Friday, May 12, 2017

Weekly Commentary: The VIX and the Scheme

There was little market reaction to Emanuel Macron’s widely-anticipated big victory in the French presidential election. The euro actually retreated somewhat, in a “sell the news” dynamic. European equities ended the week mixed. European bonds were somewhat more interesting. Bund yields declined three bps, while Italian yields jumped nine bps.

“Risk On/Risk Off” analysis was rather inconclusive this week, though there were some indications of waning risk embracement. U.S. equites came under modest selling pressure. The S&P500 declined 0.3%, while the broader indices were weaker. The midcaps fell 1.1%, and the small cap Russell 2000 declined 1.0%. With Macy’s earnings badly missing estimates, retail stocks came under heavy selling pressure. This sector has given the bears a bit of life. Financial stocks were also under notable pressure. The banks (BKX) fell 1.3% and the broker/dealers (XBD) lost 1.5%. The Transports were hit 2.1%.

The general market was resilient in the face of ongoing Washington dysfunction. It’s not that surprising that President Trump’s firing of FBI Director Comey had a much greater impact within the media than in the markets. It’s my view that markets are more dominated by liquidity flows and speculative dynamics than by the Trump agenda.

As for speculative dynamics, the Nasdaq 100 (NDX) and Morgan Stanley High Tech Index (MSH) traded at record highs this week, while the Semiconductor index (SOX) is within striking distance. For the week, the NDX gained 0.7% (up 16.9% y-t-d), the MSH rose 0.6% (up 19.6%), and Semiconductors surged 3.4% (up 15.3%).

Financial stocks were at least somewhat weaker on modest downward yield pressure. Ten-year Treasury yields dipped two bps to 2.33%. One could see a faint bid to safe haven assets supporting the fledgling Risk Off thesis, although the yen (down 0.6%) this week didn’t indicate risk aversion. U.S. equities market leadership has clearly narrowed.

Monday from Bloomberg (Samuel Potter): “U.S. stocks ended virtually unchanged near all-time highs, while the dollar rose with Treasury yields as volatility drained from financial markets after a convincing defeat of populism in France’s presidential election. The CBOE Volatility Index slumped to its lowest closing price since 1993. The S&P 500 Index rose by less than one point to close at a fresh record.”

There were a number of articles discussing the VIX’s “lowest closing price since 1993.” There was the typical focus on a stable U.S. and global growth backdrop and buoyant corporate profits. What’s missing from the discussion is the reality that global markets have developed into a sophisticated financial Scheme.

Going back to early-CBBs, I’ve devoted a significant amount of analysis to contemporary finance and the proliferation of complex risk intermediation, derivatives and market “insurance.” It seems rather clear to me that the interplay between contemporary finance and New Age central banking has over years nurtured history’s greatest market distortions and asset Bubbles.

Past writings have attempted to differentiate actual insurance from market “insurance” such as put options on the S&P 500 (key factor in VIX levels). Actual insurance – i.e. auto and home casualty – provides protection against generally independent and random loss events. Actuaries are skilled at using vast historical databases for fairly accurate forecasts of future claims/losses. Policies are priced to ensure sufficient reserves for future losses along with a profit surplus.

Securities market “insurance” is an altogether different animal. Market losses are neither independent nor random, but instead tend to unfold in unpredictable waves. Future losses are unquantifiable. Markets generally grind higher only to break lower in episodes that catch most by surprise. As such, losses tend to be biggest when they were expected to be the smallest. With historical data so deceptive, pricing such “insurance” becomes more of a speculative endeavor. And the longer the history of low “claims” the more likely an ugly black swan lurks somewhere in the future.

Over the years, I’ve used the parable Writing Flood Insurance During a Drought. Such enticing returns attract a bevy of players keen to participate in the lucrative insurance business. And, importantly, cheap insurance distorts market activity, in the process spurring progressively risky behavior in the Financial and Real Economy Spheres. In the end, financial and economic Bubbles unfold with a distorted and colossal cheap “insurance” market at its putrid core.

Why is the VIX – and other market “insurance” - so extraordinarily cheap? First taking a global Bubble perspective, I would suggest that the foundation of cheap “insurance” rests upon the perception of a relatively stable global Credit backdrop. Financial Conditions remain loose throughout much of the world. Sovereign yields persist close to historic lows around the globe, while Corporate Credit conditions continue to be ultra-loose. Of course, such conditions have been largely dictated by “whatever it takes” central banking with its near-zero rates and massive QE liquidity operations. There is faith, as well, that the heavy hand of Beijing will ensure sufficient Credit to achieve 6.5% 2017 Chinese GDP growth. And, for China and the world, that’s become an enormous amount of Credit.

Many would counter that the Federal Reserve and others have commenced normalization, with the U.S. central bank even discussing reducing the size of its balance sheet holdings. Yet such measures do close to nothing to dissuade market participants from the now deeply ingrained notion that central banks will quickly resort to zero/negative rates and more big liquidity injections in response to incipient worries of illiquidity.

Bull markets create their own self-reinforcing liquidity. Bear markets are the inevitable market self-correction after a period speculation and excess. History teaches us that markets cycle through periods of perceived ebullience and abundant liquidity followed by bouts of fear, illiquidity, dislocation and the occasional crash. In the final analysis, market-based Credit and securities-based finance have inflated to such an incredible degree that policymakers can no longer tolerate even the thought of a market down cycle. At least that is the basis for market “insurance” pricing these days.

The greatest ongoing criticism I have with contemporary central banking is that it has essentially guaranteed Continuous and Liquid Markets. Markets (after witnessing 2008 policy responses and then five years of “whatever it takes”) perceive this guarantee to be stronger today than ever before. And it is this assurance of Liquid and Continuous Markets that has become the pillar of modern derivatives trading strategies and markets.

Derivatives markets – particularly for “insurance,” risk sharing/intermediation and speculative leveraging – are fundamental to contemporary finance. And much of this boils down to those that sell market “insurance” are dependent upon highly liquid markets that allow the easy offloading (“dynamic hedging”) of risk previously written. Derivative players must be able to sell securities and establish positions that will generate the cash-flows to pay “insurance” losses on contracts they’ve sold (but not reserved for). And it all works wonderfully until it doesn’t – until a market episode unfolds where selling begets selling into sinking markets, more hedging, illiquidity and, at some point, counterparty issues.

The VIX is low because markets assume that central bankers won’t allow any such market illiquidity episode. Yet I believe just such an outcome is likely because of the markets’ faith that it’s highly unlikely (with the VIX trading as low as 9.56 this week).

So let’s touch upon what has become a sophisticated global financial scheme. First of all, (securities and derivatives) markets have become Too Big to Fail on a scope so beyond the 2002-2008 period – on a global basis. With the perception that central bankers and policymakers will not tolerate a significant market correction or recession, writers of derivative market “insurance” need not factor in the possibility of significant losses into the pricing of their products. It’s become Moral Hazard on an unprecedented scale.

There’s a major Reflexivity component at work. Cheap market “insurance” spurs risk-taking. Why not push the envelope with risk and employ added leverage, confident that inexpensive protection is readily available? This ensures that loose financial conditions spur Credit expansion, asset inflation, spending, corporate profits, rising incomes and government receipts/spending. Perceived wealth inflates tremendously, if not equitably. Rising price levels throughout the economy support the view that the future is bright, encouraging reinforcing flows into financial assets - further depressing the price of market “insurance.” Moreover, a prolonged period of low market yields boosts the relative return appeal of myriad variations of writing market protection (selling flood insurance during a drought).

May 10 – Financial Times (Robin Wigglesworth): “The global exchange-traded fund industry smashed past the $4tn in assets mark last month, as the gingerly improving performance of active asset managers this year does little to dent investor appetite for cheaper, passive alternatives. The entire ecosystem now boasts 6,835 ETFs and exchange-traded products (a broader category), from 313 providers, and total assets of $4.002tn at the end of April… ETFs and ETPs gathered a record $37.94bn last month, which was the 39th consecutive month of net inflows and brought this year’s total so far to $235.2bn – smashing 2016’s inflows of $81bn at this point of the year.”

I’ll pose the question this way: Why shouldn’t the VIX be extraordinarily low with “money” now consistently flooding into the ETF complex? In contrast to previous boom periods where flows would swamp active managers (that may have been keen to build cash levels), “money” arriving at one of thousands of ETFs will be immediately and predictively used to purchase securities. Some might be alarmed by what would be viewed traditionally as rather conspicuous market speculative excess. Not these days, however, in the age of central bankers antsy to deploy liquidity backstops. And the more likely that an abrupt reversal of ETF flows risks disrupting the markets, the more confident market operators become that central bankers will act swiftly to thwart sell-offs before they attain momentum. All part of the Scheme.

And with rates so low, equities essentially win by default, especially when they have been so outperforming other asset classes. And while central bankers are not likely to resort to the liquidity spigot in the event of minor pullbacks, players have grown quite confident that corporations, with their enormous buyback programs, are anxious to buy on any weakness. CEOs clearly find it more attractive to support this financial Scheme with stock repurchases than to deploy their cash hoards for productive investment with unclear return prospects.

What could go wrong? Lots of things. It’s a basic premise of Credit Bubble Analysis that market distortions are problematic, cumulative and inevitably resolved. Sooner the better. Central bank liquidity backstops spur myriad excesses that in the end will expand beyond the capacity of central bankers to sustain system liquidity. There are accumulations of speculative positions, leverage and maladjustment that evolve into Credit and liquidity gluttons. Over time, market misperceptions and distortions become deeply embedded. And, as we’ve witnessed, the greater the excesses the more confident are the markets that central bankers will have no alternative than to provide liquidity backstops. So, market yields remain stubbornly low in the face of efforts to tighten monetary policy, exacerbating excesses throughout the risk markets and the overall global economy. No Conundrum.

I expect U.S. system Credit growth to surpass $2.2 TN this year, roughly broken down by the government sector ($850bn), Business ($750bn), Household Mortgage ($350bn) and Consumer Credit ($250bn). Another big federal deficit is expected, with the perception of a blank checkbook ensuring that deficits inflate until the markets decide otherwise. Rising home prices coupled with low mortgage rates ensure a 2017 expansion of mortgage borrowings. Loose financial conditions and record debt issuance would seem to ensure another big year of Business debt growth. And while there appears to be some tightening in subprime auto and Credit cards, I would be surprised to see Consumer Credit expand by much less than 2016. As such, the relatively stable outlook for U.S. Credit growth certainly supports the global liquidity and market backdrop.

The situation in Chinese Credit is altogether different. Credit growth (Total Social Financing and government borrowings) is on track to approach a record $3.5 TN this year. But I wouldn’t be stunned neither by $4.0 TN or a crisis-induced rapid Credit slowdown. April lending data was out Friday. Total Social Financing (TSF) expanded $201bn during April, down from March’s $307bn. New Loans expanded $159bn during the month, about a third greater than expected. Bank lending took up some of the slack from a sharp decline in various “shadow banking” components. Overall mortgage Credit growth slowed during April. TSF (which excludes government borrowings) expanded a record $1.205 TN during the first four months of the year.

From my analytical perspective, China has evolved into the key marginal source of global Credit. Why is the VIX – along with the price of other market “insurance” - so low? Because of the market perception that Beijing these days has everything under control. Notable complacency, yes. At the same time, and making things more intriguing, I don’t believe markets are all too confident in China prospects over the intermediate and longer-term. So, we’ll continue to monitor closely for indications of escalating Chinese instability. After an “inconclusive” past five days in the markets, Risk On/Risk Off will be monitored diligently once again next week. 

For the Week:

The S&P500 slipped 0.3% (up 6.8% y-t-d), and the Dow declined 0.5% (up 5.7%). The Utilities dipped 0.2% (up 5.6%). The Banks fell 1.3% (down 0.4%), and the Broker/Dealers lost 1.5% (up 4.1%). The Transports were hit 2.1% (down 0.5%). The S&P 400 Midcaps declined 1.1% (up 3.5%), and the small cap Russell 2000 fell 1.0% (up 1.9%). The Nasdaq100 added 0.7% (up 16.9%), and the Morgan Stanley High Tech index gained 0.6% (up 19.6%). The Semiconductors surged 3.4% (up 15.3%). The Biotechs declined 0.8% (up 17.8%). With bullion recovering about $7, the HUI gold index rallied 6.0% (up 8.1%).

Three-month Treasury bill rates ended the week at 86 bps. Two-year government yields slipped two bps to 1.29% (up 10bps y-t-d). Five-year T-note yields declined three bps to 1.85% (down 8bps). Ten-year Treasury yields fell two bps to 2.33% (down 12bps). Long bond yields added a basis point to 2.99% (down 8bps).

Greek 10-year yields dropped 16 bps to 5.61% (down 141bps y-t-d). Ten-year Portuguese yields dipped two bps to 3.37% (down 37bps). Italian 10-year yields jumped nine bps to 2.25% (up 44bps). Spain's 10-year yields rose seven bps to 1.73% (up 25bps). German bund yields declined three bps to 0.39% (up 19bps). French yields were unchanged at 0.84% (up 16bps). The French to German 10-year bond spread widened three to 45 bps. U.K. 10-year gilt yields fell three bps to 1.09% (down 15bps). U.K.'s FTSE equities index rallied 1.9% (up 4.1%).

Japan's Nikkei 225 equities index jumped 2.3% (up 4.0% y-t-d). Japanese 10-year "JGB" yields rose three bps to 0.05% (up 1bp). France's CAC40 slipped 0.5% (up 11.2%). The German DAX equities index added 0.4% (up 11.2%). Spain's IBEX 35 equities index fell 2.1% (up 16.5%). Italy's FTSE MIB index increased 0.4% (up 12.2%). EM equities were mixed. Brazil's Bovespa index surged 3.8% (up 13.3%). Mexico's Bolsa was little changed (up 8.3%). South Korea's Kospi rose 2.0% (up 12.8%). India’s Sensex equities index gained 1.1% (up 13.4%). China’s Shanghai Exchange declined 0.6% (down 0.6%). Turkey's Borsa Istanbul National 100 index rose 1.1% (up 21.6%). Russia's MICEX equities index dipped 0.4% (down 10.7%).

Junk bond mutual funds saw outflows jump to $1.725 billion (from Lipper).

Freddie Mac 30-year fixed mortgage rates rose three bps to 4.05% (up 48bps y-o-y). Fifteen-year rates increased two bps to 3.29% (up 48bps). The five-year hybrid ARM rate added a basis point to 3.14% (up 36bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates up two bps to 4.16% (up 39bps).

Federal Reserve Credit last week expanded $2.1bn to $4.434 TN. Over the past year, Fed Credit declined $4.2bn (down 0.1%). Fed Credit inflated $1.623 TN, or 58%, over the past 235 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt gained $6.5bn last week to $3.222 TN. "Custody holdings" were up $2.2bn y-o-y, or 0.1%.

M2 (narrow) "money" supply last week jumped $35.5bn to a record $13.475 TN. "Narrow money" expanded $749bn, or 5.9%, over the past year. For the week, Currency increased $2.8bn. Total Checkable Deposits slipped $5.5bn, while Savings Deposits rose $36.8bn. Small Time Deposits and Retail Money Funds were little changed.

Total money market fund assets gained $6.2bn to $2.650 TN. Money Funds fell $65bn y-o-y (2.4%).

Total Commercial Paper fell $11.0bn to $981.6bn. CP declined $134bn y-o-y, or 12%.

Currency Watch:

The U.S. dollar index recovered 0.6% to 99.25 (down 3.1% y-t-d). For the week on the upside, the Brazilian real increased 1.7%, the Mexican peso 0.9%, the South Korean won 0.5%, the South African rand 0.4%, the Norwegian krone 0.4% and the Singapore dollar 0.1%. For the week on the downside, the Swiss franc declined 1.3%, the New Zealand dollar 0.8%, the British pound 0.7%, the euro 0.6%, the Japanese yen 0.6%, the Australian dollar 0.5%, the Canadian dollar 0.4% and the Swedish krona 0.4%. The Chinese renminbi added 0.05% versus the dollar this week (up 0.66% y-t-d).

Commodities Watch:

May 9 – Bloomberg (Mark Shenk): “U.S. crude production forecasts keep growing. The Energy Information Administration said domestic output will climb to a record 9.96 million barrels a day in 2018, up from 9.9 million barrels projected last month, according to the agency’s monthly Short-Term Energy Outlook… Production will average 9.31 million barrels a day in 2017, up from 9.22 million projected in April.”

The Goldman Sachs Commodities Index rallied 2.2% (down 4.8% y-t-d). Spot Gold recovered 0.5% to $1,228 (up 6.6%). Silver regained 1.1% to $16.46 (up 3.0%). Crude rallied $1.62 to $47.84 (down 11%). Gasoline recovered 5% (down 6%), and Natural Gas jumped 4.8% (down 8%). Copper slipped 0.2% (up 1%). Wheat fell 1.9% (up 6%). Corn was little changed (up 5%).

Trump Administration Watch:

May 11 – Reuters (Dan Burns and Megan Davies): “Not even a week after the Trump administration and Congress rekindled optimism that they could soon make progress on a pro-growth agenda including tax cuts, the unexpected firing of the head of the FBI late Tuesday presented investors with a fresh reason to second-guess their confidence in the ‘Trump trade.’ At the least, financial market participants viewed President Donald Trump's abrupt dismissal of FBI Director James Comey as an unwelcome distraction, while some fretted it could tie Washington in knots for months, potentially postponing already-delayed reforms. The takeaway for the stock markets: don’t bet on any quick legislation around trade, the budget, healthcare or infrastructure.”

May 10 – Bloomberg (Steven T. Dennis and Margaret Talev): “Donald Trump’s abrupt firing of FBI Director James Comey is threatening to quickly backfire on the president, who’s now facing intense scrutiny from Democrats and even some Republicans over why he dismissed the man in charge of investigating his campaign’s possible ties to Russia. Trump’s decision… jolted the multiple congressional inquiries into Russia’s role in the 2016 election, fueled calls for a special prosecutor and set the stage for a bruising battle to get Comey’s successor through Senate confirmation. Trump took to Twitter to defend the move -- and attack his foes.”

May 9 – Reuters (Olivia Oran and Pete Schroeder): “The U.S. government's review of a landmark 2010 financial reform law will not be complete by early June as originally targeted, and officials will now report findings piece-by-piece, with priority given to banking regulations, sources familiar with the matter said… President Donald Trump has pledged to do a ‘big number’ on the Dodd-Frank financial overhaul law, which raised banks' capital requirements, restricted their ability to make speculative bets with customers' money and created consumer protections in the wake of the financial crisis. In February, Trump ordered Treasury Secretary Steven Mnuchin to review the law and report back within 120 days, saying his administration expected to be cutting large parts of it.”

May 11 – Wall Street Journal (Andrew Ackerman): “The Trump administration and a bipartisan group of U.S. senators are working to address an issue that has gone unresolved for nearly a decade: how to overhaul Fannie Mae and Freddie Mac, the mortgage-finance giants the government took over in 2008. The Senate Banking Committee has begun behind-the-scenes work on the issue of how, exactly, to revamp the companies. The senators want to develop a framework to decrease the government’s outsize role backstopping the nation’s $10 trillion mortgage market.”

China Bubble Watch:

May 8 – Bloomberg (Sofia Horta E Costa): “How much pain can China’s leaders stomach? It’s becoming a key question for investors as the government’s clampdown on financial leverage ripples through markets. The tightening campaign has erased at least $453 billion from the value of Chinese stocks and bonds since mid-April, spurred $21 billion of canceled debt sales and compelled the People’s Bank of China to inject $48 billion into jittery money markets. Sales of asset-management products by lenders and trust companies have plunged by more than 30%, while domestic real estate transactions have slowed and metals prices have buckled.”

May 10 – Bloomberg: “China’s government bonds slumped across tenors, pushing the 10-year yield up by the most since February, on bets regulators’ deleveraging campaign still has a long way to go. The yield on 10-year government bonds spiked 7 bps to 3.7%..., while the cost on the five-year note jumped to the highest in more than two years. The selloff accelerated after the Ministry of Finance sold five-year debt at the highest cost since 2014. This suggests financial institutions are betting yields will climb even further, according to Guotai Junan Securities Co. ‘Bonds are plunging at a pace that’s faster than we expected,’ said David Qu, a Shanghai-based markets economist at Australia & New Zealand Banking… ‘Investors have expected the central bank to ease liquidity when strain appears, but they’ve been repeatedly disappointed. So some are being forced to sell their holdings, leading to a sharper slump in the security.’”

May 9 – Bloomberg (Chris Anstey, Isabella Cota, and Ben Bartenstein): “What may be shaping up as China’s most concerted effort yet to bring its credit boom under control is spurring investors to gauge any contagion to broader financial markets, a-la 2015, when Chinese turmoil caused global ructions. Policy makers’ moves to crack down on leverage have already wreaked about $500 billion of financial damage domestically, and… are dragging on industrial metals and iron-ore prices globally. The key metrics to watch now: the yuan’s exchange rate and cross-border capital flows.”

May 6 – Financial Times (Tom Mitchell and Gabriel Wildau): “The World Bank has warned that Chinese local governments remain addicted to off-budget borrowing, despite Beijing’s efforts to impose fiscal discipline on localities and curb ballooning debt. Runaway growth of local government debt is widely seen as a huge risk for China’s economy and financial system. Provinces, cities and counties borrowed heavily to spend on infrastructure to keep economic growth humming after the 2008 financial crisis. But the practice has continued and economists warn that returns on new investment are falling and white elephants are common. Many projects do not produce enough cash flow to service their debt.”

May 10 – Bloomberg (Jack Sidders and Vinicy Chan): “China’s biggest-ever foreign acquisition frenzy is ending almost as dramatically as it began. After stunning the world with a record $246 billion of announced outbound takeovers in 2016, Chinese dealmakers are now struggling to cope with tighter capital controls and increasingly wary counterparties. Cross-border purchases plunged 67% during the first four months of this year, the biggest drop for a comparable period since the depths of the global financial crisis in 2009…”

May 11 – Wall Street Journal (Scott Patterson): “Money from state-run Chinese companies was used to help finance the buildup of a massive aluminum stockpile that has crisscrossed the globe, depressed prices and sparked a criminal investigation in the U.S., according to business records, emails and people with direct knowledge… Any such involvement by these entities could further strain relations between China and the U.S., which says Beijing undercuts global competition by giving government assistance to its commodity companies… Financing through the deep pockets of Chinese state-run companies could explain how enormous aluminum stockpiles that have captivated the global metals industry were paid for.”

May 9 – New York Times (David Barboza): “During his first state visit to Britain, President Xi Jinping of China heralded the great economic opportunities between the two countries, in energy, infrastructure and finance. He finished off the late 2015 trip at Manchester Airport, unveiling a new direct flight to Beijing on the Chinese carrier Hainan Airlines. The political spotlight was a global coup for Chen Feng, chairman of the carrier’s parent, the HNA Group… In just over two decades, Mr. Chen, 63, has helped transform a small airline in southern China into one of the country’s few global powerhouses, with big stakes in Hilton Hotels, Swissport and Ingram Micro. This week, HNA said it was the largest investor in Germany’s Deutsche Bank, part of a broader push by Chinese players into global finance. As China’s financial might has grown, companies like HNA have embarked on ambitious expansions, spreading money around the world…”

May 10 – Bloomberg: “China’s producer price gains slowed more than expected in April, adding to signs of a potential easing of global reflation fueled by the world’s second-largest economy. Producer price index rose 6.4% from a year earlier…”

May 5 – New York Times (Keith Bradsher): “A Chinese regulator announced… that it had taken disciplinary measures against the Anbang Insurance Group, a financial behemoth that has tried to invest tens of billions of dollars overseas, for the improper sale of two investment products. The moves by the China Insurance Regulatory Commission come against a backdrop of broader worries about the country’s financial system, in addition to ones about the insurance industry. President Xi Jinping told Politburo members last month that China should place a strong emphasis on financial stability as a pillar of a strong economy…”

May 9 – Wall Street Journal (Dominique Fong): “Zheng Xiaohei, a marketer from Urumqi in western China, made his first overseas property investment without so much as a visit. Mr. Zheng, 29 years old, in March purchased a studio apartment in Thailand for about 650,000 yuan ($94,255) using his smartphone and an app called Uoolu that connects users to overseas property listings. ‘Investing in overseas real estate was mainly due to my good impression of Thailand,’ Mr. Zheng said. Founded two years ago, Beijing-based Uoolu is focused on tapping a specific group of home buyers: Chinese millennials looking for foreign properties. …The lure? A millennial’s desire to hedge against yuan depreciation and find affordable homes in cities with cleaner air for their children to live in when they study abroad. In the past year, home prices have soared to more than 30 times household income in major Chinese cities.”

May 9 – Reuters (Engen Tham): “China's lenders are swapping struggling corporates for more promising retail borrowers - restructuring branches, teams and even overhauling bankers' commissions in an unprecedented push that is fuelling a record jump in home loans. Yet the speed of the switch, the pressure to pull in more borrowers and soaring house prices are also worrying loan officers, analysts and regulators, with the central bank governor among those sounding a note of caution. Corporate lending has long made up the bulk of many Chinese banks' loan books: the deals are larger and loans have more attractive rates. But with firms faltering, economic growth slowing for key sectors and banks under pressure to deleverage, lenders are eyeing other options.”

May 9 – Reuters (Kevin Yao): “China will pay closer attention to the influence of non-bank financial institutions on financial stability, and the impact of local policy interventions on broader global markets, according to a central bank working paper… In recent years non-bank institutions such as trust and investment companies, or fund and asset management firms have expanded their activity - much of it a less regulated form of lending - even as policymakers have tried to rein in leverage in the Chinese economy. ‘Though banks still dominate China's financial system, non-bank financial institutions have considerable influence as well,’ the paper published on the People's Bank of China website said. ‘We believe that sufficient attention should be given to international spill-over effects of intervention policies, and the impact of non-bank financial institutions to financial stability,’…”

May 10 – Reuters (Saikat Chatterjee and Umesh Desai): “China's policymakers plan to open the doors wider than ever to foreign investment in the country's $3 trillion bond market, in part to help shore up the struggling yuan. But the currency is also proving to be a major barrier to the success of their plan. Foreigners own less than 2% of China's $3.3 trillion in outstanding bonds and say getting their cash out of China and recent weakness of the closely controlled currency are obstacles to investment. Foreign investors are also skeptical they can assess risk accurately when most of the $2.1 trillion in corporate bonds are rated investment grade by domestic rating agencies… ‘If investors wanted to have more exposure to Chinese bonds, we can do it tomorrow,’ said Andy Seaman, a partner and chief investment officer of… fund manager Stratton Street. ‘But unfortunately, they don't. It's very difficult to persuade people because of the currency. They don't want renminbi,’ he said.”

May 7 – Bloomberg: “China’s foreign-exchange reserves rose for a third month in April, exceeding estimates, as tighter capital controls kept money from flowing out of the country and the yuan held stable. Reserves climbed $20.4 billion to $3.03 trillion, …compared with a median estimate of $3.02 trillion…”

Europe Watch:

May 7 – CNBC (Karen Gilchrist): “Emmanuel Macron has fought off populist opponent Marine Le Pen and won the race to become France's next president. The centrist candidate secured approximately 65% of votes to far-right Le Pen's 35%... Macron's win signals a victory for both pro-Europeans and pollsters, who correctly predicted his lead… What happens now? Macron will be inaugurated on Sunday May 14. At this point he will replace the outgoing President Francois Hollande and attentions will turn to the upcoming parliamentary elections. On June 11 and 18, French citizens will once again head to the polls for two rounds of voting to elect the country's 577 members of parliament.”

May 9 – Reuters (Patrick Graham): “In December, one of the trades of 2017 for the big financial investors who play on global political and economic risk was the spread of populism in Europe and the threat that might pose to the future of the euro. Six months and two elections on, and with only a relatively traditional policy fight in prospect for Germany's vote in September, the risks have receded. Emmanuel Macron’s victory… follows defeat for Geert Wilders' Party for Freedom in the Netherlands and heads off Marine Le Pen’s promises to pull Paris out of the euro and potentially the European Union. Looking threatened six weeks ago by Martin Schulz’s reboot of Germany’s Social Democrats (SPD), Angela Merkel is again 6-8 points ahead in the polls…”

May 10 – Bloomberg (Alessandro Speciale and Corina Ruhe): “Mario Draghi said the European Central Bank’s stimulus hasn’t finished the job yet, even as he acknowledged that the region’s economy is getting stronger. ‘The economic recovery has evolved from being fragile and uneven into a firming, broad-based upswing,’ the ECB president said… ‘Nevertheless, it is too early to declare success.’ ECB policy makers are pondering whether and how to communicate a gradual removal of stimulus amid a steadily strengthening economy that has so far showed little signs of generating faster price growth.”

May 10 – Financial Times (Claire Jones and Mehreen Khan): “Mario Draghi faced a rare public grilling… that left the president of the European Central Bank rattled as he defended some of his unpopular policies to Dutch MPs. …The Dutch political establishment has been fiercely critical of the ECB’s stimulus measures, which have seen the central bank buy more than €1.8tn of assets over the past two years and cut interest rates to record lows. Mr Draghi faced accusations that he had raided Dutch pensioners’ wealth through ECB policies: many Dutch share the German view of blaming the central bank’s measures for eroding their savings… MPs finished the session with a gift of a solar-powered tulip for Mr Draghi, to remind him of the country’s famous Tulip Mania asset price bubble and financial crisis in the mid-17th century.”

Global Bubble Watch:

May 10 – Reuters (Jamie McGeever and Vikram Subhedar): “The current slump in expectations of market volatility is not just a stock market phenomenon -- it is the lowest it's been for years across fixed income, currency and commodity markets around the world. It shows little sign of reversing, which means market players are essentially not expecting much in the way of shocks or sharp movements any time soon. It's an environment in which asset prices can continue rising and bond spreads narrow further. The improving global economy, robust corporate profitability, ample central bank stimulus even as U.S. interest rates are rising, and some fading political risk from elections have all contributed to create a backdrop of relative calm. There is little evidence of investors hedging -- or seeking to protect themselves -- from adverse conditions.”

May 9 – CNBC (Fred Imbert): “The U.S. stock market may be a bit too calm right now, Goldman Sachs CEO Lloyd Blankfein said… ‘Every time I get accustomed to low volatility, like we were towards the end of the Greenspan era, and we think we have all the levers under the control ... something erupts to remind us that the idea that anybody is in control of everything is hubris,’ Blankfein told CNBC's ‘Power Lunch’… ‘I don't know what brings us out of the doldrums, but I do know this is not a normal resting state,’ he said.”

May 10 – Wall Street Journal (Spencer Jakab): “They have nothing to fear but the lack of fear itself. The low level of the market’s so-called fear gauge, formally known as the CBOE Volatility Index or VIX, is a divisive issue on Wall Street. Some assert that the lowest values in nearly a quarter-century signal investor complacency. They say that has almost always been a sign that a selloff is near. Others scoff that there is no cause-and-effect. Without wading into this debate, the VIX’s descent into the single digits—it touched 9.56 on Tuesday—is bad news for investors who bet on higher volatility. Now it is also bad news for more conservative investing strategies that profit directly from market choppiness.”

May 7 – Financial Times (Jennifer Hughes): “When two big international organisations highlight the same issue, investors should pay attention. When the issue is the risk of a scarcity of dollars outside the US, then arguably everyone should take note. The International Monetary Fund and the Bank for International Settlements both pointed to the potential danger in their most recent reports. Bank analysts and investors, too, are beginning to discuss the implications of fewer dollars, particularly for emerging markets… Fewer dollars would raise the cost of obtaining the currency from the pools that have developed outside the US since the Fed began flooding markets with money via quantitative easing in 2008.”

May 7 – Wall Street Journal (Gunjan Banerji): “Falling volumes and spiraling costs are pushing trading firms out of U.S. options, raising concerns about fragility in a market that investors rely on to protect portfolios. Trading has dwindled in most areas of the market, and investors and traders are grappling with increasing fragmentation. Liquidity, the crucial ability to do trades without significantly moving prices, has deteriorated, according to interviews with market participants… Options on key indexes, exchange-traded funds and high-volume stocks dominate trading. Meanwhile, there is less activity in the rest of the listed U.S. options world. The stresses prompted at least six prominent options market makers to exit from the business since 2012.”

May 8 – Bloomberg (Michael Heath): “Australian business confidence surged to the highest level since 2010 and firms’ conditions advanced further, signaling economic growth could accelerate.”

May 9 – Bloomberg (Emily Cadman): “Australia’s banking regulator will get new powers to curb property lending both in the shadow banking sector and in specific geographic areas. The additional powers and funding for the Australian Prudential Regulation Authority come after soaring house prices in the nation’s largest cities stoked concern… Treasurer Scott Morrison said the government will legislate to extend APRA’s ability to apply controls to the non-bank lending sector as well as ‘explicitly allow them to differentiate the application of loan controls by location.’ …Bringing non-bank lenders into APRA’s regulatory purview will strengthen oversight of a sector that has grown as the big four banks tighten their lending criteria.”

Fixed Income Bubble Watch:

May 11 – Bloomberg (Luke Kawa): “Call it a local bond market buffet. American buyers have been gorging on corporate debt after also stepping up their presence in the Treasury market. As such, investment grade credit spreads remain tight by historical standards largely thanks to a resurgence in U.S. retail enthusiasm as international demand wanes. ‘The real delta in terms of demand for U.S. investment grade credit this year is not any particular foreign buyer base, but instead the domestic mutual fund and exchange-traded fund segment, which is enjoying a banner year of inflows,’ wrote Wells Fargo Securities strategists led by Nathaniel Rosenbaum… ‘These funds have garnered over $100 billion in just four months, almost double the prior record for this point in the year.’”

May 5 – New York Times (Mary Williams Walsh): “It all goes back to 1917. Congress passed a law that year making Puerto Ricans United States citizens. That same law, still on the books today, empowered the island to raise money by issuing tax-exempt bonds. And not just federally tax-exempt bonds: Congress went on at length to bar anyone from taxing Puerto Rico’s bonds, presumably never dreaming how this would play out a century later — which, on Wednesday, led to the territory declaring a form of bankruptcy because it could not pay the $123 billion in bonds and unpaid pension debts it owes. The 100-year-old law stipulates that no one… can tax the interest that Puerto Rico pays its investors. This has spurred people with eyes on easy profits to dive in for decades.”

May 9 – Financial Times (Eric Platt): “Riskier US corporate debt regained some of its footing on Tuesday, with a number of bond sales expected over the coming days despite the weight of falling oil prices. At least 10 speculatively rated groups — companies deemed riskier than their investment-grade counterparts by the major rating agencies — borrowed through bond markets on Tuesday or were poised to complete marketing roadshows later this week for such sales. The uptick in activity follows a volatile week for junk bonds as oil prices decline.”

Federal Reserve Watch:

May 9 – Bloomberg (Craig Torres and Rich Miller): “Allan Meltzer, an economist and Federal Reserve historian who was critical of the central bank’s recent policies, died on Monday at the age of 89… A monetary policy expert who consulted with congressional committees and central banks, Meltzer brought historical perspective and a sharp knowledge of past policy foibles to his commentary.”

May 7 – Financial Times (Sam Fleming): “The Federal Reserve risks political interference and losing its independence if it maintains a large balance sheet in the longer term, former Fed officials have claimed, as debate intensifies over the central bank’s strategy for unwinding its interventions in financial markets. Kevin Warsh, a visiting fellow at the Hoover Institution at Stanford University and former Fed governor, said that permanently holding vast quantities of assets like treasuries was ‘fiscal policy in disguise’ and risked turning the central bank into a general purpose agency of the government. ‘A large balance sheet is a dangerous temptation for the rest of the political class,’ he said…”

May 8 – Bloomberg (Christopher Condon): “Federal Reserve Bank of Cleveland President Loretta Mester said the central bank should continue on its gradual path of raising interest rates to prevent the risk of overheating the U.S. economy. ‘It’s important for the FOMC to remain very vigilant against falling behind as we continue to make progress on our goals,’ Mester said… ‘If we delay too long in taking the next normalization step and then find ourselves in a situation where the labor market becomes unsustainably tight, price pressures become excessive and we have to move rates up steeply, we could risk a recession,’ she said.”

May 9 – Reuters (Jason Lange): “Kansas City Federal Reserve President Esther George… said she supported starting to wind down the Fed's massive trove of bonds this year. …George said the central bank's Federal Open Market Committee should move to stop reinvesting the maturing principal payments of its longer-term Treasuries and mortgage-backed securities. ‘The FOMC also must begin to adjust the size and composition of its securities holdings,’ George said…”

May 9 – Bloomberg (Matthew Boesler and Liz McCormick): “Tapering of the Federal Reserve’s balance sheet won’t sink the mortgage-backed securities market, said Boston Fed President Eric Rosengren, though prices may have to adjust to tempt investors into buying bonds currently being sucked up by the central bank. ‘Our capital markets are deep enough that I’m not as worried about the ability to be able to fund those mortgages,’ he told an audience… ‘Price will change, and I think market participants will step up as the price changes.’”

May 11 – Bloomberg (Anirban Nag and Matthew Boesler): “The Federal Reserve is on track to begin unwinding its balance sheet this year or next, although U.S. central bankers are not in a rush to tighten and will take care to ensure their actions don’t trigger disruptions that harm the global economy, Federal Reserve Bank of New York President William Dudley said. ‘We are pretty close to full employment,’ Dudley said… ‘Inflation is just a little bit below our target of 2% if you look at the underlying inflation trend, so clearly if the economy continues to grow above trend we are going to want to gradually remove monetary policy accommodation.”

May 10 – Bloomberg (Christopher Condon): “Federal Reserve Bank of Boston President Eric Rosengren urged his policy-making colleagues to raise interest rates three more times this year and consider starting to shrink the central bank’s balance sheet after their next hike to avoid creating an ‘over-hot economy.’”

U.S. Bubble Watch:

May 11 – Bloomberg (Sho Chandra): “A decline in U.S. jobless-benefit rolls to a 28-year low adds to signs of a tight labor market, as initial unemployment claims also remained subdued… The decline in jobless-benefit rolls dovetails with a drop in the unemployment rate, signaling the labor market continues to strengthen. Initial claims have been below 300,000 since early 2015…”

May 11 – Bloomberg (Patricia Laya): “The bigger-than-forecast rebound in April wholesale prices indicates inflation pressures continue to build in the U.S. economy and that March’s decline was short-lived… Excluding volatile items of food, energy, and trade services, producer costs rose 0.7% after climbing 0.1% the previous month; up 2.1% from a year earlier…”

May 9 – Bloomberg (Joe Carroll): “U.S. shale explorers are boosting drilling budgets 10 times faster than the rest of the world to harvest fields that register fat profits even with the recent drop in oil prices. Flush with cash from a short-lived OPEC-led crude rally, North American drillers plan to lift their 2017 outlays by 32% to $84 billion, compared with just 3% for international projects, according to… Barclays Plc. Much of the increase in spending is flowing into the Permian Basin, a sprawling, mile-thick accumulation of crude beneath Texas and New Mexico, where producers have been reaping double-digit returns even with oil commanding less than half what it did in 2014. That’s bad news for OPEC and its partners in a global campaign to crimp supplies and elevate prices.”

May 6 – Wall Street Journal (Peter Grant): “A growing labor shortage in the commercial real-estate industry is driving up the costs of some projects and could complicate lawmakers’ plans for a $1 trillion infrastructure-spending program, contractors say. ‘Ever since we came out of the great recession, many folks in our industry have been saying: it’s coming, it’s coming, it’s coming,’ said George Nash Jr., director of preconstruction for Branch and Associates… ‘Today the problem is there.’ Construction businesses, excluding those building single-family homes, employed close to 4.2 million workers in April, up 3,000 from March, according to an analysis by the Associated Builders and Contractors… That was the highest employment level since November 2008…”

May 9 – Bloomberg (Alex Webb): “Apple Inc. became the first U.S. company with a market value of more $800 billion as investors bet the next iPhone will spur a resurgence in sales. The stock rose 1% Tuesday to close at $153.99…, giving it a market capitalization of about $803 billion. The shares have gained 33% since the start of the year…”

May 10 – Bloomberg (Matt Scully): “Borrower fraud in U.S. auto loans is surging, and may approach levels seen in mortgages during last decade’s housing bubble, according to a startup firm that helps lenders sniff out bogus borrowers. As many as 1% of U.S. car loan applications include some type of material misrepresentation, executives at… Point Predictive estimated based on reports from banks, finance companies and others. Lenders’ losses from deception may double this year to $6 billion from 2015, the firm forecast.”

Japan Watch:

May 10 – Reuters (Sumio Ito and Minami Funakoshi): “Bank of Japan Governor Haruhiko Kuroda said… the central bank will consider publicizing calculations on how a future withdrawal of massive monetary stimulus could affect its financial health. The remark was the first time that Kuroda, who until now had shrugged off as premature any debate over an exit strategy for the BOJ's radical stimulus program, has signaled the chance of offering such information to the public. ‘It is very important to explain in easy-to-understand terms how monetary policy could affect the BOJ's financial health,’ Kuroda told parliament…”

May 6 – Financial Times (Leika Kihara): “The Bank of Japan is facing big challenges as inflation holds well below its 2% target, underscoring the importance for Japan's central bank to maintain its massive stimulus program, BOJ Governor Haruhiko Kuroda said… Japan's economy has shown signs of life with a pick-up in global demand boosting exports and factory output. But inflation remains subdued despite four years of aggressive money printing since Kuroda became governor in 2013, as slow wage growth dampens household spending. ‘After four years ... our inflation rate is still close to zero. This is certainly a very challenging situation for central bank governors and central bankers in Japan,’ Kuroda told a seminar…”

EM Watch:

May 10 – Financial Times (Jonathan Wheatley): “Emerging markets have come roaring back into fashion. Cross-border flows to EM bonds and equities topped $20bn for the third consecutive month in April, making this their biggest three-month positive streak since 2014… Have emerging economies found a path back to growth after the breakdown in the commodities supercycle, which was so powerfully beneficial to their own citizens and to international investors for the first dozen years of this century? The answer must be no. Of the original Brics, Brazil and Russia are struggling out of deep recessions. The best that most analysts can say of China is that the government will kick a looming debt crisis down the road until after the Communist party congress at the end of this year.”

May 9 – Bloomberg (Fercan Yalinkilic and Kerim Karakaya): “Increased spending to bolster growth sent Turkey’s Treasury on a borrowing spree to plug a widening budget deficit, shaking one of the pillars of strength for the Middle East’s largest economy. Cash budget balances have deteriorated in the last 12 months as spending spiked after a July 15 coup attempt last year and before a referendum in April gave President Recep Tayyip Erdogan sweeping new powers. Defense also became a major expense item as the army expanded operations in Syria…”

Geopolitical Watch:

May 10 – Reuters (Tulay Karadeniz and Tuvan Gumrukcu): “Turkey warned the United States… that a decision to arm Kurdish forces fighting Islamic State in Syria could end up hurting Washington, and accused its NATO ally of siding with terrorists. The rebuke came a week before President Tayyip Erdogan is due in Washington for his first meeting with U.S. President Donald Trump, who approved the arms supply to support a campaign to retake the Syrian city of Raqqa from Islamic State. Turkey views the YPG as the Syrian extension of the outlawed Kurdistan Workers Party (PKK), which has fought an insurgency in southeast Turkey since 1984…”

Friday Evening Links

[Reuters] Wall St. slips as bank, industrial stocks drag

[Reuters] G7 finance chiefs warn U.S. not to upset global growth

[BBC] Ransomware infections reported worldwide

[CNBC] US rises to the top of the list of major markets with big political risk