Developing Self-Contradiction: Near Record US Stocks as Record Negative Yielding Bonds Transform into a Crowded Trade!

Current unfolding developments in the global financial markets have truly been striking. To borrow the revolting phrase, this time does seem different!

The “difference” lies in the interrelationship and the feedback mechanism between market participants and political policies channeled through central banks. Or how present markets playout the boom bust cycle predicated mostly on political actions.

But there will be no difference in the eventual outcome.

Under today’s condition, one might observe that the worst the outlook, the greater the risks, the bigger the uncertainty, yet the fiercer the rallies in the risk markets.

Unlike the Philippines were risk asset rallies have been mostly about embedded misplaced emotional convictions about economic and financial progress, the incentives that shapes the global markets seem to be about what central bankers have done, and what they have been expected to do.

Based on labor data, US stocks soared last Friday. The S&P is about a hair away from attaining an all time high!

Yet along with US stocks, global stocks soared too. Importantly, even as global stocks melted up, global bonds had a bigger record breaking performance!

Curiously even media sees a developing self-contradiction in US stocks and bonds

The Marketwatch provides a mainstream view of current developments: “Investors typically don’t buy bonds and stocks at the same time. Bonds are considered a haven, while stocks are favored when risk appetite is higher. Bond prices move in the opposite direction of yields, so appetite for the perceived safety of bonds is driving yields lower even as investors scooped up equities at a rapid clip Friday. According to Dow Jones data, the S&P 500 has closed at a record high and the 10-year has closed below 2% only once in the last 40 years. That was back in 2013, as the U.S. economy was still emerging from the financial crisis, aided by a dollop of quantitative easing from the Federal Reserve. Colin Cieszynski, chief market strategist at CMC Markets told MarketWatch that yields diving lower can be explained by appetite from foreign investors, who are eager to gobble up Treasurys in a world where nearly $12 trillion in debt offers negative yields. Worries about embattled Italian banks and lingering concerns about sluggish growth in China, the world’s second-largest economy, are among investors’ biggest concerns. “Buying today on nonfarm payrolls has been pretty relentless. I think bond yields are being driven down by offshore uncertainty (Brexit, China, Italy/EU) rather than domestic issues,” Cieszynski said. He believes that expectations that the Fed will remain reluctant to raise interest rates due to these global growth worries creates an optimal environment for stocks to prosper. “It is like we’re heading into another Goldilocks environment of a strong economy without the fear of the Fed raining on the easy money parade by boosting rates,” he said. Another way to think about this market dynamic is a popular acronym that Wall Street has adopted lately: TINA, or there is no alternative. In other words, in a world rattled by the prospect of anemic global growth, both U.S. stocks and bonds are benefiting because they are the only game in town.”

The huge stock market rally comes even as earnings outlook for US firms are expected to remain gloomy.

From the Financial Times (bold mine): US companies face another bleak earnings season with analysts forecasting the longest profit recession since the financial crisis. Energy groups are expected to weigh heavily on S&P 500 results while a number of other sectors such as financials are struggling to increase profitability. Earnings of the major groups that comprise the S&P 500 index are seen falling 5 per cent in the second quarter from the same three-month period in 2015. That forecast is slightly lower than the 6.8 per cent decline seen during the first quarter, but will mark the fourth-straight quarterly decline, according to data from S&P Global Market Intelligence. Excluding the energy sector, S&P 500 earnings are set for a decline of 0.4 per cent. The tepid profit expectation comes as the Wall Street benchmark closed the second half of 2016 less than 1.5 per cent below its all-time high, prompting some strategists to question whether stock prices have risen ahead of fundamentals. The S&P 500 closed out the first half priced at 19.5 times trailing 12-month earnings, one of the highest multiples since 2004, according to Bloomberg data. The price/earnings ratio based on forecast profits over the next 12 months was 17.3 times, compared with a 15-year average of 16, S&P Global Market Intelligence data show.

US yield curve has been intensively tightening (upper window) as yields plunge to record lows (bottom). Meanwhile the S&P streaks to record highs!

Deutsche bank recently noted that the based on their model the yield curve points to a 60% odds of recession in the next 12 months!

Wow, furious rallies in the face of higher risks of recession! This is like playing the Russian Roulette.

Additionally, another significant development in the risk spectrum has been in the UK: Seven property funds worth “more than half of the £25 billion ($32 billion)” notes the CNN, has closed their doors to investor redemptions last week!

Reason? Increasing uncertainty and risks over property markets have virtually exposed on the maturity mismatches inherent in these funds. So the first symptom: emergent liquidity strains. Again from the CNN, “the funds are heavily exposed to offices and other prime commercial property in the U.K. that can't be unloaded quickly enough when nervous investors want their money back.”

The next issue will be solvency.

Importantly, the actions of 7 UK property funds have a signified a real time revelation of the boom bust psychology. From the same article: “It's a remarkable shift in sentiment for a market that once appeared unstoppable. In the wake of the global financial crisis, ultra-low interest rates and a flood of foreign money pushed prices through the roof, particularly in London.”

Easy money has not only failed to ensure liquidity, it has created the bubble. And like all bubbles, greed suddenly mutates into fear!

And record low yields in US treasuries have reverberated around the world. Record negative yielding bonds may have already reached $13 trillion!

According to the Times of India (bold mine(: For the first time ever, nearly $13 trillion worth of government bonds worldwide — representing more than a third of all government debt — have negative interest rates. Returns or yields on bonds drop as their prices rise following an increase in demand. Demand for bonds and gold has soared as central banks kept interest rates down and investors rushed to safe haven investments following Brexit, or UK's vote to leave the European Union.

Last week, Netherlands have joined the elite group where borrowers are being paid to borrow as expressed by negative bond yields.

As global bonds hit new records, while US stocks likewise soar to near record highs, the Chinese yuan (expressed via the offshore CNH, the same applies to the onshore CNY) fell to its lowest level in 5 years! (see lower chart)

Said differently, US dollar relative to the yuan has soared to a 5 year high! Another risk milestone for the week!

Italian and European banks have been under sustained strains as seen by crashing stocks and soaring CDS. Europe’s banking strains has resonated with Japanese banks and partly the underperformance of US bank stocks.

This week sustained pressures on Italian bank stocks has only impelled Italy’s Prime Minister Matteo Renzi to extract concessions from the EU by using derivatives as negotiating leverage to counter Italy’s Non Performing Loans. From Reuters (bold mine): Speaking at a joint news conference with Swedish Prime Minister Stefan Lofven, Renzi said other European banks had much bigger headaches than their Italian counterparts. "If this non-performing loan problem is worth one, the question of derivatives at other banks, at big banks, is worth one hundred. This is the ratio: one to one hundred," Renzi said. He did not directly name Deutsche Bank, but he has singled it out for criticism in the past, including last December, when he said he would not swap Italian banks for their German peers.

Interest rate swap derivative contracts accounted for 78% of the notional outstanding US $493 trillion worth of global OTC derivatives as of the 2H of 2015 according to the Bank for International Settlements data!

Desperate for yields, it would appear that in anticipation of expanded central banks actions plus incumbent QE programs has only set in motion an astounding frantic escalation in the “front running” dynamic that has led to the explosive growth in negative yielding bond.

And that while the selloffs in Italian and European banks have only masked the resounding buildup of risks particularly in the derivatives frontier, such has only magnified the incentives to chase yields to further push bonds deeper into negative territory.

Central bank policies have been forcing markets into a stampede towards negative yielding bonds. And that negative yielding bonds have been transformed into a one way or crowded trade!

And that spillover in the bond chasing phenomenon has partly spread to stocks.

Nevertheless, the crowded trade from a deep seated assumption that central banks “will do whatever it takes” to subsidize and provide cushion to the markets from a crash represents as a clear and present danger

As the ever sagacious Credit Bubble Bulletin analyst Doug Noland trenchantly pointed out (bold mine)

World markets are in the midst of something on a frighteningly grander scale than 2007-2008. Tens of Trillions of sovereign debt have become trapped in speculative melt-up dynamics, as central bankers, derivative traders, speculators and safe haven buyers all battle to procure precious bonds. And I don’t believe it’s coincidence that the world’s largest derivative players are seeing their stock prices suffer under intense selling pressure. Meanwhile, sinking bank shares heighten market fears, which only feeds the dislocation and reinforces the dynamic imperiling the big derivative operators. 

Markets have become entirely deformed where prices have been dramatically falsified and driven far far far away from reality. All these due to sustained and deepening interventions by central banks.

And yet as markets push in a one way direction, cracks on the real economy have become conspicuous

Again Mr Noland:

The Fed and global central bankers have nurtured the illusion that risk markets are safe and liquid (money-like). They have spurred “contemporary finance” and the transformation of increasingly risky assets into perceived safe and liquid securities. Ironically, as the liquidity myth is illuminated in UK real estate funds, a sovereign debt market dislocation ensures “money” floods into potential liquidity traps in risk markets around the world.

Truly spectacular “this time seems different” developments!

We are living in interesting times!