Weekly Commentary: Peak Monetary Stimulus

Not again. Bloomberg is referring to “the bond market riddle.” The Financial Times went with the headline, “US Government Bond Investors Left Bewildered by ‘Bonkers’ Market Move.” It’s been three weeks of declining Treasury yields in the face of robust economic data (and surging commodities prices!). Too soon to be discussing a new “conundrum,” but I am finding the various explanations of Treasury market behavior interesting – if not convincing.

Treasury market sentiment had turned negative.  A decent short position had developed, and it’s perfectly reasonable to expect the occasional squeeze. Squeezes, after all, have become commonplace throughout the markets. But could there be something more fundamental unfolding?

Over the years, I’ve relied upon a “Core vs. Periphery” model of market instability as a key facet of my analytical framework. Instability and financial crises typically emerge at the “periphery” – at the fringe where the structurally weakest and most vulnerable to risk aversion and tightening financial conditions - reside. I believe this dynamic is already in play for the global Bubble, with the emerging markets earlier in the year experiencing an opening round of instability. Are we in the “quiet” before the next EM storm?

The dog that didn’t bark. Ten-year Treasury yields are down 18 bps this month. Meanwhile, the dollar index dropped 2.5% to a six-week low. Why haven’t the emerging markets mustered a more impressive rally, especially considering the degree of bearish sentiment that had developed? Could this be as good as it gets? The week’s developments lent support to the latent fragility at the “Periphery” thesis. Are central bank responses to liquidity overabundance and mounting inflationary pressures an escalating risk to fragile EM Bubbles?

The Bank of Russia surprised markets Friday with a 50 bps rate increase (to 5.0%), while warning additional hikes could be in the offing. At her press conference, central bank governor Elvira Nabiullina commented: “There’s a real risk of delaying the return to neutral monetary policy. These risks may make it necessary for a more serious, significant increase in the rate in the future.” Russia’s annual consumer price inflation has risen to almost 6%.

April 20 – Bloomberg (Josue Leonel and Matthew Malinowski): “Brazilian policy makers should have been more cautious when cutting interest rates last year and now need to stress they will raise them as needed to bring inflation to target, according to former central bank President Ilan Goldfajn. Rather than committing to a ‘partial adjustment’ of monetary stimulus, the bank needs to show it’s ready to do whatever is necessary to control prices that will soon be rising by 8% a year, Goldfajn said… Likewise, the bank may have gone too far when it cut rates to an all-time low of 2% and signaled they would stay there for the foreseeable future, he added. ‘In an emerging market like Brazil, using forward guidance is brave,’ said Goldfajn... ‘Unfortunately, I feel that this instrument isn’t available for us yet.’”

Brazil’s year-over-year inflation rate has jumped to 7%, the high since 2016, and is projected to even move higher. CPI has surged from last year’s below 2.5% rate. The Brazilian real is down 5.4% versus the dollar year-to-date, exacerbating Brazil’s inflation problem.

April 22 – Bloomberg (Maria Eloisa Capurro): “Mexico’s annual inflation surged further above the target ceiling to the highest in over three years, a spike that for now closes the window for the central bank to resume its cycle of interest rates reductions. Consumer prices rose 6.05% in early April from the same period last year due in part to base effects, the national statistics institute reported...”

Following news of the strongest consumer price inflation since 2017, Mexico’s central bank deputy governor Gerardo Esquivel tweeted, “Inflation isn’t out of control and won’t stay in elevated levels for a prolonged period. It’s primarily an arithmetic and transitory phenomenon.” After trending lower for three years (CPI up 2.2% y-o-y in April 2020), Mexico’s inflation trend has shifted markedly. Taking pressure off Mexico’s central bank thus far (and differentiating itself from other EM banks), the Mexican peso holds a slightly positive year-to-date gain versus the dollar.

After rising above 7.5% last year, India’s y-o-y consumer price inflation had subsided to about 4% in January. India’s March (y-o-y) inflation rate was reported at a stronger-than-expected 5.52%, as inflation regains momentum. With an out of control pandemic threatening economic recovery, the Reserve Bank of India in its April meeting remained focused on spurring growth. Yet India’s loose monetary and fiscal stances are increasingly being poorly received in currency and bond markets.

April 18 – Financial Times (Hudson Lockett in Hong Kong and Benjamin Parkin): “India’s currency has swung from emerging market leader to laggard as the country battles a ferocious wave of coronavirus infections, prompting concerns among global investors that a nascent economic recovery will crumble. The rupee has dropped about 3% to 75.14 per dollar since the start of April, the worst performance among a basket of two dozen emerging market peers…”

April 18 – Bloomberg (Subhadip Sircar): “India ended up selling fewer bonds than planned for a second straight week, highlighting the weak appetite for debt even as the nation is in the grip of the world’s worst virus outbreak. The central bank sold 220b rupees of bonds as against 320b rupees planned on Friday. It scrapped all bids for a five-year bond after it had rejected all bids similarly for the benchmark 10-year bond last week. Traders now speculate that the sharp increase in virus cases means the government will have to spend and subsequently borrow more. Comments from the finance minister didn’t bring much calm when she said that the government wouldn’t hesitate to front-load borrowing as much as needed.”

India’s sovereign Credit default swap prices jumped a notable 20 bps this week to 101 bps, up from a February low 64 - to a near nine-month high. State Bank of India ($557bn of assets) CDS surged 25 bps this week to 123 bps, the high since July. India’s multinational Reliance Industries’ (largest publicly traded company in India) CDS jumped 23 bps to a seven-month high 102 bps. India’s rupee declined 0.9% this week to the low versus the dollar since August. India’s Sensex Equities Index has dropped 4.3% over the past three weeks.

April 21 – Financial Times (Ayla Jean Yackley): “When a flood of posters and banners appeared this month bearing the number 128 on them, police were quick to tear them down — arguing that they insulted President Recep Tayyip Erdogan, a crime in Turkey. ‘Where is the $128bn?’ asked the opposition Republican People’s party (CHP) on banners hung from its offices across Turkey, referring to the money it says the central bank has used to shore up the lira in recent years. Estimates vary widely over the amount spent, and Erdogan… put the figure at $165bn — the highest assessment yet.”

April 23 – New York Times (Jack Ewing): “A cryptocurrency exchange in Turkey suspended operations this week amid accusations of fraud, freezing an estimated $2 billion in investors’ money, and authorities said they were seeking the company’s founder. The Turkish authorities raided offices in Istanbul associated with Thodex, a cryptocurrency trading platform, on Friday morning and arrested more than 60 people, the private news agency Demiroren reported. Thodex’s 27-year-old founder, Faruk Fatih Ozer, left Turkey for Albania on Tuesday… The cryptocurrency firm has nearly 400,000 active users, whose accounts were nominally worth a total of $2 billion…”

As numerous EM nations can these days attest, a horde of international reserves tends to support a nation’s currency even in the face of some shaky fundamentals. Using those reserves to bolster a currency under pressure generally buoys market confidence. In short, it works until it doesn’t. When a troubled nation blows through much of its reserve position in a failed attempt to keep an unsound currency elevated and its Bubble inflating, the end result is widespread dismay (from Turkey's citizens to international holders of Turkish assets). Turkey’s 10-year bond yields surged 55 bps this week to 17.73%, the high since the spike to 18.22% on March 31st (yields ended February at 12.86%). The Turkish lira dropped 3.9% this week, pushing y-t-d losses to 11.3%. Turkey’s BIST 100 Equities Index sank 4.5% this week (down 8.9% y-t-d), trading to the low since the March 23rd panic decline.

April 23 – Bloomberg (Maria Elena Vizcaino and Ezra Fieser): “Peru’s currency hit a record low as investors dumped everything from stocks to sovereign bonds after a little-known leftist candidate gained a clear lead in presidential polls, rattling investor confidence… Pedro Castillo, a former school teacher whose party has praised Latin American leftists such as Hugo Chavez, came from no-where to lead the first-round election on April 11. Now, he is ahead in the polls for the runoff and investors are spooked.”

The Peruvian currency (sol) sank 4.1% this week, closing Friday at an all-time low versus the dollar. Peru’s 10-year local currency yields surged 54 bps this week to 5.41%, up from 3.50% to begin 2021 - to the high since the March 2020 yield spike. Peru sovereign CDS jumped 17 bps to an 11-month high 93 bps. Outside of last year’s Covid spike, Peru CDS traded this week near four-year highs. Peru’s major equities indices dropped more than 10% this week. Colombia CDS rose eight bps, and Uruguay gained seven bps.

China Huarong International CDS dropped 368 bps this week to 684 bps, though the price remains far above the 149 bps that began the month. According to a Bloomberg report, the People’s Bank of China is considering absorbing $15 billion of troubled Huarong assets. China’s asset management companies (“AMCs”) have $50 billion of dollar-denominated bonds. In a signal the storm has yet to pass, China Orient Asset Management Company CDS jumped 22 bps this week to (a contract high) 157 bps. This CDS began the month at 97 bps. Market concerns persist regarding offshore debt structures and the protections foreign investors will be afforded, and these concerns are causing a rise in yields and CDS for offshore borrowers (highly levered financial institutions and real estate companies, in particular).

April 21 – South China Morning Post (Karen Yeung): “‘On the one hand, they [Beijing] are keen to reduce a moral hazard by forcing investors to take a haircut – thereby teaching them the hard way that even state-controlled institutions such as Huarong do not enjoy blanket government guarantees,’ said Wei He, China economist at Gavekal. ‘On the other, they want to prevent any disorderly knock-on effects in the domestic financial system and to limit the damage to confidence in China’s offshore market.’ China’s onshore corporate bond market has stayed calm so far... But the issue is with Huarong’s so-called Keepwell provisions that enable China’s banks and non-bank finance companies to access foreign currency financing in the global bond markets. Essentially, a Keepwell provision is a pledge, not a guarantee, to keep an offshore subsidiary that issues the bonds solvent in the event of distress. The immediate risk is that Huarong’s offshore issuance vehicles may not be supported in any restructuring, Hank Calenti, credit analyst at research firm CreditContinuum, wrote…”

Beyond the bond market riddle, it was a kooky week in the markets. Bitcoin sank 18%. French 10-year yields jumped nine bps to a 10-month high 0.08%, as European bonds continue to disregard declining Treasury yields. The five-year Treasury inflation “breakeven rate” dropped 18 bps to a six-week low 2.44%. Meanwhile, the Bloomberg Commodities Index jumped 2.2% to an almost three-year high (even as energy prices declined). Corn surged 10.2%, Wheat jumped 8.7% and Soybeans advanced 7.4%. Coffee rose 6.0%, and Cotton was up 4.5%. Copper rose 4.2% (up 23% y-t-d), and Iron Ore jumped 5.0%. Lumber surged another 6.0%, increasing 2021 gains to 57%.

April 22 – Bloomberg (Theophilos Argitis and Ye Xie): “The Bank of Canada sent out a warning to investors this week that inflation still matters. In a surprise move, it accelerated the timetable for a possible interest-rate increase and began paring back its bond purchases... That made Canada the first major economy to signal its intent to reduce emergency levels of monetary stimulus. It’s a turn in policy by Governor Tiff Macklem that shows there’s a limit to how much he’s willing to test the upper boundaries of inflation, with new forecasts showing the central bank expects the biggest persistent overshoot of its 2% target in at least two decades. The question is whether Canada’s situation is unique, or foreshadowing the start of a global exit from stimulus.”

Give the Bank of Canada Credit. “Inflation Forces the Bank of Canada’s Hand Ahead of Fed and ECB” was the headline for the above article. Economies are recovering more quickly than expected. Inflationary pressures are much more robust. Central banks should be responding. They’re surely turning increasingly apprehensive. Another Bloomberg headline, this one from Friday: “ECB Officials Expect Heated June Decision on Crisis Program.”

It sure appears the world has embarked on a treacherous descent from Peak Monetary Stimulus. This bodes poorly for the fragile “Periphery.” And while trouble at the “Periphery” has been known to somewhat prolong Bubble excess at the “Core” (i.e. subprime blowup and the greater mortgage finance Bubble), extending the U.S. mania would come at a very steep price. From this perspective, a modicum of safe haven demand might be just what untangles the Treasury riddle.

April 21 – Bloomberg (Matthew Brooker): “Mohamed El-Erian, former co-chief investment officer of Pacific Investment Management Co., says the Federal Reserve needs to find a way to exit its extremely loose monetary policy, and delaying a start to the process is risky. It still has a window to exit in a relatively orderly manner but this is getting smaller by the day. Markets are likely to see something between the 2013 taper tantrum and the 2008 Lehman moment if the Fed misses its window, according to the former Pimco executive.”


For the Week:

The S&P500 was little changed (up 11.3% y-t-d), while the Dow slipped 0.5% (up 11.2%). The Utilities fell 1.1% (up 5.8%). The Banks were unchanged (up 25.6%), while the Broker/Dealers declined 0.7% (up 21.6%). The Transports rose 1.4% (up 21.0%). The S&P 400 Midcaps gained 0.9% (up 19.0%), and the small cap Russell 2000 added 0.4% (up 15.0%). The Nasdaq100 fell 0.7% (up 8.2%). The Semiconductors dropped 1.7% (up 14.4%). The Biotechs advanced 1.5% (down 1.9%). While bullion was little changed, the HUI gold index declined 0.6% (down 3.1%).

Three-month Treasury bill rates ended the week at 0.015%. Two-year government yields were little changed at 0.16% (up 4bps y-t-d). Five-year T-note yields declined two bps to 0.82% (up 46bps). Ten-year Treasury yields slipped two bps to 1.56% (up 64bps). Long bond yields fell three bps to 2.24% (up 59bps). Benchmark Fannie Mae MBS yields declined two bps to 1.84% (up 50bps).

Greek 10-year yields were unchanged at 0.90% (up 28bps y-t-d). Ten-year Portuguese yields were little changed at 0.40% (up 37bps). Italian 10-year yields rose three bps to 0.78% (up 24bps). Spain's 10-year yields added a basis point to 0.40% (up 35bps). German bund yields increased one basis point to negative 0.26% (up 31bps). French yields jumped nine bps to 0.08% (up 42bps). The French to German 10-year bond spread widened about nine to 34 bps. U.K. 10-year gilt yields declined two bps to 0.74% (up 55bps). U.K.'s FTSE equities index fell 1.2% (up 7.4% y-t-d).

Japan's Nikkei Equities Index dropped 2.2% (up 5.7% y-t-d). Japanese 10-year "JGB" yields declined two bps to 0.07% (up 5bps y-t-d). France's CAC40 slipped 0.5% (up 12.7%). The German DAX equities index fell 1.2% (up 11.4%). Spain's IBEX 35 equities index was little changed (up 6.7%). Italy's FTSE MIB index dropped 1.4% (up 9.7%). EM equities were mixed. Brazil's Bovespa index declined 0.5% (up 1.3%), while Mexico's Bolsa gained 0.7% (up 11.4%). South Korea's Kospi index slipped 0.4% (up 10.9%). India's Sensex equities index dropped 2.0% (up 0.3%). China's Shanghai Exchange rallied 1.4% (unchanged). Turkey's Borsa Istanbul National 100 index sank 4.5% (down 8.9%). Russia's MICEX equities index was unchanged (up 9.4%).

Investment-grade bond funds saw inflows of $4.881 billion, while junk bond funds posted outflows of $1.325 billion (from Lipper).

Federal Reserve Credit last week expanded $69.5bn to a record $7.762 TN. Over the past 84 weeks, Fed Credit expanded $4.035 TN, or 108%. Fed Credit inflated $4.951 Trillion, or 176%, over the past 441 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt last week increased $5.8bn to $3.560 TN. "Custody holdings" were up $240bn, or 7.2%, y-o-y.

Total money market fund assets increased $15.6bn to $4.470 TN. Total money funds dropped $182bn y-o-y, or 3.9%.

Total Commercial Paper rose $11.6bn to an 11-year high $1.219 TN. CP was up $85bn, or 14.1%, year-over-year.

Freddie Mac 30-year fixed mortgage rates dropped seven bps to 2.97% (down 36bps y-o-y). Fifteen-year rates fell six bps to 2.29% (down 57bps). Five-year hybrid ARM rates increased three bps to 2.83% (down 45bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-year fixed rates up a basis point to 3.07% (down 63bps).
 

Disclosure: Doug Noland is not a financial advisor nor is he providing investment services. This blog does not provide investment advice and Doug Noland's comments are an expression of opinion ...

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