June 2, 2017: Liquidity Trade

It’s not quite 1999 at this point, but it’s been moving in that direction. In about five months’ time, the Nasdaq 100 (NDX) has posted a gain of 20.5%. NDX stocks with greater than 50% y-t-d gains include Vertex Pharmaceuticals (74%), Activision (64%), Tesla (60%), JD.com (58%), Wynn Resorts (54%), CSX (53%), Autodesk (52%), Liberty Ventures (51%) and Lam Research (50%). Amazon’s 34% 2017 rise has increased market capitalization to $481bn (P/E 189). Apple’s 33% gain pushed its market cap to $806bn. Facebook has gained 33% y-t-d, Google 26%, and Netflix 32%.

There’s an interesting similarity to the 1999 backdrop: A Federal Reserve (and global central bank community) way too timid in implementing a “tightening cycle” despite bubbling asset markets. Fed funds began 1999 at 4.75%, after rates were slashed 75 bps late in 1998 in response to the Russia/LTCM financial crisis. Despite clearly overheated securities markets, rates ended 1999 at 5.5% – the same level they were for much of 1998. The Fed was content to let the speculative Bubble run, with memories of the previous year’s near financial meltdown clear in their minds. Moreover, Y2K uncertainties provided a convenient excuse to accommodate the raging Bubble.

There’s at least one huge difference to 1999. The 10-year Treasury yield began ‘99 at 4.65% and ended the year at 6.44%. Ten-year yields ended Friday’s session at 2.16%, down 29 bps so far in 2017 and near lows since the election. Astounding amounts of government debt have been issued globally since 1999. Radical central bank measures ensured prices of these securities inflated to unprecedented levels (even in the face of endless supply). Historically low yields are a global phenomenon. German bund yields closed the week at 27 bps and French yields closed at 71 bps. It’s worth noting some current 10-year sovereign debt yields: negative 27 bps in Switzerland, 31 bps in Finland, 40 bps in Sweden, 48 bps in Netherlands, 53 bps in Denmark, 54 bps in Austria and 64 bps in Belgium.

MSCI’s all-country world stock index ended the week at a record high. Both the UK FTSE (up 5.7% y-t-d) and German DAX (up 11.7%) equities indices traded Friday at new highs. European equities have been powering higher. The French CAC 40 has gained 9.9% y-t-d, Spain’s IBEX 35 16.6%, and Italy’s MIB 8.8%.

June 2 – Bloomberg (Katherine Chiglinsky): “Mohamed El-Erian, Allianz SE’s chief economic adviser, said the rally in stocks and high-yield bonds is part of a ‘liquidity trade,’ based on optimism that central bank stimulus efforts and the accumulation of corporate profits will sustain market gains. ‘That is what you’re betting on,’ El-Erian said Friday in an interview on Bloomberg Television. ‘You’re not betting on the Trump rally anymore. You’re not betting on the reflation trade anymore.’”

The “Trump Trade” provided convenient cover for what has been for some time a strengthening speculative Liquidity Trade. The histrionic bond market reaction to the weaker payroll data was telling. The long-bond surged a full point, with yields dropping five bps to the lows since November. If the issue were a weakening economy, one was challenged to see it in the reaction within the risk markets. Investment-grade corporate debt (LQD) gained about 0.5% Friday to trade to the high since November. Even junk debt (HYG) posted a small gain to trade to an almost 18-month high. The NDX jumped 1.1% Friday, with the Nasdaq Composite up 1.0% – both to record highs. The Semiconductors gained 1.0% (near year-2000 highs), and the Morgan Stanley High Tech index rose almost 1% to an all-time high. The Biotechs rose 1.9% to a 2017 high (up 20% y-t-d).

It’s worth noting that gold gained 1% on Liquidity Trade Friday, increasing 2017 gains to a notable 11%. Crude’s 1.5% Friday decline (down 4.3% for the week) was not inconsistent with Liquidity Trade dynamics. Shale exploration and extraction are thriving on easy “money.” And when it comes to Liquidity analysis, Bitcoin has earned a place at the table. Bitcoin rose $160 this week to $2,430, boosting its y-t-d gain to a remarkable 155%.

A Friday ZeroHedge article asked the relevant question: “BoJ, ECB Balance Sheets Exceed the Fed’s For First Time Ever – What Happens Next?” The over $1.0 TN global QE injections during the first four months of the year argue for “Peak QE.” The ZeroHedge article includes a chart of the G3 (Fed, BOJ, ECB) balance sheet that correlates closely with U.S. stocks going back to 2009. It’s worth noting that G3 balance sheets will soon reach $14.0 TN, up from less than $6.0 TN in early-2009 (after initial crisis-period QE). “Now what?”, indeed. Near zero rates and unprecedented “money printing” have inflated asset price Bubbles around the globe. What happens when stimulus is removed? This is by now a conspicuous problem, though markets are confident that central bankers have no stomach for finding out how big of a problem. The Liquidity Trade is premised on global central bankers being trapped in ultra-easy “money” (including ongoing printing).

May 30 – Bloomberg (Jeanna Smialek and Matthew Boesler): “Federal Reserve Governor Lael Brainard said soft inflation could cause her to reassess the path forward for monetary policy should it linger, even as the global economic outlook brightens and U.S. growth looks poised to rebound. ‘If the soft inflation data persist, that would be concerning and, ultimately, could lead me to reassess the appropriate path of policy,’ Brainard said… ‘I see some tension between signs that the economy is in the neighborhood of full employment and indications that the tentative progress we had seen on inflation may be slowing,’ Brainard said. ‘If the tension between the progress on employment and the lack of progress on inflation persists, it may lead me to reassess the expected path of the federal funds rate in the future, although it is premature to make that call today.”

This is exactly the type of dovish diffidence that feeds market speculation. The Fed needs to find a backbone and move forward in the direction of normalization without reacting to the normal ebb and flow of securities markets, inflation data and economic performance. Moreover, central bankers should jettison this notion of no tolerance for recessions or bear markets – both precious Capitalistic system cleansing mechanisms. Clearly, central bankers have come to exert profound effects on securities and asset prices. Recent history has as well demonstrated that their capacity to manipulate an index of consumer prices is suspect at best. Prolonging ultra-easy money will surely exacerbate global overcapacity (i.e. additional Chinese capacity and U.S. shale investment).

Especially after Friday’s weaker-than-expected payroll data, the markets will question whether the Fed is about to flinch. Expectations are growing that the FOMC will pull back from an already incredibly cautious rate hike cycle – one that to this point has completely failed to “tighten” financial conditions. Indeed, conditions have further loosened.

I’ve read and listened to analyses warning against the Fed committing a major policy error by tightening into a weakening economy. Yet the Federal Reserve’s mistake was waiting way too long to commence the normalization process. At this point, there is great risk in the Fed accommodating late-cycle excesses – including the global securities markets’ Liquidity Trade. Only a meaningful amount of pain will impact what has become a major inflationary/speculative psychology enveloping global securities markets. The Fed needs to bite the bullet and push rates higher.

Discussions continue regarding the Federal Reserve’s decision to shrink its balance sheet. Similar to rate discussions, the markets (for good reason) believe the Fed will refrain from measures that actually tighten financial conditions and impinge booming securities markets. If queried, most sophisticated market professionals would likely respond that they expect the next major change in the Fed’s holdings to be on the upside (another round of QE). Some Fed officials see selling assets as a positive measure that would help reduce excessive monetary accommodation. At this point, balance sheet discussions appear to be backfiring. Believing that the Fed will likely pause rate increases while reducing assets both slowly and very modestly, the markets now see potential Fed balance sheet operations as a bullish development that ensures no actual tightening of financial conditions for many months to come.

Next Thursday’s ECB meeting is widely expected to see a contentious debate regarding the process for winding down extraordinary QE and rate measures. Euro zone economies and inflation trends have bounced back. Ultra-loose financial conditions have worked their magic, although Draghi does not want any change in ECB stimulus to upset the Liquidity Trade. The Germans and others have long ago seen enough and seek to establish a timeline for winding down QE.

The markets assume Draghi will, once again, win the day. This week also saw happenings in China that embolden those believing that Beijing will also continue to win the day, month and year.

May 31 – Bloomberg: “The offshore yuan jumped the most in four months as funding costs surged amid speculation policy makers were supporting the currency in the wake of a surprise sovereign rating downgrade… ‘The sharp gain in the offshore yuan is partially due to the unwinding of short yuan positions because the high offshore yuan funding cost has made the currency too expensive to short,’ said Stephen Innes, senior Asia-Pacific currency trader at Oanda Corp… ‘Bears with short yuan positions would need to cut their exposure.’ The overnight yuan interbank rate in Hong Kong, known as Hibor, surged 15.7 percentage points on Wednesday to 21.08%, the highest since Jan. 6, while the offshore yuan’s overnight deposit rate jumped to 60%.”

May 31 – Bloomberg: “China is dishing out a tough lesson to currency traders and strategists alike: don’t bet against the yuan. The currency jumped its highest level in seven months offshore, extending Wednesday’s gain of 1.2%, despite analyst forecasts for declines this quarter. Surging interbank rates are squeezing bears by driving up the cost of short positions. The rally, which broke months of calm against the dollar, comes as a rebuke to Moody’s…, which downgraded China’s sovereign debt rating last week. The government has made its displeasure clear, calling the move ‘absolutely groundless.’”

On the back of the People’s Bank of China’s forceful interventions, the renminbi traded this week to the strongest level since November. Speculative markets have come to welcome heavy-handed Chinese intervention. The assumption is that Chinese officials are absolutely determined to hold bursting Bubble dynamics at bay.

China is not the only macro worry. Italian bank stocks were hit 4.3% this week. Talk of early elections also pressured Italian bonds. With yields rising 16 bps, the Italian to bund yield spread widened a notable 22 bps this week to a six-week high. It’s also worth mentioning the 4.3% fall in crude and the 9.4% drubbing in natural gas. And there’s the ongoing strength in the yen. The Japanese currency rose 0.8% this week (up 5.9% y-t-d) and has been notably resilient in the face of advancing equities and risk markets. I tend to believe that various macro risks continue to play a prevailing role in stubbornly low global bond yields, a backdrop that along with timid central bankers fuels dangerously speculative risk markets across the globe.

For the Week:

The S&P500 gained 1.0% (up 8.9% y-t-d), and the Dow added 0.6% (up 7.3%). The Utilities rose 1.7% (up 9.2%). The Banks fell 1.6% (down 2.6%), while the Broker/Dealers increased 0.4% (up 4.3%). The Transports rose 1.7% (up 3.2%). The S&P 400 Midcaps gained 1.4% (up 5.5%), and the small cap Russell 2000 jumped 1.7% (up 3.6%). The Nasdaq100 advanced 1.6% (up 20.9%), and the Morgan Stanley High Tech index jumped 2.0% (up 23.8%). The Semiconductors rose 1.7% (up 21.7%). The Biotechs surged 3.4% (up 20%). While bullion gained $12, the HUI gold index fell 1.6% (up 5.0%).

Three-month Treasury bill rates ended the week at 95 bps. Two-year government yields slipped a basis point to 1.29% (up 10bps y-t-d). Five-year T-note yields fell seven bps to 1.72% (down 21bps). Ten-year Treasury yields dropped nine bps to 2.16% (down 29bps). Long bond yields fell 10 bps to 2.81% (down 26bps).

Greek 10-year yields rose eight bps to 5.99% (down 103bps y-t-d). Ten-year Portuguese yields dropped 11 bps to 3.04% (down 71bps). Italian 10-year yields jumped 16 bps to 2.26% (up 45bps). Spain’s 10-year yields increased three bps to 1.57% (up 19bps). German bund yields fell six bps to 0.27% (up 7bps). French yields declined five bps to 0.71% (up 3bps). The French to German 10-year bond spread widened one to 44 bps. U.K. 10-year gilt yields added three bps to 1.04% (down 20bps). U.K.’s FTSE equities index was unchanged (up 5.7%).

Japan’s Nikkei 225 equities index surged 2.5% (up 5.6% y-t-d). Japanese 10-year “JGB” yields added a basis point to 0.055% (up 2bps). France’s CAC40 was little changed (up 9.9%). The German DAX equities index jumped 1.8% (up 11.7%). Spain’s IBEX 35 equities index was unchanged (up 16.6%). Italy’s FTSE MIB index declined 1.3% (up 8.8%). EM equities were mixed. Brazil’s Bovespa index dropped 2.5% (up 3.8%). Mexico’s Bolsa declined 0.7% (up 8.1%). South Korea’s Kospi added 0.7% (up 17%). India’s Sensex equities index gained 0.8% (up 17.5%). China’s Shanghai Exchange was little unchanged (unchanged). Turkey’s Borsa Istanbul National 100 index rose 1.4% (up 26.5%). Russia’s MICEX equities index sank 2.7% (down 15.7%).

Junk bond mutual funds saw inflows of $521 million (from Lipper).

Freddie Mac 30-year fixed mortgage rates slipped a basis point to 3.94% (up 28bps y-o-y). Fifteen-year rates were unchanged at 3.19% (up 27bps). The five-year hybrid ARM rate rose four bps to 3.11% (up 23bps). Bankrate’s survey of jumbo mortgage borrowing costs had 30-yr fixed rates down four bps to a seven-month low 4.02% (up 26bps).

Federal Reserve Credit last week declined $13.7bn to $4.421 TN. Over the past year, Fed Credit declined $0.9bn. Fed Credit inflated $1.610 TN, or 57%, over the past 238 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt declined $6.7bn last week to $3.238 TN. “Custody holdings” were up $8bn y-o-y, or 0.2%.

M2 (narrow) “money” supply last week jumped $37.7bn to a record $13.523 TN. “Narrow money” expanded $759bn, or 6.3%, over the past year. For the week, Currency increased $2.5bn. Total Checkable Deposits rose $17.7bn, and Savings Deposits gained $19.3bn. Small Time Deposits added $0.7bn. Retail Money Funds declined $2.1bn.

Total money market fund assets increased $5.0bn to $2.654 TN. Money Funds fell $80bn y-o-y (2.9%).

Total Commercial Paper gained $6.4bn to $994bn. CP declined $73bn y-o-y, or 6.8%.

Currency Watch:

The U.S. dollar index declined 0.7% to 96.72 (down 5.6% y-t-d). For the week on the upside, the New Zealand dollar increased 1.2%, the Swiss franc 1.1%, the euro 0.9%, the Japanese yen 0.8%, the Swedish krona 0.8%, the British pound 0.7%, the South African rand 0.5% and the Brazilian real 0.5%. For the week on the downside, the Mexican peso declined 0.9%, the Norwegian krone 0.5%, the Canadian dollar 0.3%, and the South Korean won 0.1%. The Chinese renminbi gained 0.67% versus the dollar this week (up 2.0% y-t-d).

Commodities Watch:

The Goldman Sachs Commodities Index dropped 2.9% (down 6.1% y-t-d). Spot Gold gained 1.0% to $1,279 (up 11%). Silver rose 1.2% to $17.53 (up 9.7%). Crude dropped $2.14 to $47.66 (down 12%). Gasoline fell 4.0% (down 6%), and Natural Gas sank 9.4% (down 20%). Copper increased 0.3% (up 3%). Wheat declined 2.0% (up 5%). Corn slipped 0.4% (up 6%).

Trump Administration Watch:

May 27 – Reuters (John Irish and Crispian Balmer): “Under pressure from Group of Seven allies, U.S. President Donald Trump backed a pledge to fight protectionism on Saturday, but refused to endorse a global climate change accord… The summit of G7 wealthy nations pitted Trump against the leaders of Germany, France, Britain, Italy, Canada and Japan on several issues, with European diplomats frustrated at having to revisit questions they had hoped were long settled. However, diplomats stressed there was broad agreement on an array of foreign policy problems, including the renewal of a threat to slap further economic sanctions on Russia if its interference in neighboring Ukraine demanded it.”

May 30 – Bloomberg (Arne Delfs and Patrick Donahue): “President Donald Trump blasted Germany anew over trade and defense, ratcheting up a dispute with Chancellor Angela Merkel that risks getting personal and undermining a trans-Atlantic bond that is the bedrock of U.S.-European relations. Trump’s comments came in an early-morning tweet… issued just as Merkel hosted Indian Prime Minister Narendra Modi in Berlin… Modi suggested that India will adhere to the Paris climate accords, while Trump makes up his mind. ‘We have a MASSIVE trade deficit with Germany, plus they pay FAR LESS than they should on NATO & military,’ the U.S. president posted on Twitter. ‘This will change.’”

May 29 – Wall Street Journal (Richard Rubin): “The boldest ideas for changing the nation’s tax code are either dead or on political life support, as the Republican effort in Congress to reshape the tax system moves much more slowly than lawmakers and their allies in business had hoped. The clear winner, so far, is the status quo. Republicans, who control both chambers, are scouring the tax code, searching for ways to offset the deep rate cuts they desire. But their proposals for border adjustment—which would tax imports—and for ending the business interest deduction and making major changes to individual tax breaks for health and retirement have all hit resistance within the party. The only big revenue-raising provision with anything close to Republican consensus is repealing the deduction for state and local taxes, and that idea faces objections from blue-state lawmakers in the party. The GOP’s dreams have collided with interest-group lobbying and the tax system’s reality.”

China Bubble Watch:

May 28 – Financial Times (Leo Lewis, Tom Mitchell and Yuan Yang): “There are few things studied as closely by the Chinese Communist party as how to avoid the fate of its Soviet counterpart. In an internal meeting after he assumed power in 2012, President Xi Jinping said no one in the Soviet Union had been ‘man enough’ to stand up to Mikhail Gorbachev and glasnost. But for Mr Xi another historical event from the same era may warrant more immediate attention. It is just over 30 years since Japan began inflating a property and stock market bubble whose implosion ravaged public confidence, cowed corporations and scarred an economy for decades. China’s priority today is to avoid that fate. It is not a new concern for Beijing. In 2010, as China’s overall indebtedness was approaching 200% of gross domestic product, Mr Xi, then the country’s vice-president, asked scholars at the Central Party School to research the subject… A subsequent paper outlined some of the lessons of the Japanese bubble, including the need for Beijing to raise awareness of financial risks, safeguard ‘economic sovereignty’ and not give in to pressure to change its currency policy. Seven years on, China’s total debt is 250% of GDP and climbing, officials are trying to rein in sky-high real estate prices and the government is still grappling with the aftermath of a stock market bubble that burst in 2015.”

May 29 – Financial Times (Don Weinland and Gabriel Wildau): “A crackdown on China’s $9.4tn shadow banking business is hitting bank share prices and rattling bond markets. The country’s new top banking regulator has already taken several shots at stemming the rapid growth of off-balance-sheet lending at banks since taking control in February. The central bank has also tightened liquidity in the financial system, sparking angst earlier this year. A flurry of rules to discourage banks from using borrowed money to invest in bonds have been issued by the regulator. The sell-off that has followed has pushed bond yields to two-year highs and even led to a rarely seen inversion of the yield curve. The moves have also dented the share prices of Chinese banks — among the world’s largest by market capitalization… ‘It’s been very clear . . . that regulators want to stamp out some of this [shadow banking] activity,’ says the Asia head of a securities unit at a global bank. ‘During that time there’s been lots of inquiries from investors and some concern on what that will look like.’”

June 1 – Financial Times (Gabriel Wildau): “China’s currency headed for its biggest two-day gain against the dollar since January on Thursday afternoon, as the central bank apparently intervened to support the renminbi amid tepid market demand for the Chinese currency. Traders said that large state-owned banks sold dollars aggressively on Wednesday and Thursday. Such concerted trading is usually viewed as a sign that these institutions are acting on behalf of the central bank to prop up demand for the renminbi. The People’s Bank of China’s currency-trading arm last week announced a change to the way it sets renminbi’s daily fix, which is intended to guide trading in the spot market. The change granted the PBoC greater flexibility to push back against what it called ‘irrational expectations’ and guide the renminbi stronger, even when market forces are pushing the other way.”

May 31 – Bloomberg: “A private gauge of Chinese manufacturing fell back into contractionary territory in May, adding to recent evidence that the economy’s strong start to 2017 is leveling off. Caixin Media and Markit Economics manufacturing purchasing managers’ index fell to 49.6 from 50.3 in April, the lowest reading since June 2016 and below the 50.1 median estimate…”

May 29 – Bloomberg (Paul Panckhurst): “Snaking queues of thousands of prospective apartment buyers in Hong Kong signaled authorities have made no progress in cooling a red-hot property market, where prices are at records. People were lining up on Friday and over the weekend at Victoria Skye, a luxury project at the former airport site of Kai Tak, and at the Ocean Pride development by Cheung Kong Property Holdings Ltd. and MTR Corp. ‘Successive moves by the government in recent memory to cool the property market only resulted in it becoming crazier,’ The Standard newspaper said in an editorial… ‘The result is a sea of madness.’”

Europe Watch:

May 30 – Bloomberg (Stefania Spezzati and Blaise Robinson): “Italian markets shuddered at the emerging prospect of early elections. Investors dumped stocks and government debt after ruling Democratic Party leader Matteo Renzi signaled the possibility of a vote in September or October, more than six months ahead of schedule. That pushed the nation’s bond-yield spread over Germany to its highest in almost four weeks today, and the benchmark FTSE MIB stock index to its biggest two-day drop in more than five weeks on Monday, led by banks.”

May 29 – Bloomberg (Alessandro Speciale): “The euro area still needs expansive monetary stimulus to restore stable inflation even as its economy accelerates, European Central Bank President Mario Draghi said. ‘We remain firmly convinced that an extraordinary amount of monetary policy support, including through our forward guidance, is still necessary,’ Draghi told lawmakers… ‘Domestic cost pressures, notably from wages, are still insufficient to support a durable and self-sustaining convergence of inflation toward our medium-term objective.’”

May 31 – Reuters (Balazs Koranyi): “With the euro zone recovery gaining strength, inflation would continue to rise even if the European Central Bank reduced stimulus, Bundesbank President Jens Weidmann said… The comments suggest that Weidmann, a long-time critic of the ECB’s exceptional stimulus, considers inflation self- sustaining, one of ECB President Mario Draghi’s top criteria before the policy can be removed. ‘The strengthening of the economic recovery makes it increasingly likely that the rise in inflation we have seen since August 2016 is not just a flash in the pan, but that we would have higher inflation rates compared to previous years even under a reduced degree of monetary policy accommodation,’ Weidmann said.”

May 31 – Reuters (Balazs Koranyi and Francesco Canepa): “European Central Bank policymakers are set to take a more benign view of the economy when they meet on June 8 and will even discuss dropping some of their pledges to ramp up stimulus if needed, four sources with direct knowledge of the discussions told Reuters. With economic growth clearly shifting into higher gear, rate setters are ready to acknowledge the improvement by dropping a long-standing reference to downside risks in the bank’s post-meeting opening statement, calling risks largely balanced… Growth indicators have been outperforming expectations all year. But they disagree on how quickly the ECB should change its policy stance, including its guidance, with countries on the currency bloc’s periphery fearing that a sharp shift in its communication could induce self-defeating market turbulence, they added. ‘After the French election the political risk is clearly down and economic indicators are by and large positive, so it’s time to acknowledge this,’ said one Governing Council member…”

June 1 – Bloomberg (Piotr Skolimowski and Alessandro Speciale): “The European Central Bank is starting to debate whether to reflect the euro area’s improving economic prospects in its policy guidance, Bundesbank President Jens Weidmann said. Speaking just hours before the ECB begins its self-imposed quiet period ahead of next week’s monetary policy meeting, Weidmann said the strengthening recovery makes it increasingly likely that the rise in the inflation rate isn’t ‘just a flash in the pan.’ Inflation would still accelerate more than in the previous years even if some of the stimulus were removed, he said, adding the ECB should consider the impact of its policies on bank profitability.”

May 30 – Wall Street Journal (Tom Fairless): “A Berlin-based law professor has filed a cease-and-desist request aimed at quickly ending Germany’s involvement in bond purchases by the European Central Bank, a surprise legal move that underlines mounting German anger over the ECB’s easy-money policies. The request for a legal injunction, sent to Germany’s top court, shows the lengths to which some Germans are prepared to go to derail a €2.3 trillion ($2.57 trillion) stimulus program they accuse of subsidizing southern European governments and hurting German savers, pensioners and smaller companies.”