Junk Bonds Are Going To Tell Us Where The Stock Market Is Heading In 2015

Submitted by Michael Snyder of The Economic Collapse blog,

Do you want to know if the STOCK MARKET is going to crash next year?  Just keep an eye on junk bonds.  Prior to the horrific collapse of stocks in 2008, high yield debt collapsed first.  And as you will see below, high yield debt is starting to crash again.  The primary reason for this is the price of oil.  The energy sector accounts for approximately 15 to 20 percent of the entire junk bond market, and those energy bonds are taking a tremendous beating right now.  This panic in energy bonds is infecting the broader high yield debt market, and investors have been pulling money out at a frightening pace.  And as I have written about previously, almost every single time junk bonds decline substantially, stocks end up following suit.  So don’t be fooled by the fact that some comforting words from Janet Yellen caused stock prices to jump over the past couple of days.  If you really want to know where the STOCK MARKET is heading in 2015, keep a close eye on the market for high yield debt.

If you are not familiar with junk bonds, the concept is actually very simple.  Corporations that do not have high credit ratings typically have to pay higher interest rates to borrow money.  The following is how USA Today describes these bonds…

High-yield bonds are long-term IOUs issued by companies with shaky credit ratings. Just like credit card users, companies with poor credit must pay higher interest rates on loans than those with gold-plated credit histories.

But in recent years, interest rates on junk bonds have gone down to ridiculously low levels.  This is another bubble that was created by Federal Reserve policies, and it is a colossal disaster waiting to happen.  And unfortunately, there are already signs that this bubble is now beginning to burst

Back in June, the average junk bond yield was 3.90 percentage points higher than Treasury securities. The average energy junk bond yielded 3.91 percentage points higher than Treasuries, Lonski says.


That spread has widened to 5.08 percentage points for junk bonds vs. 7.86 percentage points for energy bonds — an indication of how worried investors are about default, particularly for small, highly indebted companies in the fracking business.

The reason why so many analysts are becoming extremely concerned about this shift in junk bonds is because we also saw this happen just before the great STOCK MARKET crash of 2008.  In the chart below, you can see how yields on junk bonds started to absolutely skyrocket in September of that year…

High Yield Debt 2008

Of course we have not seen a move of that magnitude quite yet this year, but without a doubt yields have been spiking.  The next chart that I want to share is of this year.  As you can see, the movement over the past month or so has been quite substantial…

High Yield Debt 2014

And of course I am far from the only one that is watching this.  In fact, there are some sharks on Wall Street that plan to make an absolute boatload of cash as high yield bonds crash.

One of them is Josh Birnbaum.  He correctly made a giant bet against subprime mortgages in 2007, and now he is making a giant bet against junk bonds

When Josh Birnbaum was at Goldman Sachs in 2007, he made a huge bet against subprime mortgages.


Now he’s betting against something else: high-yield bonds.


From The Wall Street Journal:


Joshua Birnbaum, the ex-Goldman Sachs Group Inc. trader who made bets against subprime mortgages during the financial crisis, now has more than $2 billion in wagers against high-yield bonds at his Tilden Park Capital Management LP hedge-fund firm, according to investor documents.

Could you imagine betting 2 billion dollars on anything?

If he is right, he is going to make an incredible amount of money.

And I have a feeling that he will be.  As a recent New American article detailed, there is already panic in the air…

It’s a mania, said Tim Gramatovich of Peritus Asset Management who oversees a bond portfolio of $800 million: “Anything that becomes a mania — ends badly. And this is a mania.”


Bill Gross, who used to run PIMCO’s gigantic bond portfolio and now advises the Janus Capital Group, explained that “there’s very little liquidity” in junk bonds. This is the language a bond fund manager uses to tell people that no one is buying, everyone is selling. Gross added: “Everyone is trying to squeeze through a very small door.”


Bonds issued by individual energy developers have gotten hammered. For instance, Energy XXI, an oil and gas producer, issued more than $2 billion in bonds just in the last four years and, up until a couple of weeks ago, they were selling at 100 cents on the dollar. On Friday buyers were offering just 64 cents. Midstates Petroleum’s $700 million in bonds — rated “junk” by both Moody’s and Standard and Poor’s — are selling at 54 cents on the dollar, if buyers can be found.

So is there anything that could stop junk bonds from crashing?

Yes, if the price of oil goes back up to 80 dollars or more a barrel that would go a long way to settling things back down.

Unfortunately, many analysts are convinced that the price of oil is going to head even lowerinstead…

“We’re continuing to search for a bottom, and might even see another significant drop before the year-end,” said Gene McGillian, an analyst at Tradition Energy in Stamford, Connecticut.

As I write this, the price of U.S. oil has fallen $1.69 today to $54.78.

If the price of oil stays this low, junk bonds are going to keep crashing.

If junk bonds keep crashing, the STOCK MARKET is almost certainly going to follow.

For additional reading on this, please see my previous article entitled “‘Near Perfect’ Indicator That Precedes Almost Every Stock Market Correction Is Flashing A Warning Signal“.

But just like in the years leading up to the crash of 2008, there are all kinds of naysayers proclaiming that a collapse will never happen.

Even though our financial problems and our underlying economic fundamentals have gotten much worse since the last crisis, they are absolutely convinced that things are somehow going to be different this time.

In the end, a lot of those skeptics are going to lose an enormous amount of money when the dominoes start falling.

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Simply put – ignore this…


Archaea Capital’s 5 Bad Trades To Avoid Next Year

Excerpted from Achaea Capital’s Latter to Investors,

Blind faith in policymakers remains a bad trade that’s still widely held. Pressure builds everywhere we look. Not as a consequence of the Fed’s ineptitude (which is a constant in the equation, not a variable), but through the blind faith markets continuing to place bets on the very low probability outcome – that everything will turn out well this time around. And so the pressure keeps rising. Managers are under pressure to perform and missing more targets, levering up on hope. As we wrote last year, bad companies were allowed to push their debt up in order to pay generous shareholder dividends and director packages that are now (in an uninspiring turn of events) higher than their free cash flow. Buybacks are “all-in” at cycle-highs, funded with shareholder money while insiders continue to cash out their own. Individual investors pressured to pick up yield became their debt or equity holders – lured by higher returns, easy-to-use ETFs, and asking no questions. And so, just as Moody’s suggested a year ago would happen (and we presented in last year’s report), high yield spreads have widened all year – in stark contrast to the gains in stocks and one of the most supportive government Bond rallies in history. The default cycle doesn’t appear to be that far off anymore, and not just in U.S. markets. Credit markets have embarked on a new fundamental narrative – bills still need to be paid, and not everyone deserves to sell new paper at the same price. Markets are illiquid, fractured, and in many cases unable to sustain any real test of selling. Meanwhile it’s business as usual at the Fed, where credibility remains intact and market participants blindly expect another magic trick for Equities in the coming year.

We think 2015 could mark a turning point in the narrative – and for the first time in eight years we’ve begun deploying capital, albeit still conservatively, in areas with the largest potential for significant dislocations—without risking much if we are wrong.

Without further delay we present our slightly unconventional annual list. Instead of the usual what you should do, we prefer the more helpful (for us at least) what we probably wouldn’t do. Five fresh new contenders for what could become some very bad trades in the coming year. As usual this is not intended as an exhaustive list. In fact we had to leave out some rather compelling candidates on this go-around. To further complicate things, some bad trades from last year happen to be sneakily carrying over as we mentioned before. We’ll discuss these and others in the next section.

Five Bad Trades To Avoid Next Year – 2015 Edition

BAD TRADE #1 For 2015: “Leaked” Research.

In March of this year one of the biggest Emerging Markets-focused macro funds in the world leaked a 100+ page slideshow for why EM, and specifically Brazil and China, were going to implode (and bring down the world with them). Around the same time the head of macro research for a major fund published an article in a top newspaper warning of an imminent systemic calamity in Emerging Markets, and specifically China. We spoke with some managers at the time and they said: “Our team went to [insert country name here] with a bearish view, and came back even more bearish”. This statement probably deserves a whole section/discussion for itself. What followed is now history.

Long ago, there was a time when professional money managers on average possessed an informational advantage over the average market participant – as well as the ability to translate this advantage into superior performance. Some may attribute that edge to a combination of better data, research departments, experience, portfolio construction, and risk control. We don’t necessarily disagree. But a sixth factor may have been the most important of all – patience to let high-conviction, asymmetric bets pay off. Whatever the weights one assigns to each factor or edge, most have been in irreversible decline for over a decade. Data is free. Research departments are increasingly rigid. Average experience keeps falling as the industry contracts. Six years and a rising market have forced portfolios to ignore probabilistic outcomes and focus only on the past trend. Risk control is modeled so it doesn’t have to be understood. Patience has been cut to zero.

The result of this – October 2014 a prime example, is that major developed equity markets can now easily decline nearly 10% in a period of only 3-4 days, without any new or significant information released from news or government sources at the margin. And some individual stocks (which appeared liquid not even a day before) can now effectively stop trading as if the market were closed.

Valuable and timely research doesn’t come in a polished easy-to-flip format. It is planted and cultivated over time and with great care. It doesn’t copy-and-paste what is happening, but drives an ever-changing discussion of what may happen in the future. It is exchanged with clients as part of a broad conversation on future investments, goals, and strategy. Sometimes it may not even aim to recommend a specific course of action. It may simply conclude that different information is needed, and outline the paths to get there. Good research should include alternate scenarios. It should guide towards the most likely outcomes, not shut the door on everything else. Keeping an eye on the vault labeled “won’t open” can sometimes be much more rewarding. Next year should be no different.

BAD TRADE #2 For 2015: It’s A Bull Market, If Markets Rise Then Volatility Will Fall.

We’ll save the bit about “It’s A Bull Market” for Bad Trade #3. In this section we’ll discuss “Volatility Will Fall”.

Volatility used to be regarded as a highly-specialized tool for risk management. Hedgers used it to HEDGE, and every few years or so a levered speculator (read: seller) blew up. Today, six years of rising markets have turned every yield-starved investor and performance-chasing fund manager into a volatility seller.

Selling volatility has become a CASINO floor bleeping with offerings of ETFs, leveraged structures, swaps and futures. Every table offers its own brand of excitement and adventure. Yet unlike a real CASINO where some patrons know they’ll lose money – and consciously play small to enjoy a free drink on a getaway with friends – no one selling volatility today thinks they can lose at this game.

Let’s step back for a moment. The biggest monetary experiment in history has just (possibly) ended. From 2008 to 2014, the Fed was the largest synthetic seller of volatility in financial history. Following smartly along, countless asset managers and even the world’s largest Bond fund came out as proponents of selling volatility. That is, until the founder of said fund left to manage a smaller fund he could actually trade without the whole market knowing about it. Two weeks after his departure, the market collapsed and volatility briefly doubled. So the two biggest volatility sellers in history have just left the casino floor and are sitting down to eat at the complimentary buffet, while everyone else is doubling down on a new deck.

But let’s ignore all of that. It’s a bull market, you know, Mr. Partridge. So stocks will rise and volatility will fall. Well it turns out… not really. Six years into this bull market, calling this environment Mid Cycle would be very, very generous. More likely, we just ended the first year of a two-year Late Cycle phase.

Take a look at the picture below. In over a century, U.S. Equities on a year-on-year basis have made gains with falling volatility about one-third of the time, and made gains with rising volatility about a quarter of the time. In total, U.S. Equities have made gains roughly 60% (one third plus one quarter) of the time on a year-on-year basis.

As it turns out, the long-term averages are trumped by the specifics of the stage in the cycle. Very strong trending returns with rising volatility, both of which are firmly observed today, are the hallmark of late cycle bull markets with very few exceptions. In late stage bulls, the market and volatility rise together well over double the long-term average. Not very good odds. This is one of those cases where one doesn’t have to be right about the underlying trend in stocks to make a thoughtful, truly HEDGED bet. We wish the brave few hedgers luck.

BAD TRADE #3 For 2015: It Didn’t Work The First Two Times, So Let’s Go All-In On The Third.

We could spend all day on the previous comment – “It’s A Bull Market”. But the fundamental truth, at least for us, is that it doesn’t really matter what animal this is. Market participants devote too much time to this discussion and usually with little benefit other than satisfying their need for confirmation bias. We believe in watching risk instead – and letting the returns take care of themselves.

One way we define risk is price acceleration in any direction. Two of the ways we estimate this are by monitoring market conditions and assessing the equity cycle. What has become increasingly clear is that more parts of the market now behave as if we are in Late Cycle, while others have transitioned to a new Bear Market. These conditions have been developing all year.

To our surprise this late cycle pricing (and risk) had not yet started to show up in our Core Risk guidelines. So in our view, throughout most of the year we were dealing with a normal extension of prior conditions, with brief periods of elevated risk.

Then over the last 2 weeks something truly remarkable happened.

We track a number of late cycle fundamental data series that we call our Core Risk framework. Our primary concern in running these long-term price series is risk-management. The bigger the dislocation in our long-term data, the larger the risk. Further, in our experience risk is also non-linear. Historically, above certain levels of risk the probability and magnitude of severe drawdowns follow patterns similar to a power law.

The chart below offers an example. In almost thirty years, the highest value (risk) ever achieved in our Late Cycle Equity Pricing Model was during May 2008. It also led to the largest drawdown. The occasional failure such as 2005 produced a flat market, but in the process gave us valuable information that High Risk dynamics were not yet in play. Even then, caution and patience were highly rewarded.

As can be seen above, the last few weeks have finally produced what we call an “All-In” Late Cycle risk dynamic. Historically this has transitioned to very high volatility and very large drawdowns for U.S. equity markets. We can’t control how the market will respond to this. All we can do is recognize the problem and manage the risk accordingly.

Also “Going All-In”, another one of our Core Risk monitors:

We hope this drives the point that debating a Bull or Bear case is particularly irrelevant here. Yes, it could be either one. But the risk of one’s bias being wrong has almost never been higher. And going “All In” this third time around doesn’t look right either.

BAD TRADE #4 For 2015: I’ll Worry About It Tomorrow.

We live in a world where long-term thinking has been thrown out the window. Stock traders have decried this on a daily basis for over a century and yet it still rings true. Nowhere is this clearer than in the below chart. It starts at the inception of the SPY ETF in January 1993. We break out the market’s cumulative price return into overnight (which we’ll call “investors”) and cash-session (which we’ll label “day traders”) components.

During its first few years of existence, the Cumulative Return of holding the SPY overnight vs. the cash session was roughly equal. The market advance was being driven by both. Then in 1997 something changed. Day trader returns peaked and became a headwind. Overnight returns started to accelerate and overtook the Market return. Even more fascinating, this outperformance was maintained with lower volatility and lower drawdowns. None of this factors in transaction costs or taxes. Regardless, it’s an extremely powerful visualization of what we think is a key structural change in stock investing.

Recent years have been even more fascinating. Zooming in since 2009, the SPY has gained +195%, with the investor component gaining +60% and day traders gaining +84%. The chart below shows their normalized returns anchored at the March 2009 bottom:

While it may seem like day traders have collectively beaten the pants out of investors, individually today each group has only been able to reach where the broad market was roughly in 2010. As was the case since 1997 a great deal of money has been left on the table by those unwilling to hold positions past the close – which in this day and age is an ever-growing chunk of market participants. In this bull market (like the ones before it) a significant and steadily reliable component of returns came from thinking more like an investor.

As with every year before it, 2014 produced several periods of worrisome economic and geopolitical news. Sooner or later one of these hit close enough to a portfolio manager’s “sell button”, and panic ensued. In a market increasingly dominated by automated HFT DAY TRADING, speed-based market-making strategies, and generally ultrashort-term thinking, those who preferred to “Worry About It Tomorrow” instead of accepting overnight risk were accordingly giving up risk premium.

Worse, over the past year short-term thinkers have given up even more of this risk premium. And along with it, much of their performance lead. The next chart illustrates this interesting trend. Since the 2009 advance started, the Ratio of Cash to Overnight Cumulative Returns has been broadly stable between 1.10 and 1.20. This meant the cash session was maintaining a 10-20% lead. Since May 2013 however, day traders started to underperform overnight returns – giving up nearly half their previous lead. At one point in October they nearly gave it all back:

This unfolding weakness is quite significant. The S&P gained 25% since May of 2013. The overnight return was 15.3% and the cash session return was only 8.7%. Heading into next year, there is little reason to expect this gap to shift back in favor of short-term thinking. In fact, it peaked in late 2009. And then failed again in 2011. If history is our guide and late cycle dynamics become even more entrenched, investors seem more likely to outperform – and intraday returns to drift relatively lower. For those taking this to mean a strong market environment ahead, we look back to 2002-2007 when the Cash/Overnight Ratio finally fell below 1.10 for good, after a 2+ year drift lower in nearly identical fashion to what we observe today:

BAD TRADE #5 For 2015: It’s the only game in town.

Much of this section has been covered in the other four trades. Nevertheless we think a separate mention is important. Increasingly, investors are riding trends without understanding their fundamentals. We see this philosophy particularly prevalent in volatility, inflation expectations, and the Dollar. We see it mentioned alongside the Fed, with QE frequently hailed as “the only game in town”. Its siblings Abenomics and Draghinomics now compete for the same label. It’s become a well-worn phrase. We heard it in 2011 when some described the Gold market, in mid-2012 on Bonds, in mid-2013 on Japan, to name a few. Meanwhile pressure continues to build as market prices dislocate further from underlying driving forces.

This year almost no market has been spared the deadly phrase. Leaders became losers and vice-versa, in a particularly nasty game of musical chairs. Mean-reversion doing its dirty work. At one point this year European Equities were the only game in town. So were high-flying U.S. momentum stocks. Then Japan again. Then Emerging Markets. Then China. Then the Dollar, followed by U.S. Equities. These last two, along with a few others, still stand unchallenged.

We worry about the velocity of price adjustment required to close the wide gap between momentum investors extrapolating trends and what fundamentals can truly support. The consensus reasoning is that price adjustment won’t happen because markets are permanently supported by central bankers. Unfortunately in every year since 2009, despite massive coordinated central bank intervention, price adjustment did happen in virtually every major market and often with very painful knock-on effects. So when something is hailed the only game in town we’ve decided to quietly agree, pack our bags, and move to a different town.

The Biggest Economic Story Going Into 2015 Is Not Oil

Submitted by Raul Ilargi Meijer via The Automatic Earth blog,

Isn’t it fun to just watch the market numbers roll by from time to time as you go about your day, see Europe markets up 3%+, Dubai 13%, US over 2% (biggest two-day rally since 2011!), and you just know oil must get hit again? Well, it did. WTI down another 3%+. I tells ya, no Plunge Protection is going save this sucker.

And oil is not even the biggest story today. It’s plenty big enough by itself to bring down large swaths of the economy, but in the background there’s an even bigger tale a-waiting. Not entirely unconnected, but by no means the exact same story either. It’s like them tsunami waves as they come rolling in. It’s exactly like that.

That is, in the wake of the oil tsunami, which is a long way away from having finished washing down our shores, there’s the demise of emerging markets. And I’m not talking Putin, he’ll be fine, as he showed again today in his big press-op. It’s the other, smaller, emerging countries that will blow up in spectacular fashion, and then spread their mayhem around. And make no mistake: to be a contender for bigger story than oil going into 2015, you have to be major league large. This one is.

The US dollar will keep rising more or less in and of itself, simply because the Fed has ‘tapered QE’, and much of what happened in global credit markets, especially in emerging markets, was based on cheap and easily available dollars. There’s now $85 billion less of that each month than before the taper took it away in $10 billion monthly increments. The core is simple.

This is not primarily government debt, it’s corporate debt. But it’s still huge, and it has not just kept emerging economies alive since 2008, it’s given them the aura of growth. Which was temporary, and illusionary, all along. Just like in the rest of the world, Japan, EU, US. And, since countries can’t – or won’t – let their major companies fail, down the line it becomes public debt.

One major difference from the last emerging markets blow-up, in the late 20th century, is size: emerging markets today are half the world economy. And they’re about to be blown to smithereens. Sure, oil will play a part. But mostly it will be the greenback. And you know, we can all imagine what happens when you blow up half the global economy …

Erico Matias Tavares at Sinclair has a first set of details:

Emerging Markets In Danger

There are some signs of trouble in emerging markets. And the money at risk now is bigger than ever. The yield spread between high grade emerging markets and US AAA-rated corporate debt has jumped, almost doubling in less than three weeks to the highest level since mid-2012.

MSCI Emerging Markets Index and Yield Spread between High Grade Emerging Markets and US AAA Corporates: 14 March 2003 – Today. Source: US Federal Reserve.

This means that the best credit names in emerging markets have to pay a bigger premium over their US counterparts to GET FUNDING. When this spread spikes up and continues above its 200-day moving average for a sustained period of time, it is typically a bad sign for equity valuations in emerging markets, as shown in the graph above. One swallow does not a summer make, but it is worthwhile keeping an eye on this indicator.


As yields go up the value of these emerging market bonds goes down, resulting in losses for the investors holding them. The surge of the US dollar in recent months could magnify these losses: if the bonds are denominated in local currency they will be worth a lot less to US investors; otherwise, the borrowers will now have to work a lot harder to repay those US dollar debts, increasing their credit risk. Any losses could end up being very significant this time around, as demand for emerging markets bonds has literally exploded in recent years.

Average Annual Gross Debt Issuance ($ billions, percent): 2000 – Today. Source: Dealogic, US Treasury. Note: Data include private placements and publicly-issued bonds. 2014 data are through August 2014 and annualized.

As the graph above shows, the issuance of emerging market corporate debt has risen sharply since the depths of the 2008-09 financial crisis.These volumes are very large indeed, and now account for non-trivial portions of investors’ and pension funds’ portfolios worldwide.


As a result, emerging markets corporations are now leveraged to the hilt, easily exceeding the 2008 highs by almost a multiple to EBITDA. And why not? With foreign investors desperate for yield as a result of all the stimulus and money printing by their central banks, they were only too happy to oblige. And they were not alone. Governments in these countries were also busy doing some borrowing of their own, as their domestic capital markets deepened.


[..] foreign investors have also piled into locally denominated bonds of emerging markets governments. Countries like Peru and Latvia now have over 50% foreign ownership of their bonds. [..] But there are big speculative reasons behind the recent money flows going into these countries – which could reverse very quickly should the tide turn. [..]


If investors end up rushing for the emerging markets exit for whatever reason, with this unprecedented level of exposure they might be bringing home much more than a bruised ego and an empty wallet. For one, European banks are hugely exposed to emerging markets. Any impairment to their books would likely make any new lending even more difficult, at a time when there is already a dearth of non-government credit in Europe.


And if emerging economies falter, where will the growth needed to repair Western government and private balance sheets come from? It used to be said that when the US economy sneezes the rest of the world catches a cold. Now it seems all we need is a hiccup in emerging markets.

That’s what you get when emerging markets are both half the global economy AND they’ve accomplished that level off of ultra-low US Fed interest rates and ultra-high US Fed credit ‘accommodation’. All you have to do when you’re the Fed is to take both away at the same time, and you’re the feudal overlord.

Our favorite friend-to-not-like Ambrose Evans-Pritchard does what he does well: provide numbers:

Fed Calls Time On $5.7 Trillion Of Emerging Market Dollar Debt

The US Federal Reserve has pulled the trigger. Emerging markets must now brace for their ordeal by fire. They have collectively borrowed $5.7 trillion in US dollars, a currency they cannot print and do not control. This hard-currency debt has tripled in a decade, split between $3.1 trillion in bank loans and $2.6 trillion in bonds. It is comparable in scale and ratio-terms to any of the biggest cross-border lending sprees of the past two centuries.


Much of the debt was taken out at real interest rates of 1% on the implicit assumption that the Fed would continue to flood the world with liquidity for years to come. The borrowers are “short dollars”, in trading parlance. They now face the margin call from Hell as the global monetary hegemon pivots. The Fed dashed all lingering hopes for leniency on Wednesday. The pledge to keep uber-stimulus for a “considerable time” has gone, and so has the market’s security blanket, or the Fed Put as it is called. Such tweaks of language have multiplied potency in a world of zero rates.


Officials from the BIS say privately that developing countries may be just as vulnerable to a dollar shock as they were in the Fed tightening cycle of the late 1990s, which culminated in Russia’s default and the East Asia Crisis. The difference this time is that emerging markets have grown to be half the world economy. Their aggregate debt levels have reached a record 175% of GDP, up 30 percentage points since 2009.


Most have already picked the low-hanging fruit of catch-up growth, and hit structural buffers. The second assumption was that China would continue to drive a commodity supercycle even after Premier Li Keqiang vowed to overthrow his country’s obsolete, 30-year model of industrial hyper-growth, and wean the economy off $26 trillion of credit leverage before it is too late. [..]


Stress is spreading beyond Russia, Nigeria, Venezuela and other petro-states to the rest of the emerging market nexus, as might be expected since this is a story of evaporating dollar liquidity as well as a US shale supply-glut.


[..[ the Turkish lira has fallen 12% since the end of November. The Borsa Istanbul 100 index is down 20% in dollar terms. Indonesia had to intervene on Wednesday to defend the rupiah. Brazil’s real has fallen to a 10-year low against the dollar, as has the index of emerging market currencies. Sao Paolo’s Bovespa index is down 23% in dollars in 3 weeks.

The slide can be self-feeding. Funds are forced to sell holdings if investors take fright and ask for their money back, shedding the good with the bad. Pimco’s Emerging Market Corporate Bond Fund bled $237m in November, and the pain is unlikely to stop as clients discover that 24% of its portfolio is in Russia.


One might rail against the injustice of indiscriminate selling. Such are the intertwined destinies of countries that have nothing in common. The Fed has already slashed its bond purchases to zero, withdrawing $85bn of net stimulus each month. It is clearly itching to raise rates for the first time in seven years. This is the reason why the dollar index has jumped 12% since May, smashing through its 30-year downtrend line, a “seismic change” in the words of HSBC. [..]


World finance is rotating on its axis, says Stephen Jen, from SLJ Macro Partners.The stronger the US boom, the worse it will be for those countries on the wrong side of the dollar.


“Emerging market currencies could melt down. There have been way too many cumulative capital flows into these markets in the past decade. Nothing they can do will stop potential outflows, as long as the US economy recovers.

Hold it there for a moment. I don’t think it’s the US economy (its recovery is fake), it’s the US dollar.

Will this trend lead to a 1997-1998-like crisis? I am starting to think that this is extremely probable for 2015,” he said.


This time the threat does not come from insolvent states. They have learned the lesson of the late 1990s. Few have dollar debts. But their companies and banks most certainly do, some 70% of GDP in Russia, for example. This amounts to much the same thing in macro-economic terms. Private debt morphs into state debt since governments cannot allow key pillars of their economies to collapse.


These countries have, of course, built $9 trillion of foreign reserves, often the side-effect of holding down their currencies to gain export share. This certainly provides a buffer. Yet the reserves cannot fruitfully be used in a recessionary crisis because sales of foreign bonds automatically entail monetary tightening. [..]


.. these reserves are a mirage. If you deploy them in such circumstances, you choke your own economy unless you can sterilize the effects. [..]


Investors are counting on the European Central Bank to keep the world supplied with largesse as the Fed pulls back. Yet the ECB could not pick up the baton even if it were to launch a blitz of quantitative easing, and there is no conceivable consensus for action on such a commensurate scale.


The world’s financial system is on a dollar standard, not a euro standard. Global loans are in dollars. The US Treasury bond is the benchmarks for global credit markets, not the German Bund. Contracts and derivatives are priced off dollar instruments. Bank of America says the combined monetary stimulus from Europe and Japan can offset only 30% of the lost stimulus from the US.

What more can I say? This is the lead story as we go into 2015 two weeks from today. Oil will help it along, and complicate as well as deepen the whole thing to a huge degree, but the essence is what it is: the punchbowl that has kept world economies in a zombie state of virtual health and growth has been taken away on the premise of US recovery as Janet Yellen has declared it.

It doesn’t even matter whether this is a preconceived plan or not, as some people allege, it still works the same way. The US gets to be in control, for a while, until it realizes, Wile E. shuffle style, that you shouldn’t do unto others what you don’t want to be done unto you. But by then it’ll be too late. Way too late.

As I wrote just a few days ago in We’re Not In Kansas Anymore, there’s a major reset underway. We’re watching, in real time, the end of the fake reality created by the central banks. And it’s not going to be nice or feel nice. It’s going to hurt, and the lower you are on the ladder, the more painful it will be. Be that globally, if you live in poorer countries, or domestically, if you belong to a poorer segment of the population where you are. In both senses, the poorest will be hit hardest.

It’s the new model along which the clowns we allow to run the show, do so. Unless ‘we the people’ take back control, it’s pretty easy to see how this will go down.

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Still not convinced… Barclays notes this is already one of the worst sell-offs in EM credit since the crisis…