“Risk Off” Making Some Headway

By Doug Noland

Credit Bubble Bulletin: “Risk Off” Making Some Headway

Global “Risk Off” has been Making Some Headway. This week saw ten-year Treasury yields drop 15 bps to 2.23%, the low since the week following the election. German bund yields declined another four bps to a 2017 low 19 bps. The Crowded Trade hedging against higher rates is blowing apart. The Crowded yen short has similarly been blown to pieces, with the Japanese currency surging an additional 2.3% this week (increasing 2017 gains to an impressive 7.7%). Japan’s Nikkei equities index dropped 1.8% this week, with y-t-d losses rising to 4.1%.

Meanwhile, this week Gold surged 2.5%, Silver jumped 2.9% and Platinum gained 1.9%. In contrast to the safe haven precious metals, Copper dropped 2.8%, Aluminum fell 2.7% and nickel sank 4.2%.

European periphery spreads (to bunds) widened meaningfully. Italian spreads widened 14 to 213 bps, the widest since early-2014. Spanish spreads widened 13 to an eight-month high 152 bps. Portuguese spreads widened six bps and French spreads seven. Italy’s stocks fell 2.6%, with Italian banks down 5.9%. Spanish stocks lost 1.9%. European bank stocks dropped 2.6% this week.

A little air began to leak from the EM Bubble. Russian stocks were hammered 5.9% to an eight-month low, increasing 2017 losses to 14.2%. Brazilian stocks lost 2.5%. Chinese equities suffered moderate declines, while appearing increasingly vulnerable. For the most part, however, EM held its own. The weak dollar helped. EM equites (EEM) declined only 0.6% for the week, while EM bonds (EMB) gained 0.4%.

U.S. equities trade unimpressively. The VIX rose slightly above 16 Thursday to the highest level since the election. The banks (BKX) sank 3.2%, increasing 2017 losses to 4.1%. The broker/dealers also lost 3.2% (down 0.7% y-t-d). The Transports were hit 2.5% (down 1.9%). The broader market continues to struggle. The mid-caps dropped 1.5% (up 1.2%), and the small caps fell 1.4% (down 0.9%). Even the beloved tech sector has started to roll over. At the same time, high-yield and investment grade debt for the most part cling to “Risk On.”

A number of articles this week pronounced the death of the “reflation trade.” It’s worth noting that the GSCI Commodities index gained 2.2% this week, trading to a six-week high and back to positive y-t-d. Rising geopolitical tensions helped Crude rise to almost $54, before closing the week at $53.18. President Trump talked down the U.S. dollar, and I’ll add “careful what you wish for.” The dollar index declined 0.6% this week. Is it a coincidence that the President calls the dollar “too strong” only a few days after meeting with Chinese President Xi Jinping? China is no currency manipulator, not if it can rein in a psycho North Korean despot.

When it comes to global reflation, China continues to play a leading role. Chinese Credit enjoyed a historic 2016 – and, after a record first quarter, China’s Credit growth is on track to surpass $3.5 Trillion in 2017.

For March, China’s Total Social Finance (TSM) increased a much stronger-than-expected $308 billion. This put first quarter consumer and corporate Credit growth at $1.014 TN, a record exceeding even 2016’s unprecedented Q1. For comparison, China’s Q1 2017 TSM growth was 50% greater than Q1 2015. TSM ended March at $23.65 TN, up 12.5% y-o-y – expanding at a rate almost double the real economy.

And while Chinese bank loan growth slowed to a 12.4% rate in March, there were notable trends that must worry officials. First, shadow banking components expanded a much stronger-than-expected almost $110 billion during the month. Meanwhile, China’s mortgage finance Bubble continues to prove resilient in the face of various efforts to cool overheated housing markets.

April 14 – Reuters (Elias Glenn): “Loans to households surged to 797.7 billion yuan ($115bn) in March, …accounting for 78% of all new loans in the month. That was much higher than either January or February and even the 50% of new loans in 2016. The rise likely was due to a surge in short-term lending to households, as individuals may be turning to alternative types of loans as banks tighten rules on traditional mortgages, said Wendy Chen, an economist at Nomura in Shanghai. ‘We think (the increase in short-term loans) is possibly due to attempts to circumvent strict regulations on mortgages… The high loans to households reflect that property sales are still very hot, and likely shifting from top tier cities to more third or fourth tier cities.’”

In a precarious “Terminal Phase” Credit Bubble Dynamic, Chinese shadow banking has gone parabolic. Over the past five months, shadow banking assets (compiled by Bloomberg) have expanded $472 billion, or about 35% annualized. For comparison, shadow banking increased about $70 billion for all of 2015. Chinese shadow banking increased $300 billion during Q1.

April 11 – Wall Street Journal (Shen Hong): “China’s battle to counter rising stress in its financial system has escalated this week, with regulators making a fresh warning to banks not to engage in speculation that creates unhealthy asset bubbles and prevents money from flowing to more productive parts of the economy. In a directive circulated to banks Monday, the country’s banking regulator instructed banks to carry out self-checks by late November on their involvement in what it termed ‘irregularities.’ The seven-page document… said such actions include making highly leveraged bets on markets via popular investment products, and the excessive use of a newly popular form of short-term debt that banks are increasingly relying on for funding.”

April 10 – Bloomberg: “Like many individual investors in China, Yang Mo has no idea what’s in the wealth management products that make up a big chunk of her net worth. She says there’s really no point in finding out. Sure, WMPs invest in all kinds of risky assets, but the government would never let a big one fail, she says. ‘It’s not how the Chinese government does things, and it’s not even Chinese culture,’ explains Yang, a 29-year-old public relations professional… Hers is a common refrain in Asia’s largest economy, where savers have poured $9 trillion into WMPs and similar products on the assumption that they’ll get bailed out if the investments sour. Even after news in February that policy makers are drafting rules to make it clear that state guarantees don’t exist, Yang is undaunted… ‘Cracking down on implicit guarantees is just like curbing home prices,’ she says. ‘It’s something that the government needs to say, but it’s not something they will eventually do.’”

For several years now, Chinese policymakers have made myriad attempts at the old “lean against the wind” approach to counter mounting financial excess. They’re now facing a Credit typhoon of their own making. At this point, Beijing must inflict pain if they intend to break what is now deeply ingrained inflationary psychology in housing finance as well as powerful speculative impulses throughout finance more generally. Apparently, everyone – from Chinese citizen to global investor – is confident that no dramatic policy measures will be employed prior to the autumn meetings of the National Congress of the Community Party.

Yet Chinese fragility is but one of what has become a litany of risks to the global Bubble. And while largely numb to Chinese risks, speculative global markets are having more difficulty disregarding the troubling geopolitical backdrop. With North Korea at the brink of another nuclear test and warning of nuclear war – and Trump sending an “armada” to the Korean peninsula and threatening a preemptive military strike if a “looking for trouble” North Korea test appears imminent – it’s enough to take some risk off the table and buy gold, Treasuries and bunds. That Trump would send a flurry of Tomahawk missiles into Syria, confront Russia on Assad and drop “the mother of all bombs” into the Afghan mountainside have some thinking it’s time to take geopolitical risks more seriously.

Assuming we make it through Easter weekend without tensions ratcheting up in Korea or elsewhere, market attention will turn to next Sunday’s first round French election.

April 12 – Reuters (Sudip Kar-Gupta and Sarah White): “France’s presidential race looked tighter than it has all year on Friday, nine days before voting begins, as two polls put the four frontrunners within reach of a two-person run-off vote. The latest voter surveys may raise investor concerns about the outside possibility of a second round that pits the far-right candidate Marine Le Pen against hard-left challenger Jean-Luc Melenchon. The election is one of the most unpredictable in modern French history, as a groundswell of anti-establishment feeling and frustration at France’s economic malaise has seen a growing number of voters turn their backs on the mainstream parties. An Ipsos-Sopra Sterna poll showed independent centrist Emmanuel Macron and Le Pen tied on 22% in the April 23 first round, with Melenchon and conservative Francois Fillon on 20 and 19% respectively.”

Basically, there are four candidates all within the margin of statistical error vying for two spots in the May 7th second round head-to-head. For months now, far-right candidate Marine Le Pen has led first round polling numbers. While somewhat unsettling to markets, the assumption has been that Le Pen would lose badly to the leading “establishment” candidate, presently Emmanuel Macron. But with just over a week to go, far-left candidate Jean-Luc Melenchon is enjoying a surge in popularity. This increases the odds that market favorite Macron might not make it out of the first round.

A Le Pen versus Melenchon second round would be a nightmare scenario for skittish markets. Concern would quickly turn to Italy, where the anti-euro 5-Star Party has been rapidly gaining in the polls ahead of next year’s general election.

Plenty of worries globally and here at home. Especially after last week’s release of weak March auto sales data, concern is growing that tightened Credit conditions have begun to restrain the U.S. economy. For the most part, quarterly earnings reports from the major banks confirmed a weakening of loan growth. Yet it isn’t clear how much of this is the result of tightened lending standards and waning demand for borrowings, or instead more a reflection of huge corporate debt issuance (issue bonds rather than borrow from banks) and a slowing of big M&A deals.

It’s worth noting that the recent drop in mortgage rates comes at a most opportune time for the peak home sales period. Mortgage purchase applications jumped last week to the high since last June – and were the third highest weekly level since 2009. Mortgage rates remain extraordinarily low, consumer confidence quite high and the inventory of homes for sale unusually low. A significant Treasury market squeeze could further stoke housing markets already demonstrating strong inflationary/Bubble biases.

April 13 – CNBC (Diana Olick): “Homes are flying off the shelves this spring, as demand rises and supply continues to drop. Record high prices in some local markets are not thwarting hungry buyers, as they rush to take advantage of the lowest mortgage rates of the year. Home sales jumped nearly 9% in March compared with March 2016, even as the number of homes for sale plunged 13%, according to… Redfin… That demand dynamic further increased competition in the market, resulting in the fastest average sales pace since Redfin began tracking in 2010. The typical home went under contract in just 49 days, down from 60 days a year ago. Steep competition also pushed the median price of a home sold in March to $273,000, up 7.5% year over year.”

As for the U.S. stock market, it appears a decent amount of hedging has taken place over the past couple weeks. Previously such dynamics often created the firepower to squeeze the shorts and force the risk averse to unwind hedges and scamper back aboard the bull market. Complacent markets may have forgotten that put options and myriad “portfolio insurance” strategies can as well provide firepower for a self-reinforcing downside. North Korea, Syria, Russia and France provide potential for clear and present danger.

There is as well the risk of a U.S. government shutdown at the end of the month, along with all the ambiguity surrounding the Trump Administration’s shifting agenda. What appeared a united group determined to go right down the list of campaign promises – keen to focus on tax cuts/reform and infrastructure spending – these days appears confused, less than cohesive and without much of a list. If markets abhor uncertainty, it’s hard to see them enamored with the stunning degree of policy reversals and flip-flopping. Return to healthcare and deal with tax and spending legislation later? Roused from a state of deep depression, the Democrats now count down the days until next year’s mid-terms.

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