Q3 2022: “Prelude to an Accident”
It was a most fascinating quarter. The period got going with news of June’s shocking 9.1% y-o-y consumer price inflation. Curiously, Treasuries disregarded surging inflation, with yields trading down to 2.58% on August 1st. Markets interpreted Powell’s July 27th post-FOMC press conference as leaning dovish, confirming the markets’ view of a Fed poised to quickly throw in the towel on hawkish policy at the first indication of trouble.
Importantly, China’s Bubble deflation was gaining significant momentum, as a movement to boycott mortgage payments for unfinished apartments stirred systemic worries. The spectacular Chinese developer bond collapse accelerated. Anticipating waning global inflationary pressures along with a less hawkish Fed, markets rallied forcefully – stocks, Treasuries and corporate credit. Risk indicators pointed to a significant loosening of financial conditions. For example, after beginning the quarter at 580 bps, U.S. high-yield CDS prices were down to a four-month low 421 bps on August 12th. Investment-grade corporate debt issuance continued to boom.
Understandably, the Fed was uncomfortable with a loosening of market financial conditions that would counter its inflation fight. Powell delivered a short and to the point Jackson Hole message: The hawkish Federal Reserve’s singular priority was to aggressively rein in inflation. That ended the market rally.
There has been scant attention by strategists and pundits to a key point. The Fed had for years ignored an increasingly speculative marketplace. And it was now coming home to roost. Markets had come to be dominated by speculation – the leveraged speculating community, but also institutions and the general public. In particular, options trading had mushroomed to become a major force throughout the markets. Hedging downside risk in the derivatives markets is now ubiquitous, while trend-following and performance-chasing flows completely overwhelm traditional investing.
Market behavior had shifted – market structure had fundamentally changed. And speculative markets had over the years become only more convinced that any Fed hawkishness would dissolve at the first indication of market stress.
We titled today’s call “Prelude to an Accident.” I believe the markets’ rally and the resulting loosening of financial conditions had a profound effect on Fed thinking and communication strategy. I’m not alone with the view that the Fed will raise rates until something breaks. The rapid reemergence of market excess forced the Fed to get much tougher – and toughness risks breaking things. Not only would rates have to go higher, it became necessary for Fed officials to adopt a hawkish public persona.
They now appreciate the imperative of avoiding any wavering, especially when it would be interpreted as the Fed surrendering to tottering markets. Markets were pricing in an early end to tightening, and an inevitable reversal to looser monetary policy. This was pulling longer-term Treasury yields lower, and such negative real yields were working to sustain robust system Credit growth.
Data from the Fed’s Q2 Z.1 report underscore this analysis: Total Non-Financial Debt expanded at a seasonally-adjusted and annualized $4.3 TN pace, with exceptionally strong first-half Credit growth second only to 2020’s onslaught.
Household Mortgage debt grew at an 8.8% pace, the strongest since 2006. And one had to go all the way back to 2001 for a period where Consumer Credit expanded faster than Q2’s 8.5% rate.
And while there had been some corporate bond market tightening, lending businesses were absolutely booming. Bank Loans expanded at a blistering 17.3% rate during Q2, with Loans up $1.3 TN, or 10.5%, over the past year. Only half way through the year, 2022 Loan growth ($721bn) had already exceeded 2005’s annual record.
The Fed faced a major predicament: Expectations for persistently strong inflation were crystalizing throughout the economy, and booming Credit growth was providing additional inflationary firepower. What’s more, rallying markets were further loosening conditions. Already flimsy Fed credibility was on the line.
The Fed really had no choice but to play hardball. Officials united around a hawkish narrative, recognizing that any hint of a loss of nerve risked reversing nascent headway in its inflation battle. In other words, the Fed had to decisively push back against the view that it would quickly reverse course to bolster floundering markets. Officials were compelled to strike directly at market confidence in the so-called “Fed put.”
And the newfound ambiguity associated with the Fed’s liquidity backstop had a major impact on market pricing and trading dynamics – at home and abroad. This point needs to be underscored: The return of “risk on” speculation and the resulting loosening of financial conditions forced the Fed to prioritize its inflation fight, as it backed away from its decades-long market focus.
This had huge ramifications for market pricing and structure that had been distorted by years of loose money, Fed market interventions and liquidity backstops. What we witnessed in the second half of the quarter was the beginning of what we expect will prove a highly destabilizing market adjustment period.
This adjustment process quickly gathered steam in the Treasury market. Ten-year yields traded at 3.95% on September 27th, up 137 bps from early-August lows. After beginning August at 2.87%, two-year Treasury yields spiked 141 bps to end the quarter at 4.28%.
The so-called “risk-free” Treasury market is the foundation of asset valuation throughout the markets and real economy – including being the anchor for corporate and international yields. As one would expect, the unleashing of downside price adjustment in Treasuries reverberated throughout U.S. and global asset markets.
U.S. and global equities reversed sharply lower, giving back more than the rally. The MBS marketplace suffered through a difficult deleveraging. Benchmark MBS yields surged 129 bps during Q3 to 5.68% - the high since 2008. U.S. conventional 30-year mortgage rates rose to 7.17% last week, also the high since ‘08.
In some respects, the mortgage marketplace is the epicenter of fixed-income derivatives trading. The surge in Treasury yields spurred major hedging-related selling in the MBS marketplace, much of it sales of Treasuries and related instruments – selling that led to higher yields, extended MBS duration, and only more intensive hedging-related selling. There is also significant levered speculation throughout the mortgage complex, so deleveraging has also been consequential. Market liquidity concerns returned, including for Treasuries.
And while on the subject of liquidity, another very important dynamic was in play during the quarter. A hawkish Fed and surging market yields helped spur an upside dislocation in the dollar. This ex-cerbated emerging market currency and bond market weakness, intensifying de-risking/deleveraging and “hot money” exodus. To support their faltering currencies, EM central banks liquidated Treasuries and other international reserve assets. This placed only greater pressure on Treasuries and global bond markets.
My thesis has been that there are enormous amounts of global leveraged speculation, especially in higher-yielding emerging market bonds. Key EM bond yields surged to multiyear highs during the quarter, while currencies came under intense pressure. Currencies in Hungary, South Africa, Russia, Turkey, Colombia, Poland and South Korea all lost around 10%. Over the past decade, EM central banks accumulated sizable international reserve holdings. And while these reserves have been vital in thwarting acute crisis, EM central banks have been burning through their reserves.
China’s International Reserves are down $220 billion so far this year to a more than five-year low. And while China’s $3 TN reserve horde remains formidable, it is one trillion below its 2014 peak. China’s currency dropped 5.9% during Q3, trading to the weakest level since 2008. The ren-minbi is down more than 12% y-t-d versus the dollar.
The currency drop highlights an ominous Q3 and 2022 for China. During the quarter, Beijing aggressively ratcheted up fiscal and monetary support for the economy. Various measures were implemented to bolster slumping housing markets. Importantly, the efficacy of Beijing stimulus has dissipated. Even after the most onerous “Covid zero” lockdowns were lifted, China’s economy struggled to regain self-sustaining momentum. Importantly, consumer sentiment remained depressed despite Beijing’s efforts. Apartment buyer sentiment collapsed – perhaps beyond repair.
The spectacular Chinese developer crash gained momentum. After beginning the year at 6.6%, Country Garden, China’s largest developer, saw its bond yields almost double during the quarter to trade above 50%. Many bonds, including Evergrande, traded with yields above 100%. Vanke, considered the only financially rock solid top developer, saw its yields spike above 10% after beginning the year at 3%.
Indicative of heightened systemic issues, China’s “big four” bank Credit default swap prices surged to multi-year highs. And after beginning the year at 40 bps, China sovereign CDS ended the quarter at a more than five-year high 110 bps – and trade this week to 138 bps. I won’t delve into detail, but Chinese credit expanded almost $1 TN during the quarter – and an astounding $4.7 TN over the past year. I refer to perilous “Terminal Phase Excess.” Systemic risk rises exponentially nearing the end of a cycle, fueled by a surge of Credit of rapidly deteriorating quality. China’s ongoing “Terminal Phase” is in a league of its own. China’s asset Bubbles are deflating – and the economy has weakened dramatically. Still, Credit Bubble excess runs unabated, only widening the gulf between Credit and economic output. This is one historic accident in the making. I’ll return to China in our geopolitical discussion.
On the subject of accidents, Japan may not quite be in China’s league, but it’s another major developing accident. With global inflation and bond yields spiking, most of the world’s central banks adopted aggressive tightening measures. Not Japan. Not only has the Bank of Japan stuck with zero rates, it boosted bond purchases to maintain its 25 bps ceiling on 10-year JGB yields. It’s off the rails inflationist policy run completely amuck, and the Japanese have been rewarded with 22% y-t-d currency devaluation - to a level not seen since the dark Bubble bursting days of 1990. Juggling a sinking currency and problematic yield control, Japanese policymakers are at the cusp of a destabilizing crisis of confidence.
The euro is down about 12% y-t-d, trading during Q3 below parity to the dollar for the first time since 2002. The risk of a major accident in Europe has risen dramatically. The war in Ukraine has turned only more brutal and unpredictable. The Ukrainian military’s successful counteroffensive was met by threats from Putin against Ukraine and the West – including the use of nuclear weapons. Putin has warned that he’s not bluffing – and U.S. officials and governments around the world are taking Putin’s threats seriously.
European bonds have been highly unstable. After Italian yields spiked above 4% in June – despite zero rates and ongoing QE – the ECB devised its so-called “anti-fragmentation tool” for purchasing periphery bonds in the event of a disorderly yield spike. Bond yields reversed sharply lower on the news, but then traded as high as 4.73% late in the quarter – and were as high as 4.89% last Friday (today 4.05%).
The ECB would prefer not to wield its anti-fragmentation tool. If they use it and it flops, they immediately face a very serious crisis of confidence. And what's at stake is nothing short of an existential threat to European monetary integration and the survival of the euro currency. At the minimum, the unfolding periphery debt crisis risks financial, economic, social and political crises.
The UK provided a deafening warning to the world of underlying fragilities and how abruptly crisis dynamics can be unleashed. After trading at an early-August low of 1.80%, 10-year gilt yields hit 4.50% late in the period. A wake-up call to global policymakers. The new UK government’s tax and spending plans sparked a disorderly six-session 137 bps yield spike. A highly levered and derivatives-centric UK pension system was at the brink. The Bank of England (BOE) intervened with a new emergency bond purchase program. Think in terms of the official return of the bond market “vigilantes.” A disorderly bond market dislocation forced the abandonment of Truss’s “mini-budget” and, a few days later, of Prime Minister Liz Truss. This accident reverberated around the globe.
With worldwide de-risking and deleveraging in force, the era of seemingly endless bond demand has run its course. Two dominant sources of bond demand – central banks and levered speculation – have turned sellers instead of buyers. New cycle dynamics are at play, with the supply of bonds for sale now overwhelming demand. Yields have been spiking, and expect more markets to revolt against fiscal profligacy.
And while attention has been focused on the UK gilts markets and Italian yields, there are vulnerable over-levered economies around the globe. It’s worth noting the poor Q3 Asian currency performance, with the highly-levered South Korean economy suffering 9.3% won devaluation. As a region, Asia has all the necessary characteristics for a market accident and financial and economic crises.
While the Fed has displayed determination to hold the line, I’m skeptical they’ll have the resolve to dismiss unfolding global crisis dynamics. And last week there appeared to be a subtle change in tone from the likes of Fed presidents Bullard, Evans, Daly and Kashkari – seemingly to lay the groundwork for a Fed shift to a more measured tightening approach.
The Fed today walks a perilous tightrope. There are heightened concerns for global crisis dynamics and faltering marketplace liquidity, while inflation remains a major problem. the Fed surely wants to avoid unleashing a big market rally. In such a speculative market dominated by derivatives, hedging programs and trend-following trading, it wouldn’t take much of a Fed pivot to spark disorderly speculation.
But buoyant markets wouldn’t resolve our system’s deep structural maladjustment. I know there’s a popular perception that the U.S. is largely immune to global instability. But the harsh reality is that we have led the world in speculative excess, for years feasting on ultra-loose finance. The resulting market structure is acutely vulnerable to risk aversion and deleveraging. Our Bubble economy structure is susceptible to tightened Credit and liquidity conditions.
No country has our faith that central bankers have everything under control. The problem today is that the Fed understands the gravity of our inflation problem. Our central bankers recognize that financial conditions must tighten. Credit growth must slow to ensure pricing pressures and inflationary psychology don’t spiral out of control.
And this is a major issue for an entire financial structure that has for years been underpinned by the perception that the Fed will do “whatever it takes” to support the markets and grow the economy. That rates cuts and open-ended QE will be employed as necessary to thwart crisis dynamics.
But I do believe crisis dynamics globally have attained important momentum that will not be easily reversed. Moreover, in no way will the U.S. be immune. Analytically, there are interrelated Bubbles internationally that essentially create one monumental Bubble. The singular Bubble view is based on interconnectedness and commonality – similar market, policy and economic structures.
There have been similar policy regimes. The world adopted Federal Reserve inflationist doctrine – low rates, QE and market interventions and backstops - that worked to propel rapid debt growth everywhere.
Market structures are often identical – in particular, derivatives, swaps markets, leverage and speculation. The entire world readily adopted market-based “Wall Street finance.” And faith in “whatever it takes” central banking became deeply embedded in market perceptions and prices globally, stoking speculative excess everywhere.
There is today unprecedented interconnectedness between global markets: trading systems, derivatives platforms, swaps trading, the leveraged speculating community, the international mutual fund complexes. Importantly, over a most protracted global boom, international finance essentially became one fungible, commonly shared pool of liquidity – dominated by trend-following and levered speculative finance.
When I contemplate accidents, my fears turn to the global markets “seizing up” scenario – where dislocation in one market quickly reverberates around the globe. Market structure creates vulnerability for de-risking/deleveraging in one market to quickly transmit to other fragile markets. The proverbial dominos – losses, illiquidity and dislocation sparking fear and contagion across markets.
I will reiterate analysis that is particularly pertinent. Contemporary finance retains strong tailwinds so long as financial conditions are loose and Credit growth remains robust. Market-based finance functions wonderfully so long as interest-rates are relatively low, Credit spreads remain narrow, and the price for market protection stays relatively inexpensive. Importantly, low Treasury yields in the past worked to bolster system resilience, even during recurring periods of widening Credit spreads and rising Credit default swap (CDS) prices.
The current environment is different. Treasury yields have been spiking, while spreads widen and market protection costs surge. This places tremendous pressure on market structure. The hedging of interest-rate risk can overwhelm the marketplace – hedging-related selling of Treasuries, MBS, and corporate debt, but also selling associated with hedges for fixed-income generally. There are too many sellers and not enough willing and able buyers.
I’ve seen similar situations a few times during my career – 1994 and ‘98 come quickly to mind. With Treasury yields collapsing, 2008 was a different dynamic. 2020 was noteworthy for intense de-leveraging and Treasury market illiquidity even in the face of collapsing Treasury yields. The GSEs provided market liquidity backstops in ’94 and ’98, while Fed QE bailed out the markets in 2008 and 2020.
Market structure is approaching a major test. A market accident, a synchronized global accident in particular, would spark unprecedented de-risking/deleveraging – requiring a massive coordinated response from the global central bank community. Yet there are today serious impediments. Inflation has surged globally, causing newfound reluctance by the world’s central bankers to open the monetary flood gates. Moreover, central bankers surely today recognize what a monumental mistake it was to have unleashed Trillions of liquidity during the pandemic.
I’ve stated previously my view that the Fed will resort to additional QE. But I suspect their market crisis response will be atypically slow and cautious. I also expect the major central banks to struggle individually to reach consensus on the appropriate course of policy, hindering a major concerted global response. Central banks increasingly face their own domestic issues, priorities and political constraints. Individually and collectively, central banks are entering a period where their coveted independence is in jeopardy. The swashbuckling days of self-assured central bankers was an anomaly of the previous cycle.
And in our discussion of accidents, we must at least briefly address today’s distressing geopolitical backdrop. Allow me to rehash Bubble analysis especially pertinent to highly elevated new cycle geopolitical risks. Boom periods engender perceptions of an expanding global pie. Cooperation, integration and alliances are viewed as mutually beneficial. But late in the cycle perceptions begin to shift. Many see the pie stagnant or shrinking. Zero sum game thinking dominates. Insecurity, animosity, disintegration, fraught alliances and conflict take hold.
Unfortunately, these days I often feel I’m witnessing my worst fears coming to fruition. No longer can we dismiss the possibility of a nuclear accident – and that could be with one of Ukraine nuclear facilities, or even tactical and strategic weapons. There’s all the recent talk of dirty bombs. And no longer can we dismiss the possibility of China moving militarily against Taiwan – perhaps kicked off with trade embargos and blockades. There can be no denying the risk that war in Ukraine could easily spiral out of control. Putin has become a cornered animal, while his “partner without limits” is turning increasingly unpredictable.
I found Xi’s speech to open China’s communist party national congress distressing – and there were elements that recalled passages from Putin’s past diatribes. These powerful dictators share a dangerous obsession – hell-bent on forging a new world order to counter U.S. global power and influence. China faces the most extreme domestic financial and economic issues, yet Xi’s focus remains geopolitical. Everything points to Xi pushing the banks and state apparatus to the limits to achieve the growth necessary to underpin China’s global superpower status. Meanwhile, if Xi and his loyalists fail to quickly rein in unparalleled growth in non-productive Credit, China is facing the risk of a currency crisis and even financial collapse. Concern that an accident in China could set off a cascading global domino of accidents seems these days to grow by the week. Chinese markets were hammered on alarming developments out of China’s national congress – stocks dropping, bank and sovereign CDS prices surging higher, developer bond prices sinking further. Country Garden yields have spiked to 96%.
At the minimum, we’ve entered a more dangerous phase of the unfolding cold war – the new “Iron Curtain.” China will be moving aggressively toward self-sufficiency, certainly in the areas of semiconductors and high-technology. There will be escalating tit for tat retaliatory trade measures. After the U.S. recently restricted some high-tech exports to China, Beijing will seek impactful retaliation.
Shifting back to the U.S., I believe Q3 instability was also a prelude to accidents at home. I worry about our maladjusted U.S. economic structure and its vulnerability to a slowdown in Credit growth. There are too many negative-cash flow uneconomic enterprises that proliferated during the long period of loose finance. So far, booming bank and non-bank lending has supported this economic structure. But I believe a difficult adjustment period is unavoidable. This will unfold over time.
I worry about inflated U.S. housing markets. In some ways, excesses surpassed the Bubble period that culminated with the 2008 crisis. In particular, high-end markets in California and throughout the country are more vulnerable today than ever. With mortgage rates at 7% - and even higher for large mortgages – I expect affordability issues will force significant downside price adjustments. I fear we will see some crazy speculative excesses come home to roost. My sense is that the housing bust has begun, though this process also takes some time.
Market derivative-related accidents don’t take much time. I really worry about the proliferation of derivative trading – for hedging purposes and speculation. I recall the “Black Monday” 1987 stock market crash, and how so-called “portfolio insurance” played a meaningful role in the avalanche of sell orders that crashed the market. I watched as derivatives were instrumental in market crises in 1994, ’95, ’97, ‘98, 2000, ‘08, 2011, and 2020. And with each central bank market bailout the monstrous derivatives Bubble inflated to even more dangerous extremes.
Everything is in place for one historic financial accident, and we witnessed just a few weeks back in the UK how the interplay of speculative leverage and derivatives can quickly spark panic de-risking/deleveraging, illiquidity and collapse. And this shockwave immediately reverberated globally, including to our bond market. While Bank of England rescue operations and a new Prime Minister have calmed markets, fragilities were exposed.
Memories from March 2020 remain fresh. A serious de-risking/deleveraging episode required repeated announcements of ever-larger QE programs to reverse market collapse. I believe the scope of excess in speculative leverage and derivatives now exceeds 2020. And I don’t expect the Fed will again be so footloose with Trillions of QE.
These days, so much market risk – and that’s across global markets - has been offloaded to the derivatives complex. And the sellers of market protection use sophisticated trading programs - buying and selling instruments in the marketplace to have positions in place that will provide the necessary cashflow to pay on derivatives written. In particular, when derivatives dealers write market protection, the strategy dictates that they turn aggressive sellers into a declining market. This creates a clear and present danger of cascading sell orders and market accidents.
Again last week, we saw extraordinary volatility – in this case a 4.6% rally in the S&P500 – into option expiration. While smaller than recent $3.5 TN quarterly expirations, October’s expiration was said to amount to $2 TN of notional contract value. The size of contemporary derivatives markets is unfathomable. Derivatives are clearly a major factor in wild instability that has engulfed global markets – equities, sovereign debt, currencies, fixed-income and commodities. We have been witnessing a degree of market disorder that in the past was prelude to accidents.
Today’s predicament has been building for a long time. Central banks have repeatedly rescued faltering Bubbles, ensuring they inflated only more precariously. The world has now entered a new cycle of inflation, financial and economic fragility, deflating Bubbles, fragmentation and acute geopolitical instability. The answer to this distressing confluence of issues will not be found in more central bank monetary inflation. Most unfortunately, crises of confidence and an onerous adjustment period are unavoidable. I’ll end with the same words that concluded my Q2 presentation. I sincerely hope my analysis proves way too pessimistic.