Is Risk-On About To Switch To Risk-Off?

 | Sep 15, 2014 07:32AM ET

Cranking markets full of financial cocaine so they never correct simply sets up the crash-and-burn destruction of the addict.

Human memory being what it is, almost three years of risk-on euphoria has created the illusion that risk-on is The New Normal that will continue on for years to come. Perhaps, but there are converging signals that suggest the risk-on trade is about to reverse polarity to risk-off. These include:

 
1. Junk bonds. Two charts below (the first from Chris Kimble ) suggest the risk-on extremes have reached the point of reversal.
 
2. Soaring U.S. dollar. Without going into detail, it's increasingly clear that the soaring USD is destabilizing the global foreign exchange (FX) markets. FX has been the source of many of the risk-on carry trades that have been driplines of financial cocaine for global stock markets.
 
3. Reversal of the Federal Reserve's quantitative easing (QE) programs.Though the stock market has roundly ignored the withdrawal of $600 billion of free money for financiers stock market stimulus all year, the October end of the QE asset buying program now looms large. 
The Fed has already trimmed its asset-buying binge from $85 billion/month ($1 trillion/year) to $25 billion/month. Risk-on proponents claim that this reduction has been replaced by Bank of Japan and European Central Bank QE programs, but this belief fails to take into account the diminishing returns on BOJ and ECB stimulus.
 
Those spigots have been open for so long that adding more monetary stimulus no longer moves the needle positively. Rather, the extreme measures push the global financial system into increasingly risky territory.
 
4. Geopolitical spillover. One key element of the risk-on trade is the magical-thinking belief that the U.S. stock market is completely decoupled from geopolitical dynamics. In other words, Japan and Europe can sink into recession, China's growth can slow, the Mideast can be destabilized by multiple open conflicts and none of these issues will ever matter, as long as "the Fed has our backs," "corporate profits keep rising," etc.
 
Geopolitics matter even if only because global dynamics cause global players to switch from risk-on to risk-off as markets destabilize and carry trades dry up. Highly leveraged traders must delever, and that selling on the margins tends to topple dominoes that lead straight to the core.
 
The market for high-yield bonds is a well-known canary in the risk-on coalmine.These two charts should give anyone pause--the canary is stiff and cold but has been propped up in its cage by risk-on cultists fearful of any intrusion of reality: