Fwd: The World's Five Largest Bond Markets Are Syncing Up For Disaster

Another major economy is facing the ugly prospect of rising inflation.

A central theme in our analysis of The Everything Bubble is that Central Bankers are focused on only one thing: maintaining the bull market in bonds at all costs.

The reasons are as follows:

1)   Bonds are what finance the Government's massive entitlement spending/ welfare programs.

2)   With massive ownership of bonds thanks to over $15 trillion in QE, Central Banks are extremely exposed should bonds collapse (and yes, Central Banks can go bust).

With that in mind, we've been guiding our clients to focus on the dangers of rising bond yields due to surging inflation globally. Rising bond yields= falling bond prices. Falling bond prices=the bond bubble could burst.

And a bursting bond bubble= SYSTEMIC reset as entire countries go broke (think Greece in 2010).

On that note, China is the latest major economy to see its bond yields rise as inflation takes hold.  Yields on China's 10-Year Government bond are breaking out to the upside as I write this.

With China now experiencing higher bond yields (higher borrowing costs in the bond market), all FIVE of the world's largest bond markets are warning of rising inflation: the US's, Japan's, Germany's, and the United Kingdom's bonds are all flashing "DANGER" with multi-year breakouts occurring in their 10-year bond yields.

The above chart is telling us in very simple terms: the bond market is VERY worried about rising inflation. And if Central Banks don't move to stop hit now by ending their QE programs and hiking rates, we're in for a VERY dangerous time in the markets.

Put simply, BIG INFLATION is THE BIG MONEY trend today.

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The "Iron Coffin Lid": Why The Euphoric Surge In Japanese Stocks Is Coming To An End

Last week, Japan's Nikkei 225 index enjoyed its longest winning streak in history which eventually ending after 16 consecutive days of gains, only to resume rising after a brief one day hiatus. And, as foreign investors once again flood the Japanese stock market, chasing the momentum which has pushed local stocks to levels not seen since 1996, the question on everyone's lips is how much longer can this continue?

Offering a decidedly downbeat outlook on Japan's market exuberance, Shannon McConaghy - portfolio manager at what we have in the past dubbed the world's most bearish hedge fund, Horseman Capital Management - believes that the euphoria is about to end. The reason: the ominously sounding "Iron Coffin Lid."

In a note released late last week, McConaghy writes that there has been a lot of excitement over Japanese equities of late, with hyperbole from the sell-side, and others interested in promoting Japanese equities, becoming extreme. However, he cautions that "there is not a lot of discussion around the risks to Japanese equities from current elevated levels" and adds that "one observation I would make is that Japan has risen to these levels on a number of occasions over the last 25 years, only to fail spectacularly each time against what is referred to, by some in the Japan markets, as the "Iron Coffin Lid". History suggests it is far better to be short Japanese equities from these levels than to be long."

So what is this Iron Coffin, why does it have a lid, and what happens next?

Below is a visualization of this "Iron Coffin Lid" effect: it shows the key resistance level in the Topix beyond which the index has failed to progress every time in the past quarter century.

There's more than just a chart however: here is Horseman's take on why this latest rally in Japanese stocks is also set for disappointment.

For those unwilling to outright short, I would point out that historically Japan has had meaningful underperformance following past bursts of outperformance. In these periods it is particularly appealing to short against longs in higher growth areas. Japan also provides amplified short returns during global down turns. As such it can be a low cost but high return hedge to risk-off impacting long positions elsewhere. One way to identify when Japan is about to provide its greatest periods of underperformance is when its market capitalisation exceeds its Gross Domestic Product (GDP). Again, on this measure history suggests it is far better to get short Japanese equities at current levels than to get long.

One way to think about Japan's persistent underperformance is that past market rallies have been quickly frustrated by structurally weaker GDP growth, as opposed to other markets with more sustainable growth. Japan's GDP only grew +1.7% over the last 10 years, a CAGR of +0.169%. It grew even less in the 10 years prior. It is no mere coincidence that the market has failed to break out during decades of weak economic activity. Once again the market is pricing in significant economic expansion to come in Japan but its demographics, the key reason for past structural weakness, are only getting worse. I expect the euphoric hope held by many in the market, that "this time is different" in Japan, will once again be crushed by the "Iron Coffin Lid" that is Japan's structurally weak economy. Long positions in Japan will likely be buried alive again while short opportunities thrive. Yes, Japan's GDP growth rate has been higher since 2012, during what I would consider a recovery phase. But the drivers of growth in the three largest components of GDP growth are unsustainable, exhausted and now showing clear signs of reversing. Our market views to be released over coming days will look into these three major components of recent GDP growth in more detail.

Originating from Horseman Capital, hardly known for its optimistic outlook, here is the fund's take on why Japan is set for more pain once the current euphoria fades, and how to capitalize on this imminent decline:

As a short preview, Japan faces immense risks to its economic system from;

Declining private consumption as the number of households in Japan starts to decline. Nowcast data also shows a marked decline in household consumption in recent months.

A precipitous decline within the financial sector, an often forgotten component of GDP. With the Japan Financial Services Agency now reporting that most regional banks have become loss making in core businesses.

A roll-over in the real estate sector as residential oversupply hits, vacancy rates rise, rents fall, prices declinein some areas and contract ratios indicate more price cuts are coming.

Net export growth, which has been driven by a weak Yen and weak oil prices, faces a risk of the Yen strengthening 22% back to the long run real effective exchange rate, as well as continued oil price rises.

Short opportunities in regional banks, real estate developers, Real Estate Investment Trusts (REITs) and mid-size retailers are particularly appealing. The first three of these sectors, about which we have written over the last two years, have been noticeably weak but still offer significant downside. The retail sector, about which we have only recently began to write, has yet to turn down but was a notably weak performer in the last years of the last global credit cycle. Importantly we believe that shorting these sectors does not require an end to the global credit cycle, but they would likely generate amplified short returns in that environment and hence afford excellent hedges to other longs elsewhere.

Finally, it's worth recalling that as of one month ago, the BOJ already owned three quarters of all Japanese ETFs: a number which is now certainly higher, and is a non-trivial reason why Japan's stocks have enjoyed the recent surge. Of course, with ETF supply declining rapidly and the BOJ soon to be locked out of further purchases, the question is what will stoke further "flow" into risk assets (and frontrunning of central bank purchases), and will the BOJ expand its mandate further to buy single name stocks next in the name of "price stability?"

Global Macro 'Reality' - The Hopium Vs Doomium Model Explained

When Reality and Sentiment Diverge

The Hopium versus Doomium Model

The Hopium vs. Doomium model is initiating today. We first came across the word Hopium in the aftermath of the financial crisis. It was typically used by 'doomers' who believed markets were far ahead of themselves and were betting on hope rather than reality.

This model attempts to pit what we view as reality versus what view as sentiment. The scoring system is partly objective (technical indicating overbought or oversold, fund flows, positioning reports, etc.) and partly subjective (largely me trolling the media and social media trying to uncover true sentiment shifts).

What this is meant to do, is to identify opportunities where sentiment and reality diverge. If sentiment and reality are roughly lined up, then there is no obvious trade to me, but when one is very different than the other, we can identify underweight or overweight opportunities (or even long vs short ideas depending on your mandate).

Macro Hopium/Doomium

VIX

Let's start with volatility, or more specifically, the VIX index. It briefly spiked above 13 on Wednesday as global bond selling, concerns about the next Fed Chairperson and even some pre-earnings anxiety swept through the market. It finished the week at 9.8 which was lower than where it closed the prior Friday. VXN, a measure of the Nasdaq volatility, also dropped significantly as the Nasdaq composite surged more than 2%.

We do believe that the biggest risk facing the market is a spike in correlation and volatility – but I don't see that risk as very high right now. We have VIX showing up as barely in the green – meaning it might be a buy, but it isn't that compelling.

Reasons VIX can stay low

Seasonality. With fewer trading days as we start the U.S. holiday season can often push VIX lower. There have been instances, like the fiscal cliff and around elections, that hasn't been the case, but anyone looking to buy VIX must take seasonality into account.

Expectations for Tax Reform in 2017 are low. Anything short of killing all possibility of tax reform is likely to be largely ignored by the market. The market does expect Tax Reform, but not until early next year. So long as it looks like it is grinding towards that conclusion, there is little need for markets to react – keeping VIX low. Any setback that can be framed as 'negotiations' will be muted. We are not sure what will constitute derailment, but we suspect we will know it if we see it.

Surprisingly Nervous Volatility Sellers

No Rush to Sell VIX. When VIX dropped into the close on Wednesday I expect to see large inflows into the short VIX ETFs and ETNs. When VIX spiked in August, we saw extremely large inflows into those stocks. We didn't see anything like this, which is an indicator that the sellers of volatility are more cautious here, which as a contrarian, means there is less likelihood of a VIX spike.

SVXY Shares Outstanding Aug vs Oct

We did see a significant reduction in shares outstanding in UVXY – an ETF that is double long the VIX short term futures index. It looks like either profit taking, or more accurately, investors happy to get out with less of a loss than they had, but nothing so dramatic to indicate volatility bulls (market bears) have given up yet.

From a technical standpoint, the VIX futures curve is relatively flat. The 3rd VIX futures contract (January) closed at 13.35 versus the 1st VIX futures contract (November) which closed at 11.45. That spread of 1.9 is almost exactly the average for the year between the 3rd and 1st VIX futures contract (UX3 vs UX1 are the tickers on Bloomberg).

Geopolitical Tail Risk

VIX has responded most violently to increased geopolitical risk. More than any other asset class, VIX has responded when geopolitical risk has increased. Academy Securities hosted a client conference call on October 18th (replays are available) where Major General (retired) Spider Marks analyzed the White House Chief of Staff's assertion that the North Korea threat is 'manageable' and largely agreed with that assessment. We will update you as our views on current geopolitical risk evolve, but in the meantime, for those concerned about it, the best hedges are either VIX call options of long dated European Sovereign Debt – which leads us to our next asset classes.

Bunds and Treasuries

As of the initial writing of this report, we do not know who President Trump will name as next Fed Chairperson, but like everyone else, we await that decision as it should provide some clarity. We view that while there will be an initial price reaction to any decision, the market will quickly rule out the possibility of a major change in policy. The reality is that the head of the Fed is virtually forced to be dovish. If they are dovish and the economy does well – they are lauded. If they are dovish and the economy does poorly – they can just get even more dovish. The only thing that really hurts them, is being hawkish and the economy slowing. Why risk that? Draghi didn't risk that this week!

We continue to view Treasuries as a good candidate to be underweight as my ongoing target for the 10-year treasury is 2.60% with a chance of briefly spiking above that. The fundamentals for treasury investors are poor – improving economic data, D.C. trudging its way towards a near term deficit increasing tax plan, etc. There seems to be more denial in the bond market than the equity market on the potential for sustained economic growth. 

We struggle with the positioning of the bond market as many surveys indicate extreme bearish positioning, yet we find relatively few bears and a disproportionate number of bulls – who are bulls because everyone else is bearish – despite my inability to find that overwhelming bearish community.

Draghi does it again – crafting every action to be as dovish as possible.

German 10 Year Bund Yields

Bunds bounced right at the 0.49% yield level again. That is the 4th time this year that bunds have failed to rally though that level.

While it is hard to like European yields here, they are universally hated. That puts them into the 'yellow' or neutral area – at least until some more of the short positions are closed post Draghi.

It is difficult to disentangle emotions from true market impact regarding what is occurring in Spain and Catalonia. The headlines and images are awful, but it is difficult to form a direct and near-term path that impact all European markets, let alone global markets. It needs to be watched and while the market's muted reaction may 'feel' wrong, it seems correct from a trading viewpoint.

Bunds (and other high credit quality EU Sovereign Debt) can provide excellent protection from North Korean Geopolitical risk. Any risk-off trading emanating from Korea should help sovereign debt yields, but should also strengthen the Euro versus the Yen and versus the Dollar – adding an extra kicker to those bonds.

Dollar Weakness

DXY, a dollar index has rebounded sharply since threatening to break through multi-year lows in early September. While there is nothing that changes my view that this administration wants a weaker dollar and is capable of jawboning it down, the clear diversion between a Fed that seems intent on hiking and an ECB that figured out how to renew its dovish bias, could support the dollar. 

DXY Bounce on Support & Retakes Moving Averages

DXY broke the 100-day moving average last week as it closed at 94.9. That puts the 200-day moving average of 96.9 as a possible target. The model is biased towards weaker dollar, but with very limited conviction.

Domestic Stocks

After last week's surge, both U.S. Large Cap and U.S. Small Cap stocks looked stretched. Sentiment is clearly high for both groups by virtually any measure, but the fundamentals seem to warrant the valuations here. If something occurs to really disrupt the Tax Reform than look for significant pullbacks as that would dramatically shift the fundamental outlook.

Credit

Boring. Not sure that we can put a better description than boring on the overall credit market. Individual companies and sectors are exhibiting some idiosyncratic risk, but overall, risks and rewards seem balanced. Credit spreads are tight, but with the global economy marching along and volatility suppressed – there is little need for credit spreads to widen. In fact, while equities are hitting all-time highs, credit spreads are still above their pre-crisis lows.

Tax Reform can create some winners and losers – especially once Washington decides what to do, if anything, about the deductibility of interest expenses. 

We will run a full Fixed Income Hopium/Doomium Report next where we will delve deeper into the fixed income markets while drilling down into high yield, investment grade, bonds versus loans, structured credit, etc.

Oil

For much of the year, we had a range on oil of $40 to $55, but we think we could support higher oil prices here. Sentiment does seem bullish, but may be behind the bullish case. We have a bias towards domestic energy companies – equities and high yield bonds – as there is still an undercurrent in Washington that wants to focus on energy selfsufficiency. Tax Reform and Decreased Regulations should help these companies, especially if it releases any pent-up demand for M&A activity (high yield bonds tend to do better than IG bonds during periods of M&A and the high yield energy bonds could do very well if we get that combination of higher prices and reduced regulation.

Bottom Line

Relatively few obvious trades out there, at least as generated by this model. We really want to see outliers and as much as we stare at this, it is currently difficult to identify outliers.

Short treasuries and short USD might be an interesting pair.

Long oil versus short gold would need some additional work, but is another possibility.

Own some VIX calls – it hasn't worked, and we would wait to see sentiment get a bit more extreme on the 'volatility is dead' side of things before entering.

Short equities, progressively. As CenBan is losing grip on POMO or losing it on Bond Market (tertium non datur).

As mentioned earlier, we will do full update on the fixed income and credit side of things next and will add some additional Macro Asset classes in the coming weeks.

"Daggers Are Falling From The Sky" - China Stocks, Bonds Tumble After National Congress Ends

Who could have seen this coming? (somebody suspected, anyway!!! ha ha ha)

After weeks of 'calm' - demanded by The People's Party - and well-managed 'National Team' ramps top 'prove' how much Xi's plan for the nesxt five years is being received, the end of China's National Congress has been met with... a plunge in stock and bond markets.

This is the biggest drop in the Chinese market in 11 weeks...

But it's not just stocks. The Chinese bond market is getting slammed...

China 10Y yield is up 6 days in a row (the biggest surge in rates since May) to their highest since Oct 2014...

With the Chinese yield curve now inverted for 10 straight days - the longest period of inversion ever...

As Bloomberg reports, the situation that's existed for most of 2017 - sovereign yields rising, and corporate debt remaining relatively resilient - is at risk of cracking. As appetite for bonds of any kind dwindles and authorities roll out measures that target higher-risk investments, company securities are in the line of fire.

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Now that the Communist Party Congress is over, China's bond holders may be about to get hit by "daggers falling from the sky," said Huachuang Securities Co., referring to aggressive deleveraging policies.

"It's very likely we will see a significant increase in corporate yields in the coming year," said David Qu, a market economist at Australia & New Zealand Banking Group Ltd. in Shanghai.

"The trigger could be tougher regulations or a default. A majority of non-bank financial institutions' debt holdings are corporate bonds, so their selloff can lead to severe consequences. Banks are underestimating authorities' intentions to tighten regulations."

"The deleveraging campaign hasn't even gone half way, and the risk of banks redeeming entrusted funds could surface at the end of this year," said Qin Han, chief bond analyst at Guotai Junan Securities Co. in Shanghai.

"The chance of a selloff in corporate bonds is increasing, which will result in a widening of their yield premium over sovereign notes."

But this is far from over, as we noted earlier, the end of China's National Congress is also ushering in the end of 'coordinated global growth'...

As Citi writes, "China's Party Congress has concluded and Xi Jinping's position as President has been consolidated. Given there are no standing committee members in their 50s, it suggests there are no apparent heirs for Mr. Xi, opening the door for him to stay on beyond 2022. One of the key questions in the run up to the congress was that once power was consolidated, would China accelerate its economic reforms. We think this is unlikely but do expect a moderation of growth, with data momentum perhaps set to continue to slow at its current pace. Note how China's MCI tends to lead Citi's macro data index for China and our MCI is still tightening."

It gets worse.

As Capital Economics writes in its China Activity Monitor note this week, the firm's China Activity Proxy (CAP) suggests that growth in China slowed last month to the weakest pace in a year and with property sales cooling and officials continuing their efforts to rein in financial risks, Cap Econ thinks that looking ahead "the economy will slow further over the coming quarters."

CapEco's ominous conclusion:

Looking ahead, we think growth will continue to slow over the coming quarters. The current props to growth appear shaky. With investment contracting in real terms, industrial output will probably soften over the months ahead. Property sales also look set to weaken further as the government's purchase curbs continue to expand. This will weigh on construction before long. More generally, with tighter monetary conditions weighing on credit growth, activity looks set to weaken further.

That the past 18 months of coordinated global growth will end in China, is quite symmetric: back in January 2016, as global markets were tumbling, aborting the Fed's plans to hike rates 4 times in 2016 and resulting in sharp economic slowdowns around the globe, it was the (still mysterious) Shanghai Accord that "saved" the world, and unleashed a burst of unprecedented, and coordinated, growth...which only cost China some $8 trillion in debt.

It will only make sense that another major Chinese event will mark the top of this economic mini cycle, and lead to the next global downturn, not to mention spike in market volatility.