Breaking and the Q1 2022 Z.1
Doug Nolan
No mincing words; no need for sophisticated prose.
The week was ugly.
Things look bad.
There are elements similar to the year 2000 bursting of the “Dot-com” Bubble.
There are parallels to the much more systemic 2008 mortgage finance Bubble collapse.
Yet, for me, this week rekindled more distant memories.
Surging global bond yields and acute currency market instability.
Inflation fears.
Rampant Credit growth and Acute Economic Imbalances.
Policy paralysis and geopolitical tensions.
Especially late in the week, I found myself reminiscing of days intensely following developments on a Telerate machine, Quotron and the Dow Jones Newswire - on the fixed-income trading desk at Toyota’s U.S. headquarters in Torrance, CA.
It was the summer of 1987.
I place the start of today’s swiftly concluding cycle at Greenspan’s post “Black Monday” crash liquidity assurances.
I found myself on Friday pondering how many Trillions of additional liquidity the world’s central bankers would be compelled to create these days in the event of a synchronized global crash – in yet another round of desperate measures to thwart financial collapse.
Consequences?
Could it even work?
Things weren’t supposed to unfold this way.
The Fed was clearly going to be cautious, all moves made gingerly and well telegraphed to conspicuously vulnerable markets.
Given time, inflation would surely subside.
The worst-case scenario would be the Federal Reserve and global central banks raising rates until something began to “Break.”
There was time.
Rates would remain extraordinarily low for months and quarters.
Nothing too pressing.
Well, complacent markets – and central bankers – grossly misjudged two key aspects of underlying fundamentals.
Inflation Dynamics were much more powerful and well-entrenched than appreciated.
Similarly, Market Structure fragilities were greatly more acute than recognized.
The upshot: things are “Breaking” before central bank tightening cycles even get cracking.
Things are Breaking badly in periphery Europe – with the ECB yet to even nudge the policy rate off negative 50 bps.
Greek yields surged another 67 bps this week to 4.38% - with a stunning 10-session spike of 172 bps.
Italian yields jumped 36 bps to 3.76% (up 167bps in 10 sessions).
Yields were up 34 bps in Spain to 2.78% (131bps) and 32 bps to 2.80% (142bps) in Portugal.
Even German bund yields rose 24 bps to 1.52% (96 bps), as French yields rose 29 bps to 2.10% (107bps).
Eurozone annual CPI reached a record 8.1% in May.
Christine Lagarde and the ECB doves had to capitulate.
Months of justification, rationalization, obfuscation and blind faith were no longer tenable.
Lagarde now faces a challenge Draghi avoided: raising rates.
It’s a Herculean Challenge, especially after 11 years without even a wobbly little baby step.
Worse yet, rates have been negative for eight years, a period where the ECB balance sheet inflated $5 TN.
A new and notably hostile cycle is taking hold.
The ECB was a leading proponent and participant in the great global central banking experiment.
This exercise has failed – these days blowing up in faces in Washington, Tokyo, Frankfurt, and beyond.
Inflation has become unhinged, while highly levered speculative market Bubbles are bursting.
At this point, is it even feasible to contemplate giving the experiment yet another shot?
Einstein’s definition of insanity.
For the first time in years, I’m seeing reference to Greece’s 200% of GDP debt load, as well as Italy’s 150%.
Did these countries use the years of unlimited access to ultra-cheap finance to restructure their economies and get their fiscal houses in order?
If not, they’re in some deep trouble.
The cycle has turned, and the liquidity spigot is being turned off (first at the periphery).
The days of egregiously loose finance – compliments of the ECB, global central bankers, and the risk-embracing leveraged speculating community – have run their fateful course.
It’s always the riskier borrowers at the “periphery,” overwhelmed with cheap finance late in the boom cycle, that are left high and dry – illiquid and insolvent - when speculative finance reverses and Bubbles begin to succumb.
We’ve witnessed this recurring cycle: boom, bust and central bank resuscitation.
Repeat.
My thesis holds that this is the End of the Line.
Resuscitating periphery Bubbles would now require monumental liquidity injections.
This liquidity, however, would these days gravitate away from deflating bonds and financial assets – instead disposed to energy, agriculture and other commodity markets - in the process only stoking New Cycle Inflationary Dynamics.
The fates of Greece and Italy, in particular, are now at the whim of a disorderly marketplace.
Borrowing costs are rapidly escalating, while already problematic debt ratios will spike higher.
A historic Bubble has burst.
De-risking, deleveraging and illiquidity have rapidly become systemic issues.
Contagion. European bank stocks were hammered 6.0% this week, with Italian banks sinking 9.2%.
Ominously, U.S. banks (BKX) were slammed 7.8% this week.
Bank CDS prices reversed sharply higher.
JPMorgan CDS jumped eight for the week to 90 bps, the largest weekly gain since March.
BofA CDS rose eight (95bps), Citigroup eight (111bps), Morgan Stanley eight (108 bps) and Goldman Sachs four (111bps).
Friday’s six bps rise in JPMorgan CDS was the largest increase since March, while Morgan Stanley’s eight bps jump was the biggest since May 2020.
Everything points to mounting systemic crisis risk.
The sinking euro and yen helped fuel dollar strength, spurring destabilizing “risk off” de-risking/deleveraging across EM currencies and securities markets.
At the EM periphery, troubled Turkey saw its sovereign CDS spike 115 to a 19-year high 848 bps. EM CDS surged 38 this week to a three-month high 309 bps, the largest weekly increase since March.
CDS prices were up 24 bps in Brazil (260), 23 bps in Mexico (153), and 43 bps in Colombia (256).
Yields surged 57 bps in Poland, 52 bps in Cyprus, 50 bps in the Czech Republic, 42 bps in Colombia, and 32 bps in South Africa.
Brazilian, Chilean, Turkish and Colombian currencies were down about 4%.
The Hungarian forint fell 3.5% and the Polish zloty 2.3%.
Inflation dynamics are complex.
There are myriad facets to analyze and contemplate.
Yet the key dynamic is rather straightforward: inflation is a monetary phenomenon.
To help us better conceptualize how consumer price inflation could possibly reach a 41-year high of 8.6% last month, look no further than this week’s Federal Reserve Q1 Z.1 “flow of funds” Credit report.
Non-Financial Debt (NFD) expanded at a 10.2% rate during the quarter.
Excluding 2020’s extraordinary first-half Covid stimulus period, there has been only one quarter (Q2 2003’s 10.7%) of double-digit NFD growth since 1986.
Total Household Borrowings expanded at an 8.32% rate, the strongest growth since peak housing boom Q2 2007.
Household Mortgage borrowings expanded at an 8.62% rate, the high since Q3 ’06.
Non-mortgage Consumer Credit grew at an 8.73% pace - strongest in over two decades (Q4 2001).
In seasonally-adjusted and annualized (SAAR) dollars, NFD expanded $6.640 TN, second only to Q2 2020. For perspective, peak growth during the mortgage finance Bubble period was Q2 2007’s SAAR $2.770 TN.
In nominal dollars, NFD expanded $1.659 TN during Q1 to a record $66.744 TN, second only to Q2 2020’s off-the-charts $3.745 TN.
For perspective, the previous cycle peak was Q3 2008’s $754 billion.
NFD expanded $2.499 for all of 2007 (to $33.359 TN).
Total System Credit (Non-Financial, Financial Sector and Foreign U.S. borrowings) expanded nominal $2.132 TN during the first three months of the year.
Annual System Credit growth averaged $2.019 TN during the decade 2010 through 2019.
Treasury Securities increased a nominal $732 billion during the quarter (11.6% annualized) to a record $26.017 TN.
This boosted one-year growth to $2.074 TN, or 8.7%.
Over the past nine quarters, Treasuries expanded $6.998 TN, or 36.8%.
And since 2007, Treasury Securities have ballooned $19.965 TN, or 330%.
Treasuries ended Q1 at 107% of GDP, up from 41% to end 2007 and 87% to conclude 2019.
The lack of capital has certainly not constrained the GSE’s (debt backed by the U.S. Treasury).
Agency Securities expanded another $228 billion during the quarter to a record $10.927 TN, with one- and two-year growth of $700 billion and $1.158 TN.
Combined Treasury and Agency Securities expanded $960 billion during Q1 (to $36.943 TN), with one-year growth of $2.774 TN.
While we ponder the monetary forces fueling our dire inflation predicament, it’s worth examining some 11-quarter data (recall the Fed’s Q3 2019 QE restart).
Over 11 quarters, Fed Assets inflated $4.623 TN, or 115%.
The Fed’s Treasury and Agency holdings rose $3.536 TN and $1.034 TN.
Over this period, total outstanding Treasury Securities rose $8.202 TN (46%), and Agency Securities gained $1.663 TN (18%).
There’s a reality that can’t be denied: The Fed’s aggressive accommodation of Washington’s historic $9.965 TN 33-month borrowing binge is directly responsible for epic monetary disorder - including historic speculative manias and 40-year-high consumer price inflation.
Total Debt Securities increased $1.071 TN during the quarter to a record $57.211 TN, with one-year growth of $3.486 TN.
Over 11 quarters, Debt Securities inflated $11.466 TN, or 25%.
At 235%, the Total Debt Securities-to-GDP ratio compares to 201% at the end of 2007, 158% to end the nineties, and 124% to conclude the eighties.
Broker/Dealer Assets surged nominal $192 billion (17.6% annualized) during Q1 to a record $4.573 TN, with one-year growth of $328 billion.
Miscellaneous Assets jumped $171 billion and “repo” Assets rose $69 billion, while Debt Securities contracted by $58 billion.
The asset Loans added $16 billion to a record $853 billion, with notable seven-quarter growth of $479 billion, or 128%.
The lack of any contraction in Broker/Dealer Loans in the face of unstable markets is not a bullish dynamic.
Bank lending and asset growth slowed, though Q1 is typically a seasonally weak period.
At $159 billion, Asset growth was the slowest since Q3 2020.
Assets expanded $1.561 TN, or 6.4%, over the past year to a record $25.788 TN.
Over 11 quarters, Bank Assets inflated an unprecedented $6.276 TN, or 32.2% - including a $2.176 TN increase in Reserves at the Fed.
Over this period, Total Deposits inflated a historic $6.288 TN, or 42%, to $21.269 TN.
Monetary Inflation Running Wild.
Bank Mortgage Loan growth slowed, but at $82 billion still accounted for half the quarter’s asset gain.
Total system Mortgage Credit expanded $343 billion during Q1, second only to Q4 2021 in the period since 2006.
Total Mortgage Credit expanded $1.383 TN over the past year, also the strongest since 2006.
Household Mortgages expanded $240 billion during the quarter (7.7% annualized), with one-year growth of $995 billion (8.4%) near 2006 peak levels.
Commercial (up 7.6% y-o-y) and Multi-housing (up 7.8% y-o-y) lending slowed somewhat but remained strong.
Rest of World (ROW) holdings of U.S. Financial Assets contracted $1.888 TN to $45.630 TN, the first decline since Q1 2020’s $2.703 TN.
Almost half of this drop is explained by the $867 billion fall in Equities holdings.
More importantly, ROW holdings of Debt Securities dropped a record nominal $467 billion during Q1.
This was led by a $252 billion decline in Corporate bond holdings, surpassing even the $223 billion drop during de-risking/deleveraging Q1 2020.
Furthermore, ROW reduced holdings of Treasuries (-$136) and Agencies (-$81) during Q1, in contrast to expanded holdings of both during 2020’s first quarter.
Household Assets contracted $260 billion during Q1 to $167.917 TN, though one-year growth was still 9.1% ($14.025 TN).
With Household Liabilities increasing $284 billion to $18.638 TN, Household Net Worth declined $544 billion to $149, 279 TN.
Nevertheless, Household Net Worth was up $12.706 TN (9.3%) over one year, and $37.830 TN (33.9%) over three years – in history’s greatest inflation of perceived wealth.
Household Net Worth-to-GDP declined to 612% (from 624%).
But this compares to 491% at cycle peak Q1 2007, and 445% during peak Q1 2000.
Years of asset inflation have fueled a consumer spending boom.
The downside of the cycle will see sinking asset prices and tightened Credit conditions significantly restrain household spending.
June 8 – Bloomberg (Abhinav Ramnarayan and Carmen Arroyo):
“Some of the riskiest loans given to millennials and Gen Z shoppers for clothes and electronics -- and neatly repackaged for investors -- are dropping in value.
Securitization packages of buy-now-pay-later loans from one provider, Affirm Holdings Inc., are falling in price for investors to buy while becoming more expensive to issue, after rising rates and a cost of living crisis cast a shadow over the sector…
Affirm has over 12.7 million customers and extended around $3.9 billion of loans in the first three months of 2022.
In the nine months ended March 31, Affirm reported a loss of $520.1 million, outpacing the loss of $312.6 million in the prior year period.
Revenue rose 62% to almost $1 billion over that time…
Affirm pushed back its latest securitization sale in March, before selling notes maturing in May 2027 at a coupon of 4.3% on the main tranche.
It paid 0.88% on the same tranche of a similar deal issued in February 2021…”
June 8 – Bloomberg (Hema Parmar and Miles Weiss):
“Hedge funds were tallying gains on their hottest bet in years when Dan Sundheim reached an unusual deal with JPMorgan… to go even further.
With the bank’s help in August 2020, Sundheim’s D1 Capital Partners used its stakes in private companies as collateral for borrowing $2 billion that the firm could put toward yet more of those stakes, among other things.
Last year that focus on private companies looked brilliant, as D1 updated its valuations and posted a whopping 70% gain in that part of its portfolio.
Now, the industry is bracing for a reckoning.
Across Wall Street, billionaire investors and their advisers are urgently trying to figure out how much exposure they have to plunging values in Silicon Valley unicorns and other private ventures.”
June 6 – Wall Street Journal (Eliot Brown and Juliet Chung):
“Tiger Global Management rode the tech boom like no other investment firm.
It was funding more startups than any other U.S. investor when the market peaked last year, and had tens of billions of dollars from pensions, endowments and rich clients riding on some of Silicon Valley’s hottest stocks.
With tech values plunging, the New York firm is humbled.
The market rout has vaporized years of gains in a matter of months…
Fueling Tiger’s rise was a double-barreled business: A stock-picking arm put money mostly into public companies, while its venture-capital funds invested in startups throughout the world.
Both bet bigger on tech as the market crested, leaving the firm exposed on both fronts.
Tiger said in a note to investors last week that its hedge fund, which managed $23 billion at the end of 2021, was down 52% this year.
That is one of the largest-ever losses by a hedge fund.
Its other large stock fund—a long-only fund that managed $11 billion at the end of 2021 and doesn’t short stocks—has lost 61.7%.”
U.S. high-yield CDS prices surged 59 this week to 532 bps - the largest weekly increase since June 2020 – to the high since June ‘20.
The U.S. has its own “periphery” debt issue.
The collapse of the “periphery” telecom junk debt (i.e. Worldcom) Bubble certainly was a major factor in the bursting of the nineties “dotcom” Bubble.
But it was too small to be systemic.
Periphery mortgage Credit became systemic with the proliferation of subprime mortgages and derivatives.
Today, there’s a massive “periphery” loaded with “subprime” junk bonds, leveraged loans, buy-now-pay-later, auto, credit card, housing, and solar securitizations, franchise loans, private Credit, crypto Credit, DeFi, and on and on.
A massive infrastructure has evolved over this long cycle to spur consumption for tens of millions, while financing thousands of uneconomic enterprises.
The “periphery” has become systemic like never before.
And things have started to Break.
It’s fascinating to listen to some of Wall Street’s preeminent Credit managers posit that economic fundamentals continue to support their Credit strategies. They point to ongoing economic expansion and strong corporate earnings. They seem oblivious to the Cycle Change.
This week looked serious.
It was another blow for leveraged finance.
More hedge fund blood was spilled, with more pressure to de-risk and deleverage.
A momentous cycle change in speculative leverage and financial flows has gained momentum.
More corroboration of the bursting “tech” Bubble thesis.
And markets now only appear liquid during the occasional bouts of short squeezes, the unwind of hedges, and resulting bear market rallies.
And when markets reverse lower, rather quickly systemic fragilities are revealed.
Friday trading had another dynamic worthy of mention.
On the release of higher-than-expected May CPI, the dollar quickly rallied, as bond yields jumped higher.
Gold initially responded as it typically would in such circumstances, trending lower.
But then, as bank and financial shares came under heavy selling pressure (with bank CDS moving sharply higher), gold enjoyed a burst of strong buying – ending the session up almost $24.
While the precious metals of late have been caught up in de-risking/deleveraging and speculator liquidations, Friday trading provided an inkling of how a crisis of confidence in financial assets – and finance more generally – could spur safe haven buying in stores of value tested over centuries.
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