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Wall St. is finally waking up to recession risk.  The credit markets have been warning us since last November, but U.S. economists have been in deep denial.

What are plummeting interest rates saying about the outlook for the economy? The spread between the yield on 10-year U.S. Treasury notes and two-year notes is the narrowest since 2007. A model maintained by Deutsche Bank analyst Steven Zeng, who adjusts the spread for historically low short-term interest rates, suggests the yield curve is now signaling a 55 percent chance of a U.S. recession within the next 12 months. That marks the highest probability generated by the model so far in this expansion, and may be a cause for concern as Federal Reserve officials meet this week in Washington to discuss next steps for policy. – Bloomberg

 

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Time To Sell Volatility

How We Look at the VIX, Chicago Board Options Exchange Volatility Index

“The Trade: We believe the risk – reward in getting long volatility is the most attractive since last November. We are buyers of the VXX ETN.”

The Bear Traps Report, May 31

On May 31st, we stressed to subscribers there’s value in buying volatility during holiday shorted weeks.  In recent years, we’ve witnessed a collapse in volatility during light volume trading weeks near holidays.  This is especially true in and around month end / quarter end.

Dramatic Shift in the VIX Futures Curve

Over the last 15 days, the VIX has surged from 13.12 to 22.15.  On May 31, we made the point to subscribers that volatility was mispriced relative to Brexit, China and U.S. election risks.

“When funds crowd together they buoy trades well past arguable fundamental valuation, next all race out together.”

Paul Tudor Jones

Central bankers keep moving the entire student body left, then the entire student body right.  Negative interest rates globally have investors thirsting for yield and alpha, the net result has been some of the most crowded trades we’ve ever seen.   What many investors don’t realize is you can use this phenomena as your friend or your enemy.

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Our research shows, in the post Lehman era, as Fed policy has had more and more influence over market performance, stock market volatility has substantially plunged (cheapened) around holiday shortened weeks.  Memorial Day, the Fourth of July and Thanksgiving are prime examples below in the chart.

“In acknowledging global economic risks, shooting the March rate hike right between the eyes and then talking the dots from 4 to two.  The Fed drowned market volatility, held its head under the water and watched for the bubbles.  Now is the time to buy it on the cheap.  Buy the VXX ETN (iPath S&P 500 VIX Short-Term Futures ETN)”

Bear Traps, May 31st, 2016

A few weeks ago, we were between Fed meetings, thus making them ideal occurrences for maximum volatility suppression.

In the weeks ahead of the “widely expected” March rate hike (in January 83% of Wall street’s economists and strategists said the Fed would hike again rates by March).  The dollar surged, oil plunged and the street panicked and sent the VIX to its highs for the year in mid-February.

Next, the Fed took out their fire hose, they shot the March and June rate hikes between the eyes.  The dollar plunged, commodities and emerging markets soared, “risk on” was born again.

As the Fed has backed off their beloved rate hiking policy path, the VIX plummeted to around 13 in late May.  The same people who were caught holding plunging stocks in February, were telling us to sell volatility, this was a sure buy signal.  Again, volatility was clearly mispriced relative to Brexit, China and U.S. election risks.

VIX Futures Curve: From Steep Contango, to a Move Toward Backwardation

Today, the spread between the VIX 2 month futures contract vs 8 month coming way in, the most substantial curve flattening since mid April.

VIX Futures Curve

	Description	Last
	Jun16	21.7000
	Jul16	↓21.5700
	Aug16	21.4300
	Sep16	21.7300
	Oct16	22.0300
	Nov16	↓21.9900
	Dec16	↑21.7500
	Jan17	↑22.5500
	Feb17	22.6000

Market bottoms are typically found during periods of backwardation in the VIX futures curve, see above.

How We Measure Risk and Reward

Let us explain, on February 10th investors were paying up for near term downside insurance on stock prices.  The front month VIX futures contract was trading substantially higher than the longer term outer months.  In other words, the March contract was trading rich to the September contact (see the green above in the chart).

In the fear of February, this was a buy signal for stocks; we recommended our subscribers to get long financials and oil names in our Bear Traps reports and on CNBC.

In recent weeks, the opposite has occurred, the VIX futures curve went into steep contango.   In other words, the longer term VIX futures contract (December) was trading higher than the near term contracts (June).  When the contango “widens” to extreme levels it is a sign of complacency in the markets, this is one of the reasons we recommended that subscribers get long volatility.

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Fresh Record Lows

Japan’s 10 year bond touched -0.16%, a record low yield.

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Asian stocks tumbled as anxiety over the ‘Brexit’ vote and forthcoming decisions from the U.S. and Japanese central banks stoked demand for haven assets. Crude oil also slid.

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Japanese shares fell to a one-month low, leading losses in Asia following the steepest slump in global equities since February. The yen climbed with gold, and 10-year Treasury yields fell for a fifth straight session, as traders favored safer assets ahead of a week where Chinese data on factory output and retail sales will be followed by meetings of the Federal Reserve and the Bank of Japan. The pound slid to its lowest level in almost two months after a poll showing a 10 percentage-point lead for Britain to leave the European Union sent it tumbling late on Friday. Oil retreated on an increase in U.S. drilling rigs.  – Bloomberg

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IMF officials warned this weekend, China must act quickly to address mounting corporate debt, a major source of worry about the world’s second-largest economy.

China’s surging debt load has profound implications for U.S. equity markets, it’s the subprime mortgage crisis all over again, just a different serpent, another beast.

David Lipton, first deputy managing director of the IMF, warned in a speech to a group of economists in the southern city of Shenzhen that companies’ indebtedness is a “key fault line in the Chinese economy.”

Reuters

The U.S. Federal Reserve clearly has the China debt bubble’s blood on its hands.  As the Fed kept interest rates near zero for 8 years and expanded its balance sheet, Chinese companies used the easy money gravy train to LEVER up (see below).

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“Company debt problems today can become systemic debt problems tomorrow. Systemic debt problems can lead to much lower economic growth, or a banking crisis. Or both,”

IMF

China, whose economy grew in 2015 at its slowest pace in a quarter of a century, has been trying to deal with with rising debt levels and overcapacity.

People’s Bank of China warned in its mid-year work report that the government’s push to reduce debt levels and overcapacity could increase bond default risks and make it more difficult for companies to raise funds.

Corporate debt in China stands at about 145 percent of gross domestic product, a dangerously high ratio. State-owned enterprises, accounted for a staggering 55 percent of corporate debt but only 22 percent of economic output, according to IMF estimates.

China must deal with both creditors and debtors and to address governance problems in both the corporate and banking sectors.

 “The lesson that China needs to internalize if it is to avoid a repeating cycle of credit growth, indebtedness, and corporate restructuring, is to improve corporate governance.”

IMF

China leverage side effects continue to explode.  Pick up our latest trading ideas, click on this link:

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“Here’s why bonds are a screaming buy, (1.97% on the U.S. 10 year).”

Our Larry McDonald; March 14, 2016 on CNBC (1.64% today)

While Wall St. economists and strategists  have been lecturing you to get out of bonds since 2014, we’ve maintained a bullish stance on bonds for the last 3 years.  Equities have trailed bonds by a long shot in 2016.

See our Bullish Bond call on CNBC here.

100 to 150

Just look at the German 30 year bond, crushing stocks since 2014.

3.50% to 2.45% Since 2014

Where do bonds go from here, get on our next Bear Traps report below:

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If we told you the S&P 500 has made $118 for three years running with zero growth, would you believe us?

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On January 1st, Wall St. told us the S&P would make $124.25, but now they’ve come clean, they only expect $118, we’re at $113.

Earnings x Multiple = S&P Value

$118 x 19 = 2242

$118 x  18 = 2124

$118 x 17 = 2006

$118 x 16 = 1888

Ironically, it was the same story last year, $123.85 expected earnings, only to finish at $117.50.

$113 x 19 = 2147

$113 x 18 = 2034

$113 x 17 = 1921

$113 x 16 = 1808

It’s a magic act, stocks can rise for years without earnings growth, presto!

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Join our Larry McDonald on CNBC’s Trading Nation, Wednesday June 8, at 2pm.

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This morning, copper and oil continue their great divergence.  Someone’s right on the global economy, we think it’s Dr. Copper.

The amount of metals and mining bonds trading at distressed levels is $26 billion after peaking at $86 billion in February and starting at $31 billion in October. With most commodity prices below last October’s levels, it appears these changes have been driven by the various measures that the companies have undertaken rather than an upturn in commodity prices. Additionally, companies with bonds continuing to trade at distressed levels may signal the market is expecting more drastic restructuring measures. – Bloomberg

 

Janet Yellen’s Fire Hose

A dovish turn yesterday from Chair Yellen put more goodies in the “risk on” bag.

“When would it be appropriate to resume normalization of interest rates? What she really said today was: ‘I have no idea.” And it was the right answer,” said former Fed Governor Laurence Meyer, who now heads the Washington firm LH Meyer Inc. “Normalization is a concept. There is no time frame.”

In January, the Fed told use they would hike rates 4x this year, today the market is telling us they’re nearly done for 2016.  The poorly thought through four rate hike promise to markets was a horrendous risk management move by the Fed.  In a little over a month, the U.S. dollar ripped from 94 to 100.

Next, China, emerging markets and commodities were crushed by the Fed’s unwise management of global risks.  Today, Janet Yellen doesn’t have her hand of the wheel anymore, China does.  She’s still putting out the fire.

“Coming credit crisis will put Fed on hold for 2016.”

Bear Traps, December 11, 2015

Global credit and economic risks have VETOED the Fed policy path for 2016, something we stressed back in December.

This green line is even LOWER after Friday’s Jobs Bomb.

The global economy is driving the U.S. rates bus.  Over the last year, what U.S. economists have been consistently getting wrong, is the fact that global conditions are overpowering the U.S.

Global GDP

Outside the USA: $61T

Inside the USA: $18T

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