(This is not investment advice. It’s only provided as a mental exposure to complexity in the financial markets.)
A lot of market participants have been obsessing over “unsual” volatility in the first quarter of 2018. Of course, volatility is the wrong metric to follow, especially after the ETN volapocalypse earlier this year. And no, there wasn’t any huge shift in market sentiment or political risk. All that is pure rationalization – and you should know better unless you are an entry-level Wall Street analyst who’s spent the last three nights in the office. There had been no macro-level surprises and, if you are about to mention Q1 earnings jitters, that’s probably not a sense of humor most would appreciate. What’s been going on then?
Well, it’s all quite embarrassingly straightforward.
But before we take off the wrapper, a quick inventory of the piñata of real market events that broke in 2018Q1:
- LIBOR embarked on a steep and “puzzling” (not at all) climb.
- The Fed continued on its preannounced and “pre-digested” (it wasn’t) path of rate hikes and balance-sheet contraction.
- Retail shocked (not really) by withdrawing from equity ETFs.
- Gold (mostly unsecured IOUs) finally broke out of its channel and made solid, if unimpressive, gains.
- US Treasury auctions were underwhelming (unless you were paying attention) relative to recent experience of yields & oversubscription.
- Hedge funds continued to get clobbered despite the “favorable” environment (OK, OK, this is not entirely news yet, but it will be).
- The USD was beaten down and stayed there because tweets (actually, nothing to do with them).
Confusing? Not if you consider the possibility that all of these are in fact the same event. To make that notion manifest, all you need is a very basic understanding of global macro, monetary cycles and market structure.
Getting Real
Policymakers’ half-hearted narrative of Global Synchronized Growth was met with laughter from the galley. Because even central bankers didn’t believe themselves. Every market participant with a brain knew that “growth” (it was mostly inflation and fuzzy accounting) and asset prices were driven by:
- Asset purchases & liquidity operations by central banks.
- Fixed investment in China (and of Chinese corporates overseas).
- Real-estate reflation in the US and other developed markets.
- Subprime & consumer lending in the US.
- Record borrowing by US corporates.
- Momentum-driven leveraging of US financial assets.
Because these drivers were mutually reinforcing and induced second- and third-order credit expansion, debt acceleration (and, consequently, asset inflation) globally continued even after major central banks started reducing the growth rate of their balance sheets.
Turning of the Tide (Do NOT Attempt to Eat It!)
What did the same drivers of monetary expansion look like over the past couple of quarters?
- Only PBoC, ECB, BoJ and SNB are still expanding their balance sheets, but the market operations of the first two are decelerating, while the BoJ is running out of things to buy and the SNB of leverage to buy with. The Fed is contracting its balance sheet (although the PPT stepped in to prop up asset prices in Q1) and raising interest rates. The BoE and RBA are out of the game, too, because of rising inflation.
- Although no good data on Chinese fixed investment are available, after a decade of rampant overbuilding and overinvestment, it probably cannot continue to accelerate henceforth.
- Real-estate prices have been decelerating markedly in many US markets.
- The US consumer is tapped out and the savings rate has inched up for the first time in years, in part due to tightening lending conditions.
- US corporates are levered up to the hilt and have been going off the buyback binge.
- Momentum in market leaders such as large-cap equities and low-quality fixed income (Tesla paper, anyone?) is dead.
Consequences have consequences, just as they did during the debt acceleration period. That giant sucking sound you’re hearing is the (temporary) end of the global synchronized growth of money supply acceleration through credit creation. The money supply may still be growing, but it is the acceleration rate that matters. Asset prices get wobbly after money growth slows, they don’t wait for it to turn negative. Wobbliness begets wobbliness (acceleration events like the ETN blowups, margin contraction etc.), and so the MOMO train turns. It is THAT simple.
Will the Real Minsky Moment Please Stand Up?
So how does a potential Minsky moment make the first-quarter surprises unsurprising?
- LIBOR I shan’t explain because it ought to be obvious by now. Just remember how insanely overleveraged European banks are.
- The Fed has been in panic mode for about a year already, and the only reason they didn’t start tightening earlier was the change of the guard in the White House and the Eccles Building. Even if they are ignorant of real-world monetary economics, they know a recession is overdue and want to have an interest rate to cut when that happens. The jitters in the markets are only going to solidify this process, as you may have noticed from the last Fed meeting. The monetary deceleration is now causing Fed policy because reflexivity. The Fed will not (overtly) reverse course until a “policy mistake” is obvious. Literally look for that phrase in the Fake News Media before the Fed intervenes again.
- Retail investors are not getting suckered into inflated assets as much as expected because they are tapped out on the credit front and spooked by rising volatility.
- Paper gold is rising because of margin contraction.
- The US Treasury is dumping record issuance on the markets in the first half of the year (a lot of it short-term, which adds to pressure on short-horizon rates) while the Fed is winding down assets. People were loath to hold the short end of the stick when everyone was assuming yields were to go up (they will come down again soon enough) and other financial assets are going bonkers. When financial conditions are tightening, especially during a reversal, cash is king.
- So-called hedge funds are getting killed because most of them are just leveraged MOMO chasers and quants, who can’t handle tail events and market discontinuities. Volatility acceleration hits hardest at the tail end of both momentum and volatility exposures, which is where “hedge” funds had been parked – while margin interest was rising steeply. So they got clobbered like baby seals.
- The USD beatdown is the most curious aspect of this Minsky moment and the only one that requires any degree of more sophisticated knowledge. The key to understanding it is across the Pacific. There were mumblings that the Chinese authorities intervened repeatedly with liquidity injections in both the banking and the shadow-banking sector (because deceleration exposes insolvency). Official Chinese government data and records of Belgian holdings of USTs suggest that in 2018Q1 the Chinese sold off significant amounts of USD-denominated bonds. The also clamped down hard on capital flight through bitcoin and other channels. It stands to reason that both of these costly measures were motivated by the need to neutralize domestic credit expansion in order to maintain the USDCNY peg amid rampant import-led inflation of consumer prices. Both of these measures would have put significant downward pressure on the dollar – one on the supply side, the other on the demand side.
Every market top that I know something about has taken place amid parallel acceleration, where equity volatility rises alongside momentum driven by small-cap stocks. This has been accompanied by a divergence in the credit markets, where yields subject to short-horizon bias (junk, overnight, credit-card, margin etc.) rise while long-horizon yields (UST30Y, JGB50Y etc.) fall or remain flat, leading to the moth-eaten inversion of the yield curve. Neither of these signals has yet been completed this market cycle. And they may never be, although my default scenario continues to be contrarian – that we will see new ATHs in US equities before this market cycle is completed.
This Time IS Different
History rhymes, but never repeats itself. Because this probably is the most epic thinning of the US equity market as far back as broad data are available. Daily volume has been dropping since QE started some decades ago, but it gets even better. Volume in drawdown periods has been falling as well.
Bank assets, leverage and every other horror metric imaginable around the world is at record levels. Central-bank interest rates are close to the zero bound and CBs are running out of assets to buy despite massive government borrowing. The global financial system is fragilized by orders of magnitude more than it was in 2008. This spells acceleration events may become the norm rather than the tail.
On that cheerful note, I shall leave you with a classic worth pondering.