Down the Rabbit Hole

From the HRA Journal: Issue 309

We're in the midst of what I think is a fairly minor, and expected, gold correction. Junior resource traders, of course, are acting like the world is coming to an end. Multiyear bear markets are bound to make one defensive.

Major market traders seem pretty calm given so many people are suddenly talking about an impending recession. I still think we will probably see one but, like any good contrarian, I'm not liking how much company I suddenly have in thinking that. There is no evidence markets are trading based on that recession assumption though. I guess comments about it are just lip service for most.

We just completed a very successful Metals Investor Forum, with a great group of presenting companies and a large and engaged audience. I was impressed with the quality of the Q&A session. We do these so you can ask questions!

MIF is getting the presentation and interview videos up fast. Visit to access them all. It's worth your time.

Eric Coffin
September 10, 2019

Down the Rabbit Hole

Happy September! Traditionally one of the worst months of the year for large cap equity traders and one of the best ones for resource investors. (Just trying to maintain the festive mood here.)

I think this year's September will be true to form though, honestly, this is one of the toughest markets to handicap I've ever seen. It really IS different this time.

I've seen comparisons to various historic periods but most of them feel contrived to me. There's really no other period where we see the coexistence of exceptional increases in the overall mass of debt and exceptional decreases in the yield on that debt. We've definitely gone down the rabbit hole. I don't think anyone, and I mean anyone, really knows how the end game will look.

Let's start with "the mother of all bubbles", displayed graphically below. Debt carrying negative nominal yields increased to over $17 Trillion since the last issue. This is a mind-boggling number, even for bond bulls. I don't think there's anyone who isn't unnerved by this total. And I'm certainly not alone in wondering what "normalization" of this situation will look like.

How did we get here? You can thank central banks for most of this. The first real push came in 2016 when the ECB was embarked on its last major bout of QE. The ECB bought selected, mainly EU area sovereign, debt hard, driving up the price past parity, which had the effect of making yield to maturity negative. The Bank of Japan was the forerunner though, and still the "leader" thanks to its heavy buying of Japan Government Bonds (JGBs), to similar effect.

16 trillion of the negative yield bonds are roughly split between Japan and Europe, with the largest European amounts being debt issued by France, Germany, and Spain, in that order. Italy could quickly make its way up the hit parade if the apparent election of a new ruling coalition holds. That would be crazy given Italy's debt load and low growth rate but, let's face it, this is all crazy.

While many (me included) expected the long bond bull market to end in 2017, it just keeps rolling on. What possesses buyers to keep chasing bonds?

The simple answer is: returns. Remember that interest is only part of the total return bonds provide. Under the right circumstances, a gain in the value of the bond, which moves inversely to yields, can be much bigger than the yield.

Because a bond's value increases as yields fall, the best environment to be a bond investor is an era of falling yields. And, of course, that's what the world's major economies have been in for the past 38 years. Strictly speaking, bond traders don't care about yield, they care about price.

You can get a good sense of how important falling yields have been to the bond market by looking at the two charts below. The top chart is the value of "TLT", the long-term bond ETF. Remember, TLT tracks bond values, not bond yields.

The chart below it is the SPX large cap index. Both charts go back to mid-2002 when the TLT ETF came into existence. During that period, bonds have increased in value by 227%. Keep in mind, this is just capital appreciation and doesn't count bond interest. During the same period, the SPX has generated returns of about 200%.

So, bond investors have been anything but crazy. Bonds have been one of the most successful markets for a long time. If you look at the right side of the TLT chart you can see the short-term gains have improved through 2019. The yield may be small, but the gains have been large. Yields might be insane, but the fact is the bond market has put up WAY better returns so far this year.

There has to be a practical limit to the move down in bond yields, but the market hasn't found it yet. Even long-time bond bulls are looking over their shoulder. The question, however, what the catalyst will be to finally end this bull market.

At current yields, no one is buying bonds to generate interest alone. At zero yield or less, you only buy bonds because you have no choice or because you're expecting yields to fall further. Some institutions are forced to hold bonds, especially the sovereign variety. That keeps a bid under the bond market but the driving forces at this point are fear, FOMO and expected deflation.

FOMO (fear of missing out) is an increasing factor as TLTs climb steepened recently. More traders are buying bonds, some for returns and some out of fear. Not everyone is cheering lower rates. Plenty see them as a sign of distress for the word's financial markets.

I agree with that view though I think it accounts for only part of the move. FOMO is a big reason. It reminds me of the infamous comment by Citigroup's Chuck Prince just before the last crash: "As long as the music's playing, we've got to get up and dance. We're still dancing."

Yet another reason may be the "repo" (repurchase agreement) market. This is a short-term lending market, dominated by non-bank lenders. Borrowers put up collateral to borrow at low rates, determined by the price they agree to buy the collateral back at, at a specified future date.

I don't think anyone knows just how large the repo market is, other than that it's very large indeed. When writers refer to the "shadow banking" or "Eurodollar" market (a catch-all term for offshore borrowing in $US) the repo market makes up a big chunk of it.

US Treasuries are the best collateral for this type of loan due to quality and liquidity, with German Bunds a close second. I don't see a way to measure it, but the relative scarcity of Treasuries (and greater scarcity of Bunds) against high market demand may be yet another factor driving prices higher and yields lower.

Slowing inflation or even impending deflation in several markets is just one more reason for the bond bull market, Despite the best efforts of multiple central banks, inflation rates are dropping in many areas, especially in Europe and Asia. With growth slowing in these areas too, it's hard to see what keeps disinflation from becoming outright deflation.

The most obvious tool to reverse the death of inflation is currency devaluation. Indeed, many of the world major currencies outside the US have been falling. In most cases (so far at least) the moves haven't been large, and they aren't having a noticeable impact on local inflation. Inflation does lag however, so we may see a bit more of it later. If we do see inflation move higher it's highly likely local "real" rates would go even lower. There doesn't seem to be a central bank around that's serious about raising rates.

The two most likely candidates for an uptick in inflation (and I'm skeptical even there) are China and the US. China because it's letting the Yuan drift lower, though the move will have to be large to impact consumer prices. It is possible, however.

In the US, an uptick in inflation would be self-inflicted due to tariffs. Trump's latest tax tariff increases just went into effect. Unlike the earlier batches, this set mainly affects consumer items like clothing. If some of these tariffs get passed on though higher prices, we could see some upward impact on US CPI.

The next US CPI reading comes in a few days, but the data will predate the tariff increases. August consumer spending numbers come a couple of days later. The market could move on those as the consumer has accounted for almost all recent economic growth in the US.

President Trump would love to see the $US drop. He rage tweets about it regularly. So would many others. A "dollar shortage" and resulting surge in the USD seems the biggest concern among bond traders. They are concerned that a liquidity squeeze could generate a stampede into the greenback.

Most of those EuroDollar loans are backed by (hopefully positive) foreign currency cash flows. Widening the gap between their home currencies and the USD could quickly generate repayment problems. It's tough to handicap something like this, but the scale is so large that I can understand bond trader's concern.

At this point, the Fed is all but guaranteed to cut rates 25 basis points in two weeks. That may help support Wall St and gold prices both, though the announcement language will be important. Everyone "knows" the September cut is coming so it won't move things by itself.

The market is still expecting at least 2-3 rate cuts by year-end. I'm not sure we'll get them unless the US economy keeps decelerating. (I think it probably will, but the Fed will need to see that ahead of meetings to keep cutting). Several FOMC members have made it clear they don't see a reason to cut after September yet.

The ECB meets the week before the Fed. It was making noises about big stimulus programs last month. We'll see if it follows through. The EU area is close to recession. Germany, unusually, is putting up some of the weakest readings, thanks to trade wars. For once, they may not come out against ECB stimulus.

If the ECB disappoints, that could help bring the USD down slightly, though it would be a narrowing between US economic growth and that in competing currency blocks that would have the most impact. A US inflation uptick that reduces real interest rates could also help generate USD selling.

One thing that could work against lower US rates is a large increase in Treasury issuance expected between now and yearend. The Treasury ran down its reserves when the US came close to hitting its debt ceiling. Replenishing those reserves, plus paying for the bigger deficit under the spending plan that ended the standoff, could require another $800 billion in Treasury note sales.

There is concern that the heavy auction schedule could push yields higher, even with the Fed cutting rates. $800 billion is a big number, but the bond market is a big place. There's obviously a lot of demand or we wouldn't have the inverted yield curve we already do. It's likely to be a function of how the US economy looks going into year-end.

The biggest potential negative for the $USD is economic growth, and for bond yields too. I know what you're thinking. "There goes Coffin again with his 2019 US recession start speech".

Well, ok, yeah. It's September and the US hasn't rolled over. Contrary to what some may think, I'm not rooting for it. I'm just talking about data as it comes in.

It's not news that most of the world's main economic blocks are slowing. That's been going on all year. Europe looks increasingly bad, led by Germany which is the worst news of all. Americans will point out-and they are right-that the US is more of an economic "island" than any other country. US imports and exports are huge, but the economy is huger and loss of exports along isn't going to fell the US economy. Probably.

There's little doubt that this time around the US will be the last domino to fall. The problem is that some of the biggest problems are US-centered and self-inflicted. And yes, I'm talking trade war, trade war, trade war.

The chart above shows previously reported and corrected data for US job growth. The revisions are based on actual, rather than estimated data. The market always ignores this backward-looking stuff, but it's impressive how large the revisions are and how much lower actual job growth is. This is the pattern you expect near the end of a cycle.

The chart above shows how US employment gains, still slowing, are becoming less broadly based too. We can thank the trade wars for a lot of this. Manufacturing and associated industries look particularly ugly. The August non-farm payroll number missed expectations again, and revisions to prior months were negative-again. Both of these are end of cycle patterns.

The chart below is the "current situation" index of the Michigan consumer confidence survey. I don't put much stock in these surveys and find them fairly useless for timing. Nonetheless, it's interesting to note how the recent broad top in this reading is what you see near the end of an economic cycle.

None of the above is conclusive. Indeed, we've seen a bounce in bond yields and a $60 drop in gold prices in the past few market sessions. That has been almost completely due to news that China and the US will have face to face trade meetings again next month. If the two parties can actually settle things, there is a chance the economy dodges the bullet yet again.

I do think the trade war gets largely settled in the next few months. It's hurting China's economy more but is a bigger political issue for Washington than Beijing. I don't think Trump wants to get too far into an election race with the trade war hanging over him. I expect the US will try and find something face-saving to end it in early 2020.

I think the Fed cuts 25 basis points this month, but we'll only see more cuts if the US economy weakens further. I expect that if the trade fight isn't dealt with quickly, but many FOMC members don't based on recent comments from them. Their apparent reluctance to cut further isn't reflected in bond yields yet. So far this year, the bond market has been winning the fights. If that continues, yields could go lower still. I think we get a bit more bounce first.

The small move in yields and "good" trade war news generated the drop you see in the gold price below. We were overdue for some moderation. I'd like to see gold hold $1480, though it could go lower without violating the uptrend it's been in. Gold is holding its positive $US correlation which has hurt gold prices recently. I don't know if the recent top in the USD is just another short term one. I hope it's a more lasting one as a rocketing greenback is a huge risk to the world economy.

Short term moves aside, the negative real interest rate environment across the world economy is a strong underpinning for the gold price. I think the world would be far better off if we had a positive rate environment but I have no idea how we engineer that. I don't think anyone does. Normalizing rates without blowing up the economy is THE issue going forward.

Traders are still pretty calm, all things considered. They talk about recession fears but don't trade like they believe it. We've reached dynamic equilibrium. Things are calm on the surface but a roiling maelstrom below. Let's hope nothing disturbs it, or things could spin out of control fast.

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