The Big Pivot
Doug Nolan
Germany’s Deutsche Bank CDS spiked 30 higher intraday Friday, to 210 bps – surpassing panicky market levels from last October and even March 2020.
Deutsche Bank CDS had dropped 21 bps Monday, relieved Swiss officials had orchestrated a Sunday evening takeover (bailout) of troubled Credit Suisse by UBS.
With Credit Suisse’s troubles supposedly an anomaly, markets were hopeful a European banking crisis had been quickly nipped in the bud.
Not so fast.
Deutsche Bank CDS surged 50 bps Thursday and Friday to multi-year highs, as the stock was slammed almost 9%.
And a 6% late-week selloff more than reversed the post-Credit Suisse bailout European bank stock rally (STOXX 600).
March 19 – Bloomberg (Neil Callanan, Tasos Vossos and Priscila Azevedo Rocha):
“Among the biggest losers in the shotgun sale of Credit Suisse Group AG are investors in the firm’s riskiest bonds, known as AT1s, worth $17 billion.
These money managers are set to be wiped out — potentially sending that $275 billion market for bank funding into a tailspin…
Creditors are frantically poring through the fine print for these so-called additional tier 1 securities to understand if authorities in other countries could repeat what the Swiss government did on Sunday: Wiping them out while preserving $3.3 billion of value for equity investors.
That’s not supposed to be the pecking order, some holders in the bonds insist.”
Deutsche Bank’s “AT1” bonds yielded 8.7% to begin the month.
Yields spiked to 10.81% in frantic Monday trading, before settling down to 10.17% by Wednesday’s close.
Yields spiked 154 bps Friday to a record 12.02%.
March 24 – Wall Street Journal (Juliet Chung and Sam Goldfarb):
“Hedge funds that bet on big-picture market moves have been hit with steep losses as a spate of recent bank failures upends bets that interest rates would remain elevated.
The souring of the wager led some, including Maniyar Capital Advisors and Haidar Capital Management, to lose more than 20% this month.
Many of the funds, which had notched big gains as rates marched steadily upward in 2022, are now flat to down for the year following a steep recent drop in Treasury yields.
So-called trend-followers, which try to take advantage of momentum in markets, also were hurt.”
The surging cost of raising new bank capital will leave a mark.
We can assume more risk aversion throughout the global bank community, along with much greater regulatory zeal.
And despite the Credit Suisse bailout and Fed/Treasury’s extraordinary measures to stabilize the U.S. banking system, global de-risking/deleveraging gained important momentum this week.
Friday from Bloomberg: “Deutsche Bank Drops in Selloff Citi Describes as Irrational.”
Not the best choice of adjectives.
Granted, Deutsche Bank has de-risked since the GFC.
At about $1.3 TN, Total Assets are down from peak levels and about flat since 2014.
Deutsche’s investment portfolio shrank over the past two years (to $115bn), though Total Loans expanded about $50 billion during the pandemic to $506 billion.
At $72 billion, Total Equity has increased $10 billion in two years.
Its derivatives portfolio is smaller than during the GFC days.
Deutsche Bank CDS traded at a one-year low 85 bps earlier this month.
Deutsche’s problem is that it’s a highly levered and fragile institution in a market that now fears systemic fragilities.
It has $620 billion of deposits and another $105 billion of “Short-Term Borrowings and Repos.”
The bank is a significant player in global derivatives markets.
And if one is increasingly uneasy with how this market, financial and economic crisis might unfold, it’s perfectly rational to reduce exposures to Deutsche Bank.
Contagion.
The bottom line: Despite the Credit Suisse bailout, Deutsche CDS prices more than doubled in two weeks.
And from the FT (Bryce Elder):
“As for derivatives, gigantic numbers mean very little: A few investors have got excited about Deutsche’s €42.5trn notional OTC derivatives book, missing the obvious point that all but €13.1trn is centrally cleared (with no counterparty credit risk).”
Gigantic derivative numbers do mean very little – in normal times.
But when systemic worries erupt, the scope and opacity of derivative daisy-chain exposures create uncertainty and instill caution.
It's worth noting this week’s pop in CDS for the big Japanese global banks (trailing only Deutsche Bank on the weekly leaderboard).
Nomura CDS surged 25 (to 119bps), Sumitomo Mitsui Bank 17 (89bps) and Mizuho Bank 15 (93bps).
Also near the top of the leaderboard were the big U.S. financial behemoths.
Bank America CDS rose another five to 125 bps; Citigroup three to 124 bps; Wells Fargo three to 110 bps; Goldman Sachs three to 123 bps; JPMorgan three to 102 bps; and Morgan Stanley one to 122 bps.
But the week’s closing prices don’t do justice.
After closing last week at 114, Goldman Sachs CDS traded up to 123 in (post Credit Suisse bailout) Monday trading. Goldman CDS was down to 102 in late-Wednesday trading, only to surge to 123 early in Friday’s session.
JPMorgan jumped to 99 Monday, to then drop as low as 84 intraday Thursday, only to spike to 102 bps early Friday – the first time above 100 bps since unstable October.
Last Thursday, March 16th (Reuters):
“The U.S. banking system remains sound and Americans can feel confident that their deposits are safe," Treasury Secretary Janet Yellen said…, but she denied that emergency actions after two large bank failures mean that a blanket government guarantee now existed for all deposits.”
Monday (Bloomberg):
“US officials are studying ways they might temporarily expand Federal Deposit Insurance Corp. coverage to all deposits…”
Tuesday (Reuters):
“U.S. Treasury Secretary Janet Yellen told bankers on Tuesday that she is prepared to intervene to protect depositors in smaller U.S. banks suffering deposit runs…
‘The steps we took were not focused on aiding specific banks or classes of banks…
And similar actions could be warranted if smaller institutions suffer deposit runs’…”
Wednesday (Financial Times):
“US Treasury Secretary Janet Yellen ruled out a broad expansion of deposit insurance to protect savers with balances above $250,000 in the near term…
‘I have not considered or discussed anything to do with blanket insurance or guarantees of deposits.’”
Thursday (Reuters):
“Wall Street closed higher on Thursday as market participants were reassured by U.S. Treasury Secretary Janet Yellen's reassurances that measures will be taken to keep Americans’ deposits safe.”
It was fascinating to watch Secretary Yellen’s ‘not considered or discussed anything…’ blanket deposit guarantee comments hit bank and market prices in the middle of Powell’s post-FOMC press conference.”
March 22 – Associated Press (Christopher Rugaber):
“The Federal Reserve extended its year-long fight against high inflation… by raising its key interest rate by a quarter-point despite concerns that higher borrowing rates could worsen the turmoil that has gripped the banking system.
At a news conference, Fed Chair Jerome Powell sought to reassure Americans that it is safe to leave money in their banks…
‘We have the tools to protect depositors when there’s a threat of serious harm to the economy or to the financial system,’ Powell said.
‘Depositors should assume that their deposits are safe.’”
Federal Reserve Credit surged $211 billion the past week, with a two-week jump of $353 billion.
Total Fed Assets inflated $392 billion in two weeks (to $8.734 TN), the largest increase since Covid crisis April 2020.
March 22 – Reuters (Michael S. Derby):
“Federal Reserve Chair Jerome Powell said… the sharp reversal of the central bank's effort to shrink the size of its balance sheet in the wake of the collapse of Silicon Valley Bank does not mean it is using its holdings to provide renewed stimulus to the economy.
‘The balance sheet expansion is really temporary lending to banks’ and ‘it’s not intended to directly alter the stance of monetary policy,’ Powell said…”
“Really temporary” lending to banks hearkens back to “transitory” inflation.
March 20 – Bloomberg (Austin Weinstein and Max Reyes):
“The Federal Home Loan Bank System issued $304 billion in debt last week…
That’s almost double the $165 billion that liquidity-hungry lenders tapped from the Federal Reserve.
The FHLBs are a Depression-era backstop originally created to boost mortgage lending.
The system is known as the ‘lender of next-to-last resort’ — a play on the nickname for the Federal Reserve’s discount window.
Last week’s boost in debt reflects an intense demand for cash across the US banking sector after three lenders collapsed in rapid succession amid a liquidity crunch that spurred customers to yank deposits en masse.”
$304 billion in one week!
This after expanding $524 billion (72%) last year.
Where’s their regulator?
March 20 – Bloomberg (Austin Weinstein and Max Reyes):
“The FHLB System ‘is not intended or structured to function as a lender of last resort,’ said Joshua Stallings, deputy director for bank regulation at the Federal Housing Finance Agency, the FHLB System’s regulator, in a March 13 statement.
The agency is conducting a wide-ranging review of the home loan banks.
The banks were first created to free up cash for small banks to make mortgages, but have since evolved to be a short-term lender also used by Wall Street giants, including Citigroup Inc. and Wells Fargo & Co.”
March 22 – Yahoo Finance (David Hollerith):
“Federal Reserve Chair Jerome Powell made his first comments about the current banking crisis, saying that the management of Silicon Valley Bank ‘failed badly’ but that the institution’s weaknesses don't threaten the U.S. banking system.
‘This was a bank that was an outlier,’ he said… following a Fed decision to hike interest rates 0.25%, citing the institution's high percentage of uninsured deposits and its large investment in bonds with longer durations.
‘These are not weaknesses that are there at all broadly through the banking system.’”
I’ll spare readers an irate rant.
First, let me restate my long-held belief that central banks are a critical institution.
But the failings of the Fed – and contemporary central banking doctrine more generally – are reprehensible.
Our central bank embarked on a historic experiment in activist market intervention, zero rates and QE.
Their balance sheet expanded 10-fold in 14 years.
And we were repeatedly assured that - during aggressive monetary stimulus - so-called “macro prudential” measures would be the centerpiece of policies to ensure financial stability was not compromised by (loose “money”-induced) aggressive lending, leveraging and speculation.
This abject failure has begun to be exposed.
The numbers (from the Fed’s Z.1).
Total Bank Deposits surged $5.165 TN, or 33.2%, during the three years 2020 through the end of 2022.
For perspective, this was roughly equal to deposit growth for the nine-year period 2010 through 2018.
The Fed’s $5 TN QE program flooded the banking system with deposits.
Importantly – and most germane to today’s backdrop - radical monetary stimulus inundated the banking system with liquidity at the late stage of protracted Credit and speculative booms.
This fatefully extended “Terminal Phase” Bubble excess (with predictable consequences).
Banks used these deposits to lend even more aggressively, including to the plethora of negative cash-flow enterprises that proliferated during a historic period of manic behavior and Bubble excesses.
They lent freely to real estate markets grossly inflated by zero rates, ultra-loose lending conditions, and a massive flow of speculative finance (to buy homes, multi-family housing, office buildings, commercial properties generally).
Moreover, banks took deposit money and aggressively purchased securities – in markets grossly inflated by zero rates and QE.
For the banking system, the Fed’s colossal pandemic monetary stimulus – zero rates and QE – was essentially a noose wrapped in glamorously silky dove feathers.
In three years, banking system Treasury holdings surged $702 billion, or 80%, to $1.581 TN, having doubled from June 2019 (just prior to the resumption of QE).
Agency/MBS holdings jumped $580 billion, or 22%, to $3.215 TN, while Corporate Bond holdings rose $318 billion, or 49%, to $973 billion.
SVB, no doubt about it, was up to its eyeballs in idiosyncratic risk.
Yet the unfolding banking crisis is systemic.
Years of loose “money” was systemic.
Gorging on risky loans and mispriced securities – systemic.
There was a protracted period of extraordinary system-wide excess.
Crazy everywhere.
Lending will now tighten, Credit growth will slow, and the downside of the Credit Cycle will surely unleash economic stagnation and major loan quality issues.
Understandably, focus is now on the small and medium sized banks with their big exposures to vulnerable real estate loans.
Compounding U.S. risks is the harsh reality that finance and economies are fragile globally.
Is the post “zero Covid” honeymoon quickly winding down in China?
March 23 – Bloomberg:
“Sunac China Holdings Ltd. warned investors that it expects a second consecutive year of multi billion-yuan losses, underscoring the plight of the nation’s builders amid a record home-market slowdown.
The Beijing-based real estate developer predicted a preliminary net loss of as much as 28 billion yuan ($4.1bn) in 2022...
That followed a record loss of 38 billion yuan in the year prior…”
March 22 – Bloomberg (Lorretta Chen):
“State-backed developer Sino-Ocean’s dollar notes tumbled as it deferred interest due Tuesday on a perpetual bond, the latest example of the property sector’s cash crunch.
The decision doesn’t constitute a default, according to a company spokeswoman, and was prompted by efforts to ‘preserve cash’ and ‘the fact that the financing condition of the real estate industry hasn’t significantly improved.’
The firm’s dollar bonds lost more than 10% Tuesday.”
The current bullish narrative sees China as the relative safe haven, as the U.S. and Europe struggle to contain banking crises.
Apparently, Beijing has everything under control - and will surely do whatever it takes to keep it that way.
And with such confidence comes vulnerability.
Global conditions are tightening, with negative ramifications for unsound banks, companies and markets everywhere.
And is there any country where unsound pervades the entire system as it does in China?
Country Garden’s (#1 developer) bond yields surged 370 bps this week to 30.17%, the high since December 1st.
Kaisa yields spiked almost 10 percentage points to 140% - the high since November.
Longfor yields were also up almost 10 percentage points to 105% (high since Dec.).
Evergrande yields rose another 543 bps this week to 182%.
An index of Chinese high-yield dollar bonds saw yields surge 125 bps this week to 18.19% - the first time above 18% since January 3rd.
An index of Asian high-yield bonds rose 61 bps to 14.36% (high since January 3rd).
March 24 – Bloomberg (Sofia Horta e Costa):
“In the past 18 months, no group has issued more of the controversial additional Tier 1 bonds than Chinese banks.
State-owned lenders sold about $42 billion worth of AT1 notes, the riskiest type of bank debt, to onshore investors, Bloomberg Intelligence analysts Pri de Silva and Adrian Sim said in a recent note.”
Big four Chinese bank CDS surged to multi-month highs Monday.
China Construction Bank CDS traded 12 higher Monday to 110 bps (closed week at 106), the high since November 11th.
Industrial & Commercial Bank rose 12 Monday to 109 bps (closed week at 101) – also the high since mid-November.
Bank of China CDS jumped 12 this week to 106 bps, the high since November 23rd.
China Development Bank CDS rose 10 this week to 99 bps (high since Nov. 14).
March 22 – Caixin Global:
“China Huarong Asset Management Co. Ltd. expects to post a net loss of 27.6 billion yuan ($4bn) for 2022…, citing factors including volatility in the capital markets leading to declines in the value of some assets, business transition and the real estate industry slump…
Created following the Asian financial crisis in the late 1990s to safeguard China’s state-owned banks, Huarong expanded beyond its original mandate and grew into a financial conglomerate engaged in a wide range of financial services, including securities, trusts, banking and financial leasing.”
Huarong’s yields surged 220 bps this week to 11.83%, the high since November 10th.
Notably, China sovereign CDS traded as high as 88 bps in Friday trading, the highest level since mid-November.
China CDS was at 64 during the first week of the month and below 50 in February.
When analyzing the world of finance, there’s much we don’t know.
We do, however, have ample facts and data to underpin sound analysis.
Now more than ever, the analysis seems to come down to analytical frameworks.
Many view the system as resilient.
Extreme measures we’ve witnessed over the past two weeks solidify confidence that policymakers learned from 2008 and will do whatever is necessary to thwart crisis dynamics.
I have strong biases, having so closely monitored developments for more than three decades.
Facts and data support the “history’s greatest Bubble” thesis.
Credit and speculative excesses have been unprecedented.
This doesn’t matter to most.
In my analytical framework, it comes with momentous ramifications.
The amount of resource misallocation and malinvestment during this protracted boom cycle is without precedent.
This doesn’t matter to most.
From my analytical perspective, sound Credit and investment are the bedrock for sustainable growth and stability (financial, economic and social).
Things that I know are critical don’t matter to most.
They don’t matter, because the Fed can always print Trillions and Washington can run Trillions of deficits – and we can simply reflate out of any predicament.
The Fed’s balance sheet is ballooning again, in two weeks, reversing much of nine months of quantitative tightening.
The markets’ fixation on Yellen’s deposit guarantee comments suggests a deep concern for bank run contagion.
And while moral hazard is an issue, I am today more concerned about the fiscal consequences of blanket deposit guarantees.
I’ve argued that the “global government finance Bubble” is the end of the line.
There’s no new source of Credit growth that will let central banks and governments off the hook.
And it doesn’t take a wild imagination right now to envisage simultaneous uncontrolled expansions of Fed liabilities and Treasury debt.
While markets are these days fixated on an imminent Fed dovish pivot, out further on the horizon looms a crisis of confidence in government finance.
With Credit set to tighten, I understand expectations for disinflation.
But I can’t shake the feeling that there’s more structural inflation in the system than meets the conventional eye.
Especially if runaway monetization sparks a dollar problem, pricing pressures could surprise to the upside.
I also believe we could be witnessing a major shift in the workings of the Fed’s balance sheet.
The Federal Reserve’s focus on banking system liquidity is likely in its infancy.
Treasuries purchases as the predominant mechanism for system stabilization and stimulus are so previous cycle.
Maybe that’s The Big Pivot with the greatest ramifications to contemplate.
March 21 – Wall Street Journal (Editorial Board):
“Financial regulators have ignored their post-2008 rule book to contain the latest banking panic.
And on Tuesday Treasury Secretary Janet Yellen tore it up by announcing a de facto guarantee of all $17.6 trillion in U.S. bank deposits.
Regional bank stocks rallied, but it’s important to understand what this moment means: the end of market discipline in U.S. banking.
‘Our intervention was necessary to protect the broader U.S. banking system,’ Ms. Yellen told the American Bankers Association convention.
‘And similar actions could be warranted if smaller institutions suffer deposit runs that pose the risk of contagion.’
Translation: Depositors needn’t worry about the safety and soundness of banks.
Uncle Sam will make sure you don’t lose money.
This isn’t an explicit guarantee, but it’s close enough for government work.”
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