Missing the biggest threat to stability
May 9, 2021 – Weekly comment
You know that women never really faint
And that villains always blink their eyes
-Lou Reed, Sweet Jane
What they depict in the movies, and in political theater isn’t always true, no matter how many times it is repeated. Inflation expectations aren’t anchored.
The Fed released its Financial Stability report last week. It covers four topics: Asset Valuations, Borrowing by Businesses and Households, Financial Sector Leverage and Funding Risk. A link is at the bottom; a summary is on page 13 of the pdf. Throughout the report “significant government support” is cited. Valuations on assets are termed “generally high”. In the list of asset markets, the outstanding amount of equities has risen 22% in the past year, eclipsed only by the growth of treasury securities at 26%. (pg 16). “Valuations continue to be supported by low interest rates.” “Business debt vulnerabilities remain elevated.”
On page 66 there is this interesting passage:
Despite China’s relatively strong economic rebound from the pandemic, it continues to have elevated corporate and local government debt, a vulnerable financial sector, and stretched real estate valuations. Although government policy is still supportive of the broader economy, Chinese authorities have introduced measures to cool down property markets. If these measures fail to limit speculation, financial vulnerabilities will continue to rise. Under such a scenario, a sudden correction in domestic property markets could put pressure on Chinese property developers and other firms and substantially stress the financial sector. Given the size of China’s economy and financial system as well as its extensive trade linkages with the rest of the world, financial stresses in China could further strain global financial markets and negatively affect the United States.
I can’t help but think the pot is calling the kettle black. Everything said about China is applicable to the US, EXCEPT that the US authorities have done nothing to cool down residential property or asset markets. I suppose the US banking system is more robust as well. But by holding down funding rates, the Fed has introduced a risk to the currency… it was already apparent by surging crypto and commodity markets, and with Friday’s lower than expected NFP, it spilled over into DXY and the gold market.
As we face another round of auctions, my question becomes whether the US could find itself under funding stress. This week $126 billion in 3’s, 10’s and 30’s raises $78 billion in new cash.
The ‘government support’ which is so frequently mentioned in the Fed’s Stability Report is never questioned in terms of a risk to stability in and of itself. Maybe THAT’S the really big risk. Paycheck protection, loss mitigation and other government support mechanisms run the risk of blunting market signals that used to impose discipline on economic agents. Currently the only signals are soaring commodity, crypto and stock prices. The USD is declining in value against all of them, yet there is official denial in terms of inflationary implications. On Friday DXY fell, breaking a minor trendline off the low set in January. On a long term chart, it looks vulnerable to a break below the 2018 low of 8825, a move which might have the fury (in the opposite direction) of the 2014 rise when the taper tantrum highs of 2013 were exceeded.
Of course, the dollar declining against other fiat currency is just a sideshow. The dollar is declining against THINGS and everybody sees it. A Morgan Stanley report noted that 21% of all US dollars ever in existence were created in 2020.
The ransomware hackers that shut down the major Colonial Pipeline this weekend aren’t asking for dollars. Reports on this cyber-attack are saying that the price of gasoline could skyrocket in response. Vulnerabilities to cyber disruptions are increasing across all economic segments, perhaps representing more of a threat than military conflict.
As Del Preston said, “I learned it from Keith Richards when I toured with the Stones. This may be the reason Keith cannot be killed by conventional weapons.”
It’s not the conventional that we have to worry about, like elevated business debt. It’s the unconventional, unprecedented US government intervention both through fiscal and monetary measures, and it’s the rise of cyber weaponry, through both state-sponsored and private actors, (as foretold by the 1997 book The Sovereign Individual).
CPI and PPI on Wed and Thursday with yoy Core expected 2.3 and 3.7. Retail Sales Friday.
OTHER MARKET THOUGHTS/ TRADES
Jackson Hole in late August is looming large in the market’s consciousness due to a possible change in policy by the Fed. I would also bear in mind July 1, the date which will mark the celebration of the Chinese Communist Party’s 100 year anniversary. It will highlight nationalistic fervor and the dramatic gains made by China. No doubt there are agents that would like to cause disruptions around these celebrations, especially given tensions with Taiwan that the US is fanning.
Three month libor set at an all-time low last week. Friday’s setting was 0.15988. From the Financial Stability Report:
Several respondents noted that bank reserves were expected to continue to increase dramatically, potentially pressuring some short-term interest rates into negative territory and amplifying rate volatility. In particular, some contacts noted the unpredictable trajectory of balances in the Treasury General Account. Several respondents suggested that the outcome of the impending debt ceiling negotiations has contributed to this uncertainty, as a delay in an extension of the debt ceiling suspension could result in a rapid drawdown of the Treasury’s account balances, thereby increasing reserve levels. Some worried that a surge in reserves would increase froth in markets, heightening future risks of a disruptive correction.
The trade of the week concerns the purchase of 3EU 9800 puts, which were bought outright in huge size for 6.0 and 6.5, mostly ref EDU4 trading 9851.5 to 9855. On Friday this put settled 5.25 with 16 delta vs 9960.5. The change in open interest on the week was 259,000 contracts, from 190k on April 30 to 449k on Friday. Yes, this expiration covers the Jackson Hole Conference. As a comparison, note that 4EU 9750 puts settled 5.75 vs 9815 settle in EDU5. A bit further out of the money, and slightly more expensive; there are 115k open. There’s more open interest in the 3EU 9800p at 449k than there is in the underlying EDU4 future at 397k.
The curve steepened Friday with the NFP miss (266k vs 1 million expected) causing some analysts to say the Fed is “right” to be holding funding rates at zero. 2/10 rose 2.5 bps to 143.2, while 5/30 rose 6.5 to 150.5. The latter spread has been in a range from 140 to 165 since February and is likely to stay within those parameters for the time being. However, an eventual upside breakout would be supported by the ten year inflation breakeven closing at a new high of 250 bps Friday; it hasn’t been this high since 2013.
| 4/30/2021 | 5/7/2021 | chg | ||
| UST 2Y | 16.0 | 14.3 | -1.7 | |
| UST 5Y | 85.4 | 76.9 | -8.5 | |
| UST 10Y | 162.8 | 157.5 | -5.3 | w/I 158.5 |
| UST 30Y | 229.7 | 227.4 | -2.3 | w/I 226.8 |
| GERM 2Y | -68.2 | -68.5 | -0.3 | |
| GERM 10Y | -20.2 | -21.5 | -1.3 | |
| JPN 30Y | 65.7 | 65.2 | -0.5 | |
| CHINA 10Y | 315.6 | 315.2 | -0.4 | |
| EURO$ M1/M2 | 7.5 | 6.0 | -1.5 | |
| EURO$ M2/M3 | 40.0 | 32.5 | -7.5 | |
| EURO$ M3/M4 | 72.5 | 68.5 | -4.0 | |
| EUR | 120.20 | 121.63 | 1.43 | |
| CRUDE (active) | 63.58 | 64.90 | 1.32 | |
| SPX | 4181.17 | 4232.60 | 51.43 | 1.2% |
| VIX | 18.61 | 16.69 | -1.92 |
https://www.federalreserve.gov/publications/files/financial-stability-report-20210506.pdf
https://home.treasury.gov/system/files/221/TBACRecommendedFinancingTableQ22021-05052021.pdf
