"The seed of revolution is repression." - Woodrow Wilson, American president
"Each day in the Republican Calendar was divided into ten hours, each hour into 100 decimal minutes, and each decimal minute into 100 decimal seconds. Thus an hour was 144 conventional minutes (more than twice as long as a conventional hour), a minute was 86.4 conventional seconds (44% longer than a conventional minute), and a second was 0.864 conventional seconds (13.6% shorter than a conventional second).
Clocks were manufactured to display this decimal time, but it did not catch on. Mandatory use of decimal time was officially suspended 7 April 1795, although some cities continued to use decimal time as late as 1801." - source Wikipedia
"Historically the highest prices touched by wheat prior to the French Revolution were in 1789. Between 1780 and 1788, the average price for a "setier" of wheat (setier was an old French units of capacity equating to 156 liters), was stable between 19 pounds and 13 shillings and 25 pounds and 2 shillings. Between 1786 and 1787 the price was stable at 22 pounds a setier. In 1788 it rose by 15% but in 1789 it rose by 36% in one year, touching 34 pounds and 2 shillings. The harvest for 1788 was one third lower and this impact was sufficient enough to trigger the doubling of prices in the period 1788-1789. Just before "Bastille Day" on the 14th of July, there was a tremendous storm on the 13th of July 1789 which caused massive destructions to crops.
Wheat prices in "pounds per setier" units on the 24 of June every year from 1728 until 1789, source - "Le prix du blé à Pontoise en 1789" by Dr Florin Aftalion.
The proper French revolutionary period (1789-1794) was characterized by poor harvests and very similar meteorological factors witnessed in 1788 and 1789, namely very hot spring-summer periods with very bad weather followed by very cold winters (-21 degrees Celsius in Paris during the winter of 1788), of course any similarities with this year's meteorological events are purely fortuitous given we are rambling again...Are we?" - source Macronomics, September 2012
The policy baton is passing from Monetary to Fiscal stimulus in 2016/17. Central bank
rate cuts ending. New policies to address populist desire for "War on Inequality"
emerging. Policy response will be combination of:
1. Redistribution…stagflationary: winners…TIPS, munis, low-end consumption (retail,
payments, tax services); losers…brokers, luxury, growth stocks; yield curve bear
2. Protectionism…deflationary: winners…government bonds, gold, volatility, high
quality defensive stocks; losers…banks, multinational companies; yield curve bull
3. Keynesianism…reflationary (with “helicopter money): winners TIPS, commodities,
banks, value; losers…bond substitutes; yield curve bear steepens.
Fiscal flip reflects policy intent to reduce deflation, wealth inequality and wage
insecurity. Success means rotation from “deflation” to “inflation” assets; note real
assets (commodities, collectables & real estate) now at all-time lows relative to financial
assets (stocks & bonds) – Chart 1.
- source Bank of America Merrill Lynch
“There’s some risk that you lock in this policy for too long a period,” he stated. ”Once inflation gets out of control, it takes a long, long time to fix it”
"Whereas we disagree with Bank of America Merrill Lynch is with their US economy views, we believe that the US economy is weaker than what meet the eyes and that their economists suffer from "optimism bias" we think (more on this in our third bullet point), but nonetheless high quality domestic issuers are definitely credit wise a more "defensive" play.
We think that for "credibility" reasons, the Fed had no choice but to hike in December given the amount spent in its "Forward Guidance" strategy and in doing so has painted itself in a corner. We ended up 2015 stating that 2016 would provide ample opportunities in "risk-reversal" trades. The latest move by the Bank of Japan delivered yet another "sucker punch" to the long JPY crowd. Obviously, should "risk" decide to reverse course in 2016, there will be no doubt potential for significant rallies in "underloved" asset classes such as Emerging Market equities. But, for the time being, the macro picture is telling us, we think that regardless of how some pundits would like to spin it, not only is the credit cycle past "overtime" and getting weaker (hence our earlier recommendations in our conversation) but, don't forget that there is no shame in being long "cash". It is a valid strategy." - source Macronomics, January 2016
- Macro and Credit - Is it High Noon for US High Yield tourists?
- Macro and Credit - Investing Greed leaning towards Investment Grade
- Final chart: Bank stocks under pressure? Blame central banks
- Macro and Credit - Is it High Noon for US High Yield tourists?
"Furthermore, despite their alleged high degree of sophistication, credit investors have a very weak predictive power on future default rates. This was largely discussed by our Rcube friends in their long March 2013 guest post entitled "Long-Term Corporate Credit Returns":
Spreads moves between June 2007 and October 2008 (from 250bp to 2000bp in just 16 months) were a great illustration of this manic-depressive behaviour (which can also be related to Minsky’s model of the credit cycle)." - source Rcube
From a medium term perspective and assessing the "credit cycle" we believe the latest US Senior Loan Officer Survey points to yet another "warning" sign in the deterioration of the on-going credit cycle which has been so far pushed into "overtime" by central banks with ZIRP and their various iterations of QEs.
"When default rates are low, credit investors believe that stability is the norm, and start piling up on leverage, inventing new instruments to do so (CLOs, CDOs, CPDOs etc.). This recklessness leads to mal-investment, and sows the seeds of the next credit crisis." - Macronomics, November 2015
"Q2 Lending Conditions: Why did lenders tighten?
A critical linchpin in our frameworks for assessing credit spreads, defaults and the read-through to macro implications is the state of lending conditions. And, to cut to the chase, recent releases could aptly characterize current conditions as increasingly uncomfortable, albeit not alarming. The improvement in our non-bank liquidity indicator since March has stalled, with the latest reading rising from 7 to 9.1 – principally due to less robust issuance of lower-quality high yield debt since April. In our view, this gauge is superior to the Fed's SLOS survey tracking bank liquidity conditions given nearly 80% of corporate funding is done via non-banks. That said, our non-bank indicators have now largely converged with the Fed's bank liquidity gauge, with net tightening of credit standards on C&I loans to SMEs increasing from 5.8 to 7.1 in the latest survey (Figure 1).
Notably, we do not believe the latest SLOS survey results were significantly affected by the UK's Leave vote (as banks received the survey on June 28, and responses were due by July 12). For C&I lending conditions, the rationales given from bank loan officers for shifts in lending standards continued to be dominated by net tightening attributed to a weaker economic outlook and industry problems versus net easing due to competition; however, in terms of shifts there were fewer officers reporting industry specific problems (e.g., energy, but prior to the latest decline in oil prices) as a reason for tightening, more respondents citing lower risk tolerance and higher regulatory concerns as rationale for tightening, and more noting increased competition as a driver of easing (Figure 2).
And lower risk tolerance and greater regulatory pressures would be consistent with sentiment from the latest Shared National Credits (SNC) review, which continues to highlight concerns related to an elevated level of special mention and classified (i.e., higher risk) loans which may increase defaults this cycle and the prevalence of incremental facilities allowing greater sharing of priority claims which may lower recovery rates1 . In terms of our key forecasts, our HY spread forecast increases from 660bp to 666bp (vs 566bp current), our HY default forecast is unchanged at 5 – 5.5% by mid-2017, and our credit-based probability of recession rises to 33% from 31% (over the next 12mos).
Why the discomfort? First, the persistent albeit moderate tightening trend in C&I liquidity conditions bears watching as the relationship is not linear; i.e., further increases in net tightening from current readings will disproportionately increase spreads, defaults and recession risks in our models, respectively, when compared with commensurate decreases in net tightening (e.g., see recession gauge sensitivities on net tightening – Figure 4).
Second, our prior concerns related to significant easing of lending standards and rising credit risks in other sectors seem to be trending in the wrong direction2. In particular, lending standards for commercial real estate (CRE) loans contracted further, with aggregate (debt-weighted) net tightening of 27% from 20% the prior quarter (CLD to 31% from 25%, nonfarm nonresi to 18% from 12%, and multifamily to 44% from 36%). While not cited, we believe the tightening reflects increased regulatory scrutiny (e.g., 2006 CRE guidance, risk retention requirements) as well as concerns around lax lending standards and lofty valuations.
At current levels, the significant tightening observed in CRE standards, which is historically reasonably well correlated with C&I standards (as we have detailed previously), is near historical extremes (as per Figure 4).
Aside from commercial lending, the mosaic from consumer and residential sectors has been more benign in prior surveys. However, there were some signs of less easing in consumer loans – with net tightening in auto loan standards moving from -6.3 to 0 (while in credit cards net tightening was -5.6 vs -5.7 the prior quarter). Banks reported higher spreads on auto loans, and higher spreads and lower credit scores for credit card loans. For residential loans, the SLOS survey overall signaled marginally less easing – i.e., the second derivative is negative. However, like C&I loans, residential lending is primarily driven by non-bank lending (Figure 5).
In turn, the Fed's SLOS survey results should be taken with a grain of salt. One alternative, which encompasses non-bank lending, is the AEI's change in its National Mortgage Risk Indices (NMRI) 3 . This metric, updated monthly and based on actual loan origination risk metrics, suggests that while banks are reducing risk in residential originations (for FHA/VA/RHS primarily), non-banks are increasing risk in a bigger way – causing a net easing of credit conditions in resi. This point illustrates that non-bank lending standards are increasingly (if not more) important than bank lending conditions in some asset classes and, in particular, in instances when the signals can diverge. And, in this instance, continued easing in residential mortgage credit conditions is one development which is helping offset the more persistent, marginal to moderate tightening in lending standards across other asset classes. In short, for now the prognosis is increasing discomfort, but not alarm." - source UBS
"Bruce Karsh: How does this credit cycle resemble and differ from past credit cycles?
Rajath Shourie, Co-Portfolio Manager, Distressed Opportunities: The down-leg of the current cycle feels most like the down-leg we experienced in the early 2000s, when too much capital came into a popular industry; that industry blew up; and the dislocation spread to other industries. In the early 2000s, telecom was the darling industry that went bust. Today it is energy. In the early 2000s, a majority of the high yield bonds issued by telecom companies defaulted, and unless oil prices make a major recovery, today’s exploration and production companies are likely to face a similar fate.
Jordon Kruse, Co-Portfolio Manager, Global Principal: I’ll focus on a comparison of the current downleg to the one we experienced in 2008-09. They are similar in that both followed long periods of significant debt issuance, but different in that there is far less systemic risk today than there was in 2008-09. A major driver of that risk was the substantial amount of bad mortgage securities held by large financial institutions that played a major role in the financial system at large.
Bruce Karsh: What is your expectation for defaults this year?
Sheldon Stone: The 2016 default rate for U.S. high yield bonds is projected to increase to between 5 and 6%. This compares to the 2015 default rate for U.S. high yield bonds of 2.8% and the 30-year average of 4%. While this 2016 estimate is higher than what we’ve seen since 2009, it is not meaningfully higher than normal observations. As you would likely guess, defaults this year already have been—and will be—heavily impacted by oil prices. I believe that easily two-thirds, or maybe even three-quarters, of the defaults this year will stem from energy-related issuers.
Bruce Karsh: Outside of China, what factors do you think are exerting the greatest impact on the current market environment?
Sheldon Stone: The obvious ones are low energy and commodity prices; however, those are linked to China. The other one worth highlighting is liquidity. Current trading markets are significantly less liquid, causing rapid changes from a buyer’s market to a seller’s without large trading volumes. We estimate that today, banks are carrying about 20% of their 2007 peak inventory of senior loans and high yield bonds. As a result, banks are now looking for trades to cross, rather than putting their capital at risk. It doesn’t take much selling these days to move bond prices a fair amount.
Rajath Shourie: I completely agree with Sheldon. Prices have recently been declining dramatically because there’s a buyers’ strike at play, not because there is a lot of supply from forced sellers." - source Oaktree insights, July 2016
When it comes to "liquidity, to that effect we would like to repeat the quote used in the conversation "The Unbearable Lightness of Credit":Today investors face the same "optimism bias" namely that they overstate their ability to exit.
“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“
- Macro and Credit - Investing Greed leaning towards Investment Grade
"Large outflows from equities; large inflows into IG
Inflows into high-grade have accelerated. Over the past four weeks inflows have been almost doubling on a w-o-w basis. However, while inflows into credit have been strong, equity funds have been suffering continuous outflows over the past 26 weeks. Should the recent trend continue, the inflows that came into the asset class since 2015 would be erased in the next 10 weeks or so (Chart 1).
High grade funds recorded their 21st week of inflows and the highest ever since the start of our data set (table 1).
Flows into the asset class have doubled w-o-w, and propelled the year to date cumulative inflow to over $13bn. High yield funds however reported a substantial outflow, the first in five weeks. The outflows were a mix of global, US and European-focused funds. More in chart 13.
Government bond funds flows switched to positive after two weeks of outflows. Money Market funds flows also turned positive after three weeks of outflows.
Flows into equity funds remained in negative territory for the 26th consecutive week. Almost $80bn has left the asset class over that period." - source Bank of America Merrill Lynch
"Credit has not reached a low in spreads while equity indices are at all-time highs
One of the interesting cross market dynamics recently is that equity markets are reaching new highs while HG bond spreads have been range bound well off of their tightest levels. This month the Dow and S&P reached new peaks and the Nasdaq came close. The JULI spread is at 171bp, 83bp above the pre-crisis low of 89bp (29th July, 2005) and 49bp above post crisis low of 122bp (24th June, 2014). There are several logical explanations for this divergence in performance, but we still believe the trend is for tighter spreads.
The most important explanation is that HG bond yields rather than spreads are the key valuation metric for many now (particularly overseas investors), and they are almost at a record low. The JULI yield is 96bp lower YTD and at 3.32% as of Wednesday it’s just 6bp off its record low of 3.26% reached on July 8th of this year.
The second explanation is the much higher weighting of banks in credit (24.4%) vs in the S&P (5.2%). The banks index of the S&P is not at its post crisis peak – it is 16.4% below the peak reached on 22nd July, 2015.
JULI Financials are at 172bp, 96bp above where they were when JULI spreads were at a pre-crisis low and 54bp above the JULI post-crisis low point. Banks have lagged in both equity and credit markets, but it matters more in credit markets. The third explanation is that 30.5% of the JULI comes from issuers outside the US. Of this 29% is EM and 71% is DM. This subset of the JULI is at a spread of 183bp, which is 93bp and 38bp above where it was vs the pre and post crisis low spread points for the index. Excluding EM these figures are 81bp above and 54bp above for Yankee
issuers." - source JP Morgan.
On balance we view recent developments in global monetary policies from the major central banks as positive for the US HG corporate bond market. At this week’s FOMC meeting the Fed was not as hawkish as investors had feared – specifically they did not prepare investors for a September rate hike. Recall that last year - prior to starting the rate hiking cycle at their December meeting - the Fed had warned the market of that possibility explicitly in the statement from their previous (October) meeting.
In Europe, as our European credit strategist, Barnaby Martin, highlights (see: Resistance is futile), the ECB appears on a mission to deflate credit spreads in the European corporate bond market. This has to drive even more European investors into the US corporate bond market – probably when they come back from vacations in September (Figure 3).
Furthermore, unlike the BOJ the ECB has plenty of ammunition left that – if deployed – would help drive US credit spreads tighter. This includes changes to its capital key (Figure 4) that would direct QE purchases away from bunds toward assets that have more credit risk (see: Brexit pushing Draghi out the curve?).
So we continue to expect accelerating foreign purchases of US corporate bonds during the last part of the year driven by Europe, while Asian buying remains steady – which means strong.
(Reverse) Yankees are coming
In additional to accelerating European demand for US corporate bonds starting in September, we should we expect accelerating reverse Yankee issuance (i.e. US companies coming abroad in non USD currencies). Given what the ECB is doing this is certainly the case for the EUR market (Figure 5), but with global yield starvation we expect increasing reverse Yankee issuance in other currencies too (Figure 6).
That should further support USD credit spreads just like we saw for the banking sector this month post-earnings." - source Bank of America Merrill Lynch
"Honesty doesn’t pay
Spreads took another leg tighter last Monday as CSPP ISINs were disclosed. We sense “doubters” threw in the towel. But we think disclosure rubs both ways. While the aim is to facilitate securities lending – and aid credit market liquidity – we fear the sheer size of CSPP buying has heightened investors’ nervousness over credit market liquidity.
As chart 1 shows, investors are already starting to have concerns over the growth of negative yielding corporate debt across the globe. Note the weakness in European corporate bond spreads over the last 2 days despite equities being up…
How has credit market liquidity fared through CSPP life?
Chart 2 shows the average bid-offer spread (in bp) for investment-grade corporate bonds. We split the universe up into CSPP eligible, non-eligible (non-banks) and CSPP purchased bonds.
We think that the picture shows some encouraging but also some concerning developments:
• What’s clear is that the announcement of CSPP on March 10th initially caused mass confusion in the market. Bid-offers surged and liquidity deteriorated meaningfully in non-financial bonds. Yet, bid-offers remained steady in parts of the market that were expected to be untouched by Draghi (note the calm in non-eligible bid-offers).
• From March 10th until CSPP buying began (June 8th), credit market liquidity improved noticeably. Bid-offers tightened for all parts of the market as CSPP was deemed to be the policy that would rejuvenate the corporate bond market.
• But since June 8th, bid-offers have widened and liquidity has deteriorated again. True, Brexit took place on June 23rd, but nonetheless there has been a drift higher in bid-offers since Draghi started buying credit. And if anything, liquidity seems to have deteriorated further for eligible and purchased names, post the ISIN publication last week.
So while the aim of CSPP disclosure was to preserve credit market liquidity, the initial signs seem to point to something more worrying: that the ECB’s dominance in corporate bond buying is in fact becoming counterproductive for market health.
We think that this will be another reason why investors will want to accelerate their movement into non-eligible parts of the credit market post the summer break. Not only are non-eligible sectors relatively attractive spread-wise now, but they also offer an attractive combination of yield and volatility, we think, compared to CSPP purchased sectors" - source Bank of America Merrill Lynch
- Final chart: Bank stocks under pressure? Blame central banks
- source Bank of America Merrill Lynch
"Our take on QE in Europe can be summarized as follows:
Current European equation:
QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…).
QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?Obviously our "Hopeful equation" suffered from "Optimism bias" and we argued at the time:
When it comes to the Current European equation, we note with interest that civil unrest is a rising global trend." - source Macronomics, November 2014
"Our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015) " - source Macronomics, November 2014Increasingly it looks to us that we are moving towards the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). That's our take and our "realist bias" for now unless of course we finally get a wake-up call from the political class leading to the realization of our "Hopeful" equation but we would not bet on it for the time being.
"Those who make peaceful revolution impossible will make violent revolution inevitable." - John F. Kennedy