Distorted Market Signals And More Signs Of Problems In China

Includes: CYB, FXI, JNK, SPY, TLT
by: Acting Man

More Oddities

Along the lines of the recently discussed idea that central bank interventions have distorted numerous price signals, here is some additional evidence supporting this contention. The first chart shows the Eurostoxx Index compared to inflation expectations as reflected by yields on 5 year US and euro area inflation adjusted bonds. For a long time, stock prices and yields have moved in unison. This is no longer the case. They have increasingly decoupled since late 2012/early 2013. One cannot rule out that they will converge again at some point.

Eurostoxx vs. 5 yr. US and euro area TIPs yields.

Until the end of 2012, the CRB commodities index was directionally strongly correlated with US 5 year inflation breakeven rates. Since then, the two data series have become a lot less correlated. It remains to be seen if the recent surge in commodity prices will change that:

5 year US inflation breakeven rate vs. the CRB index (yellow line).

European banks have been massive buyers of government bonds in the debt expansion orgy of the faux "austerity" era (during which public debt expanded globally from $70 to $100 trillion). Ideas voiced during the sovereign debt crisis with regard to assigning some sort of risk weighting to sovereign bonds have been quietly dropped again. The biggest buyers of sovereign debt were banks in countries like Italy and Spain, which is akin to Enron propping up Worldcom.

It is well known that European banks have done comparatively little to reduce their leverage or bolster their equity. Their situation is less precarious than before as government bond yields in the euro area have once again converged at very low levels, but has this really made the banks less risky? Keep in mind that CDS spreads on 5 year Greek government debt were at 38 basis points in 2007, only to reach more than 26,000 basis points four years later. In the process the entire Greek and Cypriot banking systems were bankrupted.

So what is the perception of market participants regarding European banking risk today? Apparently, investors once again believe that there is actually almost no risk at all – our euro bank CDS index is increasingly converging toward the CDS spreads on the senior debt of US banks, which in turn are at their lowest levels since the 2008 crisis:

Our index of 5 year CDS spreads on the senior debt of eight European banks (red line), vs. 5 year CDS spreads on the senior debt of Goldman Sachs (NYSE:GS) (orange), Credit Suisse (NYSE:CS) (yellow), Citigroup (NYSE:C) (green) and Morgan Stanley (NYSE:MS) (pink).

As the chart shows, investors have with some regularity become convinced that there was little risk just before becoming convinced of the exact opposite.

The next chart shows an overview of five markets in the course of the three "QE" iterations by the Fed – the US stock market (SPX), silver, gold, copper and crude oil.

"QE" 1, 2 and 3 and five markets: SPX (red), silver (purple), gold (yellow), copper (orange), and WTI crude oil (green).

The next chart is one we haven't shown in some time – the SPX vs. the JNK/TLT ratio and the gold-silver ratio adjusted VIX. Stocks have begun to live in their own universe (very likely not for long):

The SPX is lately diverging strongly from both JNK/TLT and gold-silver ratio adjusted volatility index. This is normally a warning sign.

China: Interest Rates and Corporate Bond Spreads

As a little addendum to our recent post on China, here are two charts depicting interest rates in China. The first chart shows interbank lending rates as well as government bond yields of various maturities (3, 5, 7 and 10 years). Government bond yields have increased quite a bit since their 2012 interim lows, while overnight lending rates in the interbank market have become extremely volatile since 2011, likely due to increasing concerns over the shadow banking system and the liquidity problems it could be prone to producing:

China interbank lending rate (orange) and 3 to 10 year government bond yields.

The next chart is actually more interesting – it shows AAA and BBB+ corporate spreads in China. AAA rated corporate debt is mainly issued by state owned enterprises, and the spread is therefore basically a function of risk perceptions about government debt – when CDS spreads on China's sovereign debt spiked at the peak of the euro area crisis, AAA corporate spreads spiked as well.

Since then, they have largely gone sideways, while lower rated corporate bonds have suffered a veritable rout. The spreads on lower rated bonds are however better indicators of the situation in the private sector. Evidently, stresses are continuing to build at a rapid clip:

China: AAA rated vs. BBB+ rated corporate bond spreads.

The large increase in lower rated bond spreads reflects the growing problems bubble activities are encountering in China in the context of a sharp decrease in money supply growth.

This is yet another sign that more negative surprises could emerge from China in the course of this year. Since the government steadfastly insists that it won't enact another credit binge stimulus similar to the one that was implemented in the wake of the 2008 crisis, there is a good chance that significant parts of the shadow banking sector could get into trouble, which will inevitably affect the regular banking system as well.

In short, things could easily go pear-shaped, and it remains to be seen if the government will once again manage to keep things under control should China's credit bubble actually begin to deflate.

Charts by: Bloomberg