The question is no longer “How long until something breaks?” Something broke this week. It was the UK bond market, and it nearly resulted in a mini-Lehman moment across the UK pension complex.
The question now, rather, is “How long before the crescendoing panic is too loud for the Fed to ignore?”
Although US officials are, for now, sticking to the hawkish script, the Bank of England’s intervention and repeated pushback from the PBoC against the record-weak yuan, suggest a growing sense of angst. An “enough is enough” moment vis-à-vis i) the dollar’s “no prisoners” rally, ii) ever tighter US financial conditions and iii) the attendant appeal of USD cash as a “no-brainer” asset allocation choice, could be near at hand.
“Authorities are starting to agitate against the growing market and economic calamity caused by the impulse tightening of financial conditions and the USD wrecking ball,” Nomura’s Charlie McElligott said Friday. That, in turn, “is making the macro trend trades which have dictated all thematic performance in 2022 increasingly open to reversal.”
The problem is timing the panic pivot. Until the Fed and Treasury are spooked (e.g., by a credit event in the US), cash isn’t just attractive, it’s downright gorgeous, or at least in nominal terms. As Charlie noted, clients are “much more comfortable” sitting in cash than trying to express a view on the timing of any towel-throw from central banks. The Bloomberg screencap (below) shows why.
Just “look at these truly risk-free yields,” McElligott remarked.
Notwithstanding inflows to global equity funds over the latest weekly reporting period (on EPFR’s data), the allure of USD cash in all its various manifestations is simply too strong to resist given the risk inherent in literally everything else, from equities to bonds to FX to credit. Note that even commodities are now in peril from falling global demand and the very same dollar “wrecking ball.”
Of course, this is a self-fulfilling prophecy. The stronger the appeal of USD cash, the more money flows out of other assets, and the less demand for those assets there is, the lower they go, increasing the appeal of risk-free USD yields.
“Cash is THE asset du jour, as the macro vol just remains too substantial, and we see increasing signals of ‘breakage’ nearing in markets,” McElligott went on to say, adding that “the velocity of ‘things breaking’ around the world,” whether it’s the yen, the yuan, the euro, sterling, gilts or the entire liability-driven investor cohort in the UK, “is obviously a ‘neon swan’ telling us that we’re clearly now in the ‘market accident’ stage from the tightening surge.”
As BofA’s Michael Hartnett noted, a hodgepodge of popular credit and emerging market products, including LQD, HYG, ACWX, EEM, LQD and EMB, are all below their respective 2018 nadirs, even as US equities (as a whole) are nowhere near the lows from that fateful year, when Jerome Powell learned first-hand the perils of double-barreled Fed tightening.
As a reminder that no one needs, the S&P’s 2022 drawdown isn’t anomalous in the context of historical bear markets during recessions. During 20 bear markets going back almost a century and a half, the average peak-to-trough decline exceeded 37%, and the average duration was 289 days, according to BofA. The table (below) is a useful trip down memory lane.
For what it’s worth, Hartnett noted that over the past 100 years, the S&P trading -20% below its 200-day moving average has been “a good entry point.” Currently, that would make 3,375 attractive, and also convenient, considering that’s roughly where the US benchmark traded prior to COVID.
That rule of thumb hasn’t always worked, though. The exceptions are 1931, 1937, 1974 and 2008, all periods defined by crises and/or epic macro turmoil.
“A monster undershoot requires a monster credit event and a US recession,” Hartnett wrote. Although past isn’t always precedent, “history says the current bear market ends on October 19, the 35th anniversary of Black Monday, with the S&P 500 at 3,020,” he said.
But if one way or another, at some point the Fed comes in and saves the day (and postpones the issue), why not invest in mortgage backed securities preferreds for instance, which are basically quite safe unless the mortgage market falls apart in a way we’ve never seen before…? Sure, it could go lower, but the yield is great, and I don’t have to time the market..
I am surprised that German BUNDs are still yielding only 2.0% to 2.2%. Russia probably still has lots of tricks (e.g. blow up or cyber-attack LNG terminals in 2023+, extend the war, cause a bigger refugee crisis, assassinate EU leaders).
I think the Russian people have just about had enough Putin. I don’t think they want to go to war with the rest of the world at all.
Believe that the required “monster credit event” may be over in the private equity and private lending sectors. There’s plenty of leverage there and the exit liquidity is far from abundant.
@derek, would a PE/PD credit event tend to be slow developing given their ability to mark to model?
Right you are. Hearing that few valuations on June 30 reports were lowered. Perhaps they are hoping for a righteous rebound in the economy and markets to bail them out? Otherwise. They’ll eventually have to ‘fess up. Sometimes due to lowered prices on follow-on offerings.
Prestwick- not sure. There were some recent stories on a hanging bridge loan getting written down but I don’t know how exposed banks are to PE. The private credit groups are likely to be larger borrowers, no?
Perhaps our Dear Leader can rustle up some perspective from someone more immersed in that world than I am.
Derek, are the big banks exposed enough to that world, such that systemic breakdown becomes a real possibility?
I don’t know much about the magnitude of the problem that you cite. I’m sure it’s an issue for someone, but large enough to crash the Too Big To Fail ‘s ? If not, then Fed might not care (?)
Banks always seem to find ways to lose money lending into thesev kind of markets.