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Jon Kutsmeda

Cascading Chaos

 

“China, China, China.”

 

Chinese stocks listed in Hong Kong had their worst day (March 14th) since the global financial crisis (2009).

 

The Golden Dragon Index, which represents market performance of large and mid-cap securities in China is now cheaper than the S&P 500 for the first time since 2014, down 72% from its highs.

For perspective, the decline closely resembles the 78% decline by the US Nasdaq Index during the 2000 dot-com crash.

 

The selling accelerated in recent days – perhaps due to fears US would impose sanctions on China after reports they will (or are willing to) provide support to Russia.

The motivations of sellers may be less important at the moment, than the cascading affects it could have on global markets.

When volatility ramps up, it causes investors to run for the exits, and with buyers hesitant to catch the falling knife, sell-offs can be fast and fierce.

Anyone playing with leverage is most likely getting a margin call.

 

They either need to post more collateral or settle the trade and cover the losses, which often means they get liquidated.

This can have a domino effect on markets, like it did in 2020.

Most people were so pre-occupied with the C19 narrative in March 2020 that unless you were an active investor you had no idea how close to the end game markets were in March.

This speaks to the moral hazard I mentioned in yesterday’s blog post The Coda.

In 2020 The Fed rained down on markets with a firestorm of liquidity 5x greater than the bailouts in the 2009 crisis.

 

By the time shock and awe had started to subside come June, the Fed had unleashed a tsunami of stimulus on the capital markets, resulting in a V-shaped recovery in stocks and all-time record low mortgage rates (all-time high bond prices).

Consumers, not interested in the details of how or why this is happening, leaped into a home buying frenzy at a time when tenants could not be evicted and homes could not be foreclosed.

The scarce inventory led to a surge in home prices, fueled by low rates (all thanks to Fed Q.E.) and now here we are…

Today is the beginning of the two-day FOMC meeting, and on Wednesday it is expected that the Fed will raise the benchmark Fed Funds Rate.

NOTE: I want to remind everyone that an increase in the FFR does not mean an equivalent, or even mimicked, move higher in mortgage rates. Learn more by reading my report The TRUTH About Mortgage Rates.


Even for those assets which closely correlate to the FFR, the argument could be made that the upcoming announcement on Wednesday is mostly priced in already.

 

The Fed has hinted towards a March rate hike long enough that it is VERY unlikely there will be anyone surprised come Wednesday.

Therefore, the selling pressure today in the US bond market, which pushed mortgage bonds to levels not seen since the Spring of 2019, is less about Fed policy decisions and likely more about two things:


1) Liquidity issues

As I was alluding to with the Chinese stock declines, when volatility ramps up, and selling snowballs, somebody is getting washed out somewhere and will need to sell other more liquid assets to cover their positions.

There are very few markets as liquid as the US Bond Market (unless it is March 2020).

US Bonds are usually the safe haven during uncertain times, which would result in bond buying.

Unless volatility spreads so quickly that only the purest collateral (U.S. Treasury Bonds) will be accepted.

During this type of liquidity crisis even bonds get sold in order to cover positions.

I’m speculating here, but I’m not convinced that inflation is the only factor for the recent bond bloodbath, which leads us to #2.


2) Supply Driven Inflation

Bonds hate inflation.

Creditors are locked in a fixed rate of return, and inflation erodes the value of their principal.

The supply chain crisis that resulted from global lockdowns the last two years was already getting plenty of credit for parabolic moves in commodity prices and higher bond yields.

The war in Ukraine is further agitating supply chain woes, with Russia being a major supplier of energy (oil and gas) to the world and Ukraine a key exporter of food (wheat).

 

In addition, China is experiencing a new wave of the Corona virus (Omicron variant) and has imposed full lockdowns across the country including Shenzhen, a major port city that feeds exports to the world.

 



Much like the fog of war, the storylines unfolding real time in the trenches of the capital markets, are very different than the financial propaganda that fills our newsfeeds.

Sometimes the truth is right under our nose, other times it eludes us completely, and yet in both case we rarely, if ever, have all the information.

Likewise, things are more nuanced than what I just outlined above.



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