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Thursday, March 28, 2024

Markets Are Stirring: Complacency Meets Froth

Courtesy of ZeroHedge. View original post here.

Submitted by Tyler Durden.

Via Scotiabank’s Guy Haselmann,

Froth

Peering into the froth of a cappuccino, I noticed various sized bubbles. I guess there is a fine line between froth and bubbles. As I continued my gaze, both eventually disappeared. Stirring made the frothy bubbles disappear more quickly. Markets are beginning to stir (more later). Unsustainable states ultimately end.

Discussions about ‘froth’ are growing as financial asset price appreciations have surged with central bank stimulus programs; and now that the Fed is the first major central bank to contemplate ‘stimulus reduction’.

  • Froth-generating central banks do not have unlimited means to power markets forever (regardless of what they might say), and their efforts may even become counter-productive over time.

The best illustration of market ‘froth’ was outlined in yesterday’s Financial Times in an article by James Mackintosh (page 13) about China.  Before I quote him directly, a few facts are helpful.  The Shanghai index is up almost 100% year-over-year.   At the current pace, the number of Chinese IPO’s could set a record this year.  There are trading rules.  IPOs are only allowed to rise a maximum of 44% when floated.  Other stocks are only allowed to rise by a daily maximum of 10%.

Mr. Mackintosh writes that Beijing’s online video company Baofeng Technologies is “a leading example of the IPO excess”.  He writes that this IPO “jumped the maximum-allowed 44% a month ago when floated, and has risen by the daily-maximum of 10% every day since.  It has risen 17-fold in 26 trading days”. 

The FT article continues, “Every one of the 29 IPOs this month has risen by the daily limit each day since.  The worst performing IPO from earlier in the year has doubled in price”

This indiscriminate demand is reminiscent of the dotcom euphoria in 2000.  I remember many companies trading at several thousand times revenues.  A P/E could not be used for comparison, or determined, because many of those companies did not have any earnings.

Central Bank Hyperactivity

The Chinese IPO frenzy and enormous equity market gains since 2009 are the direct result of central bank uber-accommodative experimentation.  However, there is no ‘free lunch’. Whatever the benefits gained from the wealth effects of asset appreciation will have negative macro effects on the other side; when stimulus programs are withdrawn. This is one key reason why the FOMC is so fearful of raising rates despite being ‘close-enough’ to both of their dual mandates. Unfortunately, waiting longer only increases those risks. Trying to mitigate the negative macro impacts are one reason the Fed pounds the table about a slow and atypical hiking pace.

QE works by distorting financial markets and influencing investor behavior.  In this regard, it has been wildly successful. However, increases in recent market volatility might be a warning sign of QE’s limits.  Higher volatility is signaling one of a few possibilities, such as:  a looming hike from the most important central bank in the world (the Fed); a divergence in policy actions amongst the major central banks; additional global QE has become ineffective or counter-productive; or markets have recognized a change in the skew of their risk/reward determination after years of chasing central bank policy.

Central banks opportunistically create a perception of success, irrespective of the consequences or market direction resulting from them. Initially ECB QE was deemed successful, because the Euro weakened, yields fell and, and equities soared.  However, in the last two weeks success has been ballyhooed as markets reversed sharply.  Can both characterizations be accurate?  The former was viewed as a successful outcome due to the easing of financial conditions. The market reversal was also viewed as a successful outcome, since the reversal was explained as a rise in expectations for economic growth and inflation. 

  • Is ECB QE more or less successful if yields fall or rise?  Would a better measurement stick be the level of the Euro or the percentage change in equity markets?  Should the focus be on German indicators or those from the southern periphery countries? 

The ECB’s QE program ran into immediate denunciation on launch. The purchase program began when yields had already fallen dramatically.  Yields fell so far in fact, that several trillion of notional debt had dipped into negative yields. The fact that the program was sized to buy twice the amount of net issuance of the Eurozone had something to do with it.  The largest amount of purchases targeted Germany who, unlike the US, does not run a budget deficit (i.e. has a negative supply of net Bunds).

  • This design also created strains in ‘repo’ markets from collateral shortages, and caused abnormal capital flight from investors not willing to accept a negative yield.  Was this the main cause of the dramatic and sharp rise in yields or was it due to better than expected economic data?

The highly-anticipated ECB QE was announced on January 22.  The Euro and Bund moved that day from 1.16 to 1.12 and from 0.52% to 0.44%, respectively.  The 10-yr Bund moved to 0.36% the next day.  The Bund moved inside of 0.05%, but the yield soared back in the past 10 trading sessions, ironically, to 0.36%. Does that say anything about the ECB QE?   The Euro moved below 1.05 in April, but traded near 1.13 today.  The Dax returned 22.03% in Q1, but fell 4.28% in April.

Volatility

In percentage terms, a move from 0.05% to 0.36% is extraordinary and can wreak havoc on portfolios. Higher market volatilities should be expected and adjusted-for accordingly.  Volatility is likely to rise further and stay elevated for the balance of the year (particularly if/when the Fed begins ‘lift off’).

Commodities and EM currencies have also experienced some incredible price movements this year.  In April for example, Iron Ore fell to a six-year low and then rallied 25%.  It then fell 6%, a few days ago, after China changed a tax law.

Correlations have also broken down in the past few weeks, damaging CTA performance and causing wild price swings.  Their crowded positions in the trifecta of long dollars, long stocks, and long bonds, caused huge stop-losses to be triggered late in the month.  Poor market liquidity is exacerbating these flows.   Big losses in one area of a portfolio can often cause managers to take action in other seemingly unrelated areas.

Given such an extended period of time of market complacency resulting from aggressive central bank accommodation (which has chased investors into similar positions), positional unwinds probably have much farther to run. 

A strong employment number next Friday could provide such a catalyst as the market is forced to raise the odds of a June hike from its current 5% probability, to something much higher.  Markets will be cautious about such, since unemployment claims fell yesterday to a 15-year low and employment reports have consistently added over 200k jobs every month for over a year (except for a weather-distorted miss last month).

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