An Update on a few Obscure and Not-So Obscure Indicators
We recently discussed the market with our friend T.R. (inventor of the proprietary Au-Ag ratio adjusted VIX indicator) and he sent us a few charts of the things he is watching. While he’s not a long term bear, he does think there is sufficient evidence to warrant caution – i.e., a bigger correction may be about to get underway. This jibes with what we have been seeing lately in terms of sentiment extremes.
Note that these charts are by now three trading days old, but that doesn’t make a big difference – although the stock market has had a few bad hair days last week, it hasn’t really made a big move yet. The annotations on the charts are T.R.’s, and mainly serve as orientation. Regular readers may recall that we showed some of these charts fairly regularly at the time of the euro area debt crisis. Many of them haven’t really been all that interesting up until recently, but that has now changed.
The first chart shows the SPX, the Junk/Investment grade debt ratio and the SPX adjusted by volatility and the gold-silver ratio. The vertical white lines show the historical peaks of the margin debt/GDP ratio
SPX in green, junk-investment grade debt ratio in yellow, VIX/Au-Ag ratio adjusted SPX in orange. The white vertical lines show margin debt/GDP peaks, which tend to lead market peaks (the current lead time has been historically quite extended) – click to enlarge.
The next chart shows the Barcap high yield spread index (a measure of credit love and revulsion) vs. the MSCI emerging markets index. As you can see, the latter has been rejected at resistance just as the former has begun to rise. It is also noteworthy that during the time spreads were declining, EMs have failed to rally (which is contrary to last time around). Something is not the way it “should” be.
Barcap HY spread index vs. MSCI emerging markets index – click to enlarge.
Next: Dollar-yen and the Topix in yen terms. As can be seen, dollar-yen has just bumped into a 23 year downtrend line (a 12 year trendline shown as well has broken with ease). This line will presumably offer some technical resistance.
Dollar-yen with trendline resistance, plus the TOPIX. We would add to this: in spite of the BoJ engaging in heavy QE, Japan’s true money supply growth has recently slowed to approx. 3.5% year-on-year. That is a good sight less than US or euro area money supply growth. In Japan it is not so much the quantity, but the suspected lack of quality of the money issued by the BoJ that is of concern. We actually believe this could be kind of lose/lose demarcation – click to enlarge.
Next: 5-year zero coupon TIPS in the US and Europe as proxies of inflation expectations, vs. the Euro-Stoxx 600 Index:
Inflation expectations continue to plummet, a development so far ignored by stock markets. These data points used to be very tightly correlated, and for good reasons – click to enlarge.
Next: a closer look at margin debt/GDP peaks and stock market tops, with the lag times spelled out in the chart annotations, plus the Federal Funds rate.
The current lag between the margin-debt/GDP ratio peak and stocks is the biggest one ever (8 months). Presumably the ZIRP policy and QE have something to do with this – still, it seems to us this is a situation that won’t be maintained, i.e., something has got to give – click to enlarge.
Next, an old friend – euro basis swaps.
Three month, one year, three year and five year euro basis swaps, a.k.a. the “euro doom” indexes. There has been some movement lately, although it is probably too early to call it meaningful – but it is something we will keep an eye on – click to enlarge.
Readers who want to learn more about the basis swap markets can download this CS report (pdf), which we have uploaded to our server a while back as a useful quick reference.
And lastly, here is a chart showing China’s lending rate and reserve requirements following the recent PBoC rate cut (the one-year benchmark rate was cut from 6% to 5.6%), along with the “real rate” (the lending rate adjusted by CPI). The real rate is actually at what seems to be a historically quite high level. It is definitely a good distance from the negative real rate that obtained at the height of the post crisis credit expansion push.
What is also interesting to us is that reserve requirements have declined, a sign that the flow of dollars into China is slowing. The reserve requirement is the main tool by which the PBoC controls the relationship between the inflow of foreign exchange and domestic money supply growth. It is a far more important part of monetary policy in China than elsewhere (e.g. the ECB’s reserve requirement is just 1% – in theory, every €1 in deposit money could be used as the base for € 100 in additional credit and deposit money growth. It has mainly been instituted to support weak banks in the periphery. In the US, official reserve requirements have long been meaningless due to overnight sweeps, and these days with massive excess reserves having accumulated due to QE have even less meaning).
Interestingly, although the PBoC has so far been holding the line w.r.t. the strong yuan, there has been quite a bit of volatility in the currency recently, with market participants evidently betting that the yuan is soon going to be allowed to weaken.
China’s one-year benchmark lending rate (nominal and real), and the reserve requirement ratio – click to enlarge.
Conclusion:
We have seen numerous traditional warning signs emerge in the course of this year, but constant additions of fresh central bank liquidity and/or promises of more such additions by nearly central banks in most major currency areas have trumped everything else. And yet, one must not lose sight of the fact that the effects of these central bank actions are not independent of valuations and other contingent data (i.e., one must not fall for the “potent directors fallacy”). Moreover, money supply growth is slowing noticeably in the US, is surprisingly slow in Japan, and only shows tentative signs of life in the euro area.
In other words, the ice is actually getting thinner in terms of monetary inflation support for risk assets. An era that was similarly characterized by traditional warning signs persisting for a long time without bothering the cap-weighted indexes much was the late 1990s bubble period. In hindsight it became clear that this long persistence of divergences merely indicated that the eventual denouement would turn out to be especially harsh. Will this time be different? We doubt it.
Charts by: Bloomberg
