FAULT LINES / CREDIT BUBBLE BULLETIN

Fault Lines

Doug Nolan


Now on a weekly basis, we're witnessing things that couldn’t happen – actually happen.

April 20 – Bloomberg (Catherine Ngai, Olivia Raimonde, and Alex Longley): “Of all the wild, unprecedented swings in financial markets since the coronavirus pandemic broke out, none has been more jaw-dropping than Monday’s collapse in a key segment of U.S. oil trading. The price on the futures contract for West Texas crude that is due to expire Tuesday fell into negative territory -- minus $37.63 a barrel.”

For posterity, the latest numbers on U.S. monetary inflation:

Federal Reserve Assets expanded $205 billion last week to a record $6.573 TN.

Fed Assets surged $2.307 TN, or 56%, in just seven weeks.

Asset were up $2.645 TN over the past 33 weeks.

M2 "money" supply surged $125bn last week to a record $16.870 TN, with an unprecedented seven-week expansion of $1.362 TN.

M2 inflated $2.329 TN, or 16.0%, over the past year. Institutional Money Fund Assets (not included in M2) jumped $123 billion last week.

Over seven weeks, Institutional Money Funds were up $845 billion.

Combined, M2 and Institutional Money Funds jumped a staggering $2.207 TN over seven weeks ($100bn less than the growth of Fed Assets).

It's increasingly clear this pandemic is striking powerful blows at the most fragile Fault Lines – within communities, regions, societies, nations as well as the world order.

To see this disease clobber the most vulnerable ethnic groups and the downtrodden only compounds feelings of inequality, injustice and hopelessness.

It is as well stunning to watch COVID-19 hasten the partisan brawl. A nation terribly divided is split only more deeply on the process of restarting the economy. To witness rival global superpowers plunge further into accusation and enmity.

And to see the coronavirus viciously attack Europe’s fragile periphery, further splitting a hopelessly divided Europe and pressuring a critical global Fault Line.

There are these days three critical international Fault Lines – Europe, the emerging markets and China - that were demonstrating heightened fragility even prior to the pandemic’s catastrophic blow.

Europe – with its structurally weak economies, fragile banking systems, social and political instability, and vulnerable euro currency regime – is a precarious Fault Line.

In particular, COVID-19 is absolutely clobbering Europe's own internal Fault Line. Spain and Italy trail only the U.S. in global infections. European ministers met again yesterday in an attempt to cobble together some type of agreement for an EU COVID stimulus package.

Italian yields rose five bps this week to 1.84%. There’s more to the story. Yields traded as high as 2.27% in Wednesday trading, up 48 bps in three sessions to the high since global markets were “seizing up” back on March 18th.

Heading into Thursday’s EU emergency meeting, yields were up across the Europe’s periphery.

At Wednesday trading highs, a three-session surge had yields up 37 bps in Spain, 36 bps in Portugal, and 50 bps in Greece.

April 23 – Associated Press (Lorne Cook and Raf Casert): “European Union leaders agreed Thursday to revamp the EU’s long-term budget and set up a massive recovery fund to tackle the impact of the coronavirus and help rebuild the 27-nation bloc’s ravaged economies, but deep differences remain over the best way to achieve those goals… But the leaders did agree to task the European Commission with revamping the EU’s next seven-year budget — due to enter force on Jan. 1 but still the subject of much disagreement — and devise a massive recovery plan. While no figure was put on that plan, officials believe that 1-1.5 trillion euros ($1.1-1.6 trillion) would be needed.”

April 23 – Bloomberg (Birgit Jennen): “German Chancellor Angela Merkel called for a Europe-wide economic stimulus program to be financed by the European Union’s budget, making a national appeal that helping partners would be good for Germany. ‘A European growth program could support an upswing over the next two years, and we’ll work for that,’ Merkel said in a speech to the lower house of parliament in Berlin… ‘We want to act quickly in Europe, and we of course need instruments to be able to quickly deal with the effects of the crisis in all member states.’ She urged German lawmakers to move fast to make a planned 500 billion euros ($540bn) in EU spending available as soon as June 1.”


EU ministers, once again, kicked the can down the road – which spurred a decline in periphery yields. Who will pay for massive - Trillion plus - stimulus spending plans – other than the ECB?

Italy came into this crisis with national debt-to-GDP approaching 140%.

In a likely scenario of GDP contracting 10% - and with debt surging at least 20% this year and growing rapidly again next year – it’s not long before Italy is facing an unmanageable 200% of GDP debt load. Conservative estimates have Portugal government debt expanding to 146% of GDP this year and Greece to 219%.

Italy’s weak coalition government is arguing for the EU to issue system-wide “coronabonds,” then employing these funds for grants to troubled nations. Germany, the Netherlands, Austria and other “northern” nations remain adamantly opposed to debt mutualization.

The Conti government is warning EU officials that Italy cannot handle a surge in debt issuance - and will not put its citizens through Greek-style austerity and debt restructuring. I don’t see Germans and Italians sharing a common currency as unsustainable over the longer-term.

I have expected hardship that would accompany the piercing of the global Bubble to again place European monetary integration at risk. Italy’s deteriorating circumstance risks sparking public support for exiting the euro.

April 24 - Bloomberg (Alessandra Migliaccio): “Italy’s credit grade was left unchanged by S&P Global Ratings, which said the nation’s diversified and wealthy economy, net external creditor position and low levels of private debt partly offset the drag from high public leverage. The BBB rating is still just two notches above junk, and S&P kept its negative outlook, which means the risk of a downgrade remains. The country’s financial position has been severely weakened by the cost of dealing with the coronavirus… The country’s rating could be lowered if the ratio between government debt and gross domestic product ‘fails to shift onto a clearly discernible downward path over the next three years, or if there is a marked deterioration in borrowing conditions that jeopardizes the sovereign’s public finance sustainability,’ S&P said.” 

COVID-19 will hasten the loss of confidence in myriad institutions.

The rating agencies will not go unscathed. Italy investment-grade?

Only massive ECB purchases have kept debt service costs manageable. And who would purchase Italian bonds today if not for the unstoppable ECB backstop?

What are the ramifications for the ECB loading up on such unsound debt?

The euro traded down to almost 1.07 vs. the dollar in Friday trading – near one-month lows.

A euro breaking lower on heightened concerns for periphery debt and euro zone integration would only add fuel to the dollar’s upside dislocation.

The dollar index was back above 100 this week.

With king dollar already benefiting from the U.S.’s competitive advantage in fiscal and monetary stimulus, an additional push from a euro crisis would place only more pressure on faltering EM currencies (including the renminbi).

The Brazilian real’s 6.2% drop this the week increased y-t-d losses to 27.8%. Brazil’s local currency bond yields surged 167 bps this week to 8.77%.

Dollar-denominated yields surged 40 bps to 5.04%, the high since March 19th.

Brazil’s Credit default swap prices surged 78 bps to 368 bps, the high since March 31st – and only 14 bps below the closing high from March 18th. Brazilian stocks sank 5.5% in Friday’s selloff, increasing y-t-d declines to 34.9%.

Ominously, Banco do Brasil sank 15.6% this week, boosting 2020 losses to 54%.

Banco Bradesco fell 14.5% (down 48.5% y-t-d).

Brazil as an EM crisis Fault Line?

April 24 - UK Guardian (Dom Phillips): “Brazil’s government has been plunged into turmoil after the resignation of one of Jair Bolsonaro’s most powerful ministers sparked protests, calls for the president’s impeachment and an investigation into claims he had improperly interfered in the country’s federal police. In a rambling televised address…, Brazil’s embattled president denied claims from his outgoing justice minister Sérgio Moro that he had sought to appoint a new federal police chief in order to gain access to secret intelligence reports… ‘Sorry Mr Minister, you won’t make a liar of me,’ Bolsonaro declared… Moro’s bombshell allegations sparked pot-banging protests and an immediate outcry among Brazil’s political class, with Brazil’s prosecutor-general Augusto Aras requesting supreme court permission to launch an investigation. ‘Moro’s testimony … constitutes strong evidence for an impeachment process,’ tweeted Flávio Dino, the leftist governor of the northeastern state of Maranhão.”

This week’s EM currency weakness wasn’t limited to Brazil. The Mexican peso sank 5.1%, with y-t-d losses up to 24.2%. The Colombian peso was down 2.5%, the South Korean won 1.4%, the Hungarian forint 1.4%, and the South African rand 1.2%. Notable y-t-d EM currency declines include the South African rand’s 26.5%, Colombian peso’s 19.0%, Russian ruble’s 16.9%, Turkish lira’s 14.7%, Chilean peso’s 12.5%, Hungarian forint’s 10.4%, Indonesian Rupiah’s 10.0%, Argentine peso’s 9.9% and Czech koruna’s 9.7%.

EM booms were a central facet of the global bubble, thriving from a confluence of overheated domestic credit systems and booming Chinese demand and credit excess, along with unparalleled leveraged speculation and international inflows.

International speculative flows would gravitate freely into EM booms, only to eventually be trapped by collapsing currencies, illiquidity and capital controls – come the arrival of the bust. After the most protracted of booms, I believe a historic bust has commenced. The shocking precision of COVID-19 strikes on the susceptible – this week in Brazil.

Collapsing EM currency and bond prices were key aspects of March’s “seizing up” of global markets. Central bank policy measures – including the Fed’s expanded international swap arrangements – along with the global rally have somewhat stabilized “developing” markets.

Yet EM remains the global financial system’s weak link.

EM has added unprecedented amounts of debt during this long cycle, too much dollar-denominated. Widespread debt restructuring and defaults seem unavoidable.

EM now faces a very difficult road ahead. “Hot money” outflows have commenced, currencies have faltered, and bond markets have turned unstable. Acute financial and economic fragilities have begun to surface.

Importantly, EM central banks lack the flexibility to employ monetary stimulus to the extent enjoyed by the major central banks. Liquidity injections risk exacerbating outflows and currency crises, at the same time stoking inflationary pressures and bond yields.

Sinking EM currencies and bond prices then incite panicked “hot money” outflows, dislocation and financial crisis.

To make a bad situation worse, aggressive stimulus by the Fed bolsters U.S. Treasuries and securities markets, drawing international flows to king dollar. The stronger dollar then further pressures EM currencies and stokes de-risking/deleveraging dynamics.

EM has entered what I expect will be a deep multiyear downcycle, with far-reaching market, financial, economic, social and geopolitical ramifications. Emerging market economies, certainly including China, played a powerful role as the “global locomotive” pulling the world out of the previous crisis period.

They will now act as a major economic drag – and a Fault Line for global financial crisis.