The Mother of All Bubbles is about to Burst

BubbleUSD Crisis

Dear PGM Capital, Blog readers,
In this midweek blog article we want to discuss with you a bubble that is about to burst.

First of all let us talk about “interconnectedness.”

Manifest and growing interconnectedness creates its own bubble. The bubble enlarges as masses of banks and financial institutions and private investors end up on the same side of the same bets. The bubble bursts when they want out, when they all head for the exit doors at the same time.

Below chart gives an overview of the stages of a bubble.

Bubble-phases

In 2008, the bubble, on the outside, stretched around mortgages, subprime and prime mortgages. But on the inside, the massively inflating mortgage bubble resulted from a desperate clamor by investors of all stripes. The hunt for yield took investors further and farther out on the risk spectrum.

Low interest rates were the conduits through which hot air filled the mortgage market balloon.

Why is that important now?

Because the same-as-before manipulation of interest rates by governments and central banks has forced investors into riskier and riskier assets in the hunt for yield across the global low-rate environment, again.

In order to maximize low-yielding investments in bonds, namely sovereign and corporate bonds, collectively far and away the largest asset class on the planet, investors leverage themselves by borrowing to increase exposure to magnify their returns. It is this debt surge that underlies the interconnectedness pumping up the interconnectedness bubble.

As long as interest rates are low and yield curves around the globe are fairly steep, which means short-term rates are a lot lower than long-term rates, the leverage that investors have employed in the form of short-term borrowings to pay for higher-yielding longer-term bonds will work in their favor.

But if short-term rates rise faster than long-term rates…

It’s bad enough if long-term rates rise, knocking down the price of existing bonds that offer lower yields, in such away that investors holding those long-term bonds have mark-to-market capital losses on their books. Investors, like banks, have to contend with reserve ratios, and losses on their portfolios will cause them to have to raise capital or deleverage. Still, they don’t have to sell the bonds and actually take capital losses.

Below chart shows the yield of the 10 year-note during the last 2 years and has gone up with approx. 72 percent since the FED announced that it might start tapering its bond purchasing program soon.

2 year chart 10 yearnote

Currently the USA Central Bank, “The Federal Reserve” is sitting on over US$3 trillion in bonds and due to rise in interest rates since May of this year, they have lost approximatly US$ 200 billion on these bonds.

The FED is currently absorbing over 0.3 percent of all Ten Year Equivalents, from the private sector every week.

The total number as per the most recent weekly update is now a whopping 33.18 percent up from 32.85 percent the week before as can be seen from below chart.

Fed Holdings 30.5 percent of all USA Bond

It is worth mentioning that on 31st of January of this year, the FED owned 28.98 percent of all ten year equivalents and now just 10 months later it owns a third of the entire US bond market.

At this pace, assuming Janet Yellen keeps delaying the taper again and again over fears of how “tighter” financial conditions would get, the Fed will own between 40 – 45 percent of the entire bond market by December 31, 2014, and all of it by the end of 2018.

When the FED becomes the only buyer of USA treasuries it will be the end game.

PGM CAPITAL COMMENTS:
Investors have to watch the yield curve and know at what rates the long end of the curve and the short end of the curve are rising, both in absolute terms and relative to each other.

Rising rates will cause massive problems, economic disruptions, and losses everywhere, in some places and on some assets more than others. We’ll cover all of those scenarios in these series.

But as far as interconnectedness and the bubble brewing in global debt interconnectedness are concerned, investors can hedge their exposure to rising interest rates by buying inverse bond ETFs, by buying puts on debt-denominated ETFs, and by managing their own bond portfolios by deleveraging themselves and keeping portfolios in short term duration.

A crash of the bond market is also called the Mother of all crashes because, rising bond yields will trigger a stockmarket as well as a real estate market crash.

Secondly, it is worth mentioning that the money that the FED and other central banks have pumped into the market has not only inflated a bond-market bubble but also a stockmarket bubble.

As can be seen from below table, the Shiller P/E ratio is today, December 4th 2013, at its highest level since January 1st 2007, indicating that a stockmarket correction and/or subsequent bear market is on the horizon.

Date Shiller PE Ratio
Dec 4, 2013 25.33
Jan 1, 2013 21.90
Jan 1, 2012 21.21
Jan 1, 2011 22.97
Jan 1, 2010 20.52
Jan 1, 2009 15.17
Jan 1, 2008 24.01
Jan 1, 2007 27.20
Jan 1, 2006 26.46
Jan 1, 2005 26.58
Jan 1, 2004 27.65
Jan 1, 2003 22.89
Jan 1, 2002 30.28
Jan 1, 2001 36.98
Jan 1, 2000 43.77

Last but not least, what investors must not forget is, that money will never stop flowing and that it only changes direction from time to time and, we believe that the bust of the Bond-, Stock- and Real estate markets, combined with a cash crunch, social unrests and lost of confidence in governments, starting 2014, will create the biggest fear driven bubble ever seen on this planet.

Keep in mind that fear driven bubbles are more intense than greed driven bubbles, and that they will be short and sharp.

History has proven that gold, silver and other precious metals during a fear driven bubble have gone through the stratosphere in a very short term.

Until Next Time

Eric Panneflek

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