Q3 2023: “New Cycle Dynamics”
It became a habit to describe quarters as “extraordinary.” It just seems we’ve moved beyond extraordinary. Analysts now refer to the worst bond bear market in decades. Geopolitical experts are warning of the most dangerous environment since World War II. And I am focused on what I believe is the riskiest market environment in my more than three decades in investment management.
Our macro view holds that markets – and, really, the entire world – is in the throes of a transitional phase to a new cycle. The quarter provided important thesis confirmation.
Ten-year Treasury yields ended the quarter at 4.57%, up 73 bps, with yields last week trading above 5% for the first time since 2007. MBS yields surged to 6.85%, the high all the way back to 2002. Mortgage borrowing rates hit 8.0%.
Third quarter GDP growth surged to 4.9%. Core inflation accelerated during the quarter, with y-o-y inflation remaining above 4% (4.1%). The Unemployment Rate inched up to 3.8%, though job openings rose to 9.6 million.
These data points convey the nature of inflationary economies. Through various channels, the forces of inflation work to sustain demand. Excluding the accounting benefit from the reversal of student loan forgiveness, our federal government ran a $2 TN deficit for the fiscal year ended in September. Household spending has been supported by strong wage growth, higher stock and home prices, residual pandemic savings, and now by the added benefit of much higher returns on cash savings. It’s worth noting a remarkable statistic: Household sector combined holdings of deposits, Treasuries and Agency securities surged $6.3 TN, or 42%, just over the past four years - to $22.3 TN.
The quarter saw a major shift in market perceptions. Optimism was high to begin the period. Expectations had inflation poised to stay on a steady downward trajectory, allowing the Fed to wrap up its tightening cycle. Market chatter was of “immaculate disinflation” and the coveted “soft landing.” With the storm having passed, it was definitely time to buy bonds again. The S&P500 traded above 4,600 in late July. And recall that 10-year Treasury yields dropped to as low as 3.75% midmonth, with MBS yields trading below 5.50% in July. Popular Wall Street economist Ed Yardeni referred to a “Nirvana scenario.”
Unfortunately, the current environment is anything but Nirvana. Ten-year yields jumped 100 bps – MBS yields 200 bps – from July lows. Such confusion, indecision and market volatility are part and parcel to a transition to a new cycle. What’s more, the previous multi-decade cycle was so extraordinary – for finance, the markets, economic development, and global relations. We have been anticipating an especially challenging transition period. Such a phenomenal super cycle doesn’t changeover without fireworks.
The third quarter had elements of a transition-period inflection point. The quarter began with expectations of an imminent return to normal – to meager inflation, low market yields, an accommodative Federal Reserve, and perpetual bull markets. The Fed’s “dot plot” revisions at its late-July meeting provided a catalyst for an overdue reality check. “Higher for longer” is a catchphrase for “dynamics have changed”. We see confirmation that new cycle dynamics are now firmly in play. And it’s fitting they emerged most conspicuously in bond trading.
Indeed, we discern a momentous shift in market perceptions and pricing dynamics. For the first time in decades, Treasury supply has become a key determining factor in market yields. Bond analyst fixation has shifted away from the Fed, with focus now on deficits and Treasury auctions. And despite much more attractive yields across the curve, there is legitimate concern for the sources of demand necessary to absorb unending massive deficit spending. Dominant buyers from the previous cycle – the Fed and foreign central banks – have turned sellers.
Bond market angst is a global phenomenon. The overindebted European “periphery” has been under notable pressure. Fiscally challenged Italy bond yields have spiked to 2012 debt crisis levels. Overindebted EM country bonds have suffered major losses, with fledging de-risking/deleveraging stoking currency weakness, “hot money” outflows, and contagion. And with the Bank of Japan (BOJ) loath to commence policy normalization, the yen has sunk to lows all the way back to 1990, as rising global yields complicate the BOJ’s yield curve control policy.
I believe bubble analysis is today indispensable for grasping unfolding new cycle dynamics. After witnessing the phenomenal emergence of non-bank finance throughout the nineties, I began posting the Credit Bubble Bulletin in 1999. I watched carefully as the nineties bubble gathered momentum through a series of crises and central bank bailouts, only to succumb to parabolic excess with 1999’s almost doubling of Nasdaq. I thought the bubble had burst in 2000. But witnessing double-digit mortgage credit growth, egregious leveraged speculation, and inflating home prices, I reversed course in early 2002, warning of a mortgage finance bubble. I chronicled mortgage and speculative excess on a weekly basis. I again thought the bubble had burst in 2008. But witnessing how far policymakers were willing to go for system reflation, the following year I warned of the emerging global government finance bubble – the grandaddy of all bubbles. After 15 years, a multi-decade credit bubble is again acutely vulnerable.
Importantly, a bubble fueled by perceived safe and liquid government money is fundamentally different from preceding bubbles. Money is something we trust for its attributes of safety and liquidity. In contrast to junk bonds and Lehman Brothers liabilities, there’s no point where we protest, “No more. I’ve got enough government money.” And it’s this insatiable demand that creates the ultimate fuel for protracted bubbles and resulting deep structural maladjustment.
Outstanding Treasury securities ended June at $27.7 TN. Incredibly, Treasuries ballooned $21.7 TN, or 360%, since the end of 2007. This is precarious, end-of-cycle crazy unfolding at the very heart of finance – trusted credit bestowed with attributes of moneyness. As history informs us, such credit will be issued in increasingly gross excess, with devaluation ensuring an eventual crisis of confidence.
And let’s not disregard $12 TN of Agency securities - that expanded an unprecedented $2.8 TN, or 32%, just over the past four years. Incredibly, in four years, combined Treasury and Agency securities ballooned $12.6 TN, or 47%. This is reckless government finance bubble “terminal phase” excess – parabolic issuance of risky non-productive credit that dooms the bubble and cycle. And things have begun to come home to roost. Markets are finally demanding significantly higher risk premiums, commencing a problematic phase of bubble restraint.
Market adjustment to new paradigm dynamics had begun a year ago, only to be interrupted first by the policy response to the UK bond crisis and then in March with the U.S. banking crisis bailout. Importantly, the Fed and FHLB’s $700 billion March liquidity injection unleashed a speculative cycle that negated policy tightening. Loose market conditions stoked demand and credit growth, while sustaining tight labor markets – all conspiring to ensure inflation established deep roots.
Importantly, new paradigm dynamics are now entrenched, with markets in the throes of a major adjustment to so-called “higher for longer.” This is a huge problem for an over-indebted global system and highly leveraged markets – for a fragile China, for Bank of Japan policy normalization years overdue. It’s a problem for our banking system with their large “held to maturity” bond portfolios, along with the bloated and thinly capitalized GSEs.
With Washington facing spiraling debt service costs and uncontrollable deficits, Treasury and agency debt markets are at the epicenter of this tumultuous transition to new cycle dynamics. And it’s worth underscoring the Federal Reserve’s estimated $1 TN loss on its Treasury and Agency holdings. While this unprecedented hole in the Fed’s balance sheet doesn’t immediately pose a threat to the functioning of monetary policy, how could it not influence future Federal Reserve bailout and QE decisions. I believe the inflationary reaction to the March liquidity injection coupled with the enormous losses on Fed holdings will have the Fed reluctant to launch another QE program – especially a massive one. While I see the Federal Reserve in a crisis environment having no option than to resort to additional QE, they will likely move more slowly and with smaller scope than markets have been conditioned to expect. Market adjustment to new Fed backstop dynamics will be problematic.
I believe new paradigm dynamics pose major risk to government finance bubbles across the globe. And if Treasury and Agency markets are at the core of faltering bubbles here at home, China is the epicenter of the deflating global bubble phenomena. New paradigm dynamics took decisive hold in China during the quarter. The old foolproof policy tool kit just doesn’t work like it used to.
Despite myriad Beijing pronouncements and stimulus measures, China’s collapsing real estate bubble took a decisive turn for the worse. Country Garden is emblematic. Not many months ago, China’s largest and most well-known developer was viewed as financially sound, isolated from the travails of Evergrande and others. Having traded at 16% in February, Country Garden bond yields began the quarter at 65% - only to surge to over 250% - bonds trading at a few pennies on the dollar. It’s now in default on debt obligations, while behemoth Evergrande faces the specter of a messy liquidation. It’s incredible that these two failed developers account for over a half a trillion dollars of liabilities. In a number that is frankly difficult to comprehend, Bloomberg estimates total Chinese developer debt at $12.4 TN.
With apartment buyer confidence in tatters, new paradigm dynamics have taken firm hold. Beijing’s efforts to revive optimism are stymied, especially as developer debt crisis contagion engulfs other vulnerable sectors.
Yet focus remains on Chinese GDP, with growth on track to achieve Beijing’s 5% mandate. I say disregard China GDP statistics. The key storyline, at this late bubble phase, is that reckless credit growth is required to meet Beijing growth targets – that only unrelenting double-digit credit expansion staves off bubble collapse.
Stress is now mounting throughout China’s $12 TN local government debt sector, with special concern for local government financing vehicles – or LGFVs. For years, cities and municipalities across China used land sales proceeds to finance lavish infrastructure projects and other development. The developer implosion caused a collapse in this key revenue source, with scores of local governments and financing vehicles now financially impaired. Beijing has moved to bolster this sector. But like policies to support the developers, stabilization measures that succeeded in the past - these days have muted impact. Let me repeat the scope of the problem. The developers’ $12 TN and the local governments’ $12 TN equates to $24 TN of suspect credit.
So far, the credit cycle survives on the back of government debt growth and the ongoing historic ballooning of China’s banking system. Bank assets jumped another $5.3 TN, or over 10%, the past year, to $56 TN. Bank assets have expanded 10-fold since 2004 – and six-fold since the great financial crisis. And now China’s banking system is directed to step up risky lending, to assist the troubled developers and deflating apartment markets. Banks are also directed to lend to the local government sector, while rolling over and reducing rates on troubled government debt. The house of cards Chinese banking system is today propped up by faith that Beijing won’t allow a systemic crisis.
Prolonging such terminal phase excess is the kiss of death to a sound currency. Considering the ongoing historic expansion of credit of atrocious quality, it’s no surprise that China’s currency is trading near lows back to 2008. Beijing holds control over their companies, banks, local governments, and the Chinese people. But they do not control global currency markets. How long can China’s currency withstand such egregious excess - especially with today’s geopolitics? Over the past three decades, I’ve observed scores of emerging market bubbles and currencies succumb. I view China no differently – it’s just so much bigger.
Sticking with government finance bubble and new paradigm themes, Japan must be part of the discussion. The yen tanked 1.5% Tuesday to lows back to 1990, as the Bank of Japan drags its heels with long overdue normalization. The BOJ has for years been locked into an inflationary regime of negative policy rates and yield curve control. To sustain misguided policies, the Bank of Japan is expected to purchase an additional $860 billion of government bonds this year – with the BOJ currently holding almost 60% of total Japanese government debt. Meanwhile, the spike in global yields has significantly compounded already high-risk Japanese policy. The BOJ needs to raise rates and allow yields to rise to mitigate the risk of disorderly currency devaluation. But measures to loosen yield curve control risk a destabilizing spike in bond yields – which would inflict heavy losses on holders of Japanese debt, including the BOJ, while further destabilizing global bond markets. As was confirmed Tuesday, the usual cautious baby step approach to policy adjustment no longer works. Markets responded to the BOJ’s yield curve control tinkering with the highest bond yields in 13 years and the weakest currency in 33 years.
China and Japan are in trouble. The risk of disorderly currency devaluation and contagion is high. A collapsing China bubble comes with momentous ramifications. Beijing’s response to acute instability will surely foment geopolitical instability. The odds of Beijing using Taiwan to divert attention from its domestic failures rise as China’s bubble deflates. With Xi Jinping hell-bent on pursuing global superpower ambitions, China’s fixation on credit-induced growth is running head on into a world increasingly suspicious of all things China. Destabilizing capital flight and onerous capital controls appear inevitable.
Analysis I’ve shared previously seems only more germane. Bubbles are mechanisms of wealth destruction and redistribution – with negative consequences for social and geopolitical stability. Boom periods engender perceptions of an expanding global pie. Cooperation, integration, and alliances are viewed as mutually beneficial. But late in the cycle perceptions shift. Many see the pie stagnant or shrinking. Zero sum game thinking dominates. Insecurity, animosity, disintegration, fraught alliances, and conflict take hold.
New paradigm dynamics are very much in play within the geopolitical realm. The U.S. has become deeply involved in a second war. Risks are high that the Israeli/Hamas war escalates into a regional conflict. At the minimum, the world has become even more fragmented than it was on October 6th. It’s worth noting the prominence given to Putin in Xi Jinping’s recent “belt and road” summit. Russian Foreign Minister Lavrov was also in Beijing for high-level meetings, and upon departure flew directly to North Korea to see Kim Jong Un. Moscow and Beijing have been in close consultation with Iran. They are moving quickly in the Middle East and elsewhere to cement their anti-U.S. alliance.
The world is an increasingly hostile, risky place. Both Putin and Xi see advantages in having the U.S. bogged down in an expanding Middle East conflict. Spreading U.S. focus and military assets is a benefit both for Russia’s war with Ukraine and China’s quest for dominance in the South China Sea and Taiwan Strait.
Markets have begun to factor in heightened geopolitical risk, another important facet of the new cycle paradigm. Markets previously were content to disregard geopolitical developments, confident that central banks were willing and able to counter any negative impact that might materialize. Besides, with such interrelated markets and economies, surely no major global player would view it in their interest to allow conflicts to escalate.
As global bubbles falter, the old paradigm is losing relevance. China and Russia are moving swiftly to build their anti-U.S. alliance, developing financial and economic structures immune to Western sanctions and pressures. Old relationships and interdependencies that kept a lid on geopolitical conflict are breaking down.
For the first time in decades, markets face the prospect of a prolonged period of highly elevated geopolitical risk. We believe a fragmented and adversarial world is a higher inflation world. We face higher deficit spending to support allies at war. Expect also a significant boost in U.S. military spending, as the reality of a hostile global anti-U.S. alliance forces a reworking of military preparedness in Europe, Asia and the Middle East. And we expect deficit spending – and credit growth more generally – to be an important facet in arms race and global economic power dynamics.
We anticipate ongoing economic fragmentation will spur deepening trade frictions and sanctions, including more onerous import/export bans. There will be more “friend-sourcing” and less reliance on Chinese manufacturing. Tit-for-tat measures ensure structural supply chain vulnerabilities. Global food and energy insecurity will turn only more acute. We expect sticky inflation, along with heightened risk of inflationary shocks. And this points to greater social, political and geopolitical instability.
Let’s return to global government finance bubble dynamics. As mentioned, there is no new bubble waiting in the wings to supplant government finance. And from years of maladjustment, the U.S. bubble economy structure requires extraordinary ongoing credit growth. All scenarios point to government debt being issued in enormous quantities – at least until the marketplace has had enough and begins to impose its will.
A strong case can be made that this process has begun. Last week, 10-year yields breached the 5% level, and this week provided another example of new paradigm dynamics. A Bloomberg headline: “The Big Bond Market Event Wednesday Is at Treasury, Not the Fed.” Just think of this: In the face of a geopolitical crisis and Fed meeting, it was the Treasury’s quarterly refunding announcement that was top of mind for the bond market. Is Treasury going boost auction sizes – and at what maturities? It’s been a long time…
To wrap up this “New Paradigm” discussion, let’s shift to a holdover from the previous cycle. There remains unflinching faith in the so-called “Fed put.” Markets operate with confidence the Fed is ready and able to respond with open-ended liquidity support. This is rational. After all, the Fed in 2020 embarked on an unprecedented $5 TN QE program - in March of that year repeatedly boosting the size of its liquidity program specifically to reverse de-risking/deleveraging. And in March of this year, there was the $700 billion liquidity response to bank runs.
I’ll focus for a minute or two on comments made last week at the Robin Hood Investors Conference. Ken Griffin, the head of powerful hedge fund and trading firm Citadel, was blasting the SEC for the agency’s concerns for the popular hedge fund leveraged “basis trade.”
These “basis trades” – where hedge funds place leveraged bets in Treasury futures to play the spread between cash and futures – can be 50 to 100 times levered. Citadel and others’ highly levered “basis trade” portfolios were blowing up in March 2020, that is until they were rescued by Fed QE. Legendary hedge fund operator Paul Tudor Jones candidly admitted as much at last week’s conference, stating “the Fed’s entrance in the market bailed that particular book out.”
Not surprisingly, the “basis trade” and leveraged speculation recovered to only grow bigger than ever. Last Friday’s CBB focused on this subject, so I won’t delve too deeply into the numbers. But I will highlight that the “repo” market – a key financing source for leveraged speculation - ended June at $7.7 TN, about 40% larger than March 2020’s then record. One-year growth totaled $1.3 TN, or 20%. Broker/Dealer “repo” liabilities posted one-year growth of $521 billion, or 34%, to a record $2.1 TN.
I’m worried that unprecedented leveraged speculation is the proverbial ticking time bomb. When he wasn’t criticizing regulators, Ken Griffin made pertinent comments on market liquidity dynamics. He said the largest risk Citadel faces is when pricing correlations between assets go ‘off the rails.’ In quote: ‘When you see repeated divestitures by market participants in the same direction day in and day out, that really puts a lot of pain into our portfolio.’”
Citadel and other highly leveraged market players operate as “too big to fail” institutions. Their leverage and market positioning leave them acutely vulnerable to any serious bout of market deleveraging and resulting illiquidity. They run their incredibly lucrative operations - confident the Fed and global central bank community will intervene to reverse market “risk off” trading before speculative deleveraging attains crisis momentum – before illiquidity, dislocation, and markets going “off the rails.”
I’m quite worried by how this is playing out. Financial and economic systems should by now be well into major adjustments to much higher rates and market yields, worsening global fragilities, and a rapidly deteriorating geopolitical backdrop. Whether it’s inflation, bond yields, deficits, political disfunction, Chinese bubbles, our soured relationship with China, the new world order, conflicts in Ukraine and the Middle East, and the looming Taiwan issue, there is today extraordinary uncertainty that should have players reining in leverage. Yet market leverage is greater than ever. The system is today poised precariously at peak speculative bubble.
Faith in central banking is dangerously misguided. Granted, the Fed and others have repeatedly rescued markets and reenergized bubbles. But each bailout fostered greater speculative excess and the need for the next even larger bailout. With pandemic QE scaling $5 TN, how much will be required for the next bailout?
Circling back to New Paradigm Dynamics, I believe the bond market is returning to its roots as a powerful imposer of discipline. Washington doesn’t realize it yet, but they will finally be forced to rein in profligate spending. Moreover, I suspect going forward the bond market will not look as kindly at big Fed liquidity injections. New Cycle dynamics are much different. With inflationary forces now deeply embedded throughout the real economy, inflationary stimulus will no longer remain conveniently contained within the financial sphere. Instead, big QE will mean both higher inflation and higher bond yields. And this dynamic raises serious questions for a lot of assumptions premised on the availability of unlimited central bank liquidity for market bailouts.
Markets today are much too complacent regarding unfolding global de-risking/deleveraging. There is underappreciation for the massive scope of speculative leverage, while the efficacy of prospective central bank liquidity backstops is overrated.
And thinking in terms of Jim Griffin’s “off the rails” market instability, necessary ingredients for global crisis are in plain sight. China’s banking system and currency are accidents in the making. Bank of Japan policy normalization risks disorderly currency and bond markets. Disorderly renminbi and yen have clear potential to unleash acute global currency instability, with levered EM “carry trades” vulnerable to deleveraging and problematic contagion.
Despite all the bullish talk of “American exceptionalism,” our highly leveraged system is today exceptionally vulnerable to de-risking/deleveraging emanating from synchronized global markets. And contemplating the proliferation of derivatives trading, particularly the reliance on option hedging strategies along with the popularity of “zero days to expiration” options speculation, how does this not end with a financial accident?
The U.S. economy is today overheated, the product of the interplay between loose financial conditions, highly speculative financial markets, and powerful inflationary impulses. Don’t extrapolate current growth dynamics. I expect unfolding de-risking/deleveraging to tighten U.S. financial conditions – with clear potential for disorderly tightening. This is not a system that will function well under tight conditions. There’s too much leverage and a multitude of uneconomic enterprises – a system severely maladjusted from the previous cycle’s decades of loose conditions.
We should expect the transition to new cycle dynamics – having taken hold in the bond market during Q3 - to broadly expand - impacts to include overdue adjustments in stock market valuation and economic structure. I hope I’m wrong on this, but a transition between major cycles will most certainly be tumultuous and unnerving.