Tuesday, 18 July 2017

Macro and Credit - The Rebound effect

"Credibility is a basic survival tool." Rebecca Solnit, American writer

While listening to the somewhat "dovish" comments of Fed in chief Janet Yellen as of late, we reminded ourselves for our title analogy of the "Rebound effect", being the emergence or re-emergence of symptoms that were either absent or controlled while taking a medication, but appear when that same medication is discontinued (QE taper), or reduced in dosage. In the case of re-emergence, the severity of the symptoms is often worse than pretreatment levels, such as valuations we would argue which are somewhat rich according to Janet Yellen. Obviously in "Rebound effect" one could argue that "rich" valuations get richer even with discontinuation of sedative substances. It seems that Janet Yellen's words have fallen on deaf ears given her latest "dovish" comments have had no effect to the partygoers who have gotten seriously intoxicated on the Fed's punch bowl in recent years as indicated by the ultra-low levels of volatility reached in various indices (VIX, MOVE, to name a few). Even implied credit volatility is steering towards historical lows while inflows into Investment Grade credit in 2017 have been spectacularly strong. 

In this week's conversation, we would like to look at low volatility in the credit space as yet another sign of complacency. While everyone is basking in the sun, we think that a return in volatility is lurking in the shadows yet Goldilocks in credit, one would have to admit has been saved again by a more Dovish tone from Janet Yellen. We wonder if the Fed's chair is not more interested in preserving her legacy while still at helm, hence the more recent rhetoric but we digress.

  • Macro and Credit - Oh My God! They Killed Volatility!
  • Final chart - Get over it, the Phillips curve is dead.

  • Macro and Credit - Oh My God! They Killed Volatility!
One could easily opine that the biggest effect from overmedication from our "Generous Gamblers" aka our central bankers, has been the disappearance of volatility thanks to financial repression. As our tongue in cheek bullet point reference to the old South Park catch phrase, one might wonder if this low volatility regime will end, now that the narrative has been more hawkish somewhat as per our recent conversation "The Trail of the Hawk".

In similar fashion to Le Chiffre, aka Mario Draghi from the ECB, Janet Yellen has as well steered towards "Credit mumbo jumbo", which has had a much vaunted "Rebound effect", at least for US equities. Yet Janet Yellen's "rich" valuation word has been totally ignored by the leveraged and carry crowd, particularly in European High Yield seeing as well not only record issuance numbers but also loose covenants and record tight credit spreads as reported by Bloomberg on the 17th of July in their article entitled "Europe's Junk-Bond Boom Triggers Alarm as Safety Nets Weakened":

"The whole European junk bond market is on track for the busiest July on record, whereas issuance in the U.S. is waning. So far this month, sales swelled by 400 percent from the same period last July, while equivalent U.S. offerings dropped about 75 percent, Bloomberg data show.
- source Bloomberg

While we recently mused that gamma hedges in credit were cheap, while credit remains an attractive carry trade in this long in the tooth credit Goldilocks scenario, as we indicated last week, it's not only in the VIX that there has been systematic selling of volatility for income. The game has also been played in the credit world. The warnings sent by our central bankers have continued to fall on deaf ears and the "beta" game is continued to be played although, recently High Yield fund flows have been weaker. What goes up often goes down to paraphrase Mark Yusko from Morgan Creek's previous quarterly gravity parabola. We would add that what goes too tight often goes too wide in relation to credit spreads. That was at least the story for the second part of 2016 when it comes to the Energy sector. But, as we indicated recently, it seems to us that in terms of risk-reward, High Yield has moved from expensive or "rich" to super expensive and in particular Euro High Yield. On that note we agree with Richard Barley's article in the Wall Street Journal entitled "The Vanishing Reward for Buying High-Yield Bonds":
"The risk premia on high-yield bonds in the U.S. and Europe were negative in June, PPMG calculates. The extra yield wasn’t enough to compensate investors for the risk of owning them over time.
This has happened before, most recently in 2014. That was followed by a selloff that gathered pace in 2015 as the falling oil price hit energy-company balance sheets, most notably in the U.S. There may not be an immediate catalyst for the market to fall now. But for investors buying high-yield bonds, the risk-reward balance doesn’t look encouraging."  - source Wall Street Journal
Although oil prices have been under pressure in 2017, credit has been widening at a much slower pace than what we saw in early 2016. It seems to some instance that overmedication have led to some sort of permanent anesthetization and significant complacency although central bankers have started reducing in earnest the prescription drugs recently. Many pundits have been impressed by how resilient credit has been in the latest bout of Sovereign yields volatility. Everyone and their dog has been focusing on the low levels touched on VIX as indicative of the current complacency, but, if there is one asset class that has shown low volatility for different reasons than the equities space, it is in credit. On that subject we read with interest Morgan Stanley's take from their Credit Derivatives Research note from the 14th of July entitled Vol AWOL.
"Over the past year, we have analyzed credit valuations through several frameworks and found US credit markets to be rich most ways we slice them. Spread per leverage is close to all-time tights, and spread per duration has rarely been lower, while the quality of the IG market has deteriorated over time (see Investment Grade Research: Not Your Parents’ Market). The one exception is that credit spreads adjusted for the level of volatility still look attractive relative to history. In other words, if this low-vol environment persists, then credit may remain an attractive carry trade.
In our view, the recent bout of low volatility (implied and realized) is yet another sign of complacency in credit markets. And while volatility has been low this year, it is worth remembering that we have seen considerably higher return volatility in this cycle than in prior bull markets, with IG and HY spreads hitting ‘recessionary’ levels twice (2011, 2016).
Therefore, focusing on just the last 3-4 months misses the bigger picture. In our view, central banks have been somewhat successful in this cycle at responding to periods of tighter financial conditions, muting volatility in the process. We believe recent hawkish rhetoric out of many global central banks, on top of the Fed pushing ahead with its plan to continue hiking rates while shrinking the balance sheet is a clear catalyst for vol to again rise (see US Fixed Income Strategy: Trading the Fed's Balance Sheet). And when that happens, buying credit as a carry trade at very tight spread levels will no longer look as appealing.
Just as investors have reached for yield in this cycle, low implied volatility levels have also been driven by a search for income, a trend that has accelerated at tight spreads. We think both fundamental (central bank policy) and technical (systematic selling of vol for income) factors have driven volatility to these low levels, and an unwind of these dynamics could impact volatility in the other direction on the way down. In this week’s report, we dig into credit volatility in more detail.
Volatility and Valuations
We start by looking at the current level of volatility in credit markets on an absolute basis and in the context of credit valuations. In Exhibit 3 below, we show the level of 3M implied volatility for CDX HY.

Quite simply, implied volatility is close to historical lows across many asset classes. In the context of credit vol specifically though, we would note a few additional points. First, the repricing in credit implied volatility has been more meaningful when compared to prior lows. For example, CDX HY 3M implied vol recently hit a level of 3.5% vs. 5.2% at the tights in spreads in 2014. In comparison, 3M SPX implied vol hit a recent low of 9.6%, marginally below the lows of 2014. Second, on a historical basis, implied credit volatility trades closer to realized than in many other markets (Exhibit 4).
The importance of low volatility for credit markets should not be understated. Credit is a low-beta asset class and is inherently short volatility and tail-risk. At low yields and tight spread levels, the case for credit rests in part on attractive risk-adjusted returns. Low levels of volatility boost ‘carry’ trades, make fund Sharpe ratios look better and of course, are a general barometer of risk appetite. In Exhibit 6 below, we show trailing CDX IG spreads normalized by the level of 3M price volatility. Volatility-adjusted spreads clearly do not look as extreme as other metrics, like spreads adjusted for balance sheet leverage (Exhibit 5).

The risk with looking at spread/vol is that volatility is backward looking and is much less stable than a fundamental measure like leverage. For example, 3M realized price volatility in CDX IG would need to rise by just 0.3% for vol-adjusted spreads to trade back to historical averages. In addition, an ‘extreme’ level of spread/ volatility has not been a great predictor of future market performance. In Exhibit 7 below, we break-out the spread to volatility ratio into different buckets and show the average 1M forward index return and hit rate of performance (percentage of times returns are positive). Across both these metrics, we find that when spread/vol is high, returns going forward tend to be low and positive returns are less frequent.

Drivers of Low Realized Volatility
There are clearly many drivers of the current low vol environment. While we won’t spend much time on the fundamental elements, central banks have clearly played a role. As Exhibit 8 shows, this cycle has been characterized by elevated uncertainty and multiple growth scares. 

These environments have led to big waves of spreads widening. However, each of these episodes have also been followed by unprecedented levels of stimulus from the Fed as well as other global central banks. This ‘Fed’ put has no doubt muted volatility, at least for extended periods of time in this cycle.
Beyond central banks, portfolio dispersion has also played a role in low volatility levels this year. In fact, we think the current low level of volatility is masking some underlying dynamics in the CDX market. For example, dispersion in US credit is actually higher today than it was at the tights of the cycle in 2014. We try to show this using two charts: First, comparing the widest 10 names in the CDX IG index vs. the rest of the portfolio (Exhibit 9).

Second, we look at the standard deviation of weekly cross-sectional spread changes for the CDX IG constituents and normalize it by the level of volatility (Exhibit 10).

Both these metrics show that credit dispersion is higher today than it was at the tights of the cycle back in 2014. Effectively, this has played some role in keeping the index levels more range-bound and less volatile than may be the case otherwise.
In the equity market, very low levels of single-stock correlations have helped drive low realized volatility. In that sense, this dispersion dynamic in credit markets is not that unique. However, we would highlight an important distinction. The low correlation level in equities seems more about sector rotation (Tech unwind, value vs. growth) and certain sector-specific factors (Financials). In credit, the drivers of dispersion are mostly negative stories related to certain sectors that either face structural or fundamental challenges (e.g. Retail, Energy, Autos). As we have noted in the past, issues in credit tend to show up first in the most fundamentally stressed sectors, and are initially treated as idiosyncratic. Eventually, the stress spreads to the broader market as credit conditions tighten. As a result, we would not use the dispersion argument in credit to justify low volatility levels over a long period of time.
Drivers of Low Implied Volatility
Having discussed some of the drivers of low realized volatility, we now shift to the drivers of implied credit volatility. The first point we note is the move lower in implied is not just a function of low realized volatility. For example, at the tights of the cycle in June 2014, CDX HY 3M vol traded 1.45x 3M realized vol and CDX IG traded 1.29x 3M realized vol. Today, CDX HY vol trades 1.17x, whereas IG trades 1.19x. We see a similar trend of implied compressing to realized when comparing the credit and equity markets. However, historically, credit implied vol has traded at a larger premium to realized than the implied premium to realized in the equity market. In recent months, this relationship has flipped (i.e., a lower implied/realized ratio in credit than equities).

More specifically, looking just over the past 12 months, we have noticed a large pick-up in systematic selling of credit volatility. Anecdotally, these investors have been most active in shorter-dated expiries. In Exhibit 12, we show 1M and 3M implied volatility levels in CDX IG to highlight the importance of these flows. While 3M implied spread vol in IG is just ~3.5% below the average levels around cycle-tights (June 2014), 1M implied volatility has repriced even more meaningfully, lower by 5%.
Broadly, this selling of volatility in the credit options market, motivated by the same global reach for yield driving flows into US credit, has helped compress implied volatility to new cycle lows. Arguably, as credit valuations richened, these flows if anything strengthened as the relative benefit of selling options (vs. long spreads) became more attractive.
To the extent the selling of volatility is driven by an income-generating alternative to long carry via spreads, we think these flows may be reaching a limit. Implied volatility, when adjusted by historical index spreads levels, is already very low. We show this in Exhibit 13 below.

For example implied CDX HY spread vol today is around 27%, relative to a regression implied level of 36% based on the last 7 years of data. Also, as we mentioned earlier, historically, implied credit volatility used to trade richer to realized than many other asset classes. This is not the case today and hence selling credit volatility may not look as attractive on a cross-asset basis.
At the other end of the spectrum, demand for credit option hedges has also slowed down quite meaningfully. Large non-economic buyers of credit vol, such as banks, have been much less active this year relative to prior years. Anecdotally, the lower demand for credit hedging has been driven by expectations for easier capital requirements around less onerous stress scenarios.
Bigger picture, in our view, the conditions for volatility to remain low seem to be fading. For example, central bank rhetoric globally has turned hawkish at the margin, with the Fed seemingly more focused on financial conditions as well as risk-asset valuations. And when volatility does start picking up, some of the technicals noted above that have pushed it to such low levels, could exacerbate volatility on the way down. Just as strong and consistent flows have pushed spreads to very tight levels in this cycle multiple times, but when these flows turn the other way, weak liquidity has driven sharp moves in the other direction." - source Morgan Stanley

As we have reiterated recently, the credit mousetrap is coiled and has been set by our "Generous Gamblers". Of course flow wise the credit mouse trap continue to be coiled on a weekly basis, particularly in Investment Grade Credit according to Bank of America Merrill Lynch Follow The Flow note from the 14th of July entitled "Not giving into your (rates) tantrum":
"IG inflows are strong and stable
The high volatility in the rates markets has done little to deter the inflow stream into high grade funds. The resilience of the credit bull story (thanks for the backdrop of CSPP) is proving strong. This is evident in the divergence seen in fixed income flows, as IG credit fund flows remain high and positive, while government bond flows have moved into negative territory.
Over the past week…
High grade funds recorded another week of inflows; their 25th in a row and the third consecutive one above the $2bn mark. High yield fund flows remained negative for a third week and we note that the volume of the outflow has remained strong for a second week. Looking into the domicile breakdown, the aggregate number has been pulled down predominantly by European-focused funds, just as US focused funds flows were negative for the sixth consecutive week.
Government bond fund flows turned negative for the first time in six weeks. Overall, Fixed Income funds recorded their 17th consecutive inflow, again predominately driven by strong flows into IG credit funds." - source Bank of America Merrill Lynch
The Rebound effect is still going strong credit wise. Investors continue chasing yields, having both extended their duration and credit risk in recent years thanks to central banks meddling and selling volatility as well. No wonder volatility has been neutered. As we pointed out last week, there is a growing disconnect between fundamentals from the real economy and asset prices. We have used this analogy before of Disney's Fantasia movie and the sorcerer's apprentice. At some point having poured so much water (liquidity) our little apprentice finally loses control and eventually the old and wise wizard has to step in (BIS?). We are slowly but surely getting there. Are central bankers ready to take the proverbial credit punch bowl away? We wonder. 

Right now there are still a lot of buyers in credit with still so much liquidity sloshing around but clouds are gathering such as the US debt limit falling in the first half of October. To repeat ourselves, in the current Goldilocks scenario for credit, there is still room for further credit spreads tightening. With such strong inflows, unless we see some exogenous geopolitical factors coming into play, even with the most recent toned down rhetoric from Janet Yellen, it is hard to see just yet a change in markets volatility dynamics. As this long rally continues to be hated by so many, eventually Goldilocks will finally catch up with the three bears but it isn't the time yet. For now it is still yield chasing time but you would be well advise to start building up some "duration" and "credit" defenses while it is still cheap, just a thought. 

In our conversation "The Trail of the Hawk" we indicated that cheap gamma could be found in credit options and that in Investment Grade there were relatively cheap to own. You might already been wondering if there is a trade here. On that subject we read with interest Bank of America Merrill Lynch take in their Relative Value Strategist note from the 13th of July entitled "Volatility is low. In credit, especially so":
"Within credit, IG vol appears cheaper than HY
As we wrote recently, the plunge in oil prices and weakness in retail names have made HY quite vulnerable to macros risks. The implied vol premium in HY reflects that risk. However, the realised volatility of HY hasn’t really increased relative to IG. As a matter of fact, the beta is near its lows
Is there a trade here?
The divergence between credit volatility and comparable equity metrics has persisted for a while now. It is a symptom, we think, of the low volatility-high fragility regime that has characterized markets over the last couple of years.

We are reluctant to recommend a credit-equity relative value trade here for two (related) reasons. One, cross-asset beta has been very unstable and it is difficult to pick the ‘right’ value with any degree of confidence. Two, we suspect that unless the economic cycle turns, stocks are likely to respond more aggressively to shocks than credit i.e. the risk premium in equity vol is probably justified. All that said, for those looking for a low cost hedge, IG volatility appears to be the cheapest here, relative to equities and HY.
Why is credit volatility so low?
There are several explanations for this persistently low implied volatility. For one, there are simply more sellers than buyers. CDX options, unlike their counterparts in other asset classes, don’t enjoy a deep well of sponsorship among real money asset managers as a hedging tool. Among those who do employ derivatives, the bias has been towards selling volatility as a means to generate premium. This leaves banks as the sole structural buyers of index options. Secondly, implied volatility is low because realised volatility has remained persistently low. CDX IG has been realising less than 30% (annualised daily spread) volatility for a little over 6m now, longer than similar stretches in 2014 and 2015. Finally, economic data volatility has been subdued. While there have been some signs of weakness, the economic narrative hasn’t shifted dramatically. If economic volatility returns, either through the Fed committing a policy mistake or by falling behind the curve, we think credit volatility will follow suit." - source Bank of America Merrill Lynch
Whereas High Yield has remained more sensitive to macro risks such as the variation in oil prices, Investment Grade credit volatility has remained subdued hence its relative cheapness. Even in credit, when it comes to volatility, there is a simple rational behind the low level reached, there are simply more sellers than buyers as pointed out in Bank of America Merrill Lynch's note:
"Why is credit volatility so low?
The evident reason: more sellers than buyers CDX options, unlike their counterparts in other asset classes, don’t enjoy a deep well of sponsorship among real money asset managers as a hedging tool. While some may choose to hedge using the underlying index, the practice isn’t prevalent among a majority of money managers. Among those who do employ derivatives, the bias has been towards selling protection or selling volatility as a means to park incoming funds while ramping up the portfolio or simply to generate carry/premium. This is particularly true in CDX IG, where for several years now there has been a large non-dealer long base in the index.
The reluctance to hedge with derivatives can be attributed to a few factors. For many, it
may just stem from unfamiliarity with the product and never having used derivatives
There is also the issue of mismatch between cash credit portfolios and CDX. CDX IG
doesn’t include any Banking names, which is the largest sector within High Grade.
Similarly, until recently CDX HY had very few Energy names even though the sector is
one of the largest in High Yield.
Corporate bond benchmarks and the portfolios that follow them are weighted by market capitalization, making them highly sensitive to the largest debt issuers. In contrast the CDX portfolio is equally weighted.
Beyond differences in portfolio construction, there is also the fundamental question of risk i.e. what is the exposure that needs to be hedged? CDX is a spread product, a vehicle to gain exposure to pure credit risk. However, most high yield accounts and more than half on the high grade side are ‘total return’ investors i.e. they are sensitive to both spreads and rates.
There is very little default risk in high grade portfolios and at the portfolio level there is perhaps more concern with hedging duration risk than credit risk. Also, since rates and spreads are negatively correlated, spread widening is often accompanied by lower rates, which softens the PnL impact.
In high yield, we also think there is some ‘hedge fatigue’. Because the CDX HY index did a poor job of representing the cash market in the past, it has not always held up as a good hedge for high yield bond portfolios. This issue has been corrected to some extent with changes in the index composition, but past experience perhaps continues to sting.
All this leaves banks as the sole structural buyers of credit options. They tend to buy low delta payers to hedge their loan books or origination activity or receive regulatory capital relief, among other things. What’s more, this technical is largely isolated to IG." - source Bank of America Merrill Lynch
So all in all, there much more concerns for investors with hedging duration risk rather than credit risk when it comes to Investment Grade credit. The risk of a "convexity event" with the perilous exercise of the reduction of the Fed balance sheet means that the focus should rather be on bond volatility and its indicator the MOVE index in the coming months. Obviously the recent dovish tone from Janet Yellen is we think representative of our "Generous gamblers" concerns with bond volatility given leveraged players and carry speculators, only love one thing and that's low rate volatility. Our central bankers are walking on a tight rope. After having coiled the volatility spring with their financial repression, they are trying to unwind it at a slow pace and avoid rocking the boat. It remains to be seen in the coming months how they are going to pull it off. 

While volatility seems to be at the moment "flatlining", so is the Phillips curve dear to the economists at the Fed, in true "Japanese" fashion as per our final chart. On a side note we have become more positive on gold and gold miners as of late thanks to Janet Yellen, therefore playing the "Rebound effect".

  • Final chart - Get over it, the Phillips curve is dead.
Back in our May conversation "Wirth's law" we confided that we were part of the crowd claiming the death of the Phillips curve. As well, back in our January conversation "The Ultimatum game" we argued that the Phillips curve was dead because because the older a country's population gets, the lower its inflation rate in true "japanification" fashion. Our final chart comes from Deutsche Bank FX Daily note from the 14th of July entitled "When the Fed's punch bowl lacks punch" and displays the Phillips curve being flat on its back:
"From this we can conclude:
i) There is extreme inertia built in to inflation’s response to changes in economic activity, even if it is possible that the Phillips curve steepens in extreme circumstances of over and under capacity.
ii) The corollary is it is extremely difficult for the Fed to impact inflation through activity/growth measures. The Fed (and the Fed is not alone among Central Banks) has lost control over a half of its mandate.
iii) While doctrinaire goods and services inflation targeting persists, price cyclicality will be concentrated in larger asset price cycles. One difference between asset inflation compared with traditional goods & services inflation is that asset inflation also leads growth measures. The cycle then tends to show up as follows: asset inflation driving up capacity utilization, which does not show up meaningfully in traditional CPI measures, that leaves policy overly accommodative, that pumps up the asset cycle, until asset prices reach such extremes they turn on themselves.
iv) At least while the Phillips curve framework is being adhered to, the Fed will be very slow to ‘take away the punch bowl’.
v) The outstanding question for the Fed watchers is how will Fed deal with the status quo over the next year? IF inflation remains slightly below target, bonds handle the Fed balance sheet adjustment reasonably, risky assets remain strong, and growth remains at or above trend, will the Fed tighten in 2018? At least while the market cannot firmly answer in the affirmative, the USD is going to find limited support, especially against higher yielding currencies.
vi) The market assessment that there is more punch to be drunk, is probably correct. It still looks too early to bail-out of the positive risk story. In part because we have seen this narrative before in the late 1990s, asset froth in this cycle is prone to build more slowly and to lesser extremes. The Fed may have lost control, but the market will exert greater self-control. 
The optimistic risk conclusion is: drinking slowly from the punch bowl, extends the party – and should help with the hangover." - source Deutsche Bank
It looks to us that "The Rebound effect" is pushing towards a final melt-up regardless of the narrative of our "Generous Gamblers". For now, everyone keeps dancing, particularly in Investment Grade credit and in similar fashion to 2007, market makers keep getting hit on the bid, whether on CDS or Credit Options and continue to feel the pain of not being able to recycle effectively the relentless tightening seen in credit. As the sorcerer's apprentice in 1940 Disney's Fantasia movie, we would have to agree with Deutsche Bank, that the Fed has lost control and has tried too hard to exploit the Phillips curve as per Robert Lucas' critique. When unemployment becomes a target for the Fed, it ceases to be a good measure because like in Japan, over the years, wage growth - in both per worker and per hour terms - has become less responsive to changes in the unemployment rate. Subdued job switching is due to a mismatch between jobs and worker skills. To repeat ourselves, what matters is the quality of jobs but we should add that to ensure Americans are great again, they need to get better skills for the jobs being advertised and that goes through training. The Fed's models are built on past relationships. What these PhDs at the Fed need to understand is that these relationships change over time, making these models less reliable. At least you know that they will be slow in removing the punch bowl for the time being, that's a given. For more on the subject of the Phillips curve, we encourage you to read Hoisington Quarterly Review and Outlook for the Second Quarter 2017, a must read in our humble opinion. For now one could conclude from our conversation that "rich" valuations will get richer even with discontinuation of sedative substances. Sic transit gloria mundi...

"All things are only transitory." -  Johann Wolfgang von Goethe

Stay tuned!

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