Good morning. We got lots of lively responses to our debate with Adam Tooze about China’s future. Several critical readers argued that sceptics on China’s unbalanced economic model (such as Unhedged) have been around for years, and have been proven incorrect year after year. This is wrong, though. Those who have predicted falling growth, spiralling debt, and financial crises in China have been proven right: those things are exactly what we have seen in the past few years, culminating with the Evergrande smash-up. And all of this is acknowledged by Chinese officials, for example in the readout from the Central Economic Work Conference. Unhedged’s sceptical view of Chinese growth is nothing more or less than the view that what is happening now will keep on happening.

Email me: robert.armstrong

Muni bonds

There are probably not that many multitrillion asset classes that Unhedged has not written a single word about. Indeed, municipal bonds may be the only one. Munis are considered rather staid, and their core appeal is the tax-protected yield, so why bother.

Well, about that. Here is a Bloomberg story from Wednesday:

The $4tn state and local-debt market just logged its most volatile 10-day period since the early 2020 sell-off, according to data compiled by Bloomberg. Benchmark yields rose as much as 11 basis points on Tuesday.

The rout came after Federal Reserve chair Jay Powell’s hawkish comments triggered a tumble in Treasuries as the central bank head seeks to tame the worst inflation in 40 years. Tuesday’s move pushed the muni market to a 5.47 per cent loss this year, poised for its worst quarter since 1994.

That does not sound very staid. Here is a chart of the performance of one of the big, broad muni exchange traded funds:

As we have argued before, the return to normal after the Covid-era mass anaesthetisation of fixed income was always going to be messy. It should not be confused with some sort of harbinger of a crisis to come. That said, some particular features of the muni market make it worth watching at this transitional moment.

Steven Grey, who runs Grey Value Management, laid out some of these features for me. Muni bonds are not particularly liquid, meaning mild selling pressure can move prices quickly. A majority of the bonds have implicit call options embedded, a form of complexity poorly understood by many of the safety-oriented investors in them. Risky junk-rated munis are a small but growing slice of the market. So are bonds supported by private and semi-private enterprises, and sponsored by governmental “conduit issuers”. Financial information about the municipalities and projects that back munis often becomes available only after a long lag and is hard to find.

Meredith Whitney loudly predicted in 2010 that muni bonds would be the kindling of the next financial crisis. “The Oracle of Wall Street” was wrong: muni bonds are more resilient than mortgage bonds, as it turns out. All the same, when fixed-income markets undergo rapid change, it is the supposedly sleepy forms of credit that bear watching.

I’m very keen to hear from readers who are active in the muni market who have thoughts on opportunities and risks.

A little more on banks, short rates, and monetary policy

On Wednesday I wrote about the idea that an inverted yield curve might not just signal, but might actually cause, coming recessions. The post was extremely nerdy, which may explain the fact that I got few responses to it. But if you think I’m going to let indifference from my readers discourage me, you’re wrong. This is a crucial topic for markets right now — a curve inversion looks like a solid possibility — so I’m going to keep nattering on about it.

Recall the causal argument:

• An inverted yield curve is when short-term interest rates are higher than long-term rates.

• Banks fund themselves at short rates and lend at long rates.

• An inverted curve means their funding costs are, at the margin, higher than their loan returns — meaning lending isn’t profitable.

• Therefore an inverted curve leads banks to make less loans.

• Less lending makes the economy slow down.

A well-known paper from 2010 gives theoretical and empirical support for this reasoning. But I don’t think any of this is true any more, mostly because since the great financial crisis, banks’ funding costs have been pinned near zero. The Federal Reserve cranking up short rates used to make banks less profitable; now it makes them more profitable. These days, a Fed-driven inverted curve won’t discourage lending, so we don’t need to worry as much about inversions.

I felt so clever about making this counterargument that I called up one of the authors of the 2010 paper, the economist Artruro Estrella, to gloat. But as it turns out, he has built on the original paper, using data for the decade after the financial crisis. And he and his co-authors found the correlations between inverted curves, bank profitability, and economic growth are even stronger than they originally thought.

What is going on? Estrella agreed that things had changed, but offered a possibility as to why his theory still holds. Higher short rates (everything less than one year) might now help bank profits. But there is still going to be a difference between the rates banks fund themselves at and the rate they lend at; call these short and very short rates. An inverted yield curve caused by an aggressive Fed may push these two short rates together, crimping marginal loan profits — even as higher short rates in general are good for banks.

That may make sense, but I remain sceptical of the causal story, especially because the most recent inversion of the curve, in 2019, looks so much like a false positive (the recession that followed was driven by Covid — not anything endogenous to the economy). But we may just have to wait and see if we invert and then get a recession, or not.

One good read

My colleague Ed Luce makes a frightening point: “The west is mistaking its own unity for a global consensus” on Russia’s attack on Ukraine. If you add up the countries that did not join the UN resolution condemning Vladimir Putin’s war, you get more than half the world’s population. The moral authority of the US-led liberal democratic block is quite limited.