Q4 2023: “Prospects After a Market Melt-Up”
During the third quarter call, I stated that the environment had moved beyond “extraordinary.” The fourth quarter was nothing short of phenomenal. The Nasdaq100’s 14.6% return boosted ‘23 returns to over 55%, the strongest since peak bubble year 1999. The Semiconductor Index returned 22% during the quarter and 67% for the year.
And things definitely got pretty crazy during Q4. I’ve been doing this for over three decades now, and I’ve never seen anything quite like it – the so-called “Everything squeeze” – stocks, Treasuries, corporate credit, the credit default swap marketplace, global bonds, the emerging markets, the currencies, and crypto. Virtually all markets synchronized “risk on” - panic buying everywhere. Short positions across virtually all markets were crushed. Even the sickly yen rallied about 6%, with China’s vulnerable renminbi recovering almost 3%. Bearish positioning in derivatives – certainly including credit default swaps – were hammered across global markets. Market hedges – that made a lot of sense in such a high-risk environment - blew up in everyone’s faces. CDS prices collapsed, as bank CDS, in particular, sank to levels not seen since before the Fed began raising rates.
The Goldman Sachs Short Index gained 16.3% during Q4, though that number doesn’t do justice. The short index was down almost 15% in October, with prospects for shorting appearing quite favorable.
But from November 13th lows to December 27th highs, the Goldman Sachs Short Index surged 43%. This was a real backbreaker for a severely depleted short-selling community - fighting for survival. The popularly shorted KBW Regional Bank Index returned almost 26% during Q4, reversing virtually all banking crisis-period losses. The more speculative the stock or sector, the stronger it performed. The ARK Innovation ETF returned 32% during Q4, while Bitcoin’s 57% surge boosted ‘23 gains to 156%.
In mid-November, Jim Chanos, the “dean of short selling” all the way back to the eighties, announced the closing of his hedge funds.
But the mauling wasn’t limited to stock market bears. For the quarter, 10-yr Treasury and MBS yields collapsed 69 and 111 bps. Popular bond ETFs posted double-digit Q4 returns.
But it really was a quarter of two distinct periods. It’s easy to forget that financial conditions were tightening in October. On October 19th, 10-year Treasury yields traded at 5% for the first time since 2007. Risk premiums were rising. High yield CDS prices traded to highs since the March banking crisis. The market was pricing at least a 5% Fed funds rate all the way out to July ‘24.
But the market environment then shifted dramatically during the final week of October. A Bloomberg headline captured the change, calling it the: “Best Run for Bonds Since 2020 as Traders Bet on Fed-Hike Finale.” Treasury yields dropped 26 bps that week, but that was nothing compared to sinking MBS and emerging market yields. High yield CDS prices collapsed, right along with Bank and emerging market CDS.
There was the smaller-than-expected Treasury quarterly refunding and a weaker Non-Farm payrolls report. But the key catalyst for the reversal and squeeze was Powell’s November 1st press conference. Speaking rhetorically, the Fed Chair stated, “The question we’re asking is: Should we hike more?” And he repeatedly emphasized tightened financial conditions. It seems clear that Powell and the Fed were fretting ramifications of spiking yields and market instability.
The S&P500 jumped 5.9% that week, the largest gain in a year. The Goldman Sachs Short Index surged 12.9%. The Regional Bank Index (KRX) jumped 10.7%. The VIX Index sank more than six points to below 15. Panic short covering and the unwind of hedges were key triggers igniting the upside market dislocation.
From there, financial conditions loosened dramatically. Heading into the Fed’s December 13th meeting, markets were already overheated. The S&P500 was trading at a one-year high, with the Nasdaq100 sporting a 50% y-t-d gain. The short squeeze was intense, with the Goldman short index up over 20% from November lows.
It is somewhat of a mystery why Powell was compelled to signal a “dovish pivot” at his December 13th press conference. Financial conditions had already significantly loosened. Markets were highly speculative. Yet Powell was okay throwing gas on the fire. The Goldman short index posted a spectacular two-day 14.4% melt-up. Ten-year yields sank 30 bps in three sessions, while the CDS price collapse accelerated. Not only did Powell stoke a speculative bubble. He delivered his “dovish pivot” two days ahead of a record $5 TN quarterly options and derivatives expiration, with derivative markets in an acutely unstable state.
I don’t think “fiasco” is too strong. After all, Powell and the Fed were instrumental in a historic melt-up market dislocation. I won’t use our limited time to rail against the Fed. But at this stage of the cycle and in a world fraught with risk, stoking a runaway speculative bubble was yet another costly mistake.
Let’s shift directions a bit. Fed officials do hold great power to move markets. But asset inflation and speculative bubbles require monetary fuel. The Fed’s balance sheet contracted about $800 billion last year to $7.65 TN – and is today $1.25 TN smaller compared to its July ‘22 peak. Moreover, the M2 monetary aggregate contracted $600 billion last year, as bank lending slowed markedly. Which begs the question: What is the monetary source fueling historic asset inflation?
I believe the answer to this question is at the heart of likely post market melt-up prospects. Was the source of the market fuel of the typical and sustainable variety? Or is something more threatening going on, something abnormal and prone to a destabilizing reversal.
From the perspective of my analytical framework, speculative leverage is highly problematic. When a trader uses a margin loan to purchase stock, this new credit adds liquidity into the market. If large amounts of leverage and resulting liquidity enter the marketplace, this monetary fuel tends to be self-reinforcing. Inflating stock prices induce only more margin-financed speculation. And as the size of this speculative credit and liquidity grow, distortions to the markets, the financial system and the economy become more structural.
From my studies of the “Roaring Twenties” period, I became convinced that a historic expansion of speculative leverage created vulnerabilities to crash dynamics and economic depression. The speculative melt-up that culminated in the summer of 1929 had left a fragile system acutely vulnerable to a market reversal, the self-reinforcing unwind of speculative credit, illiquidity, market dislocation, and panic.
The historical revisionists, with Ben Bernanke at the forefront, promote the view that the failure of the Fed to print sufficient money supply and recapitalize the banking system were the root causes of the Great Depression. Contemporaneous analysis appreciated that it was loose money, credit excess, faith in the Federal Reserve backstop, and rank speculation that had fueled a protracted bubble with deep structural maladjustment.
Speculative excess during our most prolonged bubble cycle has put “Roaring Twenties” excesses to shame. Margin lending has inflated to record levels. But in today’s world, margin debt accounts for only a sliver of speculative credit. Especially with the proliferation of options trading by institutions and online traders - derivative-related leverage has surely exploded over recent years.
I suspect the “magnificent seven” phenomenon became a major source of late-cycle speculative leverage. Call option buying in the major tech stocks and associated ETFs has been hugely market impactful. And as these stocks and derivatives succumbed to speculative melt-up dynamics, traders and derivative dealers that had sold call options and upside derivatives were forced to aggressively establish leveraged long positions in the underlying instruments - to hedge their exposures. This leveraging generated powerful system liquidity expansion.
But another source of leveraged speculation has likely been an even greater liquidity generator: The so-called “basis trade,” where hedge funds borrow to buy Treasury bonds while shorting corresponding Treasury futures contracts - capturing the tiny spread between the yields on the two instruments. This trade has been around for years. It had reached several hundred billion going into the pandemic. A disorderly unwind of the “basis trade” was a factor that forced repeated Fed announcements of larger liquidity injections necessary to quell the March 2020 panic.
The Fed’s “basis trade” bailout ensured that it would later inflate into one of history’s great levered speculations - in the world’s most important market. Reports over the summer had the “basis trade” reaching $500 bn, surpassing the pre-pandemic level. By the fall, it was up to $650 bn, with reports in December of a trillion-dollar “basis trade.” And focus on the Treasury “basis trade” overlooks what is surely similar leverage in Agency securities and MBS. Moreover, huge “carry trade” leverage has accumulated in U.S. corporate debt, along with bond markets around the world. And the U.S. certainly doesn’t hold a monopoly on levered speculation. With the Bank of Japan dragging its heels on policy normalization, a hugely advantageous yen “carry trade” financed massive speculative leverage in the U.S. and globally.
So, when we ponder sources of liquidity fueling market melt-ups in the face of a contracting Fed balance sheet and weakened bank lending, we can safely assume trillions of speculative leveraging – margin debt, derivatives-related leverage, “basis trades,” “carry trades,” and such. Crazy end-of-cycle monetary disorder.
Money market fund assets expanded $1.17 TN last year, or almost 25%, to a record $5.9 TN. This crushed the $729 billion annual growth record set in tumultuous 2007. Moreover, 2023 was an acceleration of already historic ballooning that started pre-pandemic. Since the Fed resumed QE back in September 2019, money fund assets have ballooned $2.56 TN, or 75%.
This historic monetary inflation flies under the radar. Analysts simplistically assume growth is driven by both flight from bank deposits and general risk aversion. It goes unappreciated that the money fund complex has evolved into a critical funding source for levered speculation. The Wall Street firms and major banks tap the “repo” market to fund their securities finance operations. When a hedge fund is levering Treasuries as part of a “basis trade” strategy, this borrowing is done through the “repo” market. And the money market fund complex has become THE major source of lending into the “repo” marketplace.
This part of the analysis gets more complex. Back during the mortgage finance bubble period, I was focused on the money markets as the key source of financing for ballooning GSE balance sheets. The GSEs would issue new short-term debt instruments to the money funds in exchange for cash, and then use this money to buy debt securities in the open market. This new liquidity would find its way back to the money fund complex, where the GSEs would simply issue more debt instruments and borrow more.
For those familiar with the workings of fractional reserve banking and the “deposit multiplier”, this was unfettered credit creation unconstrained by reserve requirements. I refer to this dynamic as the “infinite multiplier effect.” Basically, funds could be borrowed over and over again – creating the illusion of unlimited marketplace liquidity.
Funding “basis trade” speculation with “repo” borrowings - intermediated through the money fund complex takes mortgage finance bubble speculative leverage to dangerous new extremes. For starters, this type of monetary inflation appears miraculous. The Treasury can run $2 TN annual deficits while the Fed shrinks its balance sheet. Yet markets remain seductively liquid, while general financial conditions loosen. The Citadel hedge fund group is a major “basis trade” operator. Ken Griffin, Citadel’s founder and CEO, is fond of arguing that the “basis trade” is lowering government borrowing costs and supporting economic growth.
The problem today, as it has been for centuries, is that highly levered speculative bubbles neither last forever nor work in reverse. When we ponder post-melt-up prospects, the plight of the “basis trade”, and levered speculation more generally, are at the top of our list of considerations.
In some respects, this bubble dynamic enjoys extraordinary stability. At the heart of the financial system, the “basis trade” operators have full confidence that the Federal Reserve will do whatever it takes to maintain Treasury market liquidity. The Fed would, as they’ve done in the past, also move aggressively and swiftly to ensure “repo” market and money fund stability. And unlike risky mortgage debt, markets have no fear of credit issues – no matter the size of deficits or the ballooning size of outstanding Treasury debt.
Recalling the great American economist Hyman Minsky, “stability can be destabilizing.” Decades of Federal Reserve market backstops and bailouts – “coins in the fuse box” – have incentivized an unprecedented expansion of system leverage and speculative excess. As a student of financial history who analyzed the mortgage finance bubble on a daily basis, I can state without a doubt that the current global government finance bubble has inflated momentously beyond previous bubbles.
Fallout from the so-called “great financial crisis” is not yet too distant of a memory. And we know that it required trillions of Fed QE to thwart financial collapse in 2020. The next serious bout of global de-risking/deleveraging will pose quite a challenge for the Fed and global central bank community. The bigger that bubbles inflate, the greater the amount of QE that will be necessary to stabilize market liquidity. To try to keep deleveraging from snowballing, the Fed will surely move quickly and aggressively. And, importantly, the Fed has never confronted such a policy challenge with inflation risk as elevated and the bond market as levered.
Market dynamics have been intriguing to start 2024. Opening the year to the downside, weakness in the big Nasdaq stocks seemed to spur global market liquidity concerns. Periphery markets – from the emerging markets - to peripheral European bonds - to U.S. small cap stocks – signal nascent de-risking/deleveraging concerns. And while the Nasdaq100 reversed course and rallied to new all-time highs into options expiration, markets at the global periphery have been notable underperformers.
I vividly recall how big tech turned unstable to open year-2000, following 1999’s historic bubble year. There was one final big rally into quarterly options expiration, right in the face of deteriorating industry fundamentals. The March 2000 Nasdaq peak was not reached again for 15 years. I am mindful of how a marketplace so conditioned to squeeze shorts and hedges can extend “terminal phase” bubble excess. As I know better than most: call the demise of a bubble at your own peril.
Meanwhile, economic data to begin the new year are making the Goldilocks “soft landing” crowd nervous. While downshifting from Q3’s blistering 4.9% growth, a strong holiday shopping season, surging consumer confidence, and ongoing labor tightness suggest upside economic risk. Q4 GDP was reported this morning at a much stronger-than-expected 3.3% - after such a dramatic loosening of conditions, such data shouldn’t be surprising.
The Q4 “everything rally,” with market focus shifting to looming rate cuts, brought strong correlations between stocks and bonds. The rates market ended ‘23 pricing at least six rate cuts this year. Last week, bonds globally came under heavy selling pressure, as the market began dialing back rate cut expectations. Two-year Treasury yields jumped 24 bps last week, while MBS yields surged 28.
At this point, ongoing big tech bubble inflation increases the likelihood of upside surprises to both economic growth and inflation. Highly synchronized during the melt-up, bond and stock market performance could now part ways. And I see the bond market especially vulnerable in today’s post-melt-up environment. Market yields and rate expectations traded to levels not supported by underlying fundamentals. And with sentiment turning so bullish, market players extended durations and let hedges expire. This heightens the risk of a surprise bout of aggressive hedging and selling, with negative ramifications for marketplace liquidity.
It is today important to appreciate that melt-ups often conclude the speculative cycle. Inflated prices become unsustainable. Excesses – including speculative leveraging – turn untenable. The underlying monetary disorder becomes increasingly destabilizing, for the markets as well as the real economy. That said, there is an element of George Soros’ “reflexivity” – where perceptions tend to shape reality. As we’ve witnessed again over recent months, news and analysis follow market direction. Surging stock prices feed bullish narratives built on “soft landings,” falling inflation and rate cuts. Analysts will boost earnings estimates, and company managements will do whatever they can to beat them. Loose conditions will ensure easy corporate borrowing and more IPOs.
We see ongoing support for our thesis of a world transitioning to a new cycle. Melt-up dynamics, however, have extended the current transition phase, in the process emboldening those believing previous cycle bullish market, inflation and economic dynamics will be sustained indefinitely.
The reality is one - of a precarious widening gap between bullish perceptions and deteriorating prospects. This discontinuity significantly raises the odds of a disorderly adjustment – both in the markets and within the economy. Importantly, melt-up-induced price gains and liquidity excess mask mounting fragilities. Having disregarded myriad risks, markets became acutely vulnerable to abrupt reversals, de-risking/deleveraging, illiquidity, and destabilizing shifts in market perceptions.
In general, the post melt-up backdrop is one of highly elevated liquidity and de-leveraging risks. And, to begin 2024, there is support for this thesis right where we would expect to initially observe it - at the vulnerable global periphery - most sensitive to waning liquidity and tightened conditions.
In recent CBBs, I’ve noted the surge in global yields, especially in dollar-denominated emerging market debt. If the sophisticated global players were beginning to position for an unfolding deleveraging dynamic, this is exactly where they would begin paring exposures. The more vulnerable currencies are underperforming. EM currencies have been sold aggressively to begin the year, while the yen has already lost 4.5%.
It is not atypical for nascent stress at the “periphery” to underpin excess at the “core.” Even as the subprime implosion marked the beginning of the end to the mortgage finance bubble, a big rally in “core” AAA-rated Agency and MBS securities somewhat extended the boom.
These days at the troubled periphery, we have seen Chinese equities in freefall. Despite ongoing efforts to support stock prices, major Chinese indices have already suffered double-digit y-t-d declines. Talk now is of an almost $300 billion market rescue package, a huge number that analysts view as insufficient. This is a reminder of how incredibly China’s entire system inflated during this long cycle. If $300 bn is inadequate to support Chinese stocks, how much will be required to rescue the nation’s real estate markets, local government debt, the “trust industry,” and their almost $60 TN banking system.
I won’t spend a lot of time on China. Despite major stimulus and a long list of policy measures, Chinese bubble deflation has accelerated. So far, the economy has been supported by ongoing double-digit credit growth – a record $5 TN last year. But even astounding credit excess is failing to hold apartment bubble collapse at bay. Increasingly, contagion is taking hold throughout China’s bloated financial system, including local government debt, the “shadow banks”, the so-called “small bank” sector, and in corporate credit.
Talk of China exporting deflation to the world helped support the Q4 global bond rally. But the world is unprepared for a crisis of confidence in China’s currency and banking system. Confidence remains high that Beijing can contain crisis dynamics. It has the international reserve assets to support its currency, along with the wherewithal to recapitalize its banking system as necessary.
Complacency is unjustified. The numbers are just too big. $300 billion for the stock market, hundreds billions more for the trust industry and non-banks, and literally trillions for real estate and banking system stabilization. Meanwhile, I suspect a big chunk of China’s $3.2 TN of international reserves is either already spoken for or less than liquid.
When I ponder post melt-up prospects, I fear the world is today poorly positioned to manage through a crisis in China that would reverberate throughout global markets and economies. And, as I’ve discussed in the past, I worry that worsening bubble deflation in China will trigger what I’ve called “Plan B,” Beijing launching a strategy for Taiwan unification that would divert the Chinese people’s attention away from their government’s failings. Especially after last Saturday’s DPP party presidential victory, by an independent-minded candidate Beijing detests, I would expect China to soon begin tightening the noose. It seems reasonable that “Plan B” would start with economic pressure, more military intimidation, threats, and ultimatums – and later expand to even blockades and military actions.
As recently as his New Year’s address, Xi Jinping stated that Taiwan unification is inevitable. I doubt Xi will continue to tolerate U.S. arms transfers. And while little points to imminent military operations, with wars in Eastern Europe and the Middle East, U.S. resources are stretched.
One of history’s great bubbles is deflating in China. And there are Putin’s war on Ukraine and the expanding Middle East conflict. And then I watch U.S. stock prices rise further into record territory.
Back in the nineties, I devoted a lot of hours studying the “Roaring Twenties” period. I struggled with how the market – especially in the final 1928-29 speculative melt-up – could ignore such troubling developments both at home and abroad. Over the years, I’ve witnessed how bubble environments – especially during the late-cycle hyper-speculative phase – ensure fixation on capturing market gains at the expense of sound analysis and evolving risks.
And from my readings, it was fascinating how the so-called “naysayers” were completely discredited during the final “Roaring Twenties” melt-up. And only a few short weeks prior to the great crash, Irving Fisher, the preeminent economist of that era, famously stated: “Stock prices have reached what looks like a permanently high plateau.”
I’m not predicting a crash, though one wouldn’t surprise me. There are fragile market structures and potential catalysts. I do expect a problematic global de-risking/deleveraging dynamic to be an ongoing 2024 issue. As I mentioned, there are already signs of deleveraging at the periphery. And resulting losses, selling pressures, and liquidity challenges will likely spur contagion from the most vulnerable markets to the only somewhat less vulnerable – from the “periphery” to the “core.”
U.S. markets could continue to benefit from heightened stress elsewhere. But as I also discussed earlier, I believe melt-up dynamics and resulting loose conditions are problematic for the bond market. And I do ponder how the “basis trade” will perform in an environment of fledgling global de-risking/deleveraging. Leveraging in cash Treasury bonds while shorting futures contracts is basically free money – that is until something upsets the applecart - forcing the levered players to respond to heightened risk of illiquidity and market dislocation. The near meltdown in 2020 required a massive Fed bailout. The Lehman funding crisis sparked panic de-risking/deleveraging. And further back, I remember how the Russian currency and bond collapse sparked de-risking/deleveraging that brought down LTCM - and was at the cusp of unleashing market mayhem. Global speculative leverage was miniscule in 1998 compared to today.
The market is pricing 140 basis points of tightening this year. The Fed’s December “dot plot” was at 75. There’s not much in the economic data that would suggest the need for aggressive cuts. Indeed, recent loose financial conditions and the highly speculative market backdrop beckon for tighter policy. Is the market just plain wrong? Not necessarily.
I see the rates market pricing the not unreasonable probability of the Fed forced into aggressive loosening. A major episode of de-risking/deleveraging would certainly provoke a response from the Fed. We can assume that risk aversion has just begun to take hold at the “periphery.” We’ll keep a watchful eye on signs of emerging market de-risking/deleverage and contagion effects. With China on crisis watch, we’ll closely monitor China’s currency and CDS prices. It’s worth noting reports of a surge in China-related derivatives trading – an important development raising the likelihood of instability and market dislocation. And after an incredibly long delay, the Bank of Japan’s 2024 move to normalize policies comes with major risks.
And we will, of course, closely monitor geopolitical developments. It’s not easy to imagine a global environment more fraught with risk. The trajectory of regional escalation makes direct confrontation between the U.S. and Iran increasingly likely. The new “axis of evil” – Russia, Iran, North Korea, and China – are poised to cause trouble in 2024. Is this the year Iran finally has a nuclear weapon? Now with support from other “axis” partners, does North Korea follow in the Houthis’ footsteps and ratchet up misconduct? And last week Putin warned that if the current trajectory of the war continues, Ukraine’s sovereignty will be at risk. And it may be largely a stalemate on the battlefield, but Ukraine has demonstrated the ability to attack key strategic targets outside and inside Russia.
Here at home, how can we feel sanguine about November. Our nation remains so deeply and bitterly divided. Most Americans are dissatisfied with a Biden/Trump rematch. And no matter the election outcome, the majority of Americans will see the winner as unfit for the presidency. Between now and November there are trials, appeals and Supreme Court decisions. Moreover, either candidate could suffer a health issue that would throw the election into chaos. It’s possible that strong showings by third party candidates prevent either Trump or Biden from securing the required electoral votes. The integrity of election results could be questioned.
I really wish I could feel better about things. I am prepared for markets to disregard the confluence of troubling developments - until they get knocked over the head by them. After the melt-up, I see markets resuming transition-period dynamics. Uncertainty and indecision will surely stoke volatility. I expect the world to look differently by the end of the year. How things will progress – and what to expect in Q1 – is exceptionally unclear. And when I think about “prospects after a melt-up,” I see a world incredibly unprepared. I see our markets, Washington, and the American public woefully unprepared for a destabilizing period of historic instability.