Weekly Commentary: Crazy Extremis

Dr. Bernanke has referred to the understanding of the forces behind the Great Depression as the “Holy Grail of Economics.” But was the Great Depression chiefly the consequence of post-crash policy mistakes, as conventional thinking has come profess? Was it really a case of the Federal Reserve having grossly failed in its responsibility to expand the money supply? Or did the previous “Roaring Twenties” Bubble sow the seeds of a major down-cycle and collapse?

Having in the past carefully read through Bernanke’s writings on the twenties and subsequent depression, it was clear his analysis had a fundamental flaw: it disregarded momentous market dynamics that unfolded following the creation of the Federal Reserve system and recovery after the first world war.

The unprecedented buildup of speculative leverage throughout the twenties boom played an instrumental role in systemic liquidity abundance that fueled both financial distortions and economic maladjustment. Confidence in the Federal Reserve’s capacity to sustain marketplace liquidity was instrumental in bolstering a progressively speculative market environment that culminated in the 1927 to 1929 speculative blow-off.

There are those who believe the Federal Reserve should have acted even more aggressively when subprime cracked in mid-2007. More aggressive stimulus measures (why not QE in 2007?) and a Lehman bailout would have averted the “worst financial crisis since the Great Depression,” they believe.

As the late Dr. Kurt Richebacher would often repeat, “the only cure for a Bubble is to not let it inflate.” Certainly, the longer Bubbles expand the greater the underlying fragilities – ensuring timid central bankers unwilling to risk reining in excess. This was the problem in the late-twenties and in 2006/2007. I would argue this has been a fundamental dilemma for central bankers persistently now for going on a decade. Especially after the Bernanke Fed targeted risk assets as the key system reflationary mechanism, central banks have been loath to do anything that might risk upsetting the markets. Recall the 2011 “exit strategy” – promptly scrapped in favor of another doubling of the Fed’s balance sheet to $4.5 TN (by 2014).

From my analytical perspective, things have followed the worst-case scenario now for over three decades. Alan Greenspan’s assurances and loose monetary policy after the 1987 crash spurred “decade of greed” excesses that culminated with Bubbles in junk bonds, M&A and coastal real estate. The response to severe early-nineties bank impairment and recession was aggressive monetary stimulus and the active promotion of Wall Street finance (GSEs, MBS, ABS, derivatives, hedge funds, proprietary trading, etc.).

Once the boom in highly speculative market-based Credit took hold, there was no turning back. The 1994 bond bust ensured the Fed was done with the type of rate increases that might actually impinge speculation and tighten financial conditions. The Mexican bailout guaranteed fledgling Bubbles would run wild in Southeast Asia and elsewhere. The LTCM/Russia market “bailout” ensured Bubble Dynamics turned absolutely Crazy in technology stocks and U.S. corporate Credit. Things took a turn for the worse following the “tech” Bubble collapse. With Wall Street cheering on, the Federal Reserve fatefully targeted mortgage Credit as the key mechanism for system reflation. A doubling of mortgage debt in just over six years was one of history’s more reckless monetary inflations. The panicked response to the collapsing mortgage finance Bubble fomented by far the greatest monetary inflation the world has ever experienced: China; EM; Japan; Treasury debt; central bank Credit; speculative leverage everywhere…

The “global government finance Bubble” saw egregious excess break out at the foundation of finance – central bank Credit and sovereign debt. It was a “slippery slope”; no turning back. The sordid history of inflationism has been replayed: once monetary inflation commences it becomes virtually impossible to stop. There was barely a pause following the ECB’s $2.6 TN QE program before the electronic “printing presses” were fired up again. The Fed’s balance sheet inflated from less than $1.0 TN pre-crisis to $4.5 TN. After contracting to $3.7 TN this past August, it’s now quickly back above $4.0 TN. The Bank of Japan hasn’t even attempted to rein in QE, with assets at a record $5.3 TN – up from the pre-crisis $1.0 TN.

Believing “THE” Bubble had burst in 2000, the Fed saw no basis for not aggressively “reflating.” The Fed and global central bankers were convinced “THE” Bubble collapsed in 2008. It would be reckless not to proceed with history’s greatest concerted monetary inflation. “Whatever it takes” was necessary to save the euro and European integration. Globally, the scourge of deflation has apparently been lurking around every corner – for a decade. It was imperative for the Bank of Japan to demonstrate absolute resolve.

Things got completely away from Beijing. Having studied the Japanese experience, they failed to grasp the necessity of quashing Bubble excess early. Over time, GDP targets, global power dynamics and the fear of bursting Bubbles took precedence. As it turned out, the greater their Bubble inflated the more heated the U.S./China rivalry. In theory, it seemed reasonable to let air out of the Bubble gently. In reality, powerful Bubbles only scoff. As conspicuous as debt excesses and economic maladjustment became, “structural reform” took a backseat to negotiations with Donald Trump. A key Credit Bubble adage comes to mind: There’s never a convenient time to deflate a Bubble.

My view is that Chinese financial and economic fragilities were a major contributor to this past year’s historic global yield collapse. Present a highly speculative marketplace a high probability of aggressive monetary stimulus and you’re asking for a destabilizing “blow-off.” And in this strange world in which we live, wild speculative Credit market excess (i.e. collapsing yields) is viewed by nervous central bankers as a signal to employ aggressive monetary stimulus.

November non-farm payrolls jumped 266,000, much stronger-than-expected and the largest job growth since January (41.3k returning GM workers). The jobless rate declined to 3.5% (matching low since 1969), as average hourly earnings gained 3.1% from November ’18. For a fourth consecutive month of gains, preliminary December University of Michigan Consumer Confidence jumped to (an above estimates) 99.2, the strongest reading since May (and only 2pts from the strongest reading going back to 2004). At 115.2, the reading on Current Conditions (up 10 points since August) jumped to a one-year-high.

The Fed erred in cutting rates three times this year. It was arguably a crucial policy blunder, though in all likelihood the exact opposite will be argued in the future: The Fed should have stimulated more aggressively. We can anticipate the assertion the Fed flubbed last year in raising rates. Heck, the Federal Reserve should have gone full Japanese: zero rates and QE indefinitely. The S&P500 ended the week with a year-to-date gain of 25.5%, lagging Nasdaq’s 30.5%. The Nasdaq Computer Index has jumped 43.8%, with the Semiconductors (SOX) surging 49.3%. The Banks (BKX) have enjoyed 2019 gains of 29.3%.

Markets have virtually no concern the Fed might actually reassess its policy course and reverse rate cuts (what happened to “mid-cycle adjustment”?). Markets see only a 1.7% probability of a rate increase by the June 2020 FOMC meeting, while the probability of another cut sits at 42.9%. Curiously, the bond market took Friday’s robust economic data calmly. Ten-year Treasury yields rose only three bps Friday to 1.84% (up 6bps for the week). A delayed reaction wouldn’t be surprising. Perhaps bonds are holding out hope for negative trade headlines. But an asymmetrical Fed policy bias (no rate increase at least through next November’s elections) seems for now to work for both stocks and bonds.

It’s difficult to define “Crazy”. I suppose you know it when you see it. It’s a central facet of Bubble Analysis that things get Crazy at the end of cycles. Arguing that we’re in the throes of the history’s greatest global Bubble, we shouldn’t underestimate Craziness Extremis. Bear markets and recessions have been rescinded. Stocks always go up. Debt and deficits don’t matter. The Beijing meritocracy is up to any challenge. Global central bankers have things well under control.

I’ve been thinking a lot lately about a key unheeded lesson from the mortgage finance Bubble experience: prolonged market distortions come with grave consequences. The belief that the Fed and Treasury wouldn’t tolerate a housing crisis was instrumental in the mispricing of finance that saw yields drop (prices rise) in the face of a doubling of total mortgage debt. The perception of government-imposed safety abrogated the market pricing mechanism. Supply and demand no longer dictated the price of mortgage Credit. The market became unhinged.

Over the years, I’ve described how a Bubble in high-risk junk bonds would pose limited systemic risk. If things heated up – if issuance got out of hand, the market would howl, “No More Junk!” Market discipline would essentially bring the boom to a conclusion prior to prolonged excess and the onset of deep structural maladjustment.

A Bubble financed by “money” is perilous. There is, after all, essentially unlimited demand for instruments perceived as safe and liquid stores of (nominal) value. Implied federal guarantees of GSE debt and assurance of aggressive Federal Reserve reflationary measures in the event of instability bestowed the precious attribute of moneyness to mortgage-related debt during that fateful Bubble period (“Moneyness of Credit”).

More than a decade ago I warned of the “Moneyness of Risk Assets” – with Bernanke’s reflationary measures having lavished the perception of safety and liquidity upon equities, corporate Credit and derivatives.

November 30 – Financial Times (Chris Flood): “Global assets held by exchange traded funds have climbed to a record $6tn, doubling in less than four years… The sector’s explosive growth has attracted heightened scrutiny by regulators who are concerned about the influence of ETFs as they spread deeper and wider into financial markets worldwide. ‘Passing the $6tn milestone is a historic moment but we are still in a relatively early stage of the industry’s development as ETF adoption rates across Europe and Asia are well below those seen in the US,’ said Deborah Fuhr, co-founder of ETFGI…”

And if the incredible flows into perceived safe and liquid ETF shares weren’t enough… Is this the time to run to – or away from – the bond market?

December 1 – Financial Times (Chris Flood): “Exchange traded funds linked to bond markets have attracted higher investor inflows than equivalent equity products this year in a highly unusual development in the history of the ETF industry. Bond ETFs have traditionally accounted for a fraction of the new cash entering the $5.9tn segment of the asset management world… But this pattern has reversed in 2019 for the first time. Investors have ploughed $191bn into fixed income ETFs in the first 10 months, compared with less than $158bn in new cash gathered by equity ETFs, according to ETFGI… ‘Adoption rates have accelerated noticeably as more investors have realised that fixed income ETFs can provide efficient solutions to some of the liquidity challenges of cash bond markets,’ said Deborah Fuhr, co-founder of ETFGI.”

The mortgage finance Bubble finally got into serious trouble when the “blow-off” subprime mania had driven home prices to unsustainable levels. Speculators turned cautious, financial conditions tightened, the marginal subprime buyer lost access to Credit, home prices reversed, the Bubble faltered, and the fringe of mortgage Credit lost its “moneyness.” Those highly levered in mortgage securities lost access to funding and crisis erupted. Market and economic structures having become addicted to Credit and liquidity excess were suddenly starved of both.

In a replay of the previous Bubble, government distortions have ensured a complete breakdown in market pricing mechanisms. Yields have declined (securities prices inflated) in the face of a tripling of Federal debt. And with central bank Credit and government debt fueling the Bubble, markets breathe easily. What could go wrong? There’s no subprime and home price dynamic that could bring the party to a bitter end. And as the Italian debt market has demonstrated, market concern for the quantity, quality and liquidity of sovereign debt can be alleviated through the expansion of central bank Credit (“money”).

So how might this all come to an end? Where is the current Bubble’s soft underbelly – the area of potentially acute fragility?

December 2 – Bloomberg (Yalman Onaran): “Flare-ups in the repo market could still cause worries across the global banking system, more than two months after chaos subsided in this vital corner of finance. Of particular concern: U.S. Treasuries, the world’s biggest bond market and the place where the federal government funds its escalating deficit. If repo rates become jumpy again -- and many are girding for that to happen in the middle and end of this month -- some of those leveraged investors may have to unwind Treasury holdings, potentially increasing the U.S. government’s interest costs at a time of record borrowing. ‘If repos were much harder to get at reasonable rates, Treasury prices would drop,’ said Darrell Duffie, a Stanford University finance professor who’s co-authored research on repo with Federal Reserve staffers. ‘The cost to taxpayers for funding the national debt would therefore rise.’”

Global securities funding markets could well prove a critical weak link. Over recent months, instability has erupted in China’s money markets. There have been indications of vulnerability in global dollar funding markets. And, of course, there were September’s “repo” market convulsions here at home.

The Bloomberg article noted above included the following: “As U.S. government debt rose by $1 trillion in the 12 months through March, more than 80% of it was absorbed by ‘other investors,’ a category in the U.S. Treasury Department’s latest available database that includes broker-dealers and hedge funds. In the same period, holdings by primary dealers… increased by only about $100 billion.” Another Bloomberg article (see “China Watch”) discussed China’s $4.7 TN market in local government financing vehicles (LGFV), much of this market offering relatively high interest rates. A third Bloomberg article (see “Leveraged Speculation Watch”) noted “China’s crowded market of close to 9,000 hedge funds.” These are serious problems.

Evidence and anecdotes continue to support the thesis of unprecedented global leverage having accumulated throughout this most protracted boom cycle. People’s Bank of China liquidity injections stabilized China’s money market. Federal Reserve Credit expanded $293 billion in 12 weeks, pacifying U.S. overnight “repo” funding markets. But there’s a major problem: distorted markets and central bank backstops have afforded blank checkbooks to governments around the world. The U.S. Treasury is poised to run Trillion dollar deficits as far as the eye can see. And so long as markets are fearing trade wars, recession and deflation, downward pressure on bond yields keeps the game chugging along.

Yet the possibility of a trade agreement, economic expansion and some inflationary pressures could prove problematic. Rising bond yields would put pressure on highly leveraged and vulnerable markets. In all the discussion of “repo” market issues and challenges, the key point is somehow missed: Accommodating and promoting a market that finances speculative leveraging virtually guarantees problematic Bubbles. How could this lesson not have been learned in 2008? Now it’s a global Bubble, with all the issues of financial fragility, economic maladjustment, and wealth redistribution on an unprecedented scale.

For the Week:

The S&P500 added 0.2% (up 25.5% y-t-d), while the Dow was little changed (up 20.1%). The Utilities increased 0.3% (up 19.4%). The Banks jumped 1.1% (up 29.3%), while the Broker/Dealers were unchanged (up 21.7%). The Transports fell 1.4% (up 16.8%). The S&P 400 Midcaps rose 0.6% (up 21.6%), and the small cap Russell 2000 gained 0.6% (up 21.2%). The Nasdaq100 was little changed (up 32.7%). The Semiconductors added 0.4% (up 49.3%). The Biotechs rose 1.5% (up 20.3%). With bullion rallying $16, the HUI gold index gained 1.2% (up 35.3%).

Three-month Treasury bill rates ended the week at 1.475%. Two-year government yields were little changed at 1.62% (down 87bps y-t-d). Five-year T-note yields gained four bps to 1.66% (down 85bps). Ten-year Treasury yields rose six bps to 1.84% (down 85bps). Long bond yields jumped seven bps to 2.28% (down 74bps). Benchmark Fannie Mae MBS yields gained three bps to 2.73% (down 76bps).

Greek 10-year yields rose six bps to 1.49% (down 291bps y-t-d). Ten-year Portuguese yields increased two bps 0.42% (down 130bps). Italian 10-year yields surged 12 bps to 1.35% (down 139bps). Spain's 10-year yields jumped eight bps to 0.49% (down 92bps). German bund yields gained seven bps to negative 0.29% (down 53bps). French yields jumped eight bps to 0.03% (down 68bps). The French to German 10-year bond spread widened one to 32 bps. U.K. 10-year gilt yields rose eight bps to 0.77% (down 51bps). U.K.'s FTSE equities index dropped 1.5% (up 7.6% y-t-d).

Japan's Nikkei Equities Index added 0.3% (up 16.7% y-t-d). Japanese 10-year "JGB" yields jumped seven to negative 0.01% (down 7bps y-t-d). France's CAC40 dipped 0.6% (up 24.1%). The German DAX equities index declined 0.5% (up 24.7%). Spain's IBEX 35 equities index added 0.3% (up 9.9%). Italy's FTSE MIB index slipped 0.3% (up 26.5%). EM equities were mixed. Brazil's Bovespa index rallied 2.7% (up 22.1%), while Mexico's Bolsa dropped 2.1% (up 0.7%). South Korea's Kospi index declined 0.3% (up 2.0%). India's Sensex equities index fell 0.9% (up 12.1%). China's Shanghai Exchange rose 1.4% (up 16.8%). Turkey's Borsa Istanbul National 100 index gained 1.8% (up 19.3%). Russia's MICEX equities index slipped 0.2% (up 23.6%).

Investment-grade bond funds saw inflows of $2.233 billion, while junk bond funds posted outflows of $154 million (from Lipper).

Freddie Mac 30-year fixed mortgage rates were unchanged at 3.68% (down 107bps y-o-y). Fifteen-year rates slipped a basis point to 3.14% (down 107bps). Five-year hybrid ARM rates fell four bps to 3.39% (down 68bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-year fixed rates down ten bps to 3.92% (down 79bps).

Federal Reserve Credit last week increased $17.5bn to $4.019 TN, with a 12-week gain of $293 billion. Over the past year, Fed Credit contracted $28.5bn, or 0.7%. Fed Credit inflated $1.208 Trillion, or 43%, over the past 369 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt gained $2.0 billion last week to $3.417 TN. "Custody holdings" were up $13 billion, or 0.4% y-o-y.

M2 (narrow) "money" supply jumped $38.5 billion last week to a record $15.364 TN. "Narrow money" rose $1.085 TN, or 7.6%, over the past year. For the week, Currency increased $2.0bn. Total Checkable Deposits jumped $37.3bn, and Savings Deposits gained $17.8bn. Small Time Deposits dipped $3.0bn. Retail Money Funds fell $15.7bn.

Total money market fund assets added $2.4bn to $3.579 TN. Money Funds gained $635bn y-o-y, or 21.6%.

Total Commercial Paper declined $2.7bn to $1.136 TN. CP was up $60bn, or 5.6% year-over-year.

Currency Watch:

The U.S. dollar index declined 0.6% to 97.70 (up 1.6% y-t-d). For the week on the upside, the Brazilian real increased 2.4%, the New Zealand dollar 2.2%, the British pound 1.7%, the Mexican peso 1.2%, the Australian dollar 1.2%, the Norwegian krone 1.0%, the Swiss franc 0.9%, the Japanese yen 0.8%, the Swedish krona 0.8%, the Singapore dollar 0.5%, the euro 0.4%, the South African rand 0.3%, and the Canadian dollar 0.2%. On the downside, the South Korean won declined 0.7%. The Chinese renminbi declined 0.04% versus the dollar this week (down 2.22% y-t-d).

Commodities Watch:

The Bloomberg Commodities Index rallied 1.5% this week (up 1.6% y-t-d). Spot Gold recovered 1.1% to $1,460 (up 13.9%). Silver dropped 3.0% to $16.596 (up 6.8%). WTI crude surged $4.03 to $59.20 (up 30%). Gasoline rallied 3.5% (up 25%), and Natural Gas gained 2.3% (down 21%). Copper jumped 2.4% (up 4%). Wheat sank 3.2% (up 4%). Corn fell 1.2% (up 1%).

Market Instability Watch:

December 4 – CNBC (Fred Imbert): “The stock market’s poor start to December halted in its tracks the kind of euphoric rally that has marked the end of past bull markets, a so-called blow-off top. Between mid-August and late November, the Dow Jones Industrial Average was up 10.5% in a 74-day sprint that seemed to be immune from negative headlines. According to Ned Davis Research, the Dow has posted a median gain of 13.4% during blow-off tops dating to 1901. The median rally length was 61 days. ‘Given the high valuations I see, plus these divergences between many different indices, I am aware that many bull markets have ended with a rally similar to what we have seen since August,’ firm founder Ned Davis said…”

December 4 – Bloomberg (Vivien Lou Chen): “DoubleLine Capital… agrees with the International Monetary Fund that U.S. dollar loans made by foreign banks are creating a risk for the global financial system. Banks based outside the U.S. can’t get enough dollars to satisfy demand for loans denominated in the American currency. Unlike their U.S. counterparts, they don’t have a stable base of dollar deposits so they use foreign-currency swaps, which the IMF says are expensive and occasionally unreliable, to meet borrowers’ needs as a last resort. The trouble, according to DoubleLine, is that hiccups in this complicated arrangement -- say, increased volatility that causes sources of dollar funding to dry up -- could harm the global economy.”

December 2 – Yahoo Finance (Julie La Roche): “Influential bond investor Jeffrey Gundlach… sees a scenario where U.S. stocks get crushed in the next recession — and likely won't recover for quite some time to come. Even with Wall Street benchmarks just days removed from new record highs, the bearish investor declared that ‘the pattern of the United States outperforming the rest the world has already come to an end.’ …Gundlach noted that 2019 was one of the ‘easiest’ years ever for investors in ‘just about anything... Just throw a dart, and you're up 15-20%, not just the United States, but global stocks as well.’”

December 4 – Bloomberg (Elena Popina): “An unusual sense of tranquility has descended on China’s financial markets. The country’s stocks and government bonds have slowed to a crawl. The Shanghai Composite Index reached lows in volatility unseen in nearly two years, while the benchmark 10-year bond yield is moving in the narrowest range since 2012. And despite some drama for the yuan this week, implied volatility remains near the lowest since August. That everything should go quiet while markets elsewhere in the world swing on each new development in the trade war is especially surprising to China watchers. Some have started to question whether Beijing is acting to limit volatility in its markets, something authorities have a history of doing. While there’s no clear evidence of direct intervention in equities or the yuan, state media has recently come out in support of the stock market.”

Trump Administration Watch:

December 3 – Wall Street Journal (Bob Davis and Lingling Wei): “President Trump said he was willing to wait until after next year’s presidential election to strike a limited trade deal with China, sending stock prices down and casting doubt on whether the two sides will find enough common ground to head off new tariffs. ‘In some ways, I think it’s better to wait until after the election, you want to know the truth,’ Mr. Trump said… Mr. Trump’s remarks probably indicated an effort to gain leverage during the last two weeks before a Dec. 15 deadline for new tariffs on consumer goods to take effect, rather than signaling a fundamental breakdown in talks, said U.S. officials and close allies of Mr. Trump.”

December 4 – Reuters (Steve Holland, Costas Pitas and James Davey): “U.S. President Donald Trump said… that trade talks with China were going ‘very well,’ sounding more positive than on Tuesday when he said a trade deal might have to wait until after the 2020 U.S. presidential election. ‘Discussions are going very well and we’ll see what happens,’ Trump told reporters…”

December 3 – Reuters (David Shepardson): “U.S. Commerce Secretary Wilbur Ross said… the Trump administration has not ruled out imposing tariffs on imported autos, after letting a review period end in November with no action.”

December 3 – Bloomberg (Daniel Flatley): “The U.S. House of Representatives overwhelmingly approved legislation that would impose sanctions on Chinese officials over human rights abuses against Muslim minorities, prompting Beijing to threaten possible retaliation just as the world’s two largest economies seek to close a trade deal.”

December 3 – Financial Times (Editorial Board): “Donald Trump has opened two new fronts against supposed allies in his trade war. He announced on Monday that Brazil and Argentina would lose exemptions from higher tariffs on steel and aluminium. Most worrying, however, is the disclosure that France could face 100% tariffs over its digital services tax, which aims to ensure tech companies — often American — pay their fair share of corporation tax.”

December 2 – Reuters (Andrea Shalal and Gabriel Stargardter): “U.S. President Donald Trump ambushed Brazil and Argentina…, announcing tariffs on U.S. steel and aluminum imports from the two countries in a measure that shocked South American officials and left them scrambling for answers. In an early morning tweet, Trump said the tariffs, ‘effective immediately,’ were necessary because ‘Brazil and Argentina have been presiding over a massive devaluation of their currencies. which is not good for our farmers.’”

December 2 – Reuters (Michel Rose and Estelle Shirbon): “U.S. President Donald Trump and French leader Emmanuel Macron clashed over the future of NATO on Tuesday before a summit intended to celebrate the 70th anniversary of the Western military alliance… In sharp exchanges underlining discord in a transatlantic bloc hailed by backers as the most successful military pact in history, Trump demanded that Europe pay more for its collective defense and make concessions to U.S. interests on trade.”

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