Credit - The Daisy Cutter

"A credit rating is no substitute for thought" - Jens Weidmann - President of Bundesbank

Looking at the on-going volatility in the credit and fixed income space, courtesy of the tapering / non-tapering discussions, we thought this time around we would venture towards military ordnance analogies for our chosen title, namely the BLU-82B, a 15,000 pounds (6,800 kg) conventional bomb nicknamed "Daisy Cutter" in Vietnam for its ability to flatten a forest into a helicopter landing zone. One just need to look at the devastating effect of the "QE Tapering Bomb" aka the Daisy Cutter (to prepare for an eventual QE "helicopter  Ben" landing zone), has had on financial markets which flattened in a single month the YTD fixed income gains in many different asset classes, to see the appropriatness of our chosen title. While originally the "Daisy Cutter" was used during the Vietnam war to clear helicopter landing zones, later, bombs were dropped as much for their psychological effect as for their anti-personnel effects, but we digress slightly. On another note China did as well drop its own "Daisy Cutter" which had similar devastating effect on "feral hogs"...

The "Daisy Cutter" effect as displayed by the evolution of the Merrill Lynch MOVE  index, which has been  slightly receding and CVIX indices closely followed by a rise in the VIX index albeit more muted - graph source Bloomberg:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

In this week's conversation, we would like once again to point out the deflationary forces at play, given the "Daisy Cutter" explosion has indeed created a worrying trend, namely rising yields and a rising dollar, which could have some greater implication down the line and also the evolution towards a European Banking Union  following the discussions which took place this week in Brussels. But first our usual market overview.

We have long argued that France should be seen as the new barometer of Euro Risk, looking at the data that keeps coming out of France, it is increasingly becoming evident to us that things will get much worse than anticipated by the current French government when one looks at the level reached by consumer confidence in France, at the lowest level since 1974 - graph source Bloomberg:

This lack of confidence no matter how "improved" the recent PMI Manufacturing and for Services look like, doesn't bode well for rising consumption levels, in particular with a continued surge in unemployment levels.

France unemployment rate at 11% versus Germany at 6.90% - graph source Bloomberg:

Not only France's economic growth prospects face serious headwinds with rising unemployment and lack of consumer confidence, the "Daisy Cutter" has also led to some serious repricing of government bonds in Europe leading to some higher yields going forward for government issuance.

The volatility jitters in the bond space, have led to a surge in European Government Bonds yields in the process as indicated in the below graph with German 10 year yields rising towards the 1.70% level and French yields now around 2.30% - source Bloomberg: - graph source Bloomberg:

What we found of interest as of late has been the repricing in the fixed income space which has left no bonds or bucket immune as witnessed by the significant rise of the Swiss 30 year bond yields which had remained fairly muted throughout 2012 versus the 30 year Japanese bond yields - graph source Bloomberg:

As far as global deflation is concerned, and in relation to Japan, another indicator we have been closely following has been the 30 year Swiss bond yields which had been nearly 100 bps lower than Japan 30 year bond yields throughout 2012 until the recent "Big in Japan" bang moment following the Bank of Japan "all in" move.

The "Daisy Cutter" explosion has also created a worrying trend, namely rising yields and rising credit spreads, indicative of a repricing of credit risk. For instance, the Itraxx Senior Financial 5 year CDS index has been rising in conjunction with the German 10 year yield, leading to a significant weakness in the Investment Grade space, with high beta financials (subordinated financial bonds and peripherals) taking the brunt of the widening move - graph source Bloomberg:

While the big beneficiary of the latest sell-off courtesy of the "Daisy Cutter" has been the US dollar, one of the most impacted asset commodity classes since the beginning of the year has been gold as of late - graph source Bloomberg:

As we discussed last week in our conversation "Singin' in the Rain" on why gold prices had further to fall (and they did) was as follows:

"To answer our friends Martin Sibileau's questions commodities have further to fall including gold.

Why? 

Gold is not an inflation hedge; it is a hedge against the end of the dollar’s status as a reserve currency, a deep out-of-the-money put against the US currency as a whole, ("The Night of the Yield Hunter" - Macronomics)."

What the falling gold prices are indicative of is that, like we posited in "The Night of the Yield Hunter", is that no matter how much liquidity has been injected (remember Fisher's equation - MV = PQ. Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.), the Fed has failed in igniting inflation to offset the decline in velocity. The Fed's expanding balance sheet has failed in stoking inflation expectations as displayed in the below Bloomberg graph:

"The CHART OF THE DAY shows gold prices surged 90 percent in the four years through 2012, moving in tandem with increased debt purchases by Fed policy makers. Bullion in New York has dropped 20 percent this quarter, heading for a record loss, even as the central bank’s balance sheet reached an all-time high. Consumer prices climbed 1.1 percent in the 12 months through April, according to a measure watched by the Fed that excludes food and fuel -- matching the smallest increase since records began in 1960. The speed at which money changes hands, measured by the U.S. economy’s supply of cash and equivalents known as M2, is the least in records going back to 1959, according to data compiled by Bloomberg." - source Bloomberg.

As far as Gold is concerned, we agree with the recent note from Nomura from the 26th of June entitled "Golden sell-off":

"On a longer-term basis, we think that gold is in the later stages of a fall and indeed, it is edging towards the mining cost of gold. We think that Asian buyers are likely to come into the market at some point as well, when the dip in gold prices becomes sufficiently large. This should eventually offer support as well. However, because of the change in market dynamics following the FOMC meeting, longer term we think that the size of any recovery in gold prices once flows turn is likely to be comparatively small." 

- source Nomura

In the previously mentioned conversation from April this year we added the following comment:

"We think there is currently an accumulation of worrying signs that the global economy is decelerating and that old left hand deflation has indeed a solid grip when one looks at China's shrinking electricity use, a bearish sign for a price index of industrial metals that, according to Bloomberg, has posted a first-quarter decline for the first time in 12 years"

Container rates, which we follow, have dropped 6.2% to the lowest level since March 2012 - graph source Bloomberg:

"The Drewry Hong Kong-Los Angeles 40-foot container rate benchmark fell 6.2% to $1,836 in the week ended June 26. Below the $2,000 mark for the fourth straight week, rates are at their lowest since March 2012 ($1,771). Even with three increases, rates are down 17.1% ytd, as slack capacity pressures pricing. Carriers are expected to raise rates by $400 on containers from Asia to the U.S. West Coast, and by $600 to all other destinations, effective July 1." - source Bloomberg.

So our "Daisy Cutter" explosion has indeed created a worrying trend, namely rising yields and a rising dollar with rising container rates and weaker global demand, a recipe that could spell for default for weaker container shipping companies already strained by weaker demand.

If you think rising yields are only putting global trade at risk, think as well how it will ripple through in various sectors and countries.

For instance, as reported by Frances Schwartzkopff in Bloomberg on the 26th of June in her article "World's Most Indebted Households Face Rate Pain":

"Danish consumers, who owe banks more than three times their disposable incomes, are about to find out how sustainable that debt load is as interest rates rise. Signals from the U.S. Federal Reserve that it’s preparing to scale back monetary stimulus have already sent mortgage costs higher as yields rise across global bond markets. The Nykredit Index of Denmark’s most traded mortgage bonds sank this week to its lowest in more than four months after investors sold assets once coveted for their haven status." - source Bloomberg.

Danish households owed 310 percent of disposable incomes in 2010, government debt is less than half the euro-zone average at only 45 percent of gross domestic product this year, the European Commission estimates.

On top of that, Student-Loan Interest Rates are set to double next week because the US Congress will act in time to prevent the rate hike as indicated by James Rowley and Caitlin Webber in Bloomberg on the 26th of June in their article "Student-Loan Interest Rates Set to Double as Fix Eludes Congress":

"About 7 million undergraduates borrow for college using the subsidized loans, for which the government pays the interest while these students are in school. Students must show financial need to qualify for these loans.

The rate for unsubsidized Stafford loans is already at 6.8 percent; those loans are available to any undergraduate, regardless of financial status, and to graduate students who are no longer considered their parents’ dependents. Students with unsubsidized loans pay monthly interest while in school; if they don’t, their interest charges during that time are added to their loan balance. Both subsidized and unsubsidized loans are taken out annually and are based on anticipated costs for the next academic year." - source Bloomberg

Finally rising mortgage rates and the recent REIT rout are likely to curtail the number of property purchases as indicated by Brian Louis in Bloomberg on the 26th of June in his article "REIT Rout Seen Curtailing Deals as Rising Rates Cut Share Sales":

"Property purchases by U.S. real estate investment trusts are likely to be curtailed after almost $36 billion of deals this year as a tumble in share prices makes a key source of capital costlier.

The Bloomberg REIT Index has dropped 11 percent from an almost six-year high in May as the yield on 10-year Treasury notes surged amid speculation the Federal Reserve would reduce bond purchases, which have kept borrowing costs low. The decline was three times the slump in the Standard & Poor’s 500 Index.

Just five U.S. property REITs have sold shares this month, down from 14 in May and eight in April, according to data compiled by Bloomberg, and Tom Barrack’s house-rental trust Colony American Homes Inc. postponed an initial public offering in early June. Because federal tax laws require REITs to distribute most of their earnings to investors through dividends, the companies rely on stock and debt sales to raise money for real estate purchases." - source Bloomberg.

From the same article:

"A decline in deals may limit a rebound in commercial-property values. A Green Street index of prices, compiled from estimates of REIT holdings, had recovered all of its losses from the real estate collapse and as of May was 4 percent higher than its previous peak in August 2007.

With bond yields low, REITs have been an attractive investment alternative with their higher, steady returns -- an advantage disappearing with rising interest rates. Since REITs rely on the equity and debt markets to raise money for acquisitions, they are vulnerable to jumps in interest rates. They have access to capital through credit agreements that they can use for short-term funding obligations, said Keven Lindemann, real estate group director at SNL Financial in Charlottesville, Virginia." - source Bloomberg.

The Bloomberg single-tenant index has dropped 19 percent since May 21, and the health-care REIT index has slumped 16 percent with Mortgage rates for 30-year surging to 4.46%, the highest in two years and the biggest one-week increase since 1987. Bonds tied to mortgages are on track to be the worst in almost two decades, such as Fannie Mae’s 3 percent, 30-year securities fell about 0.2 cent on Friday to 97.6 cents on the dollar as of 11:19 a.m. in New York, down from about 103 cents on March 28, according to data compiled by Bloomberg. A Bank of America Merrill Lynch index tracking the more than $5 trillion market lost 2 percent this quarter through yesterday, the most since the start of 1994. The shock and awe tactic of dropping a "Daisy-cutter" bond on pure beta plays. 

Oh well...

All in all the Daisy-Cutter Fed bomb has had "unintended consequences" which are yet to ripple on a global basis in the coming weeks and months, but has already been devastating in the fixed income space as reported by Bloomberg on the 27th of June in their article "U.S. Bond Funds Have Record $61.7 Billion in Redemptions":

"U.S.-listed bond mutual funds and exchange-traded funds saw record monthly redemptions of $61.7 billion through June 24 amid signs the country’s central bank may scale back its unprecedented stimulus.

The redemptions surpassed the previous monthly record of $41.8 billion, set in October 2008, according to an e-mailed statement by TrimTabs Investment Research in Sausalito, California. Investors withdrew $52.8 billion from bond mutual funds and $8.9 billion from ETFs during the period, said Richard Stern, a spokesman for TrimTabs." - source Bloomberg

This is why we pondered the following in our last conversation "Singin' in the Rain":
"If the dollar goes even more in short supply courtesy of Bernanke's "Tap dancing" with his "Singin' in the Rain", could it mean we will have wave number 3 namely a currency crisis on our hands? We wonder..."

Already some countries have had to take drastic measure to preserve their balance of payments, for instance Vietnam's central bank just devalued its currency for the first time since 2011 as reported by Bloomberg on the 28th of June:
"Vietnam’s central bank devalued its currency for the first time since 2011 and cut the interest-rate cap on dollar deposits to help “improve” the balance of payments and boost foreign-exchange reserves.
The State Bank of Vietnam weakened its reference rate by 1 percent to 21,036 dong per dollar, effective today, according to a statement released yesterday. The currency, which can trade up to 1 percent either side of the rate, fell 0.8 percent to 21,195 as of 12:01 p.m. at banks in Hanoi, the most since Aug. 9, 2011, according to data compiled by Bloomberg. The fixing has been kept at 20,828 since Dec. 26, 2011, and the spot rate touched a record 21,036, the lower limit of the band, on most days in June.
The change in the reference rate is the biggest since a record 8.5 percent cut in February 2011 and comes after the government announced yesterday that imports exceeded exports by $1.4 billion in the first half of this year. " - source Bloomberg.

To summarize the deflationary forces at play in the current environment, we have read with interest Russell Napier's CLSA note from the 7th of June entitled "Great reset revisited":

"The world has been in disinflation since 2011: deflation is next. Japan has won the currency war and its cheaper exports are forcing others to cut prices. Meanwhile, slowing growth and weakening currencies in emerging markets augur a debt crisis; and commodity prices continue to fall amid a global slowdown and rising supply. Most worryingly, both real interest rates and the US dollar are rising. The great reset’s deflationary shock is at hand and investors should hold as much cash as they can.

US inflation has fallen despite QE

- QE is not delivering: the Fed's balance sheet has grown by 18% since September 2011, while inflation has fallen from 3.9% to 1.1%.

- The US 30-year bond yield has remained unchanged over this period: thus US real rates have risen by 280bps despite QE.

- US nominal rates bottomed a year ago and have risen by 83bps since then, while inflation has fallen by 33bps.

- Moreover, the Treasury inflation-protected securities (TIPS) market indicates that inflation expectations are falling, while nominal yields are rising.

EM growth is slowing and exchange rates are under pressure

- Weakening emerging-market (EM) currencies augur a balance-of-payments crisis, which means either lower domestic growth or lower exchange rates and defaults.

- As the EM growth outlook deteriorates, global inflation will fall further.

- EM foreign-currency bond prices are cracking, indicating that the large capital inflows that funded current-account deficits are ending.

Japan has won the currency war and is now exporting deflation

- On the back of yen depreciation, Japan is cutting its US-dollar selling prices.

- Japan¡¦s actions have forced competitors to follow suit: now Korea and China are also exporting deflation to the USA.

- The Bank of Japan's need to prevent JGB yields from rising will mean ever greater intervention and even more deflationary pressure from a weakening yen.

Cash is the place to be

- Cash does well as inflation turns to deflation and real interest rates rise.

- Cash can finally be utilised profitably as central bankers fail to sustain asset prices.

The S&P 500 and the US 10 year breakeven, indicative of the deflationary forces at play, graph source Bloomberg (28th of June 2013):

Moving on to the subject of the evolution towards a European Banking Union  following the discussions which took place this week in Brussels surrounding the Bank Recovery and Resolution Directive (BRRD), European Finance ministers (ECOFIN) came to an agreement on the 26th of June which will have to go through the European parliament, with the objective of adoption before year end.

No timing has been given for when the resolution authorities will have to use the bail-in tools and earlier indication were for 2018, but countries will have the flexibility to adopt it earlier it seems. National resolution authorities will be in charge of the implementation of the resolution plans which comply with some common rules, in particular bail-in measures imposing losses following order of seniority.

What will be included in the bail-in?
All bank creditors will see haircuts on the principal in line with the following order of seniority:
Shareholders > Hybrids > subordinated debts > Senior debt (including CP > 7days) + unguaranteed deposits of large corporations

What will be excluded in the bail-in?
-Guaranteed deposits of individuals and SMEs (<100 -covered="" bonds="" br="" days=""> -Payables to employees
-Some commercial claims

Debts with payment systems maturing in less than 7 days, and interbank market debts with an initial maturity of less than 7 days  before debts <30days days--="">

The entry of public capital will take place once at least 8% of liabilities have absorbed losses. Direct recapitalization from the ESM would only come into play in a second phase, once all possible haircuts have been exhausted, if the bank still needs help.

The issue of course is that the consequences of rising government bond yields could accelerate the realization of losses for senior bondholders particularly if one takes into account that in the last couple of years, rather than severing the links between banks and sovereigns, governments in Europe have increased that link with the help of banks which have been big buyers of government debt as indicated by a recent post from Dr Constantin Gurdgiev on "true economics" entitled - Bank-Sovereign Contagion - It's getting worse in Europe:
"•Italy EUR404bn (26% of 2013 GDP) up on EUR177bn at the end of 2008
•Spain EUR303bn (29% of 2013 GDP) up on EUR107bn at the end of 2008

Now, recall that over the last few years:

•European authorities and nation states have pushed for banks to 'play a greater role' in 'supporting recovery' - euphemism for forcing or incentivising (or both) banks to buy more Government debt to fund fiscal deficits (gross effect: increase holdings of Government by the banks, making banks even more too-big/important-to-fail); 
•European authorities and nation states have pushed for separating the banks-sovereign contagion links, primarily by loading more contingent liabilities in the case of insolvency on investors, lenders and depositors (gross effect: attempting to decrease potential call on sovereigns from the defaulting banks);
•European authorities and nation states have continued to treat Government bonds as zero risk-weighted 'safe' assets, while pushing for banks to hold more capital (the twin effect is the direct incentive for banks to increase, not decrease, their direct links to the states via bond holdings).

The net result: the contagion risk conduit is now bigger than ever, while the customer/investor security in the banking system is now weaker than ever. If someone wanted to purposefully design a system to destroy the European banking, they couldn't have dreamt up a better one than that..." - source "true economics", Dr Constantin Gurdgiev.

While the "Daisy Cutter" is no doubt an impressive military ordnance, it looks like the European politicians have built the ultimate bomb,  similar to the "father of all bombs", equivalent to the Russian Aviation Thermobaric Bomb of Increased Power (ATBIP),but we ramble again...

On a final note, stocks and housing may take down US confidence as indicated by Bloomberg in a recent Chart of the Day (25th of June):

"Consumer confidence in the U.S. may fall victim to the Federal Reserve’s foreshadowing of reduced
bond buying, according to Brian G. Belski, chief investment strategist at BMO Capital Markets.
As the CHART OF THE DAY depicts, consumer sentiment has typically mirrored a ratio of household net worth to disposable income during the past decade. The confidence figures come from surveys by the Conference Board. The Fed compiles data on net worth, and the Commerce Department tracks income.
Swings in stock and house prices largely explain this relationship, Belski wrote in a June 21 report with a similar chart. That’s why it has lasted through the economy’s four-year expansion even though jobs and income have risen more slowly than in past recoveries, the New York-based strategist wrote. “Consumers should not become overly reliant on these ‘paper gains’ for self-assurance,” Belski wrote. “Obstacles are beginning to develop” that may hamper further advances.
Fed policy looms over stocks and housing, the report said, because possible cutbacks in bond purchases have lessened the appeal of equity dividends and made home loans more expensive.
More houses may be put up for sale as the number of homeownerswhose debt exceeds their properties’ value falls, Belski wrote. The U.S. economy has added an average of 105,000 jobs a month in the current expansion. The pace trails an average of 178,000 in similar post-World War II periods, according to data cited in the report. The comparable growth rates for disposable income are 0.9 percent and 3.8 percent, respectively." - source Bloomberg

"There is no IQ in QE but no QE = NO IQ" - Macronomics

Stay tuned!

Credit - The Week That Changed The CDS World

"One must change one's tactics every ten years if one wishes to maintain one's superiority." - Napoleon Bonaparte 

Looking at the epic compression in recent weeks of the Itraxx CDS financial subordinated index versus the Itraxx Senior Financial CDS 5 year index, tied up to the recent ISDA proposals to include Bail-In Credit Event, we decided our reference this week ought to be a shorthand for describing surprising and uncharacteristic actions in similar fashion to Kissinger's 1971 secret trip to China. This secret trip laid the groundwork for the historic visit of Nixon to China that followed in 1972. 

Given the upcoming clean up of ISDA's 2003 Credit Derivatives Credit Event definitions which were in dire need of a brush up following the recent Dutch banks SNS subordinated debt saga, as per our Napoleon Bonaparte quote goes, arguably, one indeed must change tactics every ten years if ones wishes to maintains one's superiority. It could not be more truer than for the viability of the CDS market. What happened this week in the CDS world, with the proposed introduction of a new credit event for financial CDS in the case of a bail-in triggered by a government agency and the change in deliverability rules, made this week an important one from a credit perspective.

We already discussed the implications of the SNS case in our previous conversation "House of pain and House of cards":
"The SNS case this week has had some major significant risks to the "House of pain" in the European banking sector that warrants additional close attention for the remaining subordinated bondholders.
If the recovery rate for SNS LT2 subordinated bonds is zero, the significance for the European subordinated CDS market is not neutral given the assumed recovery rate factored in to calculate the value of the CDS spread is assumed to be 20% for single name subordinated CDS and 40% for senior financial CDS. On top of that, a nationalization, such as SNS case, is not by itself a credit event trigger. Appointing an insolvency official is.
As far as delivery of LT2 underlying subordinated bonds referenced in any CDS contract referencing SNS, you would have to ask the Dutch state for delivery (if the subordinated bonds are not simply cancelled or converted into equity...).
So what's the value of your subordinated single name CDS on SNS? Could it mean single name subordinated CDS are a "House of cards"? We wonder. Oh well..."

So in this week's conversation we will look at the wider implications for the financial CDS market on the proposed ISDA Credit Events revamp on the 10 year anniversary of the ISDA 2003 Credit event definitions because the validity of the CDS market as a hedge had been put in jeopardy quite significantly by the SNS case. We will also look at debt disturbances and price-level disturbances, revisiting the wisdom of Irving Fisher in the process.

The CDS compression story in one chart - Itraxx Financial Senior index versus Itraxx Financial Subordinated 5 year index - source Bloomberg:

From the above chart one can see the severity and rapidity of the move in the subordinated financial CDS space.  

So is the move justified?

Here is BNP Paribas take on the move from their 23rd of May entitled  "ISDA Proposes Bail-in Credit Event:

"Is the Sub CDS move since last Friday justified?

Sub CDS has collapsed by more than 40bp since 16 May and the Sub/Sen ratio is now just below 1.4x, after having been at a mean of around 1.7x for a long time. The timing surprised us, as the new definitions are not finalised nor implemented yet. In addition, the market could have already reacted more than it did after the SNS news. Therefore, while we were proponents of the general Sub/Sen compression theme, we were surprised both in terms of timing and severity of the market move.

How do we explain the move then? The rapid compression of Sub vs. Sen over just a few trading sessions was probably due to the realisation that existing financial CDS contracts will over time be replaced by the new ones, making the old contracts less valuable from a long protection perspective. Thin market conditions due to European holidays may have exacerbated the move.

Other possible explanations of the significant move are the general bull market and search for yield, the gradual acceptance and pricing in of senior bail-in and the possibility of depositor preference over senior. Finally, investors may expect that, with the arrival of a new CDS contract, authorities would be less careful about legacy CDS (i.e. about making sure that there are deliverables, as the Irish authorities had ensured). That said, the change of definitions had been mentioned for a while and the implications clear, i.e. the new contracts should trade at a wider level. The old contracts can still be useful, especially as we believe that bail-in will trigger a restructuring event (as was the case with SNS), but the existence of sub deliverables is uncertain and therefore they are less valuable to a protection buyer than the new one. This information was previously available but the market reacted last Friday.

Can the magnitude of the move be justified by relative recovery expectations between senior and sub contracts? Chart 1 shows the implied Sub/Sen ratio (for the existing contracts) as a function of the senior expected recovery rate for different sub recovery rate assumptions. In most cases the sub recovery rate has been in the 0-20% range. At current market pricing, this corresponds to a senior recovery rate of 30-40%. This does not strike us as too low, especially when we consider that (i) the Moody’s average historical senior corporate recovery rate is around 38%; (ii) further developments towards resolution regimes and senior bail-in should increase the senior credit event probability relative to the sub probability; (iii) depositor preference, if forthcoming, would reduce the senior expected recovery rate; and (iv) the recent SNS event highlights a growing likelihood of events with a significantly higher sub recovery rate (for the existing contracts) than 0-20%." - source BNP Paribas.

We disagree with BNP Paribas on the implied recovery rate of 30-40%. It is not too low, it is not low enough at least on the "old contracts" because it relies on Moody's average historical senior recovery so this analysis is backward looking. The senior expected recovery rate due to the evolution of resolution regimes and senior bail-in implies lower recovery rates and wider spread levels in the new contract.

Why the new contracts should trade at a wider level you might rightly ask? 

We have touched on that subject previously in February 2013 in our conversation "Promissory Hope":

From EDHEC-Risk Institute in their January 2012 note entitled "The Link between Eurozone Sovereign Debt and CDS Prices" provides us with some insight on the aforementioned impact:
"To examine the difference between these spread measures, we priced a 5-year bond with a 5% coupon in an environment where the default-free yield curve is assumed flat at 3% and the Libor risk-free curve is also assumed to be flat at 3.5%. We considered two cases - first an expected recovery rate of 40% and second an expected recovery of 0%. We then varied the 5-year survival probability assuming a flat term structure of default rates11 and calculated the implied bond price and spread measures. In all cases we assumed k = 1.

Figure 2 Comparison of the model-implied CDS, bond yield-spread and par asset swap spread measures as a function of the full price of a 5-year bond with a 6% coupon. We show this for an expected recovery of 40% (above) and 0% (below).":

"The results are presented in Figure 2. When the expected recovery rate is 40% we find that as the 

bond price falls (and it cannot fall below 40), the CDS spread grows and asymptotically tends to infinity while the yield-spread and asset swap spread tend to different large but finite numbers. However, if we set the expected recovery rate to zero then the yield-spread also tends to infinity and is very close in value to the CDS spread as the bond price falls to zero." - source EDHEC-Risk

As we repeatedly pointed out, the importance of liquidity is paramount, particularly in the credit space, given the low level of inventories on dealers' book that can accommodate large selling movements. The lack of liquidity in the financial CDS space without a revamp of the 2003 ISDA Credit Events definitions would exacerbate potentially the movements in financial bonds. 

The liquidity in credit is already impacted by the poor liquidity in the secondary space, in this low yield, and yield hunting environment as described in a recent presentation made by Wells Fargo Credit Strategy team:

"Anecdotal evidence from our trading desk suggests the performance of secondary bonds is lagging that of new-issues. In addition, trading flows point toward more investors buying new-issues “on switch” rather than outright from cash. This is particularly true at the long end of the curve and for frequent borrowers." - source Wells Fargo

Since January the price action has been more volatile in the Investment Grade than in the US High Yield ETF space, which has mirrored much more the price action of equities, namely the S&P 500. Investment Grade is therefore a more volatility sensitive asset, whereas High Yield is a more default sensitive asset, as indicated in  by the price movement of the the iShares iBoxx $ Investment Grade Corporate Bond Fund ETF (AMEX: LQD) versus the US High Yield ETF HYG and the S&P 500- source Bloomberg:

Looking at the latest minutes from the FOMC and the discussions surrounding the Fed's QE stance and the possibility of a reduction in bond purchases in coming quarters provided an improvement in the employment data, it does make Investment Grade corporate bonds highly more volatile to interest movements in this "Japonification" of the credit markets courtesy of global ZIRP.

As per a recent Wells Fargo credit presentation, we agree with them in relation to the key risks for Q2 2013 given that:

"Lower coupons and longer maturities increase a portfolio’s duration/interest-rate sensitivity. The duration of the entire HG corporate bond market has extended 1.0 year to 7.0 years over the past five years. In maturities of greater than 10 years, duration has extended 2.0 years to 13.6. With the Fed signaling a potential shift in policy this year, long-duration corporate bond prices could be at risk of falling sharply and quickly." - source Wells Fargo Credit Strategy.

We are not surprised that the price of "stability" courtesy of massive liquidity injections from global central banks has come at a cost of increased "instability" as per Hyman Minsky's definition:

"A Minsky moment is the point in a credit cycle or business cycle when investors have cash flow problems due to spiraling debt they have incurred in order to finance speculative investments. At this point, a major selloff begins due to the fact that no counterparty can be found to bid at the high asking prices previously quoted, leading to a sudden and precipitous collapse in market clearing asset prices and a sharp drop in market liquidity." - source Wikipedia.

You might want to read again, Irving Fisher's book "The Debt-Deflation Theory of the Great Depression" published in 1933. Because in this book Irving Fisher dealt extensively with "business cycle theory".

For Irving Fisher, the two big bad actors in great booms and depressions are debt disturbances and price-level disturbances. We have both...but that's us ranting:

"Debt Starters

Easy money is the great cause of over-borrowing. When an investor thinks he can make over 100 per cent per annum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with borrowed money. This was the prime cause leading to the over indebtedness of 1929." - Irving Fisher

Just a fact:

Investors borrowed $384.4 billion in April, a 1.3% gain from the previous month which was at $379.5 billion and conveniently the second highest in the history of the NYSE going back to 1959. The April surge was a 29% rise from the same month last year. The highest level was $381.4 billion recorded in July 2007.  We have an all-time record for margin debt and it exceeds the previous high mark. 

And what else did Irving Fisher wrote in his 1933 book?

"When the starter consists of new opportunities to make unusually profitable investments, the bubble of debt tends to be blown bigger and faster than when the starter is great misfortune causing merely non-productive debts."

So no "speculation" going on, it is all going well...

As far as credit is concerned, the rapidity in the tightening movements in credit spreads is reminiscent of the warnings given in 1933 by the wise Irving Fisher. 

A recent note from Societe Generale on the 22nd of May is clearly indicative of the rapidity of how this time around the credit bubble is being blown by our "omnipotent" central bankers:

"When the music stops, we pause and then just add another chair. It's usually the slightest of breathers and the market isn't waiting too long before that relentless grind and lifting of paper resumes. Clips, blocks of paper and new issues are managing to get taken down without much fuss, and we're not seeing any contagion from the volatile stocks impacting the cash market. We're well poised here. Of course there's plenty of apprehension and it is understandable that we all need a little convincing that still adding risk at these levels is the right thing to do. It is. In the meantime, the low/high beta compression continues and was clearly evident from yesterday's deal from Plastic Omnium. The unrated - but implied non-IG - French borrower managed to raise €500m for seven years, paying just 3% for the privilege. Add in a premium for being unrated and one has to concede that the level is a funding coup for the borrower! For the broader market, the iBoxx cash index closed below B+133bp yesterday and will be lower again today after the tightening seen in today's session for corporate spreads. Even taking into account the massive February/March wobble (when the index widened 22bp), credit is tightening faster than even we - the most bullish of observers - would have expected. Hitting our original 2013 target of B+120bp is now a case of when not if, and we can only expect investor nervousness to rise even more as a result. As long as money continues to come into the asset class and supply remains at these (low) levels given the size of the demand, then the current tightening/compression dynamics will stay in place. Position for it." - source Societe Generale.

Moving back to the subject of the evolution ISDA Credit Events and the impact of expected changes recovery rates on financials, the impact of the new CDS contracts would make the CDS market in the financial space more relevant as per a note from Societe Generale from the 24th of May on the subject:
"Event: 
CDS protection may be more valuable should reported proposals for amending credit derivative definitions be accepted. The proposal is to amend credit derivative definitions for banks and comprises three main points. First, it adds a credit event to capture government enforced bail-in. Second, it expands the list of deliverables in the new credit event and keeps current deliverables available for old events, despite their potential loss-absorption ability in the future. And third, it improves successor provisions to keep CDS protection attached to the debt. Taken together, these may help to avoid a repeat of the CDS insurance failure of SNS while capturing the increased tool-kit available for governments to restructure banks out of bankruptcy. We do not expect these provisions to be retrospectively applied to existing contracts; however the amendments suggest much less value in outstanding sub contracts.
Assessment: 
ISDA’s proposed changes would make CDS protection more robust and, therefore, valuable. First, a new ‘hard’ credit event would capture government-enforced bail-in. This would be broadly defined as an action taken by government authorities that alters creditor rights under bank restructuring and resolution laws. By our understanding, this does not include the institution triggering Tier 2 contingent capital (CoCo) clauses, as this is an action undertaken by the entity itself, but it would capture Bankia-type events. If the new credit event trigger is a write-down, the event would not occur until the write-down is permanent or there is nonpayment under prior contract terms. A ‘hard’ event eliminates the maturity buckets of restructuring events. Second, deliverables in the new credit event auction may include the written-down or conversion/exchange proceeds. Again, this is Bankia-event type protection. In the event of complete write-off, à la SNS, par payment would be received by the protection buyer. In addition, deliverables under a current or new credit event could include Tier 2 or more senior securities with write-down provisions as mandated by legislation, provided they are not yet written down. This would enable most Lower Tier 2 debt to be deliverable even if it is loss absorbing Basel III-compliant via legislation. CoCos could be delivered in the new credit event provided they have not yet triggered. This captures many bail-in eventualities. Third, successor provisions would track the debt, enabling subordinated and senior CDS to succeed to different entities. This would keep CDS viable in a good bank/bad bank situation. Also, importantly, the new credit event could occur on subordinated CDS without triggering senior CDS. This may have implications for sub/snr trading levels once the new amendments are in place." - source Societe Generale

On a final note, the US equities market is increasingly being boosted by buybacks, yet another artificial jab in the on-going liquidity induced rally as indicated by Bloomberg's chart, great for CEOs and stock options and their shareholders but probably less so for the health of the balance sheet:

"Repurchases are becoming a bigger source of demand for U.S. stocks, and shares of the companies that carry them out may have an easier time beating benchmark indexes if history is any guide.
As the CHART OF THE DAY shows, the Nasdaq Buyback Achievers Index has more than tripled in the current bull market and has left the Standard & Poor’s 500 Index behind. The Nasdaq gauge consists of companies that repurchased at least 5 percent of their shares in the previous 12 months.
“Corporations have been aggressively buying back shares,” Jeffrey Kleintop, chief market strategist at LPL Financial Holdings Inc., wrote two days ago in a report. He added that the repurchases are largely designed “to boost earnings per share as revenue growth slows.” - source Bloomberg

"The public psychology of going into debt for gain passes through several more or less distinc phases: (a) the lure of big prospective dividends or gains in income in the remote future; (b) the hope of reckless promotions, taking advantage of the habituation of the public to great expectations; (d) the development of downright fraud, imposing on a public which had grown credulous and gullible". - Irving Fisher.

At some point the Fed will have to normalize, probably not now, but the more they delay the adjustment, the more painful it is going to end up.

Stay tuned!

Credit - What - We Worry?

What - Me Worry: "As an interrogatory, indicative of a nonchalant attitude towards potential criticism, not caring about what other people think, confident and self-possessed." - source wiktionary

For a fourth week in a row, we have seen the Iboxx Euro Corporate index, being one of the most used benchmark in European Investment Grade mutual funds, tightened by 5 bps in the cash market every week, as the "grabayield" game goes on or as Bill Blain, a senior fixed income broker from Mint Partners recently put it recently to a CNBC.com interview referred to as an asset "grabathon":

 "This is going to become an asset 'grabathon', put your buying boots on".

This week's title is a reference to one of one of our great teenage years read, namely Mad Magazine Alfred E. Neuman's motto. After all the "grabayield" nonchalance in the credit space, not caring about the macro outlook, and with the credit markets being confident and self-possessed, made us venture this week towards this idiomatic analogy. We would have used "Dumb and Dumber" as a title looking at the issues being thrown out with such a pace and abandon (Unbounded enthusiasm; exuberance, being more likely), but, we did use this title before. Unlike some "goldfish memory span" investors out there, we do not suffer from Anterograde amnesia, which has been created it seems, by the use of "powerful narcotics", namely massive liquidity injections by our favorite Central Bankers.

On that subject of credit investors suffering from Anterograde amnesia, we could not have agreed more with our old friend and sparring partner Anthony Peters' column in IFR (International Financing Review) entitled "Investors queue up for perp walk":

"On Tuesday last week I tweeted (@therealadmp, should you wish to follow): “Enron announces zero coupon perpetual, convertible into WorldCom – book expected to be six times oversubscribed!”

My outburst was prompted by the ever-increasing slew of bond issues that defy logic and that seem to be bought by investors, to quote George Mallory out of context, because they’re there.

What caught my eye was the €1.75bn Hutchison Whampoa perpetual issue, which attracted a book somewhere in the region of €6bn.

I couldn’t help but wonder whether investors have a clue what distinguishes subordinated from senior corporate debt and what they are thinking when they pile into corporate perpetuals.

I never had too much of a problem with banks issuing perps – from a regulatory capital perspective it makes sense – but corporates don’t have reg cap requirements and therefore the entire process of issuing such structures perplexes me.

In the case of default the subs rank below the seniors and all that jazz, but is it really necessary and are investors being rewarded for the subordination or for the strip of call options that are embedded in the structure and which they are selling to the issuers?

I’m sure that there are plenty of syndicate managers who could easily argue the point, but they also argued, not so long ago and very convincingly, that CDOs were failsafe, that Libor plus 30bp was cheap for Triple A tranches of subprime mortgage bonds and that government bonds were risk-free. Caveat emptor, in other words."

Or caveat creditor, we would add to the wise words of our estimated friend. So in this week's conversation  we will look at default rates and their predictive ability in forecasting a turn in the credit cycle as well where we are in the credit cycle, as a follow up to last week's conversation where we focused on the releveraging taking place in the US market and the Global Credit Channel Clock. But, first our quick market overview.

The correlation between the US, High Yield and equities (S&P 500) since the beginning of the year has been growing in strength. We have also noticed the strong rebound in Investment Grade as indicated by the price action in the most liquid US investment grade ETF LQD - source Bloomberg:

In trading on Friday, shares of the iShares iBoxx $ Investment Grade Corporate Bond Fund ETF (AMEX: LQD) crossed below their 200 day moving average of $120.77, changing hands as low as $120.46 per share. Since January the price action has been more volatile in the Investment Grade than in the US High Yield ETF space, which has mirrored much more the price action of equities, namely the S&P 500. HYG and JNK are the two largest investment grade ETFs accounting for 80% of assets. These two ETFs have seen 1.1 billion USD of outflows highlighting the demand towards shorter duration ETFs such as High Yield ETFs SJNK and HYS, which according to CreditSights have taken in over 1.8 billion USD in combined AUM in 2013.

Investment Grade is therefore a more volatility sensitive asset, whereas High Yield is a more default sensitive asset. We will look further into this in this week's conversation.

Although the Eurostoxx have been much more less prone in breaking records than the S&P 500 and the Japanese Nikkei index, and has been struggling to break the 2800 level, the latest rise in the German 10 year Government yields towards the 1.27% yield level makes new issues in the European Investment Grade space much more sensitive to rising interest rates due to convexity factors than European High Yield. In the financial space the Itraxx Financial Senior 5 year CDS index (indicative of credit risk for financials in Europe) has continued to  perform towards 120 in the last couple of weeks while volatility remains muted at 17.3 for the V2X index - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

In similar fashion and as displayed by the relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge), high beta credit such as financials and European High Yield have indeed continue to perform with the Itraxx Crossover falling below the 2008 levels - source Bloomberg:

At the same time, the absolute level of core European government yields has somewhat reversed with German yields rising towards 1.30% level, and non-core peripheral bond yields for Italy and Spain have stabilised following a very impressive rally induced last summer on the back of the first episode of "whatever it takes" which was led by Mario Draghi and which was followed in 2013 by "whatever it takes" episode 2 courtesy of Kuroda and the Bank of Japan leading to another raft of "grabayield" - source Bloomberg:

The continued meteoric rise in the Japanese Yen, the Nikkei index and the receding pressure on Itraxx Japan credit spreads courtesy of Abenomics continue to validate the aeronautical analogy we made in our conversation the "Coffin Corner" - graph source Bloomberg:

But, we have been following as well with much interest the relationship between credit spreads and volatility in the Japanese space, a tale of growing divergence we think - source Bloomberg:

Whereas the 1 one year Implied volatility has remained relatively stable, the shorter 3 months Implied volatility has been telling a different story and why the relationship with credit was stable until 2011, it remained fairly muted throughout 2012 but since the beginning of the year, while the Itraxx Japan index has continued to perform in similar fashion to equities and the US dollar versus the Japanese yen, 3 months implied volatility has been surging. Something, we think, warrants monitoring.

Moving on to the subject of defaults rate and US HY, as indicated by UBS in their recent Global Credit Navigator from the 8th of May, global defaults rates since 2010 have remained stubbornly low:

"Since the end of 2010, global default rates have remained stubbornly low, oscillating in a narrow range of 1.5% to 3.5% (Chart below). 

The trend has been broadly similar in the US and Europe despite a bumpy economic recovery post the ’08-’09 Great Recession and the Eurozone debt crisis. Exceptional liquidity provisions by central banks (QE from the Fed, LTROs from the ECB) as well as “amend and pretends” in Europe have arguably kept default rates artificially low, at least below levels consistent with economic fundamentals. The thesis that the credit cycle may be reaching an inflection point is becoming a growing concern to many market participants and policymakers (please see “Overheating in Credit Markets: Origins, Measurement, and Policy Responses”, J. Stein, February 2013). Over the past 12 to 18 months, HY issuance has set new records and average credit quality has deteriorated. In particular, annualized rates of PIK bond issuance and of covenant-lite loan issuance in the fourth quarter of 2012 were comparable to highs from 2007. 

These recent trends do not bode well for prospective credit returns. Default rates in the 5% area (currently 3%) could cost about half an investor’s annual carry on his/her HY investment (US HY indices currently yield c6% per year). From a rating agency perspective, Moody’s baseline forecasts for default rates in one year’s time suggest some upcoming upward pressure on European default rates but on balance no material change to the latest global trends. However, while the agency’s optimistic forecasts do not imply a significant improvement in current default rates, the agency’s pessimistic forecasts underscore material downside risk. In their “black sky” scenario, default rates could reach 7% in the US, 8% globally and 9% in Europe." - source UBS

And, as we indicated in November 2012 in our conversation "The Omnipotence Paradox", zero growth should normally led to a rise in default rates, in that context, a widening in credit spreads should be a leading indicator given credit investors were anticipatory in nature, in 2008-2009, and credit spreads started to rise well in advance (9 months) of the eventual risk of defaults:

"The empirical relationships between lagged economic indicators (e.g. global PMIs) and defaults suggests zero growth should move default rates up towards the 5-8% context over the next 12 months."

- source UBS

What credit investors forget in this deflationary environment, is that, as we argued in November 2011 in a low yield environment, defaults tend to spike and it should be normally be your concern credit wise (in relation to upcoming defaults) for High Yield, not inflation as per Morgan Stanley's 2011 note:

"While one could argue that default rates could be high during times of higher yields owing to higher debt service cost, the opposite is actually true. High inflationary environments allow corporations to inflate away their nominal debt as their assets (and revenues) grow with inflation, leading to lower default rates. Low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike." - source Morgan Stanley

So, what is driving default rates you might rightly ask? 

For us and our good friends at Rcube Global Macro Research, and also UBS, as per their recent note, the most predictive variable for default rates remains credit availability.  Availability of credit can be tracked via the ECB lending surveys in Europe as well as the  Senior Loan Officer Survey (SLOSurvey):

"Senior Loan Officer Survey of 60 large domestic US banks and 24 US branches and agencies of foreign banks. This is updated quarterly such that results are available in time for FOMC meetings. Questions cover changes in the standards and terms of the banks' lending and the state of business and household demand for loans. We have used the net percentage of banks tightening standards for commercial and industrial loans to small firms as tightening credit standards should have a direct effect on the credit market." - source UBS.

Another factor used by UBS is Nonfinancial leverage:

"Average leverage of non-financial corporate sector (Nonfinancial Corp Debt/Nonfinancial Corp Earnings, source Federal Reserve)." - source UBS

"In terms of predictive value, the SLO survey and Non-financial leverage are two clear winners and these two factors alone produce an R^2 of about 0.6 in the best two-factor model." - source UBS

And as UBS rightly indicated:

"The 2008-2009 financial crisis brought the banking sector to an abrupt halt, resulting in a significant deleveraging of dealer balance sheets and contraction in bank lending to large and small firms which found themselves unable to refinance their debt." - source Bloomberg

This is why the US is ahead of the curve when it comes to economic growth compared to Europe. We have shown this before but for indicative purposes we will use it again, the US PMI versus Europe and Leveraged Loans cash prices US versus Europe - source Bloomberg:

"Positive investor sentiment combined with an excess of demand over supply pushed the average price of S&P/LSTA Index loans up a quarter-point to a fresh post-credit-crunch high of 98.4 cents on the dollar in April 2013. In response, the Index gained 60 bps during the month, bringing loan returns for the first four months of the year to 2.7%." - source Forbes

As displayed in a recent note from our good friends from Rcube Global Macro Research in relation to the US economy:

"While demand seemed to have eased a touch in the survey, actual commercial and industrial loan growth remains robust and should stay that way"

"With all major surveys on credit availability having now been released, we can draw several

conclusions on the health of the global credit channel. Following the 2008 subprime meltdown and

the 2011/2012 European sovereign crisis, the global bank credit channel weakened substantially. It

seems that it is normalizing fast now." - source Rcube

Rcube also added in their note a very important point relating to Europe and the difference with the US economy:

"Europe remains the only place where the credit channel is malfunctioning. But even there the trend is positive. The % of banks tightening loan supply and terms is becoming smaller. As we said in yesterday’s Monthly Review, coming ECB actions will be centered on this issue, potentially improving substantially the credit transmission mechanism." - source Rcube

Where we slightly disagree with our friends is that we wonder if the damages which have been caused by lack of credit in Europe, courtesy of the rapid deleveraging imposed on banks by the European Banking Association (EBA) to reach a Core Tier 1 capital threshold of 9% by June 2012 can be reversed. Looking at the credit crunch which happened in peripheral countries in Europe leading to a surge in both unemployment and nonperforming loans plaguing peripheral banks, it still hindering bank lending, hence the dislocation in rates between core European countries and peripheral countries:

- Source Datastream / Fathom Consulting.

- Source Datastream / Fathom Consulting.

Therefore a future rebound in private loan demand in Europe is questionable.

In terms of where we are in the credit cycle, as posited by Bank of America Merrill Lynch in their recent Credit Market Strategist note from the 10th of May, we agree with their stance namely that the previous credit cycle might indeed be shorter this time:

"With vanishing systemic uncertainties one of the key questions is - Where are we in the cycle? Compared with the previous cycle credit spreads are currently relatively “early cycle” at 2H 2003 levels – high grade non-financials around August and, following the recent rally, high yield a little later (December). 

However, due largely to extreme monetary accommodation certain indicators have us at later stages of the cycle. Thus, while spread-wise we are still at an early stage, the duration of the cycle may be shorter this time. Indicators displaying “late cycle” behavior include the very steep spread curves in high grade as well as the high percentage of CCC rated issuers that are accessing the primary market in high yield.

In terms of fundamentals, although leverage has been increasing over the past two years, we are still not seeing the downgrade pressures that are typical later in the cycle. Share buybacks are running at 2006 levels while M&A and LBO announcement volumes are consistent with earlier cycle 2004 levels. One key aspect of later stages in the cycle is unlikely to recur this time – liquidity. In the new regulatory environment dealers hold less than one percent of the corporate bond market. While previously dealer inventories grew to almost 5% of the market through the cycle, this time they are unlikely to expand meaningfully from current levels. That limits the potential for spread tightening as investors require more compensation to hold off-the-run bonds. Given this, the difficulties investors face becoming completely comfortable with financials post the financial crisis, as well as likely more binding constraints on leverage this time we think potential cycle-tight US high grade spreads are 100bps this time, compared with 79bps in the previous cycle. For reference the current spread level is 143bps and our year-end 2013 target 130bps." - source Bank of America Merrill Lynch.

As we have argued in so many conversations, while the credit space is enjoying a "sugar rush" courtesy of our Central Bankers", and to quote again our friend Anthony Peters from his recent column:

"Somewhere out there, the next big bubble is forming and it will catch the unwary cold. Banks no longer have the risk capital to make big markets in all issues, least of all unconventional ones, and investors would be well served to ask themselves now where the pockets of liquidity will be when they are most needed. Don't disregard the old definition of liquidity as being something which, when needed, isn't there. I can't say where that there will be but I can be pretty certain that it won't be in corporate perp land. I rest my case." - Anthony Peters - IFR - Investors queue up for perp walk. 

We could not agree more with our good friend, the risk is real. We used a reference to Bastiat in relation to liquidity and Credit Markets in our conversation "The Unbearable Lightness of Credit": "That Which is Seen, and That Which is Not Seen". 

If you think liquidity is coming back in the credit space, then you are indeed suffering from "Anterograde amnesia" caused by the liquidity induced "sugar rush" as indicated by Bank of America Merrill Lynch recent note:

"This one is not coming back. Dodd-Frank leads to less liquidity in the corporate bond and CDS markets, as the ability of dealers to make markets is permanently impaired by the new restrictions on balance sheets. For example dealers now hold less than one percent of outstanding corporate bonds – but during the previous cycle they were able and willing to expand their holdings to as much as almost 5% in 2007 (Figure below).

In contrast, for the present cycle we do not expect inventories to expand materially from current low levels. The natural consequence of this development is – as we have seen – that liquidity becomes more concentrated in on-the-run maturities and names. Thus investors will require an increased liquidity premium to hold off-the-run bonds – the vast majority of the outstanding corporate bond market. We estimate below (Figure below) that the difference between spreads on off-the-run and on-the-run 10-year HG corporate bonds is about 15-20bps, up from 1-5bps prior to the financial crisis.

Obviously this cuts both ways as the liquidity of off-the-run bonds has declined, while on-the-runs may actually have become more liquid.

However, still one of the most straightforward impacts of Dodd-Frank is wider credit spreads for the corporate bond market as most bonds are off-the-run. While the precise magnitude of this effect is difficult to estimate it could easily amount to 10-15bps for the average bond in high grade, or about 10% of overall spread levels." - source Bank of America Merrill Lynch.

As we posited in the conversation "The Unbearable Lightness of Credit":

“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“

"So as credit investors, yes we are indeed still dancing as the music is playing, but, given the liquidity levels closer to 2002 than 2007, we'd rather be dancing close to the exit door" - Macronomics - Pain & Gain

What - We Worry?      

     

"The circulation of confidence is better than the circulation of money." - James Madison, 4th American President.

Stay tuned!

Credit - Pain & Gain

"The aim of the wise is not to secure pleasure, but to avoid pain." - Aristotle 

Looking at the continued rally in the credit space, with the Iboxx Euro Corporate benchmark tightening to the tune of 5 to 6 bps every week in the last three week in the cash market, in conjunction with the massive compression of spreads in the Itraxx Credit indices space, we thought this week, we would use a reference to 1999, New Times three-part series of articles called "Pain & Gain" by writer Pete Collins which inspired 2013 American film directed by Michael Bay.  The story revolved around a gang of local bodybuilders with a penchant for steroids (liquidity from central bankers?), strippers, and quick cash. They later became known as Miami's Sun Gym gang and quickly developed a taste for blood and money.

Gain: 

We closed the week on almost 15 bps on Itraxx Main Europe to 92, the lowest since May 2010, which is the risk gauge for Investment Grade credit, and 50 bps in Itraxx Crossover to a low of 378 bps. 

Pain: 

As one credit index trader put it in his closing comments (which are reminiscent of the early days of 2007):

"With street put short yesterday by the massive short cutting, dealers are finding it hard to recycle positions and were having more and more pain as client kept selling index today as well. With shallow volumes, every enquiry drove the market lower. The incredibly strong payrolls drove us through 90 and this was the point when people were starting to have discussions of whether these tights are the new fair trading range or whether they should put those shorts."

 

There you go, the penchant for steroids induced rallies in the credit space is starting to inflict some serious pain to market makers as they are having to bid for credit indices and getting hit in a severe tightening market, not only inflicting P&L pain, given they are having trouble recycling their positions with less players in the market place than in 2007 (gone are the prop traders, fewer credit hedge funds and fewer market making banks) but, they are also facing negative carry on the trades they have had to absorb and did not recycle. Oh well...

So this week, we will focus our attention to the credit space, the releveraging taking place in the US and Mario Draghi's ambition of reviving the Euro Zone Corporate lending . But first, a quick market overview.

The absolute level of core European government yields has continued to fall even after the 25 bps rate cut this week - source Bloomberg:

2 year Italian yields dropped to 1.068% the lowest since Bloomberg started tracking the data in 1993 and Italian 10 year yields fell 7 bps to 3.84% the lowest since October 2010. Spanish yields also receded with the 10 year falling to 3.97% below 4%, the least since October 2010 and 2 year below 1.60%, the lowest since April 2010.

Credit wise Europe is indeed turning Japanese. It's D,  D for deflation. German 2 year notes versus Japan 2 year notes going negative again and indicative of the deflationary forces at play we have been discussing over and over again - source Bloomberg:

Credit wise the rally in 2012 has been epic courtesy of "whatever it takes 1" (Mario Draghi) and "whatever it takes 2" (Abenomics). Itraxx Main Europe 5 year CDS index (Investment Grade credit risk gauge based on 125 entities) and Itraxx Crossover 5 year index (European High Yield risk gauge based on 50 European entities) - source Bloomberg:

The absolute spread between both credit indices is closing to the level of March 2011 (255 bps apart) before the liquidity crisis of summer 2011 which was tempered by a good dose of "steroids" (LTRO 1 and 2).

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:

We are back to early 2008 levels for both the Itraxx Crossover index and Eurostoxx volatility.

While the Eurostoxx seems struggling to break the 2800 level, the German 10 year Government yields have touching record low levels this week towards the 1.16% yield level  and the Itraxx Financial Senior 5 year CDS index (indicative of credit risk for financials in Europe) have been dramatically falling towards 140 in the last couple of weeks while volatility remains muted at 18 for the V2X index - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

We already indicated that divergence between the US PMI and European PMI divergence which we explained in our conversation "Growth divergence between the USA and Europe", was here to stay in 2013. This divergence can be seen as well in the difference in credit spreads risk gauges such as the Itraxx Main Europe CDS index and its US CDX counterpart - source Bloomberg:

What has been interesting has been the strong correlation between the US, High Yield and equities (S&P 500) since the beginning of the year. We have also noticed the strong rebound in Investment Grade as indicated by the price action in the most liquid US investment grade ETF LQD - source Bloomberg:

Talking about Pain and Gain, whereas March was brutal for investment grade, the rebound in April has indeed been very significant. As one can see the correlation between High Yield and equities seems to be stronger than ever as both the S&P 500 and the ETF HYG seems to be perfectly moving in synch.

But, if we focus our attention this week on credit, we would have to say that the unintended consequences of "steroids" induced policies from Central Banks is pushing investors more and more up the risk spectrum as everyone is seeking higher returns as indicated by Fitch recent European High Yield Chart book:

"As yields continue to compress in high yield, the risk-reward proposition for the investor becomes increasingly difficult to justify, shifting the dynamics in favour of issuers. European non-financial BBs now trade equal to equivalent US BBs, despite materially weaker growth, greater policy volatility and uncertain liquidity. European Bs continue to offer premia, though these too are tightening. Global monetary stimulus from quantitative easing in the US, the UK, and Japan together with an expected ECB rate leaves little choice for investors other than to move out along the maturity curve and go down the credit spectrum to seek diversification as they satisfy return objectives.
Deteriorating credit quality poses a risk to the market, but this is largely expected to translate into a migration of ratings to lower levels rather than any substantial increase in the default rate. The legacy loan market is at greater risk of rising defaults due to the concentration of riskier borrowers from 2006 and 2007 who were able to access tighter spreads and higher levels of leverage than the high-yield market could accommodate at the time.
However, further spread compression may entice riskier lower B‟ or CCC rated issuers from the leveraged loan market to issue high-yield bonds. Such developments tend to signal the end of cycle in European high yield and a period of yield and spread widening together with subdued new issuance. To date in 2013, the market is accepting lower quality instruments from higher quality borrowers, such as Sunrise Communications Holdings SA (BB−/Stable) recent PIK note (B− instrument rating). When the market tests low-quality instruments from low-quality borrowers the cycle will be set to return." - source Fitch

The European and US High Yield Market, new issuance and yields - source Fitch:

Using again our "Pain & Gain" title analogy, we would like to further delve into our analysis of the "Japonification" of credit in Europe and the difference with the US where we are seeing re-leveraging at play in the credit space.

For instance, many pundits are wondering how come peripheral EMU bond yields and peripheral bonds have been performing so strongly when indices such as the FTSE Italian bank index is still flat at 10,000.

For us, it is very simple, deleveraging is generally bad for equities and in particular financial stocks, but good for credit assets. We discussed this very subject back in April 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets":
"When companies turn conservative and start reducing debt, credit holders benefit and equity holders lose out."

Why would we have had a rally in Italian banks? It doesn't make sense. For us a bank is a leverage play on the economy, it is the second derivative of a sovereign. No credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits and no earnings for banks. Banks in peripheral countries had no choice but to shrink their loan books, reducing therefore their profitability and ROE.

European Banks ROE by countries from 2005 to 2011 - source Bloomberg - Macronomics:

Nota Bene: 2011 data for Germany not available. McKinsey & Co. said in its bank sector annual report. European bank average returns on equity were 15% to 17% in 2005-07, vs. 7% to 9% currently. With the revenue outlook poor, further cost cuts remain a key profitability lever. Median ROE in 2011 in the European Union was 2.2%.

As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation which is what we are seeing in Europe and what a 1.2% inflation rate is telling you hence the ECB rate cut this week. But, once again ECB is behind the curve courtesy of the stupid European Banking Association decision of imposing a 9% Core Tier 1 threshold to European banks to be reached by June 2012, which precipitated a credit crunch in peripheral countries, leading to a surge in unemployment, bankruptcies and rapid rise in nonperforming loans.

A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse in 2011). A solvency crisis can still happen when the loans banks have made turn sour, which implies more capital injections to avoid default (hence the flurry of subordinated bond tenders we have seen in the European banking space and other accounting tricks...). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios in peripheral countries.

Therefore in Europe, you have been much better off buying senior financial corporate bonds as part of the reflation "whatever it takes" trade in this deflationary environment than peripheral financial stocks. As seen in Japan in the past, credit outperforms equities in a deflationary environment.

Peripheral banks equities = Pain

Peripheral banks senior financial bonds = Gain

At this juncture, we think it is very important to look back on how the "Global Credit Channel Clock" operates, as designed by our good friend Cyril Castelli from Rcube Global Macro Research which we introduced in our conversation "The Night of the Yield Hunter":

Whereas credit wise, European peripheral financials are deleveraging, hence the performance of their bonds ("Gain" - Love) rather than their equities ("Pain"- Hate), what we are starting to see in the US is leverage rising as indicated by Fitch, in their recent US High Yield Default insight from March 2013:

"Credit Gains Hit Speed Bump:
In the March 2013 edition of the “Fitch Ratings/Fixed Income Forum Senior Investor Survey,” a majority of investors saw U.S. corporate leverage moving higher over the coming year and expected some credit deterioration across both high grade and high yield. Fitch’s recurring analysis of the aggregate financial performance of a large sample group of speculative grade companies shows that leverage began to turn up in 2012 — a product of higher debt balances and sluggish EBITDA growth (see Debt / EBITDA chart below).

In the second half of the year, in fact, the number of companies in Fitch’s sample reporting year-over-year increases in EBITDA (approximately 55%) had fallen to the lowest level in three years and was on par with the share reporting year over year increases in total debt (also 55%) (see Companies Reporting Increases in Debt and EBITDA chart below). 

Rating trends further confirm this pattern, offering a more complete picture of the direction of credit quality. Fitch recorded more U.S. corporate downgrades than upgrades in 2012. In the first quarter of this year rating activity was roughly even for speculative grade borrowers, and so it appears that the negative rating drift has stabilized, but trends remain lackluster, especially compared with 2010 and 2011 activity when credit quality was more firmly on the upswing. Also notable, the volume of bonds rated ‘CCC’ or lower is now $237.5 billion, up from $226.5 billion at the end of 2012 and $196.8 billion at the end of 2011. Even absent aggressive precrisis transactions, there is still plenty of organic sensitivity to the subpar domestic and global economic environment. An offset to this is funding. Thanks to the Fed’s commitment to low interest rates and the demand it has created for yield product, companies have been able to successfully push out bond and loan maturities. This provides a meaningful support for keeping default rates low in the near term."

In terms of flattening yield curve, indicative of the credit cycle, we think as credit investors you should start monitoring the flattening of CDS curves. As a market maker commented recently:
"1 year and 2 year CDS curves are flattening, only a matter of time before 3 year versus 5 year curves does the same and flatten."

We have of course seen this movie before in the credit space in the heyday of the credit bubble build up in 2006 and 2007.

So as credit investors, yes we are indeed still dancing as the music is playing, but, given the liquidity levels closer to 2002 than 2007, we'd rather be dancing close to the exit door. As Aristotle put it, our aim, being wise we think, is not to secure pleasure, but to avoid pain, which will no doubt materialise at some point.

On a finale note, Mario Draghi ambitions to revive the real economy and corporate lending that is. The LTROs after all amounted to "Money for Nothing":

"Although LTRO provides cheap funding to European banks, rising unemployment levels and deteriorating credit conditions should consequently lead to a significant rise in Non Performing Loans (NPLs) on banks balance sheet."

Meaning plenty of liquidity impact (steroids) for banks (our European Sun Gym gang which have a taste for blood and money) but confirming our 2011 fears of credit contraction for corporates and households (Italy and Spain) - source Bloomberg:

"Corporate loans across the euro zone fell more than 350 billion euros ($460 billion) to March's total of 4.5 trillion euros from January 2009 highs. ECB President Mario Draghi's lowering of the marginal lending rate and hint at reviving European Asset-backed Securities mark early steps toward enlisting banks to lend-again. An ABS market would enable banks to package new lending into an ABS structure and post with the ECB to access further funding." - source Bloomberg.

As far as we are concerned, the deflationary forces at play and the unemployment levels in Europe cannot be addressed by ZIRP for the following "creative destruction reasons" as indicated by CreditSights in their recent Sovereign Analysis from the 1st of May entitled -If the ECB doesn't mind Spain deficit, nor do we":

"Spanish non-financial corporates alone saved the equivalent of 3.3% of GDP last year. That difference between corporates' revenues and expenses was used to pay down debt. Spanish, non-financial corporates have net debts equivalent to 129% of GDP. But it comes at the expense of Spanish households'. In the process of using revenues to pay down debt, corporates are ensuring that they aren't spending it and in the vast majority of cases won't not generate incomes for households. Those cut backs in investment spending are contributing to the decline in wages and rise in unemployment.

Unemployment has now reached 27.2% as of the first quarter. And wages have fallen by 1% over the past year. The decline in incomes mean that household savings have fallen from 6% of GDP in 2009 to 1% of GDP in 2012 as they have been forced to fall back on savings to be able to maintain spending. While households added €22 bn in financial assets in 2011 they reduced their holding of financial assets by €15 bn in 2012. That swing from saving €22 bn to dis-saving €15 bn contributed €37 bn to household spending and meant that year on year it rose by 0.2% in nominal terms rather than falling by more than 5.5%." - source CreditSights

 

Since 2008, you have seen creative destruction at play, meaning companies have preserved their margins by doing more with less people. Some job will just not return. What is the benefit of QE and ZIRP on structural unemployment? Zero so far:

ZIRP isn't only a European problem in this credit "japonifiaction" process at play. It is also the case in the US.

In fact productivity in the US has been rising as companies have been indeed preserving their margins by managing very tightly their labor costs and adapting to the low growth environment they face as reported by Shobhana Chandra in her Bloomberg article from the 2nd of May - Productivity in U.S. Rises as Companies Try to Cut Labor Costs:

"The productivity of U.S. workers rose in the first quarter as companies focused on containing labor expenses.
The measure of employee output per hour increased at a 0.7 percent annual rate, after dropping 1.7 percent in the prior three months, a Labor Department report showed today in Washington. The median forecast in a Bloomberg survey of economists called for a 1 percent advance. Expenses per worker increased at a 0.5 percent rate after jumping 4.4 percent.
Employers tried to control expenses by making do with their existing staff as demand grew in the January to March period. The emphasis on wringing efficiency gains may mean hiring will take time to accelerate, particularly as across-the board federal budget cutbacks and higher payroll taxes restrain the world’s largest economy." - source Bloomberg.

By keeping interest low to promote investment, like the Fed is also currently doing, full employment would therefore be "attainable" in the pure Keynesian tradition. For Keynes, the velocity of money should move together with the level of economic activity (and the interest rate). Well guess what. It isn't.

Why?

Credit growth is a stock variable and domestic demand is a flow variable.

Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?

The only country in Europe we can think of which tackles efficiently structural unemployment by retraining the labor force is Sweden.

Why would the US labor participation rate in the US increase?

If the cost of capital is not priced but set by central banks, how can capital be efficiently deployed to innovation and not "mis-allocated"?

 

MV = PQ. (Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.).

Monetary policy at the moment is a desperate race. They are increasing money supply but velocity keeps falling. So the Fed’s problem is best understood as one of trying to bend this velocity curve.

Alan Greenspan made mistakes after mistakes, bubbles after bubbles, central bankers do not understand that negative real rates always lead to a collapse in velocity and a structural decline in Q, namely economic growth rate.

Pain in employment levels - Gain in financial markets.

"Prefer a loss to a dishonest gain; the one brings pain at the moment, the other for all time." - Chilon


Stay tuned!