By: Tim Fortier — July 21, 2021
Bonds Keep Shouting "Can You Hear Me Now?"
Beginning in 2002, Verizon ran a TV campaign called "Test Man.” which launched the unforgettable Verizon catchphrase “Can you hear me now?”.
The campaign was hugely successful and ran for nine years.
I bet that, even though the ad last ran in 2011, when you hear that phrase you not only think of the ad, but you picture in your mind actor Paul Marcarelli, aka the “Verizon Guy”.
The bond market has been running its own kind of “Can you hear me now” campaign for the last 40 years.
Thing is, if recent rhetoric is anything to go by, not many are listening to it.
Here’s what I mean.
Since 1982, interest rates have steadily declined, with only intermittent increases, as disinflation swept the globe.
(Click any image to enlarge)
Why so much disinflation?
The trend toward globalization led to a broadening of the middle class in emerging markets. Goods made with cheap labor fell in price (think of TVs, computers, toys, clothing, software).
Things that could NOT be outsourced -- child care, health care, education, housing, for example -- have all risen in price.
In developed countries, this created its own set of challenges. Among them a greater gap between the "haves" and the "have nots".
When COVID hit, it disrupted supply chains and displaced labor. This has jacked up the price of goods needed by many businesses, forcing them to pass price increases on to the consumer.
This has brought us inflation today.
When central banks poured trillions of dollars into their economies, everyone agreed that their actions would lead to runaway inflation.
Everyone, that is, except bond traders. They don't seem to care.
The bond market still broadcasts the same ad it started running some 40 years ago.
The U.S. 10 Year has fallen all the way back down to mid- February levels, from where the confusion over rates started.
The trendline in the chart below was broken two weeks ago and momentum continues to be one way -- toward lower yields.
I admit I expected the specter of lasting inflation. (It was hard to hear any counterargument over the roar of the Fed's printing press.)
But the price action of bonds has been interesting. And it has me wondering...
Is there something that the financial talking heads are missing?
So over this past weekend, I had a chat with “Mr. Bond Market". He’s a bit tired of being right for 40 years about the fact that there is no change toward runaway inflation.
But he asked me to point out one very important variable people frequently forget: the private sector.
Here’s the deal...
That hot-off-the-presses money is not making it out into the real world.
Instead, it's pooling up within banks as massive excess reserves. The banks aren't lending enough of it out. You can see this by looking at the plunge in the Total Loan to Deposit Ratio.
So while the money supply (called M2) has skyrocketed over the past year, the “money velocity” is lower than it's been in more than a century.
(The velocity of money is a measurement of the rate at which money changes hands in an economy.)
Firms and households are leveraged up to their eyeballs. Their appetite for credit is extremely low right now. And without credit demand, the only thing left to boost sustainable aggregate demand is structural growth.
Now, here’s something you might not know. Even though government debt grabs all the headlines, private debt is larger than government debt and has more of an impact on economic outcomes.
The pandemic caused the ratio of private debt to GDP to reach 165%, just shy of the GFC highs at 173%.
Look at this chart.
Remember, the private sector is a currency user, not a currency issuer like the government. It needs cash flows to service its debt.
So we have…
- An over-leveraged private sector composed of an aging population (plus a growing number of “zombie companies”)...
- All facing a structural lack of productive investment outlets.
This is NOT an environment conducive to increased borrowing.
So yes, there was a HUGE temporary boost to aggregate demand in the form of credit creation via deficits and government-sponsored bank lending.
But banks are not lending anymore, as the Return on Equity on loan books is horrible, thanks to low loan yields and tight capital requirements.
The Global Credit Impulse
The “global credit impulse” refers to the rate of change of the flow of credit to the economy. It tells you whether the credit creation process is accelerating or decelerating.
As we saw a moment ago, this matters. Credit creation brings into being money that can, and will, be used in the real economy to increase nominal economic activity.
This newly created money reaches the private sector and fosters nominal economic activity -- with a time lag.
The global credit impulse tends to lead to changes in bond yields with a 10-month time lag, and lead year-over-year industrial commodities returns by about 8 months. For stocks, the lead-time is about 12 months.
Is it a coincidence that the Global Credit Impulse peaked July-October 2020?
I don’t think so. And so… Look out!
So with weak loan demand coming from the private sector, it should surprise no one that bank stocks have been weakening along with the rest of the market.
Bank stocks actually turned down last month, as you can see on the sector’s Bullish Percent Index (BPI) chart. The chart is currently in a free-falling column of O's (at the far right of the chart) and on a point-and-figure Sell signal.
And it isn’t just banks. For the past several weeks I've been telling you about the increasingly narrow participation in the stock market.
It’s really easy to spot using a tool like the premium US Industry Bell Curve (one of the tools that comes with Sector Prophets Pro, our data and sector research platform.)
Just a month ago there were 23 positive sectors (the blue boxes) where Demand was in control.
Today there is only one. And it’s an international group (Latin America). That means the entire U. S. stock market is now a sea of red and firmly in the hands of Supply (aka, the sellers/bears).
Right now, investors should be playing defense. Your number one goal should be protecting capital.
As Mark Twain famously said, "It ain't what you don't know that gets you in trouble. It’s what you know for sure that just ain't so.”
Listen to Mr. Bond Market because he is often right. If you listen closely, you will hear him asking...
"Can you hear me now?"
Thanks for reading,
Editor, True Market Insiders