Warning signs are flashing as dangerous complacency sets in…
But it’s fundamentals that drive the markets and our trading approaches. And right now, there are massive risks beneath this current wave of complacency and optimism.
How do I know?
Easy. Both the bond market and history are telling us so. In fact, they’re screaming.
Let me explain why complacency today is a very dangerous thing, despite the party in stocks which we carefully invited you to join the moment the Fed began printing money again in mid-October.
History Rhymes – So Do Bonds
As Mark Twain might’ve said, “History may not repeat itself, but it often rhymes.”
The history of the bond market and bond behavior – as well as central bank and investor reactions to bond markets – is, in fact, eerily consistent. The story it tells, and the future it foretells is a scary one.
But human nature is equally consistent – and equally averse to scary stories. I get this. I even trade on this behavior. But we can’t ignore signals, facts and history just because it might scare us.
So, let’s look at the facts of both history and credit cycles and wake up to reality.
As we’ve said hundreds of times-the key to understanding and predicting stock markets is tracking what’s happening in the bond markets, and nothing tracks bond markets better than the yield curve.
Months back, we shared the warnings which the bond market was giving loud and clearly. That is, yields on longer term bonds were falling lower than yields on shorter term bonds.
This is called a yield-curve inversion, and inverted yield curves have been the precursor to every recession since the Second World War.
In short, an inverted yield curve is a big deal, and a clear warning.
But what 99.9% of most investors don’t know is the rhyming history of how inverted yield curves actually operate.
In fact, recessions don’t come when the yield curve inverts, they come when a yield curve inverts and then suddenly steepens, or corrects itself, after a previous inversion.
And folks, as you can see clearly in the chart below, that’s precisely what is happening now. Over the last 90 days, the yield curve is steepening (top line) after a telltale inversion (bottom line).
Don’t believe this is dangerous? Well, I get it.
So, let me show you how this rhyming cycle of bond behavior, investor complacency, and Fed hubris plays itself out time, after time, after time.
We Call This the “Complacency Cycle” – There Are Four Parts
This behavioral cycle has some distinct phases…
- The Phase 1 Warning Period;
- The Phase 2 Do-Something Quick Period;
- The Phase 3 Complacency Fantasy Period; and
- The Phase 4 Moment of Uh-Oh!
Most people think back on the disaster of 2008 and cite the collapse of Bear Sterns as the black-swan that triggered the whole melt-down.
But most people are, well… wrong.
In fact, long before Bear Sterns went belly up in 2008, the bond market was sending its same warning signals, most of which were ignored.
As early as 2006 and 2007, the yield curve was inverting. Again, that’s a big deal. I call this the Phase 1 Warning Period.
During a Phase I Warning Period, markets get choppy, investors get a little nervous as the yield curve inverts and the Fed, as usual, dismisses or ignores any problems and assures one and all that everything is solid, fine and not to worry.
But remember: The Fed’s record for forecasting recessions is 0 in 9. Its greatest talent lies in B.S.’ing investors into a false calm before every storm.
Then comes the Phase 2 Do-Something Quick Period. That’s when the Fed can no longer ignore the inverted yield curve or the bond and stock market gyrations; it has to step in and cut rates, issue money, and “save the market.”
Back in 2008, we saw this Phase 2 Do-Something Quick Period play out in a number of ways.
First, the Fed supported JPMorgan in buying out the dying Bear Sterns. Then, the Fed and other regulators got busy doing other sexy things like increasing dollar swaps and primary credit facilities.
In short, the Fed tosses money at the problem and saves the day.
Thereafter comes the next phase in the cycle, what I call the Phase 3 Complacency Fantasy Period when markets and investors breath a collective sigh of relief and the Fed congratulates itself for being awesome.
Believe it or not, even in 2008, there was a ton of complacency before the markets suddenly tanked.
This phase typically lasts anywhere from 4 to 7 months. Investors ignore systemic realities of bad debts, cancerous dollar shortage risk and rising, over-valued markets.
Instead, they collectively convince themselves that the Fed has their back, and there’s nothing to fear because markets are up. It’s a nice, warm and fuzzy time of ignoring risk and watching markets rise.
But then comes the final phase, what I call the Phase 4 Moment of Uh-Oh.
This is the historically inevitable and oft-repeated moment when the markets remind us yet again that the Fed is not stronger than market forces, and that monetary policy stunts just don’t work; they merely buy time.
Of course, we all remember how that phase played out. From September of 2008 to March of 2009, the S&P lost 46%.
Am I saying we are headed for another Phase 4 Oh-Uh moment akin to 2008?
Well, if history and bond market realities are any guide, the short answer is: Yes-but just not yet.
The four phases I’ve discussed played out in 2011 and 2012. Again they played out between 2014 and 2016, though they did so without a major U.S. recession (well, almost in 2011) but with massive pain in Europe and the emerging markets.
The U.S., however, has 1) the world’s reserve currency, 2) a loaded money printer and 3) a happy trigger finger. Thus, for more than 11 years the Fed has managed to kick the recessionary can down the road with admittedly great effect.
But here’s the rub folks: By postponing (printing away) the reality of natural market forces, the Fed is only making the recession ahead all the more disastrous.
And as for those four phases discussed, let’s look at them in the context of the current market dynamics which we can all confirm, as they are happening right before our eyes.
The Four Phases of the Current Apocalypse
The familiar Phase 1 Warning Period has already played itself out. From last November to late August of this year, the yield curve gave us that screaming warning sign that trouble lies ahead. We wrote of this here and here.
And as in every Phase 1 period, the Fed told us all not to worry, that everything was fine. Same ol’, same ol’…
Then, right on cue, came the Phase 2 Do Something Quick Period in which the Fed can’t keep lying as the markets are clearly in trouble.
This played itself out beautifully when the repo markets effectively ran out of money and the Euro dollar shortage reared its ugly, but ignored head.
And as in every Phase 2 moment, the Fed greased up its money printers, sharpened its rate cutters and came in to save the day.
By mid-October, when I bullishly interrupted my fly-fishing trip to yell “party on,” the Fed began printing $60 billion a month to buy short-term T-Bills, thus boosting their price and cutting their yields, thereby “solving” the inverted yield curve problem with a little help from $300 billion printed in less than 60 days.
But remember what I said above: the real dangers of inverted yield curves come when the yield curve suddenly corrects, as we are seeing now…
Which brings us to where we are today, happily enjoying all the melt-up bliss of the oh-so popular Phase 3 Complacency Fantasy Period.
Markets have not only recovered their losses or come off their lows, they are ripping up and to the right with new highs.
Yippie Yay! The Fed has saved the day!
And as always in the Phase 3 Complacency Fantasy Period, faith in the Fed is back as Powell once again takes credit for saving the markets and brushing off the prior hiccups in the bond markets as a mere “mid-cycle disruption.”
Mid-cycle disruption? We are currently at the tail end of the longest business cycle ever recorded. Mid cycle what?! Mid cycle huh?!
And, as always in such Phase 3 moments, investors are ignoring the systemic cancers all around them and only seeing a rising stock market.
That is, they are ignoring: 1) record-breaking global and national debt, 2) a ticking time bomb of global dollar shortages; 3) massive political unrest and unprecedented wealth disparity; 4) dangerously compressed bond yields and 5) just about every traditional indicator of market risk ever known to man flashing bright red.
In other words, folks, don’t get too complacent right now…
A trade-war resolution, even if achieved (and likely to create a market pop further up), can’t save these broken, upwardly melting markets in the long run.
Here’s a Look Ahead for Savvy Investors
And remember, after Phase 3 comes the Final Phase 4 Moment of Uh-Oh.
That Phase will come. It’s not a question of if, but when.
So, yes, we’ve called the melt-up. Heck, we’re in the melt-up.
But beneath it lies the clear warning signs coming from the bond market and the dollar shortage disaster, which we’ve spelled out in blunt, transparent English.
Which means you are in the know, not the dark. Our tools will guide you through these phases with candor rather than an appeal to a dangerous and false complacency.
For now, of course, enjoy the melt-up, which we are tracking and which the Fed will do whatever it takes to prolong. But stick to our cash recommendations, our heat maps and our frank-speak.
Why? Because the bond market, history and even me, are telling you so.
Matt and Tom
15 responses to “What Every Investor Needs to Know About the Bond Markets Right Now”
November 25 2019