Selling Pressure Wanes, But Credit Markets Still Troubling

by: Chris Puplava

Selling pressure is drying up, but for a sustainable bottom to form, we need the credit markets to improve, which hasn't happened yet.

As shown below, various major indices are either testing or hitting new lows, while the percent of stocks hitting 4-week, 12-week, and 52-week lows is drying up, similar to the August/September bottom. This may be signaling an intermediate-term bottom is in the works.

Nasdaq selling pressure is drying up:

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Russell 3000 (98% of US market capitalization) is showing selling pressure also drying up.

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As are the beaten-down small caps (Russell 2000):

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The missing link in the bottoming puzzle is improvement in the credit markets, which has failed to materialize just yet. Credit default swaps on investment grade (IG) and high yield (HY) corporate bonds keeps heading higher, with recent levels well above their October 2015 highs as well as their January 2016 highs, reaching their highest levels in five years:

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US corporate high yield option adjusted spreads (OAS) are nearing their 2011 highs with no improvement (red line below), and their spread to US Treasuries continues to creep higher as they too approach their 2011 levels (orange line below):

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The credit markets weakened in the wake of Yellen's rate hike in December, which suggests it was a policy error, particularly when viewing the tightening that already took place since 2014, as seen by the Atlanta Fed's Shadow Federal Funds Rate (middle panel below), which also coincided with a peak in global currency reserves (bottom panel). These two factors suggested that global liquidity and financial conditions were worsening, and this was the environment Yellen raised rates in.

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A watch point I highlighted previously is the Japanese yen, which is moving in the wrong direction and peaked on January 29th, the day the Bank of Japan (BOJ) joined the negative interest rate party. Rather than having a stimulative boost, the move was treated by investors as a policy error, and the yen has strengthened sharply in the last two weeks against the USD. The recent peak in January tested the underside of the broken trend that was in place when Abenomics first began in 2012 and continues to strengthen, which, historically, has not been a good sign for the markets when the yen carry trade unwinds.

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While selling pressure is drying up, which may signal a bottom, we need to see improvement in the credit markets and corresponding stabilization in the following areas:

  • European banks
  • Japanese yen
  • US Junk Bond market
  • Oil prices

As seen in the chart below, these areas continue to see new lows, with no signs of stabilization. Until these areas and the credit markets improve, a bottom will remain elusive.

In addition, there are ongoing concerns regarding spillover effects as the world's second-largest economy, China, continues to slow. Echoing similar concerns made by a number of prominent stategists on our show (see "Worth Wray on the Single Most Important Catalyst for a Global Financial Crisis"), prominent hedge fund managers like Kyle Bass are betting on a major decline in China's currency, as recently reported by the WSJ:

Investor Kyle Bass said Wednesday that China's liquid foreign reserves are "already below a critical level," intensifying a debate over China's ability to keep its currency from falling.

Mr. Bass, whose Hayman Capital Management LP has a multibillion-dollar bet that the yuan and Hong Kong dollar will fall, told clients in a letter that his firm estimates that China's liquid foreign reserves are $2.2 trillion at most. That compares with the $3.23 trillion reported by the People's Bank of China, the central bank, for the end of January...

Hayman began repositioning its portfolio after studying China's banking system and being stunned at its rapid expansion of debt. The firm's analysis suggested that past-due loans would rise sharply and eventually require a huge injection by the central government to recapitalize the banks.

In the letter, Mr. Bass wrote that the assets in China's banking system are equivalent to 340% of the country's gross domestic product and that the PBOC would need to print more than $10 trillion worth of yuan to recapitalize its banks. The magnitude of losses by China's banking system "could exceed 400% of the US banking losses incurred during the subprime crisis," he wrote.

China has several levers to pull, including cutting interest rates to zero and using reserves to recapitalize its banks, the letter said, but "ultimately a large devaluation will be a centerpiece of the response."

China is likely to remain a big wild card this year and an ongoing concern for some time, meaning even if we have a decent intermediate rally in the weeks ahead, this year is likely to prove quite difficult for investors, with risk management playing a paramount role. For two in-depth discussions on China, its dwindling currency reserves, and the implications this has for emerging markets, equities, bonds, and commodities, please see the extremely prescient interview we conducted with Felix Zulauf last August here and the more recent interview we conducted with Evergreen Gavekal's chief economist here.