The Case For A Crash
June 02, 2009
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*NOTICE--THIS POST IS NOT A STATEMENT THAT THERE WILL BE AN EQUITY CRASH IN THE NEAR FUTURE--IT IS MERELY HERE TO INFORM YOU OF THE ALARMING SIGNS THAT INDICATE THAT THERE IS AN ELEVATED POTENTIAL FOR A CRASH*
Let's talk about bonds. I can already here you saying, "but GMX, you've already been talking about bonds." However, bonds deserve more attention than you, I, or just about anybody at Motley Fool gives them.
First off, we must ask ourselves what bonds indicate. Bonds, simply are obligations between the borrower and the lender. When there is more demand for credit and or when supply of credit diminishes, the interest rates required to connsumate a lending agreement rise. This is the market we are encountering now. Due to the economic collapse, the supply of credit has dropped. Up until recently, demand for credit, however, had been falling even more quickly than supply of credit leading to a decrease in interest rates.
This all changed this spring, however,when the bond market realized that team Bush/Obama was getting loose pockets and started demanding higher interest rates from the gov in return for their investing dollars. The result--interest rates on government debt began to rise. Gov debt is the 1,000 pound gorilla of the American debt market--as the rate on 10/30 year bonds rose, the rate on mortgages, car debt and credit cards began to rise. Team Obama and Team Fed decided this was bad and rolled out "QE." Quantitative Easing was supposed to keep rates low by using the government's funding to purchase up debt. By supplying more bids (more supply) into the bond market, it matched demand and kept rates low--in theory. In practice, the banks have continued to pull credit out of the market faster than the gov can inject credit. Why, honestly, should an insolvent and functionally bankrupt bank lend money to borrowers who will, in all likelihood, never pay them back? Banks pulled in their horns despite the wishes of the gov and so supply of credit continued to fall.
The government kept running on the treadmill, pumping out new lines of liquidity as if they were record labels foisting out package after package of lousy "greatest hits" albums each holiday season. However, the gov's plans have failed. The foreign buyers (i.e. the bagholders) are starting to figure out that lending to the US at low interest rates is a bad idea. Why would anybody lend to the US for 30 years at 4%? There's clearly better opportunities elsewhere.
As expected QE, like any government intervention, has not only failed, but backfired as interest rates are rising at increasing speeds. We've got a problem and it's growing exponentially. Let's look at other times that interest rates have gone exponential (and the corrolary, as we learned in Econ 101, is that bond prices have collapsed). The early 1930's, 1980, 1987, and 1999-2000 all are interesting examples of when interest rates have suddenly soared. The aftereffect in all these cases--sharp unexpected drops in the stock market. The rise in interest rates in 1999 was a good example. As the tech bubble expanded, the IPO flood took hot money out of the real economy lowering the supply of credit for real businesses. Result, instead of being lent to solid companies, investors bought shares of dumb*ss.com and interest rates had to rise in compensation as supply of savings fell. Result, credit supply decreases, mortgage rates rises, economy sputters, Nasdaq in particular and market as a whole divebombs.
In the 1930s, there was also a collapse in the bond market despite the decade-long deflation. It was an odd situation--falling prices(CPI) yet rising interest rates. We appear to be following the same lead.
Of most interest is 1987. It was a fine year--stocks were rising, times were good, everyone was happy. Then, unexpectedly, the bottom fell out of the gov bond market as bond prices for the long bonds went from over 100 (par) into the 80s. If you don't know bonds--suffice to say that is a huge frickin drop. Bonds aren't supposed to lose 20% of their value in a few months. As bond prices fell (interest rates rising) and the dollar weakened (again, ring any bells?) the market suddenly sobered up. Faced with the prospect of higher debt costs, the lights started dimming on the Leveraged-buyout boom that drove the 1980s, the speculative juice left the market and then the ill-planned out portfolio insurance triggered the crash.
As mortgages rise ever closer to 6% on a 30-year fixed from under 5% a month ago, one has to be worried when they look at the similarities to the early 1980s, the 1931-32 period, and the fall of 1987. Will the sudden dislocation of the bond market combined with capital flight as seen by the rapidly sinking dollar cause another crash? I don't know, but I wouldn't be sleeping easy if I were "all-in" long without some hedges.
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