Nietzsche on Bubbles
Doug Nolan
Remember early in the Fed’s tightening cycle, when Chair Powell would invoke the legacy of Paul Volcker?
And there were press conferences where “financial conditions” were a focal point – referenced about a dozen times.
Wednesday’s meeting was good for a couple.
In their quarterly Summary of Economic Projections (“dot plot”) update, committee members raised forecasts for inflation, GDP and policy rates, while lowering the expected unemployment rate.
Powell:
“It’s reasonable.
It’s common sense to go a little slower…
Gives us more information to make decisions.
We may try to make better decisions.”
I’m all for the Fed trying to make better decisions.
But such complex analysis must go much deeper than “common sense”.
The so-called “hawkish skip” is both messy and problematic.
It has left analysts confounded, while a highly speculative stock market couldn’t be happier.
Loose conditions as far as the eye can see; latent fragilities safeguarding the “Fed put”.
Count me skeptical that inflation can be contained without a sustained period of tightened financial conditions.
“Immaculate disinflation” is close kin to “transitory.”
Powell:
“The committee is completely unified in the need to get inflation down to 2%, and will do whatever it takes to get it down to 2% over time.
That is our plan.”
Almost everyone – including Fed officials and the markets - is convinced this tightening cycle is quickly winding down.
Moreover, it can all be accomplished virtually pain-free.
Soft-landing and perpetual bull market.
And these fanciful misperceptions are exactly what the Fed should have worked diligently to foil.
Resulting loose financial conditions exacerbate two major systemic vulnerabilities: inflation and financial instability.
June 16 – Reuters (Gaurav Dogra and Patturaja Murugaboopathy):
“U.S. equity funds saw their most substantial weekly net purchases since early 2021 during the seven days leading up to June 14…
According to Refinitiv Lipper data, U.S. equity funds drew a net $18.85 billion worth of inflows in their biggest weekly net buying since mid-February 2021.”
For the record, the Nasdaq100 was up 15% in the six weeks ahead of Wednesday’s Fed (telegraphed “skip”) decision – closing Friday with a year-to-date gain of 38%.
The index is up almost 8% since the Fed’s first rate increase on March 16th, 2022.
The Semiconductors (SOX) sport a 45% 2023 gain (up 14% from the start of tightening).
A full-fledged mania has erupted in anything associated with A.I. – with Nvidia having tripled y-t-d to a Trillion-dollar market cap.
The S&P500’s almost 16% 2023 return puts the index up about 3% since the start of tightening.
The VIX (equities volatility) Index traded Friday at a tightening cycle low 13.53 (low since June 2021).
Particularly inopportune timing for a display of waning inflation resolve.
June 15 – Bloomberg (Lu Wang):
“The gravity-defying bull market is handing stock investors a fresh conundrum as an unusually big pile of options expires Friday: Chase gains via bullish derivatives or hedge with bearish bets?
It’s decision traders always face, but the stakes are higher this time.
About $4.2 trillion of contracts tied to stocks and indexes are scheduled to mature, according to an estimate by Rocky Fishman, founder of derivatives analytical firm Asym 500.
That’s 20% more than a year ago.
The event know as OpEx obliges Wall Street managers to either roll over existing positions or start new ones.
It usually involves portfolio adjustments known for causing spikes in trading volume and sudden price swings.”
After spiking to 111 bps last September, investment-grade CDS ended the week at 69 bps – only two bps higher than March 16th, 2022.
High-yield CDS in September surged to 627 bps, but has since dropped back down to 436 bps – up a modest 60 bps since the start of the tightening cycle for a market sector that should have been hyper-sensitive to financial tightening.
In spite of 14 months of “tightening” and an eruption of banking system instability, JPMorgan CDS closed Friday (63bps) meaningfully below the level from March 16, 2022 (72.5bps).
The unemployment rate has ticked up only a tenth since the Fed commenced rate increases – remaining at a near multi-decade low of 3.7%.
Job openings remain above 10 million, with 1.8 openings for every unemployed individual.
Financial conditions remaining so loose in the face of aggressive Fed rate hikes have been a huge surprise.
Importantly, when it comes to modern-day financial conditions and market structure, there’s a thin line between things “breaking” and the intensification of Bubble excess.
A major de-risking/deleveraging episode could bring this fragile boom to an abrupt conclusion.
But it is this acute fragility that ensures policymakers respond quickly and forcefully against fledgling instability (BOE in September and Fed in March), ensuring that deeply entrenched speculative impulses are sustained.
That which does not burst a Bubble only makes it stronger.
The banking crisis could have easily triggered major de-risking/deleveraging.
Instead, Fed assets expanded $364 billion in three weeks, while also creating a new lending facility and swap arrangement with global central banks.
And I must reiterate extraordinary Q1 and one-year financial sector growth dynamics.
GSE assets expanded a record $352 billion during Q1 to an all-time high $9.540 TN.
GSE assets inflated a record $1.022 TN, or 12.0%, over the past four quarters (FHLB asset up $802bn, or 105%).
Total Broker/Dealer assets jumped $452 billion, or 41.4% annualized, during Q1 to $4.823 TN (the high since Q3 ’08).
“Fed Funds and Security Repurchase Agreements” assets surged $815 billion, or 46% annualized, during Q1 to a record $7.895 TN – with one-year growth of $1.757 TN, or 28.6%.
It's one freaky “tightening” cycle when you see such rampant financial sector inflation.
Z.1 data help illuminate why the financial system has remained awash in liquidity.
It’s also helpful to recognize the phenomenal inflation of Household sector liquid assets since the start of the pandemic.
An analytical focus on declining deposits and the M2 monetary aggregate misses a crucial dynamic.
While Total (checking and savings) Household Deposits dropped $415 billion during Q1, Money Market Funds jumped $300 billion, or 39.1% annualized.
Treasury holdings surged $549 billion – with Agency Securities up another $280 billion.
Household liquid asset growth over the past 14 quarters has been nothing short of amazing – with clear systemic ramifications.
Total Deposits inflated $3.797 TN, or 35.8%. Money Market Funds surged $1.215 TN, or 56.5%.
Household Treasury holdings rose $520 billion, or 29.7%, and Agency Securities jumped $580 billion, or 74.9%.
In total, in only three and a half years, Household holdings of Deposits, Money Market Funds, Treasuries and Agency Securities inflated a staggering $6.112 TN, or 40.3%.
Historic monetary inflation has altered structures.
Millions over the long bull market have become impassioned speculators – stocks, ETFs, options and derivatives, crypto - with the financial resources to stay in the game.
Households have been granted Trillions of additional liquid assets (tens of Trillions of additional perceived wealth), while the Fed did exactly what it needed to avoid: its words and deeds further solidified the perception that the Fed is backstopping the markets.
June 16 – Reuters (Howard Schneider):
“U.S. Federal Reserve officials struck a hawkish tone in their first comments since the central bank held the policy interest rate steady…
‘Core inflation is not coming down like I thought it would,’ Federal Reserve Gov. Christopher Waller said…
‘Inflation is just not moving and that's going to require, probably, some more tightening to try to get that going down.’
In earlier prepared remarks he said that changes in U.S. credit conditions since the failure of Silicon Valley Bank… were ‘in line’ with financial tightening that was already underway due to Federal Reserve interest rate increases -- comments that downplayed the idea a worse-than-anticipated contraction in credit might make further Fed rate increases less necessary.
‘It is still not clear that recent strains in the banking sector materially intensified the tightening of lending conditions’…”
The Financial Sector has been hellbent on breakneck expansion.
The Household sector, bolstered by a historic financial windfall, has been keen to spend and speculate.
Powerful forces – “inflationary biases” - have thwarted Fed tightening.
But it would be deficient analysis to fixate only on domestic developments.
Japan’s Nikkei Equities Index ended the week with a 29.2% y-t-d gain.
Major stock indices are up 18% in Germany, 14% in France, 18% in Italy, 17% in South Korea, 22% in Taiwan, and 13% in Mexico.
Market liquidity is “fungible” globally – and loose global conditions are surely playing a significant role in bolstering U.S. market liquidity.
June 16 – Reuters (Leika Kihara and Tetsushi Kajimoto):
“The Bank of Japan maintained its ultra-easy monetary policy on Friday despite stronger-than-expected inflation, signalling it will remain a dovish outlier among global central banks and focus on supporting a fragile economic recovery.
The central bank also reiterated its view that inflation will slow later this year and a pledge to ‘patiently’ sustain stimulus...
‘We expect trend inflation to heighten as economic activity strengthens and the labour market tightens.
But there's very high uncertainty on next year's wage negotiations and the sustainability of wage growth,’ Governor Kazuo Ueda told a briefing.”
June 13 – Bloomberg (Masaki Kondo and Yumi Teso):
“Bank of Japan Governor Kazuo Ueda’s dovish stance has cemented the yen’s status as the most attractive funding currency for carry traders…
Thanks to the BOJ’s negative-rate policy, the yen stands alone in terms of low implied yield — a gauge of funding costs — with a three-month rate of minus 0.4% compared to the 30 other currencies analyzed by Bloomberg which have yields above zero.
That’s about 180 bps below the Swiss franc, another popular funding currency.
A proxy of sorts for the yen carry trade — lending in the currency by foreign bank branches in Japan to their offices abroad — has climbed 48% since the end of 2021 to 12.9 trillion yen ($92.4bn) at the end of April.”
Borrowing (hedge funds, global banks and non-banks, Japanese households and financial institutions, etc.) at negative rates to leverage in much higher returning assets globally might be history’s greatest leveraged speculative Bubble.
Kazuo Ueda and the BOJ are understandably reluctant to initiate long-overdue policy normalization.
But leverage, along with distortions to financial, market and economic structure, only compounds over time.
The yen dropped 1.7% against the dollar this week, while the Dollar Index declined 1.2%.
The yen this week sank 4.9% against the South African rand, 3.7% versus the Australian dollar, 3.7% against the British pound, 3.6% against the Norwegian krone, and 3.5% versus the euro.
“Carry trade” speculative leverage is not limited to Japan.
One-year rates are below 1% in Switzerland.
While the ECB raised the deposit rate to 3.50% Thursday, with consumer price inflation still above 6% real rates remain deeply negative.
And with Italian government (10-yr) yields above 4% - and Greek yields at 3.76% - we can assume European periphery bond markets continue as popular “carry trade” targets.
Surely, enormous speculative leverage has accumulated in high-yielding Chinese debt instruments.
June 16 – Bloomberg (Li Liu):
“China must adopt ‘more forceful’ measures to support economic recovery, state television reports, citing a State Council meeting chaired by Premier Li Qiang.
China is studying economic policy controls, and policies to expand demand, consolidate the economy and prevent risks in key sectors…
China’s economic recovery is hurt by the ‘more complex and severe’ external environment, slowdown in global trade and investment, the State Council says…”
More weak economic data out of China this week.
Weaker-than-expected lending data was the most concerning.
At $220 billion, May growth in Aggregate Financing (China’s system Credit metric) was 18% below forecast.
China’s Credit data can vary significantly month-to-month.
A weak month is typically followed by stronger lending.
But a slow May followed what was a dismal April (after a booming March).
It was the slowest two-month expansion since Oct./Nov. 2018.
New Loans of $191 billion, while up from April’s $100 billion, were 12% below expectations and 28% lower compared to May 2022.
Corporate Bank Loans expanded $120 billion, down from the year ago $215 billion.
At $52 billion, Consumer (chiefly mortgage) Loans recovered from April’s $34 billion contraction – though Q2 lending has slowed sharply from Q1’s $357 billion.
But despite all the commentary on weak Chinese Credit growth, Aggregate Financing increased $4.7 TN, or 9.8%, over the past year.
Loans expanded $3.36 TN, or 11.8%, in four quarters, with Corporate Loans up $2.58 TN, or 14.2% (2-yr growth 28.3% and 5-yr 79%).
Government Bonds expanded $970 billion, or 12.4% (2-yr 32% and 5-yr 81%).
Chinese bank assets surged an unprecedented $2.5 TN during Q1 to a record $55.7 TN, with one-year growth of $5.52 TN, or 11%.
Ominously, China’s recovery has weakened in the face of ongoing historic Credit excess.
Things could get interesting if Beijing decides to bring out the big stimulus guns.
The Bloomberg Commodities Index rallied 4.1% this week, bolstered by the weak dollar and prospects for aggressive Chinese stimulus measures.
Stocks succumbed to melt-up dynamics into “quadruple witch” quarterly options expiration, as nascent signs of disorderly trading appeared in currency markets.
It all leaves me questioning the sustainability of Treasury market stability.
UK two-year yields spiked 40 bps this week to 4.93% (2-wk gain 58bps) - surpassing late-September crisis levels to the highest yield since the summer of 2008.
Two-year yields were up 20 bps in Sweden, 21 bps in Germany, 20 bps in France, and 16 bps in Italy.
Australian two-year yields jumped 20 bps this week to 4.20% - to the high since the summer of 2011.
Two-year Treasury yields rose 12 bps this week to 4.71%, the high since the SVB blowup.
The market sees a 72% probability of a 25 bps hike at the Fed’s July 26th meeting, with peak Fed funds now at 5.30% for the September 20th meeting.
The market is pricing only one rate cut by the January 31, 2024, meeting.
What a big week for the major global central banks – one increase (ECB), two no actions (Fed and BOJ), and a cut (PBOC).
In all cases, there was a sense of things kind of slipping away.
It’s been a while since markets questioned whether Beijing has everything under control.
At both the Fed and ECB, central bankers face inflation and stability risks, with loose conditions and speculative Bubbles on a crash course.
The Bank of Japan locked in reckless rate and monetization policies is inviting a currency crisis.
This degree of global uncertainty is not conducive to speculative leverage, especially in vulnerable bond markets.
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