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Bond Bear Threatens Central Bank Reserves

June 18, 2015


The top headline for the last quote was "400 Billion Reasons Why Ebbing Currency Reserves Threatens Bonds", which really caught our eye. Not because of the threat to bond prices, but because the significant decline in prices represents an equivalent decline in central bank reserves.

In financial markets, cause and effect relations can be elusive. We noted that long-dated Treasuries became overbought in late January. "Ending Action" was the title of out special study. This was emphasized a number of times in March. Our April 9th Pivot concluded that falling prices and rising yields would soon spread to Europe. The best for the German note was 0.059% set on April 19. Now it's at 0.96%, representing a huge drop in price.

It is one thing to have one bank losing its reserve as when the Bank of Thailand lost its in July 1997. The Asian Crisis followed.

Not every senior central bank would be holding the same mix of maturities. But the main thing is that all of the senior bank reserves were aggressively employed and their reserves have been shrinking. And will continue to shrink until bond prices stop going down.

In the meantime, they are trying to boost the rate of CPI inflation, which may not be good for bond prices.

Do the scribes that calculate the value of central bank reserves talk to the scribes who are trying to trash the bond market?

The headline should have been "Bond Bear Threatens All Central Bank Reserves".

In very big type.

Stock Markets

There has been some big labels over the last while.

That 2007 was a classic bubble is not widely discussed, but its consequence, which was the worst financial collapse since the 1930s has been well-reviewed. It has been called the "Great Recession" and there has been "high-fives" all around because the Fed prevented "Great Depression 2.0".

The first business cycle out of the classic crash has been long but weak. The first bull market out of the crash has been outstanding in both duration and gain.

Let's call it the "Great Complacency".

As we have been reviewing it, exuberance has been extended for almost a year. This is a long time and the latest thrusts have been into the season when outstanding rallies can be accomplished. And can end.

In the mature exchange the hot action was represented by the IBB, which accomplished big-time Upside Exhaustions in late March. The correction was close to target and the index has been expected to test the high. Ross is updating this action. And this bounce is tied to Monday's Chartworks "Springboard Buy" on the S&P.

The slump into last October also generated a Springboard Buy and given the season we projected a rally into March and perhaps into "around May".

Considering the remarkably long levitation of animated spirits as well as the season, this Springboard rally could be modest. Of interest to traders for sure and for investors it could set the ultimate rally.

Great stock bubbles have been global and it is now important to monitor the senior exchanges as well as the outlying ones. In Roman times Cicero observed that financial troubles in outer regions would feed afflict financial markets in Rome.

Depending upon the source, the South Sea Bubble peaked on June 20th or the 28th. As exampled by the SSEC, the South China Sea Bubble has recorded two bursts of Upside Exhaustions and is now working on the third. It took three such extravaganzas to complete the Shanghai blow-off on October 16, 2007. It is uncertain if three will be needed to complete this mania.

In 2007, the SSEC peak was coincidental with the S&P peak.

The European STOXX is also in a pattern similar to 2007. That one found support at the 50-Week ema on the way up and set its high at 4015 on July 15th. That support was violated late July and again in late October (Step Two). The best on momentum was 70 set in April. Step One, taking out the 50-Day ma was accomplished on July 23rd.

This time around, momentum for the STOXX was more vigorous in accomplishing a Weekly RSI of 73 on March 20th. The index high was 3602 reached on April 15th. At 3300 now, the index is below the 50-Day which is at 3472. That's our Step One in keeping track of change. Step Two would be taking out the 40-Week ema, which is at 3264.

Hong Kong (FXI) soared to a Weekly RSI of 75 on April 15th. In round numbers, the index high was 53 and the low has been 49. The range has been three times at the high and three times at the low.

This week it has slipped below the 48 level and taken out the 50-Day which is at 50. The latter has to be tested before it can be called Step One. To be looking ahead, Step Two would be taking out the 40-Day ema, which is at 42.

The eyebrow-raising news story early in the week is that villagers in rural China are positioned for when the Shanghai 'A' shares will be included in the Morgan Stanley China Index. Today MSCI says it might take a while.

CNBC headlined "Stock Craze Sweeps Rural China" and the story included a villager observing the it was "easier to make money in the stock market than in farming."

This seems quite the opposite to the observation when under Communism "Why should the farmers grow rice when the state provides it free?".

Let's review the positives that have been supporting the NYSE.

The yield curve is no longer flattening. Some steepening talk has rallied the bank stocks, but when the trend has fully changed it will be indicating contraction. Narrowing credit spreads provided support until May 26th when the trend started to change. Widening has continued.

The Advance/Decline line has been very positive since October and this stopped on April 20th. It will take some technical work before the reversal is in, but it is longer supportive.

All at seasonally the happiest time of the year, and it is best to be methodical.

The broad NYA covers all the NYSE stocks and as sentiment reached cyclical highs beginning last June the index has increased a little more than 1 percent. That's from 11108 to 11254 in May. It took out the 50-Day at the end of May to a low of 10882 on Tuesday. The bounce is testing the 50-Day at 11100. Step One will depend upon how the test goes. Step Two would be taking out the 40-Week ema at 10914.

Credit Markets

Corporate spreads were expected to narrow into "around May". As we've been noting, the spread came into 176 bps and tested it five times from April to May 19. The breakout was accomplished at 180 bps on May 28th. Now, with a couple of minimal corrections it is at 185 bps. Not all that many "beeps" but they are important "beeps". This extends the trend and above 188 bps would be serious.

Spreads are turning nicely, but last week's call that that the long bond (TLT) would pop a rally has been followed by four down days. The Springboard Buy on the S&P became effective, stocks have rallied and the TLT has made new lows for the move. However, it is Daily oversold and is firming today.

The huge Upside Exhaustion registered in late January and the TLT made it to 137. This was covered in our "Ending Action" study and the two key moving averages were taken out on the slide to 117.88 in the middle of May. The rebound made to the 200-Day at 123.30. The decline to 115 marks a new low for the move.

For new readers, "Ending Action" meant the end of the bull market in Treasuries that began in 1981. It was published on January 20th.

The long rise in rates will not likely be due to the Fed discovering probity, but to shrinking liquidity in global bond markets. In so many words, it will be due to the inability to service monstrous debt burdens in the face of diminishing corporate and government revenues.

This will not be a new discovery. It has happened following every great bubble and is best tracked by the course of real long interest rates in the senior currency.

With the 2007 Bubble, the real rate declined to -1.5% and with the crash increased to 6%. That 7-percentage point increase was shocking to the establishment. However, on five previous examples, the typical increase was 12 percentage points. In each case it was enough to end the massive abuse of the credit markets, otherwise known as a "New Financial Era".

Real Long Interest Rates

As we have seen, the increase of only 7 percentage points was not enough to end the abuse of credit markets by theoreticians at the Fed. The following chart tracks the decline from almost 3 percent in 2013 to the low of 1.25 percent a year ago in June. The increase to over 3 percent has set the trend and it should be beginning to constrain all of the reckless speculators around the world. That means individual speculators as well as financial adventurers in central banking.

As in previous examples, the extension of the trend is due to rising nominal rates of interest as liquidity diminishes. The other factor is falling commodity prices as too many participants are forced to sell whatever they can to service debt. In such an environment Mother Nature constrains the ability of the senior central bank to issue credit and to depreciate the currency.

Indeed, the increase in real interest rates has been one of the key features of the acute phase of every post-bubble contraction.


Last week's view was that the DX could churn around for a while. Support at 93 would likely hold.

The Canadian unit rallied to 83.87 with the "rotation" in commodities and it slipped to 70.59 at the beginning of the month. Some "late bloomers" and crude have increased a little. The C$ popped to 81.96 yesterday, which was just above the 50-Day. It is now just below the moving average and we see little reason for a lengthy rally.

Precious Metals

The action in this sector remains dull.

Our November special study noted that a tradable bottom was possible. What was needed was to have gold stocks outperforming gold as well as silver outperforming gold. The advice was to accumulate some stocks on weakness.

Both of these guides set up the rally and it became too much, too soon. On the second rally we advised taking some money off the table. And, as noted last week, the same advice was offered on the rally into the middle of May.

GDX/GLD has been declining since the high of .187 in February and the rebound high at .181 in early May. The silver/gold ratio rallied from .129 in November and the best was .144 in the middle of May. This could hold for a while, but declining further would be not be constructive for the sector.

The other concern was that after mid-year credit conditions would resume deterioration, making most investments uncertain. Then there would be the probability of a firming dollar.

There is little point in being invested.


Commodities Close Weak

As each edition is proofed we check the numbers at the close and many commodities had a bad day. Two percentage point drops against a half-point increase in the DX.


GYX -1.7%

Lumber -2.26%

GKX -1.3%

Cotton -2.04%

CRB -1.3%

Coffee -3.27%

Emerging Market Corporate Bonds

  • Chart is of growth of funded debt.
  • How will it be serviced?

Shanghai Containerized Freight Index

  • An index resistant to manipulation by policymakers.
  • It is not telling a good story.

Somehow, it reminds of the James A. Fitzpatrick Travelogue films. They were dreadful at the time and if it was about an island it would end with "As the sun pulls away from the shore and our boat sinks slowly in the west, we bid fond farewell to the natives of .............."


Courtesy of Institutional Advisors

Bob Hoye is the chief financial strategist of Institutional Advisers.

Nearly 40 percent of all gold ever mined was recovered from South African rocks.
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