Age of Uncertainty
Doug Nolan
Prioritize, or just go chronologically.
The beginning, middle, or end of the week? DeepSeek, the Fed or Trump tariffs?
Never a dull moment.
We live in an Age of Uncertainty – The Era of Nebulous.
Was Monday’s DeepSeek tech stock swoon the first crack – the beginning of the end – for the great AI mania?
Or pretty much a lot about nothing – a mere bump in the road soon forgotten?
Are financial conditions only “somewhat accommodative” and the system at a state of stability?
Does the Fed have its eye on the ball?
Do tariffs really not matter, as the stock market has signaled?
Or is faith that President Trump won’t do anything to upset the markets further evidence of manic speculative Bubble irrationality?
Matt Egan from CNN:
“Following up on [Axios Courtenay Brown’s] question from earlier about the stock market, how concerned are you, if at all, about a potential asset bubble brewing in financial markets?
How do relatively high market valuations factor into considerations about potentially lowering interest rates further?
Is that something that’s in the back of your mind?”
Chair Powell:
“So we look from a financial stability perspective at asset prices generally, along with things like leverage in the household sector, leverage in the banking system, funding risk for banks, and things like that. But it’s just one of the four things, asset prices are.
And yeah, I’d say they’re elevated by many metrics right now.
A good part of that, of course, is this thing around tech and AI, but we look at that.
But we also look at how resilient the households and businesses and the financial sector are to those things.
So, we look at that mainly from our financial stability perspective and we think that there’s a lot of resilience out there.
Banks have high capital, and households are actually overall, not all households but in the aggregate, households are in pretty good shape financially these days.
So, that’s how we think about that.
We also, we look at overall financial conditions, and you can’t just take equity prices, you’ve got to look at rates too, and that represents a tightening in conditions with higher rates.
So, overall financial conditions are probably still somewhat accommodative, but it’s a mixed bag.”
“We think that there’s a lot of resilience out there.”
I think there’s a lot of latent fragility.
The Fed should at least pay lip service to speculative leverage.
To completely avoid the subject – as if it doesn’t matter - raises a credibility issue.
After all, hedge funds and derivatives leverage were instrumental in market crises in 1994, 1998, 2008 and 2020.
The repo market was the epicenter of the 2008 market meltdown, while hedge fund “basis trade” deleveraging was instrumental in the eruption of pandemic crisis instability.
I have chronicled the ongoing historic inflation of “repo” and money market fund assets, while discussing the key role played by the proliferation of leveraged speculation.
The Fed is seeing all the same data and more.
Some new data points this week, courtesy of analysts at Barclays.
Doozies.
January 29 – Bloomberg (Alexandra Harris):
“Hedge funds’ long Treasury positions and repo borrowing grew in 2024, exceeding the peak reached in 2019…
Barclays strategist Joseph Abate wrote...
As of September, hedge funds’ long Treasury positions reached a record $2.1 trillion.
Positions have increased 44% since 2023 and are about $800 billion larger than their 2019 peak.
Similarly, repo borrowing increased by $900 billion, or 53%, since 2023.
Barclays assumes most of this is against Treasury collateral, but the breakdown is unclear.
About 40% of transactions were overnight.
Top 10 funds with repo borrowings accounted for 62% of total repo, or about $1.55 trillion…”
Definitely worth pondering: Ten hedge funds with $1.55 TN of repo borrowings, likely most used for levered “basis trade” positions in the Treasury market.
Hedge fund “repo” borrowings expanding 53% - apparently over nine months.
Sounds like conditions have been much too loose, with the makings to trample “a lot of resilience.”
The past year has experienced historic monetary inflation.
Monetary disorder was certainly spurred by the Fed signaling the end of rate hikes - and then stoked to precarious excess by 100 bps of rates cuts over three months.
While the Fed asserted “significantly restrictive,” levered speculation and resulting liquidity excess ensured financial conditions went from loose to recklessly so.
It was a blunder more consequential than “transitory.”
It will be interesting to see if history gets this right – the direct link between loose conditions, speculative leverage, liquidity overabundance, and the AI mania.
January 27 – Financial Times:
“Technology stocks tumbled on Monday after Chinese artificial intelligence start-up DeepSeek stunned Silicon Valley with advances apparently achieved with far less computing power than US rivals.
Shares…
Nvidia, one of the biggest beneficiaries of spending on AI chips, plunged almost 17%, wiping out almost $600bn of market value, a record loss for any company.
DeepSeek last week released its latest large language AI model, which achieved a comparable performance to that of US rival OpenAI, even though the company has previously claimed to use far fewer Nvidia chips.
Venture capital investor Marc Andreessen called the new Chinese model ‘AI’s Sputnik moment’, drawing a comparison with the way the Soviet Union shocked the US by putting the first satellite into orbit.
The results sent a shockwave through markets on Monday, as investors reassessed the likely future investment in AI hardware.”
January 30 – New York Times (Andrew Ross Sorkin, Ravi Mattu, Bernhard Warner, Sarah Kessler, Michael J. de la Merced, Lauren Hirsch, Edmund Lee and Vivienne Walt):
“Wall Street has been on tenterhooks about how Silicon Valley would respond to DeepSeek, the Chinese start-up whose low-cost artificial intelligence software threatens to undercut the pricey American approach to the technology.
So far, the answer appears to be: full steam ahead.
Meta and Microsoft… said they each planned to keep spending billions on A.I. And news reports about SoftBank’s talks to inject billions more into OpenAI suggest that deep-pocketed investors are still bullish on the ChatGPT creator.
Continuing to spend heavily on A.I. will be a ‘strategic advantage over time,’ Mark Zuckerberg, Meta’s C.E.O., told analysts…, defending plans to invest up to $65 billion…
And Amy Hood, Microsoft’s C.F.O., told analysts that her company — which plans to invest about $80 billion in A.I. this fiscal year — will grow such spending next year, though at a slower rate.”
I can’t claim to know much about AI.
I have, however, analyzed my share of speculative Bubbles.
The nineties tech Bubble was extraordinary, followed by a phenomenal mortgage finance and housing Bubbles.
China’s apartment Bubble was nothing short of mind-blowing.
But nothing compares to the AI Bubble for the potential for financial excess and resource misallocation.
Odds are reasonably high that Monday was the beginning of the end, reminiscent of the subprime mortgage eruption in June 2007.
It’s worth noting that the stock market posted record highs that October.
“Core” AAA MBS initially benefited from lower policy rates and flight away from the risky “Periphery” (subprime derivatives, ABS, and Alt-A mortgages).
Technology bulls take comfort from fortress “tech oligarchy” balance sheets, with more than sufficient resources available to pursue their spectacular AI investment programs.
The good news for the tech boom is that Microsoft, Alphabet, Amazon, Apple, Meta Platforms, and Oracle, along with major global operators and scores of smaller players, have loads of cash to spend.
The bad news is that this ensures epic over-investment and all the uncertainty that goes with it.
DeepSeek is important, providing compelling evidence of how completely detached this arms race became to economic reality.
The oligarchs will each spend hundreds of billions and then compete fiercely against each other, the Chinese, myriad major global players, and a number of resourceful smaller players.
Prospective economic returns to justify Trillions of investment dollars (including for energy infrastructure) this week seem even more illusory.
How this all plays out is highly uncertain.
DeepSeek is the first of what will be ongoing market surprises.
President Trump:
“The release of DeepSeek, AI from a Chinese company, should be a wake-up call for our industries that we need to be laser-focused on competing to win.”
I don’t think “wake-up call” applies so much to the tech oligarchy.
Pocket books flung wide open, they’re in it to win it – each and every one of them.
It’s more that financial markets will wake from the dream.
Markets have been in an exceptionally deep and enchanting sleep.
The waking process will come in fits and starts – unless a nightmare sparks a panic attack.
The Credit market – especially “private Credit” and leveraged lending – is at this point so overheated it could take some time for reality to sink in.
I expect the sophisticated levered players to appreciate that the game is now rapidly changing.
But with so much at stake, there’s no reason to expect the tech bulls to easily roll over.
It’s interesting.
I struggle to see the harmony between an IA Bubble and a populist movement.
With all the talk of our economy needing to boost manufacturing and become more self-sufficient, wouldn’t it make common sense for some of the Trillions to be spent on and for AI to be more equitably allocated to other industries throughout the economy – especially to small town and working-class communities?
It sure appears that the cost of our insatiable appetite for imported goods is about to inflate.
January 13 – Bloomberg (Jennifer A. Dlouhy):
“President Donald Trump said he would impose tariffs on a wide range of imports, including oil and metals, in the coming months, expanding his plans to enact sweeping trade levies well beyond those set to hit China, Canada and Mexico on Saturday.
‘We’ll be doing pharmaceuticals and drugs, medicines, etc., all forms of medicine and pharmaceuticals.
And we’ll be doing very importantly on steel and we’ll also be doing chips and things associated with chips,’ Trump said Friday from the Oval Office…
‘We’re going to put tariffs on chips.
We’re going to put tariffs on oil and gas.
That will happen very soon, I think about the 18th of February.
And we’re going to put a lot of tariffs on steel,’ he added.
Trump said there was nothing Canada, Mexico or China could do to forestall the more immediate levies…
And Trump told reporters that the US would ‘be doing something very substantial’ with tariffs targeting the European Union.”
Markets may also need a wake-up call on tariffs.
Speculative markets are notoriously capable of disregarding (for a while) developments at odds with the bullish narrative.
Stocks are convinced President Trump won’t do anything that would put the great bull market at risk.
He’s either bluffing on the tariffs, or more likely it’s just a negotiating ploy that will be quickly resolved when our trade partners cave.
Considering the backdrop, market composure was impressive.
Nvidia’s 15.8% decline was a shock.
But the unfolding bullish narrative has the market flowing into a beautiful rotation from “Mag Seven” to the broader market.
That’s all well and good.
But who’s going to buy all the over-owned tech stocks when The Crowd is unloading?
And what about all the speculative leverage throughout big tech and related indices?
There’s also the issue of derivatives market “insurance” that takes on a life of its own in a slumping market.
In my mind, a key issue is how much volatility can be tolerated – and for how long - before the market snaps.
It was curious to see the market Monday pricing an almost eight bps lower December Fed funds rate (3.83%), as market rates begin to factor in probabilities of market instability triggering a response from the Fed.
Below is an excerpt from Thursday’s McAlvany Wealth Management Tactical Short Q4 recap conference call (with me and David McAlvany): “Historic ‘24 Excess Portends Precarious 2025.”
I struggle how best to put Q4 and 2024 excess into proper historical context.
We’ve witnessed the extraordinary for so many years that it has become business as usual.
My analytical framework generates maxims, including how, “things turn crazy at the end of cycles.”
As noted in past calls, my macro analysis journey began in the eighties, witnessing market volatility and an equities bubble, the 1987 stock market crash, Greenspan’s liquidity assurances, and the reemergence of a more systematic bubble in credit, commercial real estate, junk bonds, LBOs, and various Wall Street excess.
Post-bubble, this era was called the “decade of greed.”
Greater Fed reflationary measures stoked the nineties tech bubble.
That faltering bubble provoked a stronger reflationary response – and a much greater mortgage finance bubble.
A more powerful bubble deflation – and the so-called “great financial crisis” – provoked an historic reflationary response from the Bernanke Fed.
But that period’s trillion-dollar QE “money-printing” operation was dwarfed by the Powell Fed’s $5 TN dollar pandemic response.
My fascination was piqued in the nineties, and I’ve spent more hours studying the “Roaring Twenties” period than I care to admit.
The analytical framework and perspective I developed through my analysis of that most critical period in U.S. history are fundamental to how I view “Roaring Twenties 2.0.”
A critical debate arose after the “Roaring Twenties” boom ended with the 1929 crash and Great Depression: The conventional Milton Friedman/Ben Bernanke view - materializing decades later - holds the Fed directly responsible.
More specifically, they target the Fed’s late decade tightening measures, along with their failure to print sufficient money as the boom faltered.
Not coincidently, the Fed stops short of tightening financial conditions, while erring on the side of monetary inflation.
I’ve studied enough contemporaneous analysis from the twenties to take strong exception to revisionist dogma.
It’s certainly comforting to believe that era’s prosperity – the so-called “golden age of capitalism” – was sound and sustainable, if not for unenlightened policymaking.
We don’t hear central bankers, politicians, or even academics these days beckoning for tighter financial conditions necessary to restrain bubble excess.
The key enduring lesson from the original “Roaring Twenties” period should have been how dangerously bubble inflations evolve over years of easy money and policy neglect.
Risks to market, economic, social, and geopolitical stability are much too great to allow credit and speculative excess to run unchecked year after year.
Years ago, I incorporated elements of Austrian economics into my analytical framework.
There’s no doubt in my mind that the 1929 crash and Great Depression were the consequences of a protracted cycle of egregious financial excess - the evolution of a deranged financial apparatus that promoted unprecedented resource misallocation, and resulting deep financial and economic structural maladjustment.
Leveraged speculation – including broker call loans and highly leveraged investment trusts – was instrumental in years of systemic liquidity-overabundance.
Monetary disorder stoked self-reinforcing asset inflation and speculative excess, spending distortions, and epic mal-investment.
At this point, there should be little debate: Today’s “Roaring Twenties” excesses are the most extreme since that fateful period a century ago.
Critical long-forgotten lessons from America’s worst bubble experience are most germane: Unchecked asset inflation and speculation are pernicious.
Spending and investment fueled by liquidity emanating from leveraged speculation are self-reinforcing, but unsustainable.
Major bubbles create latent fragilities, and bubbles don’t work in reverse.
There is no cure other than to ensure that bubbles aren’t allowed to inflate indefinitely.
And something else pertinent from my study of that period: manias are incredibly insidious and powerful.
An astonishingly few in 1929 recognized how fragile the system had become late in the cycle – with speculators, investors, economists, Wall Street, bankers, central bankers, and government officials all captivated by markets in the throes of manic excess.
The two “Roaring Twenties” share key dynamics – both were extraordinarily protracted cycles characterized by rapid credit growth; prolonged speculative asset bubbles; far-reaching deviations in investment spending and momentous technological and financial innovation.
I’ll add that historic bubble inflation has a prerequisite: the environment and prospects must appear exceptionally bright – demonstrably promising.
Indeed, phenomenal technological innovation and development, along with deep-rooted optimism, are part and parcel to spectacular bubbles.
David and I have done many of these calls.
I’ve delved deeply into my analytical framework and thesis.
There’s part of my psyche that would almost prefer to say, “OK, I’m wrong on this history’s greatest bubble thesis - ready to get on with life.”
The problem is the evidence of bubble excess is unequivocal and turns only more powerful by the quarter.
From economic data to market behavior to social, political and geopolitical dynamics - from all directions come convincing thesis corroboration.
After such a long cycle, everyone is numb.
But the key takeaway from this call is that late-cycle excesses lurched to a more extreme, more precarious juncture.
I’ll share some examples.
Global issuance of corporate bonds and leveraged loans last year surged 30%, from 2023’s level to $8 TN (LSEG).
Total U.S. corporate debt issuance ballooned more than 30% to $1.96 TN.
Companies borrowed $2.22 TN of risky leveraged loans, more than double 2023’s level.
Municipal debt issuance surged 32% to a record $508 billion.
While data is scant, the historic boom in “private credit” turned increasingly manic.
The lack of transparency is an issue for what is essentially lightly regulated risky “subprime” corporate credit – too much of it funneled into annuities and other popular retail insurance products.
And a sign of the times from Bloomberg:
“The world’s 500 richest people got vastly richer in 2024, with Elon Musk, Mark Zuckerberg and Jensen Huang leading the group of billionaires to a new milestone: A combined $10 trillion net worth.”
“The eight tech titans alone gained more than $600 billion…, 43% of the $1.5 trillion increase among the 500 richest…”
Signs of runaway speculation are everywhere: For a fifth straight year, the Chicago Board Options Exchange reported record trading volume across its four US options exchanges – last year reaching 3.8 billion contracts.
Here, I’ll quote:
“Trading in options expiring the same day averaged more than 1.5 million contracts a day in the last three months of 2024, accounting for 51% of the overall S&P 500 Index options volume…”
Last year saw record trading in interest-rate and equities futures contracts.
Another quote:
“Trading volume for centralized crypto exchanges hit a record high of $11.3 trillion in December…
The Bitcoin network completed more than $19 trillion in transactions last year, more than doubling… 2023.” (Bitcoin News)
Average daily corporate debt trading surged 21% y-o-y – and it was a record year for Treasury futures trading.
Quoting from the WSJ: “Investors plowed more than $1 trillion into U.S.-based exchange-traded funds in 2024, shattering the previous record set three years ago…
Total assets in U.S.-based ETFs reached a record $10.6 trillion at the end of November…”
Collapsing risk premiums also evidence extreme market risk embracement: Investment-grade yield spreads versus Treasuries narrowed to as little as 73 bps in Q4 – the lowest level all the way back to March 2005.
High yield spreads narrowed to 253 bps – the low since June 2007.
High yield spreads traded last week only three bps off those lows.
Money market fund assets – or MMFA – expanded $873 billion, or 14.6%, last year.
Even more remarkable, MMFA ballooned at a blistering 27% pace during the final 22 weeks of the year, a period when the Fed aggressively loosened policy.
MMFA expanded an incredible $2.29 TN, or 50%, since the Fed began “tightening” in March 2022 – and $3.21 TN, or 88%, since the start of the pandemic (February 2020).
This unrelenting historic monetary inflation basically goes unreported – completely overlooked by Wall Street analysts, the economic community, and even the Federal Reserve.
I have previously discussed the interplay between the proliferation of levered speculation and growth in money market assets.
The highly levered Treasury “basis trade” reportedly surged to a record $1.15 TN (from Bloomberg) by early November – and I suspect rapid growth has been ongoing.
Some major hedge funds finance levered Treasury holdings in the “repo” market, playing the tiny spread between cash bonds and their Treasury futures short positions.
This expansion of “repo” borrowings generates new marketplace liquidity intermediated through the money market complex, resulting in an expansion of money fund assets.
Examining the data, total system “Repo” assets inflated $678 billion, or 30% annualized, during combined Q2 and Q3 - to $7.4 TN.
Broker/Dealer Assets surged $341 billion, or 26% annualized, during Q3 to a record $5.53 TN – with one-year growth of 16.2%.
Here’s a data point with huge ramifications: “Repo” assets inflated $2.58 TN, or 54%, over 19 quarters.
Powerful system-wide credit growth is unrelenting.
Non-Financial Debt (NFD - from Fed Z.1 data) expanded $3.47 TN over the 12 months ended September 30th.
For perspective, NFD expanded $2.53 TN in 2007 - an annual record that held all the way until the pandemic.
Treasury issuance continues to dominate system credit growth.
At Q3’s end, Treasuries had inflated $1.97 TN over the previous year; $3.97 TN over two years; and a reckless $10.96 TN, or 66%, over the past 19 quarters.
This historic expansion of money and credit is the fuel inflating a once-in-a-century securities bubble.
Total Debt and Equities Securities inflated $24.5 TN, or 19.0%, over the previous year, and $58.7 TN, or 62%, over five years – to a record $153 TN.
And one of my favorite bubble ratios: Total Securities ended Q3 at 522% of GDP, dwarfing cycle peaks of 375% from Q3 2007 and 357% during Q1 2000.
And to continue this chain of bubble analysis, Household Net Worth (Assets less Liabilities) inflated $17.2 TN, or 11.4%, in the 12 months ended September 30th - to a record $169 TN.
Net Worth inflated $50 TN over 17 quarters, or 42%.
Another illuminating bubble ratio: Household Net Worth ended September at 575% of GDP, eclipsing previous cycle peaks 488% in Q1 2007 and 444% during Q1 2000.
This flurry of numbers will have to suffice for “egregious ‘24 excess.”
I refer often to the concept of “terminal phase” excess – and for good reason.
Late-cycle blow-offs are self-destructive.
For one, manic speculative excess is unsustainable.
Fragility grows as the crowd pushes the limits of risk embracement – the bounds of exuberance and leverage.
Meanwhile, system stability is compromised by a parabolic rise in systemic risk – with the expansion of ever-larger quantities of increasingly risky credit.
The ongoing boom in “private credit” deserves a mention.
As an analyst who watched in disbelief as subprime loans and related derivatives ballooned during the mortgage finance bubble’s “terminal phase”, the current manic fervor throughout subprime corporate credit and leveraged lending is even more alarming.
For too long, finance has remained readily available for unprofitable and financially suspect companies.
As always, high risk lending appears almost miraculous, so long as companies enjoy unending market access to fund operations and roll over maturing obligations.
But when the music stops, the system faces a deluge of negative cash-flow enterprises and painful debt and economic crises.
With this subprime corporate debt boom in mind, some thoughts on the historic AI bubble.
This really is the embodiment of late-cycle overkill – more precisely, multi-decade super cycle “terminal” excess.
We’re talking about an epic spending black hole – literally trillions for data centers, computer servers, energy and cooling infrastructure, software development, corporate AI implementation, and so on.
And while artificial intelligence will surely have momentous positive impacts, prospects for profits sufficient to justify trillions of expenditures are anything but clear.
History informs us that these kinds of runaway manic speculation, borrowing and spending bubbles ensure a legacy of losses, insolvent companies, malinvestment, and deep structural maladjustment.
Hundreds of Internet companies failed with the collapse of the late-nineties tech bubble.
Most Internet IPOs from that period filed for bankruptcy.
The proliferation of “Roaring Twenties”-era radio and communications companies suffered a similar fate.
It was a most pivotal election in November, and on the third day of President Trump’s term, he announced an AI joint venture with Softbank, OpenAI, and Oracle - with a $500 billion investment goal.
I imagine Elon Musk and other industry heavyweights will redouble their AI efforts.
Friday, Meta Platforms announced plans for $65 billion of AI-related spending this year, 27% ahead of what analysts expected – including a new data center “so large that it would cover a significant part of Manhattan.”
And then Monday markets were rocked by a small Chinese AI startup named DeepSeek – with its low-cost and impressive AI tool.
Nvidia was slammed 17% - with the $560 billion evaporation of market capitalization the largest in history.
The Semiconductor index sank 9%. Suddenly, key aspects of the bullish narrative look flimsy.
Beyond tech - energy and utility stocks, which had been rising to the moon, abruptly headed back to earth.
President Trump called it a “wake-up call.”
This historic late-cycle global arm’s race is led by an extremely well-capitalized tech oligarchy, scores of technology operators globally, increasingly by governments desperate not to be left behind, and overheated debt markets enamored by high-yielding credit.
Risks of overheating are rising.
An economy that has been expanding at a 3% pace, with historically low unemployment, will now receive additional stimulus from the tech investment boom, weather catastrophe rebuilding in North Carolina, Florida, California and elsewhere, and a vigorous Trump 2.0 pro-growth agenda.
President Trump is determined to spur an economic boom.
With lending and system credit growth already overheated, it’s a delicate juncture in the cycle for aggressive financial and economic deregulation.
Ten-year Treasury yields, at 3.65% the session before the Fed began cutting rates in September, ended the year 92 bps higher.
Importantly, yields today are almost 100 bps higher in the face of the Fed’s 100 bps of rate cuts.
This is definitely not what Wall Street and the Fed had anticipated – and I believe this unusual move portends bond market struggles ahead.
It challenges the view that central bank rate cuts are always available to bolster markets in the event of instability.
Importantly, the surprising yield surge unleashed instability at the vulnerable global “periphery”.
For the quarter, yield spikes included Panama’s 177 bps, Brazil’s 137 bps, and Mexico's 99 bps.
Many EM bond yields surged to multiyear highs, with currencies also under pressure.
Losses for the quarter included 18% for the Russian ruble, 12% for the Brazilian real, and 11% for the South Korean won.
For the year, the Argentine peso declined 22%, the Brazilian real and Russian ruble 21%, and the Mexican peso 19%.
UK yields surged 56 bps during the quarter - and then spiked an additional 32 bps in early January to 4.89% - the high back to July 2008. Recall the UK “gilts” market suffered a bout of deleveraging back in Autumn ‘22.
The bond market revolted against new UK Prime Minister Liz Truss’s budget – cancelling her term after only 49 days.
I draw attention to this event, viewing it as a key juncture for global markets: the reappearance of the long-lost “bond vigilantes” – traders taking things into their own hands – drawing a line and finally imposing discipline on spendthrift governments.
We saw during Q4 and early in January discipline beginning to be imposed universally.
There is today elevated risk that the “vigilantes” turn their sights on U.S. Treasuries.
The Fed committed a major error, slashing rates with quite loose financial conditions, economic resilience, and sticky inflation.
Core CPI was at 3.2% in December, having declined only a tenth over the previous six months.
Expected one-year inflation from the University of Michigan’s January survey jumped to 3.3% - matching the high since November ‘23.
The risk of bond market instability is high and rising.
The Trump administration could enjoy a bit of a bond market honeymoon, especially if tariff directives are not as forceful and urgent as feared – or if equities falter.
Speaker Johnson has announced an aggressive legislative schedule, with plans to pass “one big, beautiful bill” within three months.
Congress will extend the Trump’s tax cuts while lowering the corporate tax rate.
The President reiterated his pledge to exclude tip income from taxation.
He also campaigned to eliminate taxes on overtime pay and social security.
Discussions are ongoing to boost the state and local tax deduction.
As GOP lawmakers jostle for constituent benefits, The Wall Street Journal ran with the headline, “Tax-Cut Wish List Grows for Trump’s ‘Big, Beautiful Bill.”
And, at this point, meaningful cost cutting is a work in progress.
President Trump may move forward on an aggressive tariff regime, using prospective tariff revenues to partially offset new tax cuts.
The bond market could take a dim view of the unfolding budget process.
There are unrecognized bond market vulnerabilities.
I mentioned earlier the instability that erupted at the global “periphery” during Q4.
There has been meaningful “carry trade” de-leveraging, especially in the emerging markets.
“Carry trades” proliferated over recent years, expanding to become a major source of global liquidity.
Speculators borrowed at low rates in developed markets, such as Japan, to lever in higher-yielding bonds from developing Latin America, Asia, and Eastern Europe.
Importantly, there is a “doom loop” dynamic associated with EM de-risking/deleveraging.
The unwind of speculative leverage drives outflows, currency weakness, and EM central bank currency intervention, with forced selling of Treasuries, upward yield pressure, and more deleveraging.
And deleveraging is a liquidity destroyer.
There are complexities and analytical nuance.
Instability at the “periphery” typically has initial benefits for the “core.”
The Dollar Index surged 7.6% during Q4, the largest quarterly advance since Q1 2015.
Dollar strength supported international flows into U.S. markets, with Treasury inflows helping offset EM central bank liquidations.
Importantly, after short-lived benefits, deleveraging at the “periphery” elevates risk at the “core.”
Contagion sees risk aversion and waning liquidity begin to gravitate toward “core” markets.
Over recent years, initial bouts of “periphery” instability were reversed by a powerful combination of a booming “core,” declining global yields, and general liquidity overabundance.
It’s not clear to me that “risk off” would today be mitigated by such constructive dynamics.
As noted earlier, the Fed slashed rates 100 bps, yet Treasury yields surprised with a 100 bps surge.
This new dynamic raises serious issues with respect to the efficacy of Fed and central bank market backstops – with major ramifications for the risk vs. reward calculus throughout leveraged speculation.
I’ll rephrase this important point: When sophisticated leveraged players begin to question whether central banks can maintain liquid and stable markets, some paring of risk and leverage will be forthcoming.
This is especially pertinent for the highly levered Treasury “basis trade.”
And with markets so overheated and over-levered, deleveraging at the margin is now more likely to trigger a systemic de-risking/deleveraging dynamic.
I doubt the booming “core” can continue to bail out the fragile “periphery.”
At this point, intensifying “core” bubble excess poses clear and present inflation risks that will keep Treasuries on edge.
The election sparked a meaningful boost to confidence, apparent in comments from corporate CEOs and the heads of financial institutions, along with the spike in small business optimism to a more than six-year high.
From the perspective of de-leveraging risks and heightened bond market vulnerability, this is a high-risk juncture for an aggressive pro-growth policy agenda.
The second term of a most determined “disruptor” administration is replete with extraordinary uncertainties.
While the course of tariff and trade policy is unclear, the risk of unfolding trade wars is high.
I don’t see countries easily rolling over for what is viewed as Trump bullying.
For now, I lean on the view that the President will aggressively wield the tariff flamethrower; that our trade partners are poised to retaliate; and that higher import prices will be an issue.
And keep in mind that goods price disinflation was instrumental in cooling CPI - offsetting sticky services and shelter inflation.
There’s talk on Wall Street and within the economic community that tariffs are a one-time price issue with only marginal enduring inflationary impact.
I’m skeptical of this sanguine view – sentiments I expect the bond market to share.
Considerable uncertainty exists regarding the scope of the administration’s immigration crackdown – with ramifications for already tight labor markets.
Again, there are extraordinary facets to the current environment.
Huge weather-related rebuilding challenges lie ahead – and we can presume more disasters will strike.
Average hourly earnings increased about 4% over the past year.
Until the pandemic, it had been decades since earnings inflated at such a pace.
Our system today is impacted by myriad of what I call “inflationary biases,” significantly raising the odds of inflation surprises.
Much is outside administration and Federal Reserve control.
Returning to President Trump’s announcement of a major AI initiative: This will only intensify China’s determination not to be outdone by U.S. efforts.
China’s 2025 prospects.
Beijing has expended extraordinary stimulus to hold bubble deflation at bay, with mixed results.
2024 was another dismal year in China’s ongoing apartment bubble collapse.
Yet enormous spending on myriad new technologies - electrified vehicles, clean energy tech, renewable energy infrastructure, and the like, offset weak apartment construction and consumption.
While down from 2023, massive $4.5 TN system credit growth was instrumental in sustaining growth.
But it’s increasingly apparent that enormous export-focused investment spending is unsustainable, especially with the return of President Trump.
Financial stress is mounting within both local government finance and China’s bloated banking system.
Markets have been frustrated by Beijing’s hesitancy to call out the stimulus bazookas.
But ballooning non-productive credit risks unleashing destabilizing currency instability.
China’s renminbi traded to 16-year lows to begin the year.
This is a critical juncture for China – with risks including intensifying bubble deflation, economic depression, financial system fragility, and currency vulnerability.
I’ll assume Beijing prioritizes expending whatever stimulus it takes to hold crisis dynamics at bay.
And Xi Jinping will demand measures that give China the strongest position for heated trade negotiations.
The exportation of Chinese disinflation significantly contributed to weaker goods prices and lower inflation in the U.S. and globally.
This important inflation dynamic is now at risk.
Beijing will be compelled to adopt more consequential reflationary policies.
And how much tariffs increase will depend on trade negotiations.
President Trump will surely be tough, focusing on Beijing’s failure to honor past commitments.
I expect Xi Jinping to be unwavering in his resolve not to be bullied.
Trump’s team goes into trade talks confident they enjoy the upper hand over a weakened China.
If the U.S. side overplays its hand, China could raise the issues of its Treasury holdings and Taiwan.
Economically, China is in a weaker position.
But Xi Jinping could play hardball, believing the booming U.S. has more to lose.
Generally, I see an unfolding clash from the extraordinary power President Trump enjoys domestically and his propensity to project such power internationally.
I expect much of the world to convey a low threshold for being pushed around by an in your face “America first” administration.
Trump is eager to brandish tariffs and sanctions, as we saw Sunday after Colombia refused to accommodate U.S. deportation flights.
From the Financial Times:
“Mexico and Canada forge united front in face of Donald Trump’s tariff threats.”
I expect more nations to participate in an informal anti-American trade threat alliance.
Much depends on whether President Trump backs down or doubles-down.
Add trade war risk to an already hyper-risky geopolitical environment.
Exuberant U.S. risk markets are incredibly complacent in the face of myriad current and festering risks.
Last year’s historic excesses – credit, speculation, speculative leverage, and the AI and crypto manias for starters – intensified latent fragilities.
History informs us of the precarious nature of speculative blowoffs.
They’re unsustainable and prone to abrupt and destabilizing reversals - with a propensity for triggering panic, dislocation, and market crashes.
I remember clearly the backdrops for notable market blowups in 1987, 1994, 1997/98, 2002, 2008, 2012, and 2020.
Without a doubt, the current environment has risks that dwarf previous booms.
So many things without precedent: Historic market speculation and public participation; millions trading stocks and options from their computers, tablets, and phones; $10 TN of ETFs; a $7 TN money market fund complex; approaching $8 TN of “repos”; unprecedented speculative leverage in stocks, Treasuries, and fixed-income; and hundreds of trillions of derivatives.
Let there be no doubt, over indebtedness and myriad bubble fragilities pose clear threats to system stability.
I am not resorting to whackoism or histrionics.
There has been nothing with comparable risks in almost a century.
When I ponder the dichotomy between today’s near universal optimism and a lengthy list of things that could go terribly wrong, I think of a comment made just days ahead of the 1929 market crash from the eminent American economist Irving Fisher: “Stock prices have reached what looks like a permanently high plateau.”
I’ll conclude again with my simple wish: I hope I’m wrong.
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