The Bond Bubble is still bursting
The benchmark US 30-yr Treasury yield reached its historic low just above 1% in March 2020. What a time to short them! Back then, stocks were finishing up their Corona Crash and the Fed was assumed to be pulling out all the stops to keep rates ‘lower for longer’. There was even talk about the Treasuries going negative as so many European sovereigns were.
So betting against that scenario was akin to madness on steroids (for conventional analysts). But it was the correct trade as bond yields started climbing.
This little example is just one of the many occasions where doing the obvious thing was a recipe for failure. – and going against the tide was extremely profitable.
And last week, the 30-yr reached 2.6% – an almost tripling in two years. And because of the peculiar relation ship between bond price and yields when rates are super-low, even small moves in yields down there translate into mammoth price moves (see below).
So why has it been widely described as a ‘bubble’? One reason is the gargantuan amount of debt issued (and bought) by sovereigns and corporates in recent years. Of course, the QE ‘experiment’ and ‘lower for longer’ policy of the Fed encouraged every man and his dog to take on debt as it was so freely available and cheap. Mortgage rates plumbed historic lows as house prices skyrocketed.
Here is an interesting bubble chart showing the accumulation of corporate US debt since 1990. It has risen by over eight times. Total US corporate debt now stands at $7 trn, which is about 30% of US GDP.
Of course, much of this debt has been used to produce earnings that has propelled stock indexes into record highs.
But with huge stress now appearing in fixed income as the Ukraine invasion and soaring commodity prices have focussed the minds of many equity investors, is the penny finally dropping that rising interest rates and bond yields combined with surging input costs now are actually not usually a formula for growing company profits – and ever-rising equities?
I have mentioned before of the busting of the Chinese real estate bond bubble (Evergrande and others) – and that deflationary impulse is starting to arrive Stateside.
There is little doubt that the severe Chinese bond stress is impacting equity markets with the China A50 index down about a third off its February 2021 ATH.
I rarely cover the Germany 40 Index, but I believe it is time I did as it is one of the most heavily traded stock indexes today – and the patterns are revealing!
In 2021, the index moved higher and every dip to the critical 15,000 region was met by solid support (three left arrows). The ATH was made in November at 16,300 and was matched by the high in early January making those two highs a potential Double Top pattern.
But on 21 February, the index broke hard below that shelf of support and instantly tiened that line into a line of resistance. In that moment, any rallies would be expected to be turned around after kissing that very critical line.
And that is precisely what occurred on Tuesday when it bounced off the 15,000 area – and on a strong momentum divergence.
I am now able to place very confident Elliott wave labels on the whole pattern off the ATH. We are starting a wave 5 of 3 down – and only an unlikely strong push above 15,000 in the near term would send me back to the drawing board.
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Are we in an inflationary or a deflationary world?
I have just alluded to the deflationary impulse of rising bond yields. Heavily indebted companies are being exposed to rising debt loads with obvious implications for operating profits – and in some cases, their solvency (to come).
Some may view this as in contradiction to the headline ‘inflation story’ we see all around us. But many confuse price inflation with the most basic concept in financial inflation. That is, a reduction in the amount of credit in the economy is deflationary (and vice versa) and that can be associated with either rising or falling input/output prices.
If the first chart above is to believed, we are witnessing a tailing over of o/s corporate debt – and that is deflationary.
And as short term interest rates rise, pressure is growing on household finances who usually carry much debt. And with the cost of living squeeze, a Double Whammy on disposable incomes is upon us all of a sudden. Spending cut-backs by consumers seem assured.
Already, the heady forecasts for 2022 GDP seen last year are being scaled back.
Where has the negative debt gone?
At the height of the madness in buyers scooping up debt that actually guaranteed a capital loss if held to maturity, it is estimated there was about $18 trn in negative yielding debt out there. Latest data reveals that has dropped to less than $2 trn in a year. That’s another aspect of the deflationary impulse sweeping the world.
Back then, rising interest rates seemed very far away as the herd believed the Fed could keep rates even lower for longer. But, as always, something came out of left field (Ukraine) to disrupt that story by introducing price inflation – and a sharp re-evaluation.
While it was not issued at a negative yield, the famous Austria 100-year AA-rated sovereign bond shows the huge impact small changes in rates have on duration risk (the sensitivity of price to changes in yield). They have lost 55%of face value to date. Ouch!
That is on a par with many Chinese real estate bonds (with one I see down 80% off par).
I have a feeling the next earnings season will see downgrades and with the problems in the bond market getting wider prominence, pressure will grow on equities as they enter another strong leg down.