Crisis Watch

By Doug Noland

Where to begin? Contagion… The Argentine peso dropped another 5.0% this week, bringing y-t-d losses to 23.7%. The Turkish lira fell 3.9%, boosting 2018 losses to 15.4%. As notable, the Brazilian real dropped 3.7% (down 11.5% y-t-d), and the South African rand sank 4.0% (down 3.0% y-t-d). The Colombian peso fell 3.0%, the Chilean peso 2.7%, the Mexican peso 2.7%, the Hungarian forint 2.3%, the Polish zloty 2.1% and the Czech koruna 2.0%.

EM losses were not limited to the currencies. Yields continued surging throughout EM. Notable rises this week in local EM bonds include 54 bps in Brazil, 27 bps in South Africa, 34 bps in Hungary, 36 bps in Lebanon, 25 bps in Indonesia, 28 bps in Peru, 14 bps in Turkey, 20 bps in Mexico and 11 bps in Poland.

Dollar-denominated EM debt was anything but immune. Turkey’s 10-year dollar bond yields spiked 41 bps to 7.16%, the high going back to May 2009. Brazil’s dollar bond yields surged 29 bps to 5.58%, the highest level since December 2016. Mexico’s dollar yields jumped 18 bps to 4.64%, the high going all the way back to February 2011. Dollar yields rose 19 bps in Chile, 28 bps in Colombia, 19 bps in Indonesia, 14 bps in Russia, 14 bps in Ukraine and 167 bps in Venezuela (to 32.80%). Losses are mounting quickly for those speculating in EM debt.

Developed bonds were under pressure as well. We’ll begin with Italy:

May 17 – UK Guardian (Jon Henley): “Italy’s new government, likely to be formally confirmed within the next few days, sets a perilous precedent for Brussels: it marks the first time a founding member of the EU has been led by populist, anti-EU forces. From the EU’s perspective, the coalition of the anti-establishment Five Star Movement (M5S) and the far-right League looks headstrong and unpredictable, possibly even combustible. Leaked drafts of their government ‘contract’ include provision for a ‘conciliation committee’ to settle expected disagreements. Mainly it looks alarming. Both parties toned down their fiercest anti-EU rhetoric during the election campaign, dropping previous calls for a referendum on eurozone membership… But as they approach power, the historical Euroscepticism of the M5S and the League is resurfacing. An incendiary early version of their accord called for the renegotiation of EU treaties, the creation of a euro opt-out mechanism, a reduction in Italy’s contribution to the EU budget and the cancellation of €250bn (£219bn) of Italian government debt.”

Italian 10-year yields surged 36 bps this week to 2.23%, the high since the spike last July. Perhaps even more dramatic, after ending last week at negative 29 bps, Italian 2-year yields surged 37 bps to a near 22-month high eight bps. The Italian to German two-year yield spread widened 36 bps this week to a 13-month high 68 bps.

Bonds throughout the euro zone periphery were under pressure. Greek 10-year yields surged 50 bps to a 2018 high 4.50%. Portuguese yields jumped 19 bps to 1.87%, and Spanish yields gained 17 bps to 1.44%. Elsewhere, Australian 10-year yields rose 12 bps to 2.90%, and New Zealand yields rose 14 bps to 2.86%.

Even with Friday’s six bps decline, 10-year Treasury yields ended the week up eight bps to 3.06%. Thursday’s 3.13% yield was the high going back to July 2011. With two-year yields adding a basis point this week, the two to 10-year spread widened seven bps to 51 bps. It’s worth noting that 30-year yields jumped 10 bps this week to 3.21%, the high since June 2015, and benchmark MBS yields rose 10 bps to 3.76%, a high going back to July 2011.

May 17 – Bloomberg (Selcuk Gokoluk): “Debt levels that quadrupled in a decade have made emerging markets vulnerable to tightening financial conditions in the era of rising U.S. interest rates, Fitch Ratings said. Outstanding debt securities from developing nations have ballooned to $19 trillion from $5 trillion a decade earlier… Despite the development of local-currency bond markets, borrowers will be hobbled by higher external borrowing costs, a stronger dollar and slowdown of capital inflows, it said… ‘If easy financial conditions tighten more sharply than expected, EM debt would come under pressure,’ said Monica Insoll, the head of the credit market research team at Fitch. ‘If investor appetite for EM risk reverses, issuers may face refinancing challenges even in their home markets, while capital outflows could put pressure on exchange rates or foreign exchange reserves.'”

It’s worth repeating (from above): “Outstanding debt securities from developing nations have ballooned to $19 trillion from $5 trillion a decade earlier.” Analysts this week were keen to note that EM market tumult has been less disruptive than the (soon passing) 2016 episode. Give it time. We’re still in just the initial phase of Risk Off. Only a few weeks back, universal bullishness held sway over the emerging markets and economies. Buy one ETF and own them all!

It’s worth recalling that the 2016 de-risking/de-leveraging episode was nipped in the bud by an upsurge in global QE (especially courtesy the ECB and BOJ) and a corresponding extension of easy money by the Federal Reserve. And let us not forget the commanding contribution from Beijing policymaking. After a modest slowdown in 2015, China’s Credit growth surged in 2016 and that acceleration continued well into 2017. Two additional fateful years of surging global Credit and financial flows are now coming home to roost.

Today’s backdrop is more conducive to a protracted EM crisis backdrop, along with, I would argue, an especially destabilizing global market liquidity crunch. For one, the overheated U.S. economy has the Fed rather hamstrung. Their timid baby-step approach has worked to sustain excessively loose financial conditions. And while central bankers dilly-dallied, extreme fiscal stimulus coalesced with extreme monetary stimulus – creating a most potent concoction way too late in the economic cycle. Between fiscal stimulus, a capital investment boom and reenergized housing inflation, the Fed today confronts extraordinary uncertainty as it attempts to gauge the amount of economic stimulus and inflationary juice in the pipeline.

Fed rate hikes, rising market yields and the resurgent dollar receive most of the attention when analysts contemplate EM vulnerabilities. Issues related to China are deserving of more prominence in the analysis. Chinese officials have finally become more assertive in cracking down on financial excess. China’s system Credit growth has slowed meaningfully, and there are indications that tighter financial conditions have begun to bite.

May 18 – Bloomberg (Carrie Hong): “Zhongyuan Yuzi Investment Holding Group Co. became the second Asian investment-grade company that failed to price a dollar-denominated bond offering this week after the 10-year U.S. Treasury yield hit the highest level since 2011. The Chinese local government financial vehicle decided not to proceed with a plan to sell dollar bonds on Thursday because of unfavorable market conditions… A day earlier, developer China Overseas Grand Oceans Group Ltd. also postponed a sale of five-year bonds… With the global borrowing benchmark surging this week combined with rising Libor funding cost, appetite for Asian dollar new issues is weakening…”

May 16 – Bloomberg (Lianting Tu, Carrie Hong and Denise Wee): “A slump in prices of higher-yielding bonds sold by Chinese banks risks spurring margin calls that will exacerbate the declines. Capital instruments sold by Bank of Qingdao Co. and other small Chinese lenders sank below 90 cents on the dollar this month, tumbling faster than other securities as a rise in Treasury yields sent jitters through Asian credit markets. Because the notes were marketed to wealthy individuals as part of structured products and those investors tend to be heavily leveraged, buyers may face margin calls when prices decline to between 80 cents and 90 cents on the dollar, said three people familiar with the debt…”

May 17 – Bloomberg: “The days when only obscure Chinese companies defaulted on their debt are ending. Four of the five issuers that have defaulted for the first time in 2018 are companies with public listings, which used to be regarded as assuring better governance and information disclosure. That’s as many by this type of firm as happened in 2014 through 2017… For investors, the change means it’s dangerous to make assumptions. ‘Our first and foremost task now is to avoid stepping on mines,’ says Wang Ming, chief operating officer at Shanghai Yaozhi Asset Management LLP, which oversees 12 billion yuan ($1.9bn) in assets. ‘It’s increasingly difficult to tell which one will default, which not.'”

China would not face today’s degree of fragility had it not fatefully resuscitated Bubble Dynamics back in 2016. EM, as well, would be in a sounder position if it had begun to deal with excess and mounting vulnerabilities. Instead, for both China and EM it’s been a case of extending Terminal Phase Excess, with an additional two years of rampant Credit expansion, extraordinary international “hot money” flows, and even deeper structural impairment.

May 17 – Bloomberg (Richard Frost and Emma Dai): “Hong Kong intervened to defend its currency peg for a second day after the city’s dollar fell to the weak end of its trading band The Hong Kong Monetary Authority bought HK$9.5 billion ($1.2bn) of local dollars overnight, the third-biggest intervention since the defense began last month. The HKMA mopped up HK$1.57 billion on Wednesday. Lower rates than the U.S. have made the Hong Kong dollar an attractive target for shorting. The de facto central bank has now spent $7.95 billion protecting its currency system, which has the effect of tightening liquidity in a city that’s grown fat on ultra-low borrowing costs.”

From my vantage point, EM contagion has reached critical mass. There will be ebbs and flows, but we’re now on Crisis Watch. De-risking/De-leveraging Dynamics have attained momentum, and the focus will be on waning global market liquidity and the next domino. The process of unwinding EM “carry trade” leverage has commenced. I ponder how much leverage has accumulated throughout Asian debt markets. Hong Kong’s Monetary Authority has significant international reserves (over $400bn) to support its faltering currency peg. But I would expect the reversal of “hot money” flows to accelerate, pressuring central banks throughout Asia and EM more generally. To fund outflows, central bankers will be forced sellers of Treasuries (and other sovereign debt). It’s worth noting that custody holdings held by the Fed for foreign Treasury holders have dropped $63bn over the past five weeks.

Back in 2015 and 2016, the monthly change in China’s international reserves garnered significant market interest. Recall that after peaking at almost $4.0 TN in June 2014, reserves were down to about $3.0 TN by the end of 2016. But between January 2017 and January 2018, China’s reserves recovered $160 billion, a significant quantity but still only a fraction of the previous decline. Hinting of a return of outflows, reserves have dropped $36 billion over the past three months.

Is there a big foreign “carry trade” component in Chinese debt instruments – in Hong Kong and the mainland? In the past, I posited “currency peg on steroids” – speculators could leverage in higher yielding Chinese instruments with confidence that Chinese officials would revalue the renminbi higher versus the dollar. The 2015/2016 renminbi devaluation corresponded with huge outflows and the drawdown of China’s reserve holdings. Now, for almost 18 months the renminbi has enjoyed another period of managed appreciation – concurrent with a period of global exuberance for EM and Credit more generally. How much “hot money” and leverage was enticed by China’s higher yields?

China appears increasingly vulnerable to EM contagion effects. Finance is tightening in EM, in China and globally. Over recent years, China has developed into the prevailing source of EM finance and trade. China and EM interdependency has been instrumental to their respective booms. Now comes the downside. I suspect “hot money” has begun exiting EM at least partially in anticipation of waning trade and financial flows from China. And a faltering EM Bubble certainly has negative ramifications for the increasingly fragile Chinese Bubble. If there is a big “carry trade” in Chinese Credit instruments, it’s susceptible.

Previous problems have not gone away – they’ve instead festered and metastasized. EM debt, the China Bubble, Italy and euro monetary integration, to name just a few. This week was clearly an escalation in global de-risking/de-leveraging dynamics. How much speculative leverage has accumulated (since 2012) in Italian, Greek, Portuguese and Spanish debt? ECB rate manipulation and “money printing” stoked an artificial boom. It’s come at a very steep price. Myriad problems associated with a deeply flawed monetary integration are waiting to resurface, as we’re witnessing in Italy.

I know it sounds crazy – pure heresy – to most. But there’s a shot that the world has commenced a crisis period that will unfold into something more comprehensive and challenging than 2008. And at least in the U.S., financial crisis is the furthest thing from people’s minds. Not even on the radar. Not possible.

The VIX closed the week at 13.42. Blue skies as far as eyes can see. But to one that has been chronicling the “global government finance Bubble” now for over nine years, I really worry. Excess became systemic. Deep structural maladjustment – systemic. Global imbalances – unprecedented. The amount of global debt – previously unfathomable. And, deeply concerning, the world has become so much more divisive and hostile over the past decade.

Come the next international crisis, it will not be the U.S. and a group of likeminded global central bankers coordinating a unified policy response. Expect a disparate group of bankers, politicians and strongmen autocrats pointing fingers, making threats and demanding action from others. If they can’t after months successfully negotiate trade deals, how are they to respond to crisis dynamics that they are wholly unprepared for.

But I’m getting ahead of myself. The U.S. economic boom has a head of steam. The small caps traded to record highs this week. To the naked eye, things look sound and sustainable. If only it weren’t a Bubble Illusion. The NYT’s Kevin Roose this week penned an insightful article, “The Entire Economy Is MoviePass Now. Enjoy It While You Can.”

“I’ve got a great idea for a start-up. Want to hear the pitch? It’s called the 75 Cent Dollar Store. We’re going to sell dollar bills for 75 cents – no service charges, no hidden fees, just crisp $1 bills for the price of three quarters. It’ll be huge. You’re probably thinking: Wait, won’t your store go out of business? Nope. I’ve got that part figured out, too. The plan is to get tons of people addicted to buying 75-cent dollars so that, in a year or two, we can jack up the price to $1.50 or $2 without losing any customers. Or maybe we’ll get so big that the Treasury Department will start selling us dollar bills at a discount. We could also collect data about our customers and sell it to the highest bidder. Honestly, we’ve got plenty of options. If you’re still skeptical, I don’t blame you. It used to be that in order to survive, businesses had to sell goods or services above cost. But that model is so 20th century. The new way to make it in business is to spend big, grow fast and use Kilimanjaro-size piles of investor cash to subsidize your losses, with a plan to become profitable somewhere down the road. Over all, 76% of the companies that went public last year were unprofitable on a per-share basis in the year leading up to their initial offerings, according to… Jay Ritter, a professor at the University of Florida’s Warrington College of Business. That was the largest number since the peak of the dot-com boom in 2000, when 81% of newly public companies were unprofitable. Of the 15 technology companies that have gone public so far in 2018, only three had positive earnings per share in the preceding year… The rise in unprofitable companies is partly the result of growth in the technology and biotech sectors, where companies tend to lose money for years as they spend on customer acquisition and research and development… But it also reflects the willingness of shareholders and deep-pocketed private investors to keep fast-growing upstarts afloat long enough to conquer a potential winner-take-all’ market.”

We’ve created a Bubble economic structure that will function especially poorly come faltering markets and a tightening of financial conditions.

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