What’s currently happening in markets makes little sense, to say the least, but lately, I received several interesting comments on my posts and articles that brought back memories of my time on the trading floor. One comment last week pointed at the usual practice (an open secret) between banks of cutting “gentlemen’s agreements” not to screw up each other’s positions when everyone is sitting on the same side of a massive trade gone sour.
Hopefully what I just said doesn’t come as a shock since we saw this dynamic surfacing not long ago when banks caught in the Archegos mess convened a secret conference call to discuss how to get out of those toxic positions with the minimum damage for everyone (“The last 72 hours of Archegos“). At that time, the regulator wasn’t involved, maybe that’s why the arrangement didn’t hold up too well with Goldman Sachs, Deutsche Bank, and Morgan Stanley breaking ranks and ultimately creating huge damage to Mizuho, Nomura, and Credit Suisse. This is the exact outcome of a “prisoner’s dilemma” equilibrium being broken, isn’t it?
The second interesting comment I got mentioned how such heavy Wall Street positioning for an upcoming 50bp rate cut might have a simple explanation: banks waiting for a big flush of liquidity in the markets in order to begin dumping all the JPY carry trade positions they already took over but didn’t unwind yet. Let me tell you why this comment, albeit simple, makes a lot of sense.
It’s no secret that banks (through their brokerage arms) have all been facilitating hundreds of billions of USD in JPY carry trades through the years in the same direction (borrowing JPY to invest mainly in foreign assets). As a consequence, now that all those positions are underwater, all these institutions find themselves holding billions of the same collateral concentrated in those stocks and assets the carry traders enjoyed leveraging into the most. Needless to say, all this collateral disorderly hitting the markets at the same time when most of the bids are artificially created by derivatives, wouldn’t take long to absorb all the real demand in the market and face a situation of oversupply that can quickly unfold in a swift loss of value due to lack of demand. Wait a second, wasn’t a disorderly unwinding of JPY carry trade positions exactly what happened between the 2nd and the 5th of August? Yes, it was.
In that circumstance, investors were caught completely wrong-footed and despite the biggest crash in Japanese stocks since 1987, paradoxically, no major financial institution apparently reported significant losses. If you believe in this, then you also believe unicorns exist, like JP Morgan analysts, but I trust you not to be in that group. How could stocks recover so fast? Thanks to a swift intervention from the BOJ, the GPIF, and large central banks led by the FED as I described in these two articles:
- HOW COULD JAPAN RECOVER SO FAST FROM THE WORST CRASH SINCE 1987? THANKS TO ITS GPIF “ANGEL”
- IF THE FED CUTS RATES, THE DAMAGES WILL BE FAR GREATER THAN THE BENEFITS
Clearly, Central Banks are actively involved in defending the stock bubble as long as they can, but this isn’t a surprise as we discussed before the latest FOMC and BOJ policy meetings held on the 31st of July (“FED AND BOJ WILL DO EVERYTHING THEY CAN THIS WEEK TO SAVE THE STOCKS BUBBLE ONCE AGAIN“). However, unfortunately for them, the big JPY carry trades forced unwinding couldn’t be undone and the JPY kept strengthening with the currency now trading below 140 against the USD despite all the efforts from the BOJ to stop its strengthening with billions of JPY printed out of thin air in the past month. Efforts supported by the Bank of England injections of more than 40 billion GBP into the markets via its short-term REPO open market operations. Why didn’t stocks sell off hard at the same time then? Because they haven’t been sold yet. What? Yes, let me help you understand.
If we put it all together, it all starts making sense. Stocks have been allowed to rally back up with the likes of the S&P500 currently a smidge from new all-time highs with the momentum trade finding little resistance due to the lack of selling in the markets. Yes, things started to become shaky two weeks ago after the US NFP with stocks recording the worst week in more than a year, but the situation was quickly reversed last week when, despite the US CPI print (that doesn’t give room to the FED for a rate cut, let’s be clear), traders resumed heavily betting for a 50bp FED rate cut this coming Wednesday, triggering a remarkable ramp in stocks that culminated with the best week in the past year. Why did traders resume betting for a 50bp FED rate cut despite the US CPI? Because despite the FED speakers’ blackout period, the FED allegedly leaked a “reassuring” message to traders, in great disrespect of market rules but who cares, through the WSJ (“The Fed’s Rate-Cut Dilemma: Start Big or Small?“).
All these swings should make many people dizzy and wary about markets, in particular when the current VIX level misrepresents the real volatility and risk of it, but as a matter of fact, no one cares because the FED message, in particular to banks, is clear: “we got your back”. Who cares if a FED rate cut right now wouldn’t make any sense at all and as a matter of fact will deliver more damage to the economy and financial markets than benefits (“IF THE FED CUTS RATES, THE DAMAGES WILL BE FAR GREATER THAN THE BENEFITS“), all that matters is for the FED to deliver another jolt of liquidity that can trigger another FOMO rally that lasts long enough for banks to dump their underwater JPY carry trade positions with limited losses.
Everything is awesome then? Not so fast, it depends on whether the FED or the BOJ also have a plan already in place to handle those troubled institutions that got brutally margin called in the last month and are no longer in a position to recover their losses despite the rally in yields and stocks simply because they got liquidated at much lower levels (and now those assets are with their brokers waiting for the right moment to dump them as we discussed). As the case of First Republic Bank made clear last year, central banks can keep a zombie bank alive by injecting liquidity into it. However, if this liquidity doesn’t become capital, hence the bank needs to repay it, central banks are simply delaying the moment when the insolvency becomes manifest and a public (or publicly sponsored) bailout remains the only rescue option available. Furthermore, banks cannot even borrow outright liquidity from central banks without posting collateral… except in Japan where in a great show of financial alchemy the BOJ first lends collateral to the banks for a fee and then allows them to use that collateral to borrow liquidity from the BOJ for its full amount. Although, again, being these facilities temporary, it ultimately doesn’t solve the capital deficiency at the very core of a troubled institution’s problems.
I made no mystery about Norinchukin being my number one suspect to be in trouble this time around since the bank is in such poor shape that only a public takeover can keep it standing in the long run (“NORINCHUKIN BANK CHAOS CAN TRIGGER AT ANY MOMENT“), but similar to the events of 2021 we might see another “Archegos” going belly up first before the fallout claims the life of another big financial institution like it happened to Credit Suisse. As a matter of fact, right now the market is behaving very similarly to what happened in 1998 when LTCM went bust and the FED cut rates to buy more time for the bubble to grow (“HOW LONG WILL THIS BUBBLE LAST? IT LOOKS LIKE TILL Q1-2025“). Personally, I don’t think the FED will have what it takes to do the right thing, that is not raise rates and send a powerful message to markets that the era of easy liquidity is over. Our dear Jerome Powell tried to do this in 2018 and we know how that went. Furthermore, today we are two months from the US presidential elections, rest assured that the FED won’t do anything intentionally to burst such a massive bubble and create gigantic chaos that reaches its peak right at the moment when voters are expected to choose their next US president. Nevertheless, there is a lot of brewing in this crazy market, some in plain sight some hidden, this is the reason why it’s better to be safe than sorry and make sure your portfolio is safe on high ground before the tsunami hits the shores (a matter of when not if).
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