The Great US Debt Rotation10 min read

Dear Readers,

Summer is over which means its time for us to start preparing for the worst.

Earlier this year, I made a call that we could see things come crashing down, or that the beginning of a crash may begin to set in.

Via my Letter, “How This Landmark Decision Could Destroy the Market“:

“I can’t pinpoint it, but I have this feeling that sometime in September, something is going to come crashing down – or the beginning of a crash may set it. This is just a hunch – a feeling – so it may not be wise to take it too seriously.

The market could still hold up after September, and still end up in the green this year. But I certainly won’t say that about 2016.

So why my sudden change of views?

No, it’s not just that we’re leading up to the end of another seven-year cycle.

I look back to many instances of history and compare the connection of events from those times to today. While from a technological standpoint things are drastically different, human nature has changed very little.We are now witnessing a culmination of events that can only end up in disaster: the war in the Middle East is intensifying; the media is fuelling hatred (i.e. Ferguson); we’re witnessing a major oil shock; the market is frothy; there is mistrust amongst every country (i.e. NSA); and there is a major attack on the dollar – with China and Russia leading the way.

Let’s not forget the tremendous amount of debt that has been accumulated by the world’s top economic powers in the last seven years. Example: China total debt has nearly quadrupled, rising from $7 trillion in 2007 to $28 trillion by mid-2014.

There are even religious and prophetic connections – should you be interested in that sort of thing – that call for a market crash by the will of God.”

None of the points mentioned above have dissipated: the Middle East is on the brink of all-out war, the media continues fueling hatred via its propaganda on race wars, oil continues to fall, mistrust among nations intensifies, and the market is even frothier than before.

If there is another end to the above culmination of events that you feel is possible, please do share.

For now, let’s talk about the market.

The Market is Frothy

Over the last weeks of August, and in particular on September 1, US stocks were hammered, and stock outflows streamed out of the market. It appears that my gut feeling regarding a market crash could be more than just a feeling.

On August 24, the Dow plunged nearly 1,100 points. The next day, stock funds saw $19 billion in outflows – the second-largest daily redemption since 2007, according to Bank of America Merrill Lynch.
While the market appears to have stabilized, the underlying worries remain as massive outflows from the US and emerging markets equity funds continue to pour out.
Via FT:
“Global equity funds suffered outflows of $19bn in the week up to Wednesday, bringing the four-week total outflow to $46bn.
…US equity funds have now shed $139.6bn this year amid stagnating corporate earnings, slipping stocks and uncertainty surrounding the timing of the Fed’s first rate hike.”

So where is the money going?

The US Debt Rotation

The answer to that question begins with China.

Over the last year, and more intensely over the last few months, China’s foreign exchange reserves have declined.

Via WSJ:

“China’s foreign-exchange reserves plunged by a record amount in August…
…The People’s Bank of China said Monday that its reserves fell by $93.9 billion, the biggest-ever monthly drop in dollar terms and the largest in percentage terms since May 2012.
The decline in China’s foreign-currency reserves has accelerated, deepening a trend that illustrates the pressures of the country’s slowdown, rising capital outflows and expectations for monetary tightening in the U.S.”
For decades, China has been a steady buyer of US Treasury securities and has been the single largest foreign buyer. As such, the majority of China’s reserves are US assets, leading the masses to believe that China has been dumping its US holdings.
Via CNN:
“China owned $1.3 trillion of U.S. Treasuries as of June, making it the biggest holder of U.S. debt.
But China’s foreign-exchange reserves plunged by a record $94 billion in August, according to the country’s central bank, leaving it with a war chest of $3.6 trillion.
Analysts say it’s very safe to believe a big chunk of that decline occurred due to a reduction in U.S. Treasury holdings.”

 

While its true that China has likely been dumping its US holdings, this isn’t something that’s just begun to manifest, as the media suggests. In fact, it’s been the trend over the last few years.

Since 2011, China’s holdings of US securities have consistently dropped. Take a look:

China Holdings of US Securities
(It is interesting to note that as China dumps its US securities, it is still accumulating gold. We’ll cover this another time.)

With China no longer buying the bulk of US debt, someone else – someone big – has to step up to the plate. Since 2008, the Fed has stepped up as the lender of last resort. And while there are strong reasons that suggest that the Fed will continue to soak up US debt (and in worse-case scenarios, it probably will), too much too soon could expedite the end of US dollar dominance.

So of course, there must be another plan. And I believe there is.

A while back, I said that a mass exit of stocks will likely lead to large inflows into treasuries and bonds.

Via “How This Landmark Decision Could Destroy the Market“:

“Remember what I wrote in my letter, The Fed’s True Plan:

“Eventually, the Fed will have to begin winding down its assets, which means there will be a lot of bonds to soak up.

Foreign liquidity won’t be able to soak up all that has been printed. That means money will have to come from somewhere else. And that somewhere – I believe – is from the stock market. If the stock market continues to climb, it will create more liquidity for bonds. Why? Because the stock market will eventually correct at some point, and when it does, investors will seek the safety of bonds; thus, soaking up much of the bonds held by the Fed.

The higher the stock market climbs, the more money is available for bonds on the way down.

This is the Fed’s true plan.”

Is my analysis already playing out?

According to the Bank of America, via Zero Hedge, the second largest weekly inflow of $14bn happened during the week ending February 5 2014, which was followed by last week’s inflow to all fixed income funds of $16.04bn – the highest on record going back to at least 2008.

Stocks, on the other hand, went from $1.62bn inflow in the prior week, to an outflow of $5.52bn last week.

Is this a sign of things to come?”

Since we know that China has been dumping US Treasury securities, and the Fed has not announced QE4, someone else must be picking up the slack.

And surely, as perfect timing would have it, someone else is – and it’s not the Fed (not directly, anyway).

In the weeks leading up to the recent Black Monday, when the Dow made its 1100-point plunge, bond sales have been weak.

Via Reuters on August 26, 2015:
“Weak demand at back-to-back U.S. Treasury auctions this week has bond mavens wondering if China and other emerging market central banks are spending their foreign exchange reserves at home to offset investor flight during market turbulence rather than buying U.S. debt.”
Over this time, China has also been liquidating. But mysteriously, someone has stepped in at the perfect time.
Via WSJ:
“…Other buyers have taken what China sold. Investors put $2.12 billion net cash in U.S.-based mutual funds and exchange-traded funds targeting the Treasury bond market for the week that ended Sept. 2, according to fund tracking company Lipper.

…It marks the fourth consecutive weekly inflow and the biggest one-week inflow since April. This year through Sept. 2, the fund group has attracted a net cash inflow of $16.6 billion, on track to be the biggest annual inflow since 2009.”

There are even reports of obscure hedge funds buying up bonds.Via WSJ:

“A little-known New York hedge fund run by a former Yale University math whiz has been buying tens of billions of dollars of U.S. Treasury debt at recent auctions, drawing attention from the Treasury Department and Wall Street.

Element Capital Management LLC, led by trader Jeffrey Talpins, has been the largest purchaser in dozens of government-bond auctions over the past 10 months, people familiar with the matter said.”

And all of a sudden, from weak demand, comes strong demand.

“Demand at a $13bn 30-year Treasury auction on Thursday touched its highest level in three months, days before policymakers at the US central bank meet.”
And, over the past weeks, investors have rotated funds out of the stock market and into the presumed safety of government bonds.
Via CNBC:
“Investors pulled another $19 billion from equity funds over the past week as they sought safety in government bond funds, which have enjoyed the longest run of inflows in four years, Bank of America/Merrill Lynch said on Friday.”
And Via Reuters:

“Investors pulled $16.2 billion out of U.S.-based stock funds in the week ended Sept. 9 after committing $3.9 billion to the funds over the prior week, data from Thomson Reuters’ Lipper service showed on Thursday.

Funds that specialize in U.S. shares posted $14.3 billion in outflows while funds that specialize in international shares posted $1.9 billion in outflows. The outflows were mostly from stock exchange-traded funds, which posted $13.6 billion in withdrawals.

Bond funds were beneficiaries during the latest flight from stocks. Taxable bond funds attracted their first inflows in three weeks, at $3.6 billion. U.S.-based government-Treasury funds posted $2.1 billion of inflows, its fifth straight week of inflows. U.S.-based corporate investment-grade bond funds attracted $416 million, their first inflows since late July.

Even riskier U.S.-based high-yield “junk” bond funds attracted $186 million of inflows, their first inflows in three weeks, Lipper said.”

Is the rotation from stocks to bonds a precursor to the next market crash, just as it was leading up to the crash of 2008?

Here’s a Letter I wrote from earlier this year, “The Truth About the Fed“:

“…My prediction is simple: yields will rise (which they appear to be doing already), transferring equity-side investments over to bonds to soak up the piles of debt in the market.

Meanwhile, we have a long ten years of little to no growth coming our way, with a stock market crash headed our way in the near future as the system rebalances liquidity.”

Short-Term Outlook

Despite a weak end to the summer, it seems we’re once again witnessing a back-to-school short-term rally. But is the rally real?

Not likely. Just as the bull market itself hasn’t been fueled by retail investors, but rather the algo-traders, manipulators, and corporate share buybacks.

And as an update, corporate share buybacks continue to soar.

Via Bloomberg:

“In all, U.S. companies have bought back about $260 billion in stock in 2015, bringing the overall total since the bull market began to more than $2 trillion, according to S&P Dow Jones.”

And via WSJ:

“The companies in the S&P 500 are poised to spend more than $1 trillion on buybacks and dividends in 2015, shattering the record set last year, according to a new report.

Corporate buybacks have been surging since the financial crisis, with S&P 500 companies spending nearly $2.3 trillion on them since 2009, according to a new report from Aranca Investment Research. Last year’s $553 billion in repurchases fell just short of the peak reached in 2007 while the $904 billion spent on buybacks and dividends combined set a new record, Aranca said.”

For those who haven’t read my previous letters on how the Fed has induced a stock market rally via corporate share buybacks, you can catch up by reading my past Letter, How the Fed Influences the Stock Market. The bottom line is very clear: we’re in a mass manipulated market that could easily be instructed to topple over at any given second. The market is fragile and retail investors are beginning to see that and pull out.

And its not just the public market that appears to be topping out. Over this past year, I have been solicited on numerous occasions to participate in private tech startups with insane valuations. These include some of the best-known private deals such as Spotify and Lyft. You know we’re reaching a top when private tech deals are now being financed by retail public investors.

The scary part is what happens when things do come crashing down.

Rates have been, and still are, at record lows. Mass QE has already taken place. Oil prices have already been crushed. Commodities prices have been hammered. Inventory levels are rising. What’s left to get things going if, and when, the market crashes?

Scary as it may sound, its war. And its already happening. But we’ll get into the details of the escalating tensions between world powers in another letter.

Perhaps things will finally return to normalcy after the next crash. Perhaps the aftermath will bring forth real growth – not induced growth via paper policies.

But then again, that would mean the Fed and the powers that be have lost control. That would mean the people have lost faith in the dollar. You can bet the Fed won’t go down without a fight.

Next week, between September 16-17, the market will react to the announcement of a potential rate hike by the Fed. I suspect we’ll see some front running in the market leading up to the announcement, as we almost always do.

We’re in the eye of the storm of the greatest financial world war in history. I don’t see it ending well, but I hope I am wrong.

Seek the Truth,
Ivan Lo

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