Trillions of speculative leverage.
Ten-year Treasury yields gained another five bps this week to an eight-week high of 4.43%, with yields now having spiked 49 bps in four weeks.
Benchmark MBS yields have surged 73 bps since the start of the war to 5.54%.
Pressure is even more intense in key (highly levered “core”) global bond markets.
UK 10-year gilt yields traded Friday at an intraday high of 5.10%, the high since July 2, 2008.
Thirty-year gilt yields traded up to 5.70%, the high back to May 1998.
In just four weeks, UK yields are up 74 bps.
Italian 10-year yields rose as high as 4.14% Friday, and Greek yields to 4.07% - both highs since November 2023.
French yields advanced to 3.89% (high since June 2009) and German yields to 3.13% (May 2011).
In four weeks, yields have spiked 78 bps in Italy, 72 bps in Greece, 62 bps in France, and 45 bps in Germany.
Indicative of long-term inflation concerns, 30-year German yields rose Friday to 3.57% (high since May 2010) and 30-year French yields to 4.59% (June 2009).
Italian and Greek long bond yields rose to 4.82% and 4.65% (both November 2023).
Market vigilantes are not in the mood to give highly indebted Japan a pass.
Ten-year JGB yields jumped 11 bps Friday to 2.37% - the high back to February 1999.
Thirty-year JGB yields spiked a notable 19 bps Friday to 3.71%, quickly approaching January’s spike high to a record 3.88%.
As 40-year yields surged 20 bps Friday (3.905%), the dollar/yen traded to 160 for the first time since 2024.
March 26 – Bloomberg (Alexandra Harris):
“Hedge funds’ borrowing in the repo market has surged 154% since the end of 2022 to $3.1 trillion, reflecting an increase in leveraged-trading strategies, according to the Office of Financial Research.
By last June, qualified hedge funds — or those with more than $500 million in assets — were leveraged 2.6 times, meaning they had borrowed $2.60 for every dollar they hold…
Some that follow certain strategies — particularly macro, multi-strategy and relative-value funds — were leveraged by 6 times.
The hedge funds also financed trades with prime-brokerage loans from securities firms, which increased by 83% to $3 trillion over the same period.
Such borrowing can increase the risks in financial markets if hedge funds are forced to unwind money-losing trades or unload other assets to meet demands to post more collateral.
Hedge funds’ exposure to US Treasuries and related derivatives increased by $1 trillion to $4.1 trillion.”
Doing some quick math, hedge funds’ combined “repo” and broker loan borrowings surged $3.2 TN since 2002 to $6.1 TN.
And this includes only hedge funds obligated to file SEC “form PF.”
We can assume that a decent chunk of this leverage is related to Treasury “basis trades” and other speculative bond market “spread” trades relatively immune to yield gyrations.
As we witnessed in March 2020, all hell breaks loose when deleveraging, illiquidity, and dislocation engulf the highly levered Treasury “basis trade” marketplace.
Markets have not yet reached that point, but they’re moving in that direction.
Importantly, there are Iran War scenarios that would risk unleashing 2020 and 2008-style deleveraging and panic.
I assume levered hedge funds around the globe are intensively gaming out various war scenarios.
I would see the best-case as the U.S. and Iran commencing fraught negotiations, with the U.S. and Israel winding down bombing operations in a couple weeks.
After bombings subside, I’ll assume it would take some time to get tanker traffic moving again through the Strait.
Even under this best-case, we could be at least a month before the Strait of Hormuz begins to meaningfully open up – and additional weeks for the backlog to clear.
This would still entail major global dislocations.
The worst-case scenario would see uncontrollable escalation.
Iran refuses to bow to U.S. pressure to capitulate in negotiations, while maintaining its tight grip on the Strait of Hormuz.
President Trump threatens a massive “final blow” assault.
This threat would include destruction of key Iranian energy infrastructure, U.S. troop deployments, U.S. direct control over the Strait of Hormuz, and perhaps even regime change.
The worst-case would see Iran categorically reject Trump’s demands, eliciting a major U.S. military response - triggering Iran retaliation against Gulf energy infrastructure and protracted hostilities – including mine laying - around the Strait of Hormuz, along with widening conflict throughout the Gulf region.
Interceptor inventories run low.
The Houthis enter the war, creating havoc in the Red Sea (Houthis fire first missile of the war tonight into Israel).
I’ll loosely refer to a third “base case” scenario, which would see weeks of fraught negotiations and a tailing off of overt hostilities.
The President’s desire to bring the war to a conclusion puts escalation on hold.
Iran talks, but refuses to capitulate, recognizing its capacity to inflict damage to fragile global markets and economies.
Iran agrees to allow limited traffic through the Strait of Hormuz, so long as the U.S. and Israel suspend bombings and assassinations.
Iran would buy some time, perhaps allowing shipments of drones and supplies from Russia and other replenishments from China.
Russia might even surreptitiously promote this scenario to Iranian leadership, support that would place U.S./Russian relations on a collision course.
This would drag the conflict out for months – “hot war” to “cold war” to elevated risk for hotter war.
It's difficult for me this evening to envisage high probability for a best-case outcome.
Iran doesn’t appear poised to capitulate.
History argues they won’t.
They’re fighting for survival and playing for time, confident Trump has no appetite for a protracted war, and believes it can exact a heavy price on global markets and Gulf energy infrastructure.
The President may gamble that ongoing intense bombings will force capitulation, with Iranian retaliation holding the potential to further destabilize severely impaired energy markets.
Consequences are dire if traffic doesn’t get flowing through the Strait of Hormuz (“Strait of Trump”).
I assume the major build up in U.S. forces in the Gulf is in preparation for taking control of the Strait.
How much capacity Iran has in opposing U.S. intervention is a huge unknown.
They’ve had decades to prepare for such a confrontation.
Their firepower has been severely depleted, but they surely retain capacity for asymmetric war tactics.
March 28 – Bloomberg (Hadriana Lowenkron and Eric Martin):
“The US and Israel bombed Iranian nuclear and steel facilities on Friday, while Iran retaliated across the Persian Gulf including a reported hit on a base in Saudi Arabia…
A strike on Prince Sultan Air Base in Saudi left at least 10 US troops wounded, including two seriously, and damaged several refueling aircraft…
Also on Friday, Houthi militants in Yemen, who are backed by Iran, said they were ready for direct military action if any other countries joined the US and Israel, if the Red Sea was used for hostile operations against Iran, or if escalation continued against Tehran’s proxy groups…”
March 28 – The Guardian (Hannah Ellis-Petersen):
“Gulf countries have raised concerns over the prospect of attacks by Iran-backed militias and proxy armed groups in the region, which they fear could destabilise their regimes and escalate the war in the Middle East.
In a joint statement this week, Qatar, Kuwait, the United Arab Emirates, Bahrain, Saudi Arabia and Jordan condemned Iranian attacks on their soil, both as strikes carried out directly from Iran and ‘through their proxies and armed factions they support in the region’.”
March 23 – Axios (Ben Geman and Chuck McCutcheon):
“Former Defense Secretary James Mattis offered a sobering take Monday on the Strait of Hormuz, criticizing the Trump administration for what he saw as a failure to think strategically about Iran…
‘We’re in a tough spot, ladies and gentlemen, and I can’t identify a lot of good options,’ the retired Marine general told attendees at the CERAWeek… conference.
If President Trump declares victory and pulls back the U.S. military, Iran ‘would now say we own the Strait,’ said Mattis… ‘I think that you could see a tax for any ship going through — something completely unsustainable in the international market,’ Mattis said.
The overall U.S. and Israeli strategic objectives for Iran remain ‘murky,’ he said.
‘The Americans are fighting in a markedly limited war, and I think that what we’re seeing is a situation where [airplane] targetry never makes up for a lack of strategy,’ he said.
Threat level: Mattis also explained why naval protection of ships would prove a huge challenge and leave major vulnerabilities.
Even a degraded Iran retains the ability to attack ships from shore along a vast stretch of coastline in the wider region, he said.
‘If you look at the Texas Gulf Coast, that’s about 367 miles, that gives you an idea of how difficult this will be for the U.S. Navy to try and protect ships in that shipping lane, 600 miles down the Gulf, 100 miles through the Straits and then out into the water…
And they’ve got anti-ship cruise missiles that could be fired off the back of a pickup truck that can go 100 miles.
So, there’s the problem’.”
Gaming this out, I see uncomfortably high probabilities for problematic market outcomes.
The leveraged speculating community is surely looking at various scenarios, with the current market risk vs. reward calculus extraordinarily unattractive.
For one, the risk of a highly destabilizing scenario is alarmingly high.
Furthermore, typical policy responses are not assured.
With inflationary risks escalating, the Fed will be slow and initially cautious with QE.
Meanwhile, the President and his “put” suffer a credibility crisis.
Ongoing pressure to de-risking/deleverage seems reasonable.
That said, powerful short squeezes and hedge unwinds could erupt at any time, providing markets sporadic liquidity boosts.
But I expect marketplace liquidity to become an increasingly pressing issue.
This week’s Treasury auctions warned of waning demand.
And it’s also worth noting this week’s $53 billion drop in money market fund assets and the $33 billion fall in commercial paper borrowings, what I view as indications of nascent fixed income deleveraging.
March 25 – Financial Times (Costas Mourselas):
“London-based hedge fund Caxton Associates has extended its losses to more than $1.3bn this month as the Iran war causes shockwaves in global markets.
Caxton’s $9bn Macro fund… is down 15% this month to Friday, according to two people…
The FT reported earlier this month that the fund had lost 7%, or at least $600mn, in the first week of March.
The losses make Caxton one of the highest profile hedge funds to suffer losses as the conflict in the Middle East upends energy and bond markets.”
So far, not much talk of hedge fund losses.
Expect things on that front to heat up.
There’s clearly pain out there and ample impetus to rein in risk and leverage.
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