Friday, October 26, 2018

Weekly Commentary: "Whatever They Want" Coming Home to Roost

Let's begin with global. China's yuan (CNY) traded to 6.9644 to the dollar in early-Friday trading, almost matching the low (vs. dollar) from December 2016 (6.9649). CNY is basically trading at lows going back to 2008 - and has neared the key psychological 7.0 level. CNY rallied in late-Friday trading to close the week at 6.9435. From Bloomberg (Tian Chen): "Three traders said at least one big Chinese bank sold the dollar, triggering stop-losses." Earlier, a PBOC governor "told a briefing that the central bank would continue taking measures to stabilize sentiment. 'We have dealt with short-sellers of the yuan a few years ago, and we are very familiar with each other. I think we both have vivid memories of the past.'"

The PBOC eventually won that 2016 skirmish with the CNY "shorts". In general, however, you don't want your central bank feeling compelled to do battle against the markets. It's no sign of strength. For "developing" central banks, in particular, it has too often in the past proved a perilous proposition. Threats and actions are taken, and a lot can ride on the market's response. In a brewing confrontation, the market will test the central bank. If the central bank's response appears ineffective, markets will instinctively pounce.

Often unobtrusively, the stakes can grow incredibly large. There's a dynamic that has been replayed in the past throughout the emerging markets. Bubbles are pierced and "hot money" heads for the exits. Central banks and government officials then work aggressively to bolster their faltering currencies. These efforts appear to stabilize the situation for a period of time, although the relative calm masks assertive market efforts to hedge against future currency devaluation in the derivatives markets.

If policymakers then lose control - market pressures prevail - those on the wrong side of (now outsized) derivative hedges are forced to aggressively sell/short the underlying currency. This type of self-reinforcing selling can too easily foment illiquidity, dislocation and currency collapse. As I highlighted last week, for a list of reasons such a scenario would have devastating consequences for China - and the world.

As I've noted in previous CBBs, the current global environment has some critical differences compared to China's last currency instability episode in early-2016. Global QE was ramped up to about a $2.0 TN annual pace back then, versus today's QE that will soon be only marginally positive. Buoyed by zero rates, sinking bond yields and rising equities prices, global speculative leverage was expanding - versus today's problematic contraction. China's Credit system and economy were significantly more robust in 2016. EM, in general, was still enveloped in powerful financial and economic expansion dynamics. Moreover, the global trade and geopolitical backdrops have deteriorated dramatically since 2016.

October 26 - Bloomberg: "Investors are turning up the temperature on Chinese policy makers, who were already feeling the heat. That may cause the government to resort to even tighter controls on money flowing in and out of the country, according to Citi economists. Net foreign exchange settlement by banks in China on behalf of their clients -- a proxy for capital flows -- was negative in September for a third straight month, according to… the State Administration of Foreign Exchange. At -110.3 billion yuan, purchase of foreign currencies was the most since December 2016. An escalating trade war with the U.S. has contributed to souring investor sentiment and put downward pressure on China's currency, which Friday came within striking distance of a 10-year low against the dollar. It's fallen 9% over the last six months. Measures taken by the People's Bank of China this month to support the economy as the outlook has darkened… haven't helped the exchange rate."

October 26 - Bloomberg (Alfred Liu and Benjamin Robertson): "China's finance ministry has warned the country's state-owned financial assets need further protection from mismanagement, following the release of new data on the size of their balance sheets. Total assets of state-owned financial enterprises amounted to 241 trillion yuan ($34.6 trillion) in 2017, according to a report published by China's Ministry of Finance… Their liabilities were 217.3 trillion yuan last year… 'While we are gradually upgrading the management of state financial assets, we have to be aware that there are still institutional and structural contradictions and problems,' said Liu Kun, China's finance minister… 'The mission of preventing massive risks remains tough.'"

A disorderly breakdown of the Chinese currency has the potential to be one of the most destabilizing developments for global finance and the world economy in decades. I am not confident that Chinese officials have the situation under control. At the same time, there is no doubt that Chinese finance and financial institutions have inflated to previously unimaginable dimensions. And it appears Beijing is increasingly cognizant of unfolding risks. This likely explains why officials appear less inclined than in the past to push through aggressive fiscal and monetary stimulus. A key aspect of the bullish global thesis (Chinese stimulus on demand) is due for reassessment.

The Shanghai Composite rallied 1.9% this week. It was difficult for global markets to sense anything more than fleeting relief, suspecting the "national team" was hard at work. Markets throughout Asia were under pressure. Hong Kong's Hang Seng index fell 3.3%. Major indices were down 6.0% in South Korea, 6.0% in Vietnam, 4.3% in Taiwan, 3.2% in Thailand, 2.8% in Malaysia, 2.8% in India and 1.2% in Philippines. Japan's Nikkei 225 index sank 6.0%, with the TOPIX Bank Index's 4.7% drop boosting y-t-d declines to 17.1%.

Asian bank weakness is a primary Systemic Contagion Link globally. Europe's STOXX 600 bank index fell 3.5% this week, increasing 2018 losses to 24.0%. Italian banks were down another 3.9% this week (down 28.2% y-t-d). Deutsche Bank dropped 11.4% this week (to an all-time low). Deutsche Bank (senior) credit-default swap (CDS) prices rose 11 bps this week to 156 bps, the high since early July. Many of the big global banks saw CDS prices rise this week to near one-year highs. Curiously, Goldman Sachs CDS rose seven this week to 79 bps, an almost 19-month high. The U.S. bank equities index (BKX) sank 5.0% this week, and the Broker/Dealers dropped 4.8%.

In a further indication of heightened global systemic risk, German bund yields sank 11 bps this week to 0.35%, the low since September 4th. With Italian yields declining only four bps (to 3.45%), the spread to bunds widened seven bps to 310 bps. Portuguese yields dropped 11 bps to 1.96%, and Spanish yields fell 17 bps to 1.57%. UK 10-year yields sank 19 bps to 1.38%, the low since August.

It certainly has all the appearance of bond markets beginning to discount ramification of the bursting of the global Bubble. WTI crude declined another $1.52 to $67.62, a two-month low. The dollar index increased 0.7% to 96.412, near a 16-month high. The British pound declined 1.9%, the Norwegian krone 1.6%, the Swedish krona 1.6%, the New Zealand dollar 1.4%, the South African ran 1.3% and the euro 1.0%.

October 26 - Bloomberg (Jacob Bourne): "Inflation expectations are tumbling in the U.S. bond market, suggesting traders are worried that the Federal Reserve's monetary policy is becoming too tight -- potentially by a quarter-point -- amid the slide in equities. The five-year breakeven rate, which represents bond investors' view on the annual inflation rate through 2023, dropped Friday to 1.88%, the lowest since January."

The headline for the above article was "Inflation Bets Are Tanking, Showing Bond Traders See a Tight Fed." Ten-year Treasury yields did drop 12 bps this week to 3.08%. But the overarching issue is escalating systemic risk associated with a faltering global Bubble - not a "tight Fed." The Fed would prefer to remain "data dependent." The early read on Q3 GDP came in at 3.5%, with Personal Consumption growing at a 4.0% rate (strongest since Q4 '14). A number of Fed officials this week downplayed U.S. stock market weakness.

I'm not at all sure Fed officials appreciate their predicament. The global Bubble is bursting, yet the U.S. economy at this point maintains a decent head of steam. Bond markets are quickly adjusting to the changing global backdrop. Treasuries have had more of a domestic focus but this has begun to shift. And having shown resilience until recently, junk bonds (HYG) declined 1.1% over the past two weeks. With yields jumping this week to a two-year high, junk bond funds suffered net outflows of $2.364 billion.

October 26 - Bloomberg (Adam Tempkin): "One of Wall Street's go-to shelters in times of trouble is showing cracks as broad concerns pile up. Bouts of selling have hit bonds backed by mortgages, auto loans and credit card payments -- typically havens during periods of stress -- amid the carnage in financial markets this month. Certain sectors of so-called securitized loans are 'experiencing some headwinds,' said Neil Aggarwal, senior portfolio manager and head of trading at Semper Capital. 'A combination of rates, earnings, and global concerns are having an ongoing impact.' The debt class usually does better than corporate bonds during market turmoil because the securities are linked to consumer payments, rather than company performance, and typically have cash cushions to absorb initial losses. But recent weakness highlights how the sector may be unable to shrug off the chaos enveloping other assets."

Financial conditions have now begun to meaningfully tighten at the "Core." I suspect de-risking/de-leveraging dynamics have begun to unfold throughout U.S. corporate Credit. There are also indications of tightening liquidity conditions in securitized Credit. These are important developments.

October 26 - Bloomberg (Suzy Waite and Nishant Kumar): "Hedge funds using computer-driven models to follow big market trends have been whiplashed as volatility has spiked, among the biggest casualties of a stock rout that has accelerated worldwide. Funds known as commodity trading advisers, or CTAs, have traditionally shielded investors during market selloffs such as the global financial crisis, especially when mathematical models show a clear or pronounced trend. But this time, they've been unable to navigate sharp reversals in asset prices… 'It's a bloodbath out there across almost every strategy with very few exceptions,' said Vaqar Zuberi, head of hedge funds at Mirabaud Asset Management… 'CTAs have been caught by a double-whammy with rising rates and equities plummeting,' said Zuberi. 'There's only one exit and everyone is trying to exit now because the models are telling them to do so.' Computer-driven hedge funds were already headed for their worst year ever before this month's volatility…"

As an industry, hedge funds were already struggling for performance prior to the recent bout of "Risk Off." Many funds have seen 2018 gains quickly morph into losses. There is now the distinct risk of escalating losses into year-end spurring significant industry outflows. This dynamic elevates the odds of a destabilizing de-risking/deleveraging dynamic.

Treasuries provided somewhat of a hedge against equities losses this week. Yet, overall, markets have been particularly uncooperative to popular "risk parity" hedge fund strategies. Leveraged portfolios of stocks, government securities and fixed-income are not experiencing the diversification benefits they've enjoyed for most of the past decade (or two). Losses and general performance volatility will force these strategies to deleverage, with negative consequences for liquidity across various markets.

With de-risking/deleveraging gaining momentum globally - and some of the big global "banks" under pressure - it's reasonable to begin contemplating counter-party risk. And anytime markets start indicating waning liquidity and dislocation risk, my fears return to the derivatives markets. How much market "risk insurance" has been sold by strategies that plan on hedging this risk by selling into declining markets? Stated differently, what is the risk that derivatives "insurance" "dynamically (delta) hedged" by quant models could erupt into self-reinforcing sell programs, illiquidity and market dislocation?

October 26 - Financial Times (Alfred Liu and Benjamin Robertson): "Mario Draghi has pushed back against the wave of political attacks on the world's central banks, warning that the rising pressure could lead to lower growth and undermine a vital line of defence against future financial crises. Speaking just hours after he was criticised by Italy's deputy prime minister as 'poisoning the climate' against Rome, the European Central Bank president called on legislators around the world to instead 'protect the independence' of rate-setters. 'The central bank should not be subject to . . . political dominance and should be free to choose the instruments that are most appropriate to deliver its mandate,' Mr Draghi said in a thinly-veiled rebuke to his native country."

I see things similarly to the great statesman, the ailing Paul Volcker: "A hell of a mess in every direction." The stock market is only a few weeks past all-time highs, yet the finger-pointing has already begun in earnest. The Powell Fed cautiously raising rates just past 2.0% is certainly not responsible for the world's problems. A decade of central bank-induced monetary inflation, well that's a different story. More than a couple decades of central bank experimentation and inflationism, now you're on to something. It was always going to Come Home to Roost. That's the harsh reality that no one was willing to contemplate.

Draghi: "The central bank should not be subject to… political dominance and should be free to choose the instruments that are most appropriate to deliver its mandate."

It's ridiculous to bestow a small group of global central bankers the power to do Whatever They Want in the name of delivering on some arbitrary index level of consumer price inflation. To create $14 TN of "money" and unleash it upon global securities markets is undoubtedly history's most reckless monetary mismanagement.

Inevitable Blowback has commenced. "The dog ate my homework." "The inflation mandate made us do it." With a full year remaining in his term, Draghi won't be sharing Bernanke's good fortune. This whole historic monetary experiment will be unraveling while he's still on watch. But, then again, the Trump administration already has its scapegoat. Perhaps the whole world will blame Chairman Powell - or the man that appointed him.

Following a terrifying trajectory, things somehow turn more disturbing by the week. Political travesty has degenerated into a surreal quagmire. And to see this degree of division and hostility at this cycle's boom phase should have us all thinking carefully about what the future holds. As a nation, we are alarmingly unprepared. And it's back to this same issue that's troubled me for a number of years now:

Bubbles are always mechanisms of wealth redistribution and destruction. Akin to central banking, they can inflict immeasurable harm and somehow deflect culpability. As we've already witnessed as a society, they wreak subtle - and, later, more overt - havoc. And the current astounding Bubble has been on such an unprecedented global scale. Harsh geopolitical fallout is unavoidable. For me, it's been scary for a while. It's just more palpable now. We'll see if the midterms can provide an impetus for a market rally. If not, this has all the appearances of something that could turn sour quickly.

For the Week:

The S&P500 dropped 3.9% (down 0.6% y-t-d), and the Dow fell 3.0% (down 0.1%). The Utilities declined 1.9% (up 1.2%). The Banks sank 5.0% (down 11.1%), and the Broker/Dealers fell 4.8% (down 5.7%). The Transports dropped 4.5% (down 6.1%). The S&P 400 Midcaps dropped 4.1% (up down 5.5%), and the small cap Russell 2000 fell 3.8% (down 3.4%). The Nasdaq100 declined 3.6% (up 7.1%). The Semiconductors sank 5.9% (down 8.0%). The Biotechs were slammed 7.1% (up 7.5%). Although bullion gained $6, the HUI gold index sank 7.0% (down 24.8%).

Three-month Treasury bill rates ended the week at 2.28%. Two-year government yields dropped 10 bps to 2.81% (up 92bps y-t-d). Five-year T-note yields fell 14 bps to 2.91% (up 70bps). Ten-year Treasury yields dropped 12 bps to 3.08% (up 67bps). Long bond yields declined seven bps to 3.31% (up 57bps). Benchmark Fannie Mae MBS yields fell eight bps to 3.93% (up 93bps).

Greek 10-year yields declined five bps to 4.28% (up 20bps y-t-d). Ten-year Portuguese yields fell 11 bps to 1.91% (down 4bps). Italian 10-year yields declined four bps to 3.45% (up 143bps). Spain's 10-year yields sank 17 bps to 1.57% (unchanged). German bund yields dropped 11 bps to 0.35% (down 8bps). French yields fell 10 bps to 0.74% (down 5bps). The French to German 10-year bond spread widened one to 39 bps. U.K. 10-year gilt yields sank 19 bps to 1.38% (up 19bps). U.K.'s FTSE equities index declined 1.6% (down 9.7%).

Japan's Nikkei 225 equities index sank 6.0% (down 6.9% y-t-d). Japanese 10-year "JGB" yields declined four bps to 0.11% (up 7bps). France's CAC40 declined 2.3% (down 6.5%). The German DAX equities index lost 3.1% (down 13.3%). Spain's IBEX 35 equities index fell 1.8% (down 13.1%). Italy's FTSE MIB index declined 2.1% (down 14.5%). EM equities were mostly lower. Brazil's Bovespa index gained 1.6% (up 12.0%), while Mexico's Bolsa fell 3.3% (down 7.0%). South Korea's Kospi index sank 6.0% (down 17.8%). India's Sensex equities index fell 2.8% (down 2.1%). China's Shanghai Exchange rose 1.9% (down 21.4%). Turkey's Borsa Istanbul National 100 index sank 6.1% (down 21.5%). Russia's MICEX equities index fell 2.2% (up 8.7%).

Investment-grade bond funds saw inflows of $415 million, while junk bond funds saw outflows jump to $2.364 billion (from Lipper).

Freddie Mac 30-year fixed mortgage rates added a basis point to 4.86% (up 92bps y-o-y). Fifteen-year rates gained three bps to 4.29% (up 104bps). Five-year hybrid ARM rates increased four bps to 4.14% (up 93bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates down two bps to 4.82% (up 62bps).

Federal Reserve Credit last week declined $2.6bn to $4.137 TN. Over the past year, Fed Credit contracted $291bn, or 6.6%. Fed Credit inflated $1.328 TN, or 47%, over the past 312 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt increased $0.9bn last week to $3.434 TN. "Custody holdings" were up $69bn y-o-y, or 2.1%.

M2 (narrow) "money" supply jumped $25.9bn last week to $14.262 TN. "Narrow money" gained $520bn, or 3.8%, over the past year. For the week, Currency increased $1.4bn. Total Checkable Deposits surged $38.3bn, while Savings Deposits fell $23.3bn. Small Time Deposits added $4.6bn. Retail Money Funds gained $5.1bn.

Total money market fund assets rose $9.7bn to $2.882 TN. Money Funds gained $134bn y-o-y, or 4.9%.

Total Commercial Paper increased $5.2bn to $1.088 TN. CP gained $21bn y-o-y, or 1.9%.

Currency Watch:

October 23 - Bloomberg (Emma Dai): "Dollar-yuan trading volume surpassed the frenzied levels seen during the 2015 devaluation on Wednesday, amid signs China is trying to prevent its currency from weakening too fast. Volume was up 27% at $66 billion…, the most since Bloomberg began compiling the data in 2014… 'Authorities may have offered dollar liquidity to yuan sellers in the market, so the yuan wouldn't depreciate too fast amid selling pressures,' said Li Liuyang, a financial market analyst at China Merchants Bank Co. The Chinese currency may face a lot more pressure if it easily breaks past the 6.95 per dollar level, Li said."

The U.S. dollar index gained 0.7% to 96.412 (up 4.7% y-t-d). For the week on the upside, the Brazilian real increased 2.0% and the Japanese yen gained 0.6%. For the week on the downside, the British pound declined 1.9%, the Norwegian krone 1.6%, the Swedish krona 1.6%, the New Zealand dollar 1.4%, the South African rand 1.3%, the euro 1.0%, the South African rand 0.9%, the Australian dollar 0.4%, the Mexican peso 0.4%, the Singapore dollar 0.2% and the Swiss franc 0.1%. The Chinese renminbi declined 0.21% versus the dollar this week (down 6.29% y-t-d).

Commodities Watch:

The Goldman Sachs Commodities Index declined 2.0% (up 5.1% y-t-d). Spot Gold increased 0.5% to $1,233 (down 5.4%). Silver gained 0.5% to $14.725 (down 14.1%). Crude fell $1.52 to $67.60 (up 12%). Gasoline sank 5.1% (up 1%), and Natural Gas declined 1.5% (up 8%). Copper fell 1.0% (down 17%). Wheat added 0.2% (up 18%). Corn increased 0.3% (up 5%).

Market Dislocation Watch:

October 24 - Financial Times (Isabelle Mateos y Lago): "The European Commission has rejected Italy's draft budget. Valdis Dombrovskis, the commission's vice-president responsible for the euro, said this week that Rome's arguments for increasing its fiscal deficit were 'not convincing'. The Italians had been warned. But the Five Star/League coalition government nevertheless decided to pursue a fiscal expansion instead of the adjustment prescribed by European rules. The budget aims for a fiscal deficit of 2.4% - not enormous in itself, but it is three times as large as the previous government's commitment… The bond market's reaction suggests concern, but not outright alarm. This may not last. The episode brings back memories of the confrontation that took place in 2015 between the freshly elected Greek government and European officials."

October 24 - Bloomberg (Joe Easton): "When the next downturn occurs, beware passive investors. That's the warning from JPMorgan…, which says $7.4 trillion of assets managed by passive funds around the world -- concentrated in large-cap and U.S. small- and mid-cap stocks -- will exacerbate a rout during the next recession. 'This is something worth noting at this late stage of a cycle given that passive investing seems to be trend following, with inflows pushing equities higher during bull markets, and outflows likely to magnify their fall during corrections,' analysts Eduardo Lecubarri and Nishchay Dayal wrote… Passive investing wasn't a big driver of equity returns in the last recession, they say. Back in 2007, the strategy's overall size amounted to about 26% of actively managed large and all-cap funds' assets under management (AUM) in the U.S., and about 15% outside of the U.S. Eleven years later, those figures have jumped to 83% and 53%..."

Trump Administration Watch:

October 23 - Bloomberg (Mike Dorning): "President Donald Trump stepped up his attacks on Federal Reserve Chairman Jerome Powell, saying he 'maybe' regrets appointing him and demurring when asked under what circumstances he would fire the central bank chief. Almost a year since nominating Powell to the post, Trump told the Wall Street Journal… that he was intentionally sending a direct message that he wanted lower interest rates, even as he acknowledged that the central bank is an independent entity. Trump said in the interview that Powell 'almost looks like he's happy raising interest rates' and that it's 'too early to tell, but maybe' he regrets appointing him."

October 23 - Financial Times (Ted Kemp and Joanna Tan): "President Donald Trump directly accused Federal Reserve Chairman Jerome Powell of endangering the U.S. economy by raising interest rates, according to The Wall Street Journal. 'I'm just saying this: I'm very unhappy with the Fed because Obama had zero interest rates,' Trump told the Journal… 'Every time we do something great, he raises the interest rates.'"

October 25 - Wall Street Journal (Bob Davis and Lingling Wei): "The U.S. is refusing to resume trade negotiations with China until Beijing comes up with a concrete proposal to address Washington's complaints about forced technology transfers and other economic issues, said officials on both sides… The impasse threatens to undermine a meeting between Presidents Trump and Xi Jinping scheduled for the end of November at the Group of 20 leaders summit… U.S. businesses have been counting on sufficient progress at the meeting for the Trump administration to suspend its plan to increase tariffs on $200 billion of Chinese imports to 25% on Jan. 1, from the current 10%. Such a move would be a blow to U.S. importers and consumers."

October 21 - Axios (Jonathan Swan): "President Trump has no intention of easing his tariffs on China, according to three sources with knowledge of his private conversations. Instead, these sources say he wants Chinese leaders to feel more pain from his tariffs - which he believes need more time to fully kick in. What we're hearing: 'He wants them to suffer more' from tariffs on $200 billion of Chinese goods, said a source with direct knowledge of Trump's thinking, and the president believes the longer his tariffs last, the more leverage he'll have."

October 23 - CNBC (Liz Moyer): "President Donald Trump will meet with China's president, Xi Jinping, next month at the G-20 summit in Buenos Aires, Argentina, according to Larry Kudlow… Kudlow told reporters… that the two leaders 'will meet for a bit' but didn't have other details. Any meeting between the two comes at a time of escalating tensions over trade. Most recently, the Trump administration put tariffs on some $200 billion of Chinese imports, and Beijing retaliated with tariffs on U.S. goods. The two nations have struggled to come to the negotiating table over trade, as the U.S. raises concerns about intellectual property and a widening trade deficit. 'Our asks are on the table, I'd love to see them respond,' Kudlow said… 'Thus far they haven't.'"

October 22 - Bloomberg: "U.S. President Donald Trump's top economic adviser accused China of refusing to engage on trade issues in a Financial Times interview, while a separate report said Trump believes it will take more time for tariffs to bite. 'We gave them a detailed list of asks, regarding technology for example, [which] basically hasn't changed for five or six months. The problem with the story is that they don't respond. Nothing. Nada,' National Economic Council Director Larry Kudlow told the Financial Times… 'It's really the president and the Chinese Communist party, they have to make a decision, and so far they have not, or they have made a decision not to do anything, nothing. I've never seen anything like it.'"

October 22 - Reuters (Jeff Mason): "U.S. President Donald Trump, speaking to reporters at the White House as he left on a campaign trip to Texas, said… his administration planned to produce a resolution within two weeks calling for a 10% tax cut for middle-income people. 'We're putting in a resolution sometime in the next week or week-and-a-half, two weeks… We're giving a middle-income tax reduction of about 10%. We're doing it now for middle-income people.'"

October 21 - Reuters (Lesley Wroughton): "U.S. Treasury Secretary Steven Mnuchin dismissed concerns that China's weakest economic growth since the global financial crisis could spill into other emerging markets and destabilize U.S. financial markets… 'I am not concerned about that destabilizing our markets,' Mnuchin said… 'Broadly, right now, I don't see a contagion risk,' he added."

Federal Reserve Watch:

October 24 - Bloomberg (Erik Wasson): "The chairman of the Senate Finance Committee stood by Federal Reserve Chairman Jerome Powell after President Donald Trump said he 'maybe' regrets appointing him because the Fed has increased interest rates. Asked whether Powell and the Fed are doing a good job, Senator Orrin Hatch said…:'I think so. I think they all are, to be honest with you. I don't agree with everything they do but they are still pretty good people.' Hatch of Utah… stood by the Fed's independence. 'They have a right to act the way they do,' Hatch said."

October 24 - Reuters (Kristen Haunss): "Regulators are concerned about a material loosening of terms and weaknesses in the risk management of the US$1.1trn US leveraged loan market, a Federal Reserve official said… Covenant-lite loans, incremental facilities and so-called addbacks to earnings before interest, tax, depreciation and amoritization (Ebitda) are three areas regulators are focusing their attention, according to… Todd Vermilyea, senior associate director at the Federal Reserve… 'The presence of these practices, especially without the appropriate controls, may lead to safety and soundness concerns,' he said. The leveraged loan market, which finances companies… has recently been flooded with aggressive deals featuring high debt levels and loose terms."

October 24 - Reuters (Jonathan Spicer): "A 'prolonged' fall in U.S. stock markets could eventually begin to weigh on the U.S. economy, though there are no signs of pinched credit or a pending recession so far, Cleveland Federal Reserve President Loretta Mester said… 'If there was a prolonged downturn in the market and a pullback in risk across the board with a lowering of credit extension, then of course you'll have' an effect on the data, Mester… told the Forecasters Club…"

October 23 - CNBC (Steve Matthews): "Federal Reserve Bank of Atlanta President Raphael Bostic said he supports further gradual interest rate hikes and warned that running the economy 'hot' with too much stimulus could end in a recession hurting lower-income Americans. 'Unless the data talk me out of it, I view a continued, gradual removal of policy accommodation as appropriate until we get to a neutral policy rate,' Bostic said... While there's uncertainty about neutral -- the level of rates that neither speed up nor slow down economic activity -- he said 'my assessment is that we are still a few rate hikes away.'"

October 23 - CNBC (Jeff Cox): "The risk of a powerful economy overheating is the reason the Fed should stick to its schedule of interest rate increases, Atlanta Federal Reserve President Raphael Bostic said… With the jobless rate running at 3.7% and considerably below what is considered full employment, the Fed has to weigh the risks of tightening too quickly and choking off what has been a robust economic run, and waiting too long and risking runaway price pressures. 'And while I wrestle with that choice, one thing seems clear: there is little reason to keep our foot on the gas pedal,' Bostic said…"

October 24 - Reuters (Ann Saphir): "The U.S. Federal Reserve should continue raising interest rates at least two but probably three more times before assessing whether further rate hikes to restrain growth are warranted, Dallas Federal Reserve Bank President Robert Kaplan said… 'My base case for 2019 is to gradually and patiently raise the federal funds rate into a range of 2.5 to 2.75% or, more likely, into a range of 2.75 to 3%,' Kaplan said…"

U.S. Bubble Watch:

October 23 - CNBC (Jeff Cox): "Former Federal Reserve Chairman Paul Volcker, who has reached legend status in the world of central banking, isn't optimistic about current conditions. When Volcker looks around now, he sees 'a hell of a mess in every direction,' including a lack of basic respect for government institutions, a current Fed that seems to be following a completely arbitrary benchmark and a 'swamp' in Washington run by plutocrats. 'At least the military still has all the respect. But I don't know, how can you run a democracy when nobody believes in the leadership of the country?'"

October 25 - Bloomberg (Jenny Leonard, Sarah Foster and Katia Dmitrieva): "The U.S. merchandise-trade deficit widened to a record in September while orders for business equipment declined for a second month, adding to signs that an escalating tariff war is starting to constrain economic growth. The gap in goods trade rose to $76 billion from $75.5 billion as gains in imports outpaced exports…"

October 25 - Wall Street Journal (Kate Davidson): "A stark pickup in government spending, particularly in defense, has helped fuel a broad acceleration in U.S. economic growth in the past year and a half, according to a Wall Street Journal analysis… The U.S. economy has expanded at a 2.9% annual rate since April of 2017… That growth rate is faster than the 2.2% annual growth rate between mid-2009-when the expansion started-and April 2017. Faster government spending accounted for nearly half of the acceleration, according to The Wall Street Journal analysis."

October 25 - Bloomberg (Lisa Lee, Jesse Hamilton, Sally Bakewell and Craig Torres): "In the Trump era, Wall Street banks have been testing the limits of what they can get away with in piling risky loans onto highly indebted companies. They may have finally crossed a line. A top Federal Reserve official fired a rare public warning Wednesday, saying that banks appear to be chasing increasingly dangerous deals and foregoing protections against borrowers going bust. 'There may be a material loosening of terms and weaknesses in risk management,' Todd Vermilyea, the Fed's head of risk surveillance and data, told bankers… 'Some institutions could be taking on risk without the appropriate mitigating controls.' The warnings come after watchdogs have spent most of the year expressing confidence about the health of the $1.3 trillion market for leveraged loans."

October 24 - Reuters (Jason Lange): "U.S. factories have raised their prices because of tariffs, although inflation has appeared modest or moderate in most parts of the country, the Federal Reserve said… The U.S. central bank also said in its latest 'Beige Book' report that the economy appeared to be growing modestly to moderately and that businesses across a number of industries had reported labor shortages."

October 24 - Reuters (Lucia Mutikani): "Sales of new U.S. single-family homes fell to a near two-year low in September and data for the prior three months was revised lower, the latest indications that rising mortgage rates and higher prices were undercutting the housing market. …New home sales dropped 5.5% to a seasonally adjusted annual rate of 553,000 units last month. That was the lowest level since December 2016. August's sales pace was revised down to 585,000 units from the previously reported 629,000 units."

October 24 - Reuters (Diana Olick): "Builders warned of a slowdown in home sales. And they were right - except the numbers are even worse than expected. Sales of newly built homes dropped 5.5% in September compared with August, and were 13% lower compared with a year ago, according to the U.S. Census. This was well below predictions, even with higher rates factored in."

October 23 - CNBC (David Randall): "The easy money may be over. U.S. company earnings growth is slowing after a bumper start to the year, and the reality of an escalating trade war between two of the world's largest economies is starting to weigh on companies ranging from Caterpillar Inc to Ford Motor Co. While earnings growth is still high at 22% so far this quarter, the amount by which S&P 500 index companies are beating analyst estimates is nearly half of what it was during the first quarter, according to Refinitiv data."

October 22 - Wall Street Journal (Rachel Louise Ensign): "There's less free money to go around for banks. After nearly three years of rate increases from the Federal Reserve, customers are pulling billions of dollars out of accounts that don't earn interest and putting their money into higher-yielding alternatives. That will crimp banks' ability to grow profits going forward. The four largest U.S. banks... reported a combined 5% drop in U.S. deposits that earn no interest in the third quarter compared with a year ago."

October 26 - Bloomberg (Romy Varghese): "The fiscal contrast between California Governor Jerry Brown and Gavin Newsom, the frontrunner to replace him, may best be shown through a decades-old program to fight blight. Facing a $25 billion budget deficit, Brown entered office in 2011 with a cost-cutting plan that included killing hundreds of redevelopment agencies. Eight years later, Newsom is poised to inherit an almost $9 billion surplus. One of his campaign planks: bring the agencies back. That kind of divergence is making bond investors in boom-and-bust California nervous. Newsom, a Democrat who is seen as coasting to victory over a Republican businessman, would have to balance campaign promises against the threat of a return to massive deficits."

China Watch:

October 22 - CNBC (Brian Schwartz): "Chinese government leaders have a message for American investors: They're not afraid of a trade war with the United States. On Monday in Beijing, Zhang Qingli, a leading member of a Chinese committee tasked with forging alliances with other nations, told a small group of U.S. business leaders, lobbyists and public relations executives that China refuses to be intimidated by an ongoing trade war with the Trump administration. 'China never wants a trade war with anybody, not to mention the U.S., who has been a long term strategic partner, but we also do not fear such a war,' Zhang… 'The U.S. side has disregarded a consensus with China after multiple rounds of consultations, insisting on waging a trade war against China and continuing to escalate it. In response, China is left with no other option but to make necessary counter actions,' Zhang said…"

October 21 - Bloomberg: "Chinese stocks jumped the most since March 2016 after top officials moved to shore up the economy and offer support to the struggling private sector. The Shanghai Composite Index surged 4.1% on Monday and extending Friday's 2.6% gain… President Xi Jinping vowed 'unwavering' support for non-state firms over the weekend, the country's stock exchanges committed to help manage share-pledge risks, and the government released a plan to cut personal income taxes. That follows a rare coordinated effort from top financial officials on Friday to support what's been the world's worst performing equity market."

October 24 - Wall Street Journal (Mike Bird): "Chinese stocks are widely used as collateral for loans. That introduces extra vulnerabilities to a falling market, so authorities are now attempting to contain the risks. Nearly 10% of shares in mainland China are used as collateral for loans by large shareholders. The practice has boomed even as margin lending, another form of share-backed borrowing, has decreased. Margin lending helped fuel a market selloff in 2015, as retail investors were forced to dump shares to cover their losses. 'Users of financial leverage in equities have shifted from retail investors in the 2015 episode to major shareholders in the form of stock-pledged loans,' Goldman Sachs analysts said…"

October 22 - Bloomberg: "China's central bank plans to give 10 billion yuan ($1.4bn) to China Bond Insurance Co. to provide credit support for debt sales by private enterprises, according to people familiar with the situation. The money is part of the plan the People's Bank of China announced… to support private firms issuing debt. The central bank didn't provide any details on how the plan would work, its size, or when it would begin. Officials also hadn't responded to multiple requests for comment. China's announcements… of fresh measures to ease the funding strains of private companies came after top officials commented repeatedly in an attempt to restore confidence in the world's second-largest economy. The central bank reiterated President Xi Jinping's vows to offer 'unwavering' support for the private sector, which has been most affected by the government's campaign to curb debt and cut shadow banking."

October 21 - Bloomberg (Connor Cislo): "As China braces for the full impact of President Donald Trump's trade war, it's seeking to learn from Japan's economic battles with the U.S. during the Reagan years. Chinese officials, business people and academics have been pressing Japanese counterparts to share experiences from the 1980s, when Tokyo found itself in Washington's crosshairs as its huge trade surplus and increasing industrial might sparked alarm in America. While there are differences between Japan's ascent as a commercial power a generation ago and China's emergence today as a potential superpower, Japan also has lessons for its neighbor in dealing with rising debt, asset-price bubbles and an aging population."

October 19 - Bloomberg: "China's home-price gains slowed in September, breaking a half-year streak of accelerating inflation in the housing market. New-home prices gained 1% from the previous month… That compared with a 1.5% increase in August. The Chinese government is likely to keep a tight grip on the property market at least until next year, despite a shift in policy focus from deleveraging to supporting slower growth under rising trade tensions, according to economists including Capital Economics… 'A market correction has started, as sales have undoubtedly cooled,' Yang Kewei, Shanghai-based research director at China Real Estate Information Corp., said... 'A bottleneck in residential purchasing power has been seen in some cities, especially those in second tiers.'"

October 21 - Bloomberg: "China's burst of local bond issuance is supposed to fund roads, affordable homes and other infrastructure developments that will help support its flagging economy. But there don't seem to be enough projects around to spend the money on. Provincial authorities had by the end of September already raised 92% of the 1.35 trillion yuan ($195bn) worth of special infrastructure bonds that the central government has targeted for the entire year. The bonds… are part of an attempt to counter the economic slowdown by financing projects from railwys to environmental facilities and affordable homes."

October 24 - Financial Times (Blake Schmidt and Frederik Balfour): "China Evergrande Group, the country's most indebted developer, has a lot more work to do as it tries to win over investors with plans to reduce leverage and diversify its business. One key concern as Evergrande's stock slides toward a 15-month low and its dollar bonds tumble: the company's continued reliance on China's shadow banking system. The… developer… cut its 671 billion yuan ($97bn) debt load by 8.4% in the first half… But the company has had less success reducing its exposure to high-cost trust financing: it accounted for about 45% of Evergrande's total borrowing at the end of June, the largest portion since at least 2010."

October 23 - Bloomberg: "Corporate debt investors navigating an expanding minefield of bond delinquencies in China are reaching for a hedging tool similar to credit-default swaps that was last used more than two years ago. Since September, China Bond Insurance Co. and Bank of Hangzhou Co. have sold four instruments called credit risk mitigation warrants, which insure creditors against defaults of the underlying debt. These risk hedging instruments are set to become increasingly popular as bond failures pile up, according to Golden Credit Rating International Co. Defaults have spiraled to a record 66.1 billion yuan ($9.5bn) this year as China's deleveraging campaign bites and economic headwinds batter investor confidence. That's made raising funds without resorting to credit protection tougher for some companies. Last week, the biggest state bank threw a lifeline to cash-strapped private firms by expanding a debt-to-equity swap program."

EM Watch:

October 26 - Bloomberg (Rachel Gamarski and Mario Sergio Lima): "The winner of Brazil's presidential election this Sunday will inherit a near-record stockpile of public debt. The Brazilian government's liabilities totaled 3.8 trillion reais ($1 trillion) in September, the Treasury reported… While that's down a notch from the previous month, it's still roughly twice what is was only 5 years ago."

October 26 - Bloomberg (Kartik Goyal): "India's foreign-exchange reserves are shrinking fast and may soon reach a level that could hamper the central bank's ability to defend the rupee, according to Bank of America Merrill Lynch… From a record $426 billion in mid-April, reserves have fallen by $32 billion as the Reserve Bank of India sold dollars to stem losses in Asia's worst-performing currency."

Central Bank Watch:

October 24 - Financial Times (Claire Jones): "The European Central Bank is facing serious challenges: rising tensions between Brussels and Rome, doubts about monetary policy and worries about Britain crashing out of the EU without a deal. A closely watched poll of purchasing managers… also showed that the region's businesses are struggling to come to terms with increased global trade tensions - and that the export-led slowdown is beginning to affect the much larger services sector… The ECB still insists it will halt its €2.5tn quantitative easing programme - which played a vital role in fuelling the eurozone recovery - by the end of the year. It argues that growth is still sufficiently strong and broad-based to forge ahead with its plans to phase out QE - the product of arduous negotiations within the ECB itself."

October 24 - Reuters (David Ljunggren and Steve Scherer): "The Bank of Canada… raised interest rates as expected and said it might speed up the pace of future hikes given the economy was running at almost full capacity and did not need any stimulus. The central bank, which has now lifted rates five times since July 2017, also hailed the signing of a new North American trade pact…"

October 24 - Bloomberg (Rupert Rowling): "Central banks are set to increase their purchases of gold in 2018 for the first time in five years as eastern European and Asian countries seek to diversify their reserves. Net purchases of gold by central banks are forecast to rise to 450 metric tons this year, up from 375 tons in 2017, according to consultancy Metals Focus Ltd. That will be the first increase since 2013, when banks boosted their holdings by 646 tons, the most for several decades."

Italy Watch:

October 23 - The Guardian (Daniel Boffey): "The European commission is at loggerheads with Rome after taking the unprecedented step of rejecting the Italian government's draft budget in a move designed to force the country's populist government to rein in its spending. Italy was presented with a three-week deadline to provide a revised financial plan… The commissioner, a former prime minister of Latvia, threatened to begin a procedure that could lead to the EU imposing fines on Italy unless the new government reconsiders. Dombrovskis accused Rome of 'openly and consciously going against commitments made'. 'Today, for the first time, the commission is obliged to request a euro area country to revise its draft budgetary plan… But we see no alternative … Breaking rules can be tempting on a first look. It can provide the illusion of breaking free. It can be tempting to try to cure debt with more debt. But, at some point, the debt weights too heavy and you end up having no freedom at all.'"

October 23 - Financial Times (Robert Smith): "Matteo Salvini, the leader of Italy's hard-right League party, has borrowed bond market language to create an ingenious new spin on the classic "enemies of the people" trope: the 'lords of the spread'. The spread in question is, of course, the difference between the yield on the Italian 10-year government bond and its German equivalent. This gap has soared to levels last seen half a decade ago as the budget stand-off between Rome and Brussels escalates. Italy's populist government has leapt on the bond market's obsession with this risk measure to conjure up images of shadowy and hostile external forces. With his talk of not bending to the will of the 'lords of the spread', Mr Salvini is invoking the image of faceless bond traders trying to break the government."

October 23 - Financial Times (Miles Johnson and Michael Peel): "Giuseppe Conte, Italy's prime minister, hailed Russia as a 'strategic partner' as he met Vladimir Putin in Moscow on Wednesday - the culmination of a month of diplomatic overtures by Rome's populist coalition, which has ramped up its pro-Russia rhetoric since taking power. In doing so, Italy is setting up a possible battle with fellow EU states around the bloc's painstakingly agreed rolling sanctions on Russia over its 2014 annexation of Crimea… Speaking to Italian business leader in Moscow before meeting Mr Putin, Mr Conte said Russia was a 'strategic partner'."

Europe Watch:

October 23 - CNBC (Tasos Vossos): "The days of quantitative easing in the euro area are long gone, according to signals from the region's $3 trillion corporate bond market. Investors are demanding ever-higher premiums for companies lower down the ratings spectrum over high-quality peers -- a turning point for a market long distorted by the European Central Bank juggernaut. The gap between triple B and single A spreads -- the lowest and second-lowest in the high-grade tier -- is now the widest since the start of the ECB's corporate bond purchase program…"

Global Bubble Watch:

October 24 - Reuters (Tom Miles): "The World Trade Organization is scrambling to develop a plan for the biggest reform in its 23-year history after U.S. President Donald Trump brought the world's top trade court to the brink of collapse by blocking appointments of its judges and threatening to pull the United States out of the organization. Trump's administration has targeted the WTO, the watchdog of global commerce, as part of his wider campaign against trade arrangements he contends have cost hundreds of thousands of U.S. jobs."

Japan Watch:

October 22 - Bloomberg (Issei Hazama): "It's an oddity of Japan's corporate bond market: many debt sales that bankers said were successful actually weren't. The secret may be getting harder to keep. Underwriters failed to fully sell at least 29% of company note offerings in September, twice the average over the past six months, according to information… based on more than 400 interviews with investors, underwriters and issuers."

Fixed Income Bubble Watch:

October 23 - Wall Street Journal (Daniel Kruger and Ira Iosebashvili): "Overseas investors, traders and central bankers are buying fewer Treasurys, a potential turning point for a $15 trillion market at the center of global finance and economics. Foreigners increased their holdings of Treasurys by $78 billion in the first eight months of 2018. That is just over half of what they bought during the same period last year and accounts for a much smaller share of Treasury issuance, as the government steps up the size of regular bond auctions to fill a growing U.S. budget gap. Foreign buyers now hold 41% of outstanding Treasury debt, their lowest share in 15 years, down from 50% as recently as 2013…"

October 24 - Wall Street Journal (Miriam Gottfried and Ryan Tracy): "Four years after a government crackdown on the leveraged-buyout market, risky loans are making a comeback-and few seem worried about it. Nearly 13% of LBOs in the first nine months of 2018 were financed with debt equating to at least seven times the target company's earnings before interest, taxes, depreciation and amortization, or Ebitda… That is more than double the level in all of last year and is on track to be the highest since 2014, when 13.5% of deals crossed that threshold and regulators began to crack down on leverage exceeding six times Ebitda. In another sign of growing risk, the amount of cash private-equity firms are putting into buyouts is falling. Their average equity contribution was 39.6% in the first nine months, also the lowest since 2014."

October 22 - Bloomberg (Misyrlena Egkolfopoulou and Claire Boston): "Netflix Inc. is once again turning to the junk-bond market to fund new programming as the streaming-video giant seeks to maintain its torrid subscriber growth. The $2 billion bond offering… comes just a week after the company reported a bigger jump in subscribers than Wall Street analysts expected. The bonds would push the cash-burning company's debt load above $10 billion for the first time. Netflix's market value has soared almost 70% this year to about $140 billion."

Leveraged Speculation Watch:

October 25 - Wall Street Journal (Rachael Levy): "Hedge funds tout their ability to do well during periods of market stress. But many aren't doing well during the current October rout. On Wednesday, a large group of hedge funds that bet for and against stocks had their worst day in almost seven years, according to… Goldman Sachs… The so-called fundamental long-short equity hedge funds tracked by Goldman dropped 1.44% on Wednesday… Goldman said it was the deepest one-day drop since the bank began tracking the data in January 2012. These funds are down 8.68% this month through Wednesday, bringing returns to minus-6.21% for the year, the report said."

Geopolitics Watch:

October 25 - Reuters (Ben Blanchard): "China's military will take action 'at any cost' to foil any attempt to separate the self-ruled island of Taiwan, which Beijing claims as its own, the country's defense minister said… China has been infuriated by recent U.S. sanctions on its military, one of a growing number of flashpoints in Sino-U.S. ties that include a bitter trade war, the issue of Taiwan, and China's increasingly muscular military posture in the South China Sea… 'The Taiwan issue is related to China's sovereignty and territorial integrity and touches upon China's core interests,' Chinese Defence Minister Wei Fenghe said…"

October 23 - Reuters (Ben Blanchard): "China's Foreign Ministry… said it has expressed deep concern to the United States after Washington sent two warships through the Taiwan Strait in the second such operation this year."

October 22 - Reuters (Adam Jourdan): "Chinese state media sharply criticized U.S. Secretary of State Mike Pompeo… after he made comments in Latin America warning about the hidden risks of seeking Chinese investment amid a growing battle for influence in the region… In an editorial…, the state-run China Daily newspaper said Pompeo's comments were 'ignorant and maliciou' and criticism that its ambitions Belt and Road infrastructure initiative was creating debt traps in other countries was false."

October 20 - Reuters (Jeff Mason, Idrees Ali, Polina Devitt and Michael Martina): "President Donald Trump said Washington would withdraw from a landmark Cold War-era treaty that eliminated nuclear missiles from Europe because Russia was violating the pact, triggering a warning of retaliatory measures from Moscow. The Intermediate-Range Nuclear Forces Treaty, negotiated by then-President Ronald Reagan and Soviet leader Mikhail Gorbachev in 1987, required elimination of short-range and intermediate-range nuclear and conventional missiles by both countries. 'Russia has not, unfortunately, honored the agreement so we're going to terminate the agreement and we're going to pull out,' Trump told reporters…"

Friday Afternoon Links

[Reuters] S&P 500 ends at lowest since May as tech, internet stocks tumble

[Reuters] Weak Amazon, Alphabet results ignite growth worries

[Reuters] Soothing words from Fed as rate hits ceiling for first time

[CNBC] Fed's Mester: Rate hikes are based on economic data not preconceived notions on where they should be

[Reuters] Turkey demands extradition of 18 Saudis in Khashoggi case

[FT] Draghi launches defence of central banks over political heat

[FT] No hiding place for investors in markets wobble