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A 6% drop in GBP/USD that caught investors and market makers by surprise has been partly attributed to algos failing after traders targeted downside option barriers, say three Asia-based FX dealers, Bloomberg reported.

The drop accelerated as liquidity disappeared, and dealers failed to load bids into their trading platforms.  One trader says his FX pricing aggregator of eight contributors blacked out for 30 seconds amid an absence of bids.

Last week in Bermuda, our Larry McDonald delivered the keynote speech at the World Alternative Investment Summit (WAIS) 2016.

The event was host to an audience of asset management professionals on September 28, 2016.

We’re looking at their Hank Paulson moment, Europe is set to bail out its “zombie banks” within the next few months – McDonald said.

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From the conference, Larry was interviewed live on CNBC  via phone to discuss his expertise and point of view on the Deutsche Bank Situation.

Join strategist Larry McDonald, NY Times Bestseller Author,  from the 2016 WAIS at Bermuda on CNBC; discussing the large fall in Deutsche Bank shares and the parallels to Lehman Brothers  HERE

Here is a recap of Larry’s Bermuda Conference Presentation:

Lawrence McDonald, who witnessed a bank’s collapse from the inside when he was vice-president of distressed debt at Lehman Brothers when it folded in 2008, said Deutsche Bank’s situation now is eerily similar to his former employer’s plight shortly before its demise.

Deutsche Bank’s shares took a pummelling after the US Justice Department announced its intention to fine Germany’s biggest bank $14 billion over matters relating to the subprime mortgage crisis. This has rekindled fears over the bank’s stability.

The problems are similar in some other big European banks.

Deutsche Bank has about $16 billion of equity and $162 billion of debt, In the US, Hank Paulson [the former US Treasury Secretary] got the big bank CEOs around a table in 2008 and said ‘you’re taking this money’. They took the pain and did the bailouts.

That did not happen in the same way in Europe and this has been building up for years. The truth has been coming out one drop at a time. Soon six or eight banks will be forced to sit around the table. We expect a major recapitalization to happen within the next three months.

“Zombie banks” were not capable of financing the needs of an EU economy of more than 500 million people.

The German government has stated it does not intend to give Deutsche Bank any help, but McDonald brought up charts that he said suggested that matters were coming to a head.

One graph showed that when the market believes Deutsche Bank’s debt is getting riskier, the same applies to Germany’s debt — an example of “credit spread contagion”.

There were clear signs that banks trusted each other less when lending between themselves — as occurred in the run-up to the global financial crisis — as signified by a widening spread between the Libor rate and the Fed Funds rate, he added.

Larry McDonald, the author of the New York Times bestseller A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers, specializes in identifying political and systemic risk leading to actionable trade advice.  He shares his valuable research at THE BEAR TRAPS REPORT.

Pick up the Bear Traps Report here:

The US presidential election is another source of market risk and he had seen a clear correlation between Donald Trump’s fortunes and stock market volatility. At times when Mr Trump has risen in the polls, the VIX, a measure of S&P 500 Index volatility sometimes known as the “fear index” has risen too. The big banks, in particular, were seen as having a lot to lose if the Republican Party candidate wins in November.

Regardless of whether Mr Trump takes the White House, it is possible that over the coming weeks the perceived likelihood of him winning may increase, offering trading opportunities.

Another strong risk emanates from Asia and particularly China. Credit default swaps on major Asian financial institutions — indicating their perceived level of riskiness — had risen sharply just before the past two double-digit declines in the S&P 500 Index, and they could likewise be an indicator of future dips.

Years of low interest rates had left investors craving yield, and Larry sees a “hot bubble” inflating in the commercial real estate sector and strong demand for high-yield bonds.

Larry said – “I had lunch with a fund manager last week who told me that German and Japanese insurance companies are buying up large quantities of U.S. high-yield bonds. He said it’s like nothing he’s ever seen.”

That was one of the market-warping effects of negative interest rates that exist in both Europe and Japan.  Central banks were creating potentially “catastrophic, unprecedented bond volatility” by keeping rates so low for so long.

The markets were functioning strangely, he warned, with an unusually high correlation — about 23 per cent — between stocks and bonds, which traditionally move in opposite directions.

The conference, which was opened by Michael Dunkley, the Premier, also featured Ross Webber, the chief executive officer of the Bermuda Business Development Agency, who said: “Bermuda’s economy is on the upswing — the recession is behind us.”

Mr Webber said much work had been done to bolster Bermuda’s asset management industry and that was now bearing fruit. Centaur Fund Services set up an office on the island earlier this year and he added that other managers and service providers were making plans to set up in Bermuda.

Mr Webber said there was a tendency among overseas politicians and media to lump all offshore financial centres together as an “axis of evil” and use them as a scapegoat.

Some offshore jurisdictions deserved their bad reputation for ignoring the changing regulatory landscape and embracing secrecy — but Bermuda was not one of them, he said.

Pointing to Bermuda’s success in the international reinsurance markets and its lengthy record of reliable claims-paying, he added: “Bermuda is a place to raise capital, not hide it.”

The likely exit of Britain from the European Union makes Bermuda even more attractive as a jurisdiction for fund managers, Mr Webber added, particularly as the island has applied for “passporting” rights to gain free access to EU markets.

– Special Thanks to Jonathan Kent, Business Editor of the Royal Gazette – Bermuda.

“The seventeen year river of currency reserve buildup is no longer flowing.”

David Tepper

Breaking News: One of our Lehman Risk Indicators is Flashing Bight RED

Credit Stress in China’s Banking System Reaches an All Time High

Credit-to-GDP ‘gap’ exceeds all other nations, says BIS study

This weekend, the Bank of International Settlements announced a warning indicator for banking stress rose to a record in China in the first quarter, underscoring risks to the nation and the world from a rapid build-up of Chinese corporate debt.

In Q1, credit stress in China surged to a fresh record.  As we covered in our Bear Traps reports last year, a nearly 20% spike in the U.S. dollar has the credit impact of a global wrecking ball.  We made the argument the dollar’s accent has had the impact of 3-4 Federal Reserve rate hikes.  Today, it’s rewarding to find much of Wall St’s analysts are finally waking up to this reality.

China is using debt to generate economic activity at its highest rate EVER.  Unfortunately, they’re getting substantially less return on leverage today then ever before.  Eight years of aggressively accommodative monetary policy from the U.S. federal reserve has consistently shifted capital into places it JUST SHOULDN’T BE.  As the Fed tries to EXIT the zero lower bound, the global credit contraction implications are mind blowing powerful.

China 2006-2016

Credit Growth: 1100%
GDP Growth: 500%

Hayman Capital data

After the Fed made their attempt at one rate hike, the dollar’s surge resulted in a sharp contraction in the total stock of dollar denominated credit to emerging markets.  This is a key measure of global liquidity, it was down at $3.2T at the end of March, off $137B year over year, BIS data.

Credit risk has surged globally, the Fed has this mess on it’s hands.

China’s credit-to-gross domestic product “gap” stood at 30.1 percent, the highest for the nation in data stretching back to 1995, according to the Basel-based Bank for International Settlements. Readings above 10 percent signal elevated risks of banking strains, according to the BIS, which released the latest data on Sunday, Bloomberg reported.

The gap is the difference between the credit-to-GDP ratio and its long-term trend. A blow-out in the number can signal that credit growth is excessive and a financial bust may be looming.

Yields on the Japan 10 Year bond are back to 0% for the first time since March.

Japan’s bonds are in plunge mode, now suffering their  worst month since at least 2010.   Asset managers are betting the Bank of Japan (meeting September 21st)  is plotting the return the steep yield curve.  Banks borrow short and lend long, so a flat yield curve has been a thorn in the side of lending institutions.  Banks have been suffering in Japan under the weight of negative rates, speculation is building that the BOJ will come to the rescue.

Special thanks to the Bloomberg Terminal

The Bank of Japan BOJ is under extreme pressure from their banking system.  Negative rates has backfired into a disaster for Japan’s financial institutions.  There is surging speculation the BOJ will make a major policy shirt later this month.

We have an index which tracks bonds with maturities longer than 10 years.  The basket has suffered the longest losing streak in three years.  Investors are worried Bank of Japan Governor Haruhiko Kuroda will reduce purchases of longer term debt after a comprehensive review of monetary policy on Sept. 20-21.

Thirty-year government bonds capped their biggest weekly slump since April 2013 after the BOJ refrained from purchasing the securities at its regular market operation on Sept. 2nd.

“There are many ways to short oil or oil equities based on your risk tolerance and level of sophistication. If you are long oil, we recommend you take down both equity or commodity exposure to crude. Our WTI target is $42-$44 over the next month, $35 over the next three months. Oil is a STRONG SELL in our view.”

The Bear Traps Report, August 18, 2016

“Breaking: Saudi, Russia Pledge Oil Cooperation Without Agreeing Freeze”

September 5, 2016

Since the highs of August 19th, oil plunged 11% globally.  In recent weeks, markets have witnessed rumor after head fake.  Around the world, some crude policy makers have been desperate to get prices higher.

Today, two of the largest oil producers on earth pledged to “cooperate” to stabilize global markets, while failing to announce any specific measures to bolster prices.

No concrete plans were announced at the joint press briefing in Hangzhou, and Al-Falih later told Al Arabiya television there’s no current need to cap production.

Flashback

“Breaking:  Russia, Saudi Arabia set up working group on oil, gas cooperation.”

November 26, 2015

Meanwhile, Iran is Hitting the Oil Production Gas Pedal, Reuters

Up on Euphoria, Down on Impatience

Today, after a 5% surge, oil pared gains (+0.81%) on speculation Saudi Arabia and Russia might detail a plan to drive up prices, markets later said; “where’s the beef?”

Creating temporary short squeezes has become a national summer past time in some oil producing nations.  Over the years in oil markets one thing has become very reliable.   When you see “plans” with few ambitious announcements, there’s typically a lack of decisive follow-up action.

“Yesterday, the U.S. 10 year treasury bond 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).”

Bear Traps Report

July 6, 2016

Government Jobs: June – August 108,000
Three Month Average: 232,000

Employment growth was weaker than consensus estimates at +151k in August, but above Fed estimates of the breakeven rate.

As U.S. bond yields are moving higher, so are those around the world.

U.S. companies kept adding to payrolls in August while measures of slack in the labor market were little changed, signaling steady hiring in the face of lackluster global growth.

“Our economists therefore see this report as just enough for a large majority of officials to support a September rate increase and have raised their subjective odds of a hike this month to 55% from 40%. They have also lowered their subjective odds for December to 25% from 40%, leaving the cumulative odds of at least one hike this year at 80%. ”

Goldman Sachs

Notice the yield price action in US 10s.  Sixty days ago every sell off was greeted by a stronger bid for bonds.  Today, it’s a 180, every rally in bonds has been over-powered with selling, yields want to move higher.

Bear Traps Report estimates suggest that G4 central bank (ECB, BOE, BOJ) has contributed for nearly 105bp (1.05%) of the reduction in US 10-year yields since the end of 2013.

Jobs and Economic Growth

Bloomberg reported payrolls climbed by 151,000 last month following a 275,000 gain in July that was larger than previously estimated, a Labor Department report showed Friday in Washington. The median forecast in a Bloomberg survey called for 180,000. The jobless rate and labor participation rate held steady, while wage gains moderated.

August has been light in recent years, so the market was ready for weakness.

The August figure is consistent with a simmering-down of payrolls growth so far this year as the economy slogs through a period of weak investment and some companies have difficulty finding workers. Federal Reserve officials will have to weigh the jobs data as they decide whether to raise the benchmark interest rate for the first time in 2016.

GDP

Led by a substantial inventory overhang, in recent quarters, U.S. economic growth has suffered, we’ve seen a pull back in business fixed investment. Last Friday, the second release of Q2 GDP reaffirmed the soft signal from the Bureau of Economic Analysis’ preliminary estimate showing modest growth of +1.1% (qoq ar).

On the other hand, Wall St’s economists expect above-trend growth in Q3 (+2.8% to +3.2% qoq ar) and Q4 (+2.1% to 2.5%), as a turn in the inventory cycle, continued strength in consumer spending, and a bounce back in residential investment offset any lingering weakness in capital spending and drag from trade. Beyond this year, they expect growth to slow to an only slightly above-potential pace of 2% over the course of 2017.