I’m on vacation. I decided to check the credit markets as a reprieve on a scorching hot Sunday afternoon when Outside was no longer an option. Here is what I observe:
Liquidity: On Friday, the BIS (Bank for Internation Settlements, the global bank for banks) published its quarterly global liquidity update, probably the most comprehensive lagging indicator (meaning once we read it, it’s too late) of whether we’re headed for more asset inflation or a liquidity reversal and thus credit crunch. The 31 July publication is of 31 March data, so like looking through a telescope at a star that shone eons ago. Still, we see that following the launch of the Iran War, global credit expanded substantially.
Cross-border bank claims were up $2.1 trillion, bank credit +12%. This reflects the largest quarterly expansion of global USD credit since the pandemic. Why? Middle East banks grabbed all the USD liquidity they could, not knowing what would come next in a war with Iran. Four-month-old BIS data signals no stress, everything fine here, just massively expanding liquidity as expected during wartime? All else equal, an Inflation signal, no credit crisis in sight.
Rates: The Fed appears to be a divided house. War is always inflationary, and dissent at the Open Market Committee indicates that some members are worried about where all this spending might end. Newly-installed Chairman Warsh managed to hold the line against raising rates despite inflation signals, but the committee was unconvinced, with three members voting against maintaining rates, an unusually sharp dissent. Markets fell, rates rose (30-yr UST c. 5.2% = red zone), Oil (WTI) up 21% for July (still 33% above pre-war levels, but again, I’m sure everything is fine). Prediction markets have 2/3 odds of a hike in Sept., but I expect politics will prevail (=no change). When forced to choose, and still able, debtor governments always chose inflation over higher borrowing costs, credit crisis and recession.
Japan: When the US Treasury starts to intervene in foreign currency markets, you know something bigger is afoot. With the Yen in freefall, the UST tapped the NY Fed to start selling dollars euros, to buy Yen in support of the Japanese central bank’s efforts to shore up its currency. Why? If Japan can’t find another way to support its currency, it will be forced to sell its stockpile of US Treasuries. Japan is the largest foreign holder of UST, and the scale of the operation would require a massive dump. This will pressure US rates further (i.e., yields rise), meaning that all of the borrowing the US Treasury has to do to fund the Iran War, the federal deficit, and refinance the existing $39 trillion (!) of national debt will be even more expensive than the $1.1 trillion in interest expense it costs the taxpayer to service it today. So Japan’s problem is now America’s problem.
Equity markets are still in an AI pipedream. The underlying technology and transformational benefit is most certainly real. But the investment bubble is tracing a familiar pattern, common to many periods of high innovation, whether railroads, automobiles, radio, or the internet. Innovators create, hopeful investors/speculators pile on, and fraudsters have a heyday. Cracks are starting to show. The most recent example, 25 year old Leopold Aschenbrenner’s Situational Awareness fund, a $20 billion AI giant, was just forced to liquidate all of its public securities … selling at a massive discount to Citadel, because its leveraged bets reversed spectacularly after several months of gains. This is the tip of the iceberg. While liquidity abounds, leverage on speculative investments remains high, and there are many more dominos that could fall in the coming weeks should sentiment suddenly shift. Buyer beware.