The Precipice
Doug Nolan
Global markets have found themselves again at the precipice. My sense is that everyone’s numb – literally dazed and confused from prolonged Monetary Disorder and the resulting perverted market backdrop. Repeatedly, “The Precipice” has signaled easy-money buying and trading opportunities. Again and again, selling, shorting and hedging at “The Precipice” guaranteed you were to soon look (and feel) like an absolute moron – for some, progressively poorer dunces the Bubble was pushing yet another step closer to serious dilemmas (financial, professional, personal and otherwise). A focus on risk became irrational. Fixation on seeking potential market rewards turned all-encompassing.
All of this will prove a challenge to explain to future generations. Keynes: “Worldly wisdom teaches that it is better for the reputation to fail conventionally than to succeed unconventionally.” And paraphrasing the great Charles Kindleberger: Nothing causes as much angst as to see your neighbor (associate or competitor) get rich. In short, Bubbles are all powerful.
Going back to those darks days in late-2008, global policymakers have been determined to not let the markets down. Along the way they made things too easy. “Do whatever it takes!” “Shock and Awe!” “Ready to push back against a market tightening of financial conditions.” “Do what we must to raise inflation as quickly as possible.” Historic market excess and distortions were incentivized and, predictably, things ran amuck. “QE infinity.” Seven years of zero rates, massive monetary inflation and incessant market backstopping have desensitized and anesthetized. Rational thought ultimately succumbed to “perpetual money machine” quackery. And now all of this greatly increases vulnerability to destabilizing market dislocations, as senses are restored and nerves awakened.
It was a week of ominous developments among multiple key flashpoints. Let’s start with commodities and EM, where the accelerating downward spiral is now rapidly reaching the status of “unmitigated disaster.” In a destabilizing crisis of confidence, panic outflows saw the South African rand sink 10% to an all-time low. Yields and local South African bond jumped 140 bps in two sessions to about 9% (from WSJ). The Turkish lira dropped another 3%, as Turkey’s equities were slammed for 5%. The Russian ruble dropped 3.4%. The Brazilian real declined 3.2%. Despite repeated central bank interventions, the Mexican peso sank 4.4% this week to a record low. Also hurt by collapsing crude, the Colombian peso dropped 4% to a new low.
Crude (WTI) sank 12% this week to the lowest level since the 2008 crisis. The Bloomberg Commodities Index sank to fresh 16-year lows. Natural gas dropped 9%, to lows since 2012. Iron ore was down 4% this week to a record low (going back to 2009). Iron ore prices have collapsed almost 50% this year. Crude prices are down about 35%. For highly leveraged operators throughout the commodities arena, the situation has quickly turned desperate. In the financial realm, the yen jumped 1.7% and the euro gained another 1% against the dollar this week, pressuring the leveraged “carry trade” crowd.
It has rather quickly become equally desperate for financial operators holding risky corporate debt in a marketplace that has turned illiquid and increasingly dislocated. For the first time since the 2008 crisis, a public mutual fund (Third Avenue) this week halted redemptions. A Credit hedge fund (Stone Lion Capital) also halted redemptions. The concept of “Moneyness of Risk Assets” has been integral to my “global government finance Bubble” thesis. Monetary policy coupled with aggressive risk intermediation (certainly including fund structures and derivatives) created the market perception that high-yield corporate debt could be held with minimal risk (price and liquidity). With the Credit cycle turning, this misperception is being exposed. Junk bond fund redemptions jumped to $3.5 billion this week. The halcyon notion of turning illiquid securities into perceived liquid instruments is coming home to roost. Credit spreads widened significantly this week. Ominous as well, bank stocks sank 6.2%, and the Broker/Dealers were slammed 7.5%.
A Friday Bloomberg article (Sridhar Natarajan, Miles Weiss and Charles Stein) included a pertinent quote: “‘A lot of this looks like late 2007 or early 2008,’ when the credit crunch began to take root, said [Berwyn Income Fund’s George] Cipolloni… ‘But instead of housing and mortgages, it’s energy and materials leading the decline.’”
Cipolloni is on the right track, though this week looked more like later in 2008. And it’s important to contrast the current backdrop to that of the mortgage finance Bubble. I would argue that Credit issues in “energy and materials” are akin to subprime at the “periphery”– as opposed to mortgage Credit generally. Few in 2008 appreciated the degree of mispricing that pervaded in mortgage Credit and derivatives, and the near-catastrophic consequences (to market liquidity and the flow of finance throughout the asset markets and real economy) that would materialize with the bursting of the Bubble. Today, market mispricing is systemic and global – virtually all securities classes at home and abroad.
And whether it is commodities, EM or U.S. corporate debt, this was the type of week that spurs contagion. Especially with panicked fund redemptions, problems at the “periphery” can quickly move toward the “core” as risk aversion takes hold and financial conditions tighten more generally. And when players (especially those leveraged) can’t sell what they want, they begin selling what they can. There was also a rush to hedge, a backdrop conducive to market weakness begetting selling, more hedging and more “delta hedging” (selling to offset risk from derivative protection sold).
My plan for the week was to focus on the new Z.1 “flow of funds” report released Thursday. It is important data that confirms the bursting Bubble thesis. Credit growth slowed markedly, confirming that financial conditions tightened meaningfully during the third quarter.
Total Non-Financial Debt expanded at a 2.0% rate during Q3, the slowest debt expansion since Q2 2011. Q3 debt growth slowed sharply from Q2’s 4.6% and compares to Q3 2014’s 4.5%. Importantly, the Credit slowdown was broad-based. Household debt growth slowed to 1.5% from Q2’s 4.2%, to the weakest expansion since Q4 2013. Home Mortgage growth slowed from Q3’s 2.4% to 1.6%, while Consumer Credit slowed from 8.5% to 7.2%. Federal government debt growth slowed from 2.4% to Q3’s 0.2%.
Yet the most remarkable Credit slowdown unfolded during Q3 in Corporate borrowings. Corporate debt growth slowed to a 4.3% pace, about half of Q2’s 8.8% (strongest since Q3 2013’s 10.1%). In dollar terms, Total Business Borrowings slowed to a seasonally-adjusted and annualized rate (SAAR) of $586bn, down from Q2’s $1.025 TN.
Total Non-Financial Debt growth slowed markedly to SAAR $871bn, the weakest Credit expansion since Q4 2009 (SAAR $686bn) and down from Q2’s SAAR $1.989 TN and Q3 2014’s $1.907 TN. It’s worth noting that the rate of Credit expansion during the quarter was less than half the $2.0 TN bogey that I have posited is required to sustain the Bubble and unsound economic expansion.
The downturn now enveloping Corporate Credit portends a contraction in corporate profits and an abrupt slowdown of income growth. A significant tightening in corporate Credit also has negative ramifications for stock buybacks, M&A and financial engineering more generally.
All of this will prove a challenge to explain to future generations. Keynes: “Worldly wisdom teaches that it is better for the reputation to fail conventionally than to succeed unconventionally.” And paraphrasing the great Charles Kindleberger: Nothing causes as much angst as to see your neighbor (associate or competitor) get rich. In short, Bubbles are all powerful.
Going back to those darks days in late-2008, global policymakers have been determined to not let the markets down. Along the way they made things too easy. “Do whatever it takes!” “Shock and Awe!” “Ready to push back against a market tightening of financial conditions.” “Do what we must to raise inflation as quickly as possible.” Historic market excess and distortions were incentivized and, predictably, things ran amuck. “QE infinity.” Seven years of zero rates, massive monetary inflation and incessant market backstopping have desensitized and anesthetized. Rational thought ultimately succumbed to “perpetual money machine” quackery. And now all of this greatly increases vulnerability to destabilizing market dislocations, as senses are restored and nerves awakened.
It was a week of ominous developments among multiple key flashpoints. Let’s start with commodities and EM, where the accelerating downward spiral is now rapidly reaching the status of “unmitigated disaster.” In a destabilizing crisis of confidence, panic outflows saw the South African rand sink 10% to an all-time low. Yields and local South African bond jumped 140 bps in two sessions to about 9% (from WSJ). The Turkish lira dropped another 3%, as Turkey’s equities were slammed for 5%. The Russian ruble dropped 3.4%. The Brazilian real declined 3.2%. Despite repeated central bank interventions, the Mexican peso sank 4.4% this week to a record low. Also hurt by collapsing crude, the Colombian peso dropped 4% to a new low.
Crude (WTI) sank 12% this week to the lowest level since the 2008 crisis. The Bloomberg Commodities Index sank to fresh 16-year lows. Natural gas dropped 9%, to lows since 2012. Iron ore was down 4% this week to a record low (going back to 2009). Iron ore prices have collapsed almost 50% this year. Crude prices are down about 35%. For highly leveraged operators throughout the commodities arena, the situation has quickly turned desperate. In the financial realm, the yen jumped 1.7% and the euro gained another 1% against the dollar this week, pressuring the leveraged “carry trade” crowd.
It has rather quickly become equally desperate for financial operators holding risky corporate debt in a marketplace that has turned illiquid and increasingly dislocated. For the first time since the 2008 crisis, a public mutual fund (Third Avenue) this week halted redemptions. A Credit hedge fund (Stone Lion Capital) also halted redemptions. The concept of “Moneyness of Risk Assets” has been integral to my “global government finance Bubble” thesis. Monetary policy coupled with aggressive risk intermediation (certainly including fund structures and derivatives) created the market perception that high-yield corporate debt could be held with minimal risk (price and liquidity). With the Credit cycle turning, this misperception is being exposed. Junk bond fund redemptions jumped to $3.5 billion this week. The halcyon notion of turning illiquid securities into perceived liquid instruments is coming home to roost. Credit spreads widened significantly this week. Ominous as well, bank stocks sank 6.2%, and the Broker/Dealers were slammed 7.5%.
A Friday Bloomberg article (Sridhar Natarajan, Miles Weiss and Charles Stein) included a pertinent quote: “‘A lot of this looks like late 2007 or early 2008,’ when the credit crunch began to take root, said [Berwyn Income Fund’s George] Cipolloni… ‘But instead of housing and mortgages, it’s energy and materials leading the decline.’”
Cipolloni is on the right track, though this week looked more like later in 2008. And it’s important to contrast the current backdrop to that of the mortgage finance Bubble. I would argue that Credit issues in “energy and materials” are akin to subprime at the “periphery”– as opposed to mortgage Credit generally. Few in 2008 appreciated the degree of mispricing that pervaded in mortgage Credit and derivatives, and the near-catastrophic consequences (to market liquidity and the flow of finance throughout the asset markets and real economy) that would materialize with the bursting of the Bubble. Today, market mispricing is systemic and global – virtually all securities classes at home and abroad.
And whether it is commodities, EM or U.S. corporate debt, this was the type of week that spurs contagion. Especially with panicked fund redemptions, problems at the “periphery” can quickly move toward the “core” as risk aversion takes hold and financial conditions tighten more generally. And when players (especially those leveraged) can’t sell what they want, they begin selling what they can. There was also a rush to hedge, a backdrop conducive to market weakness begetting selling, more hedging and more “delta hedging” (selling to offset risk from derivative protection sold).
My plan for the week was to focus on the new Z.1 “flow of funds” report released Thursday. It is important data that confirms the bursting Bubble thesis. Credit growth slowed markedly, confirming that financial conditions tightened meaningfully during the third quarter.
Total Non-Financial Debt expanded at a 2.0% rate during Q3, the slowest debt expansion since Q2 2011. Q3 debt growth slowed sharply from Q2’s 4.6% and compares to Q3 2014’s 4.5%. Importantly, the Credit slowdown was broad-based. Household debt growth slowed to 1.5% from Q2’s 4.2%, to the weakest expansion since Q4 2013. Home Mortgage growth slowed from Q3’s 2.4% to 1.6%, while Consumer Credit slowed from 8.5% to 7.2%. Federal government debt growth slowed from 2.4% to Q3’s 0.2%.
Yet the most remarkable Credit slowdown unfolded during Q3 in Corporate borrowings. Corporate debt growth slowed to a 4.3% pace, about half of Q2’s 8.8% (strongest since Q3 2013’s 10.1%). In dollar terms, Total Business Borrowings slowed to a seasonally-adjusted and annualized rate (SAAR) of $586bn, down from Q2’s $1.025 TN.
Total Non-Financial Debt growth slowed markedly to SAAR $871bn, the weakest Credit expansion since Q4 2009 (SAAR $686bn) and down from Q2’s SAAR $1.989 TN and Q3 2014’s $1.907 TN. It’s worth noting that the rate of Credit expansion during the quarter was less than half the $2.0 TN bogey that I have posited is required to sustain the Bubble and unsound economic expansion.
Importantly, the Credit slowdown exacerbates already acute system vulnerability to a securities market downturn. With debt market tumult and dislocation building, there will surely be further slowing in Corporate Credit. After the late-nineties boom, Corporate Credit slowed sharply in 2001 and 2002 - and was barely positive in 2003. After peaking at more than $1.1 TN in 2007, Corporate Credit growth was cut in half in 2008, before contracting $455 billion in 2009. Corporate Credit has a strong proclivity for boom and bust dynamics.
The downturn now enveloping Corporate Credit portends a contraction in corporate profits and an abrupt slowdown of income growth. A significant tightening in corporate Credit also has negative ramifications for stock buybacks, M&A and financial engineering more generally.
Such a backdrop is negative for stock prices, and Q3 provided a glimpse of the feedback loop of tightened Corporate finance, weaker stock prices, declining household perceived wealth and economic vulnerability.
During Q3, Household (and Non-Profits) Assets declined $1.153 TN, or 1.1%, to $99.55 TN. With Household Liabilities expanding slightly, Household Net Worth declined $1.232 TN during the quarter. For perspective, Household Net Worth increased on average $1.838 TN over the previous 15 quarters. As a percentage of GDP, Household Net Worth declined from Q2’s 482% to 472%. After ending 2007 at 461%, Household Net Worth fell below 350% in early 2009. Household Net Worth closed out Q1 2015 at a record 486% of GDP. It’s worth noting that Households ended Q3 with Financial Assets at $68.925 TN, or 382% of GDP. This compares to 272% to end the eighties, 361% to end Bubble year 1999 and 366% to end 2007.
Rest of World (ROW) holdings of U.S. financial assets declined a notable SAAR $299bn, led by a SAAR $492bn drop in Treasury holdings. This was an abrupt reversal from strong (Trillion plus) annual growth in ROW holdings of U.S. assets over recent years. After expanding SAAR $705 billion in Q2, ROW holding of U.S. Bond’s increased only SAAR $21 billion during Q3. ROW holdings of U.S. equities contracted SAAR $100 billion. Q3 data may suggest waning demand for U.S. securities, or perhaps it reflects more globalized de-risking and de-leveraging pressures.
Q3 had its share of market tumult. There was the August Chinese devaluation and U.S. market “flash crash.” Currency markets were highly unstable, not unlike market conditions of late. The faltering Chinese Bubble has been integral to my bursting Bubble thesis. I have posited that a disorderly Chinese devaluation poses a major potential flashpoint to global finance and economies. The yuan devalued 0.8% this week, the largest decline since August. And Friday the Bank of China indicated a new trade-weighted basket of currencies may provide a better gauge of measuring the Chinese currency than a direct peg to the U.S. dollar.
Analysts generally responded positively to China’s apparent move to a more “flexible” currency regime. It appears more of a clever devaluation ploy. Apparently now moving away from a clearly defined currency peg to the dollar, the Bank of China can more easily obfuscate its intentions and keep currency speculators in check. But this new “regime” is problematic for Chinese issuers of dollar-denominated debt, as well as “carry trade” leverage that has flooded into Chinese high-yielding securities and instruments. Previous Chinese attempts to commence devaluation proved problematic. The current backdrop is fraught with much greater risks.
And I will be part of the crowd trying to anticipate the policymaker response to unstable global markets. Draghi has already disappointed the markets. The Fed does not want to follow the ECB’s lead. The markets expect the Fed to bump up rates 25 bps. I anticipate they will follow through this time around, but it would not be surprising if they don’t. But I’ve contended for some time now that global market instability is much more about the bursting Bubble than Fed tightening – more about China and EM than U.S. monetary policy. I’ll assume a dovish Fed might spur some fleeting bullishness, but it would also further destabilize currency trading.
During Q3, Household (and Non-Profits) Assets declined $1.153 TN, or 1.1%, to $99.55 TN. With Household Liabilities expanding slightly, Household Net Worth declined $1.232 TN during the quarter. For perspective, Household Net Worth increased on average $1.838 TN over the previous 15 quarters. As a percentage of GDP, Household Net Worth declined from Q2’s 482% to 472%. After ending 2007 at 461%, Household Net Worth fell below 350% in early 2009. Household Net Worth closed out Q1 2015 at a record 486% of GDP. It’s worth noting that Households ended Q3 with Financial Assets at $68.925 TN, or 382% of GDP. This compares to 272% to end the eighties, 361% to end Bubble year 1999 and 366% to end 2007.
Rest of World (ROW) holdings of U.S. financial assets declined a notable SAAR $299bn, led by a SAAR $492bn drop in Treasury holdings. This was an abrupt reversal from strong (Trillion plus) annual growth in ROW holdings of U.S. assets over recent years. After expanding SAAR $705 billion in Q2, ROW holding of U.S. Bond’s increased only SAAR $21 billion during Q3. ROW holdings of U.S. equities contracted SAAR $100 billion. Q3 data may suggest waning demand for U.S. securities, or perhaps it reflects more globalized de-risking and de-leveraging pressures.
Q3 had its share of market tumult. There was the August Chinese devaluation and U.S. market “flash crash.” Currency markets were highly unstable, not unlike market conditions of late. The faltering Chinese Bubble has been integral to my bursting Bubble thesis. I have posited that a disorderly Chinese devaluation poses a major potential flashpoint to global finance and economies. The yuan devalued 0.8% this week, the largest decline since August. And Friday the Bank of China indicated a new trade-weighted basket of currencies may provide a better gauge of measuring the Chinese currency than a direct peg to the U.S. dollar.
Analysts generally responded positively to China’s apparent move to a more “flexible” currency regime. It appears more of a clever devaluation ploy. Apparently now moving away from a clearly defined currency peg to the dollar, the Bank of China can more easily obfuscate its intentions and keep currency speculators in check. But this new “regime” is problematic for Chinese issuers of dollar-denominated debt, as well as “carry trade” leverage that has flooded into Chinese high-yielding securities and instruments. Previous Chinese attempts to commence devaluation proved problematic. The current backdrop is fraught with much greater risks.
And I will be part of the crowd trying to anticipate the policymaker response to unstable global markets. Draghi has already disappointed the markets. The Fed does not want to follow the ECB’s lead. The markets expect the Fed to bump up rates 25 bps. I anticipate they will follow through this time around, but it would not be surprising if they don’t. But I’ve contended for some time now that global market instability is much more about the bursting Bubble than Fed tightening – more about China and EM than U.S. monetary policy. I’ll assume a dovish Fed might spur some fleeting bullishness, but it would also further destabilize currency trading.
At this point, I don’t expect (de-risking and de-leveraging) markets to respond much to rates.
They will be increasingly desperate for more QE. I fully expect the Fed to eventually reinstate QE in response to financial crisis.
In the meantime, I suspect central bankers won't have answers for what ails global markets.
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