Ok, so if you’re bearish, a market skeptic, or otherwise prone to cynicism, you know that when SocGen’s Albert f*cking Edwards comes stomping through, you just have to sit your ass down and let the master do his thing.
It’s kind of like if you’re the best player on the court in a pickup basketball game and you’re out there showin’ off and then Kobe Bryant shows up. Suddenly you’re not the best player anymore. Best to just pass it to Kobe and watch.
So while I’ve certainly been keen on warning about the dangers inherent in an overleveraged credit market and the possibility that the Fed, perceiving itself to be behind the curve, might commit a policy mistake by getting too aggressive with rate hikes, it’s probably best if I don’t try to introduce the following with any kind of bearish spin because I will invariably come up woefully short.
Via SocGen’s Albert Edwards
Make no mistake. Unlike most in the markets, I remain a secular bond bull and do not think this 35 year long bull bond market is over. I believe the US Fed has created another massive credit bubble that will, when it bursts, lay the global economy very low indeed. Combine this with the problems of a Chinese economy dependent on increasingly ineffective injections of credit to produce increasingly pedestrian GDP growth and you have a right global mess. The 2007/8 Global Financial Crisis will look like a soft-landing when the Fed blows this sucker sky high.
The seeds for that debacle have already been sown with the Fed having presided over one of the biggest corporate credit bubbles in US history. All that is needed now is for the Fed to sprinkle life-giving rate hikes onto these, as yet dormant, seeds of destruction. Accelerated Fed rate hikes will cause tremors in the Treasury bond markets, forcing rates up, most especially in the 2 year — just like 1994. But as yet another central bank-inspired global recession unfolds, I believe US 10y bond yields will ultimately converge with Japanese and European yields well below zero — in other words, buy 10y bonds on weakness!
I was arriving in San Francisco last week on the night of the Oscars. So I missed making it to Los Angeles to receive my lifetime award in the most dogged bear category – but they would probably have given it to a frothing bull anyway! Driving between meetings in LA and San Diego I passed through Orange County (OC). For those few of us in the markets of a certain age, that name conjures up only one thing: 1994 goes down in infamy as one of the biggest ever bond market bloodbaths in history culminating at the end of the year with Orange County in California going bankrupt (younger clients in their late 20s will only know the OC as the mid-2000s teen programme based in Newport Beach, which I watched religiously with my then teenage son and daughter).
I remember the 1994 period as if it were yesterday (unlike yesterday itself). Despite the Fed telegraphing the series of rate hikes and market participants forecasting multiple hikes, it was most curious how the market went into total convulsion. I was chatting to my ‘similarly young’ colleague Kit Juckes about this and he reminded me that the whole yield curve gapped up some 50bp immediately! It was a bloodbath, especially for 2y paper.
Now I realise perfectly well that rates have already risen twice in this Fed tightening cycle, but these have become such isolated hikes that the market (Fed Fund futures strip) has lost confidence that the Fed will ever deliver their promises as represented by the Fed dots.
Back in 1994, just before the Feb 4 rate hike, 2y yields were trading some 100bp above Fed funds. That one 25bp rate hike prompted the 2y-Fed Funds spread to soar from 100bp to 250bp within the space of three months while the 10y-2y curve flattened rapidly, destroying carry-trade bets along the curve. The key similarity with 1994 is that currently US 2y yields at 1.35% still trade tightly to the current Fed Funds rate of 0.75% (see left-hand chart below). If the market really takes on board Janet Yellen’s much more aggressive rhetoric, then we could easily see 2y yields rise towards the 10y as we did in 1994. If that happens and the US 2y spread with German and Japan continues to soar (see righthand chart below), this will be like rocket fuel strengthening the US dollar.