What an actual bond market catastrophe looks like

Mid-week market update: Is the bond market tantrum over?

Here is the good news. In the wake of tame PPI and CPI reports this week, the 30-year Treasury yield retreated while in a resistance zone (top panel). In addition, there is nothing worse than a failed breakout. The second panel shows the inflation factor trade, consisting of long TIPS and short long-dated zero coupon Treasuries, which staged an upside breakout and reversed itself.

The worse of the yield spike fears may have passed. But that was nothing. As a lesson. Here is an actual case of what a potential bond market catastrophe from uncontrolled debt growth looks like.

Consider Russia. An analysis of Russian finances at Navigating Russia shows how the Russian economy is straining under growing stress. On the surface, Russia’s defense expenditures appear to be well under control, but that’s not the entire story. The Kremlin has forced Russian banks to lend to defense industries at below market rates.

Moscow has been stealthily pursuing a dual-track strategy to fund its mounting war costs. One track consists of the highly scrutinized defense budget, which analysts have routinely deemed “surprisingly resilient.” The second track—largely overlooked until now—consists of a low-profile, off-budget financing scheme that appears equal in size to the defense budget. Under legislation enacted on the second day of the full-scale invasion, the Kremlin has been compelling Russian banks to extend preferential loans to war-related businesses on terms set by the state. Since mid-2022, this off-budget financing scheme has helped drive an unprecedented $415 billion surge in overall corporate borrowing. This report estimates that $210 to $250 billion of this surge consists of compulsory, preferential bank loans extended to defense contractors—many with poor credit—to help pay for war-related goods and services.

Russian corporate credit growth has surged as a consequence, and much of it will be bad debt financed at below market rates.

Most the credit increase is attributable to the war.

The payment for the off-budget financing is coming due. As with bad debts, somebody pays. As Russian interest rates have soared, the burden has fallen to the real companies in the Russian economy, such as Gazprom, which is additionally suffering from a loss of revenue from sanctions and a partial cutoff of Russian gas to Europe.

High borrowing costs are causing financial distress among otherwise healthy companies in the “real” economy, leading the CBR to voice concerns over “the risk of major companies becoming overindebted.” These at-risk companies likely includes Gazprom, which has been borrowing heavily in the domestic markets at 22% and higher to cover losses from the collapse of its core business—European exports.

To be sure, the day of reckoning hasn’t arrived for Russia just yet. The Ruble skidded against the Dollar in late December, but strengthened to a USDRUB of 102.80.

See? Even Russia’s bond market tantrum seems to be abating.

Over in the U.S., Robin Brooks has argued that it suffers from bond market tantrums owing to inflation from year-end price adjustment seasonality.

Now that both CPI and PPI are reported, it’s relatively easy to estimate PCE, which is the Fed’s preferred inflation metric, as the components of CPI and PPI are inputs into PCE. It’s just the weights are different.

The Cleveland Fed’s inflation nowcast estimates December core PCE to be 0.19%, which should allow the Fed to continue on its interest rate glide path. Whew!

Over in the stock market, equity prices are continuing their relief rally from an oversold condition. I advised readers to “trust the models” on the weekend (see What’s rattling the stock market?). With the exceptions of major systemic catastrophes like the GFC and the COVID Crash, stock prices have bounced from similar oversold readings in the past, and this is nothing like the GFC or the COVID-19 pandemic.

In addition, Rob Hanna at Quantifiable Edges revealed that his Capitulative Breadth Indicator (CBI) reached 10 on the Friday. A trading strategy based on buying the S&P 500 when it reached 10 was historically profitable – with the exception of the COVID Crash.

Under normal circumstances, the rally should continue for at least another week. However, investors will have to contend with the uncertain market reaction of the new Administration’s policies when Trump takes office on Monday.

My inner trader remains long the S&P 500. The usual disclaimers apply to my trading positions.

I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.

Disclosure: Long SPXL