$35 Trillion Was Enough (Pivot Point)

A year ago last month, the Norges Bank became the first central bank to raise rates in the pandemic era among countries with the 10 most-traded currencies.

The frantic hawkish procession that followed found developed market policymakers in unfamiliar territory: Raising rates in very large increments to catch runaway inflation. 2022 marked an unceremonious end to the four-decade bond bull market. “The Great Moderation” was over. The economic legacy of the pandemic, alongside the macro shockwaves and geostrategic jostling brought about by the war in Ukraine, conspired to usher in a new, inflationary paradigm.

Since August of last year, central banks have delivered 295 rate hikes, according to BofA, compared to 1,302 rate cuts since Lehman. At the same time, markets have seen more than $3 trillion in QT over just seven months. USD M2 growth has turned negative across the world’s four largest economies. The result: An across-the-board selloff that spared no asset.

The value destruction across global equities and bonds exceeded $35 trillion in just nine months. It was the largest value destruction event in modern history (figure above).

I’ve variously suggested markets (and economies) reached a breaking point last month. Between the yen’s collapse, the PBoC’s increasingly forceful efforts to slow the pace of yuan depreciation and, finally, the Bank of England’s intervention to prevent an overnight financial crisis in the UK, it’s obvious that markets are on the brink. Wild speculation about Credit Suisse is yet another sign that policymakers are losing control of the narrative — not that they ever had control in the first place.

This week may be remembered as the pivot point. The RBA’s smaller-than-expected rate hike on Tuesday and (arguably) dovish statement was written off by some as idiosyncratic, but the same was said of the BoE’s intervention in long-dated gilts last week. So, that’s two idiosyncrasies in five days.

I’m not suggesting deliberate coordination. Rather, I’m suggesting that conditions are deteriorating such that things are either breaking or are on the verge of breaking across locales, which is prompting a mini-panic. If policymakers turn incrementally dovish and begin intervening simultaneously, it scarcely matters whether it was planned or forced — “accidentally synchronous” feels like an oxymoron, but it also feels like an apt description of the burgeoning policy panic.

When combined with cooperative data, which on Tuesday meant a welcome drop in US job openings, the stage was (and still is) set for a powerful reversal in this year’s macro trend trades. Five-year yields in the US are down 22bps this week already. Five-year reals are 36bps lower (figure below).

That’s a powerful FCI easing impulse. Although Treasurys ended well off their best levels Tuesday, US two-year yields fell below 4% for the first time in weeks at one juncture. Short covering is likely in play, as are mechanical buy-to-cover flows (e.g., from CTA trend).

“Treasurys continued to rally on Tuesday, a move that has increasingly brought into question investors’ perception of the Fed’s commitment to following through on its hiking campaign and realizing the 4.6% terminal projection in the wake of the ‘dovish’ RBA hike of just 25bps versus the consensus call for +50bps,” BMO’s Ian Lyngen and Ben Jeffery wrote. “When combined with the upheaval in the gilt market and the BoE’s purchase of long-dated UK bonds, there’s a growing sense that financial markets are showing sufficient stress as to warrant a collective pivot away from the global trend toward tighter policy,” they added.

The dollar was sharply lower Tuesday. That too is a risk-on green light and represents easier financial conditions. Weakness in equities which saw US stocks give back the summer rally was directly attributable to an inexorably stronger dollar, a rapid move higher in US real yields and higher US terminal rate pricing. All of that slammed into reverse early this week. The two-day rally on the S&P was the largest since the volatile days of the original pandemic crash (figure below).

The setup was fortuitous. “I said [this] past Friday that we were likely to see a final-day-of-the-month- / quarter-end US equities selloff, with a particularly ugly market-on-close due to the infamous ‘Put Spread Collar’ trade that has so often marked local pivot points in equities, but which would then afford a ‘buy the dip’ on the MOC opportunity playing for a relief rally thereafter, with high absolute levels of iVol at the time (an attractive level for opportunistic vol-sellers), plus a low entry point from a spot perspective, providing a great location to get long ahead of painful ‘squeeze-able’ conditions,” Nomura’s Charlie McElligott wrote.

“The largely options-driven rally phenomenon then spun-off a number of second-order flow impacts which absolutely lit legacy downside and shorts on fire,” Charlie went on to say, referencing Monday’s trade. One certainly imagines some of the same second-order flows were in play during Tuesday’s rollicking session.

But, as Charlie was keen to emphasize, “without question the flows and the setup benefitted massively from two absolutely critical fresh macro catalysts which have changed the calculus.” Those catalysts are i) signs of panic from policymakers and ii) cooler US data.

“In less than two weeks, the US equity market priced in fears related to the hawkish outlook the FOMC provided at the September meeting and has all but fully erased the declines,” JonesTrading’s Mike O’Rourke said, on Tuesday evening, adding that,

There have been multiple catalysts for the sharp two-day relief rally. Over the past two days, markets received a global boost. Yesterday, the UK government reversed course on a key tax cut in its “growth” plan that roiled financial markets. A significant portion of today’s push higher for global equities was catalyzed by the RBA delivering a dovish surprise. US equity markets have taken solace from a couple of minor economic misses. Stock, bond and currency markets are making a concerted effort to undo the recent necessary tightening of financial conditions. Commodity markets are making their best effort to start undoing progress on the inflation front.

Note O’Rourke’s use of the term “necessary” to describe tighter financial conditions. As ever, there’s a very real sense in which the relief rally is counterproductive. The title of O’Rourke’s missive was “Old Habits Die Hard.”

Whether we’re currently witnessing an epochal shift in policy is obviously up for debate. October’s early theatrics may well be remembered as nothing more than a fleeting fireworks show to the extent they’re remembered at all. But, coming full circle, if this is “a moment,” so to speak, it comes on the one-year anniversary of the first G10 rate hike. And not a moment too soon for stocks and bonds.


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8 thoughts on “$35 Trillion Was Enough (Pivot Point)

  1. H-Man, I am going with “fleeting fireworks”. Treasuries were oversold, RBA is simply testing the waters, OPEC is adding fuel to the fire, while Britain is dancing in circles. Meanwhile Ukraine has become a Russian migraine. North Korea is lobbing rockets over Japan. Toss in a Red House in the mid-terms. And what you have is path forward to nowhere.

  2. The Fed is the gorilla among CBs.

    Has there been critical levels of stress in the US financial system – not that I see.

    Has there been critical levels of stress in the US economy – hardly.

    Will the Fed back off its US inflation fight because of stress in other countries’ financial systems or economies – I think things would have to be a lot worse before this FOMC will choose to go down in history as the Fed that presided over a repeat of the 1970s.

    Years hence, no-one will say kind things about Powell because he helped out the UK, if it was at the expense of the US.

    The UK, Japan stress episodes are in significant part due to their pro-inflationary policies, which the Fed may feel should be corrected by those who chose them. Why should Powell sacrifice himself for Truss?

    The Fed also probably has confidence in its crisis intervention tools, given it was able to pull the world back from the Covid abyss.

    If we get a few months of rapid improvement in US inflation signs – JOLTS, PCE, CPI, etc – then the Fed might be more willing to take a chance. Right now, I am pretty doubtful a Powell pivot is here or nearly here.

    My bet is that this rally ends when 3Q earnings start, if not sooner; that earnings drive a retest of the June / Sep lows; that the ultimate low is sometime in 4Q or 1Q, by which time the Fed will indeed be ready to pause, or pivot, driven either by substantial progress on inflation, major deterioration in the US economy, or a US or global financial system breakage that can’t be handled by anything short of a Fed pivot.

  3. @jyl. You may not be looking hard enough. As per the Economist: “ the American Treasury market is as volatile and illiquid as it was at the start of covid19… Measures of liquidity in the Treasury market have deteriorated. “We are seeing what happened in March 2020 again. The same Treasury bonds are trading at different prices, bid-ask spreads are widening,” says Darrell Duffie of Stanford University. Strategists at Bank of America describe their index of credit stress as “borderline critical” .

    1. Illiquidity in UST is a crisis that the Fed has very recently faced and capably handled, so the Fed is probably pretty confident in its tools and playbook. Infinite repo is already in place, Fed can flip the “buyer of last resort” switch faster than it did in 2020, and based on BOE/gilts Fed might think that it won’t actually have to do that much buying.

      Not saying the Fed wouldn’t consider having to handle a UST liquidity crisis very serious, or would want to interrupt their QT trajectory – but I think that the FOMC takes the prospect of runaway inflation for a decade, abdication of their mandate, ruination of their reputations, and potentially the end of the central bank-stabilized world economic order (so they think) much more seriously.

      Put another way, Fed is probably very confident in its crisis management powers.

      Also, the 2020 UST illiquidity reflected not just volatility but also trades being huge and all one-way: everyone around the world suddenly force-selling trillions of UST to raise USD cash for massive redemptions, floods of FX needs, business survival, etc. Does Fed forecast that happening now?

      I understand the response that Fed isn’t a good forecaster, but that doesn’t matter. Either they forecast no pending 3/2020 style UST liquidity crisis, or they don’t try to forecast but are reactive, either way they aren’t going to give in to 1970s-repeat-inflation for a fear of a UST illiquidity event that they do not forecast and that they know they can handle.

  4. It is easy to make the case that over the medium & long terms, GBP/USD and EUR/USD should be decreasing with time (after smoothing out the volatility). Energy, Putin (& hot or cold war), Brexit, etc. from 1971 to 2022, the GBP has decreased, on average, by 1.7% per year compared with USD.

    1. And add the fact that, despite our current political problems, the U.S. economy is (still) the largest and most innovative in the world.

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