A 'Foreign' Threat to the Bond Market

A 'foreign' threat to the bond market... The bond 'binge' resumes... 'Stores are closing at a record pace'... Why there's more pain ahead for retailers...


Regular Digest readers know the Federal Reserve will soon begin to "unwind" its $4.5 trillion portfolio of U.S. Treasury bonds and other debt...

According to the minutes of its March policy meeting, released last week, the Fed could start this process before year-end. In simple terms, this means the Fed will stop reinvesting the cash from maturing bonds – mostly Treasurys and mortgage debt – into these markets... thus removing a significant source of demand from the credit markets.

As Porter noted in Friday's Digest, this is a big deal...

That's like taking 25% of GDP out of the credit market. I'm fairly confident that won't be good for interest rates, default rates, or the stock market.

But even this may not be the biggest threat to the market today...

The Fed currently holds about $2.5 trillion of its $4.5 trillion portfolio in U.S. Treasury debt. That's about 18% of the $13.9 trillion Treasury market.

But foreign investors currently own nearly $6 trillion in Treasurys, or 43% of the market. And this, too, could soon change...

More than $3 trillion of negative-yielding non-U.S. government debt has turned positive in recent months, according to Bloomberg data. And more could soon follow as the central banks of Europe and Japan continue to move away from their experiments with negative-interest-rate policy ("NIRP").

As Bloomberg reported over the weekend, this could have huge consequences for the U.S. bond market...

Simply put, foreigners who have poured vast amounts of money into higher-yielding Treasuries may be less inclined to do so now that they have more viable fixed-income options at home...

"There may no longer be a tsunami of money coming from Europe and Japan," said Torsten Slok, the chief international economist at Deutsche Bank...

For now, the unraveling of the reflation trade has helped to keep Treasury yields in check. But as the Fed lays the groundwork for unwinding its debt holdings, any pullback by foreigners could spell trouble. "There is an under-appreciation in U.S. financial markets of the very, very significant role that rest of the world has played," said Slok.

In other words, the two most important buyers of Treasury debt over the past several years could be stepping back at the very same time... meaning the effects on interest rates and the markets could be far greater than either alone.

In the meantime, bond investors don't seem to be worried...

They've been buying up record volumes of new corporate and emerging market debt this year.

The Wall Street Journal reports emerging market governments and companies sold $179 billion worth of dollar-denominated debt through March. This was the strongest first quarter on record, according to market-data firm Dealogic.

Here in the U.S., investment-grade companies issued a tremendous $415 billion worth of new debt in the first three months of the year. This is an all-time record for any quarter. And junk-rated companies issued $80 billion of new debt, double the amount issued in the first quarter of last year.

In other words, investors are now piling back into bonds – including riskier high-yield bonds and bond funds – after temporarily fleeing from them last fall. From the Journal...

The hunt for yield appeared to be falling out of favor right after the presidential election...

Investors fled bonds, worried that a more-than-three-decade rally was ending. Bond mutual and exchange-traded funds world-wide saw $18.1 billion in outflows during the week after Mr. Trump's election, the largest exodus since May 2013, according to fund tracker EPFR Global. Another $22 billion moved out of bonds over the next five weeks.

But that proved to be a blip before bond investors returned forcefully this year. They have pumped more than $112 billion into bond funds since the end of December through April 5.

The Journal also notes that investors are once again paying "lofty" prices for even the lowest-rated high-yield debt...

BWAY Holding Co, a privately owned maker of plastic and metal containers, sold $2.7 billion of bonds last month to help fund an acquisition. BWAY was able to sell eight-year unsecured bonds with a 7.25% interest rate despite its low junk rating.

That is "extremely aggressive" for a company with its financial profile, [Steven Oh, global head of credit and fixed income at PineBridge Investments] said...

Investors demanded 3.93 percentage points more than going Treasury rates to own high-yield bonds, according to Bank of America Merrill Lynch index data. That is less than half the spread in February 2016, when the stock market bottomed after a selloff.

U.S retailers are now closing stores at the fastest pace on record...

According to Credit Suisse analyst Christian Buss, retailers have announced 2,880 store closings so far this year.

At this rate, more than 8,600 locations will close by the end of the year. This would be nearly 40% higher than the all-time peak of about 6,200 in 2008, during the worst of the financial crisis. And the trend shows no signs of slowing yet...

After weeks of speculation, discount shoe store Payless officially filed for bankruptcy last Tuesday. The same day, high-end retailer Ralph Lauren (RL) announced it will close its flagship Fifth Avenue Polo store in Manhattan. And on Friday, teen-apparel store Rue21 reported it could declare bankruptcy within the month.

As regular readers know, these firms join a long list of others to announce store closures and/or file bankruptcy this year, including JC Penney (JCP), Sears Holdings (SHLD), Bebe Stores (BEBE), Macy's (M), Guess (GES), The Limited, Wet Seal, BCBG, hhgregg, Gordmans (GMAN), Gander Mountain, and RadioShack, among others.

But much more pain remains ahead. As Richard Hayne – CEO of teen-apparel store Urban Outfitters (URBN) told Bloomberg recently...

The U.S. market is oversaturated with retail space and far too much of that space is occupied by stores selling apparel. Retail square feet per capita in the United States is more than six times that of Europe or Japan. And this doesn't count digital commerce...

This created a bubble, and like housing, that bubble has now burst. We are seeing the results: Doors shuttering and rents retreating. This trend will continue for the foreseeable future and may even accelerate.

New 52-week highs (as of 4/7/17): Ctrip.com International (CTRP), short position in Hertz Global (HTZ), Monsanto (MON), iShares MSCI India Small-Cap Fund (SMIN), and Guggenheim China Real Estate Fund (TAO).

A busy weekend in the mailbag... More subscriber feedback on last week's big "Metropolitan Man" event... and several more send questions and comments about Porter's latest Friday Digest. Send your notes to feedback@stansberryresearch.com.

"Porter, thanks for allowing your subscribers to listen in on an important meeting with the Met. Man and others. This certainly provided a lot of food-for-thought regarding our investment strategy going forward. I am especially appreciative of your inclusion of the Trump Trade recommendations in your Big Trade subscription service, even though you probably could have made it a separate offering as well. However, I do feel those recommendations are apropos for placement in your Big Trade service. I have already taken advantage of your first 2 recommendations and look forward to taking advantage of future ones also." – Paid-up subscriber Gary H.

"Seems a very big deal... Hard to see why tax reform of this nature won't pass. It seems both parties should like it although the deep state would suffer a confusion and change from their political donors." – Paid-up subscriber Al M.

"I read the transcript of Wednesday's briefing because I was unable to watch it live. I was impressed, found it well worth the $20 and will read it again, perhaps several times..." – Paid-up subscriber D.D.

"Porter, or should I say chicken little... eventually you could be right... eventually. Nothing matters but price and where it is at right now. We can say either way it will fall or rise and be right or wrong 50% of the time. It is guessing at best. What if for a moment this is the rise we are expecting all along. Sure people owe money on houses, credit cards, auto loans, and etc... etc... etc... but this is the new world we live in. No one saves money to buy anything anymore because it would be foolish to give cash when a bank will give you 0% interest. Not sure what the end game will be but I know I keep my house in line being the paid subscriber I am from your writings... thanks. I think when I joined the newsletter I had nothing to speak of... but slowly over time learned how to build my wealth slowly... safely... and securely... Doc is amazing and has taught me well. Thanks for all you guys do." – Paid subscriber Richard F.

Porter comment: No, I'm not Chicken Little. If you were a Total Portfolio subscriber, you'd see that. Or just look at my Investment Advisory's model portfolio. I'm warning about the risk I see. I'm not saying the world will end. And my model portfolios are all still 90%-plus long.

But I'm trying to prepare my subscribers for how this bull market will end, eventually. What would you do if our roles were reversed? Say nothing?

"Porter, loved your Friday Digest this week – prescient warnings as always, thank you. So how do we capitalize on a declining stock market and distressed debt using retirement accounts? When I've tried to set up my accounts to short stocks or buy distressed bonds recommended by your services, I've been told by my brokerage firm that I can't do that with an IRA or 401k. There may be many other subscribers who hold a large portion of their investable wealth in retirement accounts and would appreciate your insight here. Thank you." – Paid-up Stansberry Alliance member J.B.

Porter comment: J.B., I can't give you any financial advice. But I do have a question: What do you think is wrong with just holding some extra cash?

"I was reading the paragraph just above the chart showing car makers AND HAD TO STOP IMMEDIATELY. I opened up my browser to find a specific scene to watch in the movie, The Big Short. The scene, you may recall, is when Steve Carrell and his partners meet with the two mortgage brokers in Florida – pretty sure it was Florida. They realize they just found a ticking time bomb in mortgages.

"When I read your paragraph about the auto asset-backed securities, I had to reread, and reread again, before literally saying out loud – 'holy s**t, this is it!' I was referring to the notion that The Big Short could slightly be rewritten, still be a true story, and showcase auto asset-backed securities breaking the camel's back. Of course this hasn't happened yet, but the evidence is being laid out nearly identical as the movie portrayed the housing bubble.

"This will be the demise of capitalism if this thing cracks under its own weight. The fractional reserve system the global economies have adopted will be met with haste. Remember Cyprus? Or Greece? Yeah, good luck telling Americans, 'you can only withdraw 65$ a day from an ATM... oh and we just taxed your checking account without your approval.' There will be a bail-in by bank depositors in the next crisis.

"You think black lives matter demonstrations were disruptive? Think about what tens of millions of citizens in America will do in response to such a move by the government. And it will be in the tens of millions. I am going to continue reading, but todays Digest is definitely going to be shared with countless people. I don't expect to get this published in your Digest comment section. However, I would be delighted if I had some kind of confirmation you knew how blown away I was on this Fridays Digest. That is the kind of information I enjoy from Stansberry Research. Thoughtful. Well scripted. Precise. Honest." – Paid-up subscriber Austin D.

Porter comment: Yeah, well... it's hard to get most people to recognize how big this problem is... and how it's very likely to be resolved (painfully). I'm glad you "woke up."

Regards,

Justin Brill
Baltimore, Maryland
April 10, 2017