Q4 2022: “Q4 Review and 2023 Preview”
Recall that the Bank of England in late-September adopted emergency QE operations to quell crisis dynamics that had erupted in the UK bond market. Contagion had spawned a spike in yields and liquidity issues - throughout global bond markets, including Treasuries. Ten-year Treasury yields spiked to the high back to 2008.
The Bank of England bailout proved a pivotal event for global markets. Importantly, the dependability of the global central bank liquidity backstop was confirmed to nervous market participants. With policy focus having shifted to a challenging inflation fight, the so-called “Fed put” had turned ambiguous. Following the bond scare and urgent BOE response, markets were assured that central bankers might talk tough on inflation, but they would not risk tightening to the point of sparking crisis. Confidence grew that central bankers had received the message.
Q4 was notable for global markets reversing away from “risk off.” Having intensified for months, de-risking/deleveraging dynamics were subdued. After peaking at 4.24% in October, 10-year Treasury yields were down to 3.42% by the first week of December. And after trading below 3,500 on October 13th, the S&P500 was 17% higher, at 4,100, on December 1st. Equities ground higher, dominated by volatility and notably choppy trading action.
Importantly, financial conditions loosened significantly during the quarter, as evidenced by most risk indicators. I closely monitor CDS, or credit default swap prices - the cost of buying protection against various bond defaults. After ending Q3 at 108 bps (the high since the March 2020 crisis), investment-grade CDS prices were down to 77 by December 1st. High yield CDS had collapsed 170 bps by mid-December. Corporate credit risk premiums narrowed significantly. Emblematic of the banking sector, JPMorgan CDS dropped from 114 to 71 bps. After ending Q3 at about 32, the equities volatility VIX index traded below 19 on December 2nd. And the dollar, a key facet of global “risk off,” had dropped about 10% by late in the quarter.
It was a challenging period for managing short exposure – definitely “tricky”. On the one hand, risk remained highly elevated. The Powell Fed was signaling some real inflation-fighting resolve. There was Powell’s November 1st post-meeting press conference, where his hawkish comments sparked a quick 3.5% downside reversal in the S&P500 – along with a 20 bps pop in two-year yields. There was also a series of developments that risked heighted systemic risk, including the spectacular FTX collapse and downward spiraling crypto. Redemption issues surfaced for two large Blackstone funds, with ramifications for the boom in so-called “private credit.” The economy was showing vulnerability, with mounting fears of a real estate downturn. There was also serious deterioration in China.
Concerns mounted for Chinese economic, financial and social fragilities. There was the alarming Chinese National Congress, with Xi Jinping’s dramatic display of absolute power. Tough language pointed to aggressive anti-West foreign policy and hostility toward Taiwan, with fears of rapid deterioration in U.S.-Chinese relations. In Ukraine, there were worries of war escalation, along with Putin’s threats and anti-West diatribes. And just today, close Putin ally and former president Dmitry Medvedev warned that Russia defeat in Ukraine may trigger nuclear war.
In short, myriad fundamental factors pointed to an ongoing high-risk backdrop. Such an exceptionally speculative marketplace dominated by leveraged and trend-following speculation, derivatives and market hedging - guarantees instability and short squeezes.
Markets have been in the throes of a major short squeeze – in stocks, Treasuries, MBS, corporate bonds and currencies. And it’s global. Last week saw the Goldman Sachs Most Short Index surge 15.7% – the strongest weekly gain since coming out of market crisis in April 2020. Last week’s squeeze offers a timely illustration of squeeze dynamics and the challenge they present to short performance.
There seems to be an abundance of market enthusiasm for the narrative that the war against inflation has been won, the Fed’s tightening cycle is quickly coming to conclusion, and that economic prospects are somewhere between “soft landing” and mild recession.
I wish I could be as optimistic. Punditry and analysis typically follow market direction, with market performance heavily influenced by underlying financial conditions. And the big story to begin the New Year is the ongoing loosening of financial conditions that began in Q4.
Squeezes can induce powerful bursts of liquidity and optimism. Buying related to the unwind of short positions and derivative hedges creates marketplace liquidity, liquidity that engenders looser financial conditions. Moreover, this dynamic is often self-reinforcing, as the specter of a squeeze typically spurs speculation and speculative leveraging. After all, being on the winning side of a squeeze is one of the more immediately rewarding speculative endeavors.
Markets have received a shot of adrenaline from this cross-market squeeze dynamic. Some of the large macro funds posted strong 2022 performance, with an index of macro hedge funds returning 14.2%. Popular macro trades last year included shorts in Treasuries and global bonds, U.S. bubble stocks, European equities, the yen and crypto. Not coincidently, last year’s big winning macro trades have reversed sharply higher, inflicting losses upon poorly positioned funds to begin 2023.
The drop in Treasury yields has been instrumental. Market yields and the yield curve are said to be discounting imminent recession. Rate markets basically have Fed funds peaking at 4.88% for the Fed’s May 3rd meeting, only to reverse course, with rates reduced to 4.39% by the meeting on December 13th.
I’m uneasy with the narrative of a bond market signaling impending recession. Financial conditions have loosened dramatically, and such loose conditions would typically hold recessionary forces at bay.
It’s worth interjecting into the analysis that exceptionally strong U.S. credit growth permeated throughout 2022. It’s the best kept secret in macro analysis. At least through the first three quarters of the year, the banking system led a historic lending boom. From my analytical perspective, myriad speculative bubbles burst last year. Yet the overarching credit bubble persevered. There are indications of tightening bank lending standards, with some waning momentum in bank, non-bank, and “private Credit” lending.
That the great credit bubble is at an inflection point magnifies market squeeze repercussions. Importantly, with the credit system at such a critical juncture, a more sustained squeeze can function as a critical source of marginal liquidity. Rallying securities markets, associated loosening, and a bounce in confidence hold the potential to spur market-based credit growth, in the process extending overall lending and credit booms. This dynamic creates upside risk for growth and inflation. A Bloomberg headline from this morning: “Global Bond Sales Off to Record Start of Nearly $600 billion.”
The bond market is too complacent about inflation risk. It’s worth noting that gold has surged almost $100 to start the year. Copper has already posted a double-digit gain, and other base metals are off to strong starts. The dollar has been weak. And more persistent dollar weakness would support commodities and import prices.
Wall Street, not surprisingly, is eager to declare mission accomplished in the war on inflation. Surely the Fed will be more vigilant. And the significant loosening of market financial conditions is exactly what the Fed was hoping to avoid. The market has been disregarding Fed messaging that the policy rate will need to go above 5% and remain there for a while. Jay Powell has specifically stated that the Fed must not repeat the mistake of premature reversal of monetary tightening.
So why would the bond market dismiss Fed communication and price for a 2023 dovish pivot? What does the market see? I’m skeptical of the economy slumping into a deep enough recession this year to force a Fed pivot – not so long as financial conditions remain this loose.
Wall Street’s bullish narrative misses the key point. I believe the bond market is discounting probabilities of some type of an accident forcing the Fed’s hand, much as the gilt crisis forced Bank of England emergency actions. If the bond market was indeed keying off recession risk, this year’s early “risk on” and loosened conditions would spur a backup in yields and reassessment of expectations for a dovish pivot. But if bonds are instead focused on accident risk, squeezes and speculative excess are viewed as integral to an accident-prone market backdrop.
Think for a moment of enormous derivatives hedging and speculative flows as a jumbo cargo vessel that attains momentum over time and navigates turns slowly. The Bank of England got the ship to begin reversing course, and now “risk on” has gained velocity. This works somewhat to extend credit, speculative and economic cycles. It boosts confidence. But this market mini cycle only postpones unavoidable post-bubble financial and economic adjustment. Importantly, vessel direction works to dictate financial conditions. The alternating “risk on”/ “risk off” thrust of tighter or looser conditions is overpowering Fed efforts to calibrate a measured tightening of financial conditions. Furthermore, central bank measures to avoid overtightening and to thwart crisis propel “risk on” speculation. The upshot, as we’ve been witnessing, is excessively loose conditions.
We believe the world is in an unsettling transition to a new cycle - one of higher inflation; newfound central bank focus on inflation risk; tighter monetary policy; market liquidity backstop uncertainty; higher market yields, larger risk premiums and hedging costs; along with de-globalization and elevated geopolitical risk.
This unfolding secular change is problematic for asset inflation and bubbles. Indeed, we view last year’s bursting speculative bubbles as the opening salvo in what we anticipate will be ongoing financial asset instability and hard asset outperformance.
There are greater and more systemic financial bubbles vulnerable to collapse. We question the stability of existing market and financial structures. And it could be this vulnerability that has 10-year Treasury yields at only 3.40% in the face of extraordinary inflation and Fed tightening. With my view that the bond market is discounting the probability of an accident, I’ll allocate time to exploring a few areas of fragility.
According to Blackrock, $867 billion flowed into global exchange-traded funds – or ETFs – last year. While down from 2021’s record $1.29 TN, the scope of ongoing inflows is astonishing considering the market environment. A reversal of flows away from the ETF complex is a potential market accident with major ramifications. Mounting risk of a disorderly run should not be dismissed.
The hedge fund industry had some struggles and close calls last year. But the situation didn’t culminate into panic deleveraging, mass redemptions, or an industry crisis of confidence – certainly nothing compared to 1994, ‘98, 2008 or March 2020. The derivatives marketplace had a scare in September, but the Bank of England helped kick that unfolding accident down the road. The Bank of International Settlements warned of $65 TN of global speculative leverage hidden in swaps derivatives. The unhiding was left for another day.
The key point: Things could have been a whole lot worse last year. Dollar strength spawned some market instability, especially in the emerging markets. But after the Fed turned hawkish in early-2022, it was reasonable to assume the ECB and Bank of Japan would drag their heels in reversing ultra-dovish policies. The yen’s steady and deep 2022 devaluation was beneficial for yen “carry trades” and global leveraged speculation more generally.
The Bank of Japan clung to negative rates and yield curve control, policies that helped underpin global liquidity during a period of concerted tightening. BOJ governor Haru-hiko Kuroda’s term concludes at the end of March. There have been signs that Prime Minister Kishida is ready to move away from “Abenomics” and what has been years of reckless central bank monetary inflation. A shift to more reasonable Japanese monetary management after years of negative rates and massive monetization won’t go smoothly.
At the ECB, normalization still has some ways to go. With a policy rate of only 2% and an $8 TN balance sheet, conditions have remained loose. But already European periphery debt markets have shown acute fragility. Italian 10-year yields ended the year at 4.68% - up 354 bps in 2022. Italian and peripheral bond markets have been recent beneficiaries of the squeeze and loosened conditions. But there’s no doubt that European debt could be part of a global de-risking/deleveraging market accident.
Going back to 2021, I’ve posited that China risks were a factor in depressed Treasury and global yields. Dynamics in China parallel global developments. China’s historic apartment and real estate bubbles burst last year. Economic growth faltered, and crisis dynamics engulfed China’s huge developer sector. Yet things could have been much worse. Importantly, China’s credit bubble was ongoing, with system credit posting yet another year of double-digit growth.
China could avoid a major accident in 2023 – I just wouldn’t bet on it. As an analyst of credit bubble dynamics, I could not be more alarmed by how things continue to unfold. For starters, the widening divergence between ongoing rapid credit expansion and deflating GDP growth is ominous. China is locked in an extended “terminal phase” of credit bubble excess. Not only is credit expanding recklessly, the quality of underlying Chinese loans and finance continues to deteriorate. Expanding another 10%, Chinese bank assets surpassed $55 TN last year. And now Beijing is forcing its bloated and vulnerable banking system to aggressively support insolvent developers, the troubled local government sector, and the maladjusted Chinese bubble economy more generally.
Systemic risk is expanding exponentially in China. Deepening crisis appears inevitable. A long list of aggressive measures has for now somewhat stabilized the real estate developers. Meanwhile, cracks are growing for China’s $7 TN of local government financing vehicles – securities that have camouflaged risk while financing trillions of uneconomic projects. Any other country in China’s predicament would suffer a crisis of confidence in its credit system and currency. But China runs huge trade surpluses and supposedly still has its $3 TN plus international reserve hoard.
While showing cracks, confidence holds that Beijing still has things under control. The autocratic government can dictate sufficient credit growth to avoid an economic downward spiral. Moreover, Beijing retains the capacity to thwart a run on the renminbi, or so markets believe.
Presently, China is somewhat the enigma wrapped in a riddle. The nation is in the throes of a Covid wave. It’s unclear how long infections will depress demand and negatively impact supply chains and production. Beijing has abandoned “zero Covid,” while adopting aggressive stimulus measures.
Stimulus will have an impact. And there’s surely pent-up demand that should help underpin a semblance of economic recovery. But confidence in the future has taken such a hit that it will likely take years to fully recover. The deflating apartment bubble won’t reflate anytime soon. And it’s reasonable to assume waning global demand and a slowing export sector will also stir economic headwinds.
The renminbi is fortunate to have such weak competitors. Having witnessed a number of emerging market crises over the past three decades, China today has all the necessary ingredients. I don’t see how China can continue on this trajectory of ballooning non-productive debt and escalating systemic risk without currency issues. Beijing has resorted to playing games with derivatives and state-directed bank renminbi support to mask resources expended for currency stabilization. For now, China’s currency is a beneficiary of the big global short squeeze. But if the impacts of stimulus measures disappoint and financial fragilities continue to mount, I see the case later in the year for renewed flight from Chinese finance and the currency. And if the currency decline turns disorderly and Beijing appears to be losing control, there’s risk of a destabilizing crisis of confidence.
Things turn sour after major bubbles burst – in asset markets, economic performance, the public mood, geopolitics. This time last year war in Ukraine wasn’t on the world’s radar. History will look back at Russia’s invasion as hastening de-globalization and fragmentation – the so-called new “iron curtain.” The world is being forced to choose sides, and the rapidly evolving geopolitical landscape is fundamental to new cycle dynamics.
As I’ve discussed previously, boom periods engender perceptions of an expanding global pie. Cooperation, integration and alliances are seen as mutually beneficial. Late in the cycle perceptions begin to shift, with many viewing the pie stagnant or shrinking. Zero sum game thinking dominates. Insecurity, animosity, disintegration, fraught alliances and conflict take hold.
Risks are alarmingly high for ongoing deterioration and dangerous geopolitical developments. And the fraught geopolitical backdrop needs to be included when discussing the bond market pricing probabilities of an accident. Xi Jinping seems hellbent on taking Taiwan. The U.S. and West will step up military support, which increases the chance of an accident. Right now, China appears to want to ease tensions, a shift I believe is part of Beijing’s crisis management focus on its deflating bubbles and sinking economy. But with Taiwan and trade tensions likely to escalate, I expect Beijing’s stab at playing nicer in the sandbox to be short-lived.
From geopolitical, financial and economic perspectives, China is at the epicenter of an extremely high-risk 2023 backdrop. China’s bursting bubble economy is in serious trouble. Beijing will employ extraordinary fiscal and monetary stimulus, while directing its colossal financial sector to expand lending and liquidity support. Importantly, China’s dogged pursuit of global superpower status ensures policymakers will reject the premise that deep economic contraction is an unavoidable facet of post-bubble financial and economic adjustment.
The upshot is extraordinary uncertainty. Does a China downturn unleash deflationary forces, or might another year of massive Chinese credit expansion underpin global inflation dynamics? Could an unstable Chinese currency unleash global currency instability? Does Beijing use the Taiwan issue to distract its disillusioned population? Might war escalation in Ukraine see China offering more direct financial, economic and military aid to its “partner without limits”? How would the West respond? Key questions that we just don’t have answers to today.
There are major uncertainties here in the U.S. as well – relating to inflation, growth prospects, debt ceiling negotiations, tight labor markets, vulnerable real estate, political paralysis and so on. Until I see more convincing evidence of a credit slowdown, my analysis will err on the side of robust wage growth, stubborn inflation and some economic resilience. The Fed’s job only gets more challenging. While seeing inflation data - on an encouraging trajectory, inflationary risk factors will remain highly elevated. For now, loose financial conditions, strong credit growth and tight labor will keep Fed officials from relaxing.
Recall that 10-year Treasury yields were at 13-year highs just three months ago. De-risking/deleveraging was at the cusp of a precarious “seizing up” of global markets. Derivatives markets were hanging in the balance. Italian and European bond markets were at the brink. Emerging market contagion risked a domino collapse, while risk of a destabilizing run on the ETF complex was rising. Currency markets were turning disorderly – that, coupled with spiking yields, risked unleashing havoc for the global leveraged speculating community.
I don’t believe global de-risking/deleveraging risks have just melted away. The world is only a bout of upside inflation surprises away from panicked central bankers and a major bond market reassessment of inflation and policy tightening.
And the short squeeze and “risk on” backdrop to start the year could come back to haunt system stability. A lot of money will come into the market on the perception that the storm has passed. The speculator community will cover shorts and become more aggressively long the markets. Hedges will be unwound, leaving a marketplace vulnerable to a panicked effort to reestablish hedges in a deteriorating market environment.
I certainly doubt we’ve heard the last of liquidity issues. “Risk on” short covering and speculative leveraging create the illusion of liquidity abundance. And loose financial conditions will ensure the Fed continues to shrink its balance sheet, increasing the likelihood of liquidity problems erupting during the next serious bout of “risk off.”
I really wish I could be less negative. But I believe we’re still early in what will be painful post-bubble financial and economic adjustment. Most still see the world through the prism of the previous cycle. Deeply ingrained bullish optimism endures. Confidence remains high that central bankers and Beijing have everything under control. But their control is superficial, made possible by ongoing historic credit excess and risk-embracing financial markets. Policymaking turns much more difficult when credit downshifts and markets turn sour. But if excesses persist, expect more inflation and higher market yields.
I fear the unfolding new cycle could be characterized by crises of confidence in policymaking, the markets, financial structure and economic prospects. I will adjust this view if I see – in the U.S. and China, in particular - slower credit growth unfold without corresponding financial, economic and geopolitical instability. In the meantime, my analytical framework will be focused on post-bubble dynamics and the likelihood of instability, negative surprises and accidents. Be prepared for a year of dramatic swings in sentiment, and keep in mind that even very bearish fundamental underpinnings can be temporarily masked by “risk on” market dynamics and loose financial conditions.