Q2 2019: "What's Behind the Global Yield Collapse?"
The second quarter was extraordinary. Global markets were unsettled throughout the period. Building on first quarter momentum, U.S. equities posted solid April gains. Risk aversion began to take hold in early May. Chinese stocks reversed sharply, sinking almost 13% in ten sessions. A string of Chinese corporate defaults weighed on market sentiment, with contagion effects beginning to pressure the emerging markets. Powell’s early-May suggestion that inflation shortfalls were “transitory” aroused market memories of the “tone deaf” Fed from December. U.S./China trade negotiations broke down mid-quarter.
The S&P500 declined 5.6% in May, as the equities rally stumbled. Yet something much more intriguing was unfolding in global bond markets. Ten-year Treasury yields sank 38 bps during the month of May, near the low yield going back to 2016. German bund yields dropped 22 bps to a record low negative 21 bps. Japanese JGB yields fell to negative 10 bps, and Swiss yields ended May at negative 51 bps.
At that time, sinking yields were explained in the marketplace by the risk of an escalating U.S./China trade war, slowing global growth, and weakening inflation trends. Then June saw a reduction in trade tensions, capped off by the Trump/Xi G20 meeting and resulting “truce”. June posted a surprisingly strong 224k gain in U.S. payrolls, as economic data turned less concerning in the U.S. and globally. Crude and commodities prices rebounded strongly in June. Meanwhile, the global yield collapse ran unabated.
As frustrating as it was on the short side, it was a fascinating quarter from the analytical perspective of the global credit bubble and my overall thesis. I view the extraordinary surge in safe haven bonds – the collapse in yields – along with the surging gold price - as important corroboration of the thesis of vulnerable bubbles and mounting global financial fragilities.
German bund yields recently sank to a record low negative 40 bps, with Swiss 10-year yields down to negative 69 bps and Japanese yields at negative 18 bps. At a recent low of 1.95%, 10-year Treasury yields were down almost 150 bps since November. Italian yields were down over 100 bps since the end of May. Amazingly, Spanish and Portuguese yields dropped all the way to only 20 and 28 bps. Greek yields were down 150 bps in just six weeks to 2.00%. I think we’ve all become somewhat numb to incredible market dynamics.
Having been involved in the markets for some time now, I seriously doubt sovereign yields would drop precipitously to unprecedented low yields without some major festering global issue. Moreover, periphery debt such as Italian and Greek bonds would not experience such dramatic collapses without a significant market dislocation.
The collapse in yields recalls 2007’s second half, when Treasuries diverged dramatically from an equities market rallying to all-time highs. It’s also worth recalling that Treasuries suffered another bout of sinking yields in 2011 ahead of the 2012 European debt crisis.
Bond markets have a knack for sniffing out mounting risks and unfolding crises. It’s my view that global bond yields are signaling serious impending instability – and I believe China will be at its epicenter.
Every major bubble reaches a point of no return – where excesses have gone to such extremes that some level of crisis is unavoidable. I refer to the “terminal phase” of bubble excess. On the financial side, systemic risk rises parabolically with a surge in the quantity of credit of rapidly deteriorating quality. Invariably, too much of this suspect credit is held by highly leveraged institutions and speculators, while market dysfunction ensures resources are poorly allocated.
On the real economic side, there is a proliferation of uneconomic enterprises and deep structural maladjustment. The best policymakers can hope for is to provide support while allowing air to come out before the bubble inflates to dangerous extremes. But especially in today’s environment, no policymaker is willing to take the punch bowl away. Yet efforts to sustain the bubble risk catastrophic damage to the underlying financial system, currency and economy.
China experienced a faltering bubble episode in late-2015/early ’16. Aggressive reinflationary measures resuscitated China’s credit and economic bubbles. Beijing then moved to somewhat rein in credit excess last year - and their bubble again began deflating. China financial and economic fragility was at the epicenter of the fourth quarter’s global “risk off” dynamic that was reversed by the Fed’s dovish U-turn. Facing sinking markets and a weak economy - while in heated U.S. trade negotiations - Beijing one more time resorted to the accelerator.
It’s worth briefly highlighting China’s first-half credit data. Total Aggregate Financing – their measure of total non-government system credit - increased $1.921 TN during 2019’s first six months, fully 31% ahead of first-half 2018 growth. Total Aggregate Financing ended June at $31.19 TN, up almost 11% over the past year.
Even in the face of historic credit growth, ominous cracks have developed in China’s financial system. In late-May, Chinese regulators took control of Baoshang Bank, the first government bank seizure in 20 years. Even more dramatically, regulators imposed losses of up to 30% on some large institutional depositors and debt holders. These “haircuts” immediately raised questions for a marketplace that has for years boomed on faith in the implicit Beijing guarantee of virtually the entire Chinese financial system.
After the Baoshang takeover, dislocation unfolded in part of China’s $10 TN money market complex. Short-term funding rates – repurchase agreements, bankers’ acceptances, and interbank loans for small and mid-sized banks - spiked higher, as investors retreated from riskier segments of the marketplace. Market participants spoke of a loss of trust and fear of an unfolding liquidity crunch.
Enormous liquidity injections from the PBOC – and state-directed support from large financial institutions - restored calm, recalling how calm was repeatedly restored in the U.S. between the initial June 2007 subprime eruption and the onset of a full-fledged crisis some 18 months later.
Conventional thinking has it that the 2008 crisis was avoidable. If only Lehman hadn’t been allowed to fail. The Fed should have cut rates more aggressively, and perhaps even employed QE earlier. This is specious analysis.
The problem was - in 2007 there were trillions of mispriced securities and derivatives. Inflated home prices were unsustainable, and there were hundreds of billions of festering problems loans. Years of mispriced and misallocated finance had created deep economic structural maladjustment. There were enormous speculative excesses and leverage that posed great systemic risk. Both financial and economic circumstances were unsustainable: excesses from the long boom had made crisis inevitable. The Lehman collapse simply brought things to a head. As we ponder today’s bond yields, it’s important to note that the bond market back in 2007 had discerned the predicament long before Lehman lost access to “repo” financing.
While downplayed at the time, the June ’07 subprime eruption was the beginning of the end for the mortgage finance bubble. The hedge funds moved to cut risky mortgage exposure, and the marginal subprime home buyer almost immediately lost access to finance. This commenced a tightening of credit that began at the “periphery” and ended in a systemic crisis at the “core” of U.S. market-based finance.
The periphery of China’s credit system has experienced a meaningful tightening - that over time will reverberate throughout the system. Beijing has dictated the major state-directed banks to take up the slack, ensuring these bloated institutions add high-risk late-cycle credit to their already highly vulnerable loan portfolios.
Chinese finance now faces counterparty concerns along with more scrutiny of small banks, non-bank financial institutions, lower-rated local government financing vehicles, trust companies and other shadow lenders. Higher risk borrowers now face tightened credit conditions.
Of China’s almost $2.0 TN first-half lending, how much went to finance over-priced apartment purchases and how much was directed to uneconomic negative-cash generating enterprises? I’ll assume much of it. Over the past year, China’s debt load has increased to 303% of GDP from 297%, as each renminbi of credit generates less of a boost to economic output.
China’s already dire circumstances are compounded by the unfolding trade war with the U.S. American companies have begun the process of sourcing products outside of China, while manufactures operating in China are looking to relocate to more economic venues for supplying their U.S. customers. Trade deal or not, these two countries will reduce interdependencies.
China system debt is on pace to expand $4.0 TN this year, a credit boom that is masking festering financial and economic structural issues. I believe Chinese officials recognize risks associated with such lending excess, yet - under threat from the Trump administration - their near-term priority has been economic stabilization. When their bubble succumbs, they have a convenient scapegoat.
China’s bubble has passed the point of no return – and I believe crisis is unavoidable. Systemic risk now rises exponentially, raising the specter of a crisis of confidence in Chinese finance and the renminbi.
Importantly, Chinese finance evolved to become the marginal source of finance globally and the Chinese economy the marginal source of global demand. One cannot overstate ramifications for a crisis-induced plunge in China’s credit and economic growth. While China runs a huge trade surplus with the U.S., China has deficits with many EM economies. Chinese investment has been a major source of global growth, and Chinese tourists and students spend lavishly around the globe. And from corporate M&A to home buying, there’s been a powerful flow of “money” from the Chinese credit system to global asset markets. It is alarmingly reminiscent of the flow of U.S. bubble finance to the world in the late-twenties.
It’s my view that global bond markets have sniffed out an unfolding accident in Chinese credit - a highly destabilizing crisis of confidence that would be a catalyst for major market instability and bursting bubbles around the globe. From my perspective, risk is high for a global crisis much beyond the scope of 2008 – and I believe that’s what collapsing yields are signaling.
Markets now anticipate aggressive monetary stimulus – including multiple 2019 rate cuts from the Fed and a restart of ECB QE only months after concluding its latest $2.6 TN program. And the prospect of concerted open-ended QE has generated major market price distortions. Why buy German bunds at negative 40 bps, Slovakia bonds at 5 bps or Italian bonds at 1.6% - they are bought either because buyers expect to sell them to the ECB at even higher prices – or to hold them dearly to survive a crisis.
The expectation of unlimited and completely price insensitive central bank buying has created unprecedented distortions throughout global markets – starting at the foundation of international finance – sovereign debt.
Why not aggressively employ speculative leverage throughout global bond markets, confident in the stalwart central bank liquidity backstop? Why not lean on “risk parity” strategies, with their levered equities and bond holdings able to weather any market storm? Let me pose a most pertinent question: How much speculative leverage has accumulated over recent years – around the globe?
I’ll briefly digress. As the new Chairman, I do believe Powell preferred shifting to a strategy of not coming quickly to the markets’ defense – to allow the markets to begin the process of standing on their own. This would explain the Fed’s widely criticized December 19th rate increase in the face of unstable markets. But the rapid onset of acute market fragility forced the dramatic January 4th dovish U-turn - that was quickly adopted by the global central bank community. From the December experience, central bankers came to better appreciate the degree of market vulnerability. Meanwhile, markets more than ever recognized they held incredible sway over central banks.
Collapsing yields have provoked the latest iteration of New Age central banking activism – the “insurance rate cut” – Powell’s “an ounce of prevention is worth a pound of cure.” Markets have become abundantly confident that aggressive stimulus will be unleashed ahead of any onset of crisis dynamics. So, if QE purchases are set to commence at the first indication of trouble, why not use sovereign debt as a hedging vehicle to protect against declining risk markets?
Why use put options and other equities derivative strategies, when bond call options and fixed-income derivatives provide downside risk market protection while profiting handsomely - even as equities rise to records? I believe global bond markets have experienced a dislocation, fueled by self-reinforcing aggressive use of leverage; huge flows into bond and fixed-income ETFs; and unprecedented derivatives-related buying. The sellers of myriad bond call options and more sophisticated fixed-income derivatives have been forced to aggressively buy bonds to hedge exposures in a rapidly rising market. And anyone caught short bonds has been in a panic to reverse their trades.
This global market dislocation has surely spurred enormous amounts of additional speculative leverage, in the process creating self-reinforcing liquidity excess along with the perception of endless marketplace liquidity. And this is where it gets intriguing – and I believe where analysis sheds some light on an extraordinary global market backdrop.
Risks are escalating – China’s vulnerable credit system and economy; global trade wars and protectionism; weakening growth dynamics across the globe; and heightened EM fragilities. Over the past year, we’ve witnessed Argentina’s currency collapse 35%. Turkey has faced intense currency and bond market pressure. There are widening crack in India’s credit system, and Mexico is nearing recession - to name just a few EM issues.
Yet some of this year’s strongest returns have been with 100-year Argentine, Mexican and Petrobras bonds. India’s yields have sunk to 2016 lows. Turkey is still able to tap international markets. Already at $168 billion only midway through the year, EM bond issuance is at record pace and with record low yields.
Why the panic buying of bonds that could very well prove most vulnerable to the unfolding environment? Because market dislocation has created $13 TN of negative- yielding global safe haven bonds along with a surge of excess liquidity. Amazingly, it has been a case of too much “hot money” chasing too few global bonds. Despite the fundamental backdrop, it’s been a veritable flood of money into some the riskiest segments of global markets - EM, junk bonds, structured finance and some equity ETFs.
These days, the marginal borrower has virtually unlimited access to cheap finance. It recalls the summer of 2007 and the unrelenting boom in leveraged lending and M&A – Citigroup’s Chuck Prince and his infamous “still dancing” quote. Strange things happen at end-of-cycle speculative “blow-offs”. There’s just so much money being made – disregarding risk becomes an imperative.
The problem is - today’s extraordinary liquidity backdrop is highly unstable. The “dance party” can come to an abrupt halt. The liquidity bonanza created during “risk on” risk-taking and leveraging will disappear come “risk off’s” de-risking and deleveraging.
Today, virtually any company or country can tap the booming global debt markets. But today’s marginal borrowers are highly vulnerable to a bond market reversal. Just last week we saw yields jump 25 bps in Spain, 21 in Greece and 15 bps in German and France. Ten-year Treasury yields were up a quick 17 bps from lows.
There is risk of a surprising backup in yields. Markets had to digest June’s stronger-than-expected payrolls, inflation data and retail sales. The U.S. economy should receive some stimulus from record securities prices, low mortgage rates and several months of quite loose financial conditions. Things get interesting if the Treasury market starts to focus on massive supply, waning foreign demand and the potential for an upside inflation surprise. The “bid-to-cover” ratio at last Tuesday’s three-year auction was the weakest in a decade. But a Fed cut later this month appears a near certainty.
For now, global bond markets have been content to look through positive data and focus instead on mounting risks and forthcoming monetary stimulus.
While PBOC liquidity injections have calmed China’s money market, I expect this calm to prove fleeting. Crises often erupt in the money market, where dramatic consequences arise from even a subtle loss of confidence. There’s little room for error in a market where investors have near zero tolerance for risk. Runs can be unleashed when the perception of safety and liquidity is shaken. Clearly, huge risks continue to accumulate in what has become China’s massive money market. Losses are mounting throughout China’s banking and financial systems, and Beijing will not want to shoulder all the pain. The process of diluting Beijing’s implicit guarantees and shifting risk to the marketplace has commenced. This will induce heightened risk aversion – including in China’s susceptible money market.
It took 18 months from the initial subprime eruption to the 2008 breakdown. So, the timing of a Chinese crisis remains unclear. But I do believe the clock has started. Financial conditions in the money market have tightened, and there will be more financial players that find themselves in difficult predicaments. Everyone believes Beijing will support ongoing growth with whatever stimulus is required. Yet I believe global bond markets confirm my analytical thesis: We’re now very late in the game. Stimulus at this point only exacerbates excesses and imbalances, ensuring a more problematic Chinese and global crisis.
I’ve been closely monitoring Bubbles going back to Japan’s late-eighties experience. It’s always the same: Everyone is happy to ignore bubbles when they’re inflating. Bubble analysis, by its nature, will appear foolish for a while – and especially ludicrous during the late-cycle manic phase. But bubbles inevitably burst. There is no doubt that China’s historic bubble will burst, and I expect this will prove the catalyst for faltering bubbles across the globe – including here in the U.S.
The obvious transmission mechanism will be through the securities markets. Global markets have become highly synchronized – across asset classes and across countries and regions. Market-focused monetary stimulus has become highly synchronized, essentially creating a singular comprehensive global bubble.
I’ll note a particular circumstance that could catch global markets and policymakers by surprise: A dislocation in China’s “repo” securities lending market that reverberates throughout repo and derivatives markets in Asia, Europe and the U.S. This latent risk, in itself, could help explain the global yield collapse and market expectations for aggressive concerted monetary stimulus. When Chairman Powell repeats “global risks” in his talks these days, I think first to global “repo” markets, global securities finance and global derivatives.
I doubt it will take much for today’s “risk on” dynamic to shift to “risk off.” We saw in the fourth quarter how quickly things can begin to unwind – and this year’s notable excesses have only worsened fragilities. If there is as much speculative leverage globally as I believe, markets are highly vulnerable to de-risking/deleveraging developing into globalized market illiquidity. Global markets have become tightly interdependent, global derivatives trading closely intertwined and marketplace liquidity highly interconnected. I believe global bond markets and central bankers are today on the same page in fearing a “seizing up” of global markets. Importantly, the more intensely markets succumb to speculative melt-ups and upside dislocation - the greater the likelihood that market reversals unleash problematic illiquidity and dislocation.
Bubble markets have a history of going from record highs to serious trouble in a short period of time. Just last year, October’s record highs were not many weeks from December’s market swoon. Markets peaked only weeks before the ’87 crash and the Great Crash of 1929. And it’s typical for a final speculative “blow-off” to end the cycle – even with fundamental deterioration well under way. We saw this in Q1 2000 and again in Q4 2007.
Contemporary finance and policymaking are structured to support asset inflation and bubbles. The problem is - things function poorly in reverse. Markets have been in upside dislocation – fueled by speculative leverage, hot money flows, derivative-related buying and the like. We live in the age of near-zero rates, whatever it takes QE, index ETFs and passive investing, speculative leverage, algorithmic trading and derivatives – to make money ignore risk and just follow the trend. But when sentiment shifts – risk aversion, de-leveraging, outflows and derivative selling will quickly see serious liquidity issues. Central bank efforts to hold “risk off” at bay – backstopping liquidity, abolishing bear markets and recessions - has incentivized risk-taking and leveraging, creating only greater market distortions and fragilities.
The global bubble inflation has gone to precarious extremes, while central banks are left with depleted ammunition. They have adopted the notion of using their limited ammo early and aggressively to safeguard against a bigger problem later. This is dangerously flawed doctrine. I believe the global bond yield collapse is signaling this approach will prove highly unsuccessful.