Deflation & Inflation
Doug Nolan
A few headlines: WSJ: “Deflation Tightens Grip on China’s Economy.”
FT: “China’s Prices Fall at Fastest Rate in 15 years as Economy Battles Deflation.”
NYT: “China Deflation Alarms Raised by Falling Prices for Food and Cars.”
February 7 – Bloomberg:
“China’s consumer prices fell last month at the fastest pace since the global financial crisis, piling pressure on the government to step-up support for a stumbling economic rebound that’s roiling markets.
The consumer price index dropped 0.8% in January from a year ago…, the weakest since September 2009.
The drop was worse than economists’ expectations for a 0.5% decline.
‘The CPI data today shows China faces persistent deflationary pressure,’ said Zhiwei Zhang, president and chief economist at Pinpoint Asset Management Ltd.
‘China needs to take actions quickly and aggressively to avoid the risk of deflationary expectation to be entrenched among consumers.’”
Chinese Credit data belie all the deflation chatter.
The first month of the year is always a big Credit month, with January 2024 especially big.
Aggregate Financing (China’s metric for system Credit growth) expanded a monthly record $904 billion, 8% ahead of January 2023 – and 16% above estimates.
This puts three-month growth at $1.515 TN, 17% ahead of comparable 2023.
And for the first time, 12-month growth in Aggregate Financing surpassed $5 TN ($5.017 TN), expanding 13.4%.
It’s worth noting that 12-month growth exceeded pre-pandemic comparable January 2020 by 39%.
Total New Loans of a record $684 billion were slightly ahead of January 2023 – and 9% ahead of estimates.
Bank Loans expanded $3.163 TN, or 10.4%, over twelve months.
Loans expanded 23.3% over two years, 37.5% over three and 73.8% over five years – in one of history’s great Credit inflations.
Consumer (chiefly mortgage) Loan growth jumped to $136 billion, the strongest since last March, but below January 2023’s $152 billion.
Consumer Loans expanded $702 billion, or 6.6%, over the past year.
One-year growth was almost 24% higher compared to January 2023, but a third lower than comparable January 2022.
Slowing somewhat, Corporate Loans continue to expand at a brisk pace.
At $537 billion, January growth lagged the year ago expansion by 17%.
Yet Corporate Loans expanded $2.376 TN, or 12.0%, over the past year.
Loans jumped 28.7% over two years, 43.5% over three and 78.2% over five years.
With banks lending like crazy during the month, Beijing pulled back on debt issuance.
Government bonds expanded $42 billion in January, down from December’s $129 billion and January 2023’s $57 billion.
Still, three-month growth of $330 billion was almost 60% ahead of the comparable year ago increase.
One-year growth of $1.319 TN was 37% ahead of comparable January 2023.
Government Bonds expanded 15.7% over one year, 30.6% over two, 51.4% over three, and 82.1% over five years.
We’ll focus on a Bloomberg headline: “What China’s Persistent Deflation Means for the World.”
Bloomberg’s “QuickTake” offered a simple deflation definition: “The term describes a situation in which prices for goods and services fall across the economy.”
The root cause of aggregate price declines can vary.
They are typically associated with a marked drop in aggregate demand within a backdrop of overcapacity.
Both tend to be inevitable consequences of boom-time excess.
And, typically, deflation is associated with a contraction (or at least rapid slowing) of Credit.
The underlying root causes of the demand shortfall and price declines will profoundly impact policy prescriptions and their efficacy.
For example, an interruption to Credit growth and the flow of finance in an economy are amenable to government intervention.
On the other hand, deflationary forces emanating from bursting Bubbles pose a serious policy dilemma.
Inflationary measures adopted to boost demand and prices risk reigniting Bubble excess, ensuring only greater “deflationary” pressures later.
When we contemplate what China’s deflation might mean for the U.S. and the world, it’s important to appreciate that Beijing over the years repeatedly reflated its historic Bubble.
Consequences include what could be history’s greatest speculative Bubble in Chinese apartments, along with epic overcapacity and unrivaled structural maladjustment.
Moreover, there is the issue of China’s $60 TN banking system with long tentacles across global financial and economic systems.
“American exceptionalism” is topical these days.
It is no coincidence that U.S. equities are in the throes of a major speculative melt-up as Chinese stocks meltdown.
We’re now 15 years into a historic global government finance Bubble.
“GFC” reflationary measures quickly stoked China’s Bubble into a powerful “locomotive” pulling the global economy out of the post-mortgage finance Bubble muck.
But China’s Bubble was allowed to run wild, in a process that emboldened ambitions of global economic might and superpower status.
Today, intractable problems at the global “periphery” (i.e., China) bolster late-cycle Terminal Phase Bubble Excess at the “Core.”
Where would U.S. and global goods inflation be today, if not for downward price pressures from China’s massive global export machine?
How great is the flow of finance exiting China and Chinese markets in favor of U.S. and global asset markets?
How much is being borrowed at low-cost Chinese interest rates - for global speculation, including “carry trades” and such?
And there’s an argument to be made that Chinese “deflation” has acted as a pivotal countervailing factor diluting Bank of Japan (BOJ) reflationary measures in Japan.
Ongoing negative BOJ rates and yield curve control (YCC) have been instrumental in boosting late-cycle blow-off excess at the U.S. “core” and global “periphery.”
February 8 - Bloomberg (Yumi Teso and Daisuke Sakai):
“Japanese investors purchased the largest amount of US sovereign debt on record in 2023 — attracted by high yields and expectations for the end of the Federal Reserve’s tightening cycle.
The net ¥18 trillion ($121bn) of purchases runs counter to concern of the Japanese dumping Treasuries to repatriate funds back home as the central bank in Tokyo lays the ground work to raise interest rates.”
How colossal has the yen “carry trade” inflated during eight years of negative rates (15 years of near zero rates!)?
Flows out of Japan – traditional and for levered speculation - during this cycle have surely been in the Trillions.
As we approach the two-year mark for the Fed’s “tightening” cycle, we can ponder how massive flows out of Japan and China have countered rising policy rates.
Importantly, the loose global liquidity backdrop has been instrumental in perpetuating leveraged speculation in the U.S. and globally.
Without exorbitant Japanese and Chinese finance, prospects for Fed QT and attendant liquidity pressures would have instilled some caution in the leveraged speculating community.
Instead, loose global finance and last year’s Fed/FHLB liquidity injections emboldened leveraged speculation (including the “basis trade”) despite higher policy rates.
Loose conditions at this late-cycle phase both promote and validate financial innovation.
So-called “private Credit” reached critical mass, with aggressive sector growth dynamics offsetting a pullback in boom-time bank lending.
February 8 - Bloomberg (Allison McNeely):
“Apollo Global Management Inc. Chief Executive Officer Marc Rowan took a ‘victory lap’ on the firm’s record year, laying out goals to double its private credit origination business and put that asset class into retirement accounts.
The firm posted record annual earnings, beating Wall Street estimates as higher interest rates powered growth at the credit-focused alternative asset manager.
Originating private credit assets to sell to its Athene annuities business, other insurance companies and individual investors is crucial for the firm’s growth, Rowan said.
Apollo aims to raise its annual origination of private credit to $200 billion-$250 billion in five years, up from around $100 billion, he said…”
Abundant marketplace liquidity and easy Credit Availability have compressed corporate risk premiums to two-year lows.
Collapsing Credit default swap (CDS) “insurance” prices only intensify the speculative fervor, with strong demand for debt securities ensuring record corporate issuance.
February 5 – Reuters (Mark Niquette):
“The U.S. corporate bond market is set to break new issuance records as borrowers take advantage of lower financing costs than last year and investors, emboldened by the prospect of an economic ‘soft landing,’ pile into the asset class…
Issuance of bonds by companies rated investment-grade surged above $196 billion last month, making it the busiest January on record.
This record issuance may be repeated this month, with BofA Global estimating nearly $160 billion to $170 billion in just investment-grade rated bond supply, which would make it the busiest February ever.
Such back-to-back record months at the start of the year are unusual even for the prolific investment grade market, which is expected to see nearly $1.3 trillion of bond issuance this year.”
Again, it’s no coincidence that China’s Bubble deflates while the U.S. Bubble wildly inflates.
An apt Friday evening Bloomberg headline: “Stock Mania Rages On as S&P500 Closes Above 5,000.”
To go along with record corporate debt issuance, there was a flurry of new all-time highs to end the equities trading week – S&P500, S&P1500, Nasdaq100, Nasdaq Composite, Nasdaq Transportation, Nasdaq Insurance, Philadelphia Semiconductor (SOX), NYSE Healthcare, Russell 1000, Russell 3000, NYSE Arca Computer Technology, NYSE Arca Institutional, and other indices.
There will be no backing down on my part.
I’m convinced that extending “Terminal Phase Excess” - in history’s greatest Bubble - is so fraught with peril.
While central to the bullish market narrative, waning consumer price inflation is today detrimental to system stability.
At this point, it’s a full-fledged mania.
Speculation and speculative leverage are running wild.
It is critical that financial conditions tighten.
The Powell Fed’s December “dovish pivot” only stoked financial excess.
Not only will the eventual Bubble deflation be more destabilizing for the markets and economy.
But today’s raging Bubble will disregard more hawkish Fed pushback.
Markets today have no fear whatsoever that the Fed might interrupt the party with tighter conditions.
The Fed can celebrate mission accomplished in their dual mandate of full employment and price stability.
Meanwhile, I see nothing but acute price instability, especially in the asset markets.
Our central bank has over recent decades repeatedly ignored William McChesney Martin’s sage teachings: It’s the Fed’s job to take away the punch bowl just as the party gets going.
Having spiked the punch a number of times to ensure the good times keep rolling, our central bank is content today to sheepishly walk away and disavow responsibility for the drunken mess.
Chair Powell used Sunday’s “60 Minutes” interview to somewhat clean up what I referred to last week as his “immaculate disinflation” press conference comments.
CBS’s Scott Pelley:
“You’ve avoided a recession. Why not cut the rates now?”
Powell:
“Well, we have a strong economy.
Growth is going on at a solid pace.
The labor market is strong: 3.7% unemployment.
And inflation is coming down.
With the economy strong like that, we feel like we can approach the question of when to begin to reduce interest rates carefully.”
It’s a relief to see that a strong economy and strong labor market are factors in determining rate policy.
This, along with a bevy of Fed officials pushing back against market rate cut expectations (i.e., Barkin, Kashkari, Logan, Collins, Mester, Kuglar), had the bond market on edge.
Ten-year yields jumped 16 bps this week to an eight-week high 4.18%.
This week’s 16 bps increase in MBS yields (5.65%) pushed the y-t-d yield gain to 38 bps.
Market expectations for the May 1st FOMC meeting increased five bps to 5.14%, implying 19 bps of rate reduction.
The rates market is pricing a 4.20% policy rate at the December 18th meeting, up 13 bps this week - and implying 113 bps of cuts.
Curiously, the market still sees an almost one in five probability of a cut at the Fed’s March 20th meeting.
And the market is pricing 4.5 cuts by December, down from the start of the year - but still 50% more than the Fed has signaled.
A Bloomberg headline from earlier in the week:
“Banking Worries Put Five Cuts Back on Table for Traders.”
There’s something lurking out there that has the market pricing odds of the Fed forced into action this year.
While it could be looming banking problems, I tend to be skeptical.
While European bank CDS prices increased a tad this week, U.S. CDS prices continue to signal “all’s clear.”
At 43 bps, JPMorgan CDS prices are near lows back to September 2021.
Bank of America CDS declined three this week to 65 bps, Wells Fargo was little changed at 62 bps, and Citigroup was about unchanged at 63 bps – all near lows since (pre-rate hikes) February 2022.
It seems more reasonable that the rates market is pricing probabilities for a global de-risking/deleveraging event.
And this gets back to China and trouble at the “periphery.”
I’ll continue to use the mortgage finance Bubble example: The subprime eruption marked the beginning of the Bubble’s end, but it also sparked a rally in AAA rated agency bonds and MBS that extended “Terminal Phase” excess.
In a replay of 2007 dynamics, markets today don’t appreciate the major ramifications of what is unfolding in China.
It didn’t come easily, but Beijing ignited a rally into the Chinese New Year holiday.
But that won’t clear the deep gloom that is settling over China’s asset markets and economy.
The “Beijing has everything under control” adhesive holding everything together is eroding.
Another month of huge Credit growth is not supportive of renminbi stability.
Sure, formidable international reserves and trade surpluses provide currency support.
I just believe the scope of unfolding Credit and banking problems will dwarf China’s liquid international reserves.
Meanwhile, China’s export model shows vulnerability.
Manufacturing capacity is shifting to competing countries.
And just as Beijing has achieved massive EV and battery export capacity, demand trends have weakened.
A disorderly Chinese currency adjustment is on my short list of possible catalysts for a bout of global de-risking/deleveraging.
Geopolitical developments also make the list, though something could come out of the blue.
Or might it be something as simple as regulators coming down hard?
February 6 – Bloomberg (Lydia Beyoud):
“Hedge funds and proprietary trading firms that regularly trade US Treasuries are set to be labeled as dealers by the Securities and Exchange Commission — a tag that brings greater compliance costs and scrutiny.
The SEC… boosted oversight of trading by the firms, which are increasingly responsible for liquidity in the world’s biggest government bond market.
The new regulations also apply to market participants in other government bonds, equities and additional securities.
Wall Street’s main regulator under Chair Gary Gensler has homed in on the Treasuries market and the private-funds industry as needing more guardrails.”
February 9 - Bloomberg (Chris Dolmetsch):
“A new Securities and Exchange Commission market-tracking database is a ‘massive, unprecedented government surveillance system’ that could cost the financial services industry billions of dollars and compromise investors’ privacy, Citadel Securities told a US appeals court…
In a brief…, the trade group and the market-making firm founded by billionaire Ken Griffin said the… appeals court should declare the funding plan unlawful.
They argued that the Consolidated Audit Trail, or CAT, as the database is known, exceeds the statutory authority granted to the SEC and was implemented without congressional consent…
‘Not surprisingly, this program’s threats to privacy and civil liberties have set off alarm bells across the political spectrum, which have only grown louder as the public learns of the SEC’s repeated failures to safeguard its own systems against foreign hackers…
Incredibly, however, the Commission created this Big Brother regime without any approval, direction or appropriation from Congress.’”
He doth protest too much.
A Big Brother threat to privacy and civil liberties perhaps, but transparency would certainly pose a direct threat to highly levered “basis trades” (and other speculative bets).
I doubt many players would be willing to enter such highly levered trades, knowing their positioning will be evident to all.
That’ll take the fun out of one of history’s great easy money trades.
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