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A Global Phenomenon

Yield curves have steepened sharply in developed nations since May, an effect that has widely been blamed on the Fed's 'tapering' verbiage. This explanation makes little sense, as people simply heard what they wanted to hear (the Fed's language has in reality not changed one iota for a number of years), and there is no reason for the bond markets of the whole world to throw an epileptic fit based on whether the Fed buys fewer t-notes to the tune of $15 billion, or whatever the most frequently bandied about number is, per month. In fact, as QE1 and QE2 have shown, Fed buying has no positive effect on the bond market at all – it has been thoroughly trumped by inflation expectations on these occasions. We suspect that the most recent bond rout had more to do with too many players putting on too much leverage than with anything members of the Federal Open Mouth Committee said, especially as they didn't say anything unusual anyway.

This time "inflation expectations" cannot be blamed either, although assorted aggregated economic data and diffusion indexes have been a bit better of late in the developed world (as previously noted, this is mainly a side effect of galloping monetary inflation). That leaves not too many choices, and we are left with outflows from bond funds and high leverage as the most likely culprits. However, this doesn't explain why the same thing has happened in China. The chart below shows the overnight repo rate and assorted longer term government bond rates in China (the spike in the O/N rate in June occurred when the PBOC briefly refused to feed enough liquidity to the banks).

(click to enlarge)

China's overnight repo rate in orange, and 3-to-10 year government bond yields

Our corespondent T.R. judges that this indicates that Chinese GDP growth will accelerate, but strangely, a number of ancillary charts we are keeping an eye on still indicate that there are worries about China's growth. For instance, CDS spreads on the debt of major industrial commodity producers remain relatively elevated:

(click to enlarge)

5-year CDS on the senior debt of Xstrata, Vale and BHP Billiton

Likewise, CDS spreads on the debt of the "big four" Australian banks have only given back a little bit of their recent gains. They do of course remain far from the panicky 2011 levels, when the euro area debt crisis was in full swing and the markets feared Australian banks might be cut off from foreign funding (if that were ever to happen, there would be the mother of all credit crunches in Australia).

(click to enlarge)

5-year CDS on the senior debt of Australia's big four banks

Growing Instability

We wish we knew what to make of all this in toto. It seems contradictory. However, we do have a general remark: over the past two years or so, many previously well established inter-market correlations have died. In addition, many market moves seem to make little or no sense and even those that do make sense are often highly exaggerated. We believe that this is a sign of an increasingly unstable financial system that has been massively distorted by the central bank policies of recent years. In addition, there is the growing presence of computerized trading programs, the mindless activities of which are occasionally quite astonishing (especially when they take their trading cues from headlines).

It is as though one were standing on a bridge with people walking across it in lockstep and the bridge has begun to ominously swing and creak. Maybe we should start putting on the life jackets … just in case.

Charts by: Bloomberg

Source: China's Yield Curve Steepens