Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

The Yield Curve Twist Omen

Any Crash we have witnessed have been the result of the yield curve suddenly returning from undervalued to normal. That was true for the "sub prime crisis" as it was for any other crash in history. It is the only way to account for a discontinuity in stock market value. If for other crash the easy cure was to lower short term rate, this time it will be, of course, impossible.

Financial crises are characterised by discontinuous breaks in market pricing the timing of which by definition must be unanticipated - if people see them coming, then the markets arbitrage them away.


I have explained that long term yields are options or short-term yields. A normal yield curve is such that these long-term yields get their fair value. However because these options are complicated to arbitrage and banks are structural lenders moreover this inversion was aggravated by Quantitative Easing (it is their job after all) recently on Wednesday 25th, August these low long-term yields became unsustainable.

Even a Pig can Get Fed Up, Eventually!

 
These yield are now going to normalize. For reasons I have explained in Omen of Financial Nemesis Timing : FND - 7. I expect that this process of sudden normalization will end on Sept.17th.
 
These are the yield curves for the minimum on Wednesday (orange) and the expected yield curve on Sept. 17th (green).


In fact the green yield curve is not exactly normal as I expect that a switch from long-term assets toward liquidity will make short-term yields go below their normal configuration.

 
 

But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.

 
 

Although these yield curves can stay for an extended time below the normal yield curve and sometime extremely low once the process of normalization has started it can become extremely quick as for any arbitrage.

 

"Our day-by-day experiences with the effectiveness of flexible markets as they adjust to, and correct, imbalances can readily lead us to the conclusion that once markets are purged of rigidities, macroeconomic disturbances will become a historical relic.

However, the penchant of humans for quirky, often irrational, behaviour gets in the way of this conclusion. A discontinuity in valuation judgement, often the cause or consequence of a building and bursting of a bubble, can occasionally destabilize even the most liquid and flexible of markets.I do not have much to add on this issue except to reiterate our need to better understand it."

Note: that increase in bond yields is not caused by any macro economic event but only by the fair valuation of an option. It is very probable that with dismal economic figures we still witness that yield increase.

With 11 trading days to go we would need on average to gain 10 basis points on the Yield of 10 Years US treasury Notes and 10.5 basis points on the 30 Years US Treasury Bonds.

Technical Analysis:
After the Hammer we had on Wednesday 25th, August the rally (in yield) started with a probable island reversal formation tomorrow.






This will have very dramatic consequences.


Macro Economy:

The yield curve necessary to sustain our sluggish economy is the green one, the yields that will be required by investors to reward them for interest risk is the orange one. As we can see the gap will be such that there will be a sharp decrease in the level of investments from the prevalent low. We can see how insufficient it is already by watching the year to year change in M3.



Bond Market:

Of course Treasuries will exhibit a sharp decrease. But that is not the main issue. As long-term yields will increase and investors will not need to chase yields the spreads between corporate and treasuries will suddenly widen.

Of course that will be even worse for bonds that are rated below investment grades and the demand for junk bonds will vanish all together.


Real Estate Premium Near Record to U.S. Bonds Signal Time to Buy Property

Mortgage Bonds Lose Ground as Homeowners Grab Lower Rates: Credit Markets

Corporate Default Swaps Head for Biggest Monthly Rise Since May in Europe

Asia-Pacific Bond Risk Rises, Credit-Default Swap Prices Show


TED Spread:

We can see that the TED spread has started to increase after falling since mid june has started to go up on... wednesday 25th, August!


Stock Market:

By the simple application of actualization formula we can see that mechanically the SP500 as the yields of the 10 Years US Treasury Notes jumps from 2.419% to 3.500% the SP500 would go from 1040 to 719 (1040 * 2.419 / 3.500) without of course taking in account the effect on consumption employment and investment that will necessarily feed back on the fall.


Minerals:

As I have shown in my article Commodity Conundrum Solved: The Hidden Parameter in Interest Rates when the yield curve is normal or steep the prices of mineral returns quickly to their marginal cost of extraction.

For gold it is below $300 a fall of 76% with an overshoot as, of course, the gold that is stored outside the ground has, by definition a cost of extraction = $0.

For oil that marginal cost of extraction is below $20 and probably closer to $10, which means an immediate fall of 74%.

Those percentage don't take into account the rise of the price of these minerals from now till Sept 17th.

These figures are bare minimums as with demand and cost going down the marginal cost of extractions will necessarily go down too.

Quantitative Easing Again?

The astute reader may ask if it is possible by a further round of Quantitative Easing to prevent that state of affair.

First there is the fixed schedule of the FOMC meeting. The next one will be on Tuesday 21st, September. In order to prevent the market crash on Sept 17th they would have to call an emergency meeting which would increase the angst on the market. Moreover the FOMC has been divised and indesicive lately so it is doubtful that they can reach a bold decision very fast.

Second the QE concerns specific classes of bonds and it is probable that even if they acted on treasuries and MBS the action would be ineffective on corporate bonds and would even widen the spread and increase the perceived risk.

Third the increase in the slope of the yield curve may be interpreted by the Federal Reserve System as a measure of a greater confidence of market participants.

 

Risk management involves judgement as well as science, and the science is based on the past behavior of markets, which is not an infallible guide to the future.

 

7, 6, 5, 4 , 3, 2, 1, 0


The clear evidence of underpricing of risk did not prod private sector risk management to tighten the reins.

In retrospect, it appears that the most market-savvy managers, although conscious that they were taking extraordinary risks, succumbed to the concern that unless they continued to "get up and dance", as ex-Citigroup CEO Chuck Prince memorably put it, they would irretrievably lose market share.

Instead, they gambled that they could keep adding to their risky positions and still sell them out before the deluge.
Most were wrong.


Disclosure: No Positions