Too Loose
Doug Nolan
“Growing Debt Ceiling Deal Hopes Send Stocks Higher.”
The S&P500 gained 1.6% this week, pushing the index to a nine-month high.
The Nasdaq100’s 3.5% surge boosted y-t-d gains to 26.2%.
The source of all the optimism wasn’t obvious.
May 19 – Bloomberg (Billy House and Steven T. Dennis):
“White House and Republican negotiators met Friday night to resume talks to avert a catastrophic US default and conversations are expected to continue through the weekend.
The 90-minute meeting in the Capitol came after a Republican walk-out punctured optimism that a debt-limit deal was near...
Neither negotiating team commented on progress as they left the meeting.
Republican Representative Patrick McHenry, a key ally of Speaker Kevin McCarthy, asked if he was confident the two sides would reach a deal in time to prevent a default, responded, ‘No.’
Another Republican in the meeting, Representative Garret Graves of Louisiana, said it was not a negotiation.
‘This was a candid discussion about realistic numbers, a realistic path forward, and something that truly changes the trajectory of this country’s spending and debt,’ Graves said.”
Markets assume an 11th hour debt ceiling deal is a sure thing.
I’ll assume option expiration again helped juice market gains.
An ongoing short squeeze generates market fuel.
Understandably, all the talk of a fledgling equities “melt-up” rattled the Treasury market.
Two-year Treasury yields surged 28 bps this week to a 10-week high 4.27%.
Ten-year yields jumped 21 bps to a two-month high 3.67%, and benchmark MBS yields rose 27 bps to a 10-week high 5.47%.
The rates market is still pricing a couple rate cuts between June and December.
Market expectations for the Fed funds rate at the December 13th FOMC meeting jumped 25 bps this week to 4.64%.
It was as high as 4.73% in early-Friday trading, before “Powell Steers Policy Debate With Clear Signal on June Rate Pause.”
Hawkish Fed officials had the market pricing an almost 40% probability for a 25 bps June rate increase, before dovish Powell comments pushed the odds down to 18% by Friday’s close.
It will be a divided committee for the June 14th meeting.
While the U.S. stock market’s ability to dismiss myriad risks has been noteworthy, buoyant markets are a global phenomenon.
Surging 4.8% this week, “Japan’s Nikkei Powers to 1990 ‘Bubble Era’ High.”
German stocks rose 2.3%, as “DAX Nears Record as Wall Street Rally Bubbles Over.”
Up 18.1%, Japan’s Nikkei Index has almost doubled the S&P500’s y-t-d gain.
Strong 2023 advances in Europe include Germany’s DAX up 16.9%, France’s CAC40 15.7%, Italy’s MIB 16.1%, and Spain’s IBEX 12.4%.
The bottom line: Global financial conditions remain loose.
This has been good news so far for risk assets; not so much for containing inflation.
“Euro Zone Inflation Ticks Up in April.”
“BOE’s Bailey Warns of Risk of Inflation Persistence in UK.”
“Canada’s Inflation Unexpectedly Rises in April, Upping Rate-Hike Pressure.”
May 18 – Bloomberg (Takahiko Wada and Leika Kihara):
“Japan’s core consumer inflation stayed well above the central bank’s 2% target in April and a key index stripping away the effects of fuel hit a fresh four-decade high…
The reading comes a few days after data showed the world's third-largest economy grew faster than expected in the first quarter…
The nationwide core consumer price index (CPI)… rose 3.4% in April from a year earlier…
An index stripping away the effects of both fresh food and fuel - closely watched by the BOJ as a key barometer of domestic demand-driven price trends - rose 4.1% in April from a year earlier, marking the fastest annual pace since September 1981.”
May 19 – Bloomberg (Toru Fujioka):
“Bank of Japan Governor Kazuo Ueda continued to strike a dovish tone hours after data showed underlying inflation accelerating to the fastest pace in more than four decades.
‘The cost of impeding the nascent developments toward achieving the 2% price stability target, which are finally in sight, by making hasty policy changes would likely be extremely high,’ Ueda said in a speech…
‘It is appropriate to take time to decide on adjustments to monetary easing toward a future exit’…”
Global central banker inflation fights will flail until conditions tighten.
And it doesn’t take a deep search to find an explanation of loose global conditions.
For one, there are the multi-Trillions that central bankers created during the pandemic still circulating about the markets.
With borrowing costs remaining near zero in Japan, the size of the (borrow cheap in yen to leverage in higher-yielding international securities) yen “carry trade” is surely in the Trillions.
Moreover, the Bank of Japan’s $5.5 TN balance sheet expanded about 5% during Q1.
The ECB has made little progress in shrinking its massive $7.5 TN balance sheet.
China’s massive banking system continues to inflate at a double-digit rate.
Repo lending rates are only about 2%, with 10-year Chinese government bond yields at 2.70%.
The amount of finance – savings and borrowings – leaving China for greener pastures must be enormous.
May 19 – Bloomberg:
“China’s yuan jumped on Friday after the country’s central bank moved to shore up the currency following a recent selloff, vowing to curb speculation and calling for more stability in the foreign exchange market.
The People’s Bank of China and the foreign exchange regulator will ‘strengthen market expectation guidance and take actions to correct pro-cyclical and one-way market behaviors when necessary.’
The offshore yuan… pulled away from 7.0750, its weakest level since December.”
And it is difficult to see economies where central bank policy rates are actually restrictive.
The European Central Bank’s 3.75% rate is still only about half of the current 7% euro zone CPI.
Arguably, the Federal Reserve’s 5% policy rate is not sufficiently restrictive to contain inflation.
After years of stoking speculation, central banks face the impossible challenge of cautiously deflating speculative Bubbles without tanking the whole system.
The run on U.S. bank deposits has quieted for now.
This week’s hearings before the Senate Banking Committee were rather boisterous.
The CEOs from SVB, First Republic and Signature Bank came up short in taking responsibility for their banks’ collapses.
And, believe it or not, these gentlemen were not excited about returning any of their significant compensation packages.
May 16 - Bloomberg (Allyson Versprille):
“The former Silicon Valley Bank executive who’s taken the brunt of criticism for the lender’s collapse is refusing to commit to giving up any of the $10 million he received annually from the failed lender.
Former SVB Chief Executive Officer Greg Becker told lawmakers on the Senate Banking Committee… that unprecedented events, interest-rate hikes and negative social media coverage rather than mismanagement were the root causes of the firm’s March demise…
Becker has drawn ire from both Democrats and Republicans for selling $3.6 million of company stock under a trading plan less than two weeks before the firm disclosed extensive losses.”
Back from March 23 - Financial Times (Allyson Versprille):
“Executive pay at Silicon Valley Bank soared after the bank embarked on a strategy to boost profitability by buying riskier assets exposed to rising interest rates…
The jump in pay for chief executive Greg Becker and chief financial officer Daniel Beck was a result of large multiyear bonus awards pegged to the bank’s return on equity (RoE), a key measure of profitability that rose sharply between 2017 and 2021...
Becker’s cash bonus peaked at $3mn in 2021, more than double the amount he received four years earlier.”
I didn’t hear a peep on the subject.
But perhaps SVB management should not have expanded the bank so recklessly.
In the three years ending in 2022, SVB Total Assets surged 198% to $212 billion.
Total Loans expanded 124% to $74 billion.
Testimony from First Republic CEO Michael Roffler:
“‘Up until the cataclysmic events of March 10 and the following days…
First Republic was in a strong financial position…
We could not have anticipated that Silicon Valley Bank and Signature Bank would fail, or that the failure of those banks would trigger substantial deposit outflows at our bank.”
“First Republic’s financial position and strategy were regularly reviewed by our regulators, the California Department of Financial Protection and Innovation and the FDIC…
Neither regulator expressed concern regarding First Republic’s strategy, liquidity, or management performance—just the opposite.”
“To be clear, no one at First Republic could have predicted the collapse of Silicon Valley Bank and Signature Bank, the speed at which it happened, or the catastrophic effects these events had on the banking industry and consumer confidence.
Instead, First Republic was preparing for reduced profits in 2023 as compared to our record profits in 2022.”
“The run on First Republic was undoubtedly catalyzed by the widespread panic that was inspired by the abrupt failure of Silicon Valley Bank, and then Signature Bank, and exacerbated by traditional media and social media, as well as recent technological advancements that allow depositors to withdraw their money almost immediately.”
Fair enough.
But that certainly doesn’t absolve management’s hyper-aggressive growth strategy. Total Assets expanded 83% - from $116 billion to $213 billion – in just three years.
Total Loans surged 84% over this period ($91bn to $167bn).
Mr. Roffler was appointed CEO in 2022.
“His total yearly compensation is US$7.3m, comprised of 7.5% salary and 92.5% bonuses, including company stock and options.”
Testimony from Signature Bank CEO Scott Shay:
“‘Within just a few days of SVB collapse, Signature Bank customers withdrew $16 billion in assets.
Nonetheless, I was confident Signature Bank could withstand the economic earthquake that occurred that day.”
“Scott Shay, former Chairman and Co-Founder of Signature Bank, made more than $20 million from 2019 to 2023 as the Federal Deposit Insurance Corporation (FDIC) identified 45 liquidity risk issues.”
May 16 - Bloomberg (Allyson Versprille):
“During the hearing, Scott Shay, who served as chairman of Signature Bank, also refused to commit to giving back any of his pay."
Shay pointed blame for Signature’s failure to “a series of truly extraordinary and unprecedented events.”
Signature Bank’s growth was certainly extraordinary, with Total Assets surging 118% in three years to $110 billion.
Total Loans rose 90% to $75 billion.
Few businesses provide the opportunity to achieve booming accounting profits as lending – especially risky lending.
Profits can be booked up front, with bad loans and charge-offs often years down the road.
The three CEOs surely understood that such rapid growth put their banks at risk.
The long and checkered history of banking is unequivocal on the subject.
But human nature is human nature.
Of course, these executives were going to push risk to the limit.
The incentive was a backdrop with generational wealth for the taking.
From 2020 lows to 2021 highs, SVB’s stock inflated almost 500%.
Signature Bank’s stock was up 440% and First Republic almost 220%.
And it’s a “heads I win, tails you lose” dynamic.
If their banks don’t fail, the CEOs enjoy fortunes in the tens of millions. Spectacular failure left them with many millions.
Reckless monetary policy created such dangerous incentive structures.
Somehow, central bankers presumed zero rates and Trillions of money printing were benign, so long as consumer price inflation remained under control.
They ignored the corrosive easy-money impacts of Monetary Disorder and asset inflation/Bubbles.
Now we have acute fragility and inflation.
Acute fragility ensures rapid central bank crisis management operations, including the Bank of England in September and the Fed’s $400 billion liquidity support in March.
And let’s not forget the herculean FHLB crisis response.
In the year up to March 31, 2023, FHLB Total Assets surged $802 billion, or 105%, to a record $1.564 TN.
Advances (loans to member institutions) jumped $670 billion y-o-y, or 179%, to $1.045 TN.
But FHLB liquidity measures went beyond advances.
“Repo” assets gained $56.5 billion, or 83%, to $124 billion.
“Federal Funds Sold” jumped 52% y-o-y to $87 billion.
This is extraordinary, systemically impactful liquidity creation.
And this week, the Institute of International Finance (IIF) released their Q1 2023 Global Debt Monitor (GDM), highlighting the unprecedented - and ongoing - surge in global debt.
GDM Highlights:
“The global debt stock grew by $8.3 trillion to a near-record $305 trillion in Q123; the combination of high debt levels and rising interest rates has pushed up debt service costs, prompting concerns about leverage in the financial system.”
“Total debt of emerging markets hit a fresh record high of over $100 trillion (or 250% of GDP) – up from $75 trillion in 2019.”
“At close to $305 trillion, global debt is now $45 trillion higher than its pre-pandemic level and is expected to continue increasing rapidly.”
“Rise of private debt markets: Non-bank financial institutions (NBFLs) continue to gain prominence in global credit intermediation.
The so-called ‘shadow banks’ now account for more than 14% of financial markets, with the majority of growth stemming from a rapid expansion of U.S. investment and private debt markets.”
And from a chart headline: “The Size of Private Debt Markets Surpassed $2.1 Trillion in 2022, Up From Less Than $0.1 Trillion in 2007.”
From the end of Q3 2019 through Q1 2023, Total Global Debt jumped $52.3 TN, or 20.7%, to $305 TN.
Over this period, “Mature” economy debt expanded 13.4%, while “Emerging” economy debt surged 38.9%.
It’s worth nothing that in the “Emerging” category, “Household” debt surged 41.7%, “Non-Financial Corporate” 35.1%, and “Government” 55.7%.
Since 2016, total global debt-to-GDP has surged from 210% to 360%.
Global financial conditions remain loose.
When they inevitably tighten, be prepared for serious dislocation.
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