September 20 – Wall Street Journal (Daniel Kruger): “The Federal Reserve Bank of New York will offer to add at least $75 billion daily to the financial system through Oct. 10, prolonging its efforts to relieve funding pressure in money markets. In addition to at least $75 billion in overnight loans, the New York Fed… will also offer three separate 14-day repo contracts of at least $30 billion each next week… On Friday banks asked for $75.55 billion in reserves, $550 million more than the amount offered by the Fed, offering collateral in the form of Treasury and mortgage securities. The Fed’s operation was the fourth time this week it has intervened to calm roiled money markets. Rates on short-term repos briefly spiked to nearly 10% earlier this week as financial firms looked for overnight funding. The actions marked the first time since the financial crisis that the Fed had taken such measures.”
Liquidity moves markets!Follow the money. Find the profits!
With the collapse of Lehman setting off the “worst financial crisis since the Great Depression”, instability in the multi-trillion repurchase agreement marketplace generates intense interest. This crucial market for funding levered securities holdings is critical to the financial system’s “plumbing.” It is a market in perceived “money” – highly liquid and virtually risk free-instruments. If risk suddenly becomes an issue for this shadowy network, the cost and availability of Credit for highly leveraged players is suddenly in question. And any de-risking/deleveraging at the nucleus of the global financial system would pose a clear and present danger of sparking “risk off” throughout Credit markets and financial markets more generally.
I’ll usually begin contemplating the CBB on Thursdays. This week’s alarming dislocation in the “repo” market was clearly a major development worthy of focus. But I was planning on highlighting the lack of initial contagion effects in corporate Credit, a not surprising development considering the New York Fed’s aggressive liquidity injections.
Investment-grade Credit default swaps (CDS), for example, closed Thursday trading near their lowest levels since February 2018. Junk bond spreads (to Treasuries) went out Thursday near the narrowest since early-November. Bank CDS, another important indicator, also continued to signal the “all’s clear” throughout Thursday trading. As of Thursday’s close, Goldman Sachs’ (5yr) CDS was up a modest three points for the week to 58, after closing the previous Friday near low going back to January 2018.
But Friday’s trading session came with additional intrigue. Investment-grade CDS jumped 15% to 59.7, the highest close in about a month. Goldman Sachs CDS rose 9.4% to 63.1, an almost four-week high. JPMorgan CDS rose 8.9% (to 42.7), BofA 11.0% (to 47.5) and Citigroup 5.7% (to 61.1). And as key financial CDS prices moved sharply higher, safe haven bond yields dropped. Treasury yields fell six bps in Friday trading to 1.72%, and Bund yields declined two bps to negative 0.525%. Even more curious, Gold popped almost $18 Friday to $1,517, boosting the week’s gain to $28.
The Fed’s return to system liquidity injections after a decade hiatus received abundant media coverage. For the most part, analysts were pointing to a confluence of unusual factors: $35 billion money market outflows to fund September 15th quarterly corporate tax payments; settlements for outsized Treasury auctions; and the approaching end to the quarter (where money center banks generally reduce balance sheet leverage for financial reporting and regulatory purposes).
Missing from the discussion was that this week’s money market tumult followed on the heels of instability in other markets. Is it coincidence that Monday’s spike in repo rates followed last week’s extraordinary bond market reversal – where 10-year Treasury yields surged 34 bps and benchmark MBS yields spiked an incredible 46 bps (2.37% to 2.83%)?
What a nightmare it’s been over recent months for those attempting to hedge interest-rate risk. After trading to 4.10% in November, benchmark MBS yields were down to 3.02% near the end of March. MBS yields then rose to 3.34% in April, before reversing lower to trade all the way down to 2.51% by late June. Yields were back up to 2.91% in mid-July – only to then reverse to a three-year low of 2.30% on September 4th. Collapsing MBS yields spur waves of refinancings, shortening the lives (“duration”) of existing MBS securities trading in the marketplace (as old MBS are replaced with new lower-yielding securities).
The marketplace for hedging MBS and other interest-rate risks is enormous. Derivatives really do rule the world. When market yields are declining, players that had sold various types of protection against lower rates are forced into the marketplace to acquire instruments for hedging their escalating rate exposure. Much of this levered buying would typically be financed in the repurchase agreement (“repo”) marketplace. This type of hedging activity can prove strongly self-reinforcing. Intense buying forces Treasury and bond market prices higher, “squeezing” those short the market while spurring additional hedging-related buying. At the same time, the expansion of “repo” securities Credit boosts overall system liquidity, supporting the upside inflationary bias in bond and securities prices.
The recent downside dislocation in market yields included tell-tale signs of manic blow-off speculative excess. At 1.46% lows (September 3rd), an exuberant marketplace was calling for sub-1% Treasury yields – as if the unending supply from massive deficit spending would remain permanently divorced from market price dynamics. Meanwhile, booming corporate issuance was gobbled up at near record low yields – and the lowest spreads to Treasuries in two years. Inflows were inundating the bond ETF complex. Excesses in U.S. fixed-income were unfolding as $18 TN of global investment-grade bonds traded at negative yields, including European corporate debt.
Things got conspicuously out of hand. With global central bankers in aggressive easing mode – including an ECB restarting the QE machine while pushing rates further into negative territory – market participants were in the mood to believe central banks had abolished market cycles. Like deficits and Current Account Deficits, speculative excess and leverage don’t matter.
While everyone was relishing the mania, trouble was building under the markets’ surface – in the “plumbing.” As yields collapsed, speculative leverage mounted. Surging prices incited a buyers’ panic in Treasuries, MBS, corporate bonds, CDOs and structured finance – a chunk of it financed in the “repo” and money markets. Derivative player hedging activities also significantly boosted system leverage. All the speculative leveraging worked to expand system liquidity, crystallizing the market perception of endless liquidity abundance. While a deficient indicator of system liquidity, it’s still worth noting M2 “money” supply has expanded $560 billion over the past six months. Money market fund assets (retail funds included in M2) are up $350 billion since the end of April. Where’s all this “money” been coming from?
Market “melt-up” upside dislocations sow the seeds for abrupt market reversals and attendant upheaval. One day’s panic buying (on leverage) can be the following session’s frantic selling (unwind of leverage). Especially in the derivatives arena, self-reinforcing derivative-related dynamic (“delta”) hedging during an upside speculative blow-off is susceptible to abrupt reversals. Hedging programs necessitate buying into rapidly rising markets, only to immediately shift to aggressive selling in the event of market weakness. The associated leverage spurs liquidity excess on the upside, creating vulnerability for illiquidity in the event of downside sell programs and speculative deleveraging.
It is surely no coincidence that this week’s “repo” ructions followed last week’s spike in yields and resulting deleveraging. Is it a coincidence that the marketplace experienced a powerful “rotation” that saw the favorite stocks and sectors dramatically underperform the least favored? Is it a coincidence that hedge fund long/short strategies have been clobbered, in what evolved into a powerful short squeeze and dislocation? Surely, it’s no coincidence the so-called “quant quake” foresaw this week’s quake in the repo market?
Let’s expand this inquiry. Is it a coincidence that this week’s money market upheaval followed by a few months dislocation in the Chinese money market? And is it mere coincidence that U.S. money market instability erupted on the heels of the ECB’s decision to restart QE?
There are No Coincidences. Chinese money market issues and currency weakness were fundamental to the global collapse in yields. Trade war escalation risked pushing China’s vulnerable Credit system and economy over the edge. Global central bankers responded to sinking bond yields with dovish talk and monetary stimulus, feeding the unfolding bond market dislocation. Collapsing market yields and dovish central banks stoked melt-up dynamics in stocks and sectors seen benefiting from a lower rate environment. Growth stocks were caught up speculative melt-up dynamics, while short positions in underperforming financials and small caps were popular hedging targets. Both momentum longs and shorts became Crowded Trades
Meanwhile, booming markets and the resulting loosening of financial conditions quietly bolstered flagging growth dynamics – from China to the U.S. to Europe. The prospect of constructive U.S./China trade talks risked catching the manic bond market out over its skis. Some stronger U.S. data sparked a sharp bond market reversal, with rising yields spurring a reversal of Crowded equities trades. Losing on both sides, the long/short players suffered painful losses. De-risking of long/short strategies incited a powerful short squeeze, a dynamic that gained momentum into expiration week.
The S&P500 is only about 1% from all-time highs. Yet there’s been some real damage below the market’s surface. The leveraged speculating community, in particular, has been shaken. There were losses in Argentina and EM currencies more generally. Bond markets have turned unstable – on both the up- and downside. Long/short strategies have been bludgeoned. Short positions have turned highly erratic. And this week instability engulfed the overnight funding markets, with contagion effects for other short-term funding vehicles at home and abroad. Trouble brewing.
The leveraged speculating community is the marginal source of liquidity throughout U.S. and global markets. Not only have they faced heightened risk across the spectrum of their holdings, they now confront funding market uncertainty into year-end. This doesn’t necessarily indicate imminent market weakness. But it does signal vulnerability. Many players are afflicted with increasingly “weak hands.” They’ll exhibit less tolerance for pain. This dynamic increases the likelihood that market weakness will spur self-reinforcing de-risking and deleveraging.
There was considerable market vulnerability this time last year – with equities at all-time highs. Global markets, economies, trade relationships and geopolitics are all more troubling today. Central bankers have burned through precious ammunition, in the process spurring problematic late-cycle excess. Understandably, there is dissention within the ranks – from the Fed to the ECB and BOJ. Is monetary stimulus the solution or the problem?
Autumn is set up for some serious instability. There’s all this talk of the need for the Fed to create additional bank reserves. The issue is not a shortage of reserves but a gross excess of speculative leverage. It started this week. The Fed’s balance sheet will be getting much bigger. The Fed and the markets were blindsided by this week’s repo market instability. The surprises will keep coming.id it is ‘very difficult’ for China’s economy to grow at a rate of 6% or more because of the high base from which it was starting and the complicated international backdrop. The world’s No.2 economy faced ‘certain downward pressure’ due to slowing global growth as well as the rise of protectionism and unilateralism, Li said…”
September 15 – Bloomberg: “China’s slowdown is deepening just as risks for the global economy mount, piling pressure on the authorities to do more to support growth. Industrial output rose 4.4% from a year earlier in August, the lowest for a single month since 2002, while retail sales came in below expectations. Fixed-asset investment slowed to 5.5% in the first eight months, with the private sector lagging state investment for the 6th month.”
September 16 – Reuters (Yawen Chen and Ryan Woo): “China’s new home prices grew at their weakest pace in nearly a year in August as a cooling economy and existing curbs on speculative buying put a dent on overall demand. Wary of property bubbles, Chinese regulators have vowed to refrain from stimulating the real estate sector as they roll out measures to boost the broader economy hit by the Sino-U.S. trade war and slowing consumer demand. Average new home prices in China’s 70 major cities rose 8.8% in August from a year earlier, compared with a 9.7% gain in July and the weakest pace since October 2018…”
September 15 – Reuters (Yawen Chen, Kevin Yao and Roxanne Liu): “China’s property investment grew at its fastest pace in four months in August, a boon for the economy as other sectors weaken from the Sino-U.S. trade war and consumer demand slows… Property investment in August rose 10.5% from year earlier, quickening from July’s 8.5% pace…”
September 19 – Financial Times (Don Weinland): “When lossmaking Chinese iron ore miner Shandong Hongda scooped up a UK game developer in 2016, it also had grand plans to diversify into energy and healthcare businesses around the globe and move away from its low-growth mining past. In the end, it held on to Jagex, the creator of the world’s largest online role-playing game for just short of two years and its other plans have since fallen away too. The trajectory of Shandong Hongda, with its brief stint as a game developer and ambitions to expand elsewhere, has been followed by a number of Chinese companies, which have attempted to make debt-fuelled leaps into countries and industries far from their areas of expertise. But as credit conditions have tightened and authorities have taken a much more active interest in how much debt companies hold and the risks they are taking, businesses have drawn in their horns. Since the start of the year, there has been a record sell-off of global assets by Chinese companies totalling about $40bn… At the same time, the pace of acquisitions has slowed to just $35bn, as businesses worry about being labelled speculative buyers. It is the first time in a decade that Chinese companies are net sellers of global assets.”
September 19 – Wall Street Journal (Mike Bird): “China’s property giants are notorious for their rapacious issuance of debt. But a more politically sensitive liability has risen even faster, posing a less well known risk to the country’s housing market. Unearned revenue—the line on developers’ balance sheets that accounts for presales or contracted sales—now makes up a greater share of the 10 largest property developers’ liabilities than total debt. Their combined unearned revenue rose to just over $400 billion in June… The practice of selling homes once construction has started—but often years before completion—now makes up more than 85% of total sales in China. Yields of above 10% aren’t uncommon on Chinese property bonds, making presales an attractive source of financing.”
September 16 – Reuters (Clare Jim and Noah Sin): “Credit rating agency Moody’s changed its outlook on Hong Kong’s rating to negative from stable on Monday, reflecting what it called the rising risk of ‘an erosion in the strength of Hong Kong’s institutions’ amid the city’s ongoing protests… ‘The decision to change Hong Kong’s outlook to negative signals rising concern that this shift is happening, notwithstanding recent moves by Hong Kong’s government to accommodate some of the demonstrators’ demands.’”
September 15 – Reuters (Jessie Pang): “Hong Kong’s businesses and metro stations reopened as usual on Monday after a chaotic Sunday when police fired water cannon, tear gas and rubber bullets at protesters who blocked roads and threw petrol bombs outside government headquarters. On Sunday what began as a mostly peaceful protest earlier in the day spiraled into violence in some of the Chinese territory’s busiest shopping and tourist districts.”
Central Banking Watch:
September 17 – Financial Times (Stephen Morris, Olaf Storbeck and Martin Arnold): “European lenders are bracing for deeper cost cuts and consolidation after the European Central Bank extended a punishing five-year stretch of negative interest rates. The region’s banks were left disappointed by Mario Draghi’s last major act as ECB president, in which he last week cut its key deposit rate to minus 0.5%, while also unveiling a new tiering system designed to shield a portion of the deposits lenders keep at the ECB from negative rates. However, the relief provided by tiering will barely offset the lost earnings from lower base rates, according to analysts and executives…, piling pressure on a sector already struggling to generate acceptable returns. The ECB is expected to cut its deposit rate again by next year, which could lower even further the Euribor rate on which many loans are priced. ‘Deposit tiers . . . [are] a drop in the ocean,’ said Morgan Stanley analyst Magdalena Stoklosa. ‘Profitability uplifts could be minimal for most banks… as sensitivity to Euribor is multiple times greater versus savings on cash reserves parked at the ECB.’”
September 14 – Reuters (David Milliken and William James): “British Prime Minister Boris Johnson likened himself to the comic book character The Incredible Hulk in a newspaper interview where he stressed his determination to take Britain out of the European Union on Oct. 31… ‘The madder Hulk gets, the stronger Hulk gets,’ Johnson was quoted as saying. ‘Hulk always escaped, no matter how tightly bound in he seemed to be – and that is the case for this country. We will come out on October 31.’”
September 16 – Associated Press (Lorne Cook and Jill Lawless): “Boris Johnson was booed by protesters and berated by Luxembourg’s leader on a visit to the tiny nation… for his first face-to-face talks with the European Union chief about securing an elusive Brexit deal. On a day of commotion and conflicting signals, Johnson pulled out of a news conference because of noisy anti-Brexit demonstrators, leaving Luxembourg’s prime minister standing alone next to an empty lectern as he addressed the media.”
September 17 – Reuters (Michael Nienaber and Christian Kraemer): “German Finance Minister Olaf Scholz said… policymakers could not accept the emergence of parallel currencies such as Facebook’s planned Libra, adding that Berlin would reject any such plans… ‘We cannot accept a parallel currency,’ Scholz said… ‘You have to reject that clearly.’”
September 18 – Associated Press (Kim Tong-Hyung): “South Korea… dropped Japan from a list of countries receiving fast-track approvals in trade, a reaction to Tokyo’s decision to downgrade Seoul’s trade status amid a tense diplomatic dispute. South Korea’ trade ministry said Japan’s removal from a 29-member ‘white list’ of nations enjoying minimum trade restrictions went into effect as Seoul rearranged its export control system covering hundreds of sensitive materials that can be used for both civilian and military purposes. The change comes a week after South Korea initiated a complaint to the World Trade Organization over a separate Japanese move to tighten export controls on key chemicals…”
September 15 – Financial Times (Steve Johnson): “Emerging market central banks have turned more dovish than at any point since at least the global financial crisis, according to analysis of the language in 4,000 monetary policy publications. The extreme pro-easing bias is remarkable given that banks, including those of Brazil, Russia, India, China, South Africa and Turkey, have already cut rates this year… Bank of America Merrill Lynch’s Emerging Monetary Mood Indicator, based on robotic scanning of keywords used in the publications of 11 big EM central banks, is at its more dovish extreme since the height of the crisis in 2009… Based on single-month figures, the August reading — the latest available — was the most extreme since the depths of the dotcom crash in 2000.”
September 16 – Associated Press (Sheikh Saaliq): “Anuj Kapoor took over his father’s booming auto parts business in 2012, hoping to elevate the company from selling to suppliers to selling directly to carmakers. Seven years later, he’s had to lay off half his workers as drooping sales caused his profit to plummet by at least 80%. Confidence in the Indian economy is giving way to uncertainty as growth in the labor-intensive manufacturing sector has come to a near standstill, braking to 0.6% in the last quarter from 12.1% in the same period a year earlier. The economy grew at its slowest annual pace in six years in April-June, 5%.”
September 18 – Reuters (Leika Kihara and Daniel Leussink): “The Bank of Japan kept monetary policy steady on Thursday but signaled the chance of expanding stimulus as early as its next policy meeting in October… BOJ Governor Haruhiko Kuroda said the central bank has edged closer toward loosening policy than when its board last met in July, as the U.S.-China trade war and slowing overseas demand dampen prospects for achieving its elusive 2% inflation target. ‘We are more eager to act given heightening global risks. We will scrutinise economic and price developments thoroughly at next month’s meeting to decide whether to ease,’ Kuroda told a news conference…”
Global Bubble Watch:
September 16 – Bloomberg (Anooja Debnath and Susanne Barton): “Trading in the global foreign-exchange market has jumped to the highest-ever level at $6.6 trillion, according to the Bank for International Settlements. The average daily trading in April was up 29% from $5.1 trillion in the same month in 2016, the BIS reported… The growth of FX derivatives trading, primarily swaps, outpaced the spot market and now accounts for almost half of global FX turnover… Trading of outright forwards also increased, with a large part of the rise due to non-deliverable forwards. That reflected strong activity in NDF markets for the Korean won, Indian rupee and Brazilian real, the BIS said. ‘While we’ve seen growth across all forms of FX trading, swaps and forwards have seen particular growth,’ said Matthew Hodgson, CEO and founder of Mosaic Smart Data… ‘The FX market has woken up.’”
Fixed-Income Bubble Watch:
September 16 – Financial Times (Laurence Fletcher): “Parts of Wall Street’s debt securitisation engine are back running at levels not seen since the pre-financial crisis boom. …Dealogic’s indices of US securitisation activity show that issuance of collateralised debt obligations — structured products made up of bundles of bonds and loans — rose above its pre-crisis peak late last year and is currently back close to those levels this year. The market for commercial mortgage-backed securities has also rebounded strongly since late 2008 and early 2009, when issuance completely seized up in the aftermath of the financial crisis. Activity in the asset class is now some way above its 2007 high.”
September 18 – Reuters (Phil Stewart and Parisa Hafezi): “The United States believes the attacks that crippled Saudi Arabian oil facilities last weekend originated in southwestern Iran, a U.S. official told Reuters, an assessment that further increases tension in the Middle East. Three officials… said the attacks involved cruise missiles and drones, indicating that they involved a higher degree of complexity and sophistication than initially thought.”
September 15 – Bloomberg (Anthony Dipaola and Verity Ratcliffe): “The latest and most destructive attacks on Saudi oil facilities provide stark evidence of the vulnerability of global crude supply in an age of disruptive technologies that can bring a century-old industry to its knees — at least temporarily. From remote-controlled drones to anti-ship mines and computer worms, hostile parties have employed an unpredictable array of asymmetric weaponry to confound one of the best-equipped militaries in the Middle East. Saudi Arabia blames many of the attacks against its oil assets on Houthi rebels in impoverished Yemen, where Saudi forces have been fighting since 2015 in a civil war that’s spilling across their shared border.”
September 17 – Reuters (Tuqa Khalid): “Saudi King Salman said… that Riyadh was capable of dealing with the consequences of attacks on its installations. A statement issued after a meeting of Saudi Arabia’s council of ministers said the cabinet had reviewed the damage caused by the attacks on Aramco installations, and it called on world governments to confront them ‘regardless of their origin’.”
September 17 – Reuters (Stephen Kalin, Sylvia Westall): “Billions of dollars spent by Saudi Arabia on cutting edge Western military hardware mainly designed to deter high altitude attacks has proved no match for low-cost drones and cruise missiles used in a strike that crippled its giant oil industry. Saturday’s assault on Saudi oil facilities that halved production has exposed how ill-prepared the Gulf state is to defend itself despite repeated attacks on vital assets during its four-and-a-half year foray into the war in neighboring Yemen.”
September 16 – CNBC (Natasha Turak): “Satellite photos released by the U.S. government and DigitalGlobe reveal the surgical precision with which Saudi Aramco’s oil facilities were struck in attacks early Saturday. The strikes, which unidentified U.S. officials have said involved at least 20 drones and several cruise missiles, forced Saudi Arabia to shut down half its oil production capacity, or 5.7 million barrels per day of crude — 5% of the world’s global daily oil production.”
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