Market trouble is coming

I'm taking some action

This weekend I'm taking steps to boost my liquidity. I will move around some money to better diversify it between banks and credit unions, and also prepare to move a large amount into t-bills: the highest quality collateral with the best liquidity.

Why do I sense danger?

The danger is being broadcast by credit markets (bonds), not stocks. The S&P 500 is still virtually at all time highs. All of these crises start in credit. In the last round, we saw credit market trouble in early 2007, more than a year before the big crash.

Currently we're seeing junk bonds plummet, emerging market bonds plummet, and the U.S. dollar strengthening like mad (likely indicating deleveraging and rising collateral demand). This started in August 2014 and was first visible in low grade bonds, then spread to emerging market bonds. This makes sense as junk bonds were universally recognized as risky and overvalued. They have also been one of the most popular yield-chasing themes in the current QE / ZIRP-induced bubble.

Many retail-oriented bond funds now contain far higher amounts of low grade bonds in the attempt to chase yield. We've also seen the rise of exotic junk instruments such as BMO's ZFH exchange traded fund, which (believe it or not) is an ETF that contains a derivative of credit default swap derivatives on junk debt. You literally have to be a “distressed credit derivatives” expert to figure out what this ETF holds. And it's oriented to retail! This is a perfect parallel to those high-yield funds back in '06 and '07 that were full of exotic sub-prime mortgage derivatives: highly dangerous, opaque, and misrepresented to the investing public. Back then, sub-prime was the first to go. This time, it's junk bonds.

When serious credit market trouble begins, it does not stay limited to certain sectors such as junk debt and emerging market bonds. Credit problems starts at the margins (the most questionable stuff) and then may spread. If it spreads, it's bad.

Here's the problem: we have signs it's spreading.

Money market trouble

Yesterday, Moody's downgraded its outlook on U.S. Money Market funds. While retail investors treat money market funds as cash-like, they are actually bond funds holding short term bonds, usually concentrated in bank paper. Moody's warns of the risk of 'elevated asset flow volatility' (a euphemism for large withdrawals) and the fact that fund managers have pursued longer term and lower quality paper.

As a result, Moody's warns that money market funds may have difficulty remaining liquid in 2015. Those are not their exact words, but my interpretation of their message.

Remember: money market funds are not FDIC insured (USA) or CDIC insured (Canada). They are, in fact, bond funds – not cash. I don't hold any money market funds and I strongly recommend you hold cash in FDIC/CDIC insured bank deposits, or t-bills.

There is much significance in this money market warning. First, it indicates there is the possibility of contagion in credit market trouble. Second it shows a great leap across the spectrum of credit risk. Junk bonds are at one end of the risk spectrum, but money markets are at the opposite end, and considered one of the safest areas. The warning from Moody's shows that credit market trouble may be more widespread than just “junk bonds”.

What does all of this mean?

This post is not intended to be a stock market forecast. The S&P 500, and other stock markets, are manipulated by various central banks and government agencies who buy the index (e.g. futures). I don't know whether the stock market will go up or down.

However, the credit market trouble is real. It's happening now. This means risk is rising throughout the global financial system. Commodities are also crashing, and that can't be a healthy sign. In fact, crashing commodities probably sparked the credit market trouble because of the direct impact on junk bonds of energy and mining companies.

My advice: be cautious, stay liquid, and make sure you have lots of cash.

- Perpetual Bull,