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Dr. Li Wenliang

This is a syndicated repost published with the permission of Credit Bubble Bulletin . To view original, click here. Opinions herein are not those of the Wall Street Examiner or Lee Adler. Reposting does not imply endorsement. The information presented is for educational or entertainment purposes and is not individual investment advice.

The S&P500 rallied 3.2% this week (trading to all-time highs Thursday), more than reversing (by 1.5 times) the previous week’s 2.1% decline. Ten-year Treasury yields rebounded as well, yet the eight bps rise was less than half the previous week’s 18 bps drop. Commodities markets couldn’t muster any recovery this week. WTI crude fell another $1.24 (2.4%) to $50.32, a fifth straight weekly decline (“longest weekly losing streak since 2018”). The Bloomberg Commodities Index was little changed on the week. Copper did recover 1.4% – though a mere fraction of the previous week’s 6.2% drubbing. Ominously, the Singapore (small country, big financial sector) dollar dropped 1.8% this week, while the Japanese yen, Chinese renminbi and Malaysian ringgit all declined about 1.0%.

Sometimes it’s difficult to gauge which has the stronger underlying momentum – the safe havens or the risk markets (i.e. equities and corporate Credit). Ten-year Treasury yields are already down a notable 33 bps early in 2020. The iShares long-term Treasury ETF (“TLT”) has a noteworthy 6.78% y-t-d return, outpacing the 3.16% return for the S&P500. It’s a remarkable dynamic that no longer rouses much interest. Both markets look at the world and really like what they see.

It’s worth noting 10-year Treasury yields began the week at 1.51%, not far from the 1.46% closing low from September 3rd. Treasury and global yields collapsed throughout the summer, with Treasury yields dropping over 100 bps in about four months. The U.S. yield curve briefly inverted in late-August, eliciting talk of a U.S. recession and a global downturn. January’s 225k gain in non-farm payrolls is just the latest economic indictor making those recession forecasts look goofy.

I saw summer market developments as much more about China and global monetary policy than economic prospects. I believe vulnerable Chinese financial and economic Bubbles are the predominant factor behind the irrepressible demand for global sovereign debt. China has evolved into the marginal source of global Credit along with global demand for commodities and much more.

China was in a particularly fragile state over the summer, with escalating financial stress in the face of deteriorating U.S./China trade negotiations. China’s aggressive stimulus measures along with a “phase 1” trade deal reduced near-term crisis risk. Global yields then somewhat normalized. Ten-year Treasury yields ended the year at 1.92%, up almost 50 bps from early-September lows. Bund yields ended 2019 at negative 0.19%, up from negative 0.72% on August 28th. Swiss bond yields jumped 66 bps off lows to end the year at negative 0.54%.

Then arrived the coronavirus outbreak. Suddenly, Chinese economic prospects look highly uncertain at best. Even if the outbreak somehow comes under control in the coming weeks, the economy will take a significant hit. There’s a scenario where the situation continues to deteriorate and takes on longer-term significance. Global markets rallied this week on the PBOC’s aggressive liquidity injections, along with other stimulus measures. There’s no doubting Beijing’s commitment to aggressive fiscal and monetary stimulus. I just believe almost everyone is too optimistic – drowning in central bank liquidity complacency. China is confronting an unprecedented predicament, while concurrently facing acute financial and economic fragilities associated with a faltering Bubble.

Safe haven bonds and commodities have this right. Risk markets are simply playing a different game – an especially dangerous one at that. The Fed’s dual 2019 “U-turns” have profoundly changed risk market perceptions and behavior. Rates were cut, and liquidity was injected despite loose financial conditions, speculative markets and record stock prices. Understandably, risk market participants have been emboldened to believe the Fed and global central bankers have minimal tolerance for market instability.

To argue that the Fed’s $400 billion balance sheet expansion is neither QE nor culpable for surging stock prices completely misses the point. The Fed’s operations solidified the view that securities prices are the priority – even more so than the real economy. This fundamentally altered perceptions of market risk and, accordingly, price dynamics throughout equities, corporate Credit and derivatives.

Goldman Sachs Credit default swap (CDS) prices (5yr) ended the week at 45.7 bps. This was down from a high of 76 bps in October and compares to the 135 bps high on January 4th, 2019 – just minutes before Chairman Powell’s dramatic “U-turn”. Over the past five years, Goldman CDS have averaged 79 bps. Indeed, this Thursday’s 45.08 price was the low since September 2007. JPMorgan CDS closed the week near the low going back to 2007. Investment-grade corporate CDS prices also dropped back down to the lows since before the crisis. Friday’s closing price of 46 bps compares to the five-year average of 67 bps.

Is systemic risk really at the lowest point this week since before the crisis? Ridiculous. For starters, China poses a clear and present danger to both the global economy and financial system. China has added a scary amount of debt over the past decade – its “miracle” economy surely the poster child for Credit excess-induced structural maladjustment. Debt has grown tremendously across the globe. Today’s global market and financial excesses are unprecedented. Risk is extraordinarily high, certainly owing to central bank stimulus and these wacky securities and derivatives prices.

In this context, it’s not difficult to explain global safe haven yields. And it is actually not much of a challenge to define the factors behind booming risk markets. Markets have become precariously distorted and dysfunctional. Central bank monetary stimulus has succeeded in completely turning risk analysis on its head. In all the craziness, China fragilities are a positive. The coronavirus likely constructive to the U.S. economy. Even risky political and geopolitical dynamics are seen in positive light. They all ensure monetary stimulus as far as the eye can see.

And the obvious retort would be: “Doug, what’s new here?” What’s changed is the degree to which the risk markets are conditioned to disregard risk. Even a development with the clear potential to be highly disruptive to global economies and finance can be ignored. Comments I’m hearing and reading are the most detached from reality that I can recall. In my 30 plus years of following the markets, I’ve never seen such a divergence between market risk perceptions and reality.

The 2019 policy and monetary fiasco fundamentally altered market behavior. Risk markets have become incapable of adjusting for uncertainty and elevated risks. Markets instead fixate on the certainty of ongoing monetary stimulus and liquidity abundance. This incapacity for well-founded risk assessment and healthy market corrections is today a major source of systemic risk. How can eventual market adjustments not be violent and destabilizing?

Coronavirus infections have surged to 34,500, up 190% in a week. Friday’s cases increased 10% from Thursday, a slowing in the growth rate. The number of cases outside of China have increased, but there is reason for hope the outbreak to this point is largely confined to China.

There is, as well, justification for fear. Case in point: The Diamond Cruise ship now docked off Yokohama had 61 infections of the 273 passengers tested – now the largest outbreak outside of China. There are an additional 3,400 passengers that have yet to be tested. Japan’s Ministry of Defense will be prioritizing passengers for additional testing. Passengers originally believed they were subject to a 14-day quarantine. Now everything is unclear. There are even concerns that the virus may be transmitted through ventilation systems. It is clear many have tested positive for the virus despite being asymptomatic, leaving open the possibility that tens of thousands could be unknowingly infected. In Germany, a team of researchers this week reported that the coronavirus can remain infectious on surfaces for up to nine days.

But nothing compares to the nightmare unfolding in Wuhan.

February 6 – New York Times (Amy Qin, Steven Lee Myers and Elaine Yu): “The Chinese authorities resorted to increasingly extreme measures in Wuhan on Thursday to try to halt the spread of the deadly coronavirus, ordering house-to-house searches, rounding up the sick and warehousing them in enormous quarantine centers. The urgent, seemingly improvised steps come amid a worsening humanitarian crisis in Wuhan, one exacerbated by tactics that have left this city of 11 million with a death rate from the coronavirus of 4.1% as of Thursday — staggeringly higher than the rest of the country’s rate of 0.17%. With the sick being herded into makeshift quarantine camps, with minimal medical care, a growing sense of abandonment and fear has taken hold in Wuhan, fueling the sense that the city and surrounding province of Hubei are being sacrificed for the greater good of China.”

More from the NYT: “The steps were announced by the top official leading the country’s response to the virus, Vice Premier Sun Chunlan, as she visited Wuhan on Thursday. They evoked images of the emergency measures taken to combat the 1918 Spanish Flu pandemic that killed tens of millions people worldwide. Despite the severity of the new measures, however, they offered no guarantee of success. The city and country face ‘wartime conditions,’ Ms. Sun said. ‘There must be no deserters, or they will be nailed to the pillar of historical shame forever.’”

Just imagine being in Wuhan – panicked by the catastrophe overwhelming the local healthcare system – and having a medical worker arrive at your door, demand to take your temperature, and then force you leave your home to be warehoused in a stadium converted into a containment facility. While not as Draconian as Wuhan and Hubei Province, there are various degrees of quarantine in major cities throughout China.

February 6 – New York Times: “The doctor who was among the first to warn about the coronavirus outbreak in late December — only to be silenced by the police — died Friday after becoming infected with the virus… The death of the 34-year-old doctor, Li Wenliang, set off an outpouring of grief and anger on social media, with commenters on social media demanding an apology from the authorities to Dr. Li and his family…” Question last week from a NYT reporter: “How long will it take you to recover? What do you plan to do afterward?” Li: “I started coughing on Jan. 10. It will take me another 15 days or so to recover. I will join medical workers in fighting the epidemic. That’s where my responsibilities lie.”

The coronavirus will leave deep scars on the Chinese people. Trust in the government has been shaken. The future cannot appear as bright as a month ago. How could this experience not harbor deep-seated fear and insecurity? And it all crashes headlong into inflated expectations. We cannot comprehend ramifications at this point. But it goes so far beyond when automobile and technology manufacturing can return to a semblance of normality – or when western retailers will reopen their Chinese stores.

Most of all, this crisis transcends PBOC and global central bank monetary stimulus. The apt question, once again, is whether all this “money printing” is more the solution or the problem. Both the PBOC and Fed have recently expended huge amounts of stimulus in desperate measures to sustain booms. It leaves one contemplating how much stimulus will be expended when Bubbles start bursting. At this point, such stimulus measures are a losing game. They’re feeding the mania and exacerbating fragilities.

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