Q1 2021: “Contemplating an Inflection Point.
I’m compelled to begin the analysis with an update of this unbelievable monetary environment. Federal Reserve credit has inflated almost $3.6 TN over the past 58 weeks – and was up $3.9 TN – more than doubling – in just 83 weeks. After beginning 2008 at $850 billion, Fed assets are on course to surpass $8 TN in a few months.
The Fed now reports money-supply data monthly. As of the end of February, M2 had expanded $4.2 TN, or 27%, over the past year to a record $19.7 TN. Institutional Money Fund assets – not included in M2 – were up another $700 billion.
March’s $660 billion shortfall pushed the first-half fiscal year federal deficit to $1.7 TN. Washington borrowed 70 cents of every dollar spent during March and 50 cents of each dollar for the quarter. It’s a data point difficult to get off my mind: Washington ran an 18-month fiscal deficit of $4.8 TN, or almost 25% of GDP – and is on track for back-to-back $3.0 TN plus annual deficits.
I can’t do this historic monetary inflation justice without delving briefly into key data from the Fed’s Z.1 report – data that receives little attention.
U.S. Non-Financial Debt surged $6.8 TN during 2020, almost triple 2019’s $2.5 TN increase. For perspective, non-financial debt expanded on average $1.83 TN annually over the previous decade. Treasury Securities surged $4.6 TN during 2020, or 23%. After concluding 2007 at about $8.0 TN, Treasury Liabilities ended the year at $26.4 TN.
Total Non-Financial Debt ended the year at $61.2 TN, a record 292% of GDP, having increased 83% since the end of 2007. Non-Financial Debt ended 2019 at 254% of GDP, up from 230% to finish 2007 and 189% to end 1999.
Over the past six quarters, Total Debt Securities – Treasuries, agencies, corporates, munis - jumped $8.2 TN, or 18%, to $53.9 TN. History offers nothing comparable. At 251% of GDP, the Total Debt Securities ratio compares to 200% in 2007, 157% to end the nineties; 126% to end the eighties; and 74% to conclude the seventies.
Total Securities – combining Debt and Equities - ended Q1 at a record $118 TN. At 551% of GDP, this compares to cycle peaks 379% in ‘07 and 359% during Q1 2000. Total Securities ended the eighties at 194% and the seventies at 117%. And with the value of securities inflating to new records, Household Net Worth reached an all-time high $130TN. Net Worth ended Q1 at 606% of GDP, dwarfing previous cycle peaks - 492% in 2007 and 446% in early 2000.
What we’re witnessing is nothing short of history’s greatest runaway global monetary inflation, and monetary disorder has taken root everywhere, most conspicuously throughout asset markets. Importantly, we witnessed during the quarter a wild speculative mania take hold in U.S. markets.
Amazingly, stock funds attracted inflows in excess of $500 billion over the past five months. Think of this: Inflows in five months exceeded flows received over the previous 12 years. This data is from BofA, which likened the stampede to a speculative “melt-up.”
In addition to the tsunami of flows, investors in February had accumulated a record $814bn of margin debt. That was up almost 50% from a year ago, the strongest growth since prior to the ‘08 crisis. And from Z.1 data, Broker/Dealer Loans expanded a record $100 billion, or 84% annualized, during the fourth quarter, with a 2020 gain of 40%.
I’ve seen a lot of crazy over my career that goes back a few decades. I lived through incredible short squeezes in the nineties that I thought were surely a once-in-a-career anomaly. But Q1 was replete with really unimaginable market excess.
The stock of video game retailer GameStop surged from $19 to $483, one of many targets in the phenomenal “meme stock mania.” And the larger the short interest the greater the buzz in the stock chat universe.
After the Goldman Sachs Most Short Index’s 38% Q4 return, how could things possibly get any worse on the short-side? But they did, as a historic “short squeeze” captivated the entire marketplace. The Goldman Short Index returned almost 34% during Q1. Notable Q1 gains included GameStop’s 908%, AMC Entertainment’s 382%, and Express’ 342%.
The short side has been an unmitigated disaster. Assets at the actively-managed bear mutual funds are now down more than 90% from peak levels. Few short only hedge funds remain in business. The big squeeze also bludgeoned long/short strategies, most notably the $12bn dollar Melvin Capital that sank 49% during the quarter.
Excess was also on display in a booming IPO marketplace. About 300 SPACs – special purpose acquisition companies - launched on U.S. exchanges, raising almost $100 billion. It was the strongest U.S. IPO market since bubble peak Q1 2000.
Excess was anything but limited to equities, as ultra-loose financial conditions fueled excess everywhere.
Record global M&A activity saw $1.3 TN of deals. Surpassing $140 billion, junk bond issuance set a quarterly record. Bitcoin doubled, crypto inflows surged to $4.5 billion, and the value of cryptocurrencies inflated to $2.0 TN. An “NFT” – non-fungible token - digital image sold at auction for $69 million.
Importantly, mania dynamics also overwhelmed housing markets across the country, as surging prices and a dearth of inventory incited panic buying. The national S&P CoreLogic Home Price Index inflated 11.2% y-o-y, the strongest price inflation in 15 years. Mortgage credit is growing at the fastest clip since 2007. And I don’t want to omit a traditional metric for gauging the appropriateness of monetary policy. The U.S. trade deficit widened in February to a record $71 billion.
Bubbles at their core are mechanisms of wealth redistribution. Forbes’ annual world billionaires list included a record 2,755 billionaires, with this year’s list worth a combined $13.1 TN, up 64% over the past year. Monitoring for signs of a peak excess – as we contemplate characteristics of an inflection point – they’re all there, and they’re not subtle. This is, however, no ordinary cycle.
I’ve shared a lot of numbers – incredible data that’s rather mind-numbing. Let’s shift to macro analysis as we attempt to fashion an analytical framework that helps make some sense of all of this.
By the mid-90’s, I was convinced finance had fundamentally changed – out with the old bank loan dominated financial system and in with a New Age structure – a marketable securities-based system underpinned my activist central banking. It was clear to me by the mid-90’s that this new finance was highly unstable - and policy interventions were only making it more so. I thought the bubble had burst in 2000, but then shifted to warning of a mortgage finance bubble in early 2002. I again thought the bubble burst in 2008, but in 2009 reversed course and forewarned of an unfolding “global government finance bubble.”
The world is now more than a decade into history’s greatest bubble. We’re today in the late-cycle manic bubble phase where we naysayers have been discredited. As an analyst, this is my third major bubble. I’m familiar with the routine. The analysis is completely dismissed. I’m chicken little with a big dunce cap stuck on my head.
Years of loose finance have made things too easy. The punchbowl was refreshed way too many times – chronic monetary alcoholism. It became too rational to plow money into hot ETFs and trade meme stocks from home. Buy each dip; buy every breakout. Aggressively purchase call options and write puts. It’s been way too easy for Wall Street, for the leveraged speculating community, for derivatives players, and online retail traders. Meanwhile, it’s been an absolute cakewalk for borrowers of all stripes. The Fed and global central bank community have everyone’s backs. Debt and deficits don’t matter. The beaming MMT – modern monetary theory – crowd is exclaiming “told you so!”
Central bank money-creation is out of control. Washington spending out of control. Market speculation - also out of control. And it all passes for some wondrous bull market.
Some years back, I began referring to the “granddaddy of all bubbles.” The bubble had gone to the very foundation of global finance – central bank credit and government debt. Bubble excess poisoned the very heart of money and credit – perceived safe and liquid instruments. Excess had spread to every nook and cranny.
This bubble is different in kind from previous bubbles fueled by corporate and mortgage credit. With money enjoying insatiable demand, it’s the ultimate bubble fuel. As we’ve witnessed, no matter how egregious the expansion of this “money,” we just can’t get enough of it. Money’s insatiable demand has allowed central banks and governments to prolong bubble excess to unimaginable extremes.
I thought the Bernanke Fed was reckless for its TN dollar QE and determination to coerce savers into risk markets – all in the name of post-crisis system reflation. I never imagined it would get to the point that in 2019 the Fed would employ QE with markets near record highs and unemployment at multi-decade lows. I believe history will look back on that fateful decision as the beginning of this cycle’s final crazy speculative blow-off.
The Fed’s balance sheet will soon surpass $8 TN. A few years back, I posited a seemingly outlandish forecast that the Fed’s balance sheet would inflate to $10 TN. I expected this to unfold when the Fed was forced to accommodate a major de-risking/deleveraging episode – precisely what was beginning to unfold in March 2020. Instead, we’ve seen Fed holdings inflate about $4 TN while the world is in the throes of history’s greatest bout of speculative leveraging. I’ll have to revise my forecast.
Why can’t this just go on indefinitely – this New Age of market-based finance bolstered by unlimited government “money”? First of all, history informs us that “paper money” inevitably returns to its intrinsic value. Electronic money has some advantages – one being we won’t be seeing wheelbarrows toting currency. But I do believe this cycle will end with a crisis of confidence in central bank credit and sovereign debt – in policymaking and in finance more generally. Financial debasement has accelerated markedly over the past year.
In contemplating an inflection point, let’s break the analysis into four main categories: Inflation, Speculative Bubbles, China, and Social/Geopolitical. We’ll address them one at a time.
Let’s start with Inflation: The Bloomberg Commodities Index is up almost 11% already this year, to a near three-year high. Price gains have been broad-based – energy, copper, aluminum, iron ore, corn, soybeans, sugar, cotton, hogs, cattle. Lumber is up almost 50% y-t-d to a record high, prices having tripled since October. The New York Fed’s national Manufacturing Index’s Prices Paid and Received components both jumped to highs since 2011, while the Philadelphia Fed’s Business Survey Prices Paid Index surged to a 41-year-high.
The ISM Services Prices component rose in March to the high going back to 2009, while the Markit PMI Services Prices component rose to a 10-year-high. As for market expectations, the 5-year Treasury “breakeven inflation rate” is up another 65 bps already in 2021 to 2.62%, near the high going all the way back to 2005. And, importantly, heightened inflationary pressures are very much a global phenomenon. Turkey, Brazil, Russia and others have already tightened policies in response to surging price pressures.
Meanwhile, Fed officials continue to aggressively promote inflation, dismissing inflationary risks while arguing pricing pressures will prove fleeting.
Yet the history of monetary inflation is unambiguous: once it begins in earnest it becomes almost impossible to control. The expansion of credit boosts purchasing power throughout the system – in the real economy and, as we continue to witness, especially in the asset markets. Monetary inflation influences investment decisions, fueling resource misallocation along with mal- and overinvestment. And the longer the bubble inflates the deeper the structural impairment. Arguably, systemic structural maladjustment is the greatest risk associated with this most-prolonged “government finance bubble.”
Consumer price inflation is but one component of overall inflation risk. Yet consumer inflation does take on greater significance today because of mounting risks to bond markets. We believe the risk of a consumer inflation upside surprise is the highest in years, if not decades. First, there’s unrelenting monetary and fiscal stimulus that has created enormous spending power. There are, as well, redistribution policies – direct payments, minimum wage increases, and various measures shifting purchasing power to the working class. In general, even with today’s elevated unemployment there remains upward pressure on compensation. There are as well inflation risks associated with global climate change.
We’re also seeing various forms of destabilizing monetary disorder, including shortages, hording, production bottlenecks, supply chain issues along with broad-based pricing pressures. Housing markets are demonstrating powerful inflationary dynamics that will feed through to other sectors. Friday’s University of Michigan Consumer Confidence Survey had one-year inflation expectations jumping to 3.7%, up 120 bps in four months to the highest reading since 2012.
Market inflation concerns have waned somewhat over the past couple weeks as Treasury yields pulled back. Yet the risk of an inflationary surprise rocking markets is very real. Just last month, surging Treasury yields were pressuring vulnerable emerging markets. De-risking/deleverage dynamics were beginning to take hold.
There was in March 2020 confirmation of the thesis that unprecedented leverage had accumulated throughout the fixed-income universe, including Treasuries. An inflation-induced spike in yields could easily turn disorderly, with deleveraging unleashing market illiquidity and dislocation. In last month’s yield surge, conventional thinking held there was no cause for worry. Market yields were essentially capped. At some point, the Fed would purchase long-dated Treasuries as part of a yield control strategy. And the Powell Fed countered inflation fears with an uber-dovish narrative downplaying inflation risk while remaining steadfast with zero rates and $120 billion monthly QE.
At this point, the Fed is clearly behind the curve. It is actively promoting higher inflation, while its new doctrine ensures the Fed will wait to respond to higher inflation until well after it has become entrenched. It will be too late.
The confluence of mounting price pressures and the Fed’s new lax approach with inflation creates major risks to Treasury and bond markets. There is today heightened vulnerability to a market shock in the event the Fed is forced to belatedly react to mounting inflationary pressures.
Especially after the pandemic response, markets perceive instability and liquidity challenges will be quickly resolved by “whatever it takes” open-ended QE. This perception has fomented excessive risk-taking and leveraging, along with steep asset price premiums virtually across the board. It becomes an altogether different backdrop if inflationary pressures reduce the Fed’s propensity for quick QE liquidity injections. Suddenly, the marketplace would be forced to reassess the reliability of its liquidity backstop. Speculation and leverage would become high risk propositions, forcing destabilizing market adjustments. Having covered inflation…. Let’s move on to Speculative bubbles…..
Speculative Bubbles: We don’t believe it’s possible to resolve debt problems with only more non-productive debt – and we have major issues with inflationism generally. There is this now well-established dogma that troubled systems can be reflated out of over indebtedness and economic stagnation. This is deeply flawed and dangerous fiction, especially in this New Age world of unfettered market-based finance, speculative leverage and Bubbles. In short, the more aggressive the Fed’s reflationary policies late in this cycle - the greater the scope for intractable speculative Bubbles.
Importantly, if central banks inject liquidity into a backdrop of speculative zeal and bubbles – such powerful market inflationary biases - the outcome will be increasingly destabilizing speculation and perilous bubble dynamics. And never has this been on clearer display than over the past year. The Fed desperately injected a few Trillion of liquidity into the markets to hold bubble collapse at bay – only to embolden speculation and inflate even greater bubbles. Fed efforts to reflate the system out of trouble have greatly exacerbated excess and underlying fragilities.
It’s worth repeating the Fed commenced QE back in September 2019 – months ahead of the pandemic. The Powell Fed responded to repo market instability - a late-cycle speculative bubble dynamic characterized by excessive risk-taking, leverage and associated fragility. The return of QE stoked speculation and leverage - and electrified bubbles came home to roost with March’s near market collapse.
The unprecedented monetary and fiscal pandemic response has been instrumental in stoking bubbles in equities, corporate credit, derivatives, cryptocurrencies, housing, art, NFTs, and the like – the so-called “everything bubble.”
And recently we all got a glimpse of how crazy things have become – with the collapse of Archegos Capital Management. This $10bn so-called “family office” – a hedge fund structure without the regulations – was levered between 5 and 10 to 1 in concentrated holdings of volatile equities. Actually, it held third-party derivatives from the major prime brokers. And everything was going swimmingly until this scheme suddenly blew apart in a few short days – leaving the brokers (notably Credit Suisse and Nomura) with multi-billion-dollar losses.
I wrote in a recent CBB, “get the women and children off the beach!” We’re seeing some unsightly naked swimmers and it’s still high tide.
We witnessed during Q1 markets erupt into full-fledged manias – and the Fed just keeps pumping in added monetary fuel. I’ve witnessed some spectacular bouts of manic speculative excess during my career. Stocks back in early-1987, Japanese equities in 1989, U.S. bonds and derivatives in ‘93, EM ‘96, tech & Internet stocks in 1999, and subprime mortgages in 2006. And there’s been extraordinary excess across markets over the past decade. But what we’ve been witnessing of late has gone to a whole new level. One has to look all the way back to 1929 for comparable market-wide speculative excess. They’re relatively short-term phenomena by nature, yet speculative manias inflict tremendous structural damage.
We’re in uncharted waters when it comes to government policies prolonging manic speculative excess. I do believe we’re nearing an inflection point. Retail investors are all in. Institutions all in. The leveraged speculating community all in - and it would be highly unusual for such manic market excess to be sustained for long.
Speaking of historic excess, let’s shift to China. China’s Bank Assets have reached $50 TN – up from $8 TN in 2007 – and a 10-fold expansion since 2005. I want to underscore a key point: China’s historic credit expansion and boom were made possible by Federal Reserve QE. The Fed’s balance sheet inflated 10-fold since 2007 – with the Fed’s inflationist doctrine spurring QE adoption and unchecked credit expansions globally. There’s a strong case that China’s financial and economic Bubbles are the most momentous inflationary consequence emanating from the evolution of unfettered global finance.
Over the past 15 months, China’s Aggregate Financing – their broad measure of credit growth – expanded an astounding $6.9 TN – or 17%. For perspective, this was 50% greater growth than the previous 15-month period, in its own right a period of exceptional credit expansion.
As an analyst of credit and bubbles, I’ve been in awe of China for over a decade. There have been cracks in Chinese credit – that Beijing immediately sealed. Chinese officials have also made repeated attempts at reining in credit and speculative excess, only to be forced into retreat as fragilities emerged. These days, markets assume the great Beijing meritocracy has everything well under control. Markets are not oblivious to Chinese excess, but the bullish view holds that Beijing won’t dare do anything that might risk deflating bubbles.
Global markets have grown much too complacent. In particular, markets disregard the acute fragilities that arise from a 15-month credit binge. Beijing now appears determined to pull back on stimulus while sounding determined to rein in credit and speculative excess. Restraining excesses in a maladjusted system coming off such an extraordinary credit splurge is fraught with risk.
Beijing has directed banks to restrain lending. It has commanded local governments to curb apartment speculation. It has also cracked down on online lending platforms and other avenues of shadow banking. It has taken a much more aggressive regulatory stance with the big technology conglomerates. Across the board, Beijing is adopting a more co-er-cive approach than in the past.
There’s one facet of Beijing’s newfound approach that is deserving of special attention. It has begun pushing back against the view of implicit central government guarantees for debts from state-owned enterprises and local government financing vehicles. From a credit bubble perspective, this is a momentous development with far-reaching ramifications. The view that Beijing would not tolerate problematic defaults has been fundamental to the development of China’s entire credit bubble. Today, there are literally tens of Trillions of bank, corporate and local government debts whose values are underpinned by the perception that Beijing would, when push comes to shove, move to thwart systemic stress and defaults. Chinese officials, starting with president Xi, are now attempting to ween markets off this notion.
Over the past year, several state-owned enterprises defaulted on debt obligations, something previously viewed as almost implausible. And just last week, default fears erupted for China Huarong Asset management, one of four state-owned “asset management companies” created in 1999 to manage bank non-performing assets. Huarong is sizable, with $260bn of assets and over $200bn of liabilities. This is one to watch. The company has $42 billion of bonds – of which about half are due over the next year.
Huarong’s credit default swap prices began the month at 147 and closed a week ago Friday at 436 bps. In last Thursday trading, this CDS spiked to 1,466. Some offshore Huarong bond yields approached 100%, signaling market fear of imminent default. Risk premiums also surged for other Chinese financial institutions and rose generally throughout China’s corporate bond market.
By Friday, Beijing crisis management operations were in full swing. Huarong wired funds for a weekend bond payment. Chinese regulators declared the company’s operations and liquidity management were functioning normally, while requesting banks not withhold lending to the company. Huarong CDS prices ended the week near 1,000 bps and are down to a still highly elevated 500 bps.
Chinese Credit has been expanding at a blistering pace, and Beijing thus far has done little more than talk of tightening measures. Yet we’re already witnessing a major blow-up. Beyond Chinese credit, contagion effects last week saw a widening of spreads throughout Asian corporate debt markets. Even China’s sovereign CDS traded to the high since October.
China’s aged Credit boom is vulnerable to waning growth momentum. You can’t shock your system with parabolic credit growth and then expect things to just return to normal – in China, the U.S. or elsewhere. That’s not the nature of credit bubbles.
Arguably, ongoing wild Credit inflation rests on the market premise that Beijing support underpins the entire system. As such, China’s now colossal Credit apparatus buckles without trust in Beijing’s implicit and explicit backing. The entire edifice has become “too big to fail”. There’s troubled Huarong along with the other vulnerable state-owned asset management companies. The solvency of China’s fragile multi-Trillion “small” banking sector last year became an issue temporarily papered over by massive pandemic stimulus. Solvency is also a concern for a few Trillion dollars of local government financing vehicles and other local government liabilities. In short, a tremendous amount is resting on Beijing’s shoulders.
China is at a major inflection point, and I’m seeing developments consistent with how I would expect a Credit crisis to commence in China. Focus is turning to implicit Beijing guarantees. Marginal borrowers have begun to lose access to cheap borrowings. Importantly, debt at the “periphery” is beginning to lose its perceived moneyness. Foreign investors are showing some unease. Risk aversion and de-leveraging have just begun to gain momentum. Financial conditions have begun to tighten at the fringe – even in the face of massive ongoing credit growth.
Let’s shift to Social and Geopolitical: There is no escaping the reality that Bubbles are mechanisms of wealth redistribution and destruction – within societies and among nations. During the upside of the cycle, there’s a prevailing optimism and perception that the pie is getting bigger. Cooperation and integration are viewed as rationally in one’s self-interest. But things shift late in the cycle. With the pie stagnant or even shrinking, what is viewed in one’s self interest changes. Antagonism, dis-integration and conflict emerge as confrontation is viewed as necessary to secure one’s fair share of the shrinking pie.
We’ve witnessed society fray and social strife erupt across the U.S. The feeling the system promotes inequality now permeates. We see it in our fractured society, hopelessly divided politics and on the streets.
Globally, we’re witnessing an alarming deterioration in relations between the U.S. and China. The cooperation and integration that dominated the relationship in the decade following the great financial crisis have shifted to two hostile global competitors and geopolitical adversaries. Markets have to this point ignored the momentous ramifications related to this bubble dynamic. It’s as if markets rejoice competing global bubbles, confident that neither side would risk actions that might put them at a competitive disadvantage.
Yet the economic landscape is changing. Both nations now want to be less reliant on the other – more self-sufficient in myriad technologies, semiconductors, rare earth metals, health-care supplies, various supply chains and so on.
China is taking a much more aggressive stance. We’ve witnessed this with their approach to Hong Kong and increasingly with Taiwan. Hard-line - so-called “wolf diplomacy” – is on display around the world. I expect China to become only more strident as their massive financial and economic bubbles succumb.
It’s worth noting China’s angry reaction last week to President Biden and Japanese Prime Minister Suga’s joint statement committing to “working together to take on the challenges from China and on issues like the East China Sea, the South China Sea…” I have long feared that the U.S. and Japan would provide convenient scapegoats for Beijing to deflect blame from its gross mismanagement of China’s Bubble.
Identifying inflection points in social and geopolitical risk is easier in hindsight. But China has clearly adopted an aggressive posture – projecting equality with the U.S. on the global stage. After the Hong Kong crackdown, Beijing has turned its sights to Taiwan. A U.S./China confrontation over Taiwanese independence poses a “when” and not “if” predicament.
Returning to the U.S. stock market, myriad signs are consistent with a major top: Unprecedented public participation. Sentiment measures at bullish extremes. Hedge fund long exposures at multi-year highs, while S&P500 short interest has sunk to 17-year lows. About 100 new ETFs have debuted already in 2021. ETF industry assets have surpassed $6 TN. There’s the new VanEck Social Sentiment ETF – symbol BUZZ - as well as Cathie Wood’s new ARK Space Exploration ETF which quickly attained $650 million in assets. And from Archegos reporting, we know family office assets have surged to almost $7 TN.
Emblematic of today’s crazy speculative mania, online brokerage Robinhood had 9.5 million customers trade cryptocurrency on its platform during the first quarter, an almost six-fold increase from Q4.
Over the years, I’ve relied upon a “Core vs. Periphery” model of market instability as a key facet of my analytical framework. Instability and financial crises typically emerge at the “periphery” – at the fringe where the structurally weakest – the most vulnerable to risk aversion and tightening financial conditions - reside. For example, the bursting of the mortgage finance bubble began with instability in the riskiest subprime mortgages.
I believe this dynamic is already in play for the global bubble, with the emerging markets having experienced in Q1 an opening salvo of instability. Turkish yields surged 400 bps and the lira sank 15% on president Erdogan’s firing of Turkey central bank chief. Contagion effects quickly spread to Brazil, South Africa and others, as de-risking/deleveraging began to take hold.
But this process can unfold over months. Recall that it was 15 months from the initial June 2007 subprime eruption until the entire system was engulfed in crisis later in 2008.
In reality, the “core” can initially benefit from instability at the “periphery”. For example, the subprime crisis – and the Fed’s response – sparked a major collapse in bond yields in ‘07 and into ‘08 that actually bolstered prime mortgages and extended the greater bubble. Analysts dismissed the relevance of subprime, as U.S. stocks traded to record highs in October 2007.
Where are we today? We saw during the first quarter significant global market instability. Treasury yields spiked higher. The emerging markets came under pressure, with notable surges in key EM bond yields. Global currencies turned unstable.
And here at home, there was a major market dislocation in the short stock universe leading to losses and de-risking in various hedge fund strategies, including long-short and factor quant. There was, as well, the noteworthy dynamic of Treasury bonds not providing a reliable hedge against equities and the risk markets, throwing the appeal of “risk parity” and other levered strategies into question. And toward the end of March there was the Archegos blowup.
None of these developments proved a catalyst for a market correction. None even kept the market from surging higher. But I would argue all these developments work in confluence to weaken market underpinnings – amplifying latent fragilities.
I believe developments have raised the odds of a destabilizing eruption of risk aversion. Especially in the case of Archegos, racing to get ahead of the regulators, prime brokers will tighten risk parameters in securities finance and derivatives – as Credit Suisse announced this morning. Jobs were lost. Bonuses disappeared. CEOs and risk managers have been awakened. I have likened the Archegos blowup to the collapse of Bear Stearns structured credit funds in June 2007 that marked a tightening of financial conditions at the “periphery” and the beginning of the end for the mortgage finance bubble. Though at the time, everyone was quick to dismiss subprime.
When contemplating an inflection point, first quarter developments significantly increase the likelihood of a serious de-risking/deleveraging episode. Inflation expectations and Treasury yields surged higher; another massive fiscal stimulus; manic excess in equities, SPACs and cryptocurrencies; Beijing’s focus on imposing restraint spurring credit instability and, on the geopolitical front, China’s heightened pressure on Taiwan and 150,000 Russian troops positioning near Ukraine.
When I contemplate the possibility of a historic inflection point – my thoughts go to the market perception that central bankers have everything under control – that Beijing has China’s bubble well under control. It’s all a mirage. The situation is out of control – great monetary inflations invariably turn unwieldy and uncontrollable. Trillions of “money” have incited an out-of-control mania.
I believe the inflation and speculative mania backdrops are in the process of limiting central bank flexibility. We could easily see the next serious de-risking/deleveraging episode unfold in an environment of mounting inflationary pressures. Especially after the past year’s excesses, the scope of Fed QE necessary to thwart the next crisis dynamic will be even greater than last year’s. Going back to 2008, the bond market has always relished QE, while sinking yields played an instrumental role in resolving financial and economic fragilities. At this point, there’s little room for bond yield support. Instead, there’s potential for bond markets to part ways with the Fed on QE.
It would be a momentous development if QE comes to be viewed as exacerbating inflationary pressures. Imagine yields spiking higher on a Fed QE announcement. In such a scenario, the Fed would have to think twice before orchestrating another big liquidity operation – leaving bubble markets to adjust to a less reliable liquidity backstop.
I would like to leave you with this thought: Too much money playing a speculative bubble ruins the game. Today, there’s way too much money sloshing about, and market pricing mechanisms are broken. The first quarter saw some wild instability – unprecedented inflows and an historic mania; a short squeeze for the ages; chaotic market rotations; cracks in EM bubbles; a spectacular hedge fund collapse; all while bubble markets inflated higher. So many facets of the quarter pointed to a major global cycle top. I believe we’re either at - or approaching - an important inflection point – one I expect to be momentous.