The Next Likely Shoe To Drop
..and Some Signals to Use As Early Warnings

The woes of the sub-prime mortgage market are well documented by now, even if their negative effects are not yet completely manifest across the financial world. This being a "forward-looking" blog, we ask ourselves: "Where's the next trouble spot?"

My #1 candidate is Credit Derivatives for high yield corporate bonds, i.e. "junk". As the economy enters a more recessionary environment the ability of highly leveraged companies to service their debt will be seriously impaired. Rating agencies now have "junk" ratings on more companies than ever before, even as default rates are at or near a historic low. Moody's reported that the global speculative bond default rate in 2006 was at the lowest level in 25 years at just 1.57% vs. an average 4.9%. I hasten to point out that, by definition, "average" is a midpoint: such defaults can exceed 10% during bad years (see chart, click to enlarge).

Source: Moody's via ProFund Advisors

One sign of speculative excess in the high-yield market is the record number and dollar amount of LBO's done by private equity and takeover firms, financed with junk bonds and bank loans. Bloomberg reports that nine of the ten largest ever LBO's in the US were done during 2006. The total amount for debt-financed takeovers came to $735 billion, a record.

The combination of ample Asian/petrodollar savings and low interest rate carry financing (e.g. see post from 2/2/07 below, for a brief explanation of the yen carry trade) has created an ample supply of leveraged liquidity, while the explosive growth of credit derivatives is lulling investors and speculators alike into believing that risk is dead. Indeed, popular Credit Default Swap indexes for high yield and investment grade bonds are very near all time highs - see for example Markit's CDX indexes.

The virtuous cycle of: more liquidity = easier financing terms = fewer defaults = less risk = more LBO's is obviously going to come to an end at some point, though some analysts think it will last forever because financial innovation has created a permanent low risk environment (i.e. "It's different this time..." - we've heard this before, with catastrophic consequences).

What can serve as early warnings of a change in the liquidity tide? We could look at "real time" indicators of market trends at the sources:

1. Pay close attention to the USD/JPY exchange rate. A strengthening of the yen is sure to create losses in the carry trade and liquidity withdrawal. Likewise for the Swiss franc, albeit to a lesser degree.
2. Follow the Shanghai A Share index for signs of Chinese speculative capital destruction. It has now gone vertical, almost +100% in just the past 6 months. (Note: as luck would have it, closed down 9% today).
3. Petrodollar capital is more difficult to trace and follow, particularly since the major Middle East producers tend to invest abroad. A good alternative is the Russian stock market index, up 60% since last July. Following the price of crude oil is also a good idea, though it is complicated by many exogenous events and parameters, frequently resulting in counter-balancing effects.

One last remark: In the short term markets mostly depend on expectations instead of fact; sometimes they even create their own bubble-encapsulated reality, best explained as: "They are up because they are going up". This is the Chinese Year of The Golden Pig, one that comes only every 60 years and is supposedly a harbinger of riches and good fortune. Given the storied passion of the Chinese for gambling, I am sure their market discounted the "fact" well in advance and is now issuing pork chop-suey warnings.