APRIL / MAY / JUNE DYNAMIC ? / PRUDENTBEAR.COM

April/May/June Dynamic?

by Doug Noland

March 21, 2014




Putin takes Crimea, China devalues and Yellen has a shaky debut.

Last week I posited that “Ukraine and China pose clear and present dangers to global financial markets.” At least for the week, Russian troops stayed put on their side of the Russia/Ukraine border. And while the West ratcheted up sanctions against Russia, at this point leaders on both sides of this crisis appear keen to avoid actions with real economic impact. At the same time, Putin’s chilling speech Monday supported my view of a darkening geopolitical backdrop – a potential inflection point of historical significance.

So let’s direct some attention to China. The Chinese renminbi declined 1.22% this week, boosting its one-month drop to 2.16%. A Thursday Bloomberg headline read “China’s Yuan Slumps Most Since 2008 as Central Bank Cuts Fixing.” My “headline”: Beggar thy neighbor? Ramifications and consequences – financial, economic, geopolitical? After trading near multi-year lows on Thursday, Friday saw Chinese stocks spring to life with a 2.7% surge. The bullish take is that more aggressive fiscal stimulus is in the offing, while the People’s Bank of China (PBOC) is in the process of weakening the currency and is about to ease monetary policy. The increasingly confident bearish view holds that Chinese policymakers are more worried by what appears an acceleration of financial instability and economic weakness.

I am reminded that the S&P500 shot to a record high in late-2007, even as the mortgage finance Bubble faltered. The “VIX” (equities volatility/risk) index even traded at a remarkably low 20 in early September 2008, as seemingly fearless markets headed right into October’s near collapse. Clearly, markets, financial systems and economies turn highly unstable late in the “terminal phase” of Bubble excess, especially when activist policymakers begin responding to faltering Bubbles and attendant economic vulnerability. This can work for a while to feed the segments of the Bubble still demonstrating inflationary biases. To be sure, this dynamic is integral to the heightened systemic risks associated with financial imbalances and unbalanced economies.

From my perspective, all key indicators point to the beginning of the end to China’s historic Credit and economic Bubbles. Although it appears controllable at the moment (recall subprime?), keep in mind the crisis is in the earliest phase. There was another significant default this week (real estate developer), while corporate bond spreads widened further (see “China Bubble Watch”). Finance has tightened markedly, especially for real estate developers and players along the supply chain. Over time, this will more meaningfully impact local government finance that has grown highly dependent upon real estate transactions.

Data this week suggest Chinese home price inflation has slowed markedly in most major markets. This supports the view of an important change in market psychology, although this type of thing usually plays out over months. Nervous lenders and waning availability of mortgage Credit would speed the process. Importantly, the vast majority of markets still show strong year-on-year price gains and there isn’t much yet to suggest that homebuyers are losing access to Credit. The same cannot be said for the weaker developers.

The unfolding crisis in China will turn significantly more problematic as home prices and transaction volumes fall in tandem. This will likely usher in a problematic decline in overall system Credit growth, with waning Credit and liquidity exposing myriad problems. For now, there are indications of mounting apartment inventories. Meanwhile, building additional housing units (apartments) remains an important component of Chinese stimulus programs. The pesky “law diminishing marginal returns” lurks throughout Chinese stimulus and Credit more generally.

In the near-term, there are the unknown consequences related to the PBOC’s decision to devalue the yuan. Asian currencies in general were under further pressure this week. The currency devaluation issue will also evolve over weeks and months. Whether there are geopolitical factors at play in China’s move is unclear.

And while it has been only a 2% devaluation (versus the dollar) thus far, enormous amounts of “hot money” had flooded into China in anticipation of ongoing currency appreciation. Potential dislocations related to a reversal of speculative flows now create significant uncertainty. This uncertainty is compounded by what are believed to be large speculative flows associated with commodity financing deals. Copper, iron ore and other industrial commodities prices have recently been under significant pressure. Between bad debts, defaults, sinking commodity prices and an unexpected weaker currency, there’s some real pain being inflicted. But where?

Since 2008, Chinese international reserves have grown $2.293 TN, or 150% - from $1.528 TN to end December 2013 at $3.821 TN. Over a similar period, Federal Reserve Credit inflated $3.135 TN, or almost 370%, to $4.0 TN. For the past five years I’ve argued that the Fed’s balance sheet and Chinese Credit are closely interrelated facets of the “global government finance Bubble.” And these days both the Federal Reserve and People’s Bank of China are in the process of major policy adjustments. The “bulls” are generally dismissive of policy changes having much economic and market relevance. From a global Credit Bubble perspective, I don’t think one can overstate the importance of unfolding monetary developments in Beijing and Washington.

In the four months September through December, Chinese international reserve holdings jumped almost $270bn. This rise in reserves (largely Treasuries, bunds, sovereign debt, etc.) appeared related to a surge of “hot money” inflows to China. Chinese officials had last year responded to record Credit growth with measures meant to tighten financial conditions. Meanwhile, resulting higher Chinese market yields only strengthened the allure of an already powerful liquidity magnet (operating in over-liquefied and highly speculative global markets).

The “hot money” surge complicated the PBOC’s efforts to “lean against the wind” of lending and speculative excess. This torrent of foreign-sourced “money” required the PBOC to further inflate domestic Credit and, in the process, exacerbated financial and economic risks. It also required “recycling” the incoming dollar (along with other foreign currencies) balances back into Treasuries and other debt instruments. Surely, at $3.8 TN, Chinese authorities might today question the wisdom of accumulating more IOUs from the U.S. and others. A change in currency policy might serve Chinese interests on multiple fronts.

Meanwhile, chair Yellen’s first FOMC meeting and press conference didn’t go off without a hitch. The bond market was walloped. Ten-year bond yields jumped 10 bps Wednesday to 2.77%. More significantly, shorter maturities surged higher as the yield curve flattened. Wednesday’s action saw five-year Treasury yields jump 16 bps to 1.71%, the high since early-January. Three-year yields increased 13 bps, with yields ending the week at 0.90%, near the highest level since last August. Those crowded into the perceived safety of short-maturities were kicked in the teeth. I would be curious to know the degree of leverage that has built up in short-term instruments and myriad yields curve trades.

Wednesday was one of those intriguing days in the markets. As Treasury yields shot higher, the U.S. dollar rallied and EM currencies fell under immediate pressure. It was reminiscent of the “May/June Dynamic” from 2013. Last year’s so-called “taper tantrum” revolved around mounting market fears that waning Fed-induced global liquidity and attendant risk aversion might exacerbate EM outflows. This would not only further pressure EM currencies, bonds, financial systems and economies, but might also force EM central banks to liquidate Treasuries (and other reserves) as they were forced to employ reserves in an effort to stabilize faltering currencies. There was potential for contagion and a “non-virtuous” cycle.

Last year’s “May/June Dynamic” saw Treasury yields surging higher simultaneous with sinking prices in equities, commodities and throughout EM. Many leveraged “risk parity” strategies abruptly faced highly correlated losses across what were supposed to be well-diversified and risk-protected strategies. A continuation of this market dynamic would have tested a key perception of these strategies: superior risk management complimented by leverage.

Meanwhile (last spring), the enormous and still ballooning ETF (exchange-traded fund) complex faced a major reversal of flows in some EM and fixed income products. Rapidly growing funds had been providing strong market support. Suddenly, they turned sellers in what in some cases were less-than-liquid underlying securities markets (i.e. muni and EM debt). A continuation of this market dynamic would have tested one of the key perceptions of the ETF marketplace: superior liquidity.

Last year’s “May/June Dynamic” was a critical juncture for what had evolved into highly speculative markets. Key bullish perceptions were in the process of being tested. On the positive side, some excesses were finally beginning to be wrung out of an exuberant marketplace. Yet there was going to be some inevitable market pain and negative economic consequences both domestically and globally. And it was going to come at an inopportune time – as they tend to do.

First it was New York Fed president Dudley. Other Fed doves quickly lined up. And then “Bernanke’s Comment” explicitly stated the Fed was prepared to “push back” against a “tightening of financial conditions”. The Fed would even contemplate boosting QE instead of tapering. The markets got the message loud and clear: The Fed was right there willing and able to support the markets in the event of any trouble. Instead of bullish misperceptions coming to the fore – or mounting excess beginning to be wrung out – it was the polar opposite: the bulls and speculators were further emboldened by the notion that the Federal Reserve was backstopping the markets and eliminating downside risk.

Last week I discussed “tail risk” and the type of backdrop conducive to market dislocations. Are markets at risk of another “May/June Dynamic”? A 2014 variety - April/May/June Dynamic? One the one hand, markets would appear to confront similar issues – the potential for higher market yields, EM vulnerability, waning Fed liquidity, etc. On the other hand, complacency still abounds after the Fed ensured the markets more than persevered through last year’s bout of tumult.

Chinese defaults and acute financial fragility weren’t issues a year ago. Confidence in Chinese finance and economic fundamentals was much stronger. Geopolitical risks were much lower. And, importantly, the market was clear on China’s policy of steady currency appreciation versus the dollar. This year’s “April/May/June Dynamic” could easily incorporate a major Chinese component. Chinese reserve holdings declined only slightly last May and June, before “hot money” flows returned with a vengeance by late summer. The prospect of China selling Treasuries was not a market concern.

Everything is just so much bigger than before: The Fed’s balance sheet; PBOC international reserves and the Chinese Credit system; the leveraged speculating community; the big “macro” hedge funds; the powerful “quant” funds; the sovereign wealth funds; the ETF complex; the big mutual fund companies. As history has shown, epic financial Bubbles by their nature spur a concentration of financial power. I often ponder how a marketplace dominated by big players tends to function differently than traditional decentralized marketplaces. Then I contemplate how such a “centralized” marketplace operates with assurances of ongoing central bank support. In my mind – and I see evidence for as much in the marketplace – the markets become more of a game, more speculative and increasingly detached from fundamental prospects.

Janet Yellen has a really tough job ahead of her. The markets Wednesday got a glimpse of why she was not the Administration’s first choice. As the bond market was getting hammered, she was rambling on about the minutia of labor statistics. In a period of what I expect to be only rising market uncertainties (particularly Fed policy, China, EM and geopolitical), I fear our new Fed chair will not inspire confidence.

Yet only time will tell if I end up at some point titling a CBB “Yellen’s Comment.” How will she – how will the Fed – respond to a bout of destabilizing market de-risking/de-leveraging? Interestingly, Dallas Fed head Fisher stated Friday that the “Fed had taken a great deal of volatility out of the market” and that “some more market volatility would be healthy.” For the bond market, it appeared participants this week were finally forced to face up to the reality of a more hawkish bent at the FOMC. There is an increasingly assertive contingent that wants to move beyond Bernanke inflationism and get back to more traditional central banking. That would mean winding down balance sheet expansion as soon as practical and then preparing to lift rates off the “zero bound.”

And all of this really begs the question: to what degree can the Federal Reserve’s balance sheet be counted on as the markets’ future liquidity backstop? Actually, whether the Fed builds its holdings (“prints money”) or not is of seemingly little concern to the markets - that is so long as the markets remain buoyant (as they’ve been). Yet an eruption of de-risking/de-leveraging would have this backstop issue quickly elevated to the top of market worries. Moreover, this liquidity issue would be significantly compounded if the change in China’s currency policy incites a reversal of “hot money” flows and, perhaps, a resulting turnabout in China’s international reserve holdings.