Q2 2023: “Bank Bailout Spurs Bubble Revival”
Financial fragility – the highly levered “repo” market in particular – became a serious issue in the summer of 2019 – spurring the Fed to restart QE despite an expanding economy and booming markets. Not many months later, the world was hit by the worst pandemic in a century. To thwart bubble collapse, the Fed resorted to $5 TN of additional QE liquidity – with the Fed’s balance sheet surpassing $9 TN – an astounding 30-fold increase from when I began my career in investment management back in 1990.
Markets that had evolved to become highly speculative in the easy-money, post-great financial crisis landscape – turned manic and dysfunctional. Tens of millions were trading online, with millions lured to the options market. “Meme stocks” became a thing, and the sport of squeezing shorts turned highly lucrative – for hedge fund managers as well as online traders glued to their social media accounts in search of prime squeeze targets. And this dysfunction was nourished by trillions of pandemic stimulus.
I’ll start this segment by restating analysis I’ve underscored over the years. Unique in history, global finance over recent decades has operated without constraints on either the quantity or quality of new credit instruments. There’s been no gold standard or even an ad hoc dollar reserve system that would help hold credit creation in check. And, importantly, credit expansion has operated unconstrained from traditional bank reserve and capital requirements.
I came to this understanding and formed this thesis back in the late-nineties, after witnessing the unbridled expansion of non-bank credit – the “repo” market and Wall Street finance, the GSEs, mortgage and asset-backed securities, money market funds, and massive unregulated derivatives markets.
The world of finance had fundamentally changed. Credit had become more readily available – especially for risky borrowers - and the price of credit, and finance more generally, had cheapened. And as leveraged speculation mushroomed, speculative leverage evolved into a prevailing source of system liquidity creation. The unfettered expansion of leverage enlarged the pool of marketplace liquidity, creating a dangerous proclivity for self-reinforcing speculation, credit, and liquidity excesses. In short, financial innovation and structural developments fueled a secular loosening of financial conditions – a most crucial issue as we analyze current market, policy, and economic backdrops.
I’ve discussed this previously. I fully expected central bankers would eventually recognize the dangers and rein in this new financial structure. As it turned out, it was more that market-based finance took control and placed reins on central banking.
It used to be that the so-called “bond vigilantes” and the prospect of surging market yields would discipline policymakers – have central bankers erring on the side of tighter money and governments working to control deficit spending.
These days, the threat of collapsing market bubbles ensures perpetual loose conditions and runaway government debt. Let’s focus on the Fed’s current “tightening cycle.” It’s extraordinary. The Fed has moved aggressively to hike interest rates 525 bps in 16 months – yet financial conditions are arguably looser today than when the Fed commenced the process. They would never admit as much, but the Fed must be shocked and bewildered. It certainly throws a monkey-wrench into contemporary central bank doctrine.
Financial conditions indicators that I closely monitor – including investment-grade and high yield corporate spreads and CDS prices – traded last week at lows since the start of Fed tightening. While there has been some tightening of bank lending – from an egregious level, I might add – this has been offset by strong bond issuance and booming private credit and so-called “decentralized finance.”
I believe we’re today at a crossroads. I expected this to be the first actual tightening cycle since 1994. Fed rate-hiking cycles since ’94 - including during the late-nineties tech bubble period and then again during the mortgage finance bubble - failed to sufficiently tighten financial conditions.
But the impetus behind the current tightening has been more urgent to policymakers: consumer and producer inflation was spiraling out of control. Despite “core” y-o-y CPI inflation still above 5%, the Fed is widely believed to be either done or close to wrapping up this tightening cycle. Most importantly, ongoing loose financial conditions pose huge risks to the Fed and the system more generally.
I’ll break these risks into two broad categories. First, we expect inflation to prove much more persistent than either the Federal Reserve or the markets anticipate. Second, loose conditions are fueling dangerous asset inflation and speculative bubbles.
Let’s explore inflation risk. We believe the secular period of relative consumer price disinflation has largely run its course. Moreover, our view is that the previous cycle was aberrational, whereby consumer and producer price inflation remained generally contained in the face of momentous monetary inflation. Certainly, globalization and the rise of low-cost Chinese and Asian manufacturing played integral roles. But there was also the secular dynamic of powerful financial flows primarily fueling asset inflation as opposed to traditional consumer price inflation. Especially with central banks backstopping financial markets, financial assets developed a dominant competitive advantage versus real economic investment. And the greater the flows into inflating financial markets and the more certainty of central bank backstops, the more powerful the asset inflation and bubbles.
But the massive pandemic response, coming late in an already extended cycle, changed the game. You can say that unprecedented monetary inflation and fiscal deficits broke the dam, unleashing inflationary forces into the real economy while stoking a historic mania throughout the markets. Acute supply-chain issues forced businesses to rethink how they needed to manage inventories and resource procurement, while an acute shortage of workers triggered a major change in compensation expectations. And then Russia’s invasion of Ukraine – with China’s unflinching “partners without limits” amoral support – provided a major push to new cycle deglobalization.
We believe the world is transitioning to a new cycle where hard assets outperform financial assets – where commodity and consumer price inflation holds sway over asset inflation. I know it sure hasn’t looked that way over recent months, with speculative zeal overcoming the securities markets. But we expect this phenomenon to prove fleeting. While loose financial conditions have supported the markets, we believe such easy money at this phase of the cycle comes with significant risks and negative consequences.
Before jumping into the risks, let’s briefly delve into how we got to this point. In the first place, years of artificially low rates and repeated market bailouts ensured deep market maladjustment. Why haven’t financial conditions tightened – as expected, as they have historically? Because the bond market has been conditioned to anticipate the next round of monetary loosening. And the crazier the market excesses, the more the Treasury market prices in probabilities for some type of accident forcing the Fed to again slash rates and employ more QE securities purchases.
It’s worth recalling that 10-year Treasury yields surged last fall to the highs back to 2008, at least partially triggered by the UK’s bond deleveraging and market crisis. Markets were comforted that the BOE hastily resorted to additional QE – before it had even the opportunity to normalize rate policy or begin QT.
Understandably, markets feared that the central bank market liquidity backstop had been placed on the back burner, as inflation worries and monetary tightening took precedence. And after being partially allayed by the Bank of England, the Fed’s response to the March banking crisis completely resolved market concerns.
We need to take few minutes to discuss the banking crisis. And I’m sticking with the word “crisis.” After all, we saw a systemic bank run and three of the four largest bank failures in U.S. history. Moreover, there was a rapid and powerful crisis response from Washington. In just three weeks, Federal Reserve credit expanded $391 billion. But the liquidity backstop went far beyond the Fed. The government-sponsored enterprises – the GSEs - expanded assets by a record $352 billion during Q1 to an all-time high $9.54 TN, surpassing even the $325 billion response to the Q1 2020 pandemic crisis. It’s also worth noting that GSE assets inflated a record $1.02 TN over the previous four quarters, fully double peak one-year growth from pandemic 2020.
There were remarkable developments throughout the financial sector. Wall Street Broker/Dealer assets jumped $452 billion during Q1, or 41% annualized, while “Fed Funds and Security Repurchase Agreements” (this is from the Fed’s Z.1 report) surged an incredible $815 billion, or 46% annualized. And indicative of massive monetary inflation, Money Market Fund assets expanded $470 billion during Q1, to a record $5.7 TN.
The banking crisis prompted one more in what has been a series of momentous liquidity crisis responses. But that just got things going. The intervention triggered a short squeeze and unwind of hedges, both providing meaningful sources of additional liquidity. Surging markets then unleashed FOMO – fear of missing out – huge flows into the markets. And, importantly, derivatives played an additional major role. Aggressive buying of call options energized bubble dynamics, as a rapidly rising market forced those that had sold call options to hedge their positions through levered purchases of stocks and ETFs.
Stir up this degree of liquidity and speculative excess – in an already energized marketplace – and you’re asking for trouble. And there was this fledgling bubble quietly waiting for its moment: artificial intelligence – and A.I. was bubble perfect. Talk about an investment thesis open to the wildest of imaginations. Nebulous and the sky’s the limit. Perfect for the so-called “magnificent seven” dominating the major indices, and perfect as well for companies everywhere that can now name drop AI in a press release, presentation or quarterly earnings call and watch their stocks shoot higher. NVIDIA today enjoys a y-t-d gain of 207% and a $1.1 TN market cap. Meta Platforms has made a stunning recovery, with a 162% 2023 gain. Both had big short positions going into the banking crisis.
And let me explain how this works. There’s an ideal formula for cooking up a spectacular short squeeze. It’s when you have significant fundamental deterioration - and then some alluring bullish story seemingly out of nowhere is thrown into the mix. This is precisely this year’s circumstance in the technology space.
Tech was under pressure in 2022. Tightened financial conditions were bursting bubbles. This was leading to scores of layoffs and business failures, as finance abruptly tightened for venture capital and start-up finance. Scores of negative cash-flow companies were losing their lifelines. But then - the flood of liquidity, the resulting dramatic market recovery, and the AI mania rapidly loosened finance throughout the sector. It was the perfect storm for a major short squeeze. The Goldman Sachs Short Index has gained 37% y-t-d, bolstered by a 17-session 24% surge starting on June 26th.
Especially at this stage of the cycle, you cannot overstate the importance of financial conditions. For individual companies, it can be the difference between prospering and failure. For certain industries, it’s the difference between ongoing boom or bust. And with this massive short squeeze, FOMO and derivatives melt-up, the tech space this year does recall a similar dynamic that marked a 15-year top for Nasdaq back in Q1 2000.
Importantly, this year’s bubble revival dynamic has not been limited to the technology sector. I’ll use the example of online car reseller, Carvana. This stock dropped 98% last year, as the company fought for survival after losing access to borrowings – including securitizing its auto receivables. Last year’s tighter financial conditions had stirred fears of recession and credit problems, which manifest initially at credit’s risky periphery. Well, financial conditions have this year loosened, demand for securitizations has recovered, and Carvana’s stock has surged over 800%.
Carvana is a microcosm of risky lending and the significant impact fringe finance has throughout our economy. Last year’s tighter financial conditions had begun to pierce that bubble. But this year’s loosening has granted risking lending an extended lease on life – in consumer, mortgage, and corporate finance. It has made the difference between economic recession and expansion. And I would strongly argue that this year’s loosening has only extended what I refer to as “terminal phase excess” – another year of an inflating bubble that ensures only deeper and more protracted market and economic adjustment ahead.
It has been integral to my analytical thesis that years of loose finance resulted in severe structural maladjustment to the U.S. economy – major resource misallocation and malinvestment - the proliferation of score of uneconomic, negative-cash generating enterprises. This maladjustment makes the U.S. economy especially vulnerable to tightened credit and financial conditions. But as we’ve witnessed this year, a loosening of financial conditions can extend the life of this bubble economy structure.
Most economists and analysts view this year’s resilience as confirmation of sound underpinnings. I do not believe today’s loose conditions are sustainable. Indeed, I see all the confirmation of the bubble thesis imaginable. But with markets booming, analysis has turned decidedly bullish. “Soft landing,” “Goldilocks,” and “immaculate disinflation” fill the headlines. The latest is Ed Yardeni’s “Nirvana scenario” – where the bond market is supposedly signaling all gain and little pain – the end of nasty inflation without a spike in unemployment or a hit to stock prices.
In Friday’s CBB I used a quote from Paul Newman: “If you’re playing a poker game and you look around the table and can’t tell who the sucker is - it’s you.”
With the Fed today content with loose financial conditions and the “risk on” market bubble bolstering confidence and economic activity, the bond market is not feeling the nirvana. It’s instead nervously looking around the poker table.
We need to be clear on something. This is one historic global financial scheme. The system just keeps generating trillions of new credit and financial claims – while central banks print money and manipulate markets to artificially inflate market values of hundreds of trillions of financial instruments. This has inflated a historic gap between the market value of financial claims versus real economic wealth – and this gap has widened significantly more this year.
Over the years, I’ve quipped that bubbles have a propensity for inflating to unimaginable extremes – and then to double. After the pandemic crisis response, I replaced double with quadruple.
If we’re right on new cycle inflation dynamics, bond markets are vulnerable here. Bonds are the sucker, and they could end this party in a hurry. Ten-year yields spiked to 8% during the last real tightening back in 1994. Yields are half of that today – despite higher inflation than in ‘94.
Over time a new paradigm unfolded, with bond market focus shifting away from traditional fundamentals to prospects for Fed rate cuts and crisis-response QE. After the restart of QE in 2019, $5 TN of covid QE, and the recent bank crisis response, it’s understandable that bond pricing reflects the near certainty of ongoing aggressive monetary stimulus. But with financial conditions remaining so loose and the Fed winding down rate increases, I see the makings for a paradigm shift. Bond focus could pivot to the risk of sticky inflation and a more prolonged Fed tightening cycle. I see Tuesday’s Fitch U.S. debt downgrade as a shot across the bow. Fundamentals do matter. And despite all the Wall Street and Washington pushback against Fitch’s decision, Treasury debt has inflated from $6 TN to $27 TN since the end of 2007 – growing from about 40% of GDP to over 100%.
Meanwhile, inflation risks seem to be regaining some focus. Crude rallied back above $80, with surging gasoline futures prices up 20% y-t-d. Russia cancelled the black sea grain deal – and then proceeded to bomb Ukraine’s export infrastructure. A brutally hot summer is fueling global food insecurity, with India recently limiting rice exports. The heat is also impacting refinery output and spurring higher prices at the pump. And with an increasingly desperate Beijing adopting more aggressive stimulus, there’s been a bounce in copper and industrial metals prices. In total, it appears the makings of the type of strong recovery in commodities prices that would rekindle inflation fears and bond market angst.
What’s more, we’re entering a period of major global policy uncertainty. Central banks moving predictably and in unison create a backdrop of relative predictability for the global leveraged speculating community. But uncertainty now clouds the picture. Europe’s economy is weakening, with further ECB tightening now in doubt. Here at home, loose conditions raise the odds of the Fed extending tightening.
Meanwhile, pressure is mounting on the Bank of Japan to commence normalization after years of reckless negative rates and yield curve control. Between Japanese savers and institutions fleeing zero yields - and global speculators borrowing freely in yen, the amount of Japanese finance that has been fueling global bubbles is literally in the trillions. This powder keg will overhang markets over the coming months.
Today’s loose financial conditions sow the seeds for a major global financial crisis. There are different possible scenarios. I’ll focus on one in particular - that is anything but a long shot. Loose conditions underpin market speculation, economic demand, labor tightness, and inflationary pressures. Bond yields surprise to the upside, pressuring the Fed to tighten conditions and intensify its inflation fight. Higher rates and yields unnerve a complacent stock market, with particular risk for the now over-owned and leveraged “magnificent seven” and other high-flying growth stocks.
An abrupt market reversal would simultaneously trigger several liquidity-destroying dynamics. Portfolio managers that allowed their risk hedges to expire over recent months move aggressively to reestablish market protection. Hedge funds that cut back their shorts while pressing their longs try to quickly rebalance their portfolios. Derivative dealers that have been aggressively buying stocks and ETFs on leverage to hedge in-the-money call options - suddenly reverse course and become forceful sellers. And the public – having loaded up on growth stocks and ETFs after believing the all’s clear had been sounded – receives a shocking reminder of market risk.
It is the nature of contemporary market bubbles that the bullish perception of endless liquidity can quickly confront the realities of de-risking/deleveraging, illiquidity, dislocation, and panic. This was experienced in the UK last September and in the U.S. banking system this past March.
And recall the key issue from March, when suddenly bankers, regulators and Fed officials were awoken to today’s reality that destabilizing bank runs are only online chat boards and mouse clicks away. Virtually overnight, uninsured bank deposits posed a major systemic risk. So, what about latent systemic risks associated with ETF and money market funds – shares the public views as money-like – liquid and safe stores of value.
I would really prefer to not sound this way. But from my analytical perspective, this has been an ongoing trip along the worst-case scenario. History informs us that the most problematic crises erupt in money-like markets – bank deposits in March, the “repo” market in 2008, and with ETFs in 2020. Panic can quickly take hold when there’s a sudden fear of loss in instruments that had been perceived as safe and highly liquid.
It’s worth noting that household deposits have inflated $3.8 TN, or 36%, since the start of the pandemic. And money fund assets have surged $1.85 TN, or 51%. And I certainly appreciate the view that the Fed won’t allow a bank or money market crisis, and they’ll buy ETF shares if they need to. And since fragility lies just below the surface, they’ll respond quickly before crisis dynamics gain momentum – as they did in March.
But such an approach risks excessively loose conditions and spiraling inflation. I doubt it would be long before the bond market protests. And it’s the bond market that could call the shots going forward. A surge in bond yields would certainly get the Fed’s attention. I recall how the 1994 yield spike caused confusion at the Fed. Were they raising rates too fast and scaring the bond market, or were yields surging because the Fed was behind the curve?
The Fed is feeling pretty good about things right now – inflation, the economy, and markets. I call it “bubble mirage.” We’re only a jump in market yields away from a quite challenging backdrop for the markets and policymaking.
And speaking of challenging backdrops, I have brief comments on China and the geopolitical environment.
Not surprisingly, China’s post-covid recovery was short and unimpressive. Ramifications for the bursting Chinese apartment bubble have begun to sink in. The Chinese developer bond collapse has accelerated, with bonds of industry heavyweights Evergrande, Country Garden, Longfor, Sunak and others now trading for pennies on the dollar. Importantly, it appears the Chinese people have lost confidence in housing as the primary source of wealth accumulation. And as price declines accelerate, we could see an outright crisis of confidence. Today, tens of millions of apartment units bought for price speculation sit unoccupied. When owners begin sending keys to lenders and these empty units hit the market, bubble deflation will take a decided turn for the worse.
As I addressed in the Q1 call, I fear China’s bursting Bubble poses major geopolitical risks. It’s already clear that Beijing will chiefly blame the U.S. for its woes, deflecting responsibility for gross mismanagement of its financial and economic systems. And this “partners without limits” relationship with Putin’s Russia turns more ominous as the Ukraine war extends and intensifies.
I highlighted in Friday’s CBB a Reuters article reporting how Chinese and Russian officials stood shoulder to shoulder with Kim Jong Un at a military parade showcasing North Korea’s newest nuclear-capable missiles. The article noted that these armaments are banned by the U.N. and how in previous years Beijing and Moscow sought to distance themselves from such displays.
And just this weekend former Russian president and close Putin ally, Dmitry Medvedev, again warned of the risk of nuclear confrontation. Let’s assume such a catastrophe can be avoided. But we’re still left with Beijing – sights fixated on Taiwan - siding with the likes of Putin, Kim Jong Un and Iranian leadership.
Everything seems to point to a continued fracturing of the existing world order, with negative ramifications for trade and financial flows, inflation, growth, security, and overall stability. Further confrontation appears inevitable, and we can only pray it remains mainly in financial and economic realms.
At the minimum, we expect the unfolding secular shift to a bipolar world to be an important factor underpinning higher inflation. Besides trade frictions, supply-chain disruptions, and a major push toward self-sufficiency for key resources and manufacturing capabilities, the unfolding battle for global supremacy will promote inflationary policymaking. A bursting bubble certainly stands in the way of China’s objective of global superpower status and anchor to a new anti-American global alliance. Expect China to adopt whatever massive fiscal stimulus, bank lending and money printing they deem necessary to prolong the illusion of predominant economic and financial power.
To wrap this up, I want to stress that it’s no coincidence that we are witnessing manic markets in the face of mounting economic and geopolitical instability. They share the root cause of an extended period of monetary disorder. History informs us that things tend to run wild near the end of long cycles. I chalk this up to decades of monetary inflation, increasingly reckless policymaking and resulting excessive risk-taking and emboldened speculators, along with deepening structural maladjustment. Consequences include intractable bubbles, myriad fragilities, and policymakers desperate to hold collapse at bay.
Bubbles are so incredibly seductive and end up fooling just about everyone. And bubbles are, at their core, mechanisms of wealth redistribution and destruction. Insecurities, animosities, and conflicts are inevitable – domestically and globally. We bear witness to all of this today. For too long policymakers have resorted to only more egregious monetary inflation and non-productive debt growth. This deeply flawed doctrine has only made the unavoidable day of reckoning all the more frightening.