By Doug Noland
Let’s this week begin with a cursory glance at the world through the eyes of the bulls. First, the global backdrop provides the Fed convenient cover to delay “liftoff” at next week’s widely anticipated FOMC meeting. Even if they do move, it’s likely “one and done.” While on a downward trajectory, China’s $3.5 TN international reserve hoard is ample to stabilize the renminbi. Chinese officials clearly subscribe to their own commanding version of do “whatever it takes” to control finance and the economy. One way or another, they will sufficiently stabilize growth - for now. The U.S. economy enjoys general isolation from China and EM travails. Investment grade bond issuance – the lifeblood of share buybacks and M&A – has already bounced back robustly. The U.S. currency, economy and securities markets remain the envy of the world. “Money” fleeing faltering EM will continue to support U.S. asset markets along with the real economy.
September 10 – Financial Times (Netty Idayu Ismail): “The European Central Bank will ensure its policy stance remains as accommodative as needed amid financial-market turbulence, according to Executive Board member Peter Praet. ‘The Governing Council will remain vigilant that recent volatility does not materially affect the broad array of financial conditions and therefore lead to an unwarranted tightening of the monetary-policy stance,’ Praet said… ‘It has emphasized its willingness and ability to act, if warranted, by using all the instruments available within its mandate.’”
The ECB’s “unwarranted tightening of the monetary-policy stance” comes from the same playbook as Bernanke’s (the Fed’s) “push back against a tightening of financial conditions.” In a world where financial markets dictate general Credit Availability as never before, central bankers have essentially signaled open-ended commitment to liquidity injections as necessary to counteract risk aversion. Such extraordinary market exploitation underpins the fundamental bullish view that global policymakers have things under control.
On a near-term basis, policymakers retain tools to stabilize markets, though officials at the troubled Periphery are rapidly running short of policy flexibility. September’s “triple-witch” expiration of options and futures is now only a week away. Between the passing of time and the pull back in put premiums (“implied volatility”), bearish hedges and directional bets have lost tremendous value over the past two weeks.
The apparent stabilization in China has been integral to calmer global markets. Clearly, Chinese officials are in full-fledged crisis management mode. A series of measures and determined official support have stabilized the wobbly Chinese currency. Wednesday from Reuters: “Chinese Premier Li Keqiang said… that the recent adjustment in the yuan was ‘very small’ and that there is no basis for continued devaluation in the currency.”
And Thursday from the Financial Times (Jamil Anderlini): “Chinese Premier Li Keqiang… sought to reassure investors over the health of China’s economy… ‘China is not a source of risk but a source of growth for the world,’ Mr Li said in a speech to the World Economic Forum… ‘Despite some moderation in speed, the performance of the Chinese economy is stable and it is moving in a positive direction.’ …In a meeting with global business leaders at the forum, Mr Li dismissed the suggestion that China had been the trigger for instability in global markets in recent months. ‘The fluctuations in global financial markets recently are a continuation of the 2008 global financial crisis… Relevant Chinese authorities took steps to stabilise the market to prevent any spread of risks. Now we can say we have successfully forestalled potential systemic financial risks … what we did is common international practice and is in keeping with China’s national conditions.’”
“Steps to stabilize the market” have included arresting journalists and other rumor mongers accused by the central government of “destabilizing the market.” There has been a hard crackdown on hedge funds and other “manipulators”. Beijing has imposed a series of onerous measures against currency and securities markets derivatives trading. The Chinese government has also put in place controls to help impede financial outflows. Meanwhile, the state-directed “national team” has spent over $200bn buying stocks. The central bank has cut rates, slashed reserve requirements and injected enormous amounts of liquidity.
The bullish viewpoint holds that economies dictate market performance. As such, draconian measures from Chinese officials support the perception that Chinese policymakers have regained control over their markets and economy – in the process removing a major potential catalyst for global systemic dislocation. Though appalling, most take quiet comfort that Chinese-style “whatever it takes” works in the best interest of U.S. markets and the economy. The long-term rather long ago lost much of its relevance within the bull camp.
For me, it boils down to fundamental disagreement with the bulls on how the world actually works. For starters, finance is king. Credit and the financial markets drive economic activity - and not vice versa. My bursting global government finance Bubble thesis rests on the premise that global finance has by now suffered irreparable harm. Confidence is being broken and faith is being shattered. A difficult new era has begun, and it will be a long time before confidence returns to EM. De-risking/de-leveraging has taken hold, with contagion gaining momentum. And China can use all the duct tape in the world – including strips to silent the mouths of naysayers – to try to holds its stock market and Credit system together. The damage is done.
For a while now, global investors and speculators have been willing to ignore China’s shortcomings. In general, a world of over-liquefied markets tends to disregard risk while allowing a sanguine imagination to run absolutely wild. And the more finance that flooded into China and EM the more the optimists reveled in the “developing” world’s pursuit of the fruits of Capitalism. The Chinese talked a good commitment to steady free-market reform. Their aspirations for global financial and economic power seemed to ensure that they would adhere to the rules of Western finance.
In the past I gave Chinese officials too much Credit. They devoted a lot of resources to the endeavor, and at one time I believed the Chinese had gleaned valuable insight from the study of the Japanese Bubble experience. But Bubbles are both seductive and incredibly powerful, especially at the hands of authoritarian communist regimes. Massive post-2008 stimulus stoked runaway Bubble excess. Later, Chinese markets scoffed at timid little central bank measures meant to tenderly rein in excess. And the longer the Bubble inflated the greater the financial, economic, social and political risks.
In the end, the major lesson drawn from Japan’s experience was the wrong one. It was much belated, but the Japanese actually moved to pierce their Bubble. Chinese officials not only let their Credit Bubble run, they adopted the Fed’s approach to using the stock market as an expedient for system-wide inflation. That policy blunder was the Chinese Bubble’s proverbial nail in the coffin.
I’ll assume that after priority number one – stabilizing its currency – the Chinese will implement even more aggressive fiscal and monetary stimulus. EM policymakers notoriously lose flexibility at the hands of faltering currencies and attendant financial outflows (“capital flight”). Contemporary finance also ensures that deflating Bubbles entice bearish hedges and speculations that can so swiftly overwhelm already liquidity-challenged markets. The Chinese were confronting just such a scenario, before abruptly changing the course of policymaking. The adoption of onerous derivative market regulations and other measures are akin to loose capital controls – punishing measures to take pressure off the Chinese currency. After initially seeking benefits associated with greater currency market flexibility, market tumult instead forced the Chinese into a rigid yuan peg to the dollar.
So long as the peg to the dollar holds, China retains significant control over state-directed finance. It will run big fiscal deficits, print “money” and dictate lending and spending by the huge banks, financial institutions, local governments and industrial conglomerates. But can it at the same time somehow harness all this finance and keep it from fleeing the faltering Bubble? Only through capital controls.
The Shanghai Composite rallied 6.1% this week. There were some spectacular short-squeezes as well, certainly including the Nikkei’s 7.7% Wednesday surge, “The Biggest Gain Since 2008.” Copper jumped 6.3% this week. U.S. tech and biotech bounced hard. In the currencies, the Australian dollar jumped 2.7%, the South African rand 2.2%, and the euro 1.7%.
It was not, however, an encouraging week for EM’s troubled economies. Brazil’s real slipped further after last week’s 7% plunge. The Indonesia rupiah declined another 1.1%, and the Malaysian ringgit fell 1.3%. The Turkish lira dropped 1.2%. On the back of weak crude prices, the Goldman Sachs Commodities Index slipped 0.4% this week.
The crisis is taking a decisive turn for the worse in Brazil. On the back of S&P downgrading Brazilian debt to junk, the country’s CDS surged to multi-year highs. The Brazilian banking and corporate sectors have been in a six-year debt fueled borrowing binge. It’s all coming home to roost.
September 10 – Bloomberg (Michael J Moore): “Banco Bradesco SA and state-owned Banco do Brasil SA were among 13 financial-services firms in Brazil that had their global scale ratings lowered by Standard & Poor’s after the nation’s credit grade was cut to junk. The two banks were reduced to speculative grade with a negative outlook, S&P said… Itau Unibanco SA and Banco BTG Pactual also were among lenders that faced downgrades.”
September 10 – Bloomberg (Denyse Godoy): “A plunge in Petroleo Brasileiro SA, the world’s most-indebted oil producer, to a 12-year low put the Ibovespa on pace for a second week of losses. The state-controlled company extended a three-day slide to 11% after Standard & Poor’s cut its credit rating to junk, adding to speculation it will struggle to shore up its balance sheet.”
Many question how an EM crisis could possibly have a significant impact on U.S. markets. Well, for starters, Brazil has big financial institutions. The Brazilian financial sector has issued large amounts of dollar-denominated debt, while borrowing significantly from international banks. Enticing Brazilian yields have been a magnet for “hot money” flows. Now, Brazil faces the terrible prospect of a disorderly run from its currency, its securities market and its banking system. Market dislocation would have global ramifications for investors, derivative counterparties, multinational banks and the leveraged speculating community.
The degree of market complacency remains alarming. The bullish view holds that Brazil, China and others retain sufficient international reserves to defend against crisis dynamics. But with EM currencies in virtual free-fall and debt market liquidity disappearing, it sure looks and acts like an expanding crisis.
So far, it’s a different type of crisis – market tumult in the face of global QE, in the face of ultra-low interest rates and the perception of a concerted global central bank liquidity backstop. It’s the kind of crisis that’s so far been able to achieve a decent head of steam without causing much angst. And it’s difficult to interpret this bullishly. If Brazil goes into a tailspin, it will likely pull down Latin American neighbors, along with vulnerable Indonesia, Malaysia, Turkey and others. And then a full-fledged “risk off” de-risking/de-leveraging would have far-reaching ramifications, perhaps even dislocation and a collapse of the currency peg in China. China does have a number of major trading partners in trouble. Hard for me to believe the sophisticated players aren’t planning on slashing risk.
For the Week:
The S&P500 (down 4.8% y-t-d) and the Dow (down 7.8%) both rallied 2.1%. The Utilities gained 1.4% (down 9.4%). The Banks recovered 2.0% (down 3.8%), and the Broker/Dealers rose 1.7% (down 6.2%). The Transports rallied 3.3% (down 11.9%). The S&P 400 Midcaps gained 2.0% (down 2.6%), and the small cap Russell 2000 rose 1.9% (down 3.9%). The Nasdaq100 jumped 3.3% (up 2.1%), and the Morgan Stanley High Tech index rose 2.7% (down 0.5%). The Semiconductors jumped 3.0% (down 10.3%). The Biotechs surged 5.3% (up 15%). With bullion down $14, the HUI gold index declined 1.3% (down 34.6%).
Three-month Treasury bill rates ended the week at three bps. Two-year government yields were unchanged at 0.71% (up 4bps y-t-d). Five-year T-note yields rose four bps to 1.51% (down 14bps). Ten-year Treasury yields gained seven bps to 2.19% (up 2bps). Long bond yields rose seven bps to 2.95% (up 20bps).
Greek 10-year yields dropped 47 bps to 8.33% (down 142bps y-t-d). Ten-year Portuguese yields rose 10 bps to 2.59% (down 3bps). Italian 10-yr yields fell four bps to 1.83% (down 6bps). Spain's 10-year yields added three bps to a nine-week high 2.10% (up 49bps). German bund yields slipped two bps to 0.65% (up 11bps). French yields rose five bps to a nine-week high 1.06% (up 23bps). The French to German 10-year bond spread widened a notable seven to a two-month high 41 bps. U.K. 10-year gilt yields added a basis point to 1.83% (up 8bps).
Japan's Nikkei equities index rallied 2.7% (up 4.7% y-t-d). Japanese 10-year "JGB" yields declined two bps to 0.34% (up 2bps y-t-d). The German DAX equities index gained 0.9% (up 3.2%). Spain's IBEX 35 equities index lost 0.9% (down 5.3%). Italy's FTSE MIB index jumped 1.4% (up 14.5%). EM equities were mostly higher. Brazil's Bovespa index slipped 0.2% (down 7.2%). Mexico's Bolsa was little changed (down 0.8%). South Korea's Kospi index rallied 2.9% (up 1.3%). India’s Sensex equities index gained 1.6% (down 6.9%). China’s Shanghai Exchange recovered 6.1% (up 3.6%). Turkey's Borsa Istanbul National 100 index dropped 2.2% (down 16.8%). Russia's MICEX equities index gained 1.2% (up 23%).
Junk funds this week saw outflows of $714 million (from Lipper).
Freddie Mac 30-year fixed mortgage rates increased a basis point to 3.90% (up 3bps y-t-d). Fifteen-year rates added a basis point to 3.10% (down 5bps). One-year ARM rates were up a basis point to 2.63% (up 23bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates unchanged at 4.05% (down 23bps).
Federal Reserve Credit last week increased $1.6bn to $4.439 TN. Over the past year, Fed Credit inflated $61.3bn, or 1.4%. Fed Credit inflated $1.628 TN, or 58%, over the past 148 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt dropped $11.6bn last week to $3.335 TN. "Custody holdings" were up $41.9bn y-t-d.
M2 (narrow) "money" supply jumped $17.5bn to a record $12.186 TN. "Narrow money" expanded $729bn, or 6.4%, over the past year. For the week, Currency increased $4.0bn. Total Checkable Deposits dropped $16.4bn, while Savings Deposits expanded $16.4bn. Small Time Deposits increased $2.0bn. Retail Money Funds gained $6.9bn.
Money market fund assets fell $15.6bn to $2.663 TN. Money Funds were down $70bn year-to-date, while gaining $70bn y-o-y (2.7%).
Total Commercial Paper rose $10.9bn to $1.043 TN. CP increased $35.8bn year-to-date.