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The Global Credit Market Is Now A Lit Powderkeg

And markets are totally unprepared
Friday, June 26, 2015, 12:53 PM

The financial markets have had a bit of a tough time going anywhere this year.

The S&P 500 has been caught in a 6% trading band all year, capped on the upside by a 3% gain and on the downside by a 3% price loss. It has been a back-and-forth flurry while the stock market up to this point has simply marked time.

We’ve seen a bit of the same in the bond market: after rising 3.5% in the first month of the year, the ten year Treasury bond has given away its year-to-date gains and then some.

2015 stands in relative contrast to largely upward stock and bond market movement over the past three years.  What’s different this year and what are the risks to investment outcomes ahead?

Higher Interest Rates Ahead

As I have suggested in recent discussions, the probabilities are very high the US Federal Reserve will raise interest rates this year. Yes, Ms. Yellen intimated it may come later, but remember she also canceled her appearance at the Fed’s annual Jackson Hole soiree this year, a meeting that takes place just a bit before the September Fed FOMC meeting. I think the markets are attempting to “price in” the first interest rate increase in close to a decade.

Importantly, we're talking about the re-pricing of credit in the US financial system and economy broadly. We all know how important credit has been to underpinning the US economy for literally decades now. I believe this is a key part of the story of why markets are acting as they are in 2015. However, there are much larger longer term issues facing investors lurking well beyond the short term Fed interest rate increase to come: bond yields (interest rates) rest at generational lows and prices at generational highs – levels never seen before by investors.  Let’s set the stage a bit, because the origins of this secular issue reach back over three decades.

30 Years Of Lowering

It may seem hard to remember, but in September of 1981, the yield on the ten year US Treasury bond hit a monthly peak of 15.32%. At the time, Fed Chairman Paul Volcker was conquering long-simmering inflationary pressures in the US economy by hiking interest rates to levels no one alive had ever seen. 31 years later, in July of 2012, that same yield on 10 year Treasury bonds stood at 1.53%, a 90% decline in coupon yield, as Fed Chairman Bernanke was attempting to slay the perception of deflation with the lowest level of interest rates investors had ever experienced.

This 1981-to-present period encompasses one of the greatest bond bull markets in US history, and certainly over our lifetimes. Importantly, existing bond prices rise when interest rates fall, and vice versa. So from 1981 through the present, bond investors have been rewarded with coupon yield (ongoing cash flow) and rising prices (price appreciation via continually lower interest rates). Remember, this is what has already happened.

As always, what is most important to investors is not what happened yesterday, but rather what they believe will happen tomorrow.  Although this is not about to occur instantaneously, the longer term direction of interest rates globally has only one road to travel – up.  The key questions ultimately being, how fast and how high?  Why is this important?

We Have No Experience With Rising Rates

This is important for a number of reasons. 

First, since the late 1970’s, bond investments have been considered a “safe haven” destination for investors during periods of equity market and general economic turmoil.  In other words, the entirety of the career, if not more, of most investors today.  How many of today’s bond pro’s, let alone mom and pop investors, have experience navigating a bond bear market?  With all due humility I’d suggest the answer is little to none.  With interest rates at near generational lows and prices at near all-time highs, forward bond market price risk has never been higher in the experience of the investment community of today.  An asset class that has almost always been considered safe, is no longer, regardless of what happens to stock prices at any point in time.

We need to remember that so much of what has occurred in the current market cycle has been built on “confidence” in Central Bankers globally.  Central Bankers control very short term interest rates (think money market fund rates).  Yes, quantitative easing allowed these Central Banks to print money and buy longer maturity bonds, influencing longer term yields for a time.  That’s over for now in the US, although it is still occurring in Japan and Europe.  And cross border capital flows are more important than perhaps at any time in recent memory.

The New Era Of Central Bank Panic

So it's very important to note that over the last five months, we have witnessed the 10 year US Treasury yields move from 1.67% to 2.4%+, and the Fed never lifted a finger.

In Germany, the yield on a 10 year German Government Bund was roughly .05% a month ago.  As you may know, the interim high was a few ticks above 1%.  That’s a 20 fold increase in the ten year German Bund rate inside of a month’s time.  Now that’s a liquid market!  And you think this was lost on Central Bankers?

To the point, for a global market that has risen at least in part on the back of confidence in Central Bankers, this type of volatility we have seen in longer term global bond yields as of late implies investors may be concerned Central Bankers are starting to “lose control” of their respective bond markets. 

Put another way, investors may be starting to lose confidence in Central Bank policies being further supportive of bond investments. 

This is not a positive development in a cycle where this buildup of confidence has been such a meaningful support to financial asset prices in totality.  If the investment community ever came to believe, even for a short time, that Central Banks had lost control of their respective bond markets, well... you haven’t even seen volatility yet. 

As Go The Credit Markets, So Goes The World

Although the Street seems to agonize over equity valuations and recent price volatility, as I see it the real issue is the global bond market. Why?

Globally, the value of outstanding credit instruments is three times the total value of publicly traded equities. Just which do you imagine is more important to institutional investors?

As we think about the potential for global capital movements not only geographically, but also as movement among asset classes, all eyes should be on the global credit markets. So much capital is stored there that if it starts flowing out, and likely to the sidelines (i.e. safe havens), prices for everything are going to be impacted. And losses to today's most commonly-held financial securities could be absolutely tremendous.

In Part 2: What Awaits Us In The Future Of Higher Interest Rates we detail the long-forgotten aspects of life under higher interest rates. High prices, debt defaults, moribund markets -- remember the 1970s? -- the ghosts of the past are about to return. Joined this time, though, by the spectre of a collapse of the $700 trillion derivatives market -- which if it happens, will make the '70s look like the roaring '20s.

Click here to read Part 2 of this report (free executive summary, enrollment required for full access)

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4 Comments

Mark_BC's picture
Mark_BC
Status: Gold Member (Offline)
Joined: Apr 30 2010
Posts: 482
I don't understand why

I don't understand why central banks would lose control of the bond markets when they have a secretive electronic printing press that is still fully functional. They can do whatever they want and have already admitted to secretly manipulating / propping every market in the world, except of course precious metals, they'd NEVER do that.... lol

If rates want to go up then why can't they just HFT the markets or print up another trillion and inject it into bonds to send them back down? Who's going to stop them, or even know about it? They do everything secretly. Dave Kranzler responds that to prop up the long end they'd have to print up a ton of money, why is this so? I just don't understand it enough.

I agree that we're going to get higher rates, but I think not now, nothing significant. We'll get them in a new currency after we go through the wormhole, there is no way today's economy could handle significantly higher rates, I'm inclined to believe that the latest rise was some kind of a trick or setup or "stress test" antic put on by the bankers, or most likely a derivatives profit taking exercise backed by the printing press to keep things functional for a little while longer with higher rates. We know huge derivatives were triggered recently, so who were the parties that won? Are they not in the know ahead of time? Actually, are they not in control of rates as well? How did they prevent the system from imploding? Again, the electronic printing press. They just need a little time to buy up the world with their windfall profits while the currency still has value.

rlmrdl's picture
rlmrdl
Status: Member (Offline)
Joined: May 5 2008
Posts: 12
No argument that actual rates

No argument that actual rates have risen, but the vast majority of that rise appears to be the fall in value of the bonds themselves. As you say, what happens if investors lose faith in the control of the bond market by central banks? Where are these safe havens that will affect all prices? The definition of a safe haven is that it is NOT exposed to markets to be roiled by their volatility. 

Yellan cannot raise rates without crashing the equities markets and in any case, she cannot do so until there is some sign of at least some inflation that might mop up the higher rate, otherwise all she will do (aside from crashing equities) is extract more liquidity from a merket where there is precious little to start with. Velocity of money is at or below the great depression level, taking more out of the real economy will be suicidal - not that I am ruling it out.

The massive inflation caused by bank money printing over those 30 years, and especially in the first decade of the 21st century has yet to be worked out of the system. In fact more money as debt has been created since 2008 than before, so the process of inflation has continued in the face of falling prices for almost everything. The process has continued but the effect has failed because none of that money is in circulation to create general inflation. Raising rates in such an environment is absurd, again, not that I'm discounting absurdity, it seems to be the motive force of all economics for the last 20 years at least.

cmartenson's picture
cmartenson
Status: Diamond Member (Offline)
Joined: Jun 7 2007
Posts: 5731
Expect massive interventions

The Greek drama playing out right now will test the system and I fully expect that the central banks will be all over these markets beginning at 12:00:00:01 on Monday morning to limit volatility and prevent anything like reality from invading the financial "markets."

Is this absurd?  Of course it is.  Central banks should be strictly hands off of the markets, but we all know and expect them to be in there, sleeves rolled up, doing god's work, making sure the right things happen and the wrong things don't.

Stock futures should be bid relentlessly by 'somebody' as soon as practicable on Monday morning (again, very early) and don't be too surprised to see gold take a hit, and even for certain markets to be shuttered for a period of time if things don't 'go their way.'  This is just an extension of the observation that markets only seem to break with selling pressure, and never buying pressure.

We just got an email from Steen Jakobsen, the CIO of Saxo bank we've interviewed a few times and have mutual admiration for/with, where he says pretty much the same things:

I expect:

  • Markets to stay closed on Monday in Greece- 75% bank holidays / 25% capital control ……or both…
  • 25% probability of “late deal” if Germany loses its cool…….
  • Referendum will be Yes……as I think Greek population is too smart for Syriza. Syriza played for broke and will be broke. No plan is not a plan. Greece needs a “bureaucrat government” in the mold of Mario Monti in Italy to set up reform and an agenda which have broad political, business and greek voters support.
  • Greece will fail on payment to IMF – and the legal system will kick into overdrive, but remember this is “political soup” not a market based one…
  • ECB and EU will be ALL OVER MARKET on the open, floating market with excess liquidity and intervening and potentially even “forbidding” short-sales of stocks and cfd’s in high Beta stocks.

How very strange that we all now expect the same things from central banks...

At any rate, the market action on Monday will reveal a lot.  I don't expect the central banks to lose control at this early stage over something as small as Greece, but things are really stretched right now and you never quite know which pin will prick the bubble.  ​

However, someday they will, they have to , not because they will run out of money to print, but because the firmament of the ideas they are promoting will be finally revealed to/accepted by the masses as fraudulent.  

climber99's picture
climber99
Status: Silver Member (Offline)
Joined: Mar 12 2013
Posts: 183
I'll believe it when I see it.

I'll believe it when I see it.  Debt levels to GDP ratios need to come down significantly before treasury yields are allowed to go up. I guess the bond vigilantes or the market might take on the Fed but my bet is that they'll lose.  Likewise base central bank interest rates won't go up because the economy isn't strong enough and the public is over indebted.

Maybe, the more likely scenario is a equity and property crash (as a new reality sets in that we are in energy descent and permanent GDP decline),  followed by massive inflation plus massive austerity programs.  Only after the debt has been inflated away, defaulted on or possibly even forgiven do we get rising treasury yields and rising base interest rate again.

 

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