pebblewriter

Tag: debt

  • Update on XLF: Nov 17, 2020

    After being stuck in a textbook triangle pattern for almost six months, XLF finally broke out last week.

    We noted its having reached overhead resistance a few weeks ago [see: Yield Curve Model – Correction Imminent.] At the time, the 2s10s was threatening a breakout which, per our model, suggested a downturn for equities in general and XLF in particular.The 10Y did, in fact, reverse as expected and XLF dutifully tumbled – but, to a higher low. By Oct 30, a triangle was very well established and we were again facing a break out vs break down decision. Note that XLF had dropped through its SMA200 and was in a bearish SMA10/20 alignment. Had interest rates continued falling, I have no doubt that the triangle would have broken down and XLF would have reached the .618 Fib at 21.06. Instead, the 10Y popped back above its SMA200 (the yellow arrow)……and XLF got a much-needed bounce back to the top of the triangle. Yes, again. This time, however, TPTB were ready. After bumping into the top of the triangle on Nov 5 and 6, XLF received a fabulous gift.

    The 10Y gapped sharply higher, again breaking above the SMA200 it had fallen below and even above the top of the rising white channel. It was a massive move from 74.8 bps to 97.5 bps (point 6 in the chart above) in just two sessions thanks to the announcement of a vaccine from Pfizer and better than expected employment data [see: Vaccine!]

    As a result, the 2s10s broke above overhead resistance. A steeper yield curve is theoretically the solution to the banks’ woes. Though, historically, major breakouts in the 2s10s have led to equity crashes. Even for XLF. We’ll see if this time is any different.

    In the meantime, XLF has backtested the midline of the rising white channel from its 2009 lows… …following its very obvious failure to break out to new highs in February which resulted in its 44% crash. Note that a failure to push above the midline means at least a backtest of the triangle top around 25.26. Much will depend on some very fancy footwork by the Fed.The Fed’s exercise in ZIRP, which served as a lifeline to many sectors of the economy – not to mention the stock market, is a weight around the neck of the financial sector.

    Rising rates and a steeper yield curve might be okay with $7-8 trillion in debt. But, at $28 trillion, it’s a tad scary.Can the Fed find a way out of the corner into which they’ve painted themselves? Can they maintain the disconnect between the S&P 500 and the pandemic-stricken real world in which 30% of Americans are expected to be infected and another 200K are expected to die?

    “We’ll spend the next three months probably infecting another 15% and get to 30%, maybe more,” [former FDA Commissioner Scott] Gottlieb, now a CNBC contributor, said on “Squawk Box.” “Thirty percent assumes the current run rate if things don’t get any worse.”

    Stay tuned.

  • Why Interest Rates Must Not Rise

    In May 2014 many of us were shocked by a report that Ben Bernanke, who had recently departed the Fed, told a group of wealthy investors that he did “not expect the federal funds rate…to rise back to its long-term average of around 4%” in his lifetime.

    I remember feeling Bernanke’s statement represented both extraordinary hubris and wishful thinking. Surely, the trillions being pumped into the financial system would drive inflation to levels that would produce higher rates.  After all, I reasoned, the bond market isn’t as easily manipulated as is the stock market.

    Last year, I called attention to the fact that the cost of servicing the US debt had broken out to new highs [see: Why Rising Rates are a Problem This Time.]  Even though interest rates had fallen dramatically, the spiraling debt had send annual interest expense on that debt to roughly $450 billion in FY 2017.

    Bernanke’s 2014 words came back to me as I did the math.

    Clearly, if rates were to normalize the interest expense would be unmanageable… Between 2000 and 2007, the average interest rate was 4.84%.  On the current $20.6 trillion balance, that would mean an annual interest expense of roughly $1 trillion.

    Of course he was confident in his prediction!  He understood that rates could never be allowed to rise.  A return to normalcy — and, I don’t believe this to be an exaggeration — would absolutely destroy the economy.

    I had always found the Treasury’s increasing dependence on short-term, floating rate and inflation-indexed borrowings a bit unsettling. Why not lock in a boatload of 30-yr bonds at 2.1%?  Now we know.

    In their wisdom (or desperation…time will tell) the central bankers and those maxing out America’s Gold Card have bet our very futures that Bernanke was right — that everything will be okay in the end…as long as the end never gets here.

    By the way, here’s an update of the above chart…which has been appropriately renamed.

     

     

     

  • A Break or a Breakdown?

    The 10Y yield has clearly broken trend as expected, with a couple of Fib tests the only things standing between it and our downside targets.  Our 28.56 upside target from Jan 10 [see: China – It’s Not Me, It’s You] has officially yielded. This is what stocks were waiting for — a sign that interest rates’ climb past 3% wasn’t as certain as most analysts suggested.  ES broke out of its slump and pressed on to new highs, finally joining SPX in regaining its 2.24 Fib extension.

    This leaves our analog on track with our next targets easily in reach.  It also confirms the time adjustment that was suggested by the most recent dip and the redrawing of VIX’s (and everything else’s) path for the next six weeks.

    continued for members… (more…)

  • Why Rising Rates Are a Problem This Time

    A sharp drop in interest rates has traditionally been a negative for stocks.  The chart below shows that most significant declines in 10-year yields over the years were associated with steep drops in the S&P 500.  Usually, equity losses precipitated the drops in yield.  As stock declines accelerate, money flows into bonds — raising prices and depressing yields.  The crashes of 2000-2003 and 2007-2009 are striking examples.  So are the corrections of 2010, 2011, 2015 and 2016.

    There were several exceptions, when stocks were supported through carry trades and other algo-stroking forces: the 15% rise in SPX between Dec 2013 and Feb 2015, the minor 6.1% drop between Mar and Jul 2016, and the 2.5% rise between Mar and Sep 2017.

    But, significantly, not a single equity correction occurred without a concurrent and significant drop in yields.  This begs the question, then, of whether increases in yields are positive for stocks.

    In 2008, yields bottomed almost 2 months before stocks did in 2009.  But, in the 2000-2003 crash, yields bottomed 9 months after stocks.  Most other yield rallies from significant bottoms also lagged stocks: 4 months in Oct 2010, 9 months in Jul 2012, 3 months in Jan 2015, 5 months in Jul 2016.

    It would seem at least some bond buyers take a “show me” approach, waiting until the coast is clear in equities before shifting money back into bonds.  This analysis ignores the considerable influence that Fed purchases had on bond yields — an influence which the Fed maintains will diminish over the next few years.

    So, what are we to make of the latest spike in yields which began on Sep 7, 2017?  The 10Y rose from 2.03% to 2.94% through Feb 21.  SPX rallied along with it, up almost 17% by Jan 26 — then promptly did a gut wrenching 11.8% nosedive in only 2 weeks.

    Fortunately for the bulls, it got a strong bounce off its 200-day moving average and subsequently bounced to its 61.8% retracement. But, pundits seem fixated on the 10Y with rates nudging up against 3%.  Does it matter?

    In a word, yes.  Even though 3% is still well below historical yields, the level of debt has risen dramatically over the years.  The chart below shows the annual interest expense (the orange line) and the US’ rapidly growing pile of debt. Superimposed over each is the average interest rate (the black line) paid on that debt.

    Even though interest rates have flatlined since 2013, the expense of servicing the rapidly expanding debt has risen sharply — recently breaking out to all-time highs.

    Clearly, if rates were to normalize the interest expense would be unmanageable.  How unmanageable, you ask?

    Between 2000 and 2007, the average interest rate was 4.84%.  On the current $20.6 trillion balance, that would mean an annual interest expense of roughly $1 trillion.  And, we haven’t even begun to talk about the effect on consumer debt, the mortgage market, debt issued to fund corporate buybacks, etc.

    Obviously, an increase in the 10Y yield doesn’t immediately reprice the entire pile of debt.  But, it’s a clear step in the wrong direction.  And, investors are right to be concerned.  I imagine the Fed is also quite concerned — which is why I put a target of 2.85% on the 10Y back on Jan 10 [see: China – It’s Not Me, It’s You.]

    Not only did it represent channel and Fib resistance, but it seemed like a good tipping point for what I expected to be rising concern (one can hope) about our shaky fiscal situation.  TNX overshot it a little, which has been fairly common over the years (Feb 2011, Sep and Dec 2013, etc.)

    Those previous overshoots typically helped stocks get past resistance.  It might work this time, too.  But, judging from the mood out there, I don’t believe stocks will be led higher by higher interest yields this time.  And, I have trouble believing the Fed isn’t working to put a lid on long rates – yield curve be damned.

     *  *  *

    Related Posts:

    Where To Next?
    The End is (Probably) Near
    CPI: The Charade Continues
    Update on Bonds: Jan 29, 2018

     

  • US Dollar: Capitulation?

    When it comes to trade, there is no free lunch.  A lower US dollar helps US exporters.  But, for the US – a net importer by a huge margin – it raises the price of imports.

    So, it was really interesting to watch Treasury Secretary Mnuchin step in it explain that a lower USD would be “beneficial to our trade imbalances” without mentioning the offsetting, and more troubling, inflation and interest rate repercussions.

    If we didn’t have $21 trillion in debt (multiples of that off-book) in a rising interest rate environment, it probably wouldn’t matter.  But, the CBO’s numbers, which assume 10-yr rates top out just over 3% (half the historical average), argue otherwise.

    Mind you, I’m not complaining.  I’ve been bearish on the USD for a very long time.  In May 2017 [see: May 1 Update on US Dollar] we noted that DXY had broken below a long-term trend line and was susceptible to more downside.

    …if DXY drops through the SMA200 and the yellow TL, then we have some very obvious Fib targets including the .786 at 97.583, the .886 at 96.789 and the purple .618 where it intersects the purple channel midline at 96.465 in July or August.  If the purple midline breaks down, the next major support isn’t until 91 in early September and 87-88 as early as the end of the year.

    We’ve seen plenty of worrisome bumps along the way, with a couple of timely rallies in Q4 to support stocks.  But, our charts have remained bearish even as the Fed, with its ineffectual rate hikes, struggled to argue otherwise [see: Will the FOMC Minutes Save the Dollar?]

    DXY just tagged our 87-88 target, reaching 88.438 moments ago with its eye on the rising purple channel bottom around 87.423.As we discussed in yesterday’s updates on EURUSD and USDJPY, the big question is what now?  The charts offer a compelling answer.

    continued for members… (more…)

  • City of Dreams

    I’ve been harping on the incredible threat represented by the $250 trillion in almost entirely off-the-books, unregulated derivatives market — 95% of which is should be but isn’t on the books of the top five US banks [see: The Wipeout Ratio.]

    It’s an astonishing 550 times the tier 1 capital on the books of these same banks — all of which are considered too big to fail.  Looking at it another way, a two-tenths of 1% decline in the value of those derivatives could completely wipe out all tier 1 capital altogether.  If that weren’t bad enough, it’s dwarfed by the global derivatives market of $707 trillion.

    It’s hard to appreciate just how much money we’re talking about.  But, demonocracy.com does an outstanding job of putting it into perspective, focusing on the 9 largest banks’ $228.72 trillion in exposure.

    Take the time to read this, and please pass it along. Click anywhere on the nice pretty picture below.

  • The Wipeout Ratio

    A simple calculation comparing major banks’ derivatives positions to their assets and capital shows how little it would take to wipe out either.  The first ratio is the multiple that derivatives represent of Tier 1 capital.  The second shows the miniscule percentage decline in the value of derivatives portfolio it would take to completely wipe out Tier 1 capital.


    Goldman Sachs, for instance, has $47 trillion in derivatives exposure — 2,480 times its Tier 1 capital.  A 0.04% decline in the value of the derivatives portfolio would wipe out Tier 1 capital altogether.

    Overall, a 0.18% decline would do the entire bunch in.    Something to think about, especially as the vast majority of derivatives are OTC, are not priced in public markets, and are obscured/netted out in balance sheets.  Remember, “too big to fail” really means “subject to taxpayer bailout.”

    A little over a week ago in a Zerohedge article we learned that Italy’s previously hidden derivatives exposure amounted to 11% of the country’s GDP.    A recent $3.4 billion payment to Morgan Stanley to settle a 1994 contract wiped out half the value of the tax hikes recently imposed on an already crumbling economy.

    If this doesn’t seem terribly important, consider that the derivatives exposure of the five banks above alone, at $240 trillion, is four times the combined GDP of every country on earth.  JPM, by itself, has notional derivatives exposure that exceeds the combined global GDP.

    I fear this is the story of the year, folks.  And, it’s just now starting to get some press.  As we learned with AIG, if one segment of the financial markets suffers unanticipated losses, the entire house of cards can come crashing down.  Banks know how bad the situation is; how else to explain the lack of interbank lending — particularly in the euro zone?

    Stay tuned.