Trouble Brewing in Financial Asset Wonderland
Doug Nolan
Unique “global government finance Bubble” dynamics some years back compelled an adjustment to one of my favorite maxims.
Instead of doubling, Bubbles inflate to unimaginable extremes – and then quadruple.
Bubbles can inflate for a long time, sustained by loose financial conditions and government rescues.
There will always be ebbs and flows.
Scares and shocks occasionally evoke fears of bursting Bubbles.
And the more these bouts of instability are rectified by inflationist central banking, the less concern for Bubble dynamics.
That which does not destroy a Bubble only makes it stronger.
Late in the cycle, “Terminal Phase” excess takes over, with a confluence of rapid Credit expansion, intense speculation, and FOMO completely sidelining Bubble concerns.
I like to underscore that the colorful historical accounts of manias don't do reality justice.
It’s not about crowds of raving mad speculators bidding up tulip bulb prices to the stratosphere.
Late-cycle FOMO is altogether more rational.
After so many years, arguing that prices don’t always recover to new highs is borderline insanity.
Moreover, underlying fundamentals are an elemental facet of Bubble inflations, with surging profits, cash flows and incomes validating inflating asset prices and bullish narratives more generally.
In a fatefully ironic late-cycle dynamic, fear of missing out completely usurps Bubble concerns right before the inevitable reckoning.
Bubbles eventually burst – and they have this innate diabolical propensity to somehow catch the over-exposed masses by surprise, causing the greatest damage to the largest number of traders, individuals, institutions, businesses, and governments.
Only days before the 1929 stock market cataclysm, eminent – and soon to be penniless - Yale economist (and speculator) Irving Fisher infamously stated, “The nation is marching along a permanently high plateau of prosperity.”
The past week beckons for some Bubble theory rehash.
There’s a decent case to be made that the global Bubble today hangs precariously in the balance.
March CPI data confirm inflation is decidedly not on a glide path to kindly return to 2% anytime soon.
The Fed’s misguided dovish pivot unleashed precariously loose market conditions, stoking wild speculative excess while ensuring inflation became deeply embedded.
The jam-packed stock market easy “money” party now risks being crashed by “higher for longer,” a confounded Federal Reserve, and heightened global instability.
We don't want to overly fixate on the Fed’s quandary.
Odds are down to only two-thirds probability of a rate cut by the July 31st FOMC meeting.
At 4.86% (up 19bps post-CPI), the rates market ended the week pricing about two cuts (47bps) by the December 18th meeting.
Markets are not expecting much activity from the Fed for a few months.
Two key central banks are under much more immediate market pressure.
Our friends in Tokyo and adversaries in Beijing both face acute currency vulnerability, pressure made significantly more intense by U.S. Bubble dynamics (i.e. loose conditions, “higher for longer,” and booming markets).
The Dollar Index gained 1.6% this week, almost all of the gain following Wednesday morning’s disappointing CPI report.
The dollar ended the week at a five-month high.
Bloomberg:
“Dollar Caps Best Run in 18 Months on Fed Rethink, Haven Bid.” The yen dropped another 1.1% to a new 34-year low.
April 11 – Bloomberg (Erica Yokoyama and Emi Urabe):
“Japan warned that it will consider all options to combat weakness in the yen after the currency slumped to its weakest level against the dollar since 1990.
Following weeks of flirting with the closely watched 152 level versus the greenback, the yen blew straight through this mark on Wednesday and all the way to 153 as US inflation data reverberated through global markets.
That’s put traders on alert for intervention by Japanese authorities, whose jawboning of markets has done little to change the downward momentum.
‘Whether this involves currency intervention or not, we authorities are prepared for all situations all the time,’ Masato Kanda, Japan’s top currency official, told reporters Thursday morning.”
Understandably, tough-talking Japanese officials are reluctant to start a fight with the markets.
After all, unsuccessful currency intervention would only embolden the speculators.
And it’s reasonable that the BOJ today worries more about a big bond market blowup than their weak currency.
A Friday Bloomberg headline:
“Japan’s 5-Year Yield Climbs to Highest Since 2011 Amid BOJ Bets.”
Japan tetters today uncomfortably close to a nightmare scenario of unsuccessful yen support, disorderly currency devaluation, and destabilizing bond market adjustment.
“Nightmare” is appropriate because of the risk that intervention to stabilize the bond market would generate liquidity to further pressure the yen.
There are said to be large option hedging positions struck at the 152 yen/dollar level, derivatives that raise the odds of disorderly trading.
There are also massive (Trillions?) yen “carry trades” – levered speculations that have worked marvelously throughout yen devaluation, yet turn problematic in a backdrop of acute currency instability and global de-risking/deleveraging.
April 10 – Financial Times (Demetri Sevastopulo and Kana Inagaki):
“The US and Japan plan to modernise their military command and control structures in what President Joe Biden said was the ‘most significant’ upgrade to their alliance since it was created decades ago.
Speaking alongside Japanese Prime Minister Fumio Kishida…, Biden said the allies were taking significant steps to ensure their militaries could ‘work together in a seamless and effective way’.
The US president added that the two countries had transformed their relationship into a ‘truly global partnership’ over the past three years, and that the alliance now served as a ‘beacon to their entire world’.”
More irony.
President Biden and Prime Minister Kishida were deep into strategic planning this week, fixated on the rising threat from Xi’s China (and friends).
In the near-term, the enemy of my enemy dynamic would suggest that Xi befriend Kishida, with both countries facing the growing threat of hostile market aggression.
If there was one critical lesson learned from the devastating 1997 Asian Tiger Bubble collapses, it was that pegged currencies should be avoided at all cost.
Well, Beijing of late has virtually hard-pegged the renminbi to the dollar.
Chinese officials don’t prefer a strong currency.
A weaker renminbi would bolster their massive export sector.
But when the PBOC somewhat lowered the renminbi trading band a few weeks back, all hell almost broke loose.
April 7 – Bloomberg (Tania Chen):
“China stuck to a pattern of keeping yuan weakness contained as pressure from a resilient dollar and poor investor sentiment pushes it toward a policy red line…
The PBOC has stepped in aggressively to stabilize the yuan on each of the five occasions it neared that policy red line in past years.
It has adopted tools ranging from verbal warnings to boosting the cost of short wagers against the currency.
The yuan has never moved outside of its permitted range in history.
So there is little guidance on what may happen to China’s spot market if the currency tries to touch the weak end this time around.”
Beijing has been forced into a hard currency peg to avoid the slightest indication of losing control.
The certainty afforded by pegs is accommodative to speculative flows and levered speculation. But pegs under pressure demand tough decisions.
The hope is always that some moral suasion (intervention threats) and financial resources (international reserves) buy some time for the return to relative stability.
It’s a gamble where the stakes compound over time.
Forces can materialize that thwart any return to stability – such as U.S. inflationary pressures, a Fed forced into “higher for longer,” spacious interest-rate differentials, and a dollar melt-up.
Beijing now faces the wretched decision of how long to cling to a peg that appears increasingly untenable.
As was the case in Asia in the nineties, circumstances can evolve into the classic throwing good “money” after bad.
How much of China’s international reserve position is Beijing willing to fritter away while accommodating myriad players – from Chinese savers to international speculators and investors to domestic institutional flows - anxiously seeking an exit?
Meanwhile, as Beijing seeks to limit the scale of reserves expended, it has called upon its bloated banks to lend support to the renminbi.
In the process, the banking system accumulates large dollar short positions and likely massive derivatives exposures.
So long as the hard peg holds, a semblance of stability endures.
Stealthily, however, potentially cataclysmic risk mounts below the surface.
The longer the hard peg is maintained, the greater the risk of a derivatives-related market dislocation if the peg is relaxed.
Countries prefer managed currency devaluations, aka measured adjustments to the peg.
But markets, recognizing that the first is rarely the last, tend to move aggressively upon any announcement of wider trading bands or incremental devaluation.
Hedging operations become only more urgent, raising the odds of a disorderly adjustment period.
How they might decide to play this predicament is unclear and critically important.
Beijing has certainly not helped its cause.
Desperately attempting to defy Bubble dynamics with a 5% GDP target ensures ongoing epic Credit excess and malinvestment.
China’s Aggregate Financing expanded $675 billion during March and $4.700 TN y-o-y, a nonproductive Credit growth without precedence.
Moving forward brazenly with plans for a dominant global currency and international superpower status despite a collapsing Bubble creates about the most unsettled backdrop imaginable.
China’s historic apartment Bubble deflation is at the cusp of taking a turn for the worse.
April 12 – Bloomberg:
“Concern is intensifying over state-backed China Vanke Co.’s ability to stave off default, defying efforts by authorities to shore up the cash-strapped developer’s finances.
The company’s stocks and bonds tumbled this week, leading an industrywide selloff, after S&P Global Ratings became the third major ratings company to cut the developer to junk territory…
Vanke, long considered among China’s most creditworthy property giants, is one of the few to avoid default.
‘Vanke is an icon of China’s real estate industry,’ said Yu Yingdong, general manager at Shenzhen Cowin Asset Management Ltd.
‘If a company like this can face such problems, it will only increase concern about the industry’s outlook.’
Vanke’s shares tumbled 13%... this week in their biggest loss since 2021, and closed at a decade-low.
A dollar bond due 2027 traded below 40 cents on the dollar, headed for its lowest level on record…”
Beijing has responded to its apartment Bubble collapse by doubling down on exports – notably EV, solar panels, batteries, and renewable technologies.
April 12 – Reuters (Ellen Zhang and Joe Cash):
“China’s exports contracted sharply in March while imports unexpectedly shrank, undershooting forecasts by big margins, highlighting the stiff task facing policymakers as they try to bolster a shaky economic recovery.
The dour data represented a setback for the world's second-largest economy…
Exports from China slumped 7.5% year-on-year last month by value…, the biggest fall since August last year and compared with a 2.3% decline forecast in a Reuters poll of economists.
They had risen 7.1% in the January-February period…”
Global demand for EVs has weakened just as China ramps up manufacturing capacity.
Meanwhile, global pushback against the great Chinese export machine gains momentum.
April 8 – Reuters (David Lawder):
“U.S. Treasury Secretary Janet Yellen warned China… that Washington will not accept new industries being decimated by Chinese imports, as she wrapped up four days of meetings to press her case for Beijing to rein in excess industrial capacity.
Yellen told a press conference that U.S. President Joe Biden would not allow a repeat of the ‘China shock’ of the early 2000s, when a flood of Chinese imports destroyed about 2 million American manufacturing jobs.”
Beijing is rapidly losing flexibility.
Desperate measures to grow out of Bubble problems risk burying its banking system in crummy loans, while impairing the global standing of Chinese government debt.
The world is watching.
April 9 – Reuters (Joe Cash, Kevin Yao, Ellen Zhang and Akanksha Khushi):
“Fitch cut its outlook on China’s sovereign credit rating to negative…, citing risks to public finances as the economy faces increasing uncertainty in its shift to new growth models.
The outlook downgrade follows a similar move by Moody's in December and comes as Beijing ratchets up efforts to spur a feeble post-COVID recovery…
‘Fitch’s outlook revision reflects the more challenging situation in China’s public finance regarding the double whammy of decelerating growth and more debt,’ said Gary Ng, Natixis Asia-Pacific senior economist.
‘This does not mean that China will default any time soon, but it is possible to see credit polarization in some LGFVs (local government financing vehicles), especially as provincial governments see weaker fiscal health.’”
We’re witnessing the world split in real time.
The Biden administration hosts Prime Minister Kashida and Philippine President Ferdinand Marcos Jr., while Canada and New Zealand voice interest in joining the AUKUS security pact.
Meanwhile, “Russia, China to Work on ‘Double Counteracting’ US-Led Alliance,” with Russian Foreign Minister Sergei Lavrov in Beijing this week for high-level talks.
CNN:
“China is Sending its Highest-Level Delegation to North Korea Since 2019 to Kick Off a ‘Friendship Year’.”
“China Slams US-Japan-Philippines Summit, Defends Actions in South China Sea.”
It's a reasonable bet that financial flows will continue their split from China.
Currently, it is a challenge to envisage an environment conducive to foreign investment returning to China.
Short-term and longer, the renminbi peg to the dollar appears indefensible.
A disorderly devaluation with major global ramifications is not a low-probability scenario.
Risk aversion is gaining momentum throughout Asia.
The South Korean won declined another 1.7% this week, boosting its one-month drop to 4.7%.
The Singapore dollar declined 0.9% (down 2.1% over a month), the Taiwanese dollar 0.7% (2.7%), and the Malaysian ringgit 0.5% (1.9%).
Over the past month, Thai baht has dropped 2.8%, the Philippine peso 2.2%, and the Indonesia rupiah 1.6%.
Friday trading saw the first inkling of de-risking/deleveraging in a while.
Gaining 0.7%, the Dollar Index closed Friday above 106 for the first time since November 2nd.
The VIX (equities volatility) Index traded intraday to 19.2 (closed at 17.31), the high since October 31st.
The MOVE bond market volatility index traded to the high (112bps) since February 22nd.
JPMorgan CDS rose three Friday to 45 bps, as major bank CDS posted their largest one-day gains since October.
Dropping 3.75%, the KBW Bank Index suffered its largest weekly loss since September.
Gold prices spiked Friday to an all-time high $2,432, before reversing sharply back to a $2,344 close.
Silver surged Friday to a three-year high of $29.79, only to close at $27.88.
Copper prices rose Friday to a new 14-month high, as the Bloomberg Commodities Index traded to highs since early November.
Platinum surged 5.0% this week.
Hard assets seem to sense trouble brewing in financial asset wonderland.
Ten-year Treasury yields closed Thursday trading at 4.59%, the high since November 13th.
Fledgling risk off saw Treasury yields reverse lower in Friday trading, with 10-year yields ending the session at 4.52%.
Benchmark MBS yields closed the week up 23 bps to 6.02% - trading this week to the highs since November 24th.
High yield CDS jumped 16.5 bps this week, the largest weekly gain since October.
High yield spreads widened seven bps, also the biggest increase back to October.
JPMorgan CDS rose five to 45 bps, as most U.S. bank CDS prices posted their strongest weekly gains since the first week of the year.
European bank (subordinated) CDS rose eight this week to 122 bps; European high yield (“crossover”) CDS surged 26 to 325 bps; and EM CDS rose nine to 179 bps – all three the largest weekly jumps since early January.
April 12 – Wall Street Journal Gordon Lubold, Benoit Faucon and Dov Lieber):
“The U.S. rushed warships into position to protect Israel and American forces in the region, hoping to head off a direct attack from Iran on Israel that could come as soon as Friday or Saturday.
The moves by the U.S. that are part of an effort to avoid a wider conflict in the Middle East came after a warning from a person familiar with the matter about the timing and location of the potential Iranian attack…
Army Gen. Erik Kurilla, the head of U.S. Central Command, discussed a possible Iranian attack with Israeli Defense Minister Yoav Gallant in Israel on Friday.
‘We are prepared to defend ourselves on the ground and in the air, in close cooperation with our partners, and we will know how to respond,’ Gallant said…”
Perhaps the Chinese can convince the Iranians to stand down - for now.
Yet it seems global tensions have escalated (on multiple fronts) to the point where markets can no longer disregard geopolitical risk.
I’ll be surprised if the past week doesn’t mark a shift from risk embracement to risk aversion, with Friday likely the onset of problematic de-risking/deleveraging dynamics.
A backdrop of market instability (currencies, bonds, equities, and commodities), geopolitical hostility, and acute uncertainty is not conducive to levered speculation.
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