Macro and Credit - Intermezzo

"It was one of those March days when the sun shines hot and the wind blows cold: when it is summer in the light, and winter in the shade." -  Charles Dickens

Looking at the pyrrhic victory for the European technocrats in Brussels thanks the consolidation of Germany's Merkel coalition and the results of the Italian elections (which amounts to "Hunga Hunga"), and given the "regime change" put forward by many pundits thanks to the return of volatility after years of central banking repression, when it came to selecting our title analogy we reminded ourselves of the musical term "Intermezzo". In music, an intermezzo is a composition which fits between other musical or dramatic entities, such as acts of a play or movements of a larger musical work. In music history, the term has had several different usages, which fit into two general categories: the opera intermezzo and the instrumental intermezzo. In the 19th century, the intermezzo acquired another meaning: an instrumental piece which was either a movement between two others in a larger work, or a character piece which could stand on its own. As CITI's Chuck Prince said nicely in July 2007:

"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing" - Chuck Prince

To some extent, early market jitters such as the ones caused by the explosion of the pig's "short-vol" house of straw amounted to an "intermezzo" we think. A larger musical work is at play and it is the evolution of the credit cycle. It is slowly and gradually turning, with macro hard data erring on the soft side recently (US durable goods orders falling 3.7% in Jan, vs 2.0% drop expected) while consumer confidence, being soft data, printing on the strong side. When it comes to liquidity, it is being withdrawn by the Fed through its "Quantitative Tightening" (QT). While we have already seen some casualties such as the short-vol ETN complex amounting to the equity tranche in the capital structure, it remains to be seen where and when will the next larger fishes will show belly up at some point down the tightening road, but, we think the time has not yet arrived.

In this week's conversation, we would like to look at the situation of the US Consumer, given in various recent musings we were asking ourselves if he had been "maxed out" and rely heavily these days on credit card use to sustain his consumption habits. As pointed out by famous French economist Frédéric Bastiat, there is always what you see and what you don't see particularly in a country boasting a very high Gini coefficient such as the United States. 

Synopsis:

• Macro and Credit - Thanks to Gini coefficient, when it comes to consumer leverage, it's not always what you see
• Finals chart - Let the good times roll?

• Macro and Credit - Thanks to Gini coefficient, when it comes to consumer leverage, it's not always what you see

Back in March 2017 in our conversation "The Endless Summer" we concluded our long conversation asking ourselves if the US consumer was somewhat "maxed out". We indicated as well that this on-going "Endless Summer" had created a significant windfall for the holders of financial asset. The "wealth effect" has globally lifted all "financial" boats but, in our book a credit cycle's length is around 10 years, so we do believe we are entering the last inning and that the final melt-up in asset prices could be significant before the usual "Bayesian" outcome. When it comes to the US economy, US consumer credit matters a lot. We continue to monitor that space given any weakness in US consumer credit could be an additional sign the US economy is reaching a turning point. In January 2018, in our conversation "The Lindemann criterion", we indicated that measuring the level of indebted households matters and in particular the use of Consumer Credit and in particular non-revolving credit:

"US consumer debt surged by the most in over 2 years to $3.8 trillion and jumped by 8.8% in November, the most in two years, to $3.83 trillion, according to the Federal Reserve. Clearly in the coming months US Consumer Credit should be on everyone's radar in conjunction with SLOOs we think." - source Macronomics, January 2018

Another sign that caught our attention as of late has been the article in the WSJ pointing towards mounting credit card losses in their article from the 4th of March entitled "Credit-Card Losses Surge at Small Banks":

"Small banks have been fighting for a bigger piece of the credit-card market in search of higher returns. Now, they’re contending with rising losses.

Missed payments on credit cards at small banks have risen sharply over the past year, a sign that their cardholders are taking on more debt than they can handle. Their charge-off rate, or the share of outstanding card balances written off as a loss after consumers failed to pay, hit 7.2% in the fourth quarter, up from 4.5% a year ago, according to Federal Reserve data.

Concerns have been mounting in the broader credit-card industry about the recent trend of rising delinquencies. While overall card losses are still relatively low—below the historical average of the last 30 years, for instance—they’ve been slowly climbing in the last two years.

But they’ve especially surged at smaller banks, those outside the 100 largest by assets that have less than around $10.4 billion in assets. There, the average charge-off rate is near an eight-year high, while the 3.5% loss rate at large banks remains well below the 10.6% seen in 2010." - source WSJ

The US savings rate has been falling while consumer credit has been on the rise with a significant usage of the credit card in recent months it seems. This is something to be mindful about, particularly when as we will see in our conversation that when it comes to consumer leverage in the US all is not what it seems. Monitoring Fed Senior Loan Officer and Opinion Survey (SLOOS) will be paramount this year.

There were as well some additional interesting points in the WSJ article:

"The small banks’ experience is “simply a leading indicator of a downturn to come,” said Robert Hammer, founder and chief executive of credit-card industry consultant R.K. Hammer. In the run-up to the last recession, he noted, losses accelerated for small banks before they did for big ones.

Some small banks have viewed credit cards as a way to cross sell their customers and to bring in new creditworthy customers. That became a challenge as big banks pursued the same set of borrowers by charging low interest rates for promotional periods. Personal loans offered by a growing number of lenders provided even more competition.

That left many small banks with card applicants who had lower credit scores." - source WSJ

Is it a worrying sign? You would have to take into account the impact on "millenials" into the equation we think. Since the Great Financial Crisis (GFC), Congress passed the CARD Act of 2009, a comprehensive credit card reform legislation to protect consumers. Under the bill, lenders cannot issue credit cards to a consumer under the age of 21 unless they prove they have independent income or obtain a cosigner. Also, many millennials are clearly "credit mature" in their 20s compared to the previous generations. As millennials come of prime working age, many are having a hard time obtaining credit cards because lenders are unwilling to extend credit to individuals that have a short or no credit history (yes dear readers in your FICO score, credit history is the most important factor!). This is indeed slowing credit creation somewhat for them. Due to the experience of the GFC, millennials could be less inclined to "buy" using credit or are "convenience users" who pay off their entire credit card balance every month, limiting the need for multiple credit cards.

But the "millenials" are only part of the story. There is much more to it and necessitate a bigger dive into the US consumer credit market. On that very subject we read with interest Deutsche Bank's State of the US Consumer report from the 26th of February entitled "Robust Consumer with Pro-cyclical and Seasonal Tailwinds on the Horizon".

One of the most important points made in this report was the Employment Cost Index (ECI) pointing towards rising inflation:

"One measure of wage inflation is the Employment Cost Index. The ECI measures total labor costs for companies, including wages, salaries, and benefits. Historically, labor costs have been predicted with a nine month lead by companies’ plans to raise worker compensation, see chart below. Both series have trended higher since 2010 but are now beginning to reach levels at or above previous peaks, signs that the labor market could start to overheat and bring higher inflation." - source Deutsche Bank

From the above, there is indeed a potential for a surge in inflation particularly with trade war rhetoric heating up which could add to inflationary pressures building up in the near term (and that's bullish gold by the way). A move toward trade protection in the US could lead to a further decline in global trade, making everyone worse off. Also, corporations have spread their supply chains across the world in the last ten years and they could be impacted seriously via a rising cost bases due to protectionism and trade war on top of a surging ECI index.

Returning to consumer credit, more concerning and well documented has been the rise in student loans since 2007 as indicated by Deutsche Bank in their report:

"Federal student loan performance worth monitoring

Average student loan balances continue to rise, despite the leveling of the number of consumers with student loans, as outstanding balances have more than doubled since 2010. Since 2007, student loans have risen from 15% to now over a third of the entire consumer debt complex (ex- mortgage).

With the rise of student balances, student debt leverage has also continued to rise steadily since 2003. Among the bottom 60% of income households, DTI from student loans has seen an average increase of +10% pts since 2007.

While the leverage within student lending may have a spillover effect for other consumer loan categories, we note nearly ~20% are deferred or in forbearance (i.e. the impact is being pushed out). Although defaults are currently at ~15% of total recipients, the highest % of defaulted accounts are for the lowest average loans (~2/3 of defaults are for loans & $10k) with defaults usually relating to noncompletion of school.

- source Deutsche Bank

So yes Student Loans have been rising significantly since 2007 and the onset of the Great Financial Crisis (GFC) but it is part of a significant increase in overall leverage of the US consumer. Again, there is what you see and what you don't see as pointed out by Deutsche Bank in their thorough report:

"Items to watch

Lower income consumers are more levered than they appear: The aggregate deleveraging post-crisis has largely benefited from mortgage leverage sitting at its lowest level since 2001. However, other consumer leverage (card, student, auto, and personal) continues to grind higher into 2018 and is now at all time highs (~26%). Excluding disposable income for the Top 5% income bracket of US consumers, consumer debt levels are closer to 43% of adjusted disposable income—almost double the reported measure of ~26%. The latest triennial Fed Survey of Consumer Finances highlights this dynamic, with the bottom 40% income households running at ~50% non-mortgage DTI, which is ~10% more than LT averages.

The subprime/low income consumer is stretched: Sluggish wage growth and rising healthcare and rent expenses as a percentage of income (non-debt obligations near 25 year highs) among lower income households have stretched subprime consumers as they look to augment rising expenses with debt.

Banks have met this increased demand by providing deeper credit access to subprime (increased participation, especially for cards), leading to higher leverage and an increased severity risk of loss as delinquencies start to diverge for lower quality consumers. Like DTI, adjusting debt payment burdens to exclude the top 10% income brackets almost doubles the reported Fed figure (9.6% PTI vs. 5.8% reported PTI by the Fed).

Socio-economic divide driving credit cycle: While aggregate consumer fundamentals remain robust, subprime consumers are seeing rising delinquencies and losses starting to normalize much faster than other credit tiers: +90-day DQs within subprime cards have rose+300bps Y/Y in 3Q17 vs. only~30bps on average for near prime/prime borrowers. ~45% of Americans would have difficulty paying a surprise medical bill of ~$500 (Kaiser Foundation), while ~50% of US consumers live paycheck to paycheck (FITB). Taken all together, a disconnect between the lower credit tier borrowers and the economic cycle is starting to emerge.

Monitoring FICO score inflation: Consumers with a FICO score below 600 have declined from 25.5% in 2010 to ~20% (40m consumers) in April 2017, while aggregate FICO scores have increased from 680 in 1999 to 703 in 2Q17. FICO score inflation has been driven by a robust macro environment, extension of a steady business cycle, demographic aging, and methodology changes. Additionally, non-prime consumers with the same FICO score is more risky today than coming out of the recession as the long business cycle helped bankruptcies off the credit report and solid job market has enabled consumers to pay their bills." - source Deutsche Bank

Indeed as per the above, some credit cracks are starting to show, particularly within the lower credit tier borrower which had been saved by the bell thanks to central banks stepping in with its ZIRP policies and QE to stave off defaults and bankruptcies.

Of course the missing part so far of the "inflation equation" has been wage growth. Over time there has been a stable relationship between wage growth and total consumer debt but it seems that since 2013, there has been a change in the narrative as per Deutsche Bank's report:

"Modestly widening gap between wage growth and debt growth

Wage growth and total consumer debt growth have been relatively stable in the low- to mid-single digit range since 2013; however, the gap between wage growth and debt growth has widened modestly in 2017, with non-mortgage consumer debt now growing at a faster clip than wage growth (with the gap narrowing tightly in 4Q17).

Aggregate non-mortgage consumer debt expansion has come in at +5.5% Y/Y vs. 7% to start the year, and other than the pullback in 2016, has been running at 6% to 6.5% since 2013. The current 5.5% rate is ~150bps lower than the median growth rate since 1965, suggesting non-mortgage consumer debt still has room for growth heading into 2018.

- source Deutsche Bank

The rapid pace in credit card growth aka non-mortgage consumer debt expansion is running hot currently and needs to be closely monitored in the months ahead, particularly if it is starting to bite the lower tier credit borrower with already strains showing up within small banks. No surprise in the above quoted article from the WSJ that smaller banks are experiencing rising defaults given the acceleration seen in credit growth from small issuers aka small banks but also non-banks have been playing the game at an accelerating pace as well.

We pointed out the importance of tracking the quarterly Fed SLOOs for additional signs of tightening lending standards which are still quite loose. The trend though is pretty clear for auto and card, banks are starting to tighten their credit standards in these areas as indicated by Deutsche Bank:

"Banks continue to tighten credit standards on auto and card

As the credit cycle continues to slowly normalize, 4Q17 saw a continuation of a net percentage of banks starting to tighten credit card and auto lending standards, with ~10% of banks reporting tightening card standards on average so far through 2017. We believe it will take a couple years of tightened originations to reflect into total outstanding balances.

Why tightening consumer lending standards should not hurt the economy yet. 

The tightening has been driven in large part by prime/subprime auto (which is needed) and by the smaller banks in card (which does not matter as much, and given small issuers have recently returned to ~11% growth). The Fed’s senior loan officer survey includes 60 banks, but does not adjust for size, which will likely distort results. For example, in credit card, the Top 10 banks control 70% + of card balances and many are actually loosening lending standards (ie Chase and Discover, for example). Furthermore, non-banks have become a larger driver of consumer credit post-Crisis. For example, banks are only 30% of auto and personal lending. TransUnion credit bureau data shows that while banks in net aggregate have started to tighten lending standards, consumer participation across all products outside of HELOCs continues to grow at a healthy clip in 4Q17.

2017 bankcard originations tracking just slightly below highs set in 2016

With data provided by Equifax, total bankcard originations FY17 are tracking just below 2016 levels (through 3Q17) with a slight tightening in originations coming from subprime credit tiers giving prime and near-prime originations a slightly higher percent of total bankcard originations. Interestingly, private label retail cards have actually seen a slight increase of subprime consumers percent of total originations increase at the expense of prime borrowers (likely as retailer woes leave retailers looking to loosen credit standards in order to boost sales).

Card delinquencies and charge-offs are rising, but still well below 30-year averages

Concerns over credit deterioration had been worrisome in 2017, with delinquency rates starting to rise in auto and card products. While card losses have been on the rise from post-crisis lows set in 2015, they still remain ~70bps below precrisis averages and are exhibiting a steady normalization path, considering recent industry growth and the seasoning of these vintages. Outside of auto and card, other financial products are actually either improving in performance or remaining flat in 1Q18.

Within card, normalization occurring across all credit quality

Delinquencies have seen an uptick across credit tiers, however still remain below pre-crisis levels, in aggregate. Score inflation masking the underlying credit quality of the consumer, a change in the mix with newer vintages, and outsized growth for newer vintages (growth math) are contributing to higher delinquencies across these credit tiers.

Retail card delinquencies peaking faster and higher

Retail private label cards (specifically the 2015 and 2016 vintage) are exhibiting a shorter time to delinquency and a higher DQ rate than even pre-crisis vintages. We see a combination of mix shift towards lower FICO score customers, potential retail bankruptcies, and FICO score inflation as contributing factors. Regarding retailer bankruptcies, an analysis by Moody's suggests that increased charge-offs for the retailer ahead of a bankruptcy filing are more common, as these retailers start to loosen their credit standards and aggressively market to lower end consumers in order to bolster sales. Whether consumers also feel less inclined to pay off a card for a retailer that has recently gone bankrupt could be another factor to monitor." - source Deutsche Bank

It certainly feels that we are in 2007ish environment at the moment, hence our "intermezzo" title, yet given the lateness in the credit cycle as indicated by more M&A deals, a flattening of the US yield curve and a continuation of buybacks. As per our prognosis and Deutsche Bank thorough analysis, there is what you see, and what you don't see when it comes to the US consumer. As pointed out by the Kansas City Fed, 43% of the increase in average FICO scores from 1999 to 2007 is attributable to the aging of the US population. Demography is indeed "destiny" and if it looks like credit scores are higher thanks to demographics, leverage as we have seen is much higher than anticipated. This is a continuation as well from the theme we tackled back in March 2017 as well in our conversation "The Endless Summer" when we asked ourselves if "boomers" were bust, given that they are more leveraged than previous generations were ahead of retirement. Sure most of them have a relatively small exposure to student debt as their enter their golden years, but their retirement "preparedness" remains a very big issue. During the next 20 years, roughly 74 million "boomers" will retire in the United States. That is an average of more than 10,000 new retirees a day...

For now soft data in the US is strong whereas hard data is somewhat weaker, and it seems Wall Street is more pessimistic than Main Street. In our final charts below we will look at consumer confidence which seems diverging to the prevalent mood in Wall Street thanks to trade war rhetoric as of late.

• Finals chart - Let the good times roll?

Whereas there has been a change in the narrative in Wall Street with the returns of higher volatility and more gyrations in financial markets, it seems that the US consumer has remained more unfazed and upbeat as per the rise seen in consumer sentiment. Our final charts come from Wells Fargo Economics Group from the 2nd of March entitled "Consumers Remain Unfazed By Market Volatility" and displays not only Consumer Sentiment Survey but more importantly expectations of higher income to come as well as a very interesting chart displaying the US consumer uncanny ability in calling a market top in the housing market, or to put it simply, when Main Street is better at forecasting than Wall Street:

"Consumers Remain Upbeat About the Economy and Incomes

Consumer sentiment rose 4 points in February to 99.7 and is just 1 point below its recent high hit in October of last year. Consumers appear to be unfazed by the recent volatility on Wall Street. Relatively few consumers cited the stock market as a factor influencing their views on the economy and, surprisingly and reassuringly, a larger proportion of those that cited it as having an impact said it was positive for the economy rather than negative.
Consumers are clearly more focused on the underlying fundamentals. Our below chart shows consumers’ assessment of current economic conditions, which rose 4.4 points in February to 114.9.

The University of Michigan noted that more consumers reported they had recently heard favorable news about the economy in February than any other time since 1984. Two-thirds of consumers reported their attitudes were influenced by the recently enacted tax cuts and stronger overall employment growth.
The persistent improvement in consumer sentiment provides some relief for folks concerned about ballyhooed threats, such as rising interest rates or steel tariffs. Consumers are not turning a blind eye towards the threats, but appear to be balancing them against expectations for stronger job and income growth. Consumers’ assessment of their finances has improved greatly over the past year. Fifty-four percent of consumers said that their finances had improved over the past year, which is the highest share since January 2000.
Consumers are also optimistic about the labor market and income growth going forward, with a significantly larger share of consumers expecting the unemployment rate to fall over the next year (35 percent) than expecting it to rise (23 percent). The percentage of consumers expecting their income to rise over this year rose 3.8 percentage points to 55.3 percent. An even larger share (57 percent) of consumers stated that they expect the country will have continuous good times over the next 12 months, up 3 percentage points from January.

The increased confidence in job and income prospects should be good news for consumer discretionary spending, which has recently shown some signs of cooling off following a strong holiday shopping season.
While consumers are remarkably upbeat, they are still aware of many of the key risks present today. An overwhelming 77 percent of consumers said that they expect interest rates to rise over the next 12 months and 48 percent expect gasoline prices to increase. Consumers just seem to be doing a better job than the financial markets in putting these risks into perspective. Stronger economic growth and increased job security are far more important to consumers and that is apparent in buy plans for major household items, which rose 6 points in February. On a more cautionary note, plans to buy a car or a house both rose much less during the month, although the proportion of consumers stating that now is a good time to sell a house jumped 7 points to 73 percent."

- source Wells Fargo

In this ongoing "intermezzo" period giving us that 2007 feeling, what is really striking to us is that the amount of leverage for the US consumer is not what it seems, and no matter how strong the willingness of the Fed to hike is, it appears to us that much sooner than in previous hiking cycle, the Fed is going to "break" something. As per the above chart, it seems to us that Main Street has a pretty good forecasting record in calling housing market tops it seems, much better than some sell-side pundits but we ramble again...

"Pessimism of the spirit; optimism of the will." - Antonio Gramsci, Italian politician

Stay tuned!

Macro and Credit - The Endless Summer

"The fact that logic cannot satisfy us awakens an almost insatiable hunger for the irrational." - A. N. Wilson, English writer

Watching with interest the continuation in the "Trumpflation" trade with equities pushing higher, credit going tighter and USD suddenly going stronger with real rates (pushing us to significantly curtail our gold mining exposure), we reminded ourselves for our title analogy of the 1966 worldwide release of surf movie "The Endless Summer". Its title comes from the idea, expressed at both the beginning and end of the film, that if one had enough time and money it would be possible to follow the summer up and down the world, making it endless (like the perfect asset allocator...). In similar fashion, the global reflationary trend witnessed so far thanks to central banks support, like the tide, has lifted all boats overall. From real estate to stock markets reaching in the US for some instance "lofty" valuations levels, given the recent strong macro data from PMIs to the latest ADP/NFP release in the US, we are indeed wondering if this credit cycle, while being long in the tooth, doesn't amount to "The Endless Summer". So if surfing the "wealth effect" seems so far appropriate for our title and markets analogy, we are wondering where the next big wave could be coming, given we recently pointed out that in many instances High Yield had been "priced" to perfection and the rally had been significant.

In this week's conversation we would like to look at the ebb and flow in the credit markets which could determine departure times from various asset classes as we move towards the Fed's hike decision.

Synopsis:

• Macro and Credit - Caesar, beware the ides of March
• Final charts - Are Boomers "Bust" ?

• Macro and Credit - Caesar, beware the ides of March

In modern times, the Ides of March is best known as the date on which Julius Caesar was assassinated in 44 BC which corresponds, dear readers to the 15th of March and equating to the next FOMC meeting of the US Federal Reserve bank. As we pointed out on numerous occasions we tend to look not only like any good pundits in the positioning of the players (such as the overstretched position in oil longs for instance...), but we do also look at the flows which could also be indicative in the changes in allocations.  As we pointed out in our most recent musing, so far this year High Yield fund inflows have remained strong in conjunction with the performance, making it look like an "Endless Summer" given the very significant performance of the asset class since the second part of 2016. Yet, it seems that as of late, it looks like some players have been trimming their sails. While next rate hike seems to be "baked in the cake", it remains to be seen how hawkish the tone will be at the next FOMC meeting. Many analysts are pointing out that the Fed is behind the curve, we have on numerous occasions joked with other macro rates pundits that the curve is behind the Fed. In relation to the risk of a more hawkish bias, we read with interest Bank of America Merrill Lynch's take from their Securitized Products Strategy weekly note from the 10th of March:

"Turning negative

Fed rate hike odds for next week are now almost 100%, up from the mid-30s just two weeks ago. The hawkish shift by the Fed has already been reflected in corporate credit spreads and real interest rates: IG and HY CDX spreads were as much as 5 bps and 30 bps wider in the past week, respectively, while the real 10yr yield is up by over 25 bps in the last two weeks. As usual, securitized products spreads have lagged the corporate and rate market action for the most part, as technical support for securitized products, especially credit, remains very strong.

What we’ve seen over the past two weeks is a mini-version of what we expect for 2017 overall. There is still plenty of time left in the year, so no doubt there will be continued swings in both directions on rates and spreads. But the big development in the past two weeks is the rapid hawkish shift in Fed rhetoric. We see potential for additional hawkish shifts in rhetoric going forward, including discussion of normalizing the balance sheet quicker than the market anticipates, and are in the camp that thinks the Fed is behind the curve on tightening monetary policy. If economic/inflation data forces the Fed to start tightening policy more aggressively, we think the market will eventually re-price equilibrium spread levels wider.

In short, the securitized products view is turning more and more into a view on how hawkish this tightening cycle will be for the Fed. Fed accommodation, and QE in particular, has unequivocally benefitted what we think of as the benchmark sector for securitized products, agency MBS. If the Fed is finally embarking on a sustained, hawkish tightening cycle, where their ownership of agency MBS is “normalized,” the path of least resistance for securitized products spreads is likely to be wider. Meanwhile, spread tightening potential, or at least justification for it, has become limited in our
view. Asymmetry on spreads is not a good thing.

Below, we examine the data connecting the Fed's MBS portfolio size to housing inventory, and rent and home price inflation. We believe the case can be made that reducing the portfolio sooner rather than later is warranted due to inflationary pressures in the housing market, although we recognize that this is probably a deep out-of-the money view at this point. Meanwhile, for the near term, the inflationary pressures in housing are a positive for residential mortgage credit.

We retain our neutral view on securitized products credit. There are positives on the technical and even fundamental front for the sector, except perhaps for CMBS, but our concerns about a looming hawkish shift by the Fed make us wary about chasing spreads tighter. Neutral balances it out for us. We turn underweight agency MBS, where we see enough negatives to outweigh the positives on the technical side. Specifically, we see seasonal supply pressures picking up and recognize that agency MBS are likely to be the first sector adversely impacted by any talk of accelerated balance sheet normalization.

Two indicators of why the Fed is/may be (way) behind on tightening 

We look at data that shows that the Fed is or may be way behind on tightening monetary policy, both in terms of raising rates and reducing its MBS portfolio. We are well aware that to date, both the Fed and the market have shown little concern over, or perhaps even awareness, of the analysis we present. As a result, it’s probably too early to think about it having a market impact. However, at a minimum, we think the data highlight the risk that the Fed somewhat abruptly shifts to a much more hawkish policy position.

In particular, unless mortgage rates are increased, by signaling accelerated MBS portfolio reduction, we think excessive home price and rent inflation looms on the horizon. Some have asked whether losses on portfolio sales would deter the Fed from selling. Losses might be a deterrent, but if rent and home price inflation spiral out of control, the Fed may not have a choice. Before considering the balance sheet, we focus on rate hikes as a policy tool.

1. Fed Funds and the Taylor Rule

Stanford’s John Taylor of Taylor Rule fame will be the featured speaker at the BofAML 2017 Residential & Housing Finance Conference this coming Tuesday, March 14, 2017. We'll wait for that session for guidance on the appropriateness of the Taylor Rule Fed Funds level versus the current Fed Funds level. Here, we simply present the historical data in Chart 1 (the two time series) and Chart 2 (Fed Funds – Taylor Rule) and leave it to the reader to decide if he or she thinks the Fed is possibly behind the curve. Currently, Fed Funds is roughly 300 basis points (twelve 25 basis point hikes!) below the Taylor Rule level.

The last time a disparity this large was seen was in 1974-1975, during a period of extraordinary rate volatility, when Fed Funds went from 13% to 5.5% in a matter of months. In a period of such high volatility, short term dislocation between an actual value and a model value can be expected. Now, with Fed Funds barely budging in eight years, the volatility explanation of the discrepancy does not apply. Rather, it appears as if the “Rule” is simply being ignored. As a result, after 40 years of roughly moving together, with the Taylor Rule level exhibiting less volatility than actual Fed Funds, they have decoupled.

Two possibilities emerge:

1. The Rule no longer applies and the decoupling will be permanent.
2. The Rule still applies and, as has been the case in the past, economic data inevitably force the humans setting the Fed Funds level to follow the Rule.

As a simple observation on the historical data, possibility #2 seems more reasonable to us, suggesting the Fed is way behind on tightening. Others can choose possibility #1.

2. The Fed balance sheet and home price and rent inflation

Here we consider the histories of existing home sales, housing inventory (measured as months supply, the number of homes for sale relative to the annual sales rate), Case Shiller home price appreciation (HPA), rent inflation and the Fed’s MBS portfolio size. We suggest that the Fed’s MBS ownership is creating home price and rent inflation, and that may not necessarily be a good thing.

Chart 3 starts with a look at existing home sales. January’s 5.69 million rate was the highest level since early 2007. That is also the level of early 2002, just before the housing bubble period commenced. Sales are seen on a steady uptrend since the end of 2008, when the Fed began buying MBS.

Chart 4 shows existing home sales versus Case Shiller HPA. Not surprisingly, the two series tend to move together. Policymakers and homeowners may be pleased that YOY HPA is reasonably strong, 5.85% for 2016. But what if it trends higher, along with existing home sales, as it did in the early 2000s? Is there a level of home price inflation that makes policymakers uncomfortable? What about the 36% of the population that do not own homes? Are they priced out of homeownership? Does strong HPA get passed through to rents?

Chart 5 suggests the answer on rents is yes. 5%-10% HPA may be great for homeowners but do policymakers really want to see rent inflation continue the steady rise that began in 2010, a year and a half after the Fed began purchasing MBS? Chart 6 shows that, two years after the Fed stopped increasing its MBS portfolio size, rent inflation appears to be accelerating. Similar to existing home sales, rent inflation is at the highest level since 2007.

Chart 7 shows the history of housing inventory. At 3.6 months, supply is back down to the record lows seen at the height of the housing bubble in 2005. Many will say that the low inventory is because builders are not building new homes. That may be true, but does that preclude the possibility that Fed MBS purchases may also be a factor, by artificially setting mortgage rates too low? The answer, in our view, is no, Fed balance sheet holdings cannot be ruled out as a driving force. Moreover, even if the Fed is responsible for low housing inventory, why is that a problem? Well, as we will see, it leads to home price inflation, which, as noted above, leads to rent inflation, which we think is a problem.

To help show these connections, we do a mathematical trick and invert the housing inventory and compare the inverted level to the Fed MBS holdings (Chart 8) and to HPA (Chart 9).

Similar to rent inflation, Chart 8 shows that the inverted housing inventory number bottomed in 2010, about a year and a half after the Fed started buying MBS, and has been trending higher ever since, meaning that inventories have been moving steadily lower. Chart 9 shows that this inverted inventory number tends to move in synch with or in advance of HPA, ie as a leading indicator. For anyone long housing, or residential mortgage credit, this looks like very good news for 2017. The data suggest that, due to record low inventories, the risk for HPA in 2017 is to the upside. The comparison of inverted inventory levels and rent inflation in Chart 10 shows a similar story for rent inflation: upside risk in 2017.

For a policymaker whose job is to maintain price stability, escalating rent inflation is not good news. There is a simple policy “cure” for this situation: raise mortgage rates by reducing the Fed MBS portfolio. Is the Fed anywhere near reaching this conclusion? Maybe not, but it probably should be, and if there is a rapid policy shift on this issue, we will not be surprised." - source Bank of America Merrill Lynch

There you go. While the Fed has been behind most of the "Endless Summer", one could argue that the Fed is not behind the curve, but, the curve is behind the Fed. Put it more simply, the Fed is the credit cycle, so, as the Fed starts to tighten in earnest financial conditions, the credit cycle will turn and rest assured it will entail some significant repricing at some point.

To that effect we agree with Jeff Gundlach from Double Line's recent take, namely that the Fed will hike until something breaks. It is bound to happen as the Fed has once again maintained rates too low for too long, which has led to some complacency in various asset classes and lofty valuations in many instances. This is as well the feeling in credit land as per recent investors' survey where there is a feeling of overvaluation.

This has been leading to some flow rotation with a more pronounced defensive stance leading to a reduction in both credit risk (from High Yield to Investment Grade) and a reduction in duration risk. This is clearly indicated in Bank of America Merrill Lynch latest Follow The Flow note from the 10th of March entitled "Shunning duration, adding yield":

"Reaching for yield, but cutting on duration

Higher yields and tighter spreads continue to benefit IG bond funds in Europe, recording a very strong inflow last week. Equities flows are back to positive with a $1bn inflow last week as economics data are strengthening. Duration is still under attack as IG investors are cutting back with rates moving higher. The reach for yield trade is in vogue with inflows into EM debt funds doubling w-o-w.

Over the past week…

High grade funds continued on a positive trend for the seventh week in a row; and recorded the highest inflow in 18 weeks. High yield funds inflows slowed down significantly last week, but still posted their 14th consecutive week of positive flows. Looking into the domicile breakdown, European-focused funds were the ones that recorded inflows, while outflows hit US and globally-focused funds.
Government bond funds flows remained on negative territory as rates moved higher. Money market funds weekly flows are back to positive after three weeks of outflows. Overall, fixed income funds flows remained strong and positive for the eleventh consecutive week; with more than $33bn of inflows over that period.
European equity funds flows flipped back to positive territory. So far this year the asset class has recorded inflows in seven out of ten weeks. Note that in 2016 the asset class recorded only eight weeks of inflows during the entire year.

Global EM debt fund flows continued on a positive trend for a sixth week, while flows more than doubled w-o-w. Almost $13bn of AUM has been added in the asset class YTD. Commodities funds flows flipped back to negative after seven weeks of consecutive inflows as oil prices dipped lower.
On the duration front, strong inflows continued in short-term IG funds for the 12th week in a row. Mid-term funds also posted a strong week of inflows; the second in the row. Flows into long-term funds remained negative for a third week in a row." - source Bank of America Merrill Lynch

Now if indeed there is added caution and a "Great Rotation" to quality (Investment Grade), one might wonder if indeed this time around credit will be leading equities and mark an end or a pause to the "Endless Summer". We looked at the below chart from Lawrence McDonald on our twitter feed and wondered:

- source Lawrence McDonald - Bloomberg/Twitter feed

Also on our Twitter feed which caught our attention was Bloomberg Lisa Abramowicz comments relating to the outflows in the ETF HYG on the 8th of March:

"Yesterday saw the biggest one-day outflow from the biggest junk-bond ETF since the U.S. election." - source Lisa Abramowicz - Bloomberg

As pointed out by a credit market pundit on Twitter as well (H/T Fil Zucchi) $5 billion worth of new issues were bought in the cash markets. One has to remember that, when it comes to keeping it's cool under pressure, the retail crowd is much more feeble than the institutional crowd. Where we slightly disagree with Fil Zucchi is that there has been a very significant growth in passive management and in particular bonds ETFs. So while tracking bonds ETFs is of interest, it is of course not the best great gauge of real health in credit markets. Yet, in the European High Yield complex, this week has seen some heavy trading in the cash space thanks to growing redemptions in High Yield credit ETFs. So all in all, tracking flows in ETFs is necessary but, not always enough to gauge the state of the market. But, from a short term perspective, it might indicate some weakness in the near term.

Another cause for concern has been the recent sucker punch delivered in very short order to the very crowded long oil community, which once again is going to weight on credit spreads and in particular the Energy sector which have been on a tear in the second part of 2016, leading to a significant outperformance of the sector. This, we think is worth monitoring, given the correlation between oil prices and High Yield as displayed in the below chart from Tom McClellan on his twitter feed:

- source Tom McClellan - Twitter feed

So if it is indeed you are wondering when "The Endless Summer"  will end and if you are a "big wave surfer" like Bohdi in Point Break meaning you are waiting for the "50-Year Storm" and "big waves" à la Nazaré in Portugal you need to start asking yourself how will this credit cycle end. On that specific point we read with interest Société Générale's take from their Credit Market Wrap-up from the 6th of March entitled "How will this credit cycle end":

"Market thoughts

For the past two years (and most recently in “The big hangover, Part II”), we have argued that the credit cycle has become shorter since the global financial crisis. Based on data going back to the 1920s, we have noted that the typical credit cycle lasts eight years, with a bear phase, a bull phase, and a phase of broad stability. But as Chart 1 shows, in the past eight years this traditional stability phase has disappeared. The average life of a credit cycle has shrunk to three years, and we have had three full credit cycles.

Chart 2 shows that there is a historical precedent for this type of rapid cycling credit market. While the cycles of the 1980s and 1990s (and a fortiori the 1940s to mid-1960s) were relatively long, the late 1960s to late 1970s saw three cycles in the space of a decade.

Beards and flares may be back in fashion, but the current disinflationary world seems very different from the high inflation of the 1970s. Yet there is one similarity: real bond yields. Chart three shows credit spreads and US 10yr bond yields minus average CPI over the previous three years. In both the 1970s and the past ten years, US real yields were low, often negative, and always volatile. By contrast, real yields in the long 1980s and 1990s cycles were positive and well behaved. Negative real yields do seem to make credit cycles faster.

So if real rates rise as quantitative easing ends, credit cycles should lengthen again. But how would this rapid cycle phase end? The 1970s example is worrying, for the biggest spike in yields took place at the end of the period. Moreover, it’s worth noting that balance sheet leverage has been much stickier through this cycle than in the 1970s. Chart 4 shows the nonfinancial debt/assets ratio from two series from the Federal Reserve of Saint Louis, plotted against spreads.

The correlation between spreads and balance sheet leverage looks weak, as leverage was falling during the rapid cycles of the 1970s, rose during the long cycles of the 1980s (as academics convinced corporates of the value of tax shields), fell after the telecoms crisis and has risen again since nominal and real yields started to fall after the financial crisis. But the more important and worrying point is that balance sheet leverage is high now compared to history, and this may end up amplifying the impact of a crisis if one is triggered by the end of low real yields.

So to sum up, the history of the 1970s is worrying for two reasons. First, it shows that the switch from a negative real yield regime to a more normal, positive real yield regime might spark a big non-financial credit crisis. Second, this crisis could be amplified by the fact that there has been no real balance sheet deleveraging during this period of spread volatility (unlike the 1970s). The end of this credit cycle may be far off in the future – indeed further off than we might have thought at the start of this year. When it comes, however, it may be very messy indeed." - source Société Générale

Until then you might enjoy the summer lull and complacency of the credit markets, but one thing for certain is that the end of this particularly long credit cycle will see much lower recovery rates, for us that's a given.

If indeed corporate leverage is higher than in the previous cycle as pointed out by Société Générale, there also a phenomenon that needs to be taken into account and it is that the current Boomers are more leveraged than previous generations were ahead of retirement as per the final points below

• Final charts - Are Boomers "Bust" ?

While the developed world in many parts is clearly in a state of over indebtedness, what is of interest as well is that the Baby Boomers generations that benefited from many golden years and the generosity from both governments and central banks in recent years do face some challenges as per our final charts from Wells Fargo Economics Group note from the 9th of March entitled "Till Debt Do Us Part: How Leveraged Is the Typical Boomer?":

"The Boomers are more leveraged than previous generations were ahead of retirement.

We examine the liabilities side of the balance sheet for this group and explore some of the challenges they may face.

The Borrowing Boomers

Unsurprisingly, the Baby Boomers have less debt than younger generations who are currently in their prime working years and still climbing the ladder of life. However, the typical Boomer has more debt at this point in their life relative to previous generations. As of 2013, 79 percent of households age 55-64 and 66 percent of those age 65-74 had debt of some kind (top chart).

The long-run trend in the top chart signals a rising share of each successive generation approaches the traditional retirement age with debt of some sort. In addition, not only do more Boomers hold debt, the typical value in real dollars has also risen. The Great Recession pushed debt holdings for this age bracket even higher in 2010 than the bubbly 2007 period. Real debt holdings for the typical boomer receded markedly in 2013, although this in part reflects a decline in homeownership.
Like the asset side of the balance sheet, housing comprises the bulk of debt for the average Boomer. A bit under half of Boomers hold debt secured by their primary residence (middle chart), with the median value for Boomers age 55-64 amounting to about $100,000. Credit card balances and installment loans (for vehicles for example) are also common, but median balances are a relatively manageable $3,000 and $12,000, respectively. Mean debt holdings are more than double the median, however, suggesting that some Boomers are significantly more leveraged than their peers.

Old School Not So Funny for the Boomers

Student loan debt has emerged as a hot button issue for some Boomers. A recent report by the Government Accountability Office (GAO) drew attention to this issue, highlighting the number of people whose Social Security checks are being reduced to pay off delinquent student debt.* The report found that there were 114,000 people age 50 or older in fiscal year 2015 who had their benefits reduced by about $140 a month for unpaid student loans. As the bottom chart illustrates, student loan debt has increased in size and prevalence for older individuals.

We caution, however, about overstating the pervasiveness of the problem; according to Survey of Consumer Finances data, only 12 percent of 55-64 year olds have some form of student debt, with older Boomers having an even smaller share. In addition, the 114,000 individuals age 50+ from the GAO study represent less than 0.5 percent of Social Security beneficiaries. This suggests that most Boomers are not grappling with a crushing student loan burden as they enter their golden years. That said, the GAO report found that a sizable share of those who had their Social Security benefits reduced were either pushed below/pushed even further below the poverty line. Further, if the trend of growing educational debt continues, the problem will likely increase in scope over time and create further challenges for Boomers who are already struggling with retirement preparedness." - Source Wells Fargo

Although "The Endless Summer" has created a significant windfall for the holders of financial assets, it looks to us increasingly that in many ways the average US consumer is somewhat "maxed out". It remains to be seen how many hikes it will take before the Fed finally breaks something, but, we ramble again...

"Things as certain as death and taxes, can be more firmly believ’d." - Daniel Defoe, The Political History of the Devil, 1726.

 Stay tuned!