The Big Test
Doug Nolan
It’s been some time since the Fed commenced a serious tightening cycle.
Previous moves to raise rates progressed gingerly, so as not to risk upsetting the cherished stock market.
One has to go back to 1994 for a Federal Reserve determined to actually tighten financial conditions.
The Fed boosted rates 25 bps on February 4, 1994, 25 bps in both March and April, 50 bps in May, 50 bps in August, 75 bps in November and 50 bps in February 1995.
Rates were hiked 300 bps in twelve months to 6.00%.
I have vivid memories of 1994.
It was a decisive year for contemporary finance: Its First Test.
Recall the Greenspan Fed began aggressively slashing rates in response to an escalating banking crisis and recession.
There was the massive S&L bailout.
Banking system impairment was turning severe, with even worries for Citigroup’s solvency.
Enterprising Greenspan to the rescue.
Rates were slashed from 8% in October 1990, all the way down to 3% (lowest since 1963!) by September 1992.
It was the “coming of age” for the awe-inspiring “Maestro.”
Alan Greenspan faced major systemic issues.
The banking system was in trouble, and another S&L-type federal bailout risked thrusting already problematic deficits to unwieldy dimensions.
The economy was in recession, with talk of deflation and even the risk of economic depression.
Greenspan was in desperate need of a reflationary spark, along with a mechanism to recapitalize the banking system – all without blowing out fiscal deficits that would risk a bond market conniption and run on the dollar.
Enter a steep yield curve and the “government carry trade.”
Masterful.
Banks could now borrow in short-term funding markets at 3.0%, while lending to the Treasury (i.e. 10-year Treasuries) at 8.0%.
It was about as close to free money as one can get.
If something looks too good to be true, it probably is.
When I began working for Gordy Ringoen’s fund in 1990, hedge fund industry assets were estimated at about $35 billion.
By 1993, assets had surged to around $200 billon.
Greenspan’s covert bank recapitalization scheme was also doling out free money to the blossoming leveraged speculating community.
Why limit profits to 500 bps annually (borrow at 3% and lend at 8%) in the “government carry trade”, when returns could be compounded with 200% (or much greater) leverage.
Better yet, why not aggressively lever in higher-yielding mortgage securities, including esoteric “interest only” and “principal only” (IOs and POs) mortgage derivatives?
Fortunes were being made (20% of fund returns to the general partner!), and the industry was growing like wildfire.
The Greenspan Fed allowed this fire to burn too hot.
The S&P500 returned 30.4% in 1991, 7.6% in 1992 and another 10.1% in 1993.
The financial sector was expanding aggressively.
Broker/Dealer assets expanded 19% in 1991, 20% in 1992, and a blistering 24% in 1993.
The extraordinarily loose financial backdrop was stoking intense demand for securities to leverage, along with derivatives structured with embedded leverage.
The revolution to non-bank Credit (i.e. MBS, ABS, “repos,” GSEs, money market funds, corporate Credit, derivatives and Wall Street structured finance) was vigorously supported.
Coming into 1994, it was clear this new mechanism of a Fed-controlled yield curve, speculative leverage, and powerful growth in marketable Credit instruments was about to be tested.
Ten-year yields traded at 5.77% the day before the first Fed hike, and were at 6.09% two weeks later.
Yields were up to 6.52% by March 14th, 7.14% by April 18th, 7.50% by September 16th and 8.00% on November 4th.
Yet the greatest pain was inflicted on mortgage securities, particularly the more esoteric mortgage derivatives.
From Bloomberg (David Weiss):
“It was one of the biggest disasters in the history of Wall Street.
David J. Askin's $700 million array of mortgage-backed derivative funds crumbled in March, 1994, dragging down an illustrious roster of investors and triggering a collapse in the market for collateralized mortgage obligations (CMOs).”
Despite the dislocation and carnage, contemporary finance passed its first Test back in 1994.
I was surprised and also determined to understand how such an intense de-risking/deleveraging episode didn’t become more of a systemic issue.
It was the beginning of my analytical focus on the GSEs. GSE assets expanded an unprecedented $150 billion in 1994, almost double the previous year’s record.
Fannie Mae and Freddie Mac, in particular, had evolved from chiefly insurers of mortgage securities to become powerful quasi-central bank providers of market liquidity backstops.
GSE assets would expand another $115 billion in 1995, $92 billion in 1996 and $112 billion in 1997.
By 1997, hedge fund assets were approaching $400 billion.
Broker/Dealer assets surged 22% in 1995, 16% in 1996 and 21% in 1997.
Non-bank Credit was hot, hot, hot fodder for leveraged speculation.
The year 1997 witnessed the devastating “Asian Tiger” Bubble collapses.
When in early 1998 I discerned a similar fate awaiting Russia, I believed the second Big Test for the new financial structure was imminent.
The collapse of Long-Term Capital Management (LTCM) pushed global finance to the edge.
The Test, however, was ultimately passed at The Hands (in contrast to Adam Smith’s “invisible hand”) of a Fed-orchestrated LTCM bailout, rate cuts, the International Monetary Fund, and an unprecedented $305 billion 1998 expansion of GSE assets (followed up with an additional $317bn in 1999).
A critical Bubble Dynamic had been revealed: each bursting Bubble required more aggressive monetary stimulus, with reflationary effects spurring the next larger Bubble.
The aggressive response to the LTCM debacle unleashed 1999’s wild speculative excess – the Internet mania, an almost doubling of Nasdaq and crazy telecom debt.
Throw stimulus measures at a system with already powerful inflationary and speculative biases, and you’re playing with fire.
Lesson Never Learned.
A bursting “tech” Bubble would be another Test for the new financial structure.
I believed the Bubble had burst in 2000, but reversed course in early 2002 – warning of the unfolding “mortgage finance Bubble.”
The GSEs expanded another $242 billion in 2000, a record $345 billion in 2001, and $242 billion in 2002.
By the end of 2002, the GSE Assets had expanded 300% in nine years to $2.55 TN.
Not surprisingly, a strong inflationary bias had developed throughout both U.S. housing and mortgage finance, with 10.6% household mortgage growth in 2001 and 13.3% in 2002.
Accommodating rapid mortgage Credit expansion became the centerpiece of the Fed’s post-tech Bubble reflationary strategy.
“On May 23rd, [2006] the Commission and the Office of Federal Housing Enterprise Oversight jointly announced settlements with Fannie Mae for accounting fraud.”
After the revelation of widespread accounting fraud and other irregularities at Fannie and Freddie, I began warning of another systemic Test.
With the days of open-ended balance sheet growth having run their fateful course, the next serious de-risking/deleveraging episode would unfold without the GSE liquidity backstop.
By the end of 2007, hedge fund assets were up to about $1.8 TN.
Mortgage Credit had doubled in six years, with mortgage-related derivatives the epicenter of reckless leveraged speculation.
In the five reflationary years ended 2007, Broker/Dealer Assets had inflated 77% to $6.167 TN. FIASCO.
The Test arrived in 2008’s fourth quarter.
Even with the Bernanke Fed’s $1 TN QE, I thought the Bubble had burst.
Comprehending the nature of the Fed’s reflationary strategy, I began warning in early 2009 of the unfolding “global government finance Bubble.”
Fed (and global central bank) QE and Bernanke’s inflationist rhetoric had unleashed Bubble excess at the heart of global finance – central bank Credit and government debt.
Zero rates coerced savers into the risk markets, only sharpening the Fed’s focus on ensuring markets remained levitated.
Massive U.S. monetary inflation and resulting Current Account Deficits fueled Bubbles globally.
China and the emerging markets, in particular, showed strong inflationary biases heading into the crisis, with post-Bubble stimulus stoking myriad booms.
The Fed’s QE2 monetary inflation was pivotal in the spectacular growth in China’s international reserve growth - from 2007’s $1.5 TN to June 2014’s almost $4.0 TN.
“Globalization’s” inflationary heyday.
China’s Bubble went to crazy excess, with fragility surfacing in 2018 and 2019.
The Fed responded to cracks in U.S. leveraged finance with another QE program in 2019, unleashing more late-cycle speculative excess.
Another Test was approaching.
A panicked Fed responded to collapsing Bubble dynamics with unprecedented monetary inflation in March 2020.
Historic manias were unleashed, along with powerful Inflationary Dynamics.
The Test was passed, but at monumental costs.
Things turn wild at the end of cycles.
In this instance, it became more a case of things going completely berserk.
$5.0 TN of Fed monetary inflation in two years.
I had posited the Fed’s balance could reach $10 TN, as it accommodated a major de-risking/deleveraging episode.
Instead, assets inflated to $9.0 TN, as the Fed stoked the climax of history’s greatest period of Bubble excess.
The Big Test is coming, and there are many reasons why this Test is fraught with extraordinary risks.
First of all, this will be the first Test where consumer price inflation is a serious concern.
At this stage of a protracted Bubble cycle, only the Fed’s balance sheet has the capacity to operate as “buyer of last resort” in the event of serious de-risking/deleveraging.
But with today’s powerful inflationary biases in consumer and producer prices, wages, and energy, food and global commodities markets, another bout of monetary inflation risks general inflation spiraling completely out of control.
The Big Test will come with a high-risk geopolitical backdrop, unlike anything experienced during previous Tests.
Importantly, the confluence of global conflict, financial and economic insecurities, manias and market Bubbles, and surging inflation and commodities prices is no coincidence.
They are all manifestations of decades of escalating Credit Inflation and resulting Monetary Disorder.
March 23 – Financial Times (Brooke Masters):
“Russia’s invasion of Ukraine will reshape the world economy and further drive up inflation by prompting companies to pull back from their global supply chains, BlackRock chief executive Larry Fink has warned.
‘The Russian invasion of Ukraine has put an end to the globalisation we have experienced over the last three decades,’ Fink wrote…
While the immediate result had been Russia’s total isolation from capital markets, Fink predicted ‘companies and governments will also be looking more broadly at their dependencies on other nations.
This may lead companies to onshore or nearshore more of their operations, resulting in a faster pull back from some countries.’”
Previous Tests all transpired during globalization’s upcycle.
The post-2008 crisis reflation was bolstered by booming China and the emerging market “global locomotives.”
Moreover, the huge surge in low-cost Chinese and EM manufacturing was instrumental in restraining consumer price inflation in the face of massive U.S. monetary stimulus.
Seemingly no amount of U.S. monetary and fiscal stimulus could spur problematic inflation, not with Trillions of cheap imports flowing freely.
And while not as discernible as “globalization”, the evolution of technology and digitized products and services surely played a pivotal role in sopping up enormous monetary stimulus.
While there will be no end to new technologies and advancements, I’ll suggest that the growth in the share of household spending allocated to “technology” may now plateau.
PCs, the Internet, wireless, tablets and smart phones became must haves for most households.
For many, paying inflated prices for basics and necessities (including debt service) will take precedence.
March 21 – Wall Street Journal (Nick Timiraos):
“Federal Reserve Chairman Jerome Powell said the central bank was prepared to raise interest rates in half-percentage-point steps and high enough to deliberately slow the economy if it concluded such steps were warranted to bring down inflation.
‘If we think it’s appropriate to raise [by a half point] at a meeting or meetings, we will do so,’ Mr. Powell said…
Mr. Powell’s remarks struck a tougher tone than he used just days earlier in a press conference after the Fed voted to raise its benchmark rate by a quarter point, and he signaled a stronger bias toward lifting rates until the central bank sees clear evidence that inflation is falling to its 2% target.”
Might Powell’s “tougher tone” this week have something to do with the big stock market rally?
The Fed was (once again) overly sensitive to speculative market “tantrum” dynamics in its snail’s pace lead-up to last week’s baby-step increase.
The S&P500 has rallied about 6.8% since the start of last Wednesday’s Powell press conference.
And after trading at 3.38% with the release of the FOMC statement, the five-year Treasury “breakeven” rate of market inflation expectations is up a quick 35 bps to a record 3.73%.
In a market reaction that must concern central bank officials, 10-year Treasury yields are quickly up 30 bps to an almost three-year high 2.48%.
The market ended the week pricing in 8.2 25 bps rate increases by the FOMC’s December 14th meeting.
Perhaps we’re discerning a little nascent Big Test feedback.
General financial conditions are not so easily manipulated after securities markets have turned wildly speculative.
And bonds must pray for the stock market to chill out.
At least for now, it sure appears that inflation expectations and market yields will continue their upward trajectories so long as stocks rally.
It’s worth noting that the spread between three-month T-bills and two-year Treasury yields rose another 11 bps this week to a 20-year high 173 bps.
Meanwhile, the 2-yr/10-yr Treasury spread narrowed four bps this week to 20 bps, about the narrowest level since the pandemic market crisis.
Basically, long-term Treasury yields (10-yr at 2.48%) signal that inflation is not a major longer-term issue, and/or the Fed’s tightening cycle likely winds down within the next year or so.
Today, both stocks and longer-term bonds are understandably skeptical of a sustained aggressive tightening cycle.
And it is this dynamic that for now supports the sufficiently loose financial conditions conducive to sustained inflationary pressures.
The Bloomberg Commodities Index jumped 5.3% this week, boosting y-t-d gains to 30.9%.
Crude surged $9.20, or 8.8%, to $113.90, with year-to-date gains rising to 51%.
Gasoline and Natural Gas futures rose 7.1% (up 56% y-t-d) and 14.6% (up 49%).
Wheat’s 3.6% advance pushed y-t-d gains to 43%.
Corn rose 1.7%, Cotton 7.1%, Soybeans 2.5%, Sugar 3.6%, and Rubber 3.0%.
Gold gained 1.9%, and Silver rose 2.3%.
Not only are Fed officials now talking 50 bps rate increases, but the FOMC is expected to unveil a framework for shrinking its balance sheet (“quantitative tightening” or QT) at the May 4th meeting.
Understandably, there are mounting market liquidity concerns.
Reuters: “Analysis: U.S. Treasury Market Pain Amplifies Worry About Liquidity.”
Bloomberg: “Commodity Traders Sound Alarm on Plunging Market Liquidity.”
And while liquidity appears ample, so long as equities are advancing, the wildness lies in wait.
That all markets – fixed-income, equities, commodities and currencies – could simultaneously suffer liquidity issues is what makes The Big Test so daunting.
Market Structure risk – particularly with regard to speculative leverage, the ETF complex, derivative market fragilities and trend-following flows – compounded following each previous Test.
Ominously, The Big Test will also unfold as China’s historic Bubble deflates.
Despite a series of announcements from Beijing, there has been little abatement of Crisis Dynamics.
Bad news continues to pile up for the developers.
With yields for the most part reversing higher this week, the developer bond rally has been both short and unimpressive.
Moreover, the week was notable for jumps in CDS prices for the four major Chinese banks.
And China sovereign CDS gained eight bps this week to 63 bps, below the 71 bps high from Tuesday the 15th, but up significantly from the 40 bps to start the year.
The Shanghai Composite declined 1.2% this week, boosting its y-t-d drop to 11.7%.
The growth-oriented ChiNext Index sank 2.8% (down 20.6% y-t-d).
March 25 – Bloomberg (David Qu):
“China’s widening coronavirus outbreak is putting increasing strain on the economy, according to high-frequency data.
As of March 23, 21 provinces contained high- or medium-risk regions -- accounting for 77.5% of GDP -- up from 17 provinces (71% of GDP) a week earlier.
Between March 17-23, China reported an average of 2,147 domestic Covid-19 cases per day, almost triple the count in the first half of the month.
On the demand side, car sales remained below the pre-pandemic level for a third week in a row in the week to March 18.
Home sales in 50 major cities widened their year-on-year decline in the second week of March.”
Between real estate stress, Covid lockdowns, waning economic vigor, and China’s partner’s ruthless invasion of Ukraine, Chinese households have good reason to question whether Beijing’s competence and capabilities have been blown out of proportion for too long.
The Russia/Ukraine War is in ways reminiscent of the early pandemic days: clearly history-changing with far-reaching but unknowable ramifications.
Beijing will feign the middle road for as long as possible, but I’m skeptical China gets through this unscathed.
The world is now hastily repositioning for the new “Iron Curtain” global backdrop.
At the minimum, nations will be forced to respond to potentially highly problematic disruptions to energy and food supplies.
The likelihood of panic buying and broad-based supply issues throughout the commodities complex is not low.
And it’s difficult to see how already troubled global supply chain issues don’t get even worse – even if geopolitical conflicts don’t escalate.
March 20 – Financial Times (Chris Flood):
“International investors are bracing themselves for a wave of defaults on Russian debt repayments, as the Kremlin tightens its grip over the country’s financial system following its invasion of Ukraine.
Russia’s total debt owed to foreigners stood at $490bn at the end of September, according to the Central Bank of Russia.
But just how much of that exposure — spread across bonds, loans, direct investments and trade credits — will be wiped out is the thorny question confronting international investors.
Foreigners own $20bn of the $39.6bn in Russia’s outstanding ‘hard currency’ sovereign debt, issued via dollar and euro-denominated bonds.
These have plunged in value as the war in Ukraine has escalated.”
While commodities markets have quickly begun to adapt to new realities, financial markets are slow to appreciate momentous longer-term ramifications.
“Russia’s total debt owed to foreigners stood at $490bn…”
So far, Russia appears to prefer keeping its options open (making some debt payments).
But expect a furious Russian leadership to resolutely exact revenge – in any way it can.
It’s difficult to envisage a higher risk backdrop for The Big Test.
Not surprisingly, the highly speculative stock market is struggling to effectively adjust to the rapidly deteriorating backdrop (i.e. tightening cycle, fragile Bubbles, geopolitical risk, China, etc.), only raising the risk of disorderly adjustment/dislocation.
Over the past decade, Bubble Dynamics enveloped the world – in a blow-off dynamic to conclude a multi-decade experiment in unfettered global Credit and central bank inflationism, along with market and economic structure.
As such, it’s a distinct possibility that The Big Test will be more globally systemic – the U.S., China, Europe and EM all succumbing simultaneously to Crisis Dynamics.
I see The Big Test denoting the “official” conclusion to a multi-decade boom period.
From my analytical perspective, it has always been a case of a historic “global government finance Bubble” eventually culminating in a crisis of confidence in government finance and policymaking.
Most regrettably, there will be an unavoidable day of reckoning for such reckless inflation of perceived financial wealth.
The Federal Reserve has certainly done about everything possible to corrode confidence in a public institution of such vital importance.
Waning confidence in Beijing is at this point almost palpable.
In Europe, the ECB’s stubborn dovish stance on inflation is almost laughable – and certainly pathetic.
Moreover, the world today faces perhaps the greatest geopolitical crisis since WWII.
Trying to be objective, it sure appears things are coming to a head.
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