Credit Markets Pointing Toward High Drama, Euro Break 2.0

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The yield spread on French bonds is accelerating over their German counterpart. As Socialist Party candidate Hamon deepens talks with far Left Melechon, the net winner is France’s anti-Euro skeptic Marie Le Pen.

First Round, French Presidential Election

LePen : 26%
Macron: 23%
Fillon: 19%
Hamon: 15%*
Mélenchon: 12%*

Ipsos

Political Risk Driving Markets

France 10 v German

*Yield spread on French bonds accelerating over German (at 77bps, widest since Feb 8-). Socialist Party candidate Hamon deepens talks w far Left Melechon, net benefit to hard line Euro-skeptic Marie Le Pen.

Our Index of 27 Lehman Systemic Risk Indicators is on the rise, very similar to the spring of 2011.  Over the years with certainty we can say, credit leads equities.  Credit markets were stressed for weeks ahead of major drops in U.S. stocks in 2011, 2012, 2015 and 2016.

Lurking under the surface of European bond markets, capital is piling on bets that will reap large rewards if the risks in the euro zone surge substantially.

Investment Grade Bond Spreads

Europe v US

Feb 2017: +33bps
Feb 2016: -22bps

Bloomberg data

Investment grade bonds in Europe are DRAMATICLY under-performing their U.S. counterparts, even as the ECB has been buying bonds across the Eurozone.

Markets across the continent have started to price in the increased potential for anti-euro candidates to win elections in France and Italy. Recent positioning in German and French bonds are hedges against a blow-up in the risk of a breakup in the common currency,

Two Year France vs. German Bond Yields

France - GermanyWe witnessed this in 2011-12 during the height of the Grexit contagion drama across the Eurozone’s periphery.  The front end of the German yield curve has outperformed over the past three weeks, with 6-month and two-year yields dropping 10-14 basis points, while open interest in two-year futures has jumped by more than 100,000 contracts, per Bloomberg data.

France vs. German Bond Yields 2012-2017

France - Germany 2sOver a 5 year perspective, French yields are still well contained, but the divergence from Germany is profound.

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Standard and Poor’s 500 Sector Correlation through the 2006-7 Lows

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“Congress — we’re all tied up in knots. The (Better Way) House Tax Reform plan won’t get 10 votes in the Senate.”

Senator Lindsey Graham, South Carolina, February 15, 2017

As we noted in our New York Times bestseller, “A Colossal Failure of Common Sense,” correlations within the S&P 500 nearly touched 1 (hit 94% in 2008, see below**) in those fateful days following Lehman Brothers’ collapse.

As fears surge in markets, stocks as well as different sectors start acting more and more and more like each other.   Think of a powerful black hole sucking up everything in its path, one by one even the highest quality names get pulled into the abyss.

As we look at the first sixty days of 2017,  we’re witnessing a massive re-pricing of risk.  It’s as if there is no risk.  Markets have moved past the long feared Brexit and U.S. election votes, they’re looking forward to lofty promises of tax cuts and deregulation.

Sector Rotation

Steady sector rotation has had a calm hand in pushing correlations lower in 2017.  Over the last sixty days, the well advertised Trump “reflation trade” brought billions into financials, consumer cyclicals and small caps stocks (out of utilities, consumer staples and large capitalization –  FANG -stocks).  It’s been an eerie perfect pass of the baton from monetary policy to hopes for fiscal follow through in Washington.

The data below is nothing short of stunning, current correlations are through the 2007 lows!

  1. S&P 500 Sector Correlation

2017: 21%
2016: 67%
2015: 77%
2014: 55%
2013: 57%
2012: 68%
2011: 84%
2010: 74%
2009: 88%
2008: 94%**
2007: 28%
2006: 32%
2005: 51%
2004: 57%
2003: 68%
2002: 79%
2001: 82%
2000: 65%

Bear Traps Report, Bloomberg data

Sector correlation analysis is part of our 27 Lehman Systemic Risk Index of Indicators.  With certainty we can say, over the years sector correlations in the low 20s are HIGHLY unsustainable, a real warning sign to lighten up on exposure to equities.   Today, we’re well through the 2006-7 lows, an EXTREME level of equity market complacency.  No matter what the media tells you, since the Trump election fear just does not exist in financial markets.  Both sector and stock correlations are at all time lows.

2. Over the last year correlation plunged as complacency surged, we focused on EM vs DM below.

Emerging vs. Developed Market Correlation

Feb 2017: 28% (Dollar Index 100.90)
Feb 2016: 82% (Dollar Index 100.90)

Bear Traps Report, Bloomberg data

Remarkably, correlation between EMs and DMs has been extremely low relative to an elevated U.S. dollar DXY index.  Higher commodity prices, China’s controlled currency devaluation, as well as their 2016 stimulus plan have been supportive of lower correlations.

3. With Correlations Near Record Lows, Lets Look at Crowded Trades 

Commodity Futures Trading Commission

Net Speculative Bond Positions

2017: -$140B
2016: +5B
2015: -$26B
2014: -$40B
2013: +18B
2012: +$22B
2011: -$20B
2010: -5$B
2009: +$11B
2008: +$84B
2007: +$50B

CFTC data, 10 year equivalent, in billions

Will the last guy / gal getting into the reflation – short bond trade please close the door, there’s no room in here.  If you ask Wall St., you can’t find a bond bull.  Positioning is over the top bearish on bonds, one very crowded trade.

4. Wilshire 5000: Equity Mkt Cap to U.S. GDP
The Buffett Indicator

2017: 122.7%
2016: 111.4%
2015: 122.5%
2014: 110.3%
2013: 92.4%
2012: 90.1%
2011: 86.7%
2010: 81.1%
2009: 56.5%
2008: 68.2%
2007: 105.2%
2006: 93.4%
-Bloomberg, Wilshire 5000 full market cap price divided by Nominal Quarterly GDP, FOMC data
The baton has been passed from the Fed’s easy money gravy train (QE Quantitative Easing + ZIRP Zero Interest Rate Policy) on to hopes of tax cuts and deregulation.  The sad truth is NOT a soul in Washington has a clue as to how much is at stake here.  The Federal Reserve’s QE / ZIRP kept markets riding high on central bank love, but now as the FOMC is pulling away into rate hikes, Washington execution risk is sky high.  The beast in the market demands Washington deliver, there’s no room for error.

 

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Let Media Induced Drama Be Your Friend in Markets

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The hysterical media is your friend when it comes to trading political risk headlines.  While looking at populism’s global tsunami, the establishment media has been exaggerating the downside risks, helping markets create fantastic buying opportunities.

Our friend Albert Edwards notes:

While we are on the subject of inflation, Brexit has been interesting for the stupidity of many of the headlines trying to support a particular bias (both ways). Perhaps the most stupid was this one in the London Evening Standard just ahead of the June referendum, “Couples delaying having babies because of fears over a Brexit.” –

UK StocksAfter all the Brexit horror headlines, UK stocks are up 23% from the June lows.

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This nonsense persists, with surging headline UK CPI inflation being attributed to sterling’s slump in the immediate aftermath of the vote. What utter tosh. German and US headline CPI inflation have risen even more quickly!

After all the Deflation Fears surrounding the Brexit, the Inflation Surge in CPI has been Impressive

CPI UK GER USA

As the world faced the Brexit vote, there were countless stories of deflation fears.  We witnessed a wide call across the media for a U.S. ten year Treasury bond heading to 1.00%.  Then the unthinkable happened, bond yields surged with inflation fears, we touched 2.62% in December, back at 2.42% today.

We went against the crowd, recommended clients get short bonds in July.

“Yesterday, the U.S. 10 year hit our long held 1.40% target. A sea of bond bears has become an ocean of bulls. Brexit’s risk to the global economy has created an opportunity for those willing to step in and short bonds in the face of a large group of clowns rushing to the exits (abandoning their long held bearish bond positions).  Buy the TBT ETF, bonds are a screaming sell.”

The Bear Traps Report, July 7, 2016

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Larry McDonald: Risk/reward is fantastic in retail

Larry McDonald; creator of THE BEAR TRAPS REPORT and managing director of ACG Analytics, believes it’s a great time to get into the retail sector

“This Senate is toxic, guys. This tax bill is light-years away from happening, and even when it does happen, let’s just say it does pass, the tax cuts on the individual side and on the corporate side eventually will outweigh the border adjustment tax negative on retail,” he said in an interview with CNBC’s “Halftime Report” on Friday.

“Here’s the key number: 24. The retail space over the last 24 months is underperforming the S&P by 24 percent — the most significant underperformance for the retail sector since the 1990s recession. The risk reward is fantastic,” McDonald said. “Get long retail.”

CNBC Trading Nation – February 10, 2017

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Inside the January Jobs Report

Join our Larry McDonald on CNBC’s Trading Nation, Wednesday at 2pm.

Don’t miss our next trade idea. Get on the Bear Traps Report Today, click here

Where are bond yields going with risk of a euro breakup on the rise?  Click here (above) for our latest report.

Jobs Recap

Reflation Trade Hype so far Trumped by Secular Dynamics

Since mid December, Utilities (DPG ETF) are up 10%, with a flat S&P 500.   The much hyped reflation trade has been put on hold.

Net net, the today’s jobs number was a disaster.  In recent years we’ve been lectured about the 15 million jobs created since the financial crisis, but wages are not growing.

The inequality explosion continues, hello Michigan, Pennsylvania and Wisconsin.  Middle class America lives on average hourly wages times hours worked. *U6 unemployment is still growing, 9.2% To 9.4%.   This begs the question, how much worse would the numbers have been without the unemployment wage increase in 19 states in January?

*This measure of unemployment includes the total unemployed, plus all persons marginally attached to the labor force, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all persons marginally attached to the labor force. Persons marginally attached to the labor force are those who currently are neither working nor looking for work, but indicate that they want and are available for a job and have looked for work sometime in the past 12 months. Persons employed part time for economic reasons are those who want and are available for full-time work but have had to settle for a part-time schedule.

The Missing 4 Million Young People from the Labor Force

25 to 45

We don’t believe Trump wants his legacy wearing a 4.7% start in unemployment, he’s likely to shake up the bureau of labor statistics. There are approximately 4 million people 18-54 years old that are not in the U.S. labor force. On the other hand, at 250k new jobs a month, we’ll chop through that number in 16 months, about the same time the tax cuts and infrastructure spending are actually oozing through the U.S. economy.

– As we expected, the Jan jobs number was topside at 227k vs consensus estimates of 180k but the market is more focused on something else. The real story as was in the soft wages number. AHE only rose by 3 cents of 0.1% month over month, below estimates. We also saw the strong December wage growth number revised lower, with two-tenths downward revision to Dec earnings (now +0.2%). This sums up the reaction in bonds, across the curve there is strength as YoY AHE is is now 2.5% from 2.9% after the Dec report. Chances of a March hike are pretty much gone with this weaker wage number and more dovish statement from the Fed on Wednesday. March hike odds are now around 15%. We think this number puts pressures on the massive short position in bonds.

– The headline number did have strength, but much of it was priced following the ADP number on Wednesday. The market was looking for wages to continue along the lines of the December report, that is where the bonds move is. This was amplified by the fact that minimum wage rose in 19 states during January, which should have lead to a meaningful increase in AHE. But we expected it to be overshadowed by other factors.

– To us, the headline number coupled with slack in wages points to an employment picture that will still confuse the Fed. Wages should have taken the baton from headline NFP by now, if we are really at full employment. We also some of this slack in the massive plunge in “not in the labor force” which dropped 736,000. There were population adjustments in this release, but that is still a big number. The “slack” did not end there, Janet’s favored reading, U6, actually rose 0.2% to 9.4 from 9.2 in December. This jobs picture points to the fact the labor market is not so obviously at full employment. A growing 3 month moving average of 183k a month and slack in wages will push the doves to give the economy more time.

– There were some sectors that offered positives. Retail trade added 45.9k, Service Providing was strong again and manufacturing actually added jobs for the third straight month, a big pull on the headline number seems to be gone.

Join our Larry McDonald on CNBC’s Trading Nation, Wednesday at 2pm.

Don’t miss our next trade idea. Get on the Bear Traps Report Today, click here

Where are bond yields going with risk of a euro breakup on the rise?  Click here (above) for our latest report.

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