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BOND BUBBLE - Its About Supply Growth Relative to Demand Growth

The Worst Case Scenario For Bond Bears According To JPM: Rising Stock Prices 01-04-15 via ZH

We have�previously discussed�the massive, and getting bigger, Treasury supply/demand imbalance as we head into 2015, when none other than the ECB is expected to join the monetization fray alongside the BOJ, and as we previously reported using a Goldman analysis, while the BOJ is expected to monetize some 100% of all gross Japanese issuance, the ECB will buy�some 90% of all Bunds�Germany has to issue in 2015, as well as hundreds of billions in other European public debt.

So here comes JPM with its own even more startling analysis which finds that total central bank monetization of soverign debt will increase from $1.0 trillion in 2014 (between the Fed and the BOJ) to $1.3 trillion (between the BOJ and the ECB). Why? Recall Citi's analysis from October that "It Costs Central Banks $200 Billion Per Quarter To Avoid A Market Crash."

The fact that bond yields declined, credit spreads widened and the dollar rose over the past year demonstrates how atypical the current monetary policy cycle has been relative to previous cycles.

This atypical behaviour can be partly explained by the offset that the ECB and the BoJ provide to the Fed's tapering.�Based on our revised call about sovereign QE by the ECB, we project that G4 central banks will purchase more bonds in 2015 than last year. We expect the ECB and the BoJ together to purchase $1.3tr of bonds this year relative to the $1.0tr that last year was bought by the Fed and the BoJ.�And this is having a dramatic on global bond demand and supply. In our Nov 14th 2014 F&L report, we projected that the balance between supply and demand,�i.e. excess supply, will widen from -$485bn in 2014 to -$412bn in 2015. But our revised call about sovereign QE by the ECB implies $200bn more�of bond purchases and thus a balance between bond supply and demand that is�closer to -$600bn for 2015, i.e. even more negative than last year.�In other words, the demand/ supply backdrop is even more likely to remain supportive of bond markets this year. On our calculations, the balance between bond demand and supply has been supportive of bond markets during most of the post Lehman period years with the exception of 2010 and 2013. The wildcards of our bond demand/supply analysis are our estimates of bond fund demand by retail investors, the bond buying by commercial banks, the supply of spread product in Europe and the speed of asset allocation changes by GPIF.

None of this is news, and certainly not to anyone who read "Desperately Seeking $11.2 Trillion In Collateral", but for those still calling for soaring bond yields now that there is a "recovery", here is a hint: the frontrunning of central banks means there is $600 billion more demand than supply in 2015. It does not take rocket surgery to figure out what this unprecedented excess global Treasury demand means for bond, aka scarce�"High Quality Collateral", prices.

Yet one thing which JPM did note to our surprise and which is sure to lead to yet another bloodbath for the momentum-chasing, levered beta entities formerly known as hedge funds, and who - in their complete lack of creativity - have once again put on the long S&P, short 10 Year pair trade on hoping that�this is the year, is the following:

... US pension funds and insurance companies stepped up their bond buying during the mid two quarters of the year. The equity allocation [of US pension funds and insurance companies] had gone up and their bond allocation down by so much over the previous two years that they had to increase their bond purchases to stop their bond weightings from moving even lower. In a way, the more equity prices go up the higher the pressure on US pension funds and insurance companies to buy more bonds.�For example, assuming equity prices rise by 10% this year, for their bond allocation to stay at 37% (same as of Q3 2014), US pension funds and insurance companies would have to buy $550bn of bonds in 2015.

And that's a half a trillion�in additional purchases�just out of static reasons, i.e., to keep allocations flat. If asset managers decide that "bond kings" like Gundlach are correct, and that bonds will generate better returns than stocks for the second year in a row, and decide to actively raise the bond allocation above 37%, then all demand bets are off.

However, even absent that scenario, the paradox emerges: another 10% increase in the S&P, something which is roughly in line with where the consensus sees the S&P500 saying goodbye to 2015�and the bond market is suddenly subject to a historic imbalance of as much as $1 trillion in excess demand, as a result of both portfolio allocation and central bank buying!

Said otherwise, the biggest threat to bond bears and everyone else who is short the long end,�is precisely the very signal that said bears have misinterpreted as being the catalyst for the long-awaited bond market selloff: rising stock prices.

And then there is the flipside: if 2015 is the year when the inevitable 3rd consecutive bubble (after the 2001 dot com and the 2007 housing bubble) finally pops, which way will bonds trade then, or will this time be different and a wholesale stock market crash finally also result in a parallel dumping of bonds? If so, just what long-despised asset class will the algos end up having now choice but to buy then?

FINANCIAL REPRESSION - Misplaced Central Banking Policies Lead to their Demise

Below are two articles by my Co-Host at MACRO - Charles Hugh Smith that we will discuss in an upcoming MACRO video.

OUR MESSAGE: How Central Banks Unknowingly Create Their Achilles Heel: Deflation

THE OIL SHOCK IS YOUR FIRST SIGN!

Central Banks by creating 'Excessive' INFLATION actually sow their eventual destruction by creating DEFLATION

• 'EXCESS' INFLATION: Inflation creation when the business cycle needs to contract. ie 2% targets during systemic deleveraging.
  • This is because the Prime Directive of central banks is to make it ever easier to service yesterday's debt.
  • Excessive inflation results from central banks being forced to push negative real interest rates too low (to protect debt holders) relative to real economic expansion and capital wealth creation.
• DEFLATION: "Any increase in the purchasing power of nominal wages".
  • The rise of software, robotics and global wage arbitrage is resulting in wages not rising along with prices. As a result, everyone who depends on earned income is getting poorer.
  • For the actual real-world the result of central banks easing, money pumping and zero interest rates is Deflation.
  • Central bank easing and zero-interest rate policy (ZIRP) fuel over-capacity which leads to declining prices: deflation with a capital D.
  • Central bank easing and zero-interest rate policy (ZIRP) additionally fuels malinvestment which leads to over valued collateral and an eventual collateral collapse as NPL (non-performing loans) debt cannot to "rolled" (ie no one no longer wants to risk financing)
• PURCHASING POWER: The store of Purchasing Power is true WEALTH which governments are trasnferring.
• All the phantom collateral constructed with mal-invested�free money for financiers�will also implode.

CONCLUSION

EASY CREDIT CREATES EXCESS SUPPLY & DEMAND WHICH EVENTUALLY REACH EQUILIBRIUM

1. BROUGHT FORWARD DEMAND WHICH THEN LEAVES A DEMAND RATE VACUUM
2. INFLATION REDUCES REAL DISPOSABLE INCOME WHICH FURTHER REDUCES DEMAND

SHRINKING AGGREGATE DEMAND THEN REDUCES COMMODITY PRICES WHICH LEADS TO COLLAPSING COLLATERAL VALUES

THE GLOBALIZATION TRAP

�

Central Banks Create Deflation, Not Inflation�� (December 9, 2014)�

Financial and risk bubbles don't pop in a vacuum--all the phantom collateral constructed with mal-invested�free money for financiers�will also implode.

If there's one absolute truism we hear again and again, it's that central banks are desperately trying to create inflation. Perversely, their easy-money policies actually generate the exact opposite: deflation.

I will leave the debate as to what constitutes deflation to my economic betters.�My definition of deflation is simple: deflation is any increase in the purchasing power of nominal wages.

By�nominal�I mean unadjusted: $1 is simply $1. It is not seasonally adjusted or adjusted for inflation/deflation or anything else.

When your paycheck loses purchasing power--that is, it buys fewer goods and services-- that's inflation. When your paycheck gains in purchasing power--it buys more goods and services, even though you didn't get a raise--that's deflation in my terminology.

I find that�purchasing power�cuts through a lot of economic jargon and data-clutter: how much does your paycheck buy today, compared to last month or last year?

Since the economy is dynamic, purchasing power is constantly increasing or decreasing on a variety of goods and services. This bedevils any attempt to discern systemic inflation/deflation.

The Federal Reserve and other central banks desperately want inflation, even though it destroys the purchasing power of paychecks and savings, for one reason:�in a system based on phantom collateral supporting ever-increasing mountains of debt, the Prime Directive of central banks is to make it ever easier to service yesterday's debt.

The only systemic way to make it easier to service existing debt is to inflate the nominal value of money by debasing the currency. The net result of inflated money is a debt of $100 stays $100, but the face value of newly issued money keeps rising.

If a person earns $10 an hour, it will take 10 hours to earn the money to pay off the $100 debt. But if central banks debase the money so that it takes $20/hour to buy the same goods and services that were once bought with $10/hour, then it only takes 5 hours to earn enough money to pay off the $100 debt.

The fact that the owner of the debt will suffer a 50% decline in the purchasing power of the $100 is of no concern to the central banks, as long as the decline is gradual enough that the hapless owner of the $100 doesn't notice the loss of purchasing power. Hence the central banks' favored inflation target of 2%, which destroys over 20% of the purchasing power of money every decade, but does so so gradually that everyone being robbed is not motivated to protest their impoverishment.

So now we understand why central banks are desperate for inflation: it's the only way to keep the Ponzi scheme of ever-expanding debt from collapsing in an era of stagnant wages.�Since the vast majority of people aren't increasing their income, inflation is the only way to enable them to keep servicing their debts.

Unfortunately for the central banks, thanks to the rise of software, robotics and global wage arbitrage, wages are not rising along with prices. As a result, everyone who depends on earned income is getting poorer.

Japan is the leading example of this dynamic.�Despite the Bank of Japan's failure to ignite 2% inflation, they've succeeded in undermining their currency (the yen) sufficiently to cause the purchasing power of wages in Japan to fall a catastrophic 9% in the past few years.

Everyone who depends on earned income, i.e. the bottom 95%, all get progressively poorer in inflation.�Meanwhile, technology is deflationary, as the costs of producing anything digital decline to near-zero, and progressively cheaper software and robotics replace costly human labor and all the horrendously expensive labor overhead of healthcare, etc.

Central banks might want to ponder Woody Allen's famous quip,�If you want to make God laugh, tell him about your plans, for the actual real-world result of central banks easing, money pumping and zero interest rates is deflation.

As my colleague Lee Adler explains, central bank easing and zero-interest rate policy (ZIRP) fuel over-capacity which leads to declining prices: deflation with a capital D.�The current oil glut is a primary example of this dynamic:�Why Oil Is Finally Declining, Which Could Lead to Disaster�(Wall Street Examiner)

The central banks have been frustrated in their insane and misguided aim to increase inflation because QE and ZIRP actually foster the opposite of what central bankers expect. Central bankers and conomists think that to get inflation they only need to print more money, not recognizing that the inflation that does result from money printing, asset inflation, leads eventually to consumer goods deflation. ZIRP and QE cause malinvestment and overinvestment that leads to excess productive capacity.

That leads to overproduction and oversupply. Oversupply puts downward pressure on prices. That spurs a vicious cycle where the central banks print more money to try to create inflation. That puts more cash into the accounts of the leveraged speculating community and off we go again.

While ZIRP and QE encourage waves of excess speculation and malinvestment, they do so at the expense of investment in labor. Businesses become speculators in their own stocks and products rather than in costly and uncertain investments in labor. The value of labor falls in the marketplace. Mass wage and salary incomes fall. Consumption falls. Demand trends weaken, putting downward pressure on the prices of consumption goods.

That causes a vicious cycle in business where executives perpetually look for ways to shrink costs, exacerbating the economic decline of middle class working people. The "middle class" can increasingly no longer afford to buy the products of those who employ them. Thus we get the spectacle of things like WalMart holding charity food drives to benefit its workers, who are not paid enough money to feed their families.

The oil price experience is a perfect illustration of what happens when central banks promote over speculation in commodities and commodity production. A boom built on virtually free and unlimited financing becomes a ticking time bomb when the value of the collateral collapses.

Thank you, Lee.�A collapse in the value of collateral is precisely what's happening as the value of oil has fallen by 40% in the past few months.

The retail sector is another poster child of the deflationary consequences of central bank-driven mal-investment.�The astonishing expansion of retail space in the U.S. since the 2008 meltdown is increasingly divergent from the reality that sales and profits of bricks-and-mortar stores and chains are under siege from online retailers.

The market value of retail space is set to implode from the over-expansion of commercial real estate, which was entirely driven by the Fed's cheap-money policies that destroyed low-risk returns on cash and savings.

Central banks have driven investors into increasingly risky bets as investors seek some sort of return.�The bubble is not just in stocks, bonds, and other assets--most importantly, it is in risk.

Doug Nolan explains why the systemic risk created by central bank policies is ultimately deflationary--�The Unavoidable Peril of Financial Sphere Bubbles:

"Virtually unlimited cheap finance on a global basis has over recent years certainly spurred unprecedented capital investment. And, importantly, ongoing technological innovation and the “digital age” have played a momentous role in creating essentially limitless supplies of smart phones, tablets, computers, digital downloads, media and 'technology' more generally. Throw in the growth in myriad 'services', including healthcare, and we have economic structures unlike anything in the past."

In other words, this time it is truly different, but not in the way the conventional happy-story narrative would have it, i.e. financial-risk bubbles can keep expanding forever.

Financial and risk bubbles don't pop in a vacuum--all the phantom collateral constructed with mal-invested�free money for financiers�will also implode.

So go ahead, central bankers: tell God about your plans to generate inflation.

Central Banks' 2% Plan to Impoverish You�� (December 11, 2014)�

The 2% target is low enough that the household frogs in the kettle of hot water never realize they're being boiled alive because the increase is so gradual.

A comment by correspondent David C. suggested the importance of demonstrating the impoverishing consequences of central banks reaching their 2% inflation target.�David observed:�"That central bankers aren't all hanging by their necks from lamp posts everywhere is a testament to how scarce are those who grasp exponents and compounding."

Anyone with basic Excel skills can calculate the cumulative impoverishment caused by central banks' "modest" 2% annual inflation.�Here is my worksheet:

Column 1: year�
Column 2: index starting with 100�
Column 3: annual inflation sum (2% of previous year's total index)�
Column 4: cumulative total index

1� � 100.00� 2.00� 102.00
2� � 102.00� 2.04� 104.04
3� � 104.04� 2.08� 106.12
4� � 106.12� 2.12� 108.24
5� � 108.24� 2.16� 110.41
6� � 110.41� 2.21� 112.62
7� � 112.62� 2.25� 114.87
8� � 114.87� 2.30� 117.17
9� � 117.17� 2.34� 119.51
10� 119.51� 2.39��121.90

Ten years of modest 2% inflation robs households of nearly 20% of their purchasing power. What was $100 in year 1 costs about $122 after 10 years of "modest" 2% inflation. Put another way, $100 in year one is only worth $81 in year 10.

11� 121.90� 2.44� 124.34
12� 124.34� 2.49� 126.82
13� 126.82� 2.54� 129.36
14� 129.36� 2.59� 131.95
15� 131.95� 2.64� 134.59
16� 134.59� 2.69� 137.28
17� 137.28� 2.75� 140.02
18� 140.02� 2.80� 142.82
19� 142.82� 2.86� 145.68
20� 145.68� 2.91��148.59

Two decades of "modest" 2% inflation robs households of one-third of their purchasing power. What was $100 in year 1 costs about $150 after 20 years of "modest" 2% inflation. Put another way, $100 in year one is only worth $66 in year 20.

Even when central banks fail to reach their 2% annual-thievery target, incomes decline across the entire spectrum.�The middle class (however you define it) lost roughly 10% as of 2012. In Japan, famous for essentially no inflation, wages have fallen by 9% in real terms since 1997.

While wages go nowhere, costs continue lofting ever higher as central banks print and pump money and credit:

Source:�What Inflation Means to You: Inside the Consumer Price Index�(Doug Short)

Imagine central banks overshoot their 2% theft per year target and reach 3% annual inflation.�If 2% is good, 3% must be even better, right?

In one decade of 3% annual inflation, the purchasing power of $100 declines to $73, and after 20 years of central bank inflation, it drops almost in half to $54.�The central banks' inflation is a steady transfer of wealth from households to the banking sector and those holding ballooning assets like stocks. This is why central banks cling to their target so vociferously: their reason to exist is to enrich the banking sector at the expense of the rest of us.

The 2% target is low enough that the household frogs in the kettle of hot water never realize they're being boiled alive because the increase is so gradual.�The central banks assume their 2% plan to impoverish us all escaped our notice. Apparently it has.