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Mike Tyson was a beast – a boxer with a ferocious knockout punch who, at 20 years of age in November 1986, became the youngest heavyweight champ in history.
By 1996, Tyson had served a jail term and been stripped of his title because of a matchup controversy. But he was still fearsome. And he was scheduled to fight Evander Holyfield, a former champ himself who was viewed as being past his prime.
After Holyfield outlined his strategy for beating Tyson, "Iron Mike" dismissively responded: "Everyone has a plan until they get punched in the mouth."
Had Tyson only taken his own advice.
After landing some early punches, Iron Mike made a stunning – and disconcerting – discovery: Holyfield was the stronger man. He repeatedly "tied up" Tyson, kept him in clinches, pinned him against the ropes, and kept on his back foot. That kept Tyson off balance, neutralized his punching power, and opened him up to Holyfield's pummeling combinations.
By the time the bell rang ending the 10th round, Tyson was out on his feet and defenseless, but came out to start the 11th nonetheless. When Holyfield pummeled his opponent again, the referees stopped the fight – making Evander the champ.
Here's why I shared this quote – and this story: The Master Manipulators at the U.S. Federal Reserve – ferocious punchers themselves – planned to save the American stock market by backstopping the U.S. bond market.
Saying it is one thing. Pulling it off is another.
After all, every pugilist has a game plan – until they get punched in the mouth.
Fed policymakers don't realize it yet, but they're already back on their heels. That fabulous punching power they wield has been neutralized. And there's one hell of a haymaker headed for their chin.
My takeaway: It's time to short the bond market.
And today I'm going to show you how to ensure you'll walk away with the most profits…
A Grand Plan
Let me start by explaining something – and giving the U.S. central bank its full due. You see, the Fed wanted to save the stock market from imploding after it was hammered by the pandemic.
But since it doesn't actually have a mandate to buy stocks, it couldn't save the market from crashing by buying equities (though it did buy equities in the form of "credit" ETFs and set a new precedent in doing so).
So it launched a "roundhouse" punch, intending to save stocks by backstopping the U.S. bond markets – including the debt on corporate balance sheets – where borrowing was about to hit the canvas, just as it did during the Great Financial Crisis.
It was an audacious strategy. And I have to concede that the Fed has demonstrated some fancy footwork in the early rounds of its bid to save the debt markets, corporations, and the economy.
But our central boxers are going to have to do more, including the impossible, when their real opponent comes out swinging.
The shortest, fastest route to shore up imploding equities was to backstop every kind of debt instrument in sight, which, if investors saw being unconditionally supported, would signal it was safe to jump back into beaten-down stocks.
The stock market is always more important in a financial crisis than bond markets – or at least that's true in the early going. That's because stocks always fall faster than bonds – and because when stocks crash, the collapse spawns headlines, squashes investor and consumer confidence, and directly pummels savings, retirement portfolios, pensions, and standards of living more than falling bonds.
There's more, too. You see, as a company's stock price falls and squeezes its market value, the decline exposes leverage on its balance sheet, impacts corporate liquidity, and debt-to-equity-coverage ratios.
If stocks fall, bonds won't be far behind.
And in the final analysis, the bond-and-debt markets matter more than their stock counterparts.
So by backstopping debt markets – especially where corporations borrow directly – the Fed quickly calmed stocks and invited a "risk-on" flurry.
Once stocks zoomed up and away from their lows of March, bond investors took notice – tepidly at first, but then with exponentially rising enthusiasm as share prices skyrocketed. These debt investors flooded markets with "buy" orders to pick up depressed bond issues that were simultaneously being backstopped by the Fed and buttressed by buoyant stock prices.
It's All Good Until It's Not
My first job on Wall Street was with the Chicago Board Options Exchange (CBOE) in the early 1980s – just before the start of the Great Bull Market.
So I've been doing this for a very long time.
And I understand the nuances of the global debt markets far better than most folks who will take the time to get this granular.
So trust me when I tell you: There's a problem with all the "backstopping" that the debt markets have been getting. There's no meaningful "risk premium" being priced into new debt – or bonds in general – because investors believe the Fed will punch its way out of the corner and find a way to pump up asset prices.
What those investors don't get is this: There's a monumental difference between liquidity (what the Fed's been supplying) and solvency (the degree to which the current assets of a company exceed its current liabilities).
Want an example? Let's look at this.
Let's say you owe a million bucks and can't cover the interest because your assets (your means of producing income) are severely impaired – or have disappeared completely. If the Fed offers to help make the payments, you'll leap at the offer and survive in the short term.
But if your income doesn't rebound, and the new short-term borrowing you owe gets tacked onto your existing debt balance, you've increased your long-term liabilities, meaning you're likely to become insolvent and default on your debt.
The likelihood of default increases if your income declines or if interest rates start rising.
Let's next imagine that this has been happening in the corporate world for years – not a stretch because it has.
The "Zombie Companies" – firms that have rolled over their debt as the Fed consistently lowered rates, even as their revenue declined – are now being joined by "COVID-Casualty Corporations," those that have mostly survived because central-bank-liquidity spigots slaked short-term liquidity needs.
With rates manipulated to record lows, and bond investors willing to take on any and all risk believing the Fed has them covered, there's not much room in the future for the rising number of zombie companies to survive if they can't generate enough revenue to make their debt service, or if rates rise and the cost of rolling over their debt finishes them off.
Leverage Piled on Leverage
In the second quarter, the ratio of debt/EBITDA (earnings before interest taxes, depreciation and amortization) for high-grade companies was 3.53, according to Bloomberg Barclays. That's the highest it's been since 1998 and is 33% higher than the 20-year average of 2.65.
It's a lot worse for junk bonds. At the end of June, the Debt/EBITDA Ratio for junk issuers was 5.42, up from 4.93 in March and 4.44 at the end of last year.
The average junk-rated company now has debt levels three times higher than what the Fed warned companies was excessive in 2013, and again in 2016. The Master Manipulators have since dropped their warnings.
With corporate earnings down by a third – across the board – in the second quarter, while companies piled on debt to maintain liquidity and stave off insolvency, leverage is rising rapidly.
But companies continue to issue debt – it's cheap, and some firms have to do it.
U.S. corporate debt issuance is annualizing at a record rate of $2.15 trillion in 2020.
Low rates and investors' sense that the Fed's taking over default risk by taking on credit risk will keep this cycle going.
So far, it's all been good, because investors have done the bulk of the Fed's work for it, buying up new issues and secondary issues, elevating bond markets while tamping down yields with its speculative buying of everything from investment-grade bonds to credit ETFs.
Why speculate in credit ETFs? Because the Fed's promised to buy the likes of the iShares Iboxx $ Investment Grade Corporate Bond ETF (NYSE: LQD) and the SPDR Bloomberg Barclays High-Yield Bond ETF (NYSE: JNK)… yeah, it's a junk-bond ETF, all right.
The Punch Cometh
Like I said, the Fed's fight plan is working so far. But it hasn't been punched in the mouth.
A hammering one-two combination could upend the bond markets and challenge the Fed's heavyweight status as champion of asset bubbles.
If corporate revenue doesn't bounce back as predicted – or if interest rates start rising – the Fed could find itself on the ropes, and investors could end up woozy and staggered.
Revenue looks like it's rebounding – back up from the mat after a stunning knock-down. But will the corporate "top line" continue that rise into the third and fourth quarter – and into the new year?
No one knows. Large percentage gains from low levels look promising for corporate revenue. But that guarantees nothing.
The only possible "guarantee" is predicated on a successful COVID-19 vaccine.
If revenue doesn't trend higher – or if it backslides – corporate borrowers are going to feel the pain of their leverage and debt service.
More importantly, interest rates could rise – be it from the Fed tightening credit, or from inflation.
Narratives change. Rising commodities and materials costs, food inflation, and constricted supply chains are all evident now – and could lead to inflationary pressures.
Of course, the Fed's not going to raise rates, even if inflation measures flare. Indeed, Fed Chair Jerome Powell just said so in his speech from the virtual Jackson Hole central bankers' conclave.
That doesn't mean bond investors won't hedge their holdings by shorting bond derivatives, or start paring portfolios, or just stop buying new issues if they don't see enough rising rate premium in them.
That's how rates could start rising.
It wouldn't take much for even a small back-up in rates to trigger a profit-taking/loss-minimizing panic, since bond investors are always leveraged to increase their returns.
How to Short Bonds
The Fed's plan to save the stock market by saving the bond markets is equivalent to being punched in the mouth by Mike Tyson. It's a plan that worked before, and everyone knows how it goes.
As we've already seen, however, Iron Mike punching Evander Holyfield in the mouth didn't stop Holyfield from executing his own plan and pummeling Tyson in that first bout, which Holyfield won. And you may well remember their second showdown, when a frustrated, (some say crazed) Tyson bit off a piece of Holyfield's ear – leading to his own disqualification and a Holyfield win.
If the Fed's bitten off more than it can chew, we'll see it in the trading of your three best bond "bellwethers" – LQD, JNK, and the iShares 20+ Year Treasury Bond ETF (NASDAQ: TLT).
Here's what they look like. And here are the levels to watch to know when the Fed's getting staggered.
When that happens, short these ETFs and make sure you've got stop-loss orders down on your stock positions.
The green horizontal lines are support and resistance lines. The middle one here on TLT is at $160. If TLT can't hold that support level, start paring your stock positions and short TLT. If TLT breaks below its lower support at $153, you're going to be glad you shorted it and took profits on your stocks.
On LQD, support comes in at $134.50. If LQD can't hold that level, short it and start taking profits on your stock positions. If LQD breaks below its lower support at $131, you'll be glad you did.
Support on JNK – the junk-bond ETF – is at $101. JNK's trading a lot higher and looks like it can break out of resistance at $106.30 and go higher; that's because of all the speculators in high-yield bonds and because the Fed's buying shares of JNK.
But if JNK backtracks and heads down to test its support, it's a sure sign the Fed's losing control of rates, and you better take your profits everywhere – in your stock positions and any bond positions you have.
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About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.