Debt Opportunities

-the trade of a lifetime

Topics: the big risk to markets and the economy is in corporate debt. What does it mean for stock prices and gold?

Discussion: the recession is in effect already here (employment, bank stocks, yield curve etc). A recession would trigger an avalanche of downgrades among corporate bonds, effectively neutering the only active buyer of stocks, thus causing stocks to crash back toward their fundamental value.

Why now: The IOER rising above the Fed Funds rate signals a hoarding of dollars, meaning banks are seeing something ugly at the horizon and thus don’t trust each other. It’s a very clear sign of danger when the Federal Reserve loses control of the price of money (The Fed has one job, and that’s it)

Implications: Gold is going to crash upward (possibly after a short term dip, but why would you ever try to time such a thing?); bitcoin could show a similar pattern. USD should spike in the short term, and just might hold its ground after that. US treasuries (stronger dollar, rate cuts, more QE) should be the preferred trade for all who just won’t buy gold, but over time there’s bound to be leakage from bonds to gold as it’s clear massive monetization of debt is the US’s only way forward.

Possibly, there will be a “re-set” of sorts, changing the price of gold overnight in a new global monetary accord. When the dust settles, junk bonds could be the trade of a lifetime (sell your gold and buy bombed out corp debt at cents on the dollar), but don’t go catching that particular knife too soon.

Key assumptions: Recession signals (bank stocks, emplyment revisions, yield curve) are for real. Four times as much near-junk debt as ahead of 2008 is a relevant risk. There is no buyer of last resort for stocks when a corp debt freeze halts stock buybacks. Central banks will pull out all the stops and investors will seek refuge in first US treasuries and then gold. The IOER/FF situation says the timing is pretty soon.

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What’s not to like?

So, the central banks are turning dovish again and stock markets are reacting favorably. What’s not to like? Money printing in the face of a weakening economy has worked (=increasing stock prices) like a charm for a decade now.

Well, the problem is that the US is finally losing its control over the price of money. What’s happened is that US banks are hoarding cash, and are using the “Excess Reserves” possibility to park their currency overnight, despite there being an arbitrage opportunity in placing it in the Fed Funds system at a higher rate instead.

Banks ignoring risk free arbitrage means they aren’t trusting each other. Hence, they must be seeing something very dark at the horizon, if they are willing to decline a perfectly good arbitrage. The Fed Funds system is supposed to be risk free, and yet the banks won’t take IOER money and place at the FF rate.

Too few dollars, due to QT, budget deficits and less international demand for treasuries

The root of the problem is a lack of USD due to the large and increasing US budget deficit, while there’s been less demand for treasuries among foreign buyers (not least China which has actively sold some of its dollar reserves). The US Fed might soon need to pick up the slack in treasury demand, by more quantitative easing, but that would definitely signal a loss of control, so the Fed will most likely hold off from QE as long as it can – on a hope and a prayer.

The SX7E is broken

European banks have issued a lot of dollars, and they’re being pressured by both the negative yield curve and the stronger dollar. The problems are evident not least in Deutsche Bank’s woes and crushed share price. But UBS, SocGen, BBVA and many more aren’t far behind. The European bank index looks almost completely broken, and if it were to fall just slightly more, technically it looks like it’s going to zero (as Raoul Pal says in his excellent piece on Real Vision).

European bank investors apparently are sniffing something out, and the banks themselves are hoarding as much cash as they can, to create a buffer for whatever iceberg is coming up ahead. Hoarding dollars by one bank means less over for the others, which creates a bidding war for dollars pushing the exchange rate upward, making dollar debts increasingly expensive. The hoarding of dollars among those that can hoard thus makes matters even worse for those that can’t.

A dollar spike could trigger a bank crisis

One possible “resolution” is through a quick dollar spike that breaks the weakest link in the European bank chain. One bank is likely to pull the others with it as falling dominos (just like in the 2008-2013 period of recurring bank rescues)

The low yield for US 10 year treasuries as well as the German 10 year Bund spells doom for bank profitability, and the resulting negative yield curve signal recession. European banks (and to some extent even the US BKX index) are acting accordingly and showing extreme weakness over all time horizons.

Negotiator In Chief at the helm of the ECB is a harbinger of doom

In an interesting turn of events, the former lawyer and head of the IMF, Christine Lagarde, the woman who’s made more for the sunscreen business than any other human alive, has been appointed the next quiet assassin of the nation state, i.e., head of the ECB. Her background is as if bespoke for negotiating wide-ranging bank bailouts, capital control, new regulation, tighter EU bank integration and so on.

It’s almost as if the powers that be for once know what they’re doing ahead of time. Well, they should, they caused it, and they’ve had more than a decade to think about it.

…and here comes the crisis, and they plan to use it to push one step further in their plan for a United States of Europe – against the will of most people, under the auspices of need, lest a systemic crash will wreak unfathomable havoc on the continent. “Give us all the power or you will lose everything!

According to people like Jeffrey Snider, a resolution could happen quite soon, as early as by the end of summer 2019 (chart pack here). How does September 2019 sound? It’s a nice round number and historically rhyming year. By the way, Mr Snider thinks The Fed will lower rates very soon. If they lower by 50 points right away, which they probably need to do, it’s a strong crisis signal (and very reminiscent of January 2001).

Recession is coming

Why is this happening? Simple: an economic downturn, if ever so slight, is straining the economy in proportion to the amount of outstanding debt and other imbalances. It’s happening now. The signals of recession are multiplying. After 5 years on artificial life support, it’s getting increasingly difficult for authorities to sustain positive growth for the economy.

Again, it’s about time, the imbalances are worse than ever, and the signals are already here

One of those signals is revisions to employment numbers. Once the revisions turn negative, the actual numbers are soon to follow. Employment statistics are first collected at one date, and then subsequently analyzed, complemented, refined and revised with more data on several occasions. Now we’ve had three months in a row with negative revisions, clearly indicating that the first stab at the number is too positive.

Among several recession signals, the New York Fed probability of recession (POR) chart stands out. It’s currently at a level which in 100% of the previous cases have been followed by a recession. The actual chart says around 30% POR, but that level has always led to recession.

Nobody died of a recession, right?

But, come on, what’s wrong with a little recession? Nothing a little Fed easing can’t handle, or?

Well…, the problem is that the financial system is in so much worse shape this time round, than, e.g., in 2008, you know, right before the great recession. Not least the level of corporate debt have exploded since 2008. Corp debt, according to the IMF, is now at 75% of GDP in the US, or around 10Tn USD vs 5Tn USD in 2008. Even more worrying the amount of near-junk debt has quadrupled from 1Tn to 4Tn.

There are two issues here. One is that a lot of that new corporate debt has been used for stock buybacks. Actually buybacks have been more or less the only net positive inflow for equities. That means that if the corporate debt market can’t keep expanding there are no stock buyers left. And if people and institutions didn’t want to buy stocks before, why would they start doing so at these levels while facing a weakening economy?

Again: No equity buyers left.

The other issue is that there aren’t enough junk bond funds to handle all the extra volume once the downgrades hit. Bond funds have rules; some can buy junk bonds, others can’t. If 4Tn of near junk start turning into junk (once enough are downgraded the others will follow, since they are all connected through the economy and the liquidity of the bond market) and trying to enter the relatively small 1Tn junk bond market, yields will explode higher (junk bond prices crash through the floor).

No junk bond buyers either

Lower cash flow or higher yields beget more of both

There are several ways to trigger this doom loop. One starts with higher yields which adversely affect cash flows, which in turn leads to downgrades, followed by (forced) bond selling from investment grade funds to junk funds, even worse cash flows and so on. No matter what the reported profits are, bond ratings are based on cash flows, meaning there really is no escaping the doom loop once it starts.

Higher yields, lower profits, downgrades, higher yields…

Should the primary bond issue market freeze up, like it did temporarily late in the fall of 2018, the tail spin will be more or less immediate. That’s how the Powell pivot late last fall came about. That particular Fed ammo, however, has already been spent.

Demographic doom dead ahead

The more or less bankrupt US pension system has been sucking up a lot of bonds, including corporate debt for the yield pick up. The process is procyclical: when the economy is growing and total income is increasing, there’s more tax money over for bond buying (due to low treasury yields, an increasing portion of pension money has been put into corporate debt).

When the cycle turns south, there’s less available funds. Sure, in the short term there could be some rotation from stocks to bonds. However, probably not that much (read: nothing) into junk or near-junk bonds. By the way, it’s exactly the rotating out of stocks you should be wary of as an investor (even if you as a citizen should be really worried about the consequences of a freezing bond market)

A bit longer term, albeit still relevant in the decade-long horizon, the large boomer generation is retiring. Due to zero interest rates on their bond holdings, and too much risk holding a large proportion of stocks as they grow older, they’ll need to (and want to) sell securities to fund retirement.

Boomers retiring is more of  a long term partial drag on the system, both for bonds and equities. However, in terms of rate of change, up until now boomers (pension funds) were buying corporate debt for the yield pick-up, due to too low yielding treasuries, but now they’ll start selling. Combined with all of the above, that spells double doom for corporate debt prices and issuance, which in turn means much less equity buybacks than the market has become used addicted to.

What about Trump and a China deal, wouldn’t that save the markets?

Sure, Trump will most likely get to a deal, some deal, watered-down as it may be, but no doubt hailed as a triumph. However, as soon as the above doom loop manifests itself, and it will, since the trade deal won’t be enough to jump start an engine with an empty gas tank, Trump will wield his tariffs wand again, and we’re back to square one, or rather minus one.

As a final thought on geopolitics, many countries have tired of Trump’s and the US’s antics, including the weaponizing of the dollar. Those countries could band together and seize the opportunity a financial crisis entails, to design a new monetary system based on gold (priced at a much higher number per ounce).

Investment implications

A dollar spike could be in the making soon, and that might mean a short-term downturn for gold (albeit that might in effect already have happened). A flight to safety from anything European and into dollars should mean both stronger US treasury prices (falling market yields) and higher stock prices (what works works, until it doesn’t). A dovish Fed could temporarily add to these developments.

Fed easing. After the initial knee jerk reaction, the more or less inevitable economic downturn leads to weakening cash flows, corp debt downgrades, higher yields, forced selling and freezing up of new debt issuance and stock buybacks. With both bonds and stocks in free fall, the Fed has to respond by cutting rates aggressively as well as turn on the Quantitative Easing taps more than ever (already prepared for by their “slope” and “effective” lower bound language).

Gold to shine. Once the flow into dollars is exhausted and the Fed is in full panic mode, the dollar can weaken again, although hard to say to what extent, given the sad state of Europe. In any case, no matter the relative movements of USD vs EUR, JPY and RMB, gold is set to shine, owing to unlimited moneyprinting and the prospects and need for a global financial and monetary system re-set, a Beijing Accord of sorts.

You never forget your first coin. More and more seasoned investors are recommending gold as the place to hide from all the turmoil. Sam Zell, e.g., a 75-year old legendary investor known for rare but bold and successful calls, said in January that he started buying gold for the first time in his career. Maybe it’s time for your first gold purchase too?

And on July 17, Ray Dalio, the head of the world’s most successful hedge fund ever, published a long article on Linked In about shifting financial paradigms over the last 100 years. He concluded that the current state of affairs regarding not least debt and market positioning, points to gold as a preferred asset:

…those that will most likely do best will be those that do well when the value of money is being depreciated and domestic and international conflicts are significant, such as gold. Additionally, for reasons I will explain in the near future, most investors are underweighted in such assets…

I would add that sometime deep into the mayhem, maybe after 18-36 months of carnage, there’s bound to be amazing opportunities among junk bonds. Forced selling can only last so long, and once probabilities of default are more than priced in, while new junk bonds are set up, the trade of a lifetime could be found there. I almost wish I were in Howard Marks’ shoes a few years down the road. If I still were a professional investor that is.

P.S. this is all for entertainment purposes and is not a recommendation of any kind, least of all to engage in financial activities such as selling or buying securities or other assets.

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8 Comments

  1. I know of one recession that took tens of millions of lives. It happened in Germany and the disaster was mediated by the Weimar government printing money to pay its bills.

    The $64,000 question: will the US government fall? A former superpower (complete with nuclear arsenal) has a bankrupt, corrupt, and dysfunctional regime combined with a an infantile, semi-literate populace.

    A gold-based currency? Not likely. If it was attempted, the price of gold would skyrocket, but the economic consequences would be catastrophic. Bottom line: there ain’t enough gold.

    • I think you’re wrong on gold, but I have no clue if the US can fail and what the consequences would be. Regarding gold, it’s risen from 21 to 1400 without any problems :D, I mean, it’s still just a pet rock whether at 1400 or 100 000. Not that the number in terms of dollars will be any more relevant than the number in Zimbawean dollars.

      • Gold has never been sufficient for the money supply of any economy in history. Even in the days of the gold standard, the US gold reserve never exceeded 10% of the currency, and redeemability caused problems (E.g. the gold crisis of 1896). Most of the demand for gold came (and still does) from hoarding, not its intrinsic value (though it does have some use-value, as opposed to monochrome portraits of Ben Franklin).

        You can’t just say “we have X ounces of gold hoarded and Y $ of currency, the price of gold is now Y/X.” I bet the hedge fund manager of the decade could find an arbitrage opportunity or two in that. Anyway, a money supply dependent entirely on the amount of hoarded gold has its own problems, including systemic deflation.

        Fiat money works great until politicians get their hands on the printing press. Could an electronic currency with an inherently restricted growth rate work? Maybe until governments started issuing money backed by a fractional reserve of Bitcoins. Except it wouldn’t be Bitcoin – I can’t see any government making Bitcoin legal tender when they could waste $1E9 commissioning their own “crypto” currency (with a backdoor printing press for “emergencies”, of course).

        Will you sell your gold when it hits a million EuraqistaniCoins an ounce?

  2. P.S. “United States of Europe”? Ha ha. Y’all gave up your sovereignty long ago and you’re /already/ a province of Greater Islam – love it or leave it, the deal is done. Look what happened in Britain when its subjects (thought they) voted for sovereignty.

    You can check out any time you like, but you can never leave…

  3. In your last paragraph, you wrote “18-36 of carnage”. Presumably you mean “18-36 MONTHS of carnage”?

    • Hours perhaps, who knows with all the algos and HFTs…

      Thanks. Changed it to months now.

      • Yeah, it was pretty obvious that you meant “months”. But who knows, the world is changing: maybe you meant hours or minutes, lol!

        I enjoy reading your blog, by the way. I hope you continue writing. You have an interesting perspective and you express your ideas well.

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