Having been an active investor during the 2000 Dot-Com Bubble implosion and the 2008 Financial Crisis, one of the many lessons I learned from these events was how they suddenly brought to light a raft of financial "games" that had previously been hidden from public view. Though major new financial instruments had been widely developed, accepted and implemented, they were completely opaque from the general public and media reporting. These instruments turned out to be critically flawed in some aspect that led to their failure and resulting major draw-downs in the financial markets. We are seeing the same "Canaries in the Coal Mine" once again!
For example, as the 2008 Financial Crisis unfolded we discovered on an almost daily basis how esoteric instruments such as CDS's (Credit Default Swaps), CDO's (Collateralized Debt Obligations) were being used through SIVs (Structured Investment Vehicles) to fund ABCP (Asset Backed Commercial Paper) and MBS / ABS (Mortgage Backed Securites) which funded the US Housing Market. It turned out that Insurance companies were funding CDSs based on what proved to be a flawed use of accepted credit agency risk ratings.
The chart to the right, which we brought to our subscribers attention in 2014, pointed out that we were once again resuming the old game but with new acronyms, a new focus, and with supposedly better risk protection. Collateral Transformations, Credit Swaps and other untested methods received no public attention (and still haven't) as the EU Financial Crisis appeared to come under control.
FINANCIAL MARKET CONDITIONS ARE AS EASY AS THEY GET!
Broad gauges of financial conditions, which include measures of liquidity, short and long-term yields, and valuations on equities, are now the easiest they have ever been. On this, Bloomberg’s financial conditions index is in agreement with Goldman Sachs as shown below. The simple question is - is this the case? I won't bore you how the financial pundits explain it, but rather want you to consider something received absolutely no visibility which is occurring in the dark recesses of the financial markets.
THE CREDIT DEFAULT SWAP (CDS) GAME
Though we touched on this in this month's LONGWave video (I encourage you to review it if you haven't yet), I want to take it a step further in this note.
I believe we can agree that the Covid Pandemic is likely the greatest global economic and social disaster to have occurred since the 2008 Financial Crisis. It is likely to be considered an order of magnitude worse than the GFC before the final tally is taken over the next couple of years.
So let me ask you two questions regarding the data shown to the right:
Why did the 2020 CDS’s not rise to even the level of the 2012 EU Financial Crisis? In fact not even close.
Secondly and much, much more importantly, why (as shown on the left) have global CDS fallen steadily and so dramatically since the Financial Crisis?
The question is actually how can Risk insurance fall from 514 in Italy in 2012 to 84 today when the Italian industrial north is in near ruin from Covid. Why would German CDS's fall from 101.35 in 2012 to only 10.22 today when EU T2 accounts show Germany on the hook for the debt of the all the weak EU members? Why has UK debt fallen from 71.66 to 10.22 when clearly the post Brexit nation has major inextinguishable sovereign debt problems? This drop in Credit Default Swap protection costs is the same around the world.
Quietly Credit Risk Insurance has become a fraction of what it used to be only 10 years ago, yet sovereign debt is at historic highs against GDP? What gives?
When Credit Risk insurance is so cheap you can take massive leveraged risk and yet be protected for next to nothing!
Obviously Central Bank Liquidity will rapidly be turned into Financial Flows if Risk Protection costs border on being nearly free!
How could this occur?? Who is holding the bag? Many of you may recall it was insurance companies such as AIG during the Housing debacle of the 2008 Financial Crisis. But this is about Sovereign Debt!
I lay out my suspicions to the answer to these and other questions in the video, but what I didn't address is the use of something called " Inflation Swaps". Are you familiar with them? Few are, but they're huge!
WHY THE DIFFERENCE?
What is important about them now? Well for starters if they are used as intended, then the 5Y5Y Inflation Swap should be exactly what the 5Y5Y Breakeven Inflation Rate is. However, that is not the case!
The latter reflects the basis for the Nominal value of the 5 Year Treasury & the TIPS.
The former is what the banks are actually trading.
What is particularly suspicious is normally when US Yields rise, the US Dollar strengthens. This is not what happens when the difference between Breakeven and Inflation Swaps differ. This rings of calculated manipulation through OTC bank trading.
Though they are exactly the same at the moment (for the first time in years) this is likely to once again differ. When it does, we will likely see marked moves in US Treasury Yields and the US Dollar.
BOND MARKET - 10Y UST YIELD
MARKED BY: Noticeable & Steadily Rising Yields
US DOLLAR - DXY
MARKED BY: A Reversing Downward US Dollar
WHAT IS THE FED REALLY UP TO?
Global Central Banks appear to be caught in a trap of either:
Keeping the money spigot wide open and allowing an asset bubble and inflation to blow out of control, OR
Slow the money spigot and implode an artificially over leveraged credit edifice, OR
Try and manage the balance by controlling rates along the entire yield curve through YCC and potentially sacrifice the US dollar.
The Feds Dilemma:
Needs Inflation but hasn't been able to get it to the degree they feel is required (a sustained +2% rate),
Needs to take some of the Euphoria out of the exploding 'Everything Bubble',
Needs to raise rates but does not want to kill the Golden Goose of Wealth Effect and excess leverage,
Doesn't Want to use YCC because it will drop the value of the dollar and cause product pricing inflation (rising import costs for consumer products),
Concerned about a Taper Tantrum II if it slows liquidity even to a minor degree,
CURRENT PUBLIC STRATEGY
DO NOTHING - Appear to be letting the markets deliver the 'Forcing Function',
TRANSITORY INFLATION - Let the Post-Covid Supply Chain ramp do its work for it,
CHINESE CREDIT IMPULSE (CCI) - Let the Chinese Credit Impulse (12 month lead) do its work for it until CCI reverses in late Q3
INFLATION SWAPS - Let Bank of International Settlements (BIS) Control Global Rates through Sovereign CDS's to tighten or control the credit spigot versus the visible actions by central banks.
YIELD CURVE CONTROL (YCC) - Adopt YCC in Q4.
Rates are headed higher but will be controlled via the Bank of International Settlement Credit influence with global Credit Default Swaps and 'tuned' via Inflation Swaps at the Sovereign level.
US Yield Curve Control (YCC) is coming but only in concert with BIS actions to protect the US Dollar from what will be determined to be 'excess damage'.
NOTE TO EQUITY INVESTORS
As this month's video spells out, Credit leads Bonds and Currencies, which lead the equity markets. So as not to get blindsided in the equity markets, you need to watch the under markets closely! There is also a consistent pattern where if the equity market is up then either or both the 10Y UST (TNX) and US$ (DXY) are down with gold and silver up. Though you may not be interested in Bonds the charts of the TNX, below may save you some major losses!
"Aside from the fraud, chicanery, and balderdash of it all, there’s a serious flaw to the Team Powell-Yellen inflation scheme…How can dollar debasement policies aimed at inflating away the debt ever succeed when it’s these very policies that induce the massive growth of debt in the first place?"