The Next Big Bubble Ready to Burst

Next Thursday, October 8, marks the seven-year anniversary of a date that will forever be remembered in monetary infamy.

That was the memorable day in 2008 when the Fed began to dramatically slash its already-low Fed Funds target rate  in the wake of the Lehman Brothers failure — first to 1.5% … then to 1% two weeks later … and finally to near-zero on December 16 of that year.

Plus, it was also the memorable time when the Fed launched forward with the most audacious money-printing binge since the birth of the U.S. dollar exactly 229 years and 20 days ago.

In last week’s article, under the title “The Real Reasons Yellen Didn’t Raise Rates,” I showed you the enormous size of that adventure.

It was 44 times larger than the Fed’s emergency response to fears of a Y2K disaster back in 1999 …

It was 81 times larger than the Fed’s emergency response to the 9/11 terrorist attacks, and …

It was far larger than anything mankind had ever witnessed on this planet before.

Now, the big question before us is: What happens when the Fed begins to reverse this audacious escapade, even if meekly and gingerly?

The first and best answer: We don’t know.

We don’t know for the simple reason that there’s no historic precedent — no previous 7-year period of zero interest rates and nonstop monetary binging.

We do have, however, some other historical facts that can help us better understand what the future may bring:

Historical fact #1. The Fed’s 7-year money frenzy forced the hand of other major central banks around the world — the Bank of England, the European Central Bank and the Bank of Japan — to also open their money floodgates in tandem. Ditto for many emerging market countries and even frontier economies.

Historical fact #2. The near constant gusher of liquidity into the global economy — considered by investors to be almost as reliable as America’s famous “Old Faithful” geyser — gave rise to a series of speculative bubbles:

• Commodities went through the roof, led by oil, up to $130 per barrel.
• Stocks in major emerging markets like Brazil, Russia and China exploded higher.
• Junk bond issuance in the U.S. surged to $1.81 trillion, nearly double their high-water mark just prior to the 2008 debt crisis.
• Investors plowed into the riskier small-cap stocks, valued at $2.2 trillion, also far exceeding pre-2008 peak levels.
• And globally, corporate debt grew to levels beyond the danger zone reached just prior to the 2008 debt crisis.

Historical fact #3. The first two of these bubbles have already burst:

• From peak to recent trough, crude oil has plunged 74.3%. Silver has plummeted 72.1%. Copper has crashed 52.5%. And gold has been hammered to the tune of 42.8%.
• Stocks in emerging markets have taken an equally big beating: China down 53.5% from peak to trough; Brazil, down 42.2%, and Russia, down 27.4%.

Historical fact #4. The three other speculative bubbles — small cap stocks, junk bonds, and other corporate debts — have not yet burst; they’re still largely intact. But past cycles tell us that these three sectors are very sensitive (and vulnerable) to any kind of money tightening.

When the Fed raises rates, which will be the next to burst? It’s hard to say with certainty. But my best guess is …

The Junk Bond Bubble

Any corporate bond can be risky. If the company misses a payment — or it’s simply downgraded by one of the major rating agencies — the market price for its bonds can crater almost as swiftly as the price of a stock.

And I’m talking about investment grade bonds (rated triple-B or higher). When it comes to speculative grade bonds (double-B or lower), the risk is even greater.

That’s why, in the common parlance of Wall Street, they’re called “junk.” And it’s also why, in normal times, most average investors have considered them forbidden fruit.

But whatever you call them, the fact is that, in the zero-interest rate Eden of the past seven years, junk bonds have been virtually the only fruit that yielded any juice. So investors flocked to them in droves, creating the greatest junk bond bubble of all time:

Click image for larger view

Just take one look at this chart, take a walk through history, and you’ll see exactly what I mean:

1999: Most of Wall Street is going gaga over tech stocks. So junk bonds, even with their higher yields, are considered dull and boring. By 2000, they’ve attracted only about $650 billion of investor funds.

2007: This time, the big bingeing has been in real estate and mortgages. Yes, the junk bond market had grown since the beginning of the decade — to $960 billion. But it’s still not the primary focus of speculation.

2015: Now, junk bonds are back – in a big way. While the real estate markets have been less leveraged and more subdued, junk bonds have suddenly emerged as the poison of choice for yield-thirsty investors.

Try to remind them that junk really does mean junk, and their likely response is to roll their eyes or shrug their shoulders. “Where else can I get a halfway decent yield?” they ask. “And who gives a damn about risk?”

Sound crazy? Perhaps. But these are actually rational responses to a Garden-of-Eden world where the Fed pegs official rates at zero with one hand … and guarantees a virtually risk-free environment with the other.

Nevertheless, junk bonds are a giant house of cards, waiting for the day when the Fed decides to throws up both hands and eject investors into the real world.

When will that begin? There are some early signs it already has begun:

• Junk bonds issued by energy companies, coal miners and metals producers (about one-third of the junk bond market) have already been falling all year — along with the plunge in commodity prices. But the idea that investors could escape the carnage simply by avoiding commodity-related junk isn’t working anymore.
• For example, Moody’s recently downgraded much of Sprint’s junk bonds to Caa1, precipitating a chaotic and fierce market response. Sprint’s $2.5 billion of bonds maturing in 2028 plunged as low as 80.8 from 88.4 the day before, while $4.2 billion of its notes maturing in 2023 fell to as low as 90.1 from 98.6. For bonds, which rarely move by more than a point on any given day, that was the equivalent of a big crash.
• Junk bond mutual funds and ETFs have also been a big part of the junk bond bubble with over 200 funds in all. But in recent months, more than $8 billion of investor money rushed for the exits, a prelude to the stock market exodus we saw in August.

Next big questions:

What happens when the party ends — either because the Fed is shutting off the lights or because investors see the handwriting on the wall?

How will a junk bond bust impact other markets — investment grade bonds, small cap stocks, and other recent targets of high-risk capital?

It’s too soon for any definitive, quantitative answers. But if you’re heavily invested in any of these areas, I would not wait for the final word before taking protective action.

If you own junk or “high yield” mutual funds and ETFs, seriously consider taking advantage of any intermediate market strength to get out.

Good luck and God bless!

Martin