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Bond Market Strength Forged in the Fires of Adversity


Contrary to the consensus belief, we may actually be in the early innings of the capacity liquidation adjustment process.

Last week investors were provided a wake-up call regarding the effects of currency volatility risk lurking beneath the surface of equity and bond markets. Since the beginning of the year I have warned that the insane volatility would eventually find its way into US markets, and Monday (Feb. 25) we got our first taste test of what this looks like. On January 22, my article Are We Witnessing a Tectonic Shift in Which Central Bank Policy Dominates Asset Prices and Risk Premiums? pointing to the parabolic moves in EURJPY and THBJPY, I concluded:

The FX market is very deep and liquid. This kind of volatility is significant, and if it continues, it's only a matter of time until it finds its way into the US capital markets.... It's not US economic and earnings growth that will derail this rally in risk. Like in 2008 and in 1998, it's a systemic second or third derivative event that the market cannot discount.

Then on February 11 in Bank of Japan Meeting: The St. Valentine's Day Massacre I analyzed how the yen reflation trade was affecting the bond market, and more specifically, how the 143-00 level in US bond futures that I have been monitoring would come into play:

As you can see on the 10-day tick chart during the following two weeks the US bond futures is clearly "vibrating" 143-00 and has repeatedly tested this level only to turn higher. If the BOJ can't take out 143-00 next week the bond market could be setting up for a big rally as it appears all the yen reflation trade selling has been absorbed.

Then last week in Bernanke's Date With Deflationary Destiny I noted that the long end had taken its hits but that support was holding despite equity prices that looked to make new highs.

You wouldn't know by the price action in stocks, but if you look under the hood, all is not well. This is not a surprise though; equity investors are usually last to get the memo. Usually the first to get the memo are bond investors, and despite insanity in currency and equity markets that has driven attempts to take out 2.00% in the 10-year and my critical 143-00 level in the US bond futures contract, the bond market remains bid. Don't get me wrong. I will respect a failure of these two levels, but if the market makes this area support as fundamentals continue to deteriorate we could see a significant rally as Bernanke's date with deflationary destiny becomes a reality.

US Bond Futures Tick Chart

Click to enlarge

On Monday the market gave us the move I had been anticipating as bond prices rocketed higher with yen currency pairs seeing a massive short squeeze. The EURJPY dropped 5% in a matter of hours and USDJPY lost 3.45%. Stocks briefly melted from the lunchtime highs to lows of the day with the Russell 2000 (INDEXRUSSELL:RUT) losing 2.4% with the S&P 500 (INDEXSP:.INX) seeing similar damage. Though the subsequent swings were large and intense, the equity indices mostly recovered ending the week basically unchanged.

The media focused on the events surrounding the chaotic Italian election and corresponding impact on the euro, but in my mind the catalyst was irrelevant. The takeaway from Monday is that when markets are subject to currency volatility they can turn on a dime and the move can be swift. It would be naïve to think this was an aberration, so investors need to be cognizant of the impact of further yen-based volatility. I will be sticking with the playbook looking to the bond market for guidance.

You may be getting tired of my constant attention to the 143-00 level in US bond futures (March) but hopefully now you are starting to see why it's important. This exercise is the essence of ex ante analysis. On December 28, 2012 in A 2013 Bond Market Prognostication: Why a Breakout Appears Likely, the target was identified due to historical significance and because I believed this level would be the crossroads where the bond market bull/bear battle would be waged. By the end of January the target was met and the idea was that it would see intense consolidation providing a make or break level for the bond market. Then on February 19 in Bond Market Convexity: Objects in Mirror Are Closer Than They Appear I began to tighten up the analysis:

Clearly the market has recognized the 143-00 pivot as the consolidation is in its third consecutive week and there's no doubt that a bull/bear battle is underway as participants jockey for positioning. The key factor for me in determining who wins this battle is whether economic growth and the demand for credit is increasing, or whether recent optimism is simply a function of rising stock prices on the back of a depreciating yen.

When analyzing price action, I believe that you should derive more significance for how markets handle information that is adverse to the trend rather than favorable. For instance, it's easy for markets to perform when the data is bullish but what's more important is how markets perform when the data is bearish.

This rally in equity markets has had plenty of favorable conditions to ride to new highs, including better-than-expected earnings, strengthening economic data, highly accommodative reflationary central bank policy, and not to mention fast money chasing performance. On the flip side the bond market has been given every opportunity to push yields higher, not only contending with the equity bullish data, but also increased pressure coming from the tapering debate, Fed exit talk, as well as more specific market dynamics such as MBS convexity selling that I have been addressing in recent weeks. With bonds holding their gains in the face of a full recovery in equity markets, the bond market strength is even more impressive.

US Bond Futures - Weekly

Click to enlarge

The 143-00 level wasn't a guess; it was forged by the fires in 2008 and 2011. Back-testing this area was not a coincidence and the market is telling you this level is real. In last week's rally price stopped where you would expect it to find resistance at the first standard deviation of the regression line but if we are indeed making 143-00 support the rally could take us to at least back to 150-00 and new highs are likely. At this low level of interest rates a move of this nature has dire economic implications.

Investors are trying to rationalize why the bond market remains bid and what it means for the economy. This is a natural progression in the analysis. When the Fed initially launched QE I myself was bearish as I saw the attempts to weaken the dollar in order to reflate assets as very bearish for bond prices as the coupon was under assault to negate its real return. However after 4 years of unprecedented monetary stimulus not only is there no evidence the economy is being stimulated but these reflationary metrics are now seemingly deteriorating as the diminishing QE return is kicking in. At this point you have respect price and holding my critical 143-00 level is key.

One bond trader who obviously gets it and is doing a really good job of rationalizing the situation is Kevin Ferry of Cronus Futures Management. Monday on the contrariancorner blog Kevin argues that the US economic situation has received a misdiagnosis. It's not the assumed liquidity trap that ails us which is being fought with reflation remedies but rather a structural trap that requires a different treatment.

Structurally Trapped economies exhibit similar symptoms but the vast majority of monetary easing is directed at debt support from the prior cycle and political "reform" is timid and tilted toward inefficient industries. The primary beneficiaries of US stimulus were the banks and the auto industry. When the financial system absorbs the principle amount of CB ease, the Structural Trap calcifies in the political arena.

The treatment of a Structural Trap can come in two forms and we advocate a blend. 1) Radical governmental reform at the tax and subsidy level coupled with capacity liquidation. 2) An increasing nominal interest rate term structure.

Reading Kevin you might conclude he is speaking in tongues as his words often transcend consciousness. I am still not sure I completely grasp what he is getting at but nevertheless his concept of a structural trap and the need for capacity liquidation got me thinking about where we sit today in this post crisis process and the consequences for what it will take to come out the other side.

The consensus among just about everyone with an opinion is that we are still suffering from the back-to-back bubbles in technology and then real estate. I think this is extremely shortsighted. The one common denominator behind both bubbles was what I have referred to as the era of easy money that began when Greenspan bailed out Long Term Capital Management in 1998. The era of easy money didn't foster bubbles in tech and real estate, it ignited a bubble in the supply of credit capacity in the banking and so-called shadow banking system.

Since the end of WWII total credit in the banking system (loans + securities) averaged around 45% of nominal GDP (NGDP). However in 1998 credit growth began to expand above this long term average at a rate that far exceeded NGDP growth and by 2008 the ratio of banking credit to NGDP had reached 65%. This relationship is statistically off the charts.

Total Bank Credit NGDP Vs. Marshallian K

Click to enlarge

Marshallian K, named for economist Alfred Marshall, is a measure of excess liquidity in the economy by plotting M2 vs.Nominal GDP (essentially the inverse of velocity). When Marshallian K falls, money demand exceeds supply; when it rises, money supply exceeds demand.

Throughout the '70s, '80s and '90s, when the total credit in the banking sector was within the 45% historical average, Marshallian K generally was in a downward trajectory. You can see that in the late '90s as banking credit began to rise relative to NGDP, so too did Marshallian K, suggesting this credit supply was exceeding demand. I overlaid the yield curve (5s/10s) because the slope of the curve is a manifestation of the inflation discount; this is a product of excess liquidity in the system clearly showing a widening trend (higher inflation discount), acting as a coincident indicator as excess liquidity expanded.

In my interpretation, part of the structural trap that must be remedied is in the banking system because there is simply too much credit capacity to meet credit demand. This credit capacity must be liquidated before the economy can experience sustainable organic growth, and that process will not be pleasant.

In my opinion, the financial crisis was the market's solution to the necessary adjustment of liquidating credit capacity in the banking system, but the Federal Reserve and US government stepped in to prevent it from happening all at once. They have been successful in stemming the severity of the capacity liquidation, but the adjustment must still occur in order to return the supply and demand for credit to equilibrium.

Since the financial crisis, total credit as a ratio of NGDP has eased somewhat but still remains near recent peaks. This is not because banks are creating credit by expanding lending, but rather the increase has come in the form of increased securities holdings. As total loan credit has fallen as a ratio to NGDP from 50% to 45%, total securities credit has continued to rise, pushing total credit at the end of 2012 to just under $10 trillion equal to 63% of NGDP.

Perhaps the bond market is trying to force the credit adjustment through the back door. Banks have no loan demand and continue to purchase securities with meager returns. Eventually bond yields will fall to a level where they are no longer economical to hold. Once we reach that level (and we aren't far) if the banking system has no credit demand they will be forced to kick out the deposits and shrink the balance sheet. It seems this is the inevitable end game. The banking system must contract until the supply of credit meets the demand.

For total credit to return to its historical mean of 45% of NGDP, it would require a substantial contraction in the US banking system which would put considerable pressure on economic activity. Based on the current $15.8 trillion level of NGDP, you would be looking at total bank credit at $7.11 trillion vs. today's level of $9.98 trillion, representing a contraction in credit of $2.87 trillion equal to 18% of NGDP. It's safe to say that for an economy based on fractional reserve banking, that kind of credit contraction will have a significant impact on economic growth.

With NGDP already growing at a tepid 3.5% annual rate, even if you spread the credit contraction over a decade you would still potentially be looking at nominal growth below 2.0%. This would ironically bring the 10-year yield NGDP spread I discussed last week back in-line with the historical mean. Now all of the sudden the 2.0% 10-year doesn't look so rich. With the US bond futures contract holding the critical 143-00 level in the fires of adversity, maybe the bond market strength is trying to tell us something. Contrary to the consensus belief, we may actually be in the early innings of the capacity liquidation adjustment process. As scary as this may sound, it's conceivable that the big bubble hasn't even imploded yet.

Twitter: @exantefactor
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