TRANSITORY HISTRIONICS / CREDIT BUBBLES BULLETIN

Transitory Histrionics

Doug Nolan


May 3 – Financial Times (Sam Fleming): “Having lamented low inflation as one of the great challenges facing central bankers today in March, Jay Powell on Wednesday wrongfooted many investors with comments that seemed to play down the gravity of the problem. The new message from the Federal Reserve chairman — that ‘transitory’ drags may be slowing price growth, rather than more persistent problems — marked a rude awakening for investors who had been hoping that he would signal an ‘insurance’ interest rate cut this summer because of low inflation. To critics, Mr Powell’s sharp change in tone extends a pattern of unpredictable communications that have made Fed policy more difficult to read. While many accept that investors got ahead of themselves in treating a 2019 rate cut as a fait accompli, the risk is that in his effort to dial back expectations of easier policy Mr Powell undercut the central bank’s broader message: that it will do whatever is necessary to get stubbornly low inflation back on target.”

To many, Chairman Powell’s Wednesday news conference was one more bungled performance. It may not have been at the same level as December’s “tone deaf” “incompetence.” But his message on inflation was muddled and clumsily inconsistent. How on earth can Powell refer to below-target inflation as “Transitory”?

Chairman Powell should be applauded. Sure, he “caved” in January. And while he can be faulted (along with about everyone) for not appreciating the degree of market fragility back in December, markets had over years grown way too comfortable with the Fed “put”/backstop.

I don’t fault the Powell Fed for having attempted in December to let the markets begin standing on their own. It was about time – actually, way overdue. Fault instead unsound markets and decades of “activist” Fed policymaking. And when markets were on the cusp of dislocating, Chairman Powell did what he believed the Fed had to do: Dovish U-turn. From my point of view, the grave mistake was the unnecessary (“gas on a flame”) “exceed dovish expectations” March 20th meeting. I’ll assume the FOMC was prepared in March to err on the side of both caution and message consistency.

But it’s May now. Record stock prices, bubbling bond markets and a return to quite loose financial conditions – along with a marketplace having gone a little crazy with the rate cut narrative. It would have been unwise for the Fed to oblige. To further accommodate this highly speculative market environment would ensure an only greater price to pay down the line. Besides, does it really make sense to split hairs on the undershooting of the Fed’s 2% inflation target with the S&P500 returning 18% in about four months and the unemployment rate down to a 49-year low 3.6%? “Transitory” Histrionics.

We live in an era where unstable global financial markets dictate financial conditions and economic performance like never before. Moreover, the world is in the throes of history’s greatest financial and market Bubbles. So discard any fanciful notion of “equilibrium.” At this point, the Bubble either inflates or falters – and the longer it inflates the more acutely vulnerable everything becomes. The global Bubble was in jeopardy in December, with ill-prepared central bankers coming feverishly to the markets’ rescue. Their next rescue attempt will come with greater challenges.

It’s worth noting that monthly y-o-y gains in CPI averaged 2.5% in 2018 (up from 2017’s 2.1%). July’s 2.9% was the strongest reading since February 2012. Year-over-year CPI inflation was at 2.5% in October before dropping back to 1.5% by February.

Is it reasonable to contemplate that this recent pullback in inflation could prove Transitory?

After Q4’s market instability and resulting tightening of financial conditions, major U.S. equities indices have since recovered back to record highs. Most indicators of credit conditions are now pointing to the loosest backdrop since early-October (some loosest since last summer).

At $747 billion, year-to-date global corporate debt issuance is running at a record pace (Dealogic data courtesy of the FT). Synthetic CDOs are back. In China, the Credit slowdown from much of last year has reversed course, exemplified by a record expansion in Q1. And after the Q4 collapse from $75 to $43, the most important commodity for inflation (crude oil) has in 2019 rallied back to $62 (WTI).

Despite Powell’s “Transitory” coupled with a much stronger-than-expected (“goldilocks”) 263,000 April gain in Non-Farm Payrolls, markets still see a 50% probability of a rate cut by the December 11th FOMC meeting. While this is down from the previous week’s 66.4%, it remains above the 44.6% from two weeks ago and the 41.7% from April 12th. Ten-year Treasury yields ended the week at 2.53%, up a few bps for the week but still below the 2.56% close from two weeks ago. I’ll suggest it’s an appropriate juncture for analysts and pundits to contemplate factors beyond current Fed thinking for an explanation of why the markets expect rate cuts in the not too distant future.

It’s no coincidence that market probabilities for Fed rate cuts jumped as China indicated waning inclination to press ahead with aggressive stimulus. Curiously, the trading week ending April 26th saw a 5.6% drop in the Shanghai Composite along with a surge in Fed rate cut probabilities (by 12/11/19) to 66.4% from 44.6%. It’s worth adding that recent declines in crude, copper, aluminum, nickel and commodities more generally have been highly correlated with the reversal in Chinese equities. Furthermore, the dollar index jumped to two-year highs as China’s stocks reversed sharply lower.

Friday evening’s Drudge headlines are worthy of documenting for posterity: “Envy of the World. Unemployment 49-year Low. Wage Hits $27.77/hour. Stock Market Endless Rally. Trump Approval 50%.”

With Nasdaq up 23% so far this year, IPOs coming left and right and generally the most speculative market environment in two decades, it’s effortless these days to completely disregard China. Besides, Beijing has everything under control – don’t they? They always do.

My fascination with Bubbles goes back more than 30 years (Japan in 1986). There have been so many – seemingly an endless stream of Bubbles: Japan, U.S. equities, junk bonds and leveraged buyouts, the S&Ls, and coastal real estate Bubbles from the second-half of the eighties. Bonds, mortgage derivatives, Mexico from the early nineties. SE Asia, Russia and EM from the mid-nineties. A major U.S. Bubble in technology, telecommunications and corporate Credit more generally. Argentina. Iceland. The historic U.S. mortgage finance Bubble. Europe, especially Greece and the European periphery. Dubai and so on – to mention only the first that come to mind.

In my 30 years of studying Bubbles, a few things have become clear – I would argue indisputable: They always burst. During the Bubble, virtually everyone dismisses Bubble analysis, instead believing the boom is well-founded and sustainable. The pain on the downside is proportional to the excesses during the preceding boom. Tremendous damage is inflicted during the final “Terminal Phase” of excess.

There’s no sound reason to believe China has discovered some magic formula for escaping the downside. These days there’s every reason to contemplate what a bursting Chinese Bubble will mean to China and the rest of the world. And I find it very intriguing that there is absolutely no mention of China in all the discussion of inflation and Fed policy. I actually believe that acute Chinese fragilities go a long way towards explaining (the latest “conundrum” of) depressed global sovereign yields (especially Treasuries, bunds and JGBs) in the face of surging risk markets.

Sure, China’s boom has been inflating for so long that the naysayers (arguing the view of an unsustainable Bubble) have been long discredited. I would strongly argue that the historic Chinese Bubble has been the most perilous consequence of Bernanke’s zero rates/QE, Draghi’s “whatever it takes,” Kuroda’s “QE infinity,” and, more generally, the most aggressive and protracted synchronized global monetary stimulus imaginable. In many respects, China has become the epicenter of the now decadelong global government finance Bubble. Today, no market – sovereign debt, equities, corporate credit, commodities, currencies and derivatives – is immune to the Virulent China Syndrome.

The upshot to the most globally accommodated Bubble ever has been history’s greatest credit excesses; unprecedented domestic over/mal-investment; unparalleled inflations in bank Credit and apartment finance; a massive pool of Chinese global spending and investment; and the most dangerous distortions in global trade, financial flows, and structural imbalances the world has ever experienced.

The China Bubble has altered global inflation dynamics – it has fundamentally changed geopolitics and the world order. It has certainly played a prevailing role in a global backdrop promoting asset inflation at the expense of wages – in the process exacerbating inequality. And, increasingly, China’s ascendency on the world stage has spurred an extraordinary Arms Race in everything technology, industrial, military and geopolitical. In short, China has become the Global Poster Child for Unsound “Money” - with incredibly far-reaching consequences.

May 1 – Bloomberg (Susanne Barton): “Traders borrowing U.S. dollars to buy China’s yuan can count on Asia’s best risk-adjusted carry trade to perform well for another couple of months, according to Bank of America. The backdrop should remain favorable through June as the U.S. and China are unlikely to reach a trade deal before then and the Asian country won’t let its currency depreciate significantly in the meantime, said Claudio Piron, the bank’s co-head of Asian currency and rates strategy… The trade is being supported by a plunge in currency volatility, growing yield divergence between China and the U.S. and the prospect of bond and equity inflows into the world’s second-largest economy, Piron said. The drivers are allowing the yuan ‘to become increasingly stable and attract risk-on carry trades and CNY asset exposure,’ Piron wrote in a note to clients.”

How much speculative leverage has accumulated in Chinese Credit over the past decade? I have a difficult time believing it’s not History’s Greatest “Carry Trade”. Chinese banks and corporations are estimated to have borrowed more than $3.0 TN in dollar-denominated liabilities. In January, a Bloomberg article (Christopher Balding) pointed to $1.2 TN of Chinese dollar debt that would need to be rolled over during 2019.

Beijing’s huge horde of international reserve assets created the capacity for sustaining its Bubble beyond that of all previous developing economies. While down from the $4.0 TN peak back in mid-2014, China’s $3.1 TN of reserves has been sufficient to maintain confidence in the Chinese currency and hold market crisis fears at bay. There was a scare in late 2015. Fears subsided when China pushed through aggressive stimulus while global central banks adopted only greater QE and monetary stimulus. And when currency weakness again posed risk to the Chinese Bubble late last year, Beijing pivots to yet another round of stimulus.

While conventional thinking holds that Beijing can stimulate Chinese Credit and economic output at its discretion indefinitely, such optimism is at this point misguided. A large and growing portion of the recent Credit expansion has flowed into non-productive purposes – including inflated apartment markets, hopelessly insolvent corporate borrowers and egregiously overleveraged local government entities. Stimulus operations are losing the battle of diminishing marginal returns. Meanwhile, “Terminal” excess continues to ensure systemic risk rises exponentially – the apartment Bubble, the ballooning banking sector, resource misallocation and deep structural impairment. And let’s throw in unquantifiable “carry trade” speculative leveraging that has surely ballooned precariously.

It’s worth pondering that China’s international reserve holdings have not expanded in eight years. Over this period, Chinese banking system assets have inflated 165% (to $39TN). Chinese GDP has inflated 113% ($13.6TN). System Credit has easily more than doubled. And let’s not forget that there is little transparency as to the composition of China’s $3.1 TN of reserves. Much has been committed to China’s fledgling international lending programs.

While global risk markets have grown complacent with regard to China, the scope of myriad China-related latent risks should have alarm bells ringing. Yet I’ll be the first to admit that such risks can remain largely masked so long as Chinese Bubble inflation is uninterrupted. For this, Credit growth must accelerate.

Pedal to the metal in Beijing equates to pushing worries out to the future. But I don’t believe sustained aggressive stimulus is something China’s leadership is comfortable with. After a booming Q1, I expect Beijing to attempt to cautiously slow lending and somewhat tighten financial conditions. We’re at the precarious late-stage of Bubble excess where any slowdown in Credit and speculation poses acute systemic risk.

I believe markets are pricing in the high probability for some Chinese-related instability between now and year-end that will force the Fed and global central bankers into additional monetary stimulus. The Fed is fashioning a new “inflation targeting” regime that will be used to justify easing measures in the face of the lowest unemployment rate in five decades. Bond markets relish the prospect of rate cuts and the redeployment of QE.

Meanwhile, reminiscent of the second-half of 2007, collapsing market yields and anticipation of another round of Fed stimulus throw gas on the speculative mania burning white-hot in the risk markets. Why fret some potentially lurking Chinese developments months (or years) into the future with such easy “money” to be made in the risk markets in the here and now? If I were Chairman Powell, I certainly wouldn’t be interested in stoking that fire either.