RUDE AWAKING COMING / CREDIT BUBBLE BULLETIN

Rude Awaking Coming

Doug Nolan


There's little satisfaction writing the CBB after a big down week in the markets. Motivation seems easier to come by after up weeks, perhaps my defiant streak kicking in. I find myself especially melancholy at the end of this week. There's a Rude Awaking Coming - perhaps it's finally starting to unfold.

Many will compare this week's market downdraft to the bout of market tumult back in early-February. At the time, I likened the blowup of some short volatility products to the June 2017 failure of two Bear Stearns structured Credit funds - an episode marking the beginning of the end for subprime and the greater mortgage finance Bubble. First cracks in vulnerable Bubbles. Back in 2007, it took 15 months for the initial fissure to develop into the "worst financial crisis since the Great Depression."

I posited some months back that tumult in the emerging markets marked the second phase of unfolding crisis dynamics. I have argued that the global government finance Bubble, history's greatest Bubble, has been pierced at the "periphery." More recently, the analytical focus has been on "Periphery to Core Crisis Dynamics." I've chronicled de-risking/deleveraging dynamics making headway toward the "Core." This week the "Core" became fully enveloped, as the unfolding global crisis entered a critical third phase.

Today's backdrop is altogether different than that of February. For one, back in February "money" was flow readily into the emerging markets - too much of it "hot money." "Risk on" was still dominant early in the year. Speculative leverage was expanding, with resulting liquidity abundance on an unprecedented global basis. With such a powerful global liquidity backdrop, a fleeting dislocation in U.S. equities proved no impediment to the hard-charging U.S. bull market. Indeed, global liquidity rushed into U.S. securities markets, fueling powerful speculation blow-off dynamics.

February market instability did, however, mark a key inflection point for risk embracement at the "Periphery." And the combination of acutely vulnerable Bubbles at the "Periphery" and blow-off dynamics at the "Core" proved highly destabilizing. The dollar rally helped push EM currencies over the cliff, while booming markets and economic activity in the U.S. pressured both the Fed and market yields. The upshot was a rather abrupt tightening of financial conditions for the emerging markets that, ironically, spurred a dangerous late-cycle Terminal Phase of speculative excess and resulting loose financial conditions in the U.S.

In stark contrast to February's robust financial conditions, the global liquidity backdrop these days is acutely fragile. Rather than the risk embracement environment from early in the year, risk aversion holds sway. On a global basis, speculative dynamics are dominated by de-risking and deleveraging. Liquidity is being destroyed instead of created, and it is anything but clear in my mind how the unfolding tightening of financial conditions would be reversed.

It is not only the speculative backdrop that has experienced momentous change. The Fed has liquidated about $250bn of its holdings since February. Both the ECB and BOJ have significantly reduced monthly QE liquidity injections from earlier in the year. The Fed has increased rates three times for a total of 75 bps. Rates were hiked to 60% in Argentina and 24% in Turkey. Throughout the emerging markets, central banks have been raising rates.

Global bond yields are much higher than in early-February. Argentine 10-year yields have surged 360 bps to 9.66%. Yields are up 685 bps in Turkey (21.1%), 340 bps in Pakistan (11.56%), 326 bps in Lebanon, 250 bps in Indonesia, 157 bps in Russia, 152 bps in Hungary, 114 bps in Brazil, 112 bps in Philippines, 105 bps in Peru, 82 bps in South Africa, 72 bps in Colombia and 56 bps in Mexico. And these are sovereign yields. Corporate debt has performed even worse, with notable weakness in Asian high-yield and dollar-denominated corporates more generally. And it's not as if European finance is sound. Italian 10-year yields have jumped 160 bps to 3.58%. This ongoing spike in global yields has certainly placed intense pressure on leveraged speculation.

Here at home, after trading as high as 3.26% in Monday's session, 10-year Treasury yields ended the week down seven bps to 3.16%. Yields were at 2.84% on February 2nd and then dropped to 2.71% during a tumultuous day for equities on February 5th. WTI crude traded down to $55 in February.

The Bloomberg Barclays US Corporate High Yield index began February at 5.78%, jumped to 6.36% by February 9th and then dropped back below 6.00% in April. And after reaching 6.54% in early July, yields declined to as low as 6.17% last Tuesday (10/2). This index saw yields surge 22 bps this week to 6.63%, the high going back to 2016.

It's my view that enormous amounts of leverage have accumulated throughout U.S. corporate Credit over this prolonged period of easy "money." It appears "Risk Off" dynamics attained important momentum in the U.S. corporate market this week.

October 12 - Bloomberg (Cecile Gutscher): "Nervous money managers fled from corporate bonds like never before in an exodus that outpaced stocks. Record outflows hit funds that buy investment-grade debt…, according to Bank of America Corp. strategists citing EPFR Global data. The redemptions totaled $7.5 billion in the week through Oct. 10. By comparison, investors pulled $1.4 billion from equity portfolios during the period, while government and Treasuries actually saw inflows… High-grade bond gauges have also suffered the steepest losses of all the Bloomberg Barclays indexes in this month's market meltdown."

As is generally the case, news and analysis follow market direction. With the market breaking to the downside, attention turns to the Federal Reserve and the unfolding trade war with China. Last Wednesday, with the market at record highs, pundits were celebrating the robust U.S. economy. What a difference a week makes.

I've received numerous emails over recent months questioning the supportive comments I've directed at Chairman Powell. This historic Bubble inflated throughout the watches of Drs. Greenspan, Bernanke and Yellen. Powell will surely be the scapegoat when things fall apart. The President has wasted no time in pointing fingers. It has to be the first time a central bank has been lambasted for gradually raising rates to a loco 2.25%.

October 10 - Bloomberg (Justin Sink and Shannon Pettypiece): "President Donald Trump slammed the Federal Reserve as 'going loco' for its interest-rate increases this year in comments hours after the worst U.S. stock market sell-off since February. Trump said… the market plunge wasn't because of his trade conflict with China: 'That wasn't it. The problem I have is with the Fed,' he said. 'The Fed is going wild. They're raising interest rates and it's ridiculous.' 'That's not the problem,' he said of the trade standoff. 'The problem in my opinion is the Fed,' he added. 'The Fed is going loco.' His latest criticism of the central bank began earlier Wednesday as he arrived in Pennsylvania for a campaign rally. 'They're so tight. I think the Fed has gone crazy,' the president said."

We're now, in real time, witnessing the inevitable dilemma created when a central bank falls "behind the curve." And keep in mind that rising asset prices are contemporary finance's prevailing type of inflation (inflationary manifestation). Leaving rates so low for such a long period of time was responsible for inflating myriad major Bubbles. And now central bankers face the high-risk proposition of normalizing rates in an acutely fragile Bubble backdrop. The bulls, of course, believe it would be negligent for a central bank not to reduce rates when the markets find themselves in a bit of trouble. Continuing to raise rates would be gross negligence; a show of total incompetence; and so on. President Trump wants to pin blame on Fed rate hikes, seemingly with no recollection of the "big fat ugly Bubble" he would herald on the campaign trail.

I'll assume that short rates will be heading back to zero - and that more QE will be forthcoming. But that's of little help for today's increasingly illiquid markets. Markets in the near-term have a problem: central bankers are not at the edge of their seats fretting a market meltdown. Dr. Bernanke had a persistently weak stomach, fearful his entire monetary experiment would come crashing down upon him at any time. Markets were similarly confident that a risk averse chair Yellen wouldn't dare try anything that might put global markets at risk.

So inflating Bubbles were left to run wild, market participants ever confident that the greater Bubbles inflated the more averse central bankers would be to removing the punchbowl. Monetary madness stretched out for way too long. The job of returning central banking to some semblance of normality is left to Chairman Powell. It's a thankless job; a winless job. It is deeply unfair - and I would argue disturbing - to see him setup to be the villain. I believe deeply that monetary inflation is the enemy of the people. Responsible central banking is not.

It would not be surprising if the Fed Chairman and central bankers, more generally, are not at this point overly concerned with the current bout of market instability. After all, markets have over recent years taken these types of selloffs in stride, "buying opportunities" as markets quickly bounced back to ever-higher new records. Besides, aren't speculative markets overdue for a wakeup call? Markets fear that central bankers lack fear.

Hedging and option-related selling surely played a significant role in this week's downdraft. And with expiration next Friday, expect option-related trading to play a major role well into next week - either up or down. Repeatedly we've seen expiration-week rallies destroy put value. If market strength does force a self-reinforcing reversal of hedges into expiration, the bulls will see the rally as evidence of a market on sound footing (the week was notable for the amount of bullish pontification in the face of an unbullish market reality).

But don't be fooled by fleeting option-related buy programs and the appearance of abundant liquidity. The backdrop is changing. Importantly, de-risking/deleveraging dynamics have arrived at the "Core." They have not only made it to the "Core," they've afflicted a vulnerable "Core" in a global backdrop of waning central bank liquidity, rising short-term rates and surging market yields.

"Risk Off" has become a global phenomenon - de-risking/deleveraging within a backdrop of central banks hoping to move beyond years of repeated market liquidity backstop operations. Moreover, it is a backdrop of highly divisive politics and troubling geopolitics. It is a worrying backdrop of escalating populism, nationalism and protectionism - that will matter now that markets are faltering.

I tell my wife that "it's over" just to hear her laugh. "How many times have you said that?," she'll say. With a chuckle, I respond, "This time I mean it." We shared a little laugh together, but this time I wasn't kidding. I do vividly recall thinking "it's over" in the summer of 2012, not anticipating that the German's would tolerate Draghi's "whatever it takes" unlimited "money" printing operations. And I similarly recall thinking "it's over" with China's Bubble at the precipice in early-2016. I guess I should have anticipated China's "national team," along with a ratcheting up of QE from the BOJ and ECB and an abrupt postponement of Fed "normalization" (after one tiny baby step).

I think "It's over" because all these market bailouts ensured things turned really crazy - and I believe this time around it's going to take central bankers longer to respond. I sense little appetite for another round of concerted global "money" printing operations. The focus is on domestic issues rather than some global agenda.

And market structure has become acutely vulnerable. Trillions in perceived safe and liquid ETFs. Trillions in a hedge fund industry struggling with performance and susceptible to huge outflows. Hundreds of Trillions of derivatives susceptible to market dislocation and illiquidity. Too much derivative market "insurance" that risks fomenting an avalanche of self-feeding sell orders. And let's not forget the maladjusted U.S. economic structure that will function surprisingly poorly in a backdrop of tighter financial conditions and sinking securities markets.

In particular, it was an ominous week for the two great intertwined Bubbles, illustrated by the Shanghai Composite's and S&P500's respective 7.6% and 4.1% declines. I could go on and on, but I find it all sad and frustrating.