Tossing Caution to the Wind

The latest piece of evidence confirming that the interventions by central bankers have created yet another giant bubble that will eventually land investors in hot water comes to us via Reuters. A major boom in the debt of so-called 'frontier markets' has begun. Readers may recall that the last time these markets experienced a similar boom was in the period mid 2007 to early 2008. Here are a few excerpts from the Reuters article:


“With the world's biggest central banks driving yields on safe assets to near zero, some investors are tossing caution to the wind and rushing to buy illiquid and previously overlooked bonds sold by countries with no capital markets track record.

Even the biggest investors acknowledge that "frontier markets" like Vietnam and Romania aren't for the faint of heart because nobody knows whether these new debt market players will be able to make good on their obligations.


Bolivia, Paraguay and Honduras, three of Latin America's poorest nations with a collective gross domestic product of roughly $67 billion – less than half of war-torn Iraq's economy – have each recently debuted sovereign bond sales. Paraguay, a first-time issuer with no track record of repaying foreign investors its debt, auctioned $500 million of sovereign bonds in January, four months before its presidential elections.

"The election wasn't much of a worry because in Paraguay there is a fairly broad consensus among the policy makers and parties around economic policy-making and what is good for the country," Jaquier said, adding that politics play a big factor in investment decisions. The sale was nothing anyone anticipated. Investors grappled for a piece of the junk-rated 10-year bonds despite their paltry 4.625 percent interest. By contrast, highly rated General Electric (GE.N) 10-year bonds go for 0.58 percentage points more than Paraguay's.

Paraguay's debt offering, which had demand 12 times its total amount of debt for sale, or triple the norm, taps into the investor temperature for risk-taking and yield-hunting. It illustrates the unintended consequences of the more than $2.7 trillion the Federal Reserve has injected directly into the U.S. economy. More recently, the Bank of Japan (BOJ) has joined the fray, launching a $1.4 trillion asset-purchase program of its own.

The aggressive policies of central banks like the Fed and BOJ have pushed investors – even conservative ones – to buy into more illiquid assets in underdeveloped and opaque markets that offer slightly higher returns, but at a much higher risk, amid persistently low rates for safer bonds.

Jim Carlen, portfolio manager of Columbia Management's Emerging Markets Bond Fund, with $166 billion in assets agrees that investment is on a "country by country basis but if you look at all these countries as a whole, like Rwanda, Paraguay, Honduras, and you ask yourself: are you really getting compensated for the level of risk in these countries? I would argue not."

"The tightness in the spreads that you are seeing in these countries is really a factor of the significant level of liquidity in global markets and significant inflows into emerging market fixed income specifically," Carlen added.

The frothiness of investing in frontier markets is mounting, however.


In late April, Rwanda, ravaged by genocide 19 years ago, sold $400 million of euro-denominated bonds, its first international debt sale, with a coupon of 6.625 percent, only half a percentage point above the average yield to maturity for a U.S. high-yield corporate bond, according to Bank of America Merrill LynchFixed Income Index data.

The deal, described by one underwriter as "priced to perfection," drew $3.5 billion in orders.


(emphasis added)

What can one say to that but 'whoa'. On the one hand we hear every day that one should sell one's gold because the future is so bright we will all need to wear shades, and then a debt sale by Rwanda is not only 'priced to perfection' but draws $3.5 billion in bids.

We would argue that such news are a strong indication that we have  arrived in yet another period of investor mass delusion driven by monetary pumping on the part of central banks. It will eventually end with another crash. Anyone exposed to 'risk assets' should take the news above as a major warning sign.

Of course bond investors are not the only one's 'tossing caution to the wind'. Below is a three year weekly chart of the SPX and the latest Hulbert stock market advisors sentiment index. Three things are worth noting: the market has become extremely overbought on a weekly basis; it has rallied on steadily declining volume; and lastly, the bullish consensus has reached yet another record high.

Usually the stock market takes its time to peak out – there is almost always a period of consolidation following market peaks (the distribution phase), so there is no hurry until one spots the requisite pattern. The difficulty is of course that the patterns that appear right after an important peak are not distinguishable from normal consolidation patterns. However, we would argue that in view of the current frothy sentiment and the fact that investors are once again piling into 'frontier markets' for the first time since 2007 means that every consolidation pattern that forms from here on out must be viewed with the utmost suspicion.




The 'no volume' rally in the SPX – the market is now extremely overbought on a weekly basis – via StockCharts  – click to enlarge.



Hulbert stocks

Mark Hulbert's stock market advisors sentiment index: a new record high in the bullish consensus  has been reached – via Sentimentrader – click to enlarge.





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