Friday, 1 November 2013

Credit - The Anna Karenina principle

“In the chaos of maladaptation, there is an order. It seems, paradoxically, that as systems become more different they actually become more correlated within limits.” -  Professor Alexander Gorban

While looking at Europe's inflation level coming at 0.7%, indicative of the seriousness of the deflationary threat in conjunction with the rise of unemployment to 12.2%, we thought we would use this week in our title, a reference to the Anna Karenina principle:
"The Anna Karenina principle describes an endeavor in which a deficiency in any one of a number of factors dooms it to failure. Consequently, a successful endeavor (subject to this principle) is one where every possible deficiency has been avoided.

The name of the principle derives from Leo Tolstoy's book Anna Karenina, which begins:
Happy families are all alike; every unhappy family is unhappy in its own way." - source Wikipedia

Indeed when one looks at the European family and the diverging data, it seems that every member of the family has been unhappy somewhat in its own way. For instance Cyprus  has seen its unemployment in one year jump from 12.7% to 17.1% while Ireland following years of misery due to the excruciating price for bailing out its financial system has been on the slow mend train and having its unemployment falling from 14.7% a year ago to 13.6% today. At the same time Italy is sinking in the deflationary trap set up by the euro with unemployment rising to 12.5%, the highest since 1977, while Germany enjoys an unemployment rate of 5.2%. Compared with a year ago, the unemployment rate increased in sixteen Member States, a clear unhappy family in its own way, but we ramble again...

While we mused at length on the "Cantillon Effects" generated by the abundant liquidity provided by our "generous gamblers" aka central bankers around the world, as far as the Anna Karenina principle goes, in this chaos of "mal-investment", there is indeed an order and of course rising "forced positive correlations" which we mused on in our previous conversation "Alive and Kicking".  We agreed at the time with Martin Hutchinson's take on the subject of positive correlations in his article "Forced Correlations" published in Asia Times:
"Negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. 

Since central banks worldwide are now pursuing the same easy-money policies as the Bernanke Fed, the same correlations are appearing elsewhere, with the exception of the majority of emerging markets, where economic reality remains in play."

The rise of the S&P 500 and the rise of the Balance Sheet of the Fed in conjunction with the fall in the US Labor Force Participation Rate - graph source Bloomberg:

The rise of the S&P 500 a story of growing divergence between the S&P 500 and trailing PE since January 2012 - graph source Bloomberg:

So you might be already asking yourselves where we going with this Anna Karenina principle and all our gibberish surrounding correlations and forced correlations and growing disconnects.

It is very simple:
"By studying the dynamics of correlation and variance in many systems facing external, or environmental, factors, we can typically, even before obvious symptoms of crisis appear, predict when one might occur, as correlation between individuals increases, and, at the same time, variance (and volatility) goes up. ... All well-adapted systems are alike, all non-adapted systems experience maladaptation in their own way,... But in the chaos of maladaptation, there is an order. It seems, paradoxically, that as systems become more different they actually become more correlated within limits." - University of Leicester - Anna Karenina principle explains bodily stress and stock market crashes.

In the "chaos" of mal-investment there is indeed an order we think. So, in this week conversation, we will look into correlations, volatility (which has become the wrong signal thanks to central banks meddling), correlation breakdowns and rising correlations, and the risk for "disorder" with increasing disconnections.

As reported in Bloomberg by Nikolaj Gammeltoft, Nick Taborek and Audrey Pringle on October 28th in their article "Correlations Bets at Six-Year Low as Debt Turmoil Fades" complacency is clear and present:
"U.S. options traders are convinced that profits, buybacks and takeovers will exert a greater influence on stock prices in coming months, sending an index tracking expectations for lockstep moves to a six-year low.
The Chicago Board Options Exchange S&P 500 Implied Correlation Index tumbled 37 percent to 37.21 since Oct. 8, according to data compiled by Bloomberg. The gauge, which uses options to indicate how closely stocks in the Standard & Poor’s 500 Index will move together, reached 36.07 on Oct. 18, the lowest level since February 2007." - source Bloomberg.

From the same Bloomberg article:
"The CBOE Volatility Index, the gauge of S&P 500 options prices known as the VIX, has fallen 36 percent to 13.09 since Oct. 8, according to data compiled by Bloomberg. The measure soared 23 percent from the beginning of the government shutdown on Oct. 1 to Oct. 8 as politicians struggled to reach an agreement to avoid a default."
‘Big Deal’
It’s a big deal because when correlation gets this low in conjunction with low levels of volatility,” Peter Cecchini,global head of institutional equity derivatives and macro strategy at New York-based Cantor Fitzgerald LP, said in an interview, “it may mean that market participants are complacent and markets are vulnerable to a correction.” 
This month’s drop in the CBOE’s correlation index has been greater than the retreat at the beginning of 2013 after U.S. lawmakers agreed to pass a bill averting spending cuts and tax increases known as the fiscal cliff. The measure dropped as much as 20 percent in the two months after Dec. 28, 2012." - source Bloomberg

The evolution of VIX versus its European counterpart V2X since April 2011 - source Bloomberg:
The highest point reached by VIX in 2011 was 48 whereas V2X was 51. VIX is around 14, at 13.65 and V2X at 15.54, highlighting as well the significant drop between US and Europe in relation to risk perception.

As CITI indicated back in August from our previous conversation "Alive and Kicking":
"It's not hard to figure out why the 'Great Rotation' has been such a hot topic this year. It seems so intuitive: as yields rise over the next few years in response to a gradual economic recovery, total returns in fixed income will be weighed down, if not outright negative. The asset class that has the most to benefit from growth is equities.
For example, for the past year we have continuously highlighted the asymmetry in risk/reward between equities and credit. As illustrated in Figures 2 and 3, credit and equities have correlated closely over the last few years and almost in a constant ratio. We don't see why that wouldn't work in reverse also.
However, as credit spreads get closer and closer to the lower bound it becomes increasingly difficult for them to continue performing in the historical relationship with equities. The slight gap that appears to be opening up in both charts recently seems to bear that out.
In other words, to our minds there is an obvious long-equities-short-credit relative value trade insofar as credit has all the downside potential of equities, and much less of the upside." - source CITI

We also argued at the time:
"For us, there is no "Great Rotation" there are only "Great Correlations""

An evidence from our statement can be seen in the rising positive correlation between Asian currencies and the S&P 500 which have been moving in lockstep for the first time in a year as per Bloomberg's Chart of the Day from the 30th of October:
"Asian currencies are moving in lockstep with the Standard & Poor’s 500 Index for the first time
in a year, suggesting investors are returning to riskier assets on bets the world’s biggest economies will strengthen.
The CHART OF THE DAY shows the Bloomberg-JPMorgan Asia Dollar Index rebounded to 116.84 after falling to a three-year low of 113.58 on Aug. 28, while the S&P 500 surged to a record yesterday. The lower panel shows the 60-day correlation coefficient between the two gauges rose 50 percent in the past two months to 0.56 out of a maximum of 1, approaching the highest in a year and the 0.64 average from 2009 to 2012, when markets worldwide were roiled by Europe’s debt crisis.
Investors are seeking higher-yielding assets as concern over a breakup of the euro bloc evaporates, optimism the U.S. and China are rebounding from slowing growth increases, and speculation rises the Federal Reserve won’t slow quantitative easing until the first quarter. In the past four years, Asian currencies gained 5.1 percent on average when the correlations strengthened and peaked over the 0.7 zone, according to data compiled by Bloomberg.
“The market is looking for a sweet spot -- an improving global growth and a dovish Fed pushing QE tapering further out,” Marcelo Assalin, who oversees $3 billion of local-currency emerging-market debt in Atlanta for ING Groep NV, said in a phone interview on Oct. 28. “I honestly don’t see catalysts for a breakdown in correlation in the near term.” China’s economy, the world’s second-biggest after the U.S., expanded at a faster pace for the first time in three quarters, quickening 7.8 percent in the three months through September from a year earlier. The Fed decided to press on with $85 billion in monthly bond purchases yesterday, saying it needs to see more evidence that the economy will continue to improve.
Investors should buy India’s rupee and Indonesia’s rupiah as a delayed tapering bolsters carry trades, where investors borrow in low-interest-rate currencies to buy higher-yielding assets, Assalin said. The Fed has maintained its target rate for overnight loans between banks in record-low range of zero to 0.25 percent since December 2008." - source Bloomberg

Another impact of the "tampering in the tapering stance" by the Fed has as well led to the breakdown in the correlation between bond yields and equity prices as investors keep on hoping the punchbowl will not be pull back too soon by the everlasting accommodative Fed as displayed in another Chart of the Day from Bloomberg from the 24th of October:
"Emerging-market currencies are benefiting from the breakdown in the correlation between bond yields and equity prices as investor expectations for monetary stimulus by the Federal Reserve lengthen.
The CHART OF THE DAY shows that a Bloomberg index of the 20 most-traded emerging-market currencies and the Standard & Poor’s 500 Index have, since the beginning of July, appreciated when 10-year U.S. Treasury note yields declined on an average of 14 out of the previous 50 days on a rolling basis. The figure compares to an average of five days out of a similar period from the start of 2012 through June 2013.
“What the Fed really wanted was to get interest rates low and get real activity going,” Steven Englander, the global head of Group of 10 currency strategy at Citigroup Inc. in New York, said in a phone interview. “As a side effect, what happened was this was a spur to asset markets. This is spilling over into EM currencies.”
Bloomberg’s emerging-market currency index has increased 3.7 percent since the start of September after declining 7.9 percent in 2013 through August. Meanwhile, the S&P 500 has climbed 7.2 percent since the beginning of September after increasing 2 percent over the previous two months.
Fed policy makers last month cited the need for more evidence that economic growth will be sustained for continuing to pump $85 billion a month into the economy by purchasing bonds. BlackRock Inc. and Pacific Investment Management Co. have said the central bank will postpone tapering stimulus.
A rebound in the carry trade, which lost money for four straight months through August in the longest slump since 2011, bodes well for high-yielding emerging-market currencies such as Brazil’s real and South Africa’s rand." - source Bloomberg

So while investors continue to get "carried away" in "beta" terms in this sea of liquidity plentiness, what has caught our attention is another breakdown in correlation in the credit space, namely the one between credit volatility and spreads that is. This specific matter has been highlighted by CITI on the 29th of October in their note entitled "Has Credit Vol Decoupled from Spreads?":
  • "Relationship between credit volatility and spreads has broken down - Using CDX IG as an example, we find that after September 2012, the traditionally high volatility/spread correlation drops from 85% to 10%. In contrast, the correlation between CDX IG spreads and equity volatility has remained meaningful.
  • Price volatility is a better risk indicator - In contrast to the spread volatility quoted in volatility markets, the equivalent price volatility exhibits better sensitivity and much stronger correlation to credit spread moves. We find that this relationship persists for recent (post September 2012) data.
  • Credit spreads are currently tight relative to price volatility - A simple regression model using the past 1 year of spread/price volatility data indicates that index spreads are too low compared to both 1M and 3M price volatility levels." - source CITI

In their note CITI highlights this correlation disconnect, which is of great interest bearing in mind the Anna Karenina principle mentioned above:
"The Great Disconnect
Traditionally, investors have used volatility in risk asset classes as a measure of systemic risk. This is because, while (in theory) volatility can spike when markets make large moves, the reality is different. Given human psychology, risky asset volatility has always tended to spike during periods of market downturns because of the gappy nature of selloffs, while market rallies have tended to be relatively smooth. Therefore, volatility has always been regarded as a good hedge against sharp market down turns, and both options and volatility indices (e.g. VIX) have found a good market in hedge buyers.
What if that situation were to change? If we take a look at what is going on in the US credit volatility markets, it would certainly appear that there has been a regime change, and one that does not bode well for those that hedge with credit volatility products.
To illustrate this issue, we use the CDX IG index as an example. Using data dating back to 2011, we find that the traditionally strong positive correlation (volatility rises as spreads widen during a market selloff) between CDX IG index spreads and ATM implied volatility has taken a nosedive recently (see Figure 1).
Figure 1. Strong correlation between 1M or 3M ATM volatility and CDX IG spreads breaks down post Sep 2012 (left). Simple linear regressions between 3M ATM volatility (X-axis) and the underlying index spread (Y-axis) confirm the strong relationship pre-Sep 2012 (top right) and almost no relationship post-Sep 2012 (bottom right).

Specifically, it would appear that the market has undergone a regime change after Sep 2012, and for the past year, the correlation between index spreads and implied volatility has been extremely weak – for example, the correlation between 3M ATM volatility and IG spreads has gone from a respectable 85% pre Sep 2012 to a paltry 10% post Sep 2012, and the weak correlation persists to this day." - source CITI

CITI's conclusion that this disconnect does not bode well for those that hedge with credit volatility products is not surprising to us. It validates our January 2013 take on the subject of the impact central banks play on volatility which we wrote about in our post "Volatility Regime Change and Central Banks - a key driver":
"One thing for sure, the on-going excessive search for yields could have a long-term impact (relative immunisation risk of credit versus equities)."

CITI also makes the following interesting point in their note on the correlation breakdown between index spreads and implied volatility being extremely weak:
"Furthermore, this is true across credit indices and option maturities – both 1M and 3M ATM implied volatility for CDX IG and HY indices exhibit the same behavior recently. At the same time, we find that the correlation between equity volatility (e.g. 3M ATM SPX volatility) and credit spreads does not suffer to this extent (see Figure2). 
Figure 2. In contrast to credit volatility, equity volatility shows stronger correlation to CDX IG index spreads in the post-Sep 2012 period (left). This is confirmed by regressions between 3M ATM SPX vol (X-axis) and CDX IG spreads (Y-axis) in the pre-Sep 2012 (top right) and post-Sep 2012
(bottom right) periods.

Does this mean that the credit volatility market has lost its signaling power as a
barometer of systemic risk? Further, are equity volatility markets a better barometer for credit risk itself?" - source CITI

Why  such a decoupling? It's the Low Spread Regime stupid! According to CITI:
Why are we seeing this apparent decoupling? After all, the only significant thing that happened in Sep 2012 was the OMT announcement from ECB president Draghi which did send spreads tighter, and volatility lower, across the board. However, while this announcement served to take tail risk off the table for most investors, it is unlikely that it would cause the correlation between spreads and volatility to break down in this spectacular fashion.
We believe that the reason is different, but related. Once systemic risk was off the table after the OMT announcement, there was a sustained rally in spreads that has more or less continued unabated to the present. For most of this period, CDX IG spreads have remained at relatively low levels (see Figure 1). As spreads have gone tighter, implied (spread) volatility levels have approached a floor.
Why did this happen? Remember that implied volatility for credit spreads is represented as a percentage of the underlying spot (spread) level. For example, when the CDX IG index is trading at 120bp, an implied spread volatility of 40% means that the index is expected to move around 3bp/day1. However, if the index spread falls to 60bp, the expected move falls to 1.5bp/day.
As spreads go tighter, the expected implied move in bp/day approaches a floor which is determined by the bid/ask spread for the index. In other words, in a tight spread regime, the implied volatility for the index cannot go below a floor that puts the corresponding expected index move in bp/day below the index bid/ask spread.
As we approach this implied (spread) volatility floor, the behavior of implied volatility begins to exhibit less sensitivity to spread moves, thus giving rise to convexity. This kind of behavior is a well-known phenomenon and can readily be seen in the relationships between other asset pairs, such as credit spreads and equity prices (e.g., CDX IG versus S&P 500), where credit spreads at very tight levels become de-sensitized to equity index moves." - source CITI

With so much "Greed" and no "Fear" thanks to the postponement of "tapering" in the near future, risky assets have rallied hard, as displayed in the rally seen in High Yield and the continuous rally in the S&P 500, but increasingly the performances for credit  investment grade is being "capped" due to the growing disconnect and correlation breakdown mentioned by CITI - graph source Bloomberg:
The correlation between the US, High Yield and equities (S&P 500) is back thanks to "no tapering". US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG.

The surge in risky assets is of course entirely driven by the fall in volatility as a whole in various asset classes as displayed in the below Bloomberg graph:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.
EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market currencies. The index is based on three-month at-the-money forward options, weighted by market turnover.

In true Anna Karenina principle, we think the rising disconnect and positive correlations are tantamount to rising instability in the system as a whole as posited by Gorban's work quoted by  the University of Leicester - Anna Karenina principle explains bodily stress and stock market crashes:
"Adaptation energy as described by Selye, represents physiological resources that can be drawn on when an organism is under biological stress. Gorban and colleagues have demonstrated that the same notion can be applied to financial systems.

This is not the end of the story. If the load increases further then the "order of maldaptation disorder" is destroyed and the systems progress to a fatal outcome in a fully disordered state. This conclusion is the complete realisation of the Anna Karenina Principle, Gorban says.

The research was published in the August 15 issue of the journal Physica A, (Vol. 389, Issue 16, 2010, pp 3193-3217). A preprint is also available online:"

The regime change in both lower volatility and lower yields is indicative of the adaptation of the financial system not under biological stress but under central banks "financial repression" that is:
"Many examples from human physiology support this observation: from the adaptation of healthy people to a change in climate conditions to the analysis of fatal outcomes in oncological and cardiological clinics.

The same effect is found in the stock market. For example, in the dynamics of the 30 largest companies traded on the London Stock Exchanges, from 14/08/2008 to 14/10/2008 the correlations increased five times and the variance increased seven times." - source University of Leicester - Anna Karenina principle explains bodily stress and stock market crashes

In addition to the adaptation of the financial system under this time around "regulatory repression", the growing instability can be ascertained we think in "dwindling liquidity" as indicated in Bloomberg by Lisa Abramowicz on October 18th in her article entitled "Wall Street Dodging Bonds Lifts Risk in Tapering: Credit Markets":
"Wall Street’s biggest banks are demonstrating an unwillingness to wager on corporate debt in times of stress, raising concern that any losses will be magnified when the Federal Reserve tapers its record stimulus.
As speculation mounted in the two weeks ended Oct. 9 that the U.S. could default on its debt, the 21 primary dealers that trade directly with the central bank sold a net $180 million of investment-grade notes, Fed data show. The flight was bigger four months ago as the market spiraled into its worst performance since the financial crisis, with dealers slicing inventories by a net $4.77 billion.
Banks that traditionally sought to profit from debt-market dislocations now are shunning risk during periods of deteriorating sentiment as they eliminate proprietary trading groups and reduce leverage. Dealer reluctance to use balance sheets to absorb investment-grade credit amplified the 4.98 percent loss in May and June on the Bank of America Merrill Lynch U.S. Corporate Index as central bankers considered reducing the monthly bond purchases and Treasury yields soared toward a two-year high, New York Fed researchers wrote in an Oct. 16 report." - source Bloomberg.

The article also fuels our "liquidity" concerns which have been a regular feature in our numerous "credit" conversations. The increased volatility and sensitivity in bond prices are clearly for us an indication of the system adapting in true "Anna Kareninia principle" fashion leading to an overall significant build-up in "instability":
"Corporate-bond prices are experiencing bigger swings as policy makers debate slowing the economic stimulus that’s boosted the Fed’s balance sheet to $3.8 trillion. The central bank may start reducing bond purchases as soon as December, according to 59 percent of 41 economists in a Sept. 18-19 Bloomberg survey.
After cutting a broad measure of corporate and some asset-backed debt from a peak of $235 billion in October 2007, dealers pared investment-grade holdings to a net $11.5 billion as of Oct. 9, Fed data show. That’s down from $13.5 billion at the end of May, when Fed Chairman Ben S. Bernanke said sustainable labor-market progress could prompt a reduction in the $85 billion of monthly bond purchases through the quantitative easing program." - source Bloomberg

We used a reference to Bastiat in relation to liquidity and Credit Markets in our conversation "The Unbearable Lightness of Credit": "That Which is Seen, and That Which is Not Seen". 

As we have argued in so many conversations, the credit space is still enjoying a "sugar rush" courtesy of our Central Bankers", and to quote again our friend Anthony Peters in one of his column:
"Somewhere out there, the next big bubble is forming and it will catch the unwary cold. Banks no longer have the risk capital to make big markets in all issues, least of all unconventional ones, and investors would be well served to ask themselves now where the pockets of liquidity will be when they are most needed. Don't disregard the old definition of liquidity as being something which, when needed, isn't there. I can't say where that there will be but I can be pretty certain that it won't be in corporate perp land. I rest my case." - Anthony Peters - IFR - Investors queue up for perp walk

"If you think liquidity is coming back in the credit space, then you are indeed suffering from Anterograde amnesia" - Macronomics - May 2013 - "What - We Worry?"

Of course when it comes to the "Anna Karenina principle" as well as Bayesian learning history shows the final phases of rallies have provided some of the biggest gains.
But we are drivelling again given in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

On a final note, given shipping has been our favorite deflationary indicator we give you the latest reading of the Drewry-Hong-Los Angeles container rate benchmark given it will be raised again by $400 USD on the 15th of November on all US destinations - graph source Bloomberg:
"The Drewry Hong Kong-Los Angeles container rate benchmark was unchanged at $1,736 in the week ended Oct. 30, holding at the lowest level since December 2011 ($1,436) for a third week. Even with six increases in 2013, rates are 27.7% lower yoy and down 21.6% ytd, as slack capacity continues to pressure pricing. Carriers are expected to implement a $400 general rate increase on containers from Asia to all U.S. destinations, effective Nov. 15. Containership lines have announced 11 rate increases, totaling $4,850, on Asia-U.S. routes since the beginning of 2012. The increases have largely failed to hold because of excess capacity and a sluggish global economy. As such, benchmark Hong Kong-Los Angeles rates have only risen 21% since the end of 2011 and are down 33% yoy. In a Bear Case scenario, operators will continue to struggle to sustain rate increases." - source Bloomberg

"Even the Fed does not have access to large enough printing presses to keep these correlations going once they start to turn negative." Martin Hutchinson - "Forced Correlations" published in Asia Times

Stay tuned!

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