When the cup is empty, you can only pretend it’s full for so long. So it is with the capital base of the United States.
Before the collapse in the share prices of Citigroup and BofA in 2007-8, along with those of so many other financial companies, the stocks began underperforming the general market in 2006, implying that smart money knew that there was less “there” there in their capital bases than the companies were saying.
The beneficiaries of this destruction of capital were bond bulls.
I suspect the same thing is happening now, perhaps in an “echo” fashion. One look at BofA’s stock chart tells the story. It’s an ugly double rollover pattern. (Citi’s is worse.)
Markit, similarly, shows a recent collapse in its “CMBX” indices of commercial real estate securities prices.
Similarly, when oil pushed past $100/barrel in the last expansion, that signaled the onset of recession. While momentum and exaggerated stories of peak oil pushed the price much higher, the drop to under $35 demonstrated that prices much over $100 were bubble prices.
Given how little aggregate wage growth has occurred the past few years in the main oil-using parts of the world, meaning the US, Western Europe, and Japan, we can assume that oil prices, which have been at or over $100/bbl for months now considering Brent prices as well as West Texas Intermediate prices, have been doing their usual thing to oil-importing economies.
In the past, that decline in industrial activity has typically been associated with declines in Treasury yields, as the corrective action of declining oil prices is in fact disinflationary. In 2008, the financial collapse was so severe that there was actually a brief period of deflation. The result was zero short term interest rates, which over time have a gravitational effect on 5 and 10 year bond yields as it becomes evident that ZIRP is here to stay. In that context, I view Goldman as probably getting it wrong on rates:
Goldman Sachs says in a note today that 10-year Treasury yields, trading recently at 3.022%, have stabilized around 3% on both sides of the Atlantic and below the bank’s measures of “fair value”. . . Goldman sticks with its year-end call of a 3.75% yield on the 10-year, even as some other major banks have cut their yield calls. (WSJ)
I think that 2.25% is more likely than 3.75%, not that I am assigning a 50+% probability to such an extreme downward movement in rates by year end or ever again. But between the two, I’ve taken the “under” by converting cash yielding nothing into Treasurys of 8-30 years duration. (I blogged on this last week in Rolling Down the Yield Curve.)
The worst nightmare of crude bears has just come true:
- OPEC secretary general says OPEC unable to reach consensus to boost production
- OPEC delegate says OPEC has no consensus for agreement
- OPEC president says some in OPEC believed should have had production increase, other said more time needed to assess
- OPEC secretary general says OPEC spare capacity down to 4-4.5MBPD after Libya
What I think more likely is that demand will surprise on the downside, that Libyan oil production will not be shut in forever, that oil is in secular decline vs. renewable energy and possibly natural gas, and that non-OPEC production will grow substantially. Thus when I look at the charts, I see $80 oil as a first downside target in a global industrial slowdown, with $60-70 not a stretch at all. That 4-4.5 M barrel per day spare capacity might end up becoming gigantic as new production comes on line as global industrial businesses retrench.
After all, it was only the middle of the last decade that international oil companies were using $20 as their go-no go cut point for decisions on developing new fields. $80 would still be a quadrupling and $60 still a tripling from there. And of course these downside targets I have put forth could both be achieved and could easily be followed by strong new highs to and above $200/bbl in the next correlated economic expansion accompanied by yet another acceleration of global money-printing.
Investors and traders may want to get ready for at least a mini-rerun of the 2007-8 cycle. In this scenario, gold will be pressured, but industrial commodities will be much more pressured, and silver will be intermediate in its price movement. In such a situation, capital will be trapped and the path of least resistance will be purchasing of bonds farther out the yield curve at yet higher prices (lower yields), encouraged by the gigantic powers of the State.
We are now begun our fourth decade of declining bond rates. The longest such cycle in US history is 36 years. With record low short-term rates due to persist until at least 2012, who knows if this bond bull market will not also become the longest, and thus have a number of years, and a number of basis points, of life left before it ends?