WASHINGTON—The Trump administration proposed a wide-ranging rethink of the rules governing the U.S. financial sector in a report that makes scores of recommendations that have been on the banking industry’s wish list for years.
….If Mr. Trump’s regulatory appointees eventually implement them, the recommendations would neuter or pare back restrictions from the Obama administration, which argued the rules were necessary to guard against excessive risk taking and a repeat of the 2008 financial crisis.
Seems to me like the exact opposite of ‘draining the swamp’. The new administration proposes removing or limiting the rules intended to reduce risk-taking in the financial sector.
Falling wage rate growth suggests that we are headed for a period of low growth in employment and personal consumption.
The impact is already evident in the Retail sector.
The RBA would normally intervene to stimulate investment and employment but its hands are tied. Lowering interest rates would aggravate the housing bubble. Household debt is already precariously high in relation to disposable income.
Like Mister Micawber in David Copperfield, we are waiting in the hope that something turns up to rescue us from our predicament. It’s not a good situation to be in. If something bad turns up and the RBA is low on ammunition.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery. The blossom is blighted, the leaf is withered, the god of day goes down upon the dreary scene, and — and in short you are for ever floored….
~ Mr. Micawber in Charles Dickens’ David Copperfield
Copper rallied off long-term support at 5400. The reaction is secondary and breach of 5400 remains likely, signaling a primary down-trend.
Iron ore is consolidating in a narrow bearish pattern above support at 60. Breach seems likely and would signal another decline, with a target of 50*.
* Target: 60 – ( 70 – 60 ) = 50
Shanghai’s Composite Index rallied to test its new resistance level at 3100, after breach signaled a primary down-trend. Respect would confirm the decline, with a medium-term target of 2800*, but government intervention may bolster support. Recovery above 3100 would mean all bets are off for the present.
The big banks fell sharply on the week’s turmoil, with the ASX 300 Banks Index breaking support at 8500. Breach signals a primary trend reversal, offering a medium-term target of 8000*.
* Target: 8500 – ( 9000 – 8500 ) = 8000
Resources stocks rallied over the week. Expect strong resistance on the ASX 300 Metals & Mining index at 3000.
Iron ore continues in a bearish narrow consolidation above support at $60. Breach would offer a short-term target of $50*.
* Target: 60 – ( 70 – 60 ) = 50
These are ominous signs for the ASX 200 which is testing medium-term support at 5700. A sharp fall on Twiggs Money Flow flags strong selling pressure. Breach of primary support at 5600* would signal a reversal, offering a target of 5200*.
Markets fell sharply today. But before we look at the charts, let’s examine three fundamental measures of market stress.
A yield differential near zero indicates bank margins are being squeezed. Lending normally slows, leading to a recession. But the current yield differential of 1.45%, calculated by subtracting the yield on 3-month T-bills from the yield on 10-year Treasuries, is reasonably healthy.
The yield spread between the lowest investment grade corporate bonds (Baa) and 10-year Treasuries is a useful measure of market risk. The risk premium widens in times of uncertainty. Since 2016 the Baa spread has fallen by more than one percent, to 2.25%, indicating low market risk.
The above indications are supported by the St Louis Fed Financial Stress Index which is at a record low of -1.451 since its commencement in 1994.
The St Louis Fed Financial Stress Index measures the degree of financial stress in the markets and is constructed from 18 weekly data series: seven interest rate series, six yield spreads and five other indicators. Each of these variables captures some aspect of financial stress. Accordingly, as the level of financial stress in the economy changes, the data series are likely to move together.
The average value of the index, which begins in late 1993, is designed to be zero. Thus, zero is viewed as representing normal financial market conditions. Values below zero suggest below-average financial market stress, while values above zero suggest above-average financial market stress.
Real GDP growth dipped to 1.9% for the first quarter 2017, compared to 2.0% for Q4 2016. While growth is modest, hours worked by nonfarm employees improved to 1.55% in April 2017 from a low of 1.03% in February, suggesting that growth is likely to continue.
There is little sign of stress in financial markets other than the latest Trump turmoil.
Raising interest rates would increase mortgage stress and threaten stability of the banking system.
Lowering interest rates would aggravate the housing bubble, creating a bigger threat in years to come.
The underlying problem is record high household debt to income levels. Housing affordability is merely a symptom.
There are only two possible solutions:
Raise incomes; or
Reduce debt levels.
Both have negative consequences.
Raising incomes would primarily take place through higher inflation. This would generate more demand for debt to buy inflation-hedge assets, so would have to be linked to strong macroprudential (e.g. lower maximum LVRs for housing) to prevent this. A positive offshoot would be a weaker Dollar, strengthening local industry. The big negative would be the restrictive monetary policy needed to slow inflation when the job is done, with a likely recession.
Shrinking debt levels without raising interest rates is difficult but macroprudential policies would help. Also policies that penalize banks for offshore borrowings. The big negative would be falling housing prices as investors try to liquidate some of their investments and the consequent threat to banking stability. The slow-down in new construction would also threaten an economy-wide down-turn.
Of the two, I would favor the former option as having less risk. But there is a third option: wait in the hope that something will turn up. That is the line of least resistance and therefore the most likely course government will take.
….China’s commodity futures markets are the ‘canary in the coalmine’ for hints that the markets may be in for an even wilder ride.
Most WMPs [wealth management products] have a maturity between 1-4 months and managers of these WMPs need their Chinese retail investors to roll over by buying new WMPs. If this stops or slows, (which is happening now – see Bloomberg) it will result in assets being force-sold by fund managers to pay back expiring WMPs. The liquid assets that have boomed in recent months such as iron ore futures, will be, and have been, the first to be sold. Next to be sold will be shares, international assets and local property and local corporate bonds if there is still a functioning market for them.
Lars Christensen is one of the founding members of the Market Monetarism school of economic thought, having coined the term himself. Market Monetarists advocate that central banks target nominal GDP, instead of inflation, in order to achieve more responsive monetary policy and more stable economic growth.
While we, as well as the few bearish peers we have, have warned of a pending “credit event” in China for some time now – admittedly incorrectly (China has proved much more resilient than expected) – the more recent red flags are among the most profound we’ve seen in years – in short, we agree with fresh observations made by some of the world’s most famous iron ore bears. Thus, while it is nearly impossible to pinpoint exactly when the credit bubble will definitively pop in China, a number of recent events, in our view, suggest the threat level is currently at red/severe.
WHERE IS CHINA AT TODAY VS. WHERE THE US WAS AT AHEAD OF THE SUBPRIME CRISIS? At the peak of the US subprime bubble (before the failure of Bear Stearns in Mar. ‘08, and subsequently Lehman Brothers in Sep. ’08, troubles in the US credit system emerged as early as Feb. ’07), the asset/liability mismatch was 2% when compared to the total banking system. However, in China, currently, there is a massive duration mismatch in wealth management products (“WMPs”). And, at $4tn in total WMPs outstanding, the asset/liability mismatch in China is now above 10% – China’s entire banking system is ~$34tn, which is a scary scenario. In our view, this is a very important dynamic to track given it foretells where a country is at in the credit cycle.
WHAT ARE THE SIGNS WE ARE SEEING? In short, we see a number of signs that point to what could be the beginning of the “popping” of the credit bubble in China. More specifically: (1) interbank rates in China are spiking, meaning banks, increasingly, don’t trust each other – this is how any banking crisis begins (Exhibit 1), (2) China’s Minsheng Bank recently issued a ghost/fraudulent WMP (they raised $436mn in funds for a CDO-like asset that had no assets backing it [yes, you heard that right] – link), (2) Anbang, the Chinese conglomerate who has used WMP issuance as a means to buy a number of assets globally (including the Waldorf Astoria here in the US), is now having issues gaining approval for incremental asset purchases (link), suggesting global investors may be getting weary of the way in which Anbang has “beefed up” its balance sheet, (3) China’s top insurance regulator, Xiang Junbo, chairman of the China Insurance Regulatory Commission, is currently under investigation for “severe” disciplinary violations (link), implying some/many of the “shadow” forms of transacting in China could become a bit harder to maneuver (which would manifest itself in higher rates, which his exactly what we are seeing today), and (4) as would be expected from all of this, as was revealed overnight in China, bank WMP issuance crashed 15% m/m in April to 10,038 from 11,823 in March, a strong indicator that faith in these products is indeed waning.
Exhibit 1: Interbank Rates in China
Source: Bloomberg.
DOES CHINESE PRESIDENT XI JINPING HAVE ALL OF THIS UNDER CONTROL? In a word, increasingly, it seems the answer is no. What’s the evidence? Well, in March, interbank rates spiked WAY past the upper corridor of 3.45% to ~11% (Exhibit 2), a strong indicator that the PBoC is losing its ability to “maintain order”. And, admittedly, while there are levers the PBoC can pull, FX reserves are at scary low levels (discussed below), suggesting the PBoC is quickly running out of bullets. Furthermore, corporate bond issuance in China was negative in C1Q, which means M2 is going to be VERY hard to grow (when MO is negative); at risk of stating the obvious, without M2 growth in China, economic growth (i.e., GDP) will undoubtedly slow – this is not the current Consensus among market prognosticators who think things are quite rosy right now in China; yet, while global stock markets are soaring, the ChiNext Composite index is down -7.5% YTD vs. the Nasdaq Composite Index being up +12.8% YTD. In our view, given China’s importance to the global commodity backdrop, we see this as a key leading indicator (the folks on the ground in China are betting with their wallets, while global investors continue to place their hopes on: [a.] a reflationary tailwind that we do not believe is ever coming [China is now destocking], and [b.] hope that President Trump will deliver everything he’s promised [which, in this political environment, we see is virtually impossible]).
Exhibit 2: Overnight Reverse Repo Rate
Source: Bloomberg.
CHINA’S FOREIGN EXCHANGE (“FX”) RESERVES ARE DANGEROUSLY CLOSE TO LOW LEVELS THAT WILL LIKELY CAUSE AN INFLECTION LOWER IN THE CURRENCY. Based on a fine-tuning of its formula to calculate “reserve-adequacy” over the years, the International Monetary Funds’ (“IMF”) approach can be best summed up as follows: Minimum FX Reserves = 10% of Exports + 30% of Short-term FX Debt + 10% of M2 + 15% of Other Liabilities. Thus, for China, the equation is as follows: 10% * $2.2tn + 30% * $680bn + 10% * (RMB 139.3tn ÷ 6.6) + 15% * $1.0tn = $2.7tn of required minimum reserves. Furthermore, when considering China’s FX reserve balance was roughly $4tn just 2 years ago, we find it concerning that experts now peg China’s unofficial FX reserve balance somewhere in the $1.6-$1.7tn range. Why does this differ from China’s $3.0tn in reported FX reserves as of Feb. 2017? Well, according to our contacts, when adjusting for China’s investment in its own sovereign wealth fund (i.e., the CIC) of roughly $600bn, as well as bank injections from: (a) China Development Bank (“CDB”) of roughly $975bn, (b) The Export-Import Bank of China (“EXIM”) of roughly $30bn, (c) the Agricultural Development Bank of China (“ADBC”) of roughly $10bn, as well as capital commitments from, (d) the BRICs Bank of roughly $50bn, (e) the Asian Infrastructure Investment Bank (“AIIB”) of $50bn, (f) open short RMB forwards by agent banks of $300bn, (g) the China Africa Fund of roughly $50bn, and (h) Oil-Currency Swaps with Russia of roughly $50bn, the actual FX reserve balance in China is closer to $1.69tn (Exhibit 3).
Stated differently, based on the IMFs formula, sharply contrasting the Consensus view that China has years of reserves to burn through, China is already below the critical level of minimum reserve adequacy. However, using expert estimates that $1.0tn-$1.5tn in reserves is the “critical level”, and also considering that China is burning $25bn-$75bn in reserves each month, the point at which the country will no longer be able to support the renminbi via FX reserves appears to be a 2017 event. At that point, there would be considerable devaluation in China’s currency, sending a deflationary shock through the world’s commodity markets; in short, we feel this would be bad for the steel/iron ore stocks we cover, yet is being completely un-discounted in stocks today (no one ever expects this event to occur).
The early 2007 analogy is a good one. This is coming at some point in the next few years. I remain on guard but skeptical at this point given China does have other levers it can pull to keep the credit running and is indeed pulling them in fiscal policy. As well, the problem can always be made worse before it’s made better. Authorities are, after all, bringing this on.
It’s a fascinating question. Could China endure a “sudden stop” in credit if counter-party risk exploded, much like happened to Wall St in 2008? The usual analysis reckons that China’s publicly owned banks can always be ordered to lend more but what if they lose faith in each other? It’s probably true that Chinese authorities could still force feed credit into the economy but, equally, it’s difficult to see how an interbank crash in confidence would not slow the injection, at minimum via choked off-balance sheet vehicles like WMPs.
There is no doubt, at least, about what happens when it does arrive:
the final washout of commodity prices;
Australian house price crash;
multiple sovereign downgrades, and
an Aussie dollar at 40 cents or below.
It’s the great reset event for Australia’s bloated living standards. That is why we say to you get your money offshore today. We can help you do that when the MB Fund launches in the next month with 70% international allocation.
Comment from Colin:
I share Macrobusiness’ skepticism over the timing of a possible Chinese crash, especially because they have in the past shown a preparedness to kick the can down the road rather than address thorny issues – making their problems worse in the long run. But I do see China’s stability as a long-term threat to the global financial system which could precipitate a major down-turn on global stock markets.
The ASX 300 Metals & Mining Index has taken some encouragement from the rally, with support at 2850. But bear rallies are normally short in duration and reverse sharply.
The ASX 200 advance has slowed after the recent sell-off in the resources sector. But rising Twiggs Money Flow still signals buying pressure and another attempt at 6000 seems likely.
ASX 300 Banks, the largest sector in the broad index, is consolidating above its new support level at 9000. Declining Twiggs Money Flow warns of medium-term selling pressure. Reversal below 8900 is unlikely but would warn of a correction.
Bank exposure to residential mortgages is the Achilles heel of the Australian economy and APRA is likely to keep the pressure on banks to raise lending standards and increase capital reserves, which would lower return on equity.
