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The Yield Curve Twist Omen

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All the Market Crashes we have witnessed have been the result of the yield curve suddenly returning from undervalued to normal. That was true for the "sub prime crisis" as it was for any other crash in history : it is the only way to account for a discontinuity in stock market value If for other crash the easy cure was to lower short term rate, this time it will be, of course, impossible.

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Financial crises are characterised by discontinuous breaks in market pricing the timing of which by definition must be unanticipated - if people see them coming, then the markets arbitrage them away.

I have explained that long term yields are options or short-term yields. A normal yield curve is such that these long-term yields get their fair value. However because these options are complicated to arbitrage, banks are structural lenders (it is their job after all) and of Quantitative Easing, which aggravated this inversion, recently, on Wednesday 25th, August these low long-term yields became unsustainable.

Even a Pig can Get Fed Up, Eventually!

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These yield are now going to normalize. For reasons I have explained in Omen of Financial Nemesis Timing : FND - 7. this process of sudden normalization will end on Sept.17th.

These are the yield curves for the minimum on Wednesday (orange)
and the expected yield curve on Sept. 17th (green).

In fact the green yield curve is not exactly normal. I expect that a switch from long-term assets toward liquidity will make short-term yields go below their normal configuration.

But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.
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Although these yield curves can stay for an extended time below the normal yield curve [undervalued], and sometime extremely so. But once the process of normalization has started it can revert to its normal configuration quick as for any arbitrage. [It is the reason that a restrictive monetary policy is almost impossible to implement smoothly and while ineffective at the start of its implementation it generally ends with a rout of bonds and the stock market (1987).]

Our day-by-day experiences with the effectiveness of flexible markets as they adjust to, and correct, imbalances can readily lead us to the conclusion that once markets are purged of rigidities, macroeconomic disturbances will become a historical relic.

However, the penchant of humans for quirky, often irrational, behaviour gets in the way of this conclusion. A discontinuity in valuation judgement, often the cause or consequence of a building and bursting of a bubble, can occasionally destabilize even the most liquid and flexible of markets. I do not have much to add on this issue except to reiterate our need to better understand it.

Note: that increase in bond yields is not caused by any macro economic event but only by the fair valuation of an option. It is very probable that with dismal economic figures we still witness that yield increase.

With 11 trading days to go we would need on average to gain 10 basis points on the Yield of 10 Years US treasury Notes and 10.5 basis points on the 30 Years US Treasury Bonds.

Technical Analysis:
After the Hammer we had on Wednesday 25th, August expect a dowmfall

This will have very dramatic consequences.

Macro Economy:

The yield curve necessary to sustain our sluggish economy is the green one, the yields that will be required by investors to reward them for interest risk is the orange one. As we can see the gap will be such that there will be a sharp decrease in the level of investments from the prevalent low. We can see how insufficient it is already by watching the year to year change in M3.

Bond Market:

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I have an engineer diploma from Ecole Centrale de Lyon (France) and a MBA from Boston University. Since 1986 till 1994 I have worked as a broker dealer on the French Domestic Fixed interest market. Since the spring of 1994 I have worked on the (more...)

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