Central Banks Own Bonds But Want Inflation

December 4, 2015

Signs of The Times

"Investors who piled into anything and everything in the junk market in recent years have begun to run in the other direction."

- Bloomberg, November 17.

The transition took a long time. The market surged into June 2014 and reversed then.

"Chinese borrowers are taking on record amounts of debt to repay interest on their existing obligations."[1]

- Bloomberg, November 19.

"Draghi: We will do what we must to raise inflation as quickly as possible."

- Financial Times, November 20.


Some $2 trillion of Euro-debt is yielding minus and yet Draghi calls for more boost. This represents not one, but three failures. One dates back to the early 1600s when Edward Missleden theorized that credit created out of thin air would fix a problem in the credit markets. The other is to apply the nonsense. And the third failure is not to end the application.

So, central bankers are positioned in bonds and are praying for a significant increase in the rate of CPI inflation.

Arbitrary ambition leads to weird positions.

The real problem is that they put on a lot of anti-deflation stuff in 2007, 2008 and 2009 and did not know when to quit.

The irony is that the 2008 Crash would have ended on its own. The Fed need not have done anything at all.

In 1929 London was the financial market and the FTSE fell in half. In the same bear New York was not the senior market and it fell 85%. This time around, the NYSE is the senior market and the S&P fell 48%.

The wide realization of that the Fed need not have done anything would be very daunting to all central bankers. Their careers and powers rest upon the invention of "hobgoblins" and their abilities to vanquish them.

Stock Markets

The global crash in so many items into August 24th was outstanding. So have been the rebounds. The ChartWorks had the high-side at DJIA 17870 and the high was 17797, which was reached at the first of the month. The correction was to 17210 and the high has been 17914.

The highs accomplished an impressive swing in momentum and a Sequential (9) Sell, which is pattern. An intermediate correction seems likely.

Within the rally, the financials (BKX and XBD) did well, set some excesses and are vulnerable. This would be due to the next phase of curve-flattening. The Treasury curve has reversed trend and is no longer supporting the financials.

Broker-Dealers (XBD) rebounded up to the 50-Week ma in early November and has been unable get above it. The highs have been declining.

Going the other way, Resource and Materials have been very beat up and seem eligible for another "Rotation" trade.

In looking around, central bankers are becoming even more desperate. That they can no longer drive the economy is becoming more apparent. So they have been working to drive the stock market.

While this may be just another example of official naiveté, it represents the potential for enhancing short squeezes. The one coming out of the August hit was enhanced by a massive REPO operation. The chart follows.

This, and it is always a threat, could limit the declines.

What would prompt a test of the lows?

More curve flattening.

Volatile conditions are always tough to deal with. That's for the buy-side as well as for independent research. Lately the Fed is a loose cannon in a financial storm.

Credit Markets

The reversal to widening spreads has been critical in determining this year's major opportunities.

A reversal to widening in June was possible and a breakout in July would set up a major hit. The worst for spreads was reached at 242 bps on October 2nd. The correction ended at 217 bps on November 7th and the spread has been at 222 bps for a week. Stability could run for some weeks.

The long bond (TLT) reached its best for the year at 135.63 in late January when we called it "Ending Action". The high was against the crash in crude and despite some hits to oil as well as to the S&P a series of lower highs has been set. The latest rally was within a pattern ending with a MACD Sell.

The old game of using the long bond as the "flight" to quality has not been the performer it was.

Crude and base metals are close to setting intermediate lows and any rise would not be good for the TLT.

JNK is somewhat oversold at 35.11, which is right at the low set on October 2nd. Some stability, perhaps even a brief rally for lower-grade stuff is possible.

Diminishing Liquidity

REPO Activity

  • Note the increase in the desperation of 2008.
  • Note the increase in September-October.

Junk (CCC) Yield: 2011 European Crisis

  • The rise in BBB yields has been noteworthy, but at 8.34% has been modest compared to what's going on in the CCC. This is at 15.19%.
  • It is approaching the worst with the European Crisis in 2011.
  • There has been no headlines.

Junk (CCC) Yield: 2008 Crisis

  • The worst was 45 percent.
  • That got headlines.

[1]The April 27, 1872 Edition of The Economist advised: "Avoid states which are constantly borrowing, which must therefore be paying off the interest on their old debt with the fresh loans."

Bob HoyeBob Hoye is the chief financial strategist of Institutional Advisers.

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