Friday from Bloomberg: “US Stocks Rise After ‘Major Overreaction” to Fed.” There was certainly more to Wednesday’s steep market selloff than a meaningfully more hawkish Fed statement and Powell press conference. Welcome to Washington dysfunction on steroids meets global market dysfunction.
The Musk/Trump memes are entertaining, leaving some of us curious how they’re playing in Mar-a-Lago. Musk’s antics are less amusing. Are we okay with the world’s richest person torpedoing last-minute bipartisan legislation to keep the government operating, using the threat of his well-funded PAC and being “primaried” against Republican (and Democrat) lawmakers that refuse to fall in line?
Not even enduring to next month’s inauguration, the election honeymoon period was abruptly cut short by a few tweets. Many cheer on Musk and the disruption agenda. Euphoric markets have reveled in the notion of disruption. But the actual variety comes with major uncertainties – uncertainty that only compounds already highly elevated risks in today’s extraordinary economic, political, geopolitical and market environments.
Elon and President Trump will not appreciate that the Powell Fed has now embarked on a “new phase,” only weeks ahead of disruption city.
December 17 – New York Times (Jeanna Smialek and Ana Swanson): “If you ask many a Wall Street investor, tax cuts are poised for extension, deregulation is all but guaranteed, immigration reform for high-skill workers has real potential and President-elect Donald J. Trump’s Department of Government Efficiency (DOGE) might just cut the deficit. Tariffs, by contrast, are a mere bargaining chip. Immigrant expulsions will probably be limited, and there is no way on earth that the incoming White House would meddle with the independent Federal Reserve. Hope has been riding high in financial markets and corporate boardrooms in the month-and-change since the presidential election. But it is often predicated on a bet: Many of the optimists are choosing to believe that the Trump promises they want to see fulfilled are going to become reality, while dismissing those they think would be bad for the economy as mere posturing.”
As we’ve witnessed for a while, exuberant markets are all too happy to ignore myriad risks. “‘The Fed Made A Concession To Reality’ – Goldman Top Trader Frames The Chaos This Week” – read a captivating headline. Markets were a lot happier with the pre-concession Fed, with officials determined to ignore extraordinarily loose financial conditions, economic resilience, and booming markets – while arguing “significantly restrictive.”
With Fed credibility hanging in the balance, Powell had to come clean: “Downside risks to the labor market do appear to have diminished.” “12-month inflation has actually been moving sideways.” “Inflation has once again underperformed relative to expectations.” “We are at or near a point at which it will be appropriate to slow the pace of further adjustments.” “As for additional cuts, we’re going to be looking for further progress on inflation.” “And as long as the economy and the labor market are solid, we can be cautious about, as we consider further cuts.” “It’s a new phase and we’re going to be cautious about further cuts.”
Two weeks after Fed Governor Christopher Waller’s “I believe the evidence is strong that policy continues to be significantly restrictive,” Powell made a significant change in the use of “significantly.” “Now significantly less restrictive.” “We’re significantly closer to neutral.” To emphasize the point, he repeated “meaningfully restrictive” three times. “We are though in a new phase in the process.”
It went beyond a crafty pivot back to “balanced Powell.” The Fed Chair was compelled to reflect the significant shift in committee thinking – that was evident in upgrades to inflation, growth, and policy rate forecasts in the Fed’s Summary of Economic Projections (SEP).
But what might be behind such an abrupt deviation? A few disappointing inflation reports? Some stronger economic data, including a post-election boost in confidence? Have bubbling markets – stocks and crypto for starters – finally become a Fed worry? Have Federal Reserve officials come to appreciate risks associated with excessively loose financial conditions? Is it becoming clearer to the Committee that the Trump agenda seeks to aggressively stimulate market and economic booms?
A few hours before the Fed’s policy statement, the Bureau of Economic Analysis released data that was deemed quite important early in my career – that these days barely generates a headline.
December 18 – Reuters (Lucia Mutikani): “The U.S. current account deficit widened to a record high in the third quarter on strong growth in imports and lower income receipts, with some economists warning of a potential threat to a country already saddled with a large government budget deficit. The… current account deficit, which measures the flow of goods, services and investments into and out of the country, increased $35.9 billion, or 13.1%, to an all-time high of $310.9 billion last quarter. Economists… had forecast the current account deficit would be $284.0 billion. The current account gap represented 4.2% of gross domestic product…”
When the Current Account Deficit surged to an annual record $161 billion in 1987, it was generally recognized that the “twin deficits” (fiscal and trade) contributed to financial, market, and economic instability. By the time it had ballooned to $817 billion in 2006 – while the system was in the throes of mortgage finance Bubble excess – the Fed and Wall Street could not have cared less.
For generations, adept economic thinkers recognized that a nation’s Current Account was an invaluable indicator of financial conditions and the appropriateness of monetary policy. A large deficit reflected loose conditions and resulting spending excesses. What’s more, expanding trade and Current Account deficits were viewed as portending policy tightening measures, in this way providing somewhat of an automatic system stabilizer function. The travesty of scuttling the Current Account from important Fed (hence Wall Street) considerations came with the embrace of the radical doctrine of Ben Bernanke inflationism. Dollar Bubble liquidity has since inundated the world.
When I contemplate the degradation of Current Account analysis, my thoughts gravitate to Hyman Minsky’s “stability is de-stabilizing.” Current Account Deficit ballooning was not coincidental with the 1987 stock market crash or the 2008 crisis. Moreover, serial nineties EM crises (i.e., Mexico ’95, SE Asia ’97, Russia/LTCM ’98) were the consequence of U.S. Current Account Deficit-induced global liquidity and speculation boom and bust dynamics.
Like much within finance over this super-cycle, invariably the wrong lessons were learned. Rather than the battered EM universe recognizing the critical role loose U.S. conditions and Current Account Deficits had played in their Bubble collapses, they doubled down on the dysfunctional global financial structure. Countries believed that larger holdings of international dollar reserves would buttress their currencies and safeguard their systems from devastating “hot money” exodus – and resulting currency and bond market collapses. Accommodating massive U.S. deficits has for years now seemingly promoted “stability.”
December 20 – Bloomberg (Giovanna Bellotti Azevedo, Leda Alvim and Maria Elena Vizcaino): “Brazilian markets bounced at the end of the week amid extraordinary central bank moves to curb a selloff in the currency that was spreading across the nation’s markets. The real gained as much as 1.4% on Friday, briefly erasing weekly losses, after policymakers stepped in again with both a spot sale and a credit line auction totaling a combined $7 billion… The reprieve comes after the central bank stepped in almost every day for the past week to try to meet a surge in demand for US dollars. It sold $8 billion in back-to-back spot auctions on Thursday alone in the biggest daily sale of greenbacks since at least 1999. They’ve spent about $17 billion in spot sales so far.”
While Wall Street was fixated Wednesday on the Fed statement, Powell presser, and Elon tweets – crisis dynamics were engulfing Brazilian markets. Brazil’s real (currency) was hammered 3% in Wednesday trading, as the country’s bonds came under heavy selling pressure. Brazil’s 10-year local currency yields spiked to 15.62% in chaotic Wednesday trading, up 113 bps from Tuesday’s close and 138 bps from the previous week. Dollar-denominated yields jumped as high as 7.15% – up 36 bps on the session and 65 bps from the previous Friday close. Brazil sovereign CDS spiked 31 Wednesday to a 19-month high 221 bps.
Things had settled down somewhat by the end of the week, with Friday’s 0.9% gain reducing the real’s weekly decline to 0.5%. Local currency yields sank 76 bps Thursday and Friday to end the week little changed, with dollar yields dropping 14 bps Friday to end the week 52 bps higher.
The good news: Brazil reports international reserves of $347 billion, up significantly from the $200 billion back during the 2008 crisis and the $50 billion during the country’s 2000 currency and financial crisis. The bad news: the surge in currency reserves corresponded with a huge increase in speculative “hot money” inflows – likely much of it of the levered “carry trade” variety. Moreover, Brazil’s central bank – like many of its EM brethren – has become a big player in currency derivatives, preferring to bolster its currency through derivatives trading rather than burning through currency reserves. Works until it doesn’t. As the above Bloomberg article noted, a quick $17 billion was burned through to stabilize the real.
The VIX spiked to 28.32 in late Wednesday trading, the high since the now long-forgotten August 5th bout of global market (fledgling de-leveraging) instability. Wednesday’s currency trading was the most chaotic since August 5th. Curiously, disorderly yen strength was behind August 5th instability, while the yen declined 1.7% this week to the weakest level versus the dollar since July. August 5th instability was quickly quelled by dovish comments from a key Bank of Japan official, soon followed by a dovish Powell in Jackson Hole. I don’t expect this week’s instability to prove so transitory.
December 20 – Bloomberg (Marcus Wong and Prima Wirayani): “From Brazil to South Korea, emerging-market central banks are forming a line of defense as a rising dollar pushes their currencies to multi-year lows. Bangko Sentral ng Pilipinas is watching the peso’s drop closely and has stepped up intervention in the currency market, Governor Eli Remolona said Friday. Brazil’s central bank has spent almost $14 billion in the past week to support the real while Bank Indonesia vowed to guard the rupiah ‘boldly’ to build market confidence. In Europe, Hungary’s central bank joined the trend, raising the interest rate on its foreign-currency swap tender to calm markets. Authorities in developing economies are on the defensive as the greenback’s strength wreaks havoc across global markets…”
I still view August 5th as the initial ruction of unavoidable global de-risking/deleveraging. Policymakers quickly reversed “risk off” and triggered a major cross-market short squeeze and reversal of hedges. Aggressive Fed easing exacerbated already excessively loose financial conditions, stoking a speculative melt-up that was then given a further shot of adrenaline on November 5th.
Wednesday was telling. Even in the face of “risk off” Brazil/EM currency instability and spiking EM/global yields, typical safe haven Treasury demand was MIA. Ten-year Treasury yields jumped 12 bps points to the highest level (4.52%) since the late-May spike. It appeared the dreadful de-leveraging “doom loop” was taking hold – disorderly currency weakness forcing EM central banks into international reserve (chiefly Treasuries) liquidations to fund currency market intervention.
The specter of aggressive central bank liquidations then pressures various leveraged trades in Treasuries, MBS, corporate bonds, Munis, and such – triggering Treasury deleveraging and hedging-related selling. Interestingly, the 2-year/10-year Treasury spread widened a notable nine bps Wednesday to the widest level since June 2022. Levered yield-curve trades were under pressure, along with most levered strategies. With equities slammed and Treasuries and commodities under pressure, levered “risk parity” strategies must have suffered a rotten session and week.
From my perspective, this week likely concludes the post-August 5th “risk on” recovery and speculative melt-up. Year-end trading dynamics add a layer of complexity, raising the possibility of a rally and year-end markup – or intense hedge fund selling to protect fading 2024 gains (and payouts). Especially in this highly speculative environment, market squeezes can erupt at any time. But it appears that there is elevated risk that de-risking/deleveraging gains momentum from here. And with inflation and growth elevated even before Team Trump takes the world by storm, euphoric markets, all dressed up for a fun Fed easing cycle party, now face the reality of a divided and more hawkish Federal Reserve.
