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MISPRICED RISK & CREDIT CRACKS
TRIGGER$ - JUNE 2014
Gordon T Long
5/28/2014

MISPRICED RISK & CREDIT CRACKS

We have talked extensively over the last few years, of the specific Moral Hazard and Unintended
Consequences that has emerged as a result of what I have referred to as Monetary Malpractice.
This is not to suggest that it is driven
by incompetence, but rather it is part
of an orchestrated plan to ensure
government debt financing continues
despite the magnitude it has grown
to.
The most important role of the all
Central Banks, but seldom mentioned,
is to make sure that proliferate
government spending is funded.
When Taxes (which include all forms
and levels of taxes, licenses, fees,
penalties etc) and then the stealth tax
of Inflation run out of room,
democratic governments are forced
to resort to the Macro Prudential
strategy of Financial Repression.
The corner stone of Financial Repression is
sustained negative real interest rates. As
such the Federal Reserve has steadily
orchestrated a continuous and highly
controlled (as can be seen how tightly the
10 Year UST channel declines as shown
here) to reduce nominal interest rates and
the consequence of reduced financing
costs for government debt financing.
If we were paying interest rates we had
only a few years ago the US government
and most developed economies would be
in the midst of even a worse financial and
currency crisis.

The point here is that this sort of
manipulation does not come free, as has
been most evidently witnessed by the serial
bubbles that we have experienced over at
least the last two decades.
When we look at factors such as Margin Debt
levels it is blatantly obvious we are once
again at levels that have proven in the past
not to be kind to the equity markets. Actually
we are levels we have never experienced
since the US came off the gold standard.
No doubt you are familiar with the Emotional
Euphoric Cycle which the equity markets go
through. An example of which is shown here on the left. What you may not be as familiar with is that
the credit markets go through a similar cycle despite it being more analytic and traditionally more
conservative that equity markets.
When you map developments and milestones in the credit markets you immediately see we are at levels
that are traditionally considered elevated and excessive.


US distressed debt spreads have now reached five year highs. We are quickly reaching levels which we
witnessed prior to the 2008 financial crisis and when you look at the details appear to be accelerating.

Though this is a US chart I would be a miss if I didnt tell you that Chinas is even more dramatic with
Non-Performing Loans going through the roof.
COVENANT LITE & PIK LOANS
There are various kinds of loans such as PIK Loans (which is short for Payment in Kind), Covenant Lite
Loans and others that are good indicators of the risk being taken by lenders and borrowers assuming
higher levels of leveraged risk. As you can see they are also at extremes.


I have mentioned previously in Trigger$ of a Bloomberg Proprietary Credit analysis which involves a
regression analysis of a number of key credit metrics. I refer you to PAY ATTENTION TO CREDIT
MARKETS for more detail. I have been finding it extremely accurate if analyzed properly.

It is presently signaling a significant 70 point S&P 500 divergence. If credit weakens further, which I
expect, this divergence could worsen. Certainly it says caution is advised near term or volatility may
soon be the order of the day.
BOND ROTATION
I am also seeing signs of a potential bond
rotation and potentially major portfolio
rebalancing moves from equity positions to
Treasuries.
As big as the US deficit is it must be
remembered it is being brought down from
well over $1T to the $600-$700B level. This
means shrinking near term supply. When
you couple it with the actions of the Fed to
dominate the buying of USTs there is a
potential supply shortage coming that any

sort of fear trade would ignite.
This is precisely what the engineers of Financial Repression would consider a home run and would map
perfectly to the long term treasury chart I showed earlier.
CONSUMER CREDIT MARKETS
In a recent article entitled Consumer Credit Cracks - The 'New Shadow Banking' Collateral Problem I
showed the emerging cracks in the US consumer lending details and practices. Whether we are talking:
1. HELOC Delinquencies
2. Non Performing Student Loan levels,
3. Car Loan subprime lending and leasing levels,
4. Home Mortgage credit scores
5. Housing Down payment requirements
6. Shipping Credit
.. . There is mounting evidence of serious decay in credit.
The problem is that most of this credit is funded through the shadow banking intermediation channel. A
process built on borrowing short and lending loan with significant duration risk exposures if credit was
to tighten abruptly due to fear for whatever reason. During the financial crisis it was an Asset Backed
Commercial Paper problem. Today the acronyms have changed but the exposure is the same when we
delve into the world of Repos and Collateral Transformations.
Dodd Franks has done almost nothing to fix this systemic hot spot.
Another article I recently wrote entitled Risk is Leaving the Market - Stealth Movements Warn of
Potential Q2 Market Troubles I showed the cascading nature of risk-off leaving the market. By that I
mean how the higher risk stocks are weakening ahead of what is considered the less risky stocks. This is
a classic market topping signal. It may not be a long term top but is likely, minimally an intermediate
term top.
The large players are leaving as the public begins feeling confident enough to re-enter. As usual it is the
fear of missing out that attracts them when the risk is the highest.


An indicator I like for situations like this is the Russell 2000 to Russell 1000 ratio. As risk leaves and risk-
off begins to take hold the ratio will fall, which it has. You then pay attention to the moving average
crosses for confirmation of a trend reversal. We see here this is also happening though the oscillators
suggest is may be overdone in the short term. As I said earlier, Credit is not a great market timing device
but it does do a great job of keeping you out of trouble at critical times.


KEY LONG TERM INDICATORS
I would like to shift gears slightly and talk about credit from the big picture perspective. F.F. Wiley
published at the Cyniconomics blog three interesting charts.

The first chart shows the percentage of total borrowing thats funded by the three riskiest sources of
funds. Three periods stand out for an unusually high percentage of risky borrowing. The first two
coincide with the creeping inflation of the 1960s and Great Inflation of the 1970s. The third overlaps
the serial bubbles of the last two decades and leads into the 2008 financial crisis. Problems with either
inflation or financial instability are exactly what you should expect when debt funding is tilted
heavily towards risky sources.

The second chart divides risky
borrowing by GDP. This chart can
help you gauge how hard the
economy might fall after the
inevitable cracks appear in credit
markets. Not surprisingly, it shows
that the three periods with the
greatest amounts of risky
borrowing were followed by the
three hardest falls severe
recessions in 1973-75, 1980-82
and 2008-09. Virtually every
recession follows a drop in risky
borrowing. Large amounts of risky
borrowing eventually lead to
vicious circles in which soured
loans and a slower borrowing pace

drag economic activity lower then you should expect recessions to occur after risky borrowing
peaks. This is exactly what we see.
The third indicator measures the change in risky borrowing using a two year change. It helps to
narrow down recession probabilities. And while it doesnt offer ironclad proof that borrowing in excess
of non-money savings leads to recessions (theres no such thing), it fits into the very process
described by economists whove dared suggest that such borrowing is risky.

These charts ring hard when we consider this next chart.


Companies are reporting revenue problems though they are still able maintain the bottom line through
labor costs cuts, financial engineering, low interest rates, and stock buybacks (as well as dividends to
keep stock prices up), but for how long?
A recession scare is not out of line from a historical perspective.
My work with Richard Duncan says that there is a liquidity problem coming in the 2
nd
half if the TAPER
program is maintained. I personally expect that by Q4 the Fed will be forced insert liquidity or face a
potential recession. The markets will react to all of this with fear from very elevated levels.

COPPOCK LONG WAVES
My Macro Analytics Co-Host Charles Hugh Smith recently posted this chart.

I have long prized the Coppock measure in the bond market so I found the analysis interesting. This
chart shows the Coppock Curve for the S&P 500, overlaid against previous deflationary secular Bear
Markets in the late 1800s, the U.S market in the 1920s and 30s and the Japanese Nikkei stock market
index from 1986 to the present. Charles added notes to the chart to mark the potential market
bottom in early 2015 and a possible peak in Fall 2016. He also added a note that suggests the
shallow troughs in 2005 and 2011 were the result of unprecedented financial engineering by central
banks> He suggests that financial authorities have been dead-set on limiting market declines and
"buying time" so the broken parasitic financial system could feed off the real economy long enough to
restore its viability.
It fits with our expectations of a an Intermediate correction/consolidation into the fall elections and
then a rise to new highs in the first half of 2015. Charles Coppock Curve suggests this could last
longer and go higher than my forecast for the final hyperinflation wave


BE PATIENT WAIT FOR THE DEATH CROSSES

As a lay out in Be Patient: Wait for the Death Crosses! The key here is to anticipate but wait on
confirmations.

I expect major liquidity injection announcements from the ECB by June and the BOJ in Q3. These will be
market movers as will Ukraine events and a potential US$ damaging Energy deal between Russia and
China.

The bottom line to me is that I see volatility increasing over the next 60 days, between now and June
quadruple witch with a major market correction beginning by July options expiration and lasting into the
fall.

Gordon T Long
Publisher & Editor
general@GordonTLong.com

Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only
and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity
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