DISEQUILIBRIUM / CREDIT BUBBLE BULLETIN

Disequilibrium

Doug Nolan


Much to the consternation of our allies, President Trump withdraws from the Iran nuclear deal. WTI crude adds another 1.5% (up 17% y-t-d) this week to the high since November 2014. Iran and Israel moved closer to direct military confrontation. With even 40% rates unable to staunch the bleeding, a stunned Argentine government warily negotiates an IMF bailout. Italy's far right and far left parties - both populist, anti-establishment, anti-euro and anti-immigration - begin negotiations to form a coalition government. Malaysians elect 92-year old Mahathir Mohamad, ending the 60-year reign of the Barisan Nasional party (including Mahathir as prime minister between 1981 and 2003).

Some astounding developments, but not enough these days to shake financial markets. Why fret a complex and increasingly unstable world, not with the timely return of Goldilocks. She's back… Headline U.S. April CPI was up 0.2% vs. expectations of 0.3%. Core CPI was up only 0.1% against expectations of 0.2%. April Import Prices were up 0.3% vs. estimates of 0.5%. Forget surging energy prices, rather quickly the rosy narrative shifts to peak inflation.

May 11 - Reuters (Howard Schneider): "St. Louis Federal Reserve Bank President James Bullard on Friday spelled out the case against any further interest rate increases, saying rates may already have reached a 'neutral' level that is no longer stimulating the economy… 'We should be opening the champagne here,' not raising interest rates with unemployment low and inflation in no seeming danger of accelerating, Bullard said… 'The economy is operating quite well right now.'"

I suggest the Fed and global central bankers hold back on carting out the bubbly. "Opening the champagne" is reminiscent of Citigroup CEO Chuck Prince's summer of 2007 "still dancing." Bullard focuses on traditional yield curve analysis. "I would say the yield curve inversion is getting close to crunch time." "The yield curve inversion would be a bearish signal for the US economy if that develops."

I would argue the yield curve has become an especially poor indicator for gauging the appropriateness of monetary policy or predicting imminent recession. "Whatever it takes" monetary management fundamentally altered the structure of global interest rates. Long-term bond prices now incorporate a significant premium based on the expectation for aggressive future rate cuts and bond purchase programs (QE). And the longer the artificially depressed interest rate structure fuels Bubble excess, the greater the long-term bond premium (lower yields) and the flatter the curve. Bubble Dynamics

Bullard proffered additional interesting analysis: "'This is an equilibrium process, not an inflationary one,' Bullard said, and 'it is not necessary to disrupt' it with higher interest rates."

"Equilibrium" with short-term rates between 1.5% and 1.75% - with the Fed having avoided actually tightening financial conditions? Equilibrium with annual Current Account Deficits approaching $500 billion? With the Dow up 18.5% over the past year and the Nasdaq Composite surging almost 21%? With historically low housing inventory and home price inflation significantly above after-tax borrowing costs - and accelerating? With the unemployment rate at 3.9% and businesses struggling to find qualified applicants? With Trillion dollar U.S. fiscal deficits in the offing? With the ECB and BOJ still monetizing debt in large quantities? With 10-year JGB yields at five bps and Italian yields at 1.87%? With still Trillions of negatively-yielding debt instruments globally? Equilibrium with most central banks around the world hesitating to tighten policy - with global monetary policy nowhere in the vicinity of a semblance of normality? Disequilibrium.

May 10 - Financial Times (Robin Wigglesworth): "The investor withdrawal from emerging markets accelerated over the past week, with equity funds suffering their worst outflows in nearly a year and bond funds losing money for a third week running - the longest streak of withdrawals since late 2016… EM equity funds had outflows of $1.6bn in the seven days to May 9, the first weekly outflow since February and the biggest since August 2017… Fixed-income funds focused on the developing world saw their outflows accelerate. Investors withdrew $2.1bn from EM bond funds, the third consecutive week of outflows and the worst one since February. EM debt funds have now suffered outflows of more than $4bn since mid-April."

A decade of ultra-easy monetary policies has ensured deep structural maladjustment. Importantly, "activist" policies have nurtured way too much "money" playing global risk assets. Indeed, global financial speculation has become one historic Crowded Trade. And too much "money" in the game alters market dynamics. The bastardized yield curve is one momentous manifestation. Serial market boom and bust dynamics is another.

The speed by which the EM boom has faltered offers a warning to all. After all, it was only weeks ago that EM prospects were viewed as exceptionally bullish. And with "money" flooding into "developing" markets, it was too easy to disregard structural vulnerabilities and mounting risks. As always, there was ample "hot money" originating from leveraged "carry trades," derivatives and the leveraged speculating community more generally. But these days, with the broad menu of available hot international ETF products, it has never been so easy for retail "money" to jump aboard the EM boom cycle. Jump they did, late definitely not better than never.

This long cycle's EM excesses have been unprecedented. A down-cycle is long overdue. Let's hope the downside can somehow avoid being proportional to this cycle's unprecedented excesses. Outflows have just begun.

May 8 - Financial Times (Benedict Mander and John Paul Rathbone): "Seventeen years ago, economic policies backed by the IMF brought Argentina to its knees. Five years later, then-president Néstor Kirchner severed IMF ties, swearing never again. This week, a run on the currency forced President Mauricio Macri to return to the international lender. On Tuesday, in a televised address to the nation, a sober-faced Mr Macri said assistance from the International Monetary Fund would help 'avoid a crisis like the ones we have faced before . . . [it] will allow us to strengthen our programme of growth and development'. It was a stunning reversal for the 59-year-old former businessman who came to power in December 2015 vowing to make Argentina a 'normal country', after 12 years of leftist rule…"

Argentina was not without its share of responsibility, yet unfettered global finance ran roughshod through Argentine financial and economic structure. At U.S. and IMF insistence, Argentina in the nineties adopted a U.S. dollar-based currency board system. This was to ensure that money supply growth did not exceed dollar reserve holdings, thereby containing inflation and, supposedly, ensuring financial stability. Inflation did collapse, but the Washington-dictated policy regime was a powerful magnet for global "hot money" flows. The currency board held narrow money supply growth in check, yet it did the very opposite for Credit. The onslaught of international inflows spurred massive government and corporate debt growth - too much of it denominated in dollars. The Argentine miracle economy boomed and became the poster child for enlightened "Washington Consensus" policymaking. It was all a Bubble Mirage. Conventional wisdom could not have been more detached from reality.

The Bubble inevitably faltered (2001/2002), and "hot money," as it does, raced for the exits. There were no buyers, no liquidity and meager real wealth to make good on all the debt that had been extended. It was a horrendous collapse and tragedy for the Argentine people, for which they're still suffering some 17 years later. Like many Bubbles before and since, it's amazing how long markets remain oblivious to financial imbalances and mounting structural impairment.

Brazil's 2001 crisis sealed the fate for their neighbor Argentina's flawed dollar currency board regime. Might the unfolding Argentine crisis this time push Brazil over the edge? It's worth noting that Brazil's sovereign CDS rose above 200 bps Wednesday for the first time in eight months. And while it doesn't compare to the Argentine peso's 5.8% drop (down 11.5% in 2-wks), Brazil's real fell 2.0% this week. The Brazilian real is down 4.0% over two weeks and 8.1% y-t-d. Brazil's local currency 10-year yields spiked Wednesday to a 2018-high 10.25% (closed the week at 10.0%).

Mexican local 10-year yields jumped to 7.75% Wednesday, just below multi-year highs, before ending the week at 7.58%. Mexico's peso traded to a 2018 low in Wednesday trading. Now down 5.1% y-t-d, the Indian rupee ended the week at 15-month lows. Hungary's local bond yields jumped 19 bps to an eight-month high 2.80%.

Turkey, another recent EM "darling," saw its currency drop another 2% this week, boosting its two-week decline to 6.3% and y-t-d losses to 12.0%. Turkey sovereign CDS rose another 13 bps this week to a 14-month high 238. Turkish government 10-year dollar-denominated yields jumped 14 bps to 6.66%, nearing the high going all the way back to 2009.

May 11 - Reuters (Ali Kucukgocmen and Behiye Selin Taner): "Turkish President Tayyip Erdogan called for lower interest rates on Friday and described them as the 'mother and father of all evil', triggering a fresh slide in the lira as investors worried about the central bank's ability to rein in high inflation… 'If my people say continue on this path in the elections, I say I will emerge with victory in the fight against this curse of interest rates,' Erdogan said in a speech to business people in Ankara…"

"Evil" is not possessed in too high interest rates - but rather in too much debt. And foreign-denominated debt, which Turkey has accumulated aplenty, can prove the "mother of all evil" when currency crisis devolves swiftly into a full-fledged financial panic. With the lira sinking and inflation surging, Turkey's central bank will likely have no alternative than to raise rates - perhaps aggressively - heading into June 24th snap elections. Lira 10-year bond yields spiked above 14% to an eight-year high in Wednesday trading.

May 9 - Financial Times (Gabriel Wildau): "China credit spreads hit their widest level in nearly two years this week following new regulations that undermined long-held assumptions about implicit guarantees on debt linked to local governments. Chinese localities have long used arm's length local government financing vehicles (LGFVs) to skirt restrictions on direct fiscal borrowing and to finance infrastructure, contributing to a surge in economy-wide debt since 2008. LGFVs are among the biggest borrowers in the local bond market. The spread between yields on 5-year Chinese government bonds and 5-year medium-term notes rated double A minus reached 3.6 percentage points on Monday and remained at that level on Tuesday… Six months ago the spread was only 2.51 points."

May 9 - Bloomberg (Lianting Tu and Carrie Hong): "The average yield on China's junk-rated dollar bonds rose above the 8% mark, fueling concerns of further gains amid a bulging issuance pipeline and the absence of a strong demand from mainland investors. Yields on dollar junk bonds from Chinese firms rose to the highest since April 2016, while those from the broader region yielded 7.4%... It took just 43 days for China's average yield to rise from 7% to 8%, after having taken more than four months for the move from 6% to 7%. BNP Paribas Asset Management expects credit spreads in the region to widen by a further 25-50 bps."

Turkey, China and others may hold crisis at bay for now. Argentina, an EM Bubble weak link, has rather precipitously succumbed. Even as the central bank (with a reasonable quantity of international reserve holdings) hiked interest rates to 40% and the Macri government sent a delegation to Washington to negotiate with the IMF, the currency plunge ran unabated. Argentina less than 11 months ago sold $2.75 billion 100-year bonds at a 7.9% yield.

May 11 - Financial Times (John Paul Rathbone): "A hundred years ago, at about the same time that the Titanic hit the iceberg, Argentina was among the 10 richest countries in the world. Today it ranks 87th. In all, it has defaulted on its debt eight times, suffered hyperinflation twice, and gone through 20 IMF-supported economic programmes in 60 years. The most brutal of these ended in 2001, triggering a $100bn default and crushing devaluation. The spectacular collapse left one in five Argentines unemployed, and with an understandable allergy to anything associated with the IMF. It also led to 12 years of populist rule. All this has made Mr Macri's subsequent quest for 'normality' harder still."

The S&P500 jumped 2.4% this week. EM instability worked to hold 10-year Treasury yields back from the 3.0% breakout level. Timely reports of less-than-expected inflation data didn't hurt either. The S&P500 bouncing off the 200-day moving average helped spur a bout of short covering - and short squeezes can take on lives of their own.

But, mainly, it was another week where U.S. markets were content to disregard myriad risks. And why not? A focus on risk can lead to untimely hedging and reductions in long exposures - and resulting underperformance. And underperforming active managers risk losing only more assets to the ballooning passive index ETF complex. In a world of too much "money" and Crowded Trades prevailing throughout the risk markets, it regresses into a dysfunctional game of disregarding risk and chasing performance. Buy and hold an equities index is, these days, pure genius.

This speculative dynamic, however, is coming home to roost in the emerging markets. At the same time, "developed" market outperformance spurs a rush to play - and talk of Goldilocks and dreams of new eras of permanent prosperity. Serious issues are in play at the "Periphery." It's an inopportune time for complacency at the "Core," let alone exuberance. That Bubble at the Periphery - it's been absolutely historic.

May 11 - Wall Street Journal (Chelsey Dulaney, Jon Sindreu and Saumya Vaishampayan): "The dollar's rise is squeezing bond markets in developing countries like Argentina, Indonesia and Turkey, gutting what had been a popular trade for investors seeking stronger returns. Countries in the developing world have been borrowing heavily, supported by upbeat expectations for global growth and a long period of low to negative interest rates that drove investors into emerging markets to get any sort of yield. Emerging markets added on $7.7 trillion in new debt last year, including bonds and other types of loans, with about $800 billion of that denominated in foreign currencies, according to data from the Institute of International Finance."