Summary
- The debt ceiling crisis is fueling extraordinary declines in yields (rise in prices), but shortly after the government can borrow again, bonds give back their gains, and yields rise correspondingly.
- Gold outperformance was a function of weaker DXY caused by falling yields. But shortly the debt ceiling is lifted, yields rise, the DXY recovers, and gold give back its gains.
- The USDollar weakens sharply early in the debt ceiling crisis, but even before the debt ceiling is lifted, the lagged impact foreign capital inflows into US treasuries boosts the DXY.
- SPX and 10yr yields diverged at this stage during 2011 DCC; that divergence stayed after the crisis -- SPX rose sharply to year-end, even as yields stayed sideways to lower.
- Bitcoin assets should be making new highs in a few trading days. But time may also be running out for the bitcoin universe. We expect declines to initiate very soon, with a trough expected by mid-July. Cryptos are very sensitive to systemic liquidity then, and now.
Original article is here.
(This article was based on an actual Market Report was written pre-NY market opening, on Thursday, June 20, 2019, and was updated until the NY market closed. Seeking Alpha has been encouraging SA service providers to become more transparent, and show actual reports and interaction between providers and subscribers. We are providing this report to showcase what PAM provides to the members of the community).
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Seeking Alpha contributor extraordinaire Alan Longbon, and a service subscriber at Predictive Analytic Models ((PAM)), has written a series of articles at SA about the impact of the ongoing debt ceiling crisis on major financial assets (here, and here). On Thursday, June 20, Mr. Longbon posed several questions at the PAM chat room about the impact of prior similar debt ceiling crises on financial assets, specifically that of 2011. His queries sparked an exploration, and subsequent exposition, of 2011 events that may provide significant clues on how the current debt ceiling crisis will similarly impact financial assets further out.
The US debt ceiling had routinely been raised in the past without partisan debate and without any additional terms or conditions. This reflects the fact that the debt ceiling does not prescribe the amount of spending, but only ensures that the government can pay for the spending to which it has already committed itself. Its akin to an individual "paying his/her bills" that are due.
However, in 2011, the Republican Party, which had retaken the House of Representatives the prior year, demanded that President Barak Obama negotiate over deficit reduction in exchange for an increase in the debt ceiling, the statutory maximum of money the US Treasury is allowed to borrow. If the United States breached its debt ceiling and were unable to resort to other "extraordinary measures" the Treasury would have to either default on payments to bondholders or immediately curtail payment of funds owed to various companies and individuals that had been mandated but not fully funded by Congress (Wikipedia).
2011 Debt Ceiling Crisis (DCC)
The crisis sparked the most volatile period for financial markets since the 2008 crisis, with the stock market trending significantly downward, the VIX exploding upwards, and US bond yields plunging sharply as domestic and foreign investors fled into the still-perceived relative safety of US government bonds (see chart above and below). The credit-rating agency Standard & Poor downgraded the credit rating of the United States government for the first time in the country's history.
Zoomed in view of 2011 Debt Ceiling Crisis (DCC)
Mr. Longbon wanted to know how financial assets performed at that time relative to their average performance over a period of time, say, over five-years. He wanted an equivalent gauge of this year's relative asset performance from the period labeled as "we are here" in the 2011 asset chart shown above. He asked:
What does throwing in a treasury securities paper drought do to the liquidity equation? Even more significantly lower highs and deeper lows in equities and yields on relative basis? It is an extraordinary event that is at work now.
His interest was piqued by the fact that the ongoing debt crisis is unfolding at a time that a seasonal "liquidity drought" is pressuring bond yields lower at this time of the year. There's a tendency for yields to decline, sometimes sharply, during the late part of H1 of any year, as negative newsflow is amplified by a drought of systemic liquidity starting in early May, in any given year. We discussed this at length in a one-on-one Q&A with Mr. Daniel Shvartsman, Director of Seeking Alpha's Marketplace, which was published on May 25, 2019 ("Looking At Systemic Liquidity"). The chart below shows an updated version of the illustrations we showed in the Shvartsman article.
Yearly seasonal trends of the Treasury Cash Balance (TCB), nsa
We claimed at that time that the normalized 10yr bond yield profile this year will probably be not much different from its average profile of the past five years. In fact, what is happening at this juncture in yields had happened in 2017, as well as in 2011, even as the debt ceiling crisis was raging . There is a tendency at this time of the year for 10Yr yields to fall sharply by early May, do a mid-course recovery in late June-early July, then fall again until late August-early September. Those moves are consequence of seasonal trends which are dictated by confluence and divergence of liquidity flows at this time of the year (see chart below). The general dearth (outflow) of liquidity during the recent period amplifies any negative newsflow that comes along (like the debt ceiling crisis), causing sharp downside moves in yields and equities when given the appropriate nudge.
Nonetheless, the lagged countervailing liquidity inflows have been strong in the past several days (see 2019 SOMA and Treasury Models in the chart below) -- there is a sudden and sharp influx of liquidity into the Treasury Cash Balances, and into the Fed balance sheets -- at this period of the year (and during any year), and that has been consistent since the recovery from the Great Financial Crisis of 2008. Therefore, it is highly likely that bond yields will rise in response -- we already saw that on Friday. The rally in yields could last for a week at least, or even as long as three weeks (see chart below).
10yr yield in the 2019 Debt Ceiling Crisis
PAM's response to Mr. Longbon query on yields performance during a Debt Ceiling Crisis (DCC) year culminated in a structure which may look like the illustration below, taking the net effect of the seasonal liquidity inflows and outflows from today to the end of the year. The prominent feature is a projected bottom in late August-early September period, which Mr. Longbon pointed out as a period when "perhaps the debt ceiling crisis comes off then, too".
PAM also pointed out to Mr. Longbon that even during the 2011 DCC, the raw, non-seasonally adjusted Treasury Cash Balances (TCB) pretty much defined the subsequent general expectations for lower bond yields, and that the crisis merely accentuated the decline in the 10yr yield in 2011 (purple line), as it is doing this year (green line); see chart below. The good fit and covariance of the 10yr yield to the TCB (yellow line) and to the 10yr 5-year average (dashed blue line) remained true even during unprecedented turmoil brought about by brouhaha over fiscal and political priorities in 2011.
10yr Yield during 2011 DCC
The debt ceiling crisis is fueling extraordinary declines in yields (rise in prices) due to investors' flight to safe haven, but shortly after the government can borrow again, bonds give back their gains, and yields rise correspondingly. Mr. Longbon agreed, and said it is a good template for what to expect for the 10yr yield during this year's debt ceiling episode.
Next, Alan wanted to know the stock market performance during the 2011 DCC episode; PAM provided the chart shown below. He noted as well the fidelity both the 10yr yield (purple) and the S&P 500 Index (light blue) displayed with regards to the 2011 TCB seasonality (yellow).
Even at that time, the SPX and the 10yr yields showed some divergence at this stage in the DCC, in the same extent that we are seeing in this year's crisis. In the short-term the SPX could and did diverge against the changes in the 10yr yield (see chart below). After the debt ceiling crisis passed by, the SPX traded according to liquidity trends, and indeed front-ran the seasonal changes of the TCB in rising higher, even as yields traded sideways.
SPX during the 2011 DCC
What remains unchanged was the tendency of the current year (2019) to hew according to the seasonality displayed by the 5yr yield average, and even to that of the 2011 10yr yield (see chart above).
After this, Mr. Longbon wanted the entire story on how financial assets performed during the 2011 Debt Ceiling Crisis. This is how the other major assets fared at that time:
Gold Bullion during the 2011 DCC
Gold outperformance was a function of weaker DXY caused by falling yields. But shortly the debt ceiling is lifted, yields rise, the DXY recovers, and gold gave back most of its gains 2 months after the debt ceiling was lifted. By the 5th month, gold was practically back where it started its outperformance during the onset of the DCC.
US Dollar (DXY) during the 2011 DCC
The USDollar weakens sharply early in the debt ceiling crisis, but even before the debt ceiling is lifted, the lagged impact foreign capital inflows into US treasuries boosts the DXY. The Dollar thereafter went on to post even higher highs for the year after the debt ceiling was lifted, as the full impact of the foreign capital inflows was fully assimilated in the US Dollar's exchange rate.
WTI Oil during the 2011 DCC
WTI Oil tracked the bond yields closely to the downside during the 2011 DCC (as it has done during this year's DCC episode), but once the debt ceiling was lifted, WTI Oil responded to the changes in the US Dollar. We are seeing WTI Oil starting to diverge from falling bond yields, and Oil will likely track independently of the bond yields from here on.
The historical facts are clear, and the 2011 DCC experience provides clear templates for this year's DCC end-game for risk assets:
- A debt ceiling crisis fuels extraordinary declines in risk asset prices and a fall in bond yields -- but not long after the government can borrow again, the risk assets recover their losses (and sometimes, more); and safe haven assets give back their gains.
- The prime mover of the recent sharp decline in US yields has been the inability of the Treasury to borrow (which means dearth of securities supply) which mechanically depresses yields. But once that ceiling is removed, bond yields bounce back with a vengeance, gold sells-off sharply, the US Dollar strongly recovers, and equities post significant rallies.
- The dearth of securities supply was, and will be, further exacerbated by a plunge in systemic liquidity from both the Treasury and the Fed, from early May until Sept-October, with and intermediate pause in late June-early. The liquidity conditions define the major trends in both yields and equity indexes, even during the Debt Ceiling Crisis (see boxed portion, chart below).
- After the seasonal low of equities and bond yields in the Q3 of any year, stocks and yields tend to rise until early January of any year (see chart below).
Bitcoin Futures and Assets
This is how Bitcoin assets performed during the 2011 Debt Ceiling Crisis:
Even then, classic Bitcoin assets appear to respond to systemic liquidity conditions.That sensitivity appears to have carried over to the "modern" versions of bitcoin. Although BTCc1 futures and (OTCQX:GBTC) made higher highs on Friday, Grayscale Ethereum Classic (OTCQX:ETCG) has gone sharply lower -- which is an appropriate response to the PAM BTC (liquidity) model which has fallen much much earlier (red line); see chart below.
PAM expects a decline in bitcoin asset prices over the next several weeks, with a trough indicated by the PAM bitcoin-sensitive liquidity model (red line in chart above) optimally on July 16. This brief correction should be followed by a high-amplitude rally towards the middle of September, 2019.
This article was taken from a PAM report to subscribers on Thursday, June 20; more details are available here.
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Robert, Excellent to see you broadening your scope of exposure. Hopefully this source will bring other skilled market participants into the PAM group to further the excellent writing and commentary available on PAM on a daily basis. Congrats, Fred