BUBBLE MEETS PANDEMIC CONSEQUENCES / CREDIT BUBBLE BULLETIN

Bubble Meets Pandemic Consequences

Doug Nolan


For posterity, some numbers: Over the past three weeks (14 sessions), the S&P500 gained 11.5%.

The KBW Bank Index surged 36.1%, with the NYSE Financials up 23.9%.

The Dow Transports rose 27.2% in 14 sessions, with the Bloomberg Americas Airlines Index up 75.8%.

Over this period, the broader market significantly outperformed the S&P500. The small cap Russell 2000 jumped 19.9% and the S&P400 Midcaps 21.1%. The Philadelphia Oil Services Index surged 50.0%. The Homebuilders (XHB) jumped 26.2% and the Bloomberg REIT index rose 22.5%. The average stock (Value Line Arithmetic Index) surged 25.3% in three weeks.

Over three weeks, United Airlines rose 113%, American Airlines 106%, Norwegian Cruise Line 105%, Royal Caribbean Cruises 85%, CIT Group 86%, Delta Air Lines 78%, Simon Property Group 73%, L Brands 72%, Boeing 71%, Carnival Corp 68%, Macy’s 68%, Alaska Air Group 67%, Kimco Realty 66%, Gap 62%, and Southwest Airlines 60%.

The Nasdaq Composite rose 8.9% over the past three weeks to close this week at all-time highs.

The Semiconductors jumped 17.8% to end Friday at record highs. The Nasdaq100 (NDX) gained 7.3% in three weeks to new highs.

June 5 – Bloomberg (Sarah Ponczek): “The latest U.S. jobs report will go down in history as the data that shocked economists. And the market. Forecasts for a drop of 7.5 million in payrolls were met with the reality of a 2.5 million increase in May, supporting the view that the world’s largest economy may be more resilient than previously thought.

A stock market already up 40% in a record period of time rallied further, with particular pockets going haywire. From a blowup in the momentum factor trade to a surge in small-cap shares, here’s a sample of what was happening under the equity market’s surface Friday. The momentum factor, which in essence bets that the recent winners will keep on winning, got pummeled Friday.

At its lows, a Dow Jones market neutral momentum portfolio that goes long the highest momentum stocks and shorts those with the least momentum dropped 9% -- the worst day since at least 2002.”

I try to stay laser-focused on the analysis, conscious not to stray into the conspiracy realm. The Fed may buy S&P futures contracts at key market junctures and the government might at times fudge the numbers.

I don’t know, and I’m not going there. Some will question the veracity of Friday’s payrolls data.

Forecasts were for the May unemployment rate to jump to 19.0%, surging from April’s 14.7%.

Private Payrolls were to see a 6.75 million drop, with manufacturing jobs down 400,000.

Instead, Private Payrolls surged almost 3.1 million, with manufacturers adding 225,000 workers. The Unemployment rate fell to 13.3%. Bloomberg: “Economists Have Biggest Miss Ever in U.S. Jobs-Report Shocker.”

June 5 – Fox News (Tyler Olson): “President Trump declared Friday that jobs are coming back on the heels of a surprise labor report that may indicate the start of an economic recovery amid historic job losses, as he also upped his demands on states to lift lingering coronavirus-related lockdowns… ‘We’re bringing our jobs back,’ Trump said during upbeat remarks to members of the media in the Rose Garden. ‘We’re gonna be back there. I think we’re actually going to be back there higher next year than ever before.’ He added, in reference to predictions that the economy could eventually bounce back to where it was before the pandemic: ‘We’ve been talking about a ‘V.’ This is far better than a ‘V.’ This is a rocketship.’”

Securities markets are indeed on a moonshot; the real economy not so much.

The 2016 election cycle was nothing short of unbelievable. We’re now only five months from what is poised to be a historic election. The President has stumbled in a most challenging backdrop – and is down in the polls.

With the pandemic, economic turmoil, protests and riots, it’s a surreal environment. We should expect things to turn even crazier in the months heading into voting. It was as if the presidential campaign finale officially commenced, buoyed by a stunningly better-than-expected employment report.

We’re witnessing final convulsions from a historic global speculative Bubble.

Markets enjoy unparalleled support from the President and Federal Reserve, along with central bankers and other policymakers spanning the globe.

Keep in mind, the Fed began aggressively expanding its balance sheet – injecting marketplace liquidity – back in September in response to heightened repo market strain. So-called “insurance” policy measures were adopted: apply stimulus measures early and aggressively to ward off potential instability.

Employing liquidity injections in an environment of record securities prices significantly exacerbated speculative excess. Bubble markets could not have been in a more vulnerable state when the pandemic hit.

As powerful self-reinforcing de-risking/deleveraging took hold, Bubbles were bursting in synchronized fashion. Dislocating markets were swiftly pushing global finance to the precipice. The upshot: global stimulus measures were taken to a whole new level, including an additional $3.0 TN of support from the Federal Reserve.

It was 15 months between the piercing of the mortgage finance Bubble (June ’07 subprime blowup) and the Fed’s $1.0 TN crisis-fighting QE program. Stocks had been weakening for about a year. Importantly, speculative impulses and Bubble Dynamics had been in the process of deflating for months prior to the Fed unleashing (at the time) unprecedented liquidity support. The economy was already well on its way to long overdue restructuring and adjustment. QE1 didn’t stoke craziness.

For this cycle, the Fed had been applying aggressive stimulus measures months ahead of the crisis. When mayhem hit, it was only nine trading sessions between February 19th all-time stock market highs to the March 3rd emergency rate cut. Within 10 weeks of record stock highs, the Fed had ballooned its balance sheet by almost $2.5 TN.

Dangerous speculative dynamics hadn’t had time to dissipate. Indeed, the most problematic outcome in such a situation is to aggressively fuel the speculative excess and market distortions that had fomented underlying fragilities in the first place. Speculators were further emboldened. Dysfunctional Market Structure was further crystallized.

June 5 – Financial Times (Richard Henderson and Eric Platt): “Investors pumped a record $22.5bn into US bond funds in the week to Wednesday as they shifted out of haven money market accounts to riskier but higher paying investments. The cash infusion into US bond mutual and exchange traded funds was the most since 2007, when the data provider EPFR began tracking the figures.”

The impact of QE liquidity injections varies profoundly based on prevailing inflationary biases, speculative impulses and Market Structure. QE in ’08 was administered to help stabilize a system in a deflated post-Bubble backdrop. Much bigger QE was administered in March and April specifically to hold financial collapse at bay - speculative zeal restored in the process.

We don’t want to lose sight of today’s extraordinary global backdrop. It is a world of desperate trial-and-error monetary inflation, with momentous yet uncertain consequences.

The ECB Thursday “beat expectations” by almost doubling the size of its latest QE program, to $1.5 TN.

In combination with the EU’s recent proposed $825 billion stimulus plan, policymakers have altered European risk market dynamics. Amazingly, major equities indices posted double-digit percentage gains this week in Germany, France, Spain, Italy and Belgium.

Over two-weeks, stock market gains were nothing short of astonishing. Germany’s DAX and France’s CAC40 surged 16.0% and 17.0%. Major equities indices jumped 17.5% in Spain, 16.6% in Italy, 16.8% in Austria, 12.2% in Greece and 12.2% in Poland. European bank stocks (STOXX 600) surged 24.4% in 10 sessions.

It’s worth noting that in 10 sessions (May 25th to June 5th) the euro gained almost 4% versus the U.S. dollar (1.09 vs. 1.13). This was a major contributor to the Dollar Index’s drop from 100 to 97. It’s easy to attribute dollar weakness (and euro strength) to the reversal of more Crowded Trades in generally chaotic market conditions. Yet there might be more important fundamental factors to contemplate.

In the traditional sense, the U.S. dollar is a fundamentally weak currency.

Incredibly, the U.S. has run persistent Trade and Current Account Deficits going all the way back to the early eighties (small surplus during ’91 recession). The U.S. has essentially flooded the world with dollar balances, liquidity arguably at the root of Global Bubble Dynamics.

As the world’s dominant reserve currency, only the dollar could maintain international value in the face of such unrelenting supply. Currency values are all relative. And in a world of unsound currencies, the dollar has more than held its own.

March’s global crisis backdrop saw the reemergence of king dollar dynamics, as the dollar advanced against most currencies (dollar index approaching seven-year highs). Dollar bulls are always quick to extol the U.S. economy as “envy of the world.”

There’s an element of truth to this, of course. Let us not forget, however, that the flexibility afforded to the Federal Reserve is definitely envied round the globe – and has been a key attribute supporting king dollar.

In a crisis environment, the Federal Reserve enjoys near total freedom to slash rates, “print money,” aggressively intervene in markets and employ myriad financing programs. No central bank has the flexibility to directly support its nation’s securities markets and, through booming markets and resulting loose financial conditions, underpin the overall U.S. economy. This has been a key dynamic supporting “king dollar” financial flows (floods) to U.S. markets during periods of instability and crisis.

A key question today: Is the dollar in the process of losing some of its competitive advantage – now that the ECB and EU are resorting to such massive stimulus operations?

If the “whatever it takes” ECB is willing to bend the rules as it bolsters Italian (and periphery) bonds, while the EU rewrites the rule book for supporting Italy’s and others’ economies – does this not lower near-term odds of EU crisis and disintegration?

And, does this not lend support to European securities (and derivatives) markets and the euro – at the expense of “king dollar” dominance? Moreover, did resulting dollar weakness not come at a critical market juncture, with hedges and short positions already under acute pressure on every continent?

Over two weeks, the Brazilian real surged 11.5% (including “best week since 2008”), the Czech koruna 6.2%, the Indonesian rupiah 6.0%, the Colombian peso 5.8%, the Polish zloty 5.4%, the Hungarian forint 5.4%, the Mexican peso 5.3%, the Chilean peso 4.8%, the South African rand 4.4% and the Russian ruble 4.3%.

Stocks were up 8.3% this week in Brazil, 7.8% in Mexico, 7.5% in South Korea, 10.6% in Chile, 19.0% in Argentina, 5.7% in India, 4.9% in Indonesia, 10.7% in Philippines, 5.6% in Malaysia, 4.9% in Taiwan, 7.3% in Thailand, 7.0% in Poland, 7.0% in Hungary and 4.3% in Turkey.

The iShares MSCI Emerging Markets ETF (EEM) jumped 8.5% this week and 12.3% over the past two weeks.

We’re in the throes of an extraordinary upside global market dislocation. I do not recall such a ferocious globalized short squeeze – stocks, corporate Credit, currencies and EM sovereign debt. We can only imagine the behind the scenes fracas in derivatives trading. And I know it’s exciting to watch markets recover and to book some easy speculative trading profits. We all want to believe markets are signaling the worst of the pandemic and economic downturn is behind us. It’s comforting to imagine that Mr. Market is flashing that everything is in the process of returning to normal.

I just don’t believe markets these days function as discounting mechanisms. Speculative dynamics dictate markets like never before.

FOMO – fear of missing out. What stocks, sectors, indices and markets are vulnerable to short squeezes? Where are the Crowded Trades? Where are the over- and underweights? What stocks and sectors have large outstanding call option positioning, leaving them susceptible to melt-up dynamics? How are the big derivatives players positioned?

I have similar issues as I had during last fall’s QE program: Fed liquidity was fueling leveraged speculation, ensuring huge QE measures would inevitably be required to mitigate “risk off” de-risking/deleveraging dynamics. These days, global QE foments upside market dislocation that leaves the world acutely vulnerable to an even more problematic market deleveraging episode.

But with markets having turned conspicuously speculative and detached from economic realities, I’ll presume central banks will be somewhat more measured with QE during the next bout of market instability. Bottom line: Today’s melt-up creates great risk of another major global illiquidity event, yet central bankers may hesitate to immediately throw Trillions more at the problem.

It was only Crazier this week – at home and abroad. We’ve only begun to scratch the surface of Bubble Meets Pandemic Consequences. I’ve previously identified three global crisis Fault Lines – Europe, EM and China. Europe’s grandiose “money” printing and government spending may have bought them some time.

Resulting dollar weakness and the unwind of hedges and shorts might have temporarily suppressed EM Crisis Dynamics. So, how ironic would it be for panicked reflationary dynamics globally and a disorderly unwind of hedges and short positions to trigger the onset of a dollar bear market?

Ten-year Treasury yields surged a notable 24 bps this week to 0.90%, the high going back to March 19th. It could prove an interesting juncture for “safe haven” Treasuries. The Fed has been reducing purchases, while waves of issuance are approaching as far as the eye can see.

There are as well anomalous market concerns for U.S. social and political stability. And perhaps the Chinese are keen to reduce their Treasury trove. Moreover, what are Treasury market ramifications if this crazy period marks an inflection point for the world’s reserve currency?

The unfolding geopolitical backdrop may not be as conducive to “king” dollar as the speculator community has assumed. Prospective U.S. economic fundamentals may no longer prove the “envy of the world.” And as crazy as it sounds, perhaps fundamentals including trade and Current Account Deficits, economic structure, debt and deficits actually begin to matter.

In a world of “pain trade” proliferation, it doesn’t take a wild imagination to envisage the Crowded long dollar trade suffering a bout of discomfort.