HORDE OF JUMBO BAZOOKAS / CREDIT BUBBLE BULLETIN

Horde of Jumbo Bazookas

Doug Nolan


“Stocks Eye Best Week of 2019 on ‘Powell Put’ Bets,” read the Friday Bloomberg headline. By the close of Friday trading, the S&P500 had posted a gain of 4.4% (“best week since November”). Also from Bloomberg: “Fed Watchers Say a July Rate Cut Is In Play, June Not Likely.” Markets now price in a 25% probability of a cut by the June 19th meeting, 86% by July 31st and 96% by September 18th. Markets a month ago saw only a 33% chance of a cut by the September meeting.

Ten-year Treasury yields declined four bps this week to 2.08%. German bund yields dropped another six bps this week to a record low negative 0.26%, with Swiss 10-year yields down three bps to negative 0.52%. Japanese JGB yields declined three bps to negative 0.12%. Some of the more spectacular yield moves have unfolded away from the typical safe havens. Spanish 10-year yields dropped 16 bps this week to a record low 0.55%, and Portuguese yields sank 19 bps to a record low 0.62%. Greek yields fell eight bps to 2.81%.

And if there is any doubt that market prices have completely detached from underlying fundamentals, look no further than Italy. Italian 10-year yields collapsed 31 bps this week to 2.36%. Spectacular panic buying across global bond markets.

June 4 – Wall Street Journal (Nick Timiraos): “Markets rallied Tuesday after Federal Reserve officials said they were closely monitoring the recent escalation in trade tensions and indicated they could respond to any economic deterioration by cutting interest rates. ‘We do not know how or when these trade issues will be resolved,’ Fed Chairman Jerome Powell said… ‘We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion.’ Mr. Powell didn’t say whether he thought a rate cut would be needed. The comments show the Fed has ended a debate over whether its next move would be to raise or lower rates and is focusing now on whether and when to cut them.”

The Fed Chairman didn’t suggest – or so much as mention - a rate cut. Markets take “closely monitoring” as assurance that the FOMC learned its lesson back in December. A Thursday headline from the Wall Street Journal: “Fed Begins Debate on Whether to Cut Rate as Soon as June.” And Friday from CNBC: “It’s No Longer a Question of if the Fed Will Cut Interest Rates, But When.”

Assuming the market has this right, the Federal Reserve is preparing for additional monetary stimulus - perhaps in less than two weeks. This means the Fed would be cutting rates from already extremely low levels, with the unemployment rate at 3.6%, 3.1% y-o-y wage growth, 10-year bond yields just above 2.0%, y-o-y CPI up 2.0% (core up 2.1% y-o-y), along with highly speculative stock prices posting strong gains for the year and the S&P500 less than 3% below all-time record highs.

Back in the nineties, the Greenspan Fed attracted some criticism for their “asymmetrical” policy bias: Greenspan was prone to slash rates aggressively in the event of market instability, but then to increase cautiously in “baby step” 25 bps increments even in the face of booming output and bubbling asset markets. This policy approach corrupted market incentives, fostered speculative excess, and progressively distorted market function.

Yet the old “asymmetrical” appears a remarkably prudent and balanced policy approach in comparison to what we’re witnessing these days. At this point, it might take 4% GDP growth, an upside inflation surprise and an equities melt-up for the Fed to ponder another 25 bps rate increase. But the very prospect of some market instability is enough to unleash aggressive rate slashing and a mad dash to QE and other unconventional measures.

From Chairman Powell’s Tuesday opening remarks before the “Conference on Monetary Policy Strategy, Tools, and Communications Practices:” “Perhaps it is time to retire the term ‘unconventional’ when referring to tools that were used in the crisis. We know that tools like these are likely to be needed in some form in future ELB spells, which we hope will be rare. We now have a significant body of evidence regarding the effectiveness, costs, and risks of these tools, including those used by the FOMC and others tried elsewhere. Our plans must take advantage of this growing understanding as assessments are refined.”

Thursday from the Wall Street Journal (Nick Timiraos): “...One loud message out of this week’s Chicago conference is that Fed officials should move more quickly than the central bank has in the past to shore up growth at the first sign of weakness, because with their short-term benchmark rate at a historically low level they don’t have as much room to cut rates as in previous downturns.”

I have posited that the Fed’s balance sheet could swell to $10 TN during the next crisis. When the current Bubble bursts, the Fed and global central bankers will see no alternative than to flood the global financial system with central bank Credit. This is a terrible, reprehensible prospect.

I warned a decade ago that QE was a slippery slope. After a decade, central bankers would surely today prefer to rebrand QE as a “conventional” – and elemental – part of their arsenals.

But it will not be until the next bursting Bubble phase before there is a modicum of a “body of evidence” (from only one cycle) for assessing the effectiveness of history’s most radical monetary experiment. Today, global securities markets are eagerly anticipating the return of zero rates and more QE. Chairman Powell, Draghi and others are conveying the message that they are getting their arsenals ready.

I contemplate global issues (China, financial and economic fragilities, mounting geopolitical risks) and understand why they are compelled to reassure the markets. With limited tools, moving early and aggressively might even seem reasonable. There is one monumental problem: at this stage of a protracted speculative super-cycle these reassurances are throwing gas on a raging fire. That Which Insulates the Bubble Only Makes It Stronger.

Powell: “In short, the proximity of interest rates to the ELB has become the preeminent monetary policy challenge of our time, tainting all manner of issues with ELB risk and imbuing many old challenges with greater significance.”

The ELB (“effective lower bound” – aka zero rates) predicament is of the Fed/central bankers’ own making. After the Fed cut rates to zero (to 0.25%) on December 16, 2008 (having slashed 500 bps in 15 months), it took a full decade to reverse Fed funds 200 bps higher (to 2.25% to 2.50%). It’s worth adding that after beginning “normalization” with a 25 bps increase in December 2015, it was then almost three years before rates were raised to 2.0%. Over this period, the S&P500 surged 40%.

Having delayed, postponed and ultimately abandoned “normalization,” the resulting “ELB” predicament ensures the Fed (and fellow central banks) will be swiftly resorting to QE. This prospect has been fundamental to the collapse in global yields, a dynamic that has been fueling precarious Bubble Dynamics throughout global securities markets (sovereign debt, equities and corporate Credit, in particular). This has caused the already gaping divergence between inflating risk market prices and deflating global fundamental prospects to deviate to an unprecedented degree (beyond even late ’07).

Allow me to posit that speculative finance – rather than “ELB” – is “the preeminent monetary policy challenge of our time.” Chairman Powell played the briefest lip service to “Using monetary policy to push sufficiently hard on labor markets to lift inflation could pose risks of destabilizing excesses in financial markets or elsewhere.”

Powell, Draghi, Kuroda and the like fully appreciate that a decade of ultra-loose monetary policies have fueled dangerous Bubbles. But they’ve thrown in the towel; a fight they are afraid to confront. The Fed has not only abandoned “normalization,” it has deserted its primary responsibility for safeguarding financial stability. We’re witnessing nothing short of a historic failure in the Bernanke inflationary policy doctrine, today masked by precarious Speculative Dynamics throughout the risk markets and a historic melt-up in global sovereign bond prices.

History has never experienced such powerful financial Bubbles on a globalized basis. The scope of international trend-following and performance-chasing finance is unprecedented (many tens of Trillions). And with these Bubbles at risk of bursting, central bankers are resolved to employ “whatever it takes” monetary stimulus to hold dislocation at bay. The upshot is only further emboldened market participants, more intense speculation, a greater accumulation of speculative leverage and even more precarious “Terminal Phase” Bubble excess.

June 6 – Reuters (Balazs Koranyi and Francesco Canepa): “The European Central Bank… ruled out raising interest rates in the next year and even opened the door to cutting them or buying more bonds as risk factors such as global trade war and Brexit drag the euro zone economy down. Hoping to maintain the flow of credit to the economy, it also offered to effectively pay banks to borrow from it and lend that money on to the real economy. With the bloc’s inflation prospects diminishing rapidly, ECB President Mario Draghi sought to reassure investors that the central bank was ready to act if needed to support an economy hurt by weaker global trade and that it could even resort to once-taboo measures.”

Markets are highly confident the ECB will soon redeploy its bond purchase program. There was an interesting exchange in Mario Draghi’s Thursday news conference:

Journalist question: “It feels like we’re further away than ever from returning to normal monetary policy. Have we actually reached the new normal? Is the big question now for central banks not whether or for how long to use non-standard monetary policy tools, but rather in what combination and with what weighting?”

Mario Draghi: “…Is the world more normal today than it was a year ago or three years ago? Monetary policy uses the instruments that are adequate to cope with the contingencies and the challenges that come out. Now we say the monetary policy is non-conventional, that we are far away from normalization. We are far away from normalization because the rest of the world, the rest of the challenges are far away from being normal. It’s been like that now for many, many, many years following first the great financial crisis, then the sovereign debt crisis, then the Greek crisis. Now we have the threat of rising protectionism, the geopolitical threats that we see every day. We have developments in the Eurozone itself that warrant this.”

The world is certainly anything but normal. The critical issue that the world refuses to address is how three decades of progressively “activist” central banking have played a profoundly deleterious role in global financial and economic development. Fed policymaking was fundamental in fueling the “tech” and mortgage finance Bubbles. The bursting of the Bubble in 2008 then incited history’s greatest central banking stimulus. Without this radical stimulus the historic Chinese Bubble would not have been possible. It was this radical stimulus that also exacerbated inequality within and between nations. It was the backdrop of inequality and general insecurity that contributed to the global rise of the “strongman” leader. And headstrong leadership, extreme economic imbalances and the zero-sum game mentality today create epic economic and geopolitical risks.

June 6 – Financial Times (Claire Jones): “Throughout his eight years as the European Central Bank’s president, Mario Draghi has stood ready to live by his most famous maxim and do ‘whatever it takes’ to shore up the eurozone economy. Whether they agree with that approach or not, his successor will now have to stomach much of Mr Draghi’s approach after he steps down in the autumn. He has managed to not only lock his successor in to keeping interest rates on hold until the middle of 2020, but he has also now made the first move in shaping the central bank’s reaction if economic conditions worsen. Mr Draghi has controversially remodelled the eurozone’s monetary guardian from a Bundesbank-style central bank to something more akin to the US Federal Reserve, purchasing trillions of euros-worth of bonds to stamp out the threat of deflation — despite fierce opposition in northern member states.”

Draghi’s replacement will suffer the same fate as Bernanke’s successors. Once you’ve pulled out the monetary bazooka, there will be no dropping it from the arsenal. Nothing in fact will suffice but a bigger bazooka. Bigger Bubble Demands Bigger Bazooka. And global bond markets are these days priced for a Horde of Jumbo Bazookas. Yet there’s more to this story than central banks held hostage by speculative Bubbles. More than trade wars, weak global manufacturing and even the fragile European banking system, the vulnerable Chinese Bubble is a potential catalyst that could rather abruptly panic global markets and central bankers alike.

The Shanghai Composite dropped 2.4% this week. The Chinese renminbi has not yet mustered a rally attempt after the recent steep sell-off. More bank worries and another active week for the People’s Bank of China:

June 2 – Reuters (Andrew Galbraith): “China’s central bank sought to calm investors… after last month’s takeover of Inner Mongolia-based Baoshang Bank, saying regulators are not planning any more such moves for the moment… In response to concerns that regulators planned more takeovers of financial institutions, the PBOC said on Sunday that Baoshang was a standalone case. ‘Everyone, please don’t worry. At present we don’t yet have this plan,’ it said in a statement…”

June 5 – Bloomberg (Livia Yap and Claire Che): “China’s central bank added 500 billion yuan ($72bn) to the financial system, more than offsetting the medium-term loans that were maturing Thursday. The People’s Bank of China offered the one-year medium-term lending facilities at 3.3%, and sold 10 billion yuan of seven-day reverse repo at 2.55%... The loans, the second-largest of their kind on record, were offered…”

June 2 – Bloomberg: “Bank of Jinzhou Co. said its auditors resigned, sending some of its debt securities plunging and reigniting investor concerns about the riskiness of China’s smaller lenders. Ernst & Young Hua Ming LLP and Ernst & Young said in a resignation letter to the bank that there are indications that some loans to institutional customers weren’t used in ways consistent with the purposes stated in documents… There are almost 4,000 small city and rural banks in China and these typically have ‘more vulnerable funding and liquidity profiles, larger shadow-financing activities and lower loss-absorption capacity’ than larger commercial banks, according to Fitch Ratings. Bank of Jinzhou was set up in 1997 in Liaoning province in northeastern China. It has total assets of $113 billion and total deposits of $53 billion…”

June 3 – Bloomberg: “Investors in China’s money market avoided debt sold by smaller lenders on Monday as the government’s seizure of Baoshang Bank Co. remained fresh on their minds. Short-term funding costs for China’s top banks swung back to normal by Thursday after an initial jump that followed the first government seizure of a local lender in about more than two decades. However, yields on negotiable certificates of deposits -- a popular instrument of interbank lending – issued by smaller banks were still indicated 20 bps higher than ChinaBond valuations this morning… Some of Baoshang’s creditors face potential losses. Demand for smaller bank NCDs remained scarce on Monday after a sharp drop in issuance last week…”

June 4 – Bloomberg: “Some of China’s smaller banks have delayed plans to sell tier-2 bonds in the local market due to weak investor demand after the first government seizure of a lender in about 20 years, according to people familiar with the matter. Guilin Bank Co. and Jincheng Bank Co.’s planned tier 2 bond sales have been postponed, said the people…”

June 3 – Bloomberg: “Underwriters of a new Chinese credit hedging tool just narrowly avoided their first-ever payout in the nation’s $13 trillion bond market. An investor protection clause on two of Beijing Orient Landscape & Environment Co.’s bonds was triggered last month after the note repayment funds were used for other purposes. Bondholders recently gave waivers, not calling them defaults. The close shave is making underwriters more wary of selling credit risk mitigation warrants (CRMWs), according to Southwest Securities Co.”

June 4 – Financial Times (Don Weinland): “China’s stock market was hit by the biggest outflow of foreign capital on record in April and May as the trade war with the US and concerns over the stability of the renminbi darkened investors’ view of the country. A total of about $12bn left the market during April and May, according to data from CEIC and Morgan Stanley, the largest exodus since the launch five years ago of a ‘stock connect’ programme that provides global investors with access to Chinese shares, via Hong Kong.”

June 5 – Financial Times (Don Weinland and Archie Zhang): “A $647bn blind spot in financial reporting by China’s city and rural commercial banks is fuelling investor concerns that more of the country’s lenders face government intervention or collapse in the wake of the state takeover of Baoshang Bank. Baoshang was one of 19 banks with a combined Rmb4.47tn ($647bn) in assets that have yet to publish 2018 financial results, according to… Barclays. The delays are a potential sign of a build-up in non-performing loans and leave investors blind to how many of those assets may have turned into bad debt, as was the case with Baoshang, analysts said.”

June 4 – Bloomberg: “Chinese authorities are taking fresh steps to cool the property market, curtailing onshore fundraising for developers found to have bid aggressively in land auctions. The curbs have affected companies including Sunac China Holdings Ltd. and Gemdale Corp., said people with knowledge of the matter… In some cases, developers’ underwriters were asked by regulators not to tap unused quotas for selling yuan bonds or asset-backed securities… By targeting developers’ financing plans, authorities signal they’re willing to use a wide range of levers for keeping the housing market in check…”

June 6 – Bloomberg: “China’s central bank governor said there’s ‘tremendous’ room to adjust monetary policy if the trade war deepens, joining counterparts in Europe and the U.S. in displaying readiness to act to support the economy. In an exclusive interview with Bloomberg in Beijing, People’s Bank of China Governor Yi Gang also signaled that he’s not wedded to defending the nation’s currency at a particular level, and stressed that the value of the yuan should be set by market forces… ‘We have plenty of room in interest rates, we have plenty of room in required reserve ratio rate, and also for the fiscal, monetary policy toolkit, I think the room for adjustment is tremendous,’ he said. Yi said the currency has been weaker recently due to ‘tremendous pressure’ from the U.S. side but the impact will be temporary.”

There’s “tremendous room to adjust monetary policy” – that is, until the renminbi buckles and Beijing faces a run on its currency and financial system. “Everyone, please don’t worry.” Worry. “China’s stock market was hit by the biggest outflow of foreign capital on record…” How about the huge international flows that were enticed into China’s booming bond market? “A $647bn blind spot in financial reporting by China’s city and rural commercial banks…” “Steps to cool the property market.” All the characteristic of an unfolding crisis.