The Inflation Is in Junk Bonds
The following is part of Pivotal Events that was published for our subscribers May 22, 2014.
Signs Of The Times
"Bond buyers have never paid so little to lend to the riskiest junk-rated companies, yet they're gobbling up the debt at an accelerating rate."
- Bloomberg, May 6
"Investors hungry for high yielding bonds are turning to one of the riskiest corners of the US corporate debt market."
- Financial Times, May 9
"Continue to overweight high yield bonds."
- BCA [Bank Credit Analyst], May 13
"In the leveraged loan market, strength has returned, in part because buyers are using more leverage. We do not expect any downside from the trend in 2014."
- Barclays, May 16
"US industrial output posts biggest drop in more than 1-1/2 years"
- Reuters, May 15
"China's bad loans rose for the 10th straight quarter to the highest level in more than five years."
- Bloomberg, May 15
It seems that the best for the bull market that arose as the panic ended in the spring of 2009 is in. That bottom was accompanied by very bearish technical readings. Actually, numbers seen at cyclical bottoms. Spreads between high-grade and low-grade bonds were at panic "wides".
February-March recorded the maximum celebration of this bull market. This accomplished the most outstanding sentiment and momentum numbers since 2007.
We noted that these only register at cyclical peaks. Credit spreads have narrowed, exceptionally.
Leadership as provided by the NDX peaked in early March and on the slump into April took out key support. The rebound to last week was the key test of the high and is now rolling over.
This leadership burned itself out.
Noteworthy, is that the banks (BKX) also peaked in March and have been acting worse than the NDX since. New lows were set this week.
The action in the S&P continued to last week. Perhaps the shift from "growth" to "value" had some influence. The shift is typical of this stage of a stock market. Ross used it as an indicator.
Tuesday's decline was explained as weakness ahead of some Fed minutes. For us, it was that spreads (JNK:TLT) broke down as the Greek bond jumped in yield- last Thursday.
There was some relief until Monday when spreads were again weak and the Spanish bond accomplished new highs in yield.
The cyclical bottom in 2009 was accompanied by dismal technical readings and was followed by a cyclical bull market. It stands to reason the that cyclically bullish readings would be followed by a cyclical bear.
This melancholy condition is becoming evident this week and prompts the question "How bad will it be?".
We have long described conditions as the first business cycle and bull market out of a classic crash. Similar to the one that peaked in 1937, it was preceded and accompanied by massive policy intrusions. Zero short rates and lots of bond buying.
The other part of our position has been that economic and business numbers would be positive until the stock market peaked. As with the 2007 Bubble, the recession would start virtually with the bear market.
The old normal was that the stock market would lead the economy by some 12 months. That was the case with the Dot-Com Bubble of 2000. If the recession starts with the bear, then the trading community will not have to suffer economists going on about how good things are as the senior indexes decline.
Back to how bad?
The inflation in central bank credit is without precedent. This official speculation has been allowed because of the massive speculation by private investors. It is worth recalling that the Fed became aggressive with the Bear Stearns failure in June 2007. Then even more ambitious as the contraction became more evident in 2008. Extraordinary easing did not prevent a classic crash.
Unwitting taxpayers and witting speculators and investors sponsored the Fed's reckless adventure. And the latter groups have created a cyclical peak in both stock and bond markets.
Bear markets are always ugly, and the developing one will put policymakers in a very bad light.
The speech to the CMRE Spring Dinner includes the comment that the Fed was formed with the earnest belief that it would prevent the financial setbacks that initiate recessions. The next one will be number 19. Of course, this has not been good for the resume. But not preventing two Classic Bubbles and Crashes has been a real clanger.
We have noted that the decline in yield for the Spanish bond had generated four weeks of Downside Exhaustion readings. This has been our proxy for the general Euro bond market. And the action was extreme going into the time-window when reversals can happen.
The low was 2.84% on May 14th and key resistance was at 3.11%, which was taken out with the surge to 3.14% last week.
Also last week, in a rush to join the action, the Italian bond registered a Weekly Downside Exhaustion. The yield has plunged from 7.08% reached in the 2011 Panic to 2.90% on May 14th. The rebound reached 3.28%, taking out key resistance at 3.20%. The Greek bond set its best at 5.85% on April 8th and had fully reversed on May 16 at 6.86% yield.
The Spanish (our proxy for the sector), the Greek and Italian bonds represent different characteristics of the European Sovereign Debt Market. They all enjoyed outstanding and measurable dynamics going into the window when major reversals can happen.
The reversal has been accomplished and it will take some time to unwind the excesses.
Keep in mind that the action has had full government participation and that was the case going into a similar reversal in May-June of 1998 - the LTCM collapse.
This was mentioned last May and while most bond prices got whacked, spreads did not widen. Treasuries dropped with the market. The full five-year cycle had to run.
This time the excesses have been greater in lower-grades than in treasuries. On the latter our target of 136 to 138 has been reached, but the rise is not overbought on the Weekly.
As the above headlines indicate the action is mainly in the hands of highly-leveraged fund managers. Also there are stories that retail buying of junk funds has ended. But in recalling when the "odd-lotter" was a key technical measure in stock market research. The odd-lotter was a small trader and considered as uninformed. However, as we recall he did get the market right - at important tops.
Who knows if it is still applicable but it is fun to mention some of the old tools.
As credit conditions deteriorate we expect that the investment demand for gold will increase. This would likely be accompanied by silver underperforming gold, which is an indicator of developing trouble.
This was signaled when the gold/silver ratio rose through 66 in April. The high was 67.7 at the end of April and today it is at 66.6.
Our conclusion last week was that the developing rise in gold would again make the world safe for fundamental supply/demand research. The next phase of the post-bubble contraction may not be safe for fundamental research on silver.
Every long post-bubble contraction has moved the gold/silver ratio up. This Pivot is being written in NYC and the files are not handy, but on the contraction into the 1840s the ratio rose to around 35.
Then there was the great Silver Corner attempt by the Hunt Brothers that blew out in January 1980. The ratio declined to 16, which was considered its natural level.
On that post-commodity bubble financial disaster the ratio soared to a little over 100 in December 1990 when Citi and Chase Manhattan became insolvent.
With the 2000 Bubble it declined to 42 and it rose to 83 with the subsequent collapse.
In the 2007 Classic Bubble the ratio declined to 46 and increased to 93 with the bust.
The decline in the ratio with the 2011 blow-off in precious metals was the most sensational since January 1980. We noted that the action had become "dangerous".
Using history as a guide, the gold/silver ratio could increase to around 90 on the developing contraction.
Most gold and silver stocks could decline with global financial troubles.
High-Yield Default Rate
- BCA's advice on May 13 was "Continue to overweight high yield bonds".
- Yields and the default rate are close to a cyclical minimum.
- Hedge funds are long and leveraged.
- The move from terror and panic to bliss and confidence has taken four years.
Italian Bond Yield: Downside Capitulation
- This is the first such extreme reading in 10 years.
- Buying is compulsive.
- There are no concerns about adversity.
The Dreadful Sub-Prime Mortgage Bond
- The rally from a little less than 56 in February to 64.12 has been outstanding.
- The action had big momentum and is running out of steam.
- The high on this issue was 99.33, back in the halcyon days of the housing mania.
- The low was 23.10 (no typo) in 2009.
High Yield Spreads
- Note the reversal to widening spreads in May-June 2007.
- Our conclusions in June of that fateful year was that "The greatest train wreck in the history of credit" had started.
- Another run-a-way train is thundering down the track and is out of control.
- These have a tendency to be discovered in the May-June slot.