Has a derivatives bomb just gone off?

I've never seen so many sophisticated Wall Street'ers this scared in my entire career.

This comment comes from a very well-connected Wall Street/DC insider and is in reference to how illiquid the bond markets have become.

Something deep and dark has transpired behind the Orwellian "curtain" used by the elitists to hide the inner workings of the financial markets, especially with regard to big bank balance sheets and OTC derivatives. What's happening right now reminds of the movie "Jurassic Park." You can hear and feel the monster coming but you can't see it yet and you don't know it will pop up in your face or how big it is.

It was the sudden firing of Deutche Bank's co-CEOs this past weekend - The Brown Stuff Is About To Hit The Fan - that prompted me to spend more time analyzing a sequence of events which indicate to me some sort of derivatives position, possibly at Deutsche Bank, has exploded. In addition, the stock and bond markets have been emitting some curious signals which reflect that fact that something happened in the global economic and financial system.

Let's look at some charts first (click on any chart to enlarge). The first graph below shows a 1-yr plot Dow Jones Transportation Average vs. the S&P 500:

As you can see, the DJ Transports and the S&P 500 were tightly correlated until the end of April 2015. The Transports hit an all-time high on October 25, 2014, which is about when the Fed formally ended its QE program. The DJT began to under-perform the S&P 500 at the end of April. Since then it began to diverge quite negatively from the S&P 500. The DJ Transports are largely made up of trucking, railroad and delivery services stocks. This sector of the market reflects the heart-beat of economic activity, especially as it relates to consumer spending in the United States. The Transports are down 9.4% from its all-time high. I wrote about the collapsing U.S. economy a week ago: LINK The behavior of the Dow Jones Transports is the market's confirmation that the U.S. economy is contracting.

A collapsing global economic system will exert an unanticipated and extreme amount of stress on highly leveraged financial systems. This stress is "magnified" by the enormous amount of derivatives which are connected to the disastrous amount of global debt.

An even more curious chart is the relationship between the yield on the 10yr Treasury bond and the DJ Transports:

As you can see, the yield on the 10yr Treasury bond has been trending higher since the beginning of February while the DJ Transports has been trending lower. Notice a problem? In a "clean" market - i.e. a market free from Central Bank and Government interventions, interest rates and the DJ Transports should be positively correlated. If the economy is contracting, as reflected by the direction in the DJ Transports, the yield on the 10yr Treasury should be declining - not rising. You can see that when the DJ Transports ran up to an all-time high, the 10yr yield spiked up, reflecting the markets perception that the U.S. economy might be strengthening.

It does not make sense that the 10-yr Treasury yield is moving higher - quite rapidly - while the DJ Transports are tanking - quite rapidly. In the first week of June, the yield on the 10yr Treasury bond spiked up from 2.09 to 2.40, a 14.8% move. This is a big move for yields in just 5 trading days, especially in the context of a rapidly weakening economy. Worst case, 10yr yields should have remained flat.

I believe the illogical movement in 10yr Treasury yields reflects the fact the Fed is losing control of its tight grip on the bond market and longer term interest rates. Note that German bunds have also experienced a similar spike up in interest rates and volatility. In the context of my view that there was a derivatives accident somewhere in the global banking system in the last two weeks, it could well have been an OTC interest rate swap bomb that detonated.

As of the latest OCC quarterly report on bank derivatives activity (Q4 2014), JP Morgan held $63.7 trillion notional amount of derivatives, $40 trillion of which were various interest rate derivatives. If you look at the ratio of interest rate derivatives to total holdings for the top 4 U.S. banks, they all own roughly same proportion of interest rate derivatives as percent of total holdings. Deutsche Bank is reported to have about a $73 trillion derivatives book. If we assume that ratio of interest rate derivatives is likely similar to JP Morgan's, it means that DB's potential derivatives exposure to interest rates is around $46 trillion. I will elaborate on this below.

But first, one more graph related to interest rates:

This graph shows the price of the 10yr Treasury bond futures contract going back to May 2014. Interestingly, the price of the 10yr moved abruptly higher after the Fed ended QE. This is the opposite of what many of us would have expected. It wasn't until early February that 10yr bond price began to decline (yields move higher). As you can see on the right side of the graph above, the 10yr bond price plunged below the blue uptrend line. The 10yr bond price also crashed through its 200 day moving average - an ominous technical signal. Both of these events happened within the last week.

Again, I believe that this action in the bond market is pointing to the fact that the Fed is losing control of the markets. I also believe that the catalyst for this loss of control is a big derivatives accident of some sort in the last two weeks.

Another clear indication that something has melted down "behind the scenes" recently is an ominous market call by self-made hedge fund billionaire Paul Singer, founder and CEO of Elliott Management. In his latest letter to investors, released the last week of May, he stated that the best trade in a generation is to short "long term claims on paper money."

A savvy investor like Paul Singer would not make a public market call like that unless 1) he had already positioned his fund accordingly 2) he had some sort of insight about what was happening "behind the scenes" either first-hand or from insiders who were in a position to give him information and 3) he was 99% certain that his insight and information was correct. In other words, it highly likely Singer had already made huge position bets for his fund and his own money which would capitalize on a systemic disruption of some sort (Elliott Management was one of the hedge funds with which I dealt when I traded junk bonds in the 1990's. I knew them to be methodical and always looking for inside information).

Finally, I believe that whatever type of financial explosion occurred is related to the sudden firing of Deutsche Bank's co-CEOs, Anshu Jain and Jurgen Fitschen. Fitschen is the equivalent of corporate executive abortion. He's under investigation for tax evasion and on trial for giving false testimony in a long-running legal battle related to the collapse of the Kirch media conglomerate (one of Germany's biggest media empires. It's incredulous to me that he wasn't fired a long time ago. It tells us just how recklessly this bank is managed by the Board of Directors. It also suggests a grand failure by German bank regulators.

It's the firing of Jain that caught my interest. In a management shake-up a little over two weeks ago, Jain was given more power by the Board and shareholders. So why was Jain suddenly and unexpectedly fired less than three weeks after having been given more control over the bank?

As I wrote yesterday, Jain's raison d'etre was to build Deutsche Bank into the world's largest derivatives dealer. On May 26, it was announced that Deutsche Bank had reached a settlement with the SEC for improperly valuing its its risk exposure to its Leveraged Super Senior trades book of business (credit derivatives). This in and of itself was not the cause of the Bank's reversal on Jain. But I can guarantee that this is just the tip of the iceberg with regard to fraud and risk exposure connected to Deutsche Bank's derivatives business under Jain's stewardship. We found out in 2008 that bank CEOs and CFOs not only lie to each other and their employees, they also lie to regulators.

I referenced Deutsche Bank above in connection to big bank interest rate derivatives exposure. I believe that the high volatility in the global fixed income markets has triggered some kind of derivatives blow-up at Deutsche Bank. While the smoking gun points to some kind of interest rate-related derivatives melt-down, it could also have been related to Greece sovereign debt credit default swaps or energy-related derivatives.

While I'm fairly certain that all the evidence points to Deutsche Bank as the source of what I believe is a derivatives accident that has occurred in the last two weeks, don't forget that the majority of banks and hedge funds globally are linked directly or indirectly through the "magic" of OTC derivatives and counter-party default risk. We saw this "natural" law of derivatives risk in action in 2008 and recently when a small German bank blew up from its exposure to an Austrian bank which choked to death of Greece-connected credit default swaps.

There's other signals which I didn't cover, like the fact that the S&P 500 is has dropped 2.5% in the last 10 trading days since hitting an all-time high May 21. In addition, the US dollar index has plunged 170 basis points in the last six trading days. This is a huge move for a currency in such a short time period. Having said that, regardless of which bank and what "flavor" of derivative may have blown up, I believe that something big and hidden melted down in global financial system during the last two weeks.

This could be the start of the big financial markets inferno that many of us have been expecting for quite some time.

My best advice for anyone who wants to protect themselves financially is to get as much money OUT of the system as you can. It's up to you whether or not you convert your cash into physical gold and silver, but I think at this point only an idiot would leave his money in the system and denominated in paper dollars.