The Flashing Market Indicators To Watch For

Monday, October 24, 2011

Executive Summary

Foreign official demand for US Treasurys is at its weakest in five years
Fed insiders are increasingly voicing the need for more stimulus
Why the US stock market will crash before the bond market does
The key metrics to watch closely as this story unfolds
Why higher prices AND higher unemployment are on the way

Part I – The Real Contagion Risk

If you have not yet read Part I, available free to all readers, please click here to read it first.

Part II – The Flashing Market Indicators To Watch For

Custody Account Holdings Fall

In Step #1 (in Part I), the first thing I am watching for is a decrease in central bank holdings of Treasury debt. The easiest way to track this trend is through the custody account at the Fed, which is where most of the official holdings of US government securities held by foreign central banks are stored. In this custody account are both Treasury and Agency debt; luckily, they are reported independently.

It’s still early in the day on this story, but notably we’ve just witnessed the largest two-month drop in the custody account in the past five years. Maybe it means nothing and will soon reverse, but it is possibly also the first warning sign that something has dramatically shifted in this story.

Here’s the data. Let’s start with the total amount of custody holdings over the past 20 years.

I know that little wiggle up there in the green circle does not look like much, but it’s the first departure in a pronounced cycle of US debt accumulation by foreign central banks since the credit crisis first erupted. On that basis alone, it’s worth sitting up and paying attention to.

Notice in the above chart that the inflection point in the chart begins in late 2003, the same period when interest rates were forced to zero by Greenspan igniting the afterburners on the global accumulation of dollars. This means that the story we are tracking here is not one that began in 2008 with the credit crisis; it predates that and actually represents the aftermath of the 2000/2001 crisis and the Fed’s decision to flood the world with cheap money.

If we zoom in on the above chart and look at the past five years, it is perhaps easier to appreciate how that little wiggle is actually an important change in trend. That little wiggle represents a little more than $80 billion in reduced holdings since the August 24, 2011 peak — not exactly chump change.

Economy

The Flashing Market Indicators To Watch For