Hint: it’s all about a bond bubble.
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By Tom Essaye
As I begin thinking about the outlook for 2014, my mind almost always wanders first to “what could go wrong in the financial markets this year?” Having been raised in this business as a trader, I learned early that avoiding disaster is the first step to making money.
So, I’ve spent some time thinking about what could go “wrong” in 2014.
Maybe I’m just a product of my environment, but I entered this business in the dot-com bubble burst of the summer of 2000, started on the floor one year after 9/11, and after a few good years then ran smack into the financial crisis. So, despite my relative youth, I’ve seen a lot of mess over a relatively short time.
Now, in fairness, the macro horizon is as “clear” as it has been for some time. Europe is no longer teetering on the brink of a breakup or massive sovereign default. The financial system and banks are well-capitalized and as healthy as at any time since the crisis. Even the U.S. government appears to be trying to behave, as we’ve got a budget for the next two years. So, all things considered, the horizon looks pretty clear.
Still, I am conditioned to look for places where something could go “wrong,” and what I keep coming back to is the bond market. I don’t think there are many people who would argue that the bond market, in general, reached “bubble” territory (or at least a blow-off top of a 30+ year bull market) over the past year.
The chart here of the iShares 20+ Year Treasury Bond ETF (TLT) shows the clear meltdown in long-term bond prices in 2013.
A declining bond market, by itself, doesn’t mean a crisis. Bonds can go down like any other asset and not cause a crisis that infects other asset classes. However, what makes me nervous about a crisis emanating from the bond market is the fact that we have a market in a blow-off top that was largely manufactured by government policy (the Fed), combined with government-mandated structural changes to the industry that has drained liquidity and will likely have multiple unintended consequences. (I’m referring to Dodd-Frank.)
This sort of dangerous cocktail should sound familiar to people. The potential negative consequence of this, of course, is a stampede to the exit by investors, but no one to buy the dip, thereby causing a liquidity crisis in the bond market and specifically the corporate bond market (with ground zero potentially being the high-yield market). And, the potential set-up is for a liquidity crisis in the corporate bond market that infects all other asset classes (like subprime did to everything else).
Throw in the explosion of bond-related ETFs and the retail money that’s flooded into them, and I can imagine a scenario where there is lots of selling of these ETFs and mutual funds. This in turn results in the bonds themselves having to be sold, but there simply being “no bid” for the specific corporate bonds, which then breeds a liquidity crisis that begins to feed on itself.
As I think of risks coming out of left field that could result in an end to this rally, this bond scenario is the one that keeps popping up in my head. Again, this is a very, very low probability scenario, and one that likely won’t ever come to fruition. But if we’re looking for something that could go wrong next year, most of the pieces here certainly are in place.
Tom Essaye is Founder and Editor, of The 7:00’s Report, a daily investment research note that provides need-to-know analysis of markets, economics, and geopolitics—all delivered by 7:00 AM, and readable in 7 minutes or less. At the time of publication, the authors held a long position in DXJ.
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