EPIC Collateral Short Squeeze: Governments’ and Central Banks’ Magnus Opus

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Much has been said about the quality of the cooperation between central banks and governments. One tightens while the other eases and so on and so forth. These petulant children have seesawed their way through the “post” crisis era for far too long.

 

The mechanical disconnect between their incongruent policies has become so deafening that it is difficult to verbalize. Instead I must ask you to look. Look at the sovereign bond markets of the world. Look at the rates. Look at their trajectory.

What do you see?

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Record low interest rates in every major developed country in the world. From Australia to France and from the US to the UK and every place in between record low bond yields continue to plummet with no signs of abating.

Before I continue, I must bring this back to our petulant little kids who appear to have made a very big mess in the collateral markets.

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Banks, pension funds, institutions and insurance companies used to be able to count risky assets as collateral, but since the crisis governments have regulated away this practice. In essence, the governments shrank the overall pool of good collateral and forced them to hold more government bonds, which deceased the liquidity and availability in the government bond markets.

Unfortunately for us, governments are about as accurate as a Salvador Dali clock and after decades of fiscal profligacy governments suddenly found religion and decided cut deficit spending which further reduced the already shrunken supply of good collateral.

Central banks then went in and bought a lot of the remaining debt, once again shrinking the pool of available good collateral, drying it from a once vast lake to a now empty crater.

 

Then all of a sudden…

BOOM! Brexit!

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This cherry lands on top of the proverbial three scoop sundae delight. The plucky underdog who came from a poor house in a rough neighbor on the wrong side of Leeds. No one gave this guy a shot. But damn did he show them.

So now the world is in a “risk on” environment. Everyone is running for the exit, searching for safety but finding a barren desert with scattered fat central banking fish helplessly flopping in the dried pools.

The result is a massive supply and demand imbalance, with prices going one way. Bond yields around the world are accelerating into negative territory.

We live in a world where people buy equities for yield and bonds for appreciation and as bond valuations sky rocket despite underlying fundamentals, the game of the greater fool approaches its climax.

In light of these recent dynamics it seems prudent to entertain the possibility of a blow out top in sovereign bonds.

First, the psychological impact of crashing rates could become a self-fulfilling prophecy. As more and more people cram into bonds yields will fall and the global economy may actually start to believe what the rates are telling it – there’s a crisis brewing.

Try to imagine what equities would do if the US 10 yr dropped below 1.00% after falling 70 bps in under a months time. What the heck does the SPY look like in that environment? Do you think it’s still at 2100?

How does gold behave when Japan, Germany and Switzerland can’t muster up a positive yield between the three of them?

What happens if we have a huge snap back rally in yields? What if the game of the greater fool ends quite abruptly? People awake from their foolish trances and start selling but with French paper negative out to 9 years, this sell off is incredibly steep. Potentially steeper than the rally itself. Trillions in losses pile up quickly and this bond market volatility now spreads to other asset classes.

The number of outcomes, and the negative convexity to each of them is worrying. Based on the incredibly foolish excitement this bond rally has generated, I believe that people are not prepared for the consequences.

In light of this revelation, I further added to my S&P put position while holding my gold and treasury holdings steady. If you want to wait for the S&P to break 1800 be my guest but at this point, I’m done adding equity exposure and am looking to trim what parts I can.

 

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