NO COINCIDENCE / CREDIT BUBBLE BULLETIN

No Coincidences

Doug Nolan


September 20 – Wall Street Journal (Daniel Kruger): “The Federal Reserve Bank of New York will offer to add at least $75 billion daily to the financial system through Oct. 10, prolonging its efforts to relieve funding pressure in money markets. In addition to at least $75 billion in overnight loans, the New York Fed… will also offer three separate 14-day repo contracts of at least $30 billion each next week… On Friday banks asked for $75.55 billion in reserves, $550 million more than the amount offered by the Fed, offering collateral in the form of Treasury and mortgage securities. The Fed’s operation was the fourth time this week it has intervened to calm roiled money markets. Rates on short-term repos briefly spiked to nearly 10% earlier this week as financial firms looked for overnight funding. The actions marked the first time since the financial crisis that the Fed had taken such measures.”

With the collapse of Lehman setting off the “worst financial crisis since the Great Depression”, instability in the multi-trillion repurchase agreement marketplace generates intense interest.

This crucial market for funding levered securities holdings is critical to the financial system’s “plumbing.” It is a market in perceived “money” – highly liquid and virtually risk free-instruments.

If risk suddenly becomes an issue for this shadowy network, the cost and availability of Credit for highly leveraged players is suddenly in question. And any de-risking/deleveraging at the nucleus of the global financial system would pose a clear and present danger of sparking “risk off” throughout Credit markets and financial markets more generally.

I’ll usually begin contemplating the CBB on Thursdays. This week’s alarming dislocation in the “repo” market was clearly a major development worthy of focus. But I was planning on highlighting the lack of initial contagion effects in corporate Credit, a not surprising development considering the New York Fed’s aggressive liquidity injections.

Investment-grade Credit default swaps (CDS), for example, closed Thursday trading near their lowest levels since February 2018. Junk bond spreads (to Treasuries) went out Thursday near the narrowest since early-November. Bank CDS, another important indicator, also continued to signal the “all’s clear” throughout Thursday trading. As of Thursday’s close, Goldman Sachs’ (5yr) CDS was up a modest three points for the week to 58, after closing the previous Friday near low going back to January 2018.

But Friday’s trading session came with additional intrigue. Investment-grade CDS jumped 15% to 59.7, the highest close in about a month. Goldman Sachs CDS rose 9.4% to 63.1, an almost four-week high. JPMorgan CDS rose 8.9% (to 42.7), BofA 11.0% (to 47.5) and Citigroup 5.7% (to 61.1). And as key financial CDS prices moved sharply higher, safe haven bond yields dropped. Treasury yields fell six bps in Friday trading to 1.72%, and Bund yields declined two bps to negative 0.525%. Even more curious, Gold popped almost $18 Friday to $1,517, boosting the week’s gain to $28.

The Fed’s return to system liquidity injections after a decade hiatus received abundant media coverage. For the most part, analysts were pointing to a confluence of unusual factors: $35 billion money market outflows to fund September 15th quarterly corporate tax payments; settlements for outsized Treasury auctions; and the approaching end to the quarter (where money center banks generally reduce balance sheet leverage for financial reporting and regulatory purposes).

Missing from the discussion was that this week’s money market tumult followed on the heels of instability in other markets. Is it coincidence that Monday’s spike in repo rates followed last week’s extraordinary bond market reversal – where 10-year Treasury yields surged 34 bps and benchmark MBS yields spiked an incredible 46 bps (2.37% to 2.83%)?

What a nightmare it’s been over recent months for those attempting to hedge interest-rate risk. After trading to 4.10% in November, benchmark MBS yields were down to 3.02% near the end of March. MBS yields then rose to 3.34% in April, before reversing lower to trade all the way down to 2.51% by late June. Yields were back up to 2.91% in mid-July – only to then reverse to a three-year low of 2.30% on September 4th. Collapsing MBS yields spur waves of refinancings, shortening the lives (“duration”) of existing MBS securities trading in the marketplace (as old MBS are replaced with new lower-yielding securities).

The marketplace for hedging MBS and other interest-rate risks is enormous. Derivatives really do rule the world. When market yields are declining, players that had sold various types of protection against lower rates are forced into the marketplace to acquire instruments for hedging their escalating rate exposure.

Much of this levered buying would typically be financed in the repurchase agreement (“repo”) marketplace. This type of hedging activity can prove strongly self-reinforcing. Intense buying forces Treasury and bond market prices higher, “squeezing” those short the market while spurring additional hedging-related buying. At the same time, the expansion of “repo” securities Credit boosts overall system liquidity, supporting the upside inflationary bias in bond and securities prices.

The recent downside dislocation in market yields included tell-tale signs of manic blow-off speculative excess. At 1.46% lows (September 3rd), an exuberant marketplace was calling for sub-1% Treasury yields – as if the unending supply from massive deficit spending would remain permanently divorced from market price dynamics. Meanwhile, booming corporate issuance was gobbled up at near record low yields - and the lowest spreads to Treasuries in two years. Inflows were inundating the bond ETF complex.

Excesses in U.S. fixed-income were unfolding as $18 TN of global investment-grade bonds traded at negative yields, including European corporate debt.

Things got conspicuously out of hand. With global central bankers in aggressive easing mode – including an ECB restarting the QE machine while pushing rates further into negative territory – market participants were in the mood to believe central banks had abolished market cycles. Like deficits and Current Account Deficits, speculative excess and leverage don’t matter.

While everyone was relishing the mania, trouble was building under the markets’ surface – in the “plumbing.” As yields collapsed, speculative leverage mounted. Surging prices incited a buyers’ panic in Treasuries, MBS, corporate bonds, CDOs and structured finance – a chunk of it financed in the “repo” and money markets.

Derivative player hedging activities also significantly boosted system leverage. All the speculative leveraging worked to expand system liquidity, crystallizing the market perception of endless liquidity abundance. While a deficient indicator of system liquidity, it’s still worth noting M2 “money” supply has expanded $560 billion over the past six months. Money market fund assets (retail funds included in M2) are up $350 billion since the end of April. Where’s all this “money” been coming from?

Market “melt-up” upside dislocations sow the seeds for abrupt market reversals and attendant upheaval. One day’s panic buying (on leverage) can be the following session’s frantic selling (unwind of leverage). Especially in the derivatives arena, self-reinforcing derivative-related dynamic (“delta”) hedging during an upside speculative blow-off is susceptible to abrupt reversals.

Hedging programs necessitate buying into rapidly rising markets, only to immediately shift to aggressive selling in the event of market weakness. The associated leverage spurs liquidity excess on the upside, creating vulnerability for illiquidity in the event of downside sell programs and speculative deleveraging.

It is surely no coincidence that this week’s “repo” ructions followed last week’s spike in yields and resulting deleveraging. Is it a coincidence that the marketplace experienced a powerful “rotation” that saw the favorite stocks and sectors dramatically underperform the least favored? Is it a coincidence that hedge fund long/short strategies have been clobbered, in what evolved into a powerful short squeeze and dislocation? Surely, it’s no coincidence the so-called “quant quake” foresaw this week’s quake in the repo market?

Let’s expand this inquiry. Is it a coincidence that this week’s money market upheaval followed by a few months dislocation in the Chinese money market? And is it mere coincidence that U.S. money market instability erupted on the heels of the ECB’s decision to restart QE?

There are No Coincidences. Chinese money market issues and currency weakness were fundamental to the global collapse in yields. Trade war escalation risked pushing China’s vulnerable Credit system and economy over the edge.

Global central bankers responded to sinking bond yields with dovish talk and monetary stimulus, feeding the unfolding bond market dislocation. Collapsing market yields and dovish central banks stoked melt-up dynamics in stocks and sectors seen benefiting from a lower rate environment. Growth stocks were caught up speculative melt-up dynamics, while short positions in underperforming financials and small caps were popular hedging targets.

Both momentum longs and shorts became Crowded Trades.

Meanwhile, booming markets and the resulting loosening of financial conditions quietly bolstered flagging growth dynamics – from China to the U.S. to Europe. The prospect of constructive U.S./China trade talks risked catching the manic bond market out over its skis.

Some stronger U.S. data sparked a sharp bond market reversal, with rising yields spurring a reversal of Crowded equities trades. Losing on both sides, the long/short players suffered painful losses. De-risking of long/short strategies incited a powerful short squeeze, a dynamic that gained momentum into expiration week.

The S&P500 is only about 1% from all-time highs. Yet there’s been some real damage below the market’s surface. The leveraged speculating community, in particular, has been shaken.

There were losses in Argentina and EM currencies more generally. Bond markets have turned unstable – on both the up- and downside. Long/short strategies have been bludgeoned. Short positions have turned highly erratic. And this week instability engulfed the overnight funding markets, with contagion effects for other short-term funding vehicles at home and abroad.

Trouble brewing.

The leveraged speculating community is the marginal source of liquidity throughout U.S. and global markets. Not only have they faced heightened risk across the spectrum of their holdings, they now confront funding market uncertainty into year-end. This doesn’t necessarily indicate imminent market weakness.

But it does signal vulnerability. Many players are afflicted with increasingly “weak hands.” They’ll exhibit less tolerance for pain. This dynamic increases the likelihood that market weakness will spur self-reinforcing de-risking and deleveraging.

There was considerable market vulnerability this time last year – with equities at all-time highs.

Global markets, economies, trade relationships and geopolitics are all more troubling today.

Central bankers have burned through precious ammunition, in the process spurring problematic late-cycle excess. Understandably, there is dissention within the ranks – from the Fed to the ECB and BOJ. Is monetary stimulus the solution or the problem?

Autumn is set up for some serious instability. There’s all this talk of the need for the Fed to create additional bank reserves. The issue is not a shortage of reserves but a gross excess of speculative leverage. It started this week. The Fed’s balance sheet will be getting much bigger.

The Fed and the markets were blindsided by this week’s repo market instability. The surprises will keep coming.