This “Looney” Market Is Looking Over The Edge Of A Cliff… Just Before It Falls

Many of you remember the old Warner Bros. cartoon series, Looney Tunes – specifically the slapstick episodes involving the hilarious duo, Wile E. Coyote and the Road Runner.

Somehow, in every episode, the fast-running ground bird manages to outwit the coyote, despite repeated attempts by the coyote to catch and eat it.

No matter how ingenious and complex the contraptions the coyote devises, they always manage to backfire – often with the coyote running off the cliff, falling deep into the canyon, as seen from a bird’s-eye view.

And this is exactly what we are seeing right now with the Federal Reserve.

The market is overinflated, and the Fed has concocted an elaborate plan to engineer a soft landing.

But it won’t be a soft landing. It will be a hard landing, just like the coyote running off the cliff and falling deep into the canyon.

So today we’ll look at the interplay between the Fed and the Treasury, and how that’s influencing the markets.

The Market Has Been Tricked by Increased Leverage, But Not for Long…

Over the past month commercial bank and foreign central bank buying, and increased borrowing by shadow banks, drove bond yields toward the low side of their range for the year.

That buying and borrowing also provided liquidity to drive the stock market rally.

While predicting how long this can last is difficult, it’s certain that it will end, and end with a thud, after buyers realize, like Wile E. Coyote, that there’s no ground beneath them.

The rally is simply not sustainable, as the Fed relentlessly pulls money out of the system.

There are two forces – buyers buying and using debt to do so, versus the Fed pulling money out of the system. The Fed isn’t going to yield.This creates increasing risk of a disorderly unwinding of leveraged positions – in other words, a crash.

Let’s look at some of the details. Treasury issuance (supply) is surging, but Primary Dealer buying has not kept pace.  Foreign demand for long term Treasuries has virtually disappeared, while surging for short term bills.

Weak dealer buying and the disappearance of foreign demand means that other buyers have been taking up the slack.

Those other buyers are investment funds. As the funds buy more bonds, it means that they’ll have less cash available to buy stocks.

And while Primary Dealers haven’t bought as big a portion of the Treasury issuance as they used to, they’re still forced to massively increase their holdings. That’s simply due to the massive increase in the size of the Treasury’s auctions.

So the dealers are forced to buy more, without the Fed backstopping them with endless cash as it did under QE. The dealers therefore are seeing their cash depleted and their debt soaring.

This increase in debt shows up in the steadily rising trend of bank lending to shadow banks. And that correlates directly with the rise in stock prices.

(Click on image to enlarge)

Despite this record financing of securities purchases, Treasury prices have barely rallied at all. There’s simply too much supply. Much of the increased financing has been diverted into the stock market.

The increase in leverage driving the stock market rally raises the risk of a disorderly denouement. The longer this goes on, the more dangerous it becomes.

Not Even the Newest Character in Town Will Show You Sympathy

Meanwhile, the new sheriff in town, Jerome Jerry Jay Powell, isn’t showing any sympathy. The Fed will continue to tighten the screws until the market breaks.

With Treasury supply steadily increasing, and cash in the system falling, eventually bond prices must fall. Overleveraged dealers will be forced to liquidate. We know what happened when dealers were positioned wrong in 2008. Apparently, nobody learned the lesson of history.

Only the timing is in question.Under the circumstances, the correct strategy would be to hold T-bills, which will be increasingly rewarded, and get out of long term paper.

Aggressive traders could short bond ETFs or buy inverse Treasury ETFs on a yield breakout.

However, there’s little to be gained by being early. The bond rally may yet have more life, particularly if the 10 year yield ends the week below 2.80.

We’ll need to keep an eye on the bond market for technical indications of the time to go short.

Ditto for stocks.

Disclosure: None.

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Gary Anderson 5 years ago Contributor's comment

If you are of the school that bond prices cannot fall, that they cannot afford to let them fall that much, then stocks will go and bonds will be in more demand. Other than that this is a very interesting article.

David J. Tanner 5 years ago Member's comment

Interesting point, Gary.

Samantha Carter 5 years ago Member's comment

I hope!! I own $UVXY