De-risking/Deleveraging at the Periphery
Doug Nolan
It was another unsettled week for notably synchronized global markets.
The week began with a decent bout of hope.
The S&P500 rallied 2.8% in Monday trading, “its strongest one-day gain since June.”
Having begun in Asia, the market rally gained momentum in European trading, which set the stage for a gap higher opening for U.S. equities.
A spark was provided by the Reserve Bank of Australia.
After its previous Friday attempt fell flat, Australia’s central bank Monday doubled down on its bond purchases, essentially expending $3.1 billion in its yield control operation.
Australian 10-year yields collapsed a remarkable 35 bps to 1.67%, more than reversing the previous Friday’s price spike.
After Japanese 10-year yields rose to a five-year high 16 bps Friday, there was a report Monday claiming the Bank of Japan was prepared to act against any excessive rise in yields.
And then ECB governing council member Francois Villeroy stated the ECB “can and must react” against any unwarranted tightening (aka higher bond yields).
European yields reversed sharply lower on his comments, with double-digit declines in Italian and Greek yields. Equities caught fire.
Relief that a concerted central bank effort was poised to counter rising global yields powered Monday’s risk market recovery.
It would prove fleeting.
March 4 – Financial Times (Naomi Rovnick, Neil Hume, Joshua Oliver, Aziza Kasumov and Colby Smith):
“Government bond prices sustained a further blow on Thursday, prompting benchmark stocks to wipe out close to all gains for the year, after comments from Federal Reserve chairman Jay Powell failed to reassure investors… ‘Today was a really interesting day because the market was really firm, a little tentative but firm, and then Powell spoke,’ said George Cipolloni, a portfolio manager at Penn Mutual Asset Management. ‘He really didn’t say anything dramatically different, other than that they’re not at their target yet… which is rattling markets.’”
Ten-year Treasury yields were trading at 1.46% Thursday morning ahead of Chairman Powell’s scheduled Q&A session at the Wall Street Journal’s Jobs Summit – up about five bps for the week.
Yields surged soon after Powell began speaking, ending the session almost nine bps higher at 1.57%.
Powell could not have been clearer.
The Fed Chairman went into significant detail as to what it will take for the Fed to begin tapering QE along with what would be required to commence an increase in short-term rates.
It’s all dovish – as expected. At least outwardly, the policy focus is geared specifically for a return to full employment.
The Fed will not be responding to what it views as a transient uptick in inflation.
It was all the normal dovish creed we’ve grown accustomed to – that up until recently was manna to Treasury and risk markets.
But it’s just not working – and why it’s not is both intriguing and critical for global market Bubbles at a heightened risk of deflating.
Why did bond yields surge on Powell’s boilerplate comments?
The more obvious – and conventional – view would be his avoidance of any mention of another “operation twist” or, indeed, any measure that might indicate the Fed was considering additional buying at the long-end of the Treasury curve.
Hopes the Fed would be part of a concerted global central bank “yield control” effort were dashed.
Listening to the entirety of Powell’s comments, there’s much to concern bond investors.
For one, the Fed is lax on inflation in an extraordinary environment that beckons for vigilance.
Our central bank is locked into experimental policy doctrine when it should be open-minded and flexible.
Moreover, the Fed is trapped by a backdrop of Bubble markets and resulting acute fragilities.
A Friday headline read, “Investors are having a ‘Crisis of Confidence’ in the Fed.”
While somewhat premature, the Powell Federal Reserve is increasingly suffering from a credibility problem.
Powell (from the WSJ Q&A session, March 4, 2021):
“I think the Fed established its credibility several decades ago on inflation and since that time the connection between having a lot of people out of work and inflation under control has gotten very, very weak.
So, our new framework very explicitly takes that new learning, that new understanding, and says that we won’t raise the interest rates to cool down the economy just because unemployment gets lower - just because employment gets high.
We’re going to wait to see signs of actual inflation or the appearance of other risks that could threaten the achievement of our goals.
And we’ve seen that the economy can sustain very low levels of unemployment without inflation.”
Powell:
“So many people, particularly people who are now entering the job market, will not have lived through high inflation.
And high inflation is a very bad state of affairs. And it hurts people the most on fixed incomes and lower incomes…
Inflation was very high when I was in college and coming into the job market.
So, it’s really not something we want.
But I would say, at the Fed, we are well-aware of the history and how it happened and [we’re] not going to allow it to happen again.
It was a situation where the Fed didn’t step in when it should have, when inflation pressures were building.
Not at all the current situation. Inflation is currently running below 2%.
It’s running at 1.5%. But we’re very mindful of what happened in really the 1960s and 1970s and determined not to repeat that mistake.”
Powell:
“The key thing is to keep longer-run inflation expectations anchored at 2%.
If that happens then a transient increase in inflation will not affect inflation over a longer period.
And we intend to use our tools to keep inflation expectations anchored at 2%, which gives us the ability to do all the things we do when the economy is weak.”
It’s reasonable to conclude markets were disappointed by Powell not directly addressing potential yield suppression measures.
I’ll assume the Fed would at this point prefer to save its “operation twist” (sell T-bills to purchase longer-term Treasury bonds) announcement to spring on the markets in the event of more serious instability.
Echoing governor Lael Brainard, Powell said the Fed didn’t want to see “disorderly conditions” or a “persistent tightening in broader financial conditions.”
This signals the Fed’s willingness to intervene if necessary, but without risking the possibility of a market selloff on an announcement of actual market support.
But I do discern a bond market increasingly uneasy with the Fed’s cavalier approach to inflation.
There’s an incongruity that should trouble holders of long-term fixed-income securities: The Fed is not only explicitly stating its intention to disregard an uptick in pricing pressures, its new “inflation targeting” doctrine explicitly seeks to promote a period of above target inflation (compensating for previous below-target price increases).
Meanwhile, Powell wants to have it both ways.
He claims traditional resolve, stating the Fed is “determined not to repeat that mistake” when it “didn’t step in when it should have, when inflation pressures were building.”
Does anyone at this point actually believe the Fed would step in to repress inflationary pressures?
Clearly, they won’t be reacting to nip “building” price pressures – they’ve said as much.
And I see about zero chance of the Fed moving to tighten financial conditions in the event of inflation gaining a serious foothold.
By that point, bond markets would surely already be in a state of disarray.
The FOMC wouldn’t dare tighten during a period of market tumult.
One could argue the Fed retains credibility today when it comes to its “whatever it takes” crisis-fighting resolve.
It has essentially committed to erring on the side of a continuation with runaway balance sheet expansion.
This bolsters its credibility in handling market instability as well as a reemergence of disinflationary pressures – the two key risks weighing on markets over recent years.
But rather suddenly, there’s a third major risk: rising consumer price inflation.
And the problem is there’s no reason these days to afford the Fed any credibility when it comes to controlling a reemergence of heightened inflationary pressures.
We will never witness the “whatever it takes” mindset employed to secure a “WIN” – Whip Inflation Now.
Powell’s “we intend to use our tools to keep inflation expectations anchored at 2%, which gives us the ability to do all the things we do when the economy is weak” rings hollow.
The five-year Treasury inflation “breakeven rate” rose another six bps this week, surpassing 2.5% Thursday for the first time since July 2008.
The adoption of QE as a routine (crisis and non-crisis) policy measure essentially rendered obsolete the Fed’s capacity “to keep inflation expectations anchored at 2%” through the entire cycle.
Aggressively employing QE to counter inevitable late-cycle market instability (i.e. September 2019) placed the Fed in the precarious position of reinforcing Bubble markets.
Go there and there’s no turning back.
As we’ve witnessed – having been spurred on by the pandemic – the amount of stimulus necessary to support Bubble markets and economies inflates exponentially.
Inflationary pressures are now mounting, while inflationary dynamics are becoming increasingly entrenched – at home and abroad.
And while the future is as murky as ever, bond markets can’t trust the Federal Reserve (or global central bank community) to keep inflationary expectations anchored. Powell’s clutching of a crumbling myth is not confidence inspiring.
March 5 – Bloomberg (Jack Pitcher, Ameya Karve and Priscila Azevedo Rocha):
“Signs of caution mounted in corporate credit markets globally as longer-term Treasury yields kept rising on Friday, leading some borrowers from New York to Tokyo to delay bond sales and strategists to caution about trouble ahead.
Gauges of credit fear jumped in Europe for investment-grade and high yield debt on Friday in derivatives markets.
Two borrowers that had expected to sell bonds in the U.S. opted to push their offerings into next week, after a stronger-than-expected jobs report brought fresh inflation concerns and lifted the 10 year Treasury yield briefly above 1.6%.”
March 5 – Bloomberg (Davide Scigliuzzo and Katherine Doherty):
“Junk-bond investors appear to have their limits after all. Following several weeks of talks with potential creditors, Ronald Perelman’s Vericast Corp. is scrapping a $1.775 billion bond sale after struggling to agree on terms…
The scrapped sale proves the junk-bond frenzy that’s allowed a growing list of troubled companies to take advantage of record-low costs to refinance debt and push out maturities has its bounds.
The deal is the first to be pulled in the U.S. junk bond market in four months…”
High yield Credit default swap (CDS) traded up to 314 bps in early Friday trading, the high since February 1st. Investment-grade CDS rose to 57.5 bps – the high since January 29th.
And while these prices remain a fraction of last March’s highs (886 and 159 bps), it does appear CDS prices are poised to move higher after benefiting from months of liquidity excess and aggressive market risk embracement.
To this point, however, U.S. corporate Credit has been a sideshow.
March 4 – Bloomberg (Stephen Spratt, John Ainger and Alexandra Harris):
“The cost of borrowing U.S. Treasury 10-year notes continues to spiral higher despite record-size auctions, fueled by a growing pool of investors who want to bet on higher yields.
The interest rate on overnight cash loans backed by the newest 10-year note -- repurchase agreements, or repos -- plummeted below minus 3% Wednesday for only the third time since the beginning of 2018, according to Scott Skrym of Curvature Securities LLC.
That’s the threshold below which it’s cheaper to pay a regulatory fine than to complete the transaction, and it’s an indication of huge demand to be short the issue after last week’s selloff pushed its yield to a one-year high.”
March 5 – Bloomberg (Alexandra Harris):
“The Federal Reserve looks poised to disappoint Wall Street by not extending an emergency exemption that’s propped up the Treasury market since last year’s pandemic panic.
After bond market liquidity dramatically disappeared a year ago, the Fed let banks stop factoring in Treasuries to their so-called supplemental liquidity ratios -- letting them stockpile U.S. debt without breaking regulations.
That exemption expires March 31, and central bankers have given no indication it’ll get authorized for longer.
The impending expiration, some say, is a reason why Treasuries just suddenly got so volatile.
Disorderly trading provides a justification for regulators to keep the SLR exemption, Bank of America strategists Ralph Axel and Mark Cabana wrote...
They don’t expect an extension, but said there’s some alternatives that could help.”
I won’t delve into the “SLR” (supplemental liquidity ratios) issue.
And while it has become a more salient concern following recent bond market liquidity challenges, I would tend to put more weight on mounting inflation risk, hedging-related selling and deleveraging as key factors behind Treasury market volatility, surging market yields and liquidity issues.
With unprecedented Treasury and corporate bond issuance at record low yields, markets have never been exposed to today’s level of interest-rate/duration risk.
This explains why equities have become hypersensitive to every tick increase in Treasury yields – recognizing today’s heightened risk of a backup in market yields turning disorderly and destabilizing.
I’ll assume at this point that some of the sophisticated operators playing the speculative Bubble blow-off have begun to take chips off the table.
A number of market darlings have been under pressure.
This week saw double-digit losses for Moderna (14.6%), Twitter (13.1%), Peloton (12.7%), Tesla (11.5%) and Zoom (9.7%).
Crazy volatility has returned.
The Nasdaq100 (NDX) was down nearly 2.0% in Friday morning trading, only to rally almost 4% off intraday lows (ending the session up 1.65%).
The Semiconductors fell 2.4% and then rallied 5.8%.
While not as dramatic, after being down 1% in the morning the S&P500 rallied 3.2% to more than erase the week’s decline.
For the most part, U.S. equities emerged out of a fog of instability seemingly unscathed.
Out at the “periphery,” things were more scathing.
EM currencies were suffering, with Eastern Europe under notable pressure.
Over the past two weeks, the Turkish lira has dropped 7.5%, the Brazilian real 5.2%, the South African rand 4.3%, the Mexican peso 4.2%, and the Hungarian forint 4.0%.
The surge in dollar-denominated EM bond yields was ongoing.
Yields were up 41 bps this week in Turkey, 36 bps in Ukraine, 28 bps in Peru, 24 bps in Brazil, and 20 bps in Saudi Arabia.
That put the two-week yield spike at 68 bps in Turkey, 62 bps in Ukraine, 56 bps in Brazil, 56 bps in Peru - and those are dollar bond yields.
In two weeks, local currency bond yields were up 173 bps in Lebanon, 79 bps in Turkey, 70 bps in Colombia, 47 bps in Thailand, and 41 bps in South Africa.
March 5 – Bloomberg (Divya Patil and Rahul Satija):
“A surge in bond yields is bleeding into Asian markets where at least two state-backed Indian companies and three Japanese firms pulled planned debt sales.
Indian Railway Finance Corp. and National Cooperative Development Corp. withdrew rupee note offerings Thursday…
In Japan, Santen Pharmaceutical put off a yen bond sale that it had planned to price Friday, after two other issuers there also paused deals in recent days.
A jump in the 10-year Treasury yield -- the global bond benchmark -- to a one-year high is sending shockwaves through markets.
Global credit markets have stumbled in one of their worst weeks this year, with Asian junk bond prices extending their drop this week to the worst since October.”
De-risking/deleveraging has initiated a tightening of financial conditions out at the global “periphery”.
Not atypically, incipient tightening at the “periphery” provides transitory favor to the “core.”
The dollar index’s 1.2% gain this week surely lent some support to U.S. Treasuries and securities markets more generally.
With massive stimulus as far as the eye can see, the U.S. “periphery” (i.e. junk bonds) has so far remained bulletproof.
Indications of vulnerability began to emerge this week.
I fully expect the tightening of financial conditions at the “periphery” to gravitate to the “core.”
Despite the Fed’s ongoing $120 billion monthly liquidity injections, I don’t believe the “core” is immune to de-risking/deleveraging dynamics.
That U.S. equities are in a full-fledged mania and U.S. corporate Credit still demonstrating a powerful Bubble Dynamic complicate the analysis.
Beijing also creates a high degree of uncertainty.
March 2 – Wall Street Journal (Jonathan Cheng):
“China’s chief banking regulator warned about rising risks from the country’s property sector and from global financial markets, underscoring Beijing’s focus on risk controls after a robust pandemic recovery.
Guo Shuqing, chairman of the China Banking and Insurance Regulatory Commission, told reporters… he was concerned about what he called a ‘bubble’ in Chinese real-estate prices, which he said could threaten the country’s financial sector and its broader economy.
‘Many people buy homes not to live in, but to invest or speculate.
This is very dangerous,’ said Mr. Guo, comparing the property bubble to a ‘gray rhino’—an obvious but neglected threat.
Mr. Guo also warned about the possibility of spillover from what he described as asset bubbles in global financial markets, which he added were out of sync with real-world economic conditions.”
March 5 – Bloomberg:
“China’s government set a conservative economic growth target for this year, shifting its focus from recovery mode to longer-term challenges like reining in debt and reducing technological dependence on the U.S.
The growth target was set at above 6%, well below economists forecasts, with the budget deficit expected to fall to 3.2% of gross domestic product…
In sharp contrast to places like the U.S., where the Biden administration is trying to push through a new $1.9 trillion stimulus package, Beijing outlined a plan to normalize policy now that the pandemic is under control domestically and the economy has bounced back.
The target for 2021 stands in contrast to the 8.4% expansion that economists predict…”
Beijing recognizes it faces acute Bubble risk both at home and from abroad.
Unrelenting U.S. fiscal and monetary stimulus - with resulting massive trade deficits - ensures powerful inflows into China.
This only further complicates Beijing’s already great challenge of reining in Bubble excess without unleashing the forces of risk aversion, panic and collapse.
I’ll take this week’s announcements as indicating that Beijing believes it must sacrifice growth to mitigate escalating risks associated with over-indebtedness and asset Bubbles.
Surging global yields, fragile equities Bubbles, and prospective Chinese tightening measures.
That’s a confluence of risks that beckon for a more cautious approach to leverage and risk-taking more generally.
Indeed, today’s backdrop places myriad levered strategies in harm’s way.
I’ll assume the global leveraged speculating community – the marginal source of finance globally – has commenced de-risking/deleveraging.
Issues in the “repo” and dollar swaps markets point to mounting stress in derivative hedging markets.
In sum, the volatility experienced across markets over the past couple weeks indicates growing risk of a financial accident.
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