THURSDAY / CREDIT BUBBLE BULLETIN

Thursday

Doug Nolan 

Wednesday, July 5, 2023: ISI’s Ed Hyman speaking on Bloomberg Television:

“Inflation is coming down around the world. 

They just reported this morning the PPI for the Eurozone was now in deflation… 

Last week, Spain's CPI went below 2% for the first time. 

I try and connect the dots the best I can, and it looks to me like inflation is really going down. 

And with that policy backdrop I mentioned, it’s going to keep going down.”

“At this point, the one more (rate hike) is baked in the cake. 

I think anything (hikes) from now is a mistake – they’re just creating a deeper recession… 

Five and a quarter (Fed funds rate) with the bond yield at 3.80% - they’re pretty much done - and inflation is slowing… 

Near as I can tell, by the time they cut rates, inflation will be so far down it will make them look a little wrong footed again.”

A Google search returns “legendary economist” and “ranked the Street’s top economist for an extraordinary 42 years.” 

Mr. Hyman’s reputation speaks for itself. 

He is widely recognized as the preeminent economic forecaster throughout what I refer to as the “previous cycle.”

Pointing to the “really” inverted yield curve, a contraction in money supply growth (“most since the 1930s”), and significant Fed tightening (rates and QT), Hyman sees mild recession on the horizon. 

Yet he remains constructive on stocks (until recession hits).

I am compelled to note that the yield curve has been inverted for a year. 

I believe the inversion is more related to the bond market discounting the odds of an accident and panicked Fed response than a recession forecast.

And my analytical framework deemphasizes the contraction in M2 when money fund assets have expanded $581 billion (36% annualized) over the past 17 weeks, with one-year growth of $917 billion, or 20.1%. 

The bottom line is that the Fed/FHLB liquidity surge in response to the March banking crisis unleashed major speculative and liquidity excesses. 

Bursting Bubbles today pose extreme systemic risk.

I highlight Ed Hyman’s Wednesday comments, as they encapsulate the consensus bullish view for financial assets. 

Contracting money supply ensures inflation is no longer an issue; the yield curve signals the nearing conclusion to the Fed’s tightening cycle; and an economic slowdown will be constructive for bonds and stocks.

That was Wednesday. 

Things looked different Thursday.

July 6 – CNBC (Jeff Cox): 

“The U.S. labor market showed no signs of letting up in June, as companies created far more jobs than expected, payroll processing firm ADP reported… 

Private sector jobs surged by 497,000 for the month, well ahead of the downwardly revised 267,000 gain in May and much better than the 220,000… estimate. 

The increase resulted in the biggest monthly rise since July 2022. 

From a sector standpoint, leisure and hospitality led with 232,000 new hires, followed by construction with 97,000, and trade, transportation and utilities at 90,000. 

Annual pay rose at a 6.4% rate…”

And then stronger-than-expected service sector data hit. 

The ISM Services Index rose three points to a stronger-than-expected 53.9, underscoring notably broad-based strength. 

The June Business Activity component surged to 59.2 from May’s 51.5, the strongest reading since January. 

Employment rose to 53.1 from 49.2 (strongest since February), while New Orders gained from 52.9 to 55.5. 

Fifteen of the 18 industries surveyed reported a June boost in activity.

Also Thursday, persistent labor market strength was confirmed by JOLTS (job vacancies), Challenger Job Cuts, and weekly jobless claims data.

Market reaction was swift and forceful. 

Two-year Treasury yields traded up as much as 16 bps to 5.11% - the high back to July 2006. 

Ten-year Treasury yields rose to 4.08%, the high since November 9th. 

Benchmark MBS surged a notable 25 bps at Thursday’s intraday high to 6.05%, nearing the 6.10% peak during October bond market tumult (which was the high since pre-GFC July 2008). 

Indicative of mounting stress in interest-rate hedging markets, MBS yields surged 31 bps this week to 5.95%. 

Ten-year Treasury yields jumped 23 bps this week to close Friday at 4.06%. 

The rates market now prices peak Fed funds of 5.43% at the November 1st FOMC meeting.

Thursday’s market action appeared important. 

Booming ADP and strong Service ISM – that followed earlier reports of strengthened housing, construction and auto sales – basically blew apart the thesis of imminent economic weakening. 

And with the consumer ready to travel and spend for the summer – and the Atlanta Fed’s GDPNow indicator back above 2% - third quarter growth could easily surprise to the upside. 

Moreover, ongoing strong wage gains and services pricing pressures threw cold water on the view of consumer inflation on a trajectory to return to the Fed’s 2% target.

There was market recognition Thursday that perhaps all bets are off. 

If 500 bps of Fed rate hikes (and $600bn of QT) haven’t meaningfully tightened financial conditions, slowed demand or reined in inflation, what might it take to get the job done?

July 6 – CNBC (Anmar Frangoul): 

“The Bank of England could increase interest rates to 7% as it tries to tame inflation, according to JP Morgan, which said the risks of a hard landing for the economy are also rising. 

The… bank expects rates to peak at 5.75% by November, but cautions that they could go higher ‘under some scenarios,’ hitting as much as 7%. 

The analysis from JP Morgan Economist Allan Monks comes as U.K. homeowners face a significant jump in borrowing costs as they’re usually linked to the central bank’s main interest rate.”

Global central bankers must monitor deteriorating UK circumstances with heightened anxiety. 

UK 10-year yields surged 26 bps this week to 4.65%, blowing through the September 27th 4.50% closing high (BOE crisis intervention on the 28th). 

Two-year UK yields added five bps to 4.95%, the high since July 2007.

UK 10-year yields were up 16 bps Thursday to 5.54%, with two-year yields surging as much as 18 bps to a 15-year high 5.54%. 

Reminiscent of last fall, UK yields were pulling global yields higher – even before the jolt from strong U.S. data. 

Italian 10-year yields surged 21 bps Thursday (4.37%), while Greek yields jumped 18 bps (3.97%). 

Ten-year yields rose 17 bps in Spain (3.70%) and Portugal (3.36%).

Canadian 10-year yields surged 30 bps this week to an eight-month high of 3.57%. Australian 10-year yields jumped 23 bps this week to 4.26% - the high since January 2014. 

New Zealand yields rose 22 bps to 4.85% - the high since July 2011.

Emerging Market (EM) bond yields reversed sharply higher. 

Local currency yields rose 33 bps in Hungary (7.33%), 32 bps in South Africa (12.07%), and 25 bps in Mexico (8.93%). 

Dollar denominated EM debt was under notable pressure. 

Dollar yields jumped 25 bps in Chile (5.13%), 25 bps in Indonesia (5.05%), 25 bps in Colombia (8.26%), 24 bps in the Philippines (5.00%), 23 bps in Panama (6.04%), and 22 bps in Turkey (8.89%). 

The EM bond ETF (EMB) dropped 1.43% Thursday and 2.25% for the week – the largest daily and weekly losses since February. 

Ominously for “carry trade” levered speculation, EM bond losses were compounded by an abrupt rally in the (popular financing currency) Japanese yen. 

This week’s 1.46% yen gain versus the dollar was the biggest since December.

In the U.S. and abroad, markets have been content to disregard “higher for longer.” 

It was as if markets were convinced that higher for longer would break things – so it just wouldn’t happen. 

The bond market Thursday was forced to start reckoning with the possibility of higher for longer.

The iShares Investment Grade Corporate ETF (LQD) declined 1.01% Thursday, the largest loss since May 1st. 

The 2.40% loss for the week was the largest since February. 

The iShares High Yield ETF (HYG) declined 0.73% Thursday, the largest decline since May 1st. 

This ETF lost 1.63% for the week, the worst weekly performance since early-March. 

Friday Bloomberg headlines: 

“HYG ETF Daily Outflows $1.13 Bln, Biggest Move Since March 28th.” 

“Two Giant Credit ETFs Hit by $2 Billion Exit on Hawkish Fed Bets.”

Higher for longer is a big problem. 

Surging market yields are a serious issue for a banking system loaded with long duration securities portfolios. 

It will be a push over the cliff for troubled commercial real estate. 

It will be a major blow for leveraged lending and leveraged finance more generally. 

There are Trillions of floating rate loans that will pose a much bigger issue than Wall Street has assumed. 

So many borrowers – individuals, speculators, businesses, and countries – planning to ride out a short and sweet tightening cycle are in for rude awakenings.

And it all portends trouble for a stock market speculative Bubble. 

And while equities were under pressure Thursday, losses for the week were meager.

July 7 – Bloomberg (Lu Wang): 

“A worrisome thought for the stock faithful: You won’t have the bears to kick around anymore. 

Fresh off the strongest first half for the S&P 500 in five years, the rooting out of unbelievers has shown signs of picking up speed. 

A source of anxious buying when the tide turned upward, short sellers who came into 2023 preparing to feast have been backing away from positions as stocks rally. 

Shifting sentiment can be seen in data showing bearish positions in exchange-traded funds slipped to three-year lows while shorts in S&P 500 futures were unwound at the fastest pace since 2020. 

Meanwhile, the population of optimists is exploding, with bullish newsletter writers in Investors Intelligence survey outstripping bearish ones by 3-to-1, the highest level since late 2022.”

The bear market rally has worked its magic. 

Gaining 1.6% this week, the Goldman Sachs Short Index evaded weaker stock prices. 

The Goldman Short Index was up 9.0% over the past nine trading sessions, crushing the 1.6% gain in the S&P500. 

Not surprisingly, the Fed’s “skip” threw gas on a fire of speculation.

Greed and Fear – and the stock bulls have really had the bears running for their bloody lives. 

Of course, bullish market operators will not be keen to surrender control. 

And it certainly helps that it’s summer. 

Nonetheless, I suspect Thursday marked the beginning of what will evolve into a challenging de-risking/deleveraging episode.

As I’ve explained in recent CBBs, there are major lurking market liquidity issues. 

Short squeezes tend to reverse abruptly. 

Months of liquidity excess and buoyant markets surely have left stock and bond portfolios less than adequately hedged. 

The leveraged speculating community – having covered shorts and unwound hedges – will be uncomfortably long when “risk off” erupts. 

Assuming massive speculative leverage (derivatives and margin debt) accumulated during this rally in the big tech stocks and related indices, there’s clear potential for a destabilizing reversal and de-risking/deleveraging. 

It brings back memories of the culminating squeeze and derivatives melt-up that marked a 15-year high in the Nasdaq100 back in Q1 2000.

Meanwhile, Crisis Dynamics have gained momentum in China.

July 7 – Bloomberg (Dorothy Ma): 

“Chinese high-yield dollar bonds are on course for their biggest weekly loss since November, as a plunge involving state-backed builder Sino-Ocean fueled worries for the embattling market as new-home sales are again falling. 

The company’s offshore notes have lost nearly 50% this week…”

The developer bond collapse has accelerated. 

Number one developer Country Garden bond yields surged 25 percentage points this week to a record 80%. 

Everything points to a rapid – and decisive - loss of confidence in the housing recovery. 

Meanwhile, Beijing and the state-directed banks are being forced to move aggressively to support troubled local governments – including LGFV (local government financing vehicles) debt. 

And Beijing has also moved to support the vulnerable renminbi. 

How long can Beijing suppress the great unraveling?

July 6 – Bloomberg (John Cheng): 

“A state-owned Chinese newspaper issued a rare rebuttal of Goldman Sachs… research after the securities firm’s analysts recommended selling shares of local banks, the latest sign of official attempts to counter negative sentiment in markets as the economy slows… 

The public rebuke is a fresh sign of Beijing’s growing unease with eroding investor confidence…”

July 6 – Reuters (Samuel Shen, Winni Zhou, Georgina Lee and Summer Zhen): 

“Chinese investors are rushing offshore to make dollar deposits and buy Hong Kong insurance in a signal domestic confidence is languishing and that the ailing yuan faces more pressure. 

The outflows highlight deep-seated concern about the state of China's economy as its much-awaited pandemic recovery stalls… 

Brokers say individuals are responsible for the surge and it shows no sign of letting up, which analysts warn could put further pressure on the yuan as it teeters at eight-month lows.”