Credit - The Anna Karenina principle

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

While looking at Europe's inflation level coming at 0.7%, indicative of the seriousness of the deflationary threat in conjunction with the rise of unemployment to 12.2%, we thought we would use this week in our title, a reference to the Anna Karenina principle:

"The Anna Karenina principle describes an endeavor in which a deficiency in any one of a number of factors dooms it to failure. Consequently, a successful endeavor (subject to this principle) is one where every possible deficiency has been avoided.

The name of the principle derives from Leo Tolstoy's book Anna Karenina, which begins:

Happy families are all alike; every unhappy family is unhappy in its own way." - source Wikipedia

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

While we mused at length on the "Cantillon Effects" generated by the abundant liquidity provided by our "generous gamblers" aka central bankers around the world, as far as the Anna Karenina principle goes, in this chaos of "mal-investment", there is indeed an order and of course rising "forced positive correlations" which we mused on in our previous conversation "Alive and Kicking".  We agreed at the time with Martin Hutchinson's take on the subject of positive correlations in his article "Forced Correlations" published in Asia Times:

"Negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. 

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

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

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

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

It is very simple:

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

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

As reported in Bloomberg by Nikolaj Gammeltoft, Nick Taborek and Audrey Pringle on October 28th in their article "Correlations Bets at Six-Year Low as Debt Turmoil Fades" complacency is clear and present:

"U.S. options traders are convinced that profits, buybacks and takeovers will exert a greater influence on stock prices in coming months, sending an index tracking expectations for lockstep moves to a six-year low.

The Chicago Board Options Exchange S&P 500 Implied Correlation Index tumbled 37 percent to 37.21 since Oct. 8, according to data compiled by Bloomberg. The gauge, which uses options to indicate how closely stocks in the Standard & Poor’s 500 Index will move together, reached 36.07 on Oct. 18, the lowest level since February 2007." - source Bloomberg.

From the same Bloomberg article:

"The CBOE Volatility Index, the gauge of S&P 500 options prices known as the VIX, has fallen 36 percent to 13.09 since Oct. 8, according to data compiled by Bloomberg. The measure soared 23 percent from the beginning of the government shutdown on Oct. 1 to Oct. 8 as politicians struggled to reach an agreement to avoid a default."

‘Big Deal’

“It’s a big deal because when correlation gets this low in conjunction with low levels of volatility,” Peter Cecchini,global head of institutional equity derivatives and macro strategy at New York-based Cantor Fitzgerald LP, said in an interview, “it may mean that market participants are complacent and markets are vulnerable to a correction.” 

This month’s drop in the CBOE’s correlation index has been greater than the retreat at the beginning of 2013 after U.S. lawmakers agreed to pass a bill averting spending cuts and tax increases known as the fiscal cliff. The measure dropped as much as 20 percent in the two months after Dec. 28, 2012." - source Bloomberg

The evolution of VIX versus its European counterpart V2X since April 2011 - source Bloomberg:

The highest point reached by VIX in 2011 was 48 whereas V2X was 51. VIX is around 14, at 13.65 and V2X at 15.54, highlighting as well the significant drop between US and Europe in relation to risk perception.

As CITI indicated back in August from our previous conversation "Alive and Kicking":

"It's not hard to figure out why the 'Great Rotation' has been such a hot topic this year. It seems so intuitive: as yields rise over the next few years in response to a gradual economic recovery, total returns in fixed income will be weighed down, if not outright negative. The asset class that has the most to benefit from growth is equities.
For example, for the past year we have continuously highlighted the asymmetry in risk/reward between equities and credit. As illustrated in Figures 2 and 3, credit and equities have correlated closely over the last few years and almost in a constant ratio. We don't see why that wouldn't work in reverse also.

However, as credit spreads get closer and closer to the lower bound it becomes increasingly difficult for them to continue performing in the historical relationship with equities. The slight gap that appears to be opening up in both charts recently seems to bear that out.
In other words, to our minds there is an obvious long-equities-short-credit relative value trade insofar as credit has all the downside potential of equities, and much less of the upside." - source CITI

We also argued at the time:

"For us, there is no "Great Rotation" there are only "Great Correlations""

An evidence from our statement can be seen in the rising positive correlation between Asian currencies and the S&P 500 which have been moving in lockstep for the first time in a year as per Bloomberg's Chart of the Day from the 30th of October:

"Asian currencies are moving in lockstep with the Standard & Poor’s 500 Index for the first time

in a year, suggesting investors are returning to riskier assets on bets the world’s biggest economies will strengthen.

The CHART OF THE DAY shows the Bloomberg-JPMorgan Asia Dollar Index rebounded to 116.84 after falling to a three-year low of 113.58 on Aug. 28, while the S&P 500 surged to a record yesterday. The lower panel shows the 60-day correlation coefficient between the two gauges rose 50 percent in the past two months to 0.56 out of a maximum of 1, approaching the highest in a year and the 0.64 average from 2009 to 2012, when markets worldwide were roiled by Europe’s debt crisis.

Investors are seeking higher-yielding assets as concern over a breakup of the euro bloc evaporates, optimism the U.S. and China are rebounding from slowing growth increases, and speculation rises the Federal Reserve won’t slow quantitative easing until the first quarter. In the past four years, Asian currencies gained 5.1 percent on average when the correlations strengthened and peaked over the 0.7 zone, according to data compiled by Bloomberg.

“The market is looking for a sweet spot -- an improving global growth and a dovish Fed pushing QE tapering further out,” Marcelo Assalin, who oversees $3 billion of local-currency emerging-market debt in Atlanta for ING Groep NV, said in a phone interview on Oct. 28. “I honestly don’t see catalysts for a breakdown in correlation in the near term.” China’s economy, the world’s second-biggest after the U.S., expanded at a faster pace for the first time in three quarters, quickening 7.8 percent in the three months through September from a year earlier. The Fed decided to press on with $85 billion in monthly bond purchases yesterday, saying it needs to see more evidence that the economy will continue to improve.

Investors should buy India’s rupee and Indonesia’s rupiah as a delayed tapering bolsters carry trades, where investors borrow in low-interest-rate currencies to buy higher-yielding assets, Assalin said. The Fed has maintained its target rate for overnight loans between banks in record-low range of zero to 0.25 percent since December 2008." - source Bloomberg

Another impact of the "tampering in the tapering stance" by the Fed has as well led to the breakdown in the correlation between bond yields and equity prices as investors keep on hoping the punchbowl will not be pull back too soon by the everlasting accommodative Fed as displayed in another Chart of the Day from Bloomberg from the 24th of October:

"Emerging-market currencies are benefiting from the breakdown in the correlation between bond yields and equity prices as investor expectations for monetary stimulus by the Federal Reserve lengthen.

The CHART OF THE DAY shows that a Bloomberg index of the 20 most-traded emerging-market currencies and the Standard & Poor’s 500 Index have, since the beginning of July, appreciated when 10-year U.S. Treasury note yields declined on an average of 14 out of the previous 50 days on a rolling basis. The figure compares to an average of five days out of a similar period from the start of 2012 through June 2013.

“What the Fed really wanted was to get interest rates low and get real activity going,” Steven Englander, the global head of Group of 10 currency strategy at Citigroup Inc. in New York, said in a phone interview. “As a side effect, what happened was this was a spur to asset markets. This is spilling over into EM currencies.”

Bloomberg’s emerging-market currency index has increased 3.7 percent since the start of September after declining 7.9 percent in 2013 through August. Meanwhile, the S&P 500 has climbed 7.2 percent since the beginning of September after increasing 2 percent over the previous two months.

Fed policy makers last month cited the need for more evidence that economic growth will be sustained for continuing to pump $85 billion a month into the economy by purchasing bonds. BlackRock Inc. and Pacific Investment Management Co. have said the central bank will postpone tapering stimulus.

A rebound in the carry trade, which lost money for four straight months through August in the longest slump since 2011, bodes well for high-yielding emerging-market currencies such as Brazil’s real and South Africa’s rand." - source Bloomberg

So while investors continue to get "carried away" in "beta" terms in this sea of liquidity plentiness, what has caught our attention is another breakdown in correlation in the credit space, namely the one between credit volatility and spreads that is. This specific matter has been highlighted by CITI on the 29th of October in their note entitled "Has Credit Vol Decoupled from Spreads?":

• "Relationship between credit volatility and spreads has broken down - Using CDX IG as an example, we find that after September 2012, the traditionally high volatility/spread correlation drops from 85% to 10%. In contrast, the correlation between CDX IG spreads and equity volatility has remained meaningful.
• Price volatility is a better risk indicator - In contrast to the spread volatility quoted in volatility markets, the equivalent price volatility exhibits better sensitivity and much stronger correlation to credit spread moves. We find that this relationship persists for recent (post September 2012) data.
• Credit spreads are currently tight relative to price volatility - A simple regression model using the past 1 year of spread/price volatility data indicates that index spreads are too low compared to both 1M and 3M price volatility levels." - source CITI

In their note CITI highlights this correlation disconnect, which is of great interest bearing in mind the Anna Karenina principle mentioned above:

"The Great Disconnect

Traditionally, investors have used volatility in risk asset classes as a measure of systemic risk. This is because, while (in theory) volatility can spike when markets make large moves, the reality is different. Given human psychology, risky asset volatility has always tended to spike during periods of market downturns because of the gappy nature of selloffs, while market rallies have tended to be relatively smooth. Therefore, volatility has always been regarded as a good hedge against sharp market down turns, and both options and volatility indices (e.g. VIX) have found a good market in hedge buyers.

What if that situation were to change? If we take a look at what is going on in the US credit volatility markets, it would certainly appear that there has been a regime change, and one that does not bode well for those that hedge with credit volatility products.

To illustrate this issue, we use the CDX IG index as an example. Using data dating back to 2011, we find that the traditionally strong positive correlation (volatility rises as spreads widen during a market selloff) between CDX IG index spreads and ATM implied volatility has taken a nosedive recently (see Figure 1).

Figure 1. Strong correlation between 1M or 3M ATM volatility and CDX IG spreads breaks down post Sep 2012 (left). Simple linear regressions between 3M ATM volatility (X-axis) and the underlying index spread (Y-axis) confirm the strong relationship pre-Sep 2012 (top right) and almost no relationship post-Sep 2012 (bottom right).

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

CITI's conclusion that this disconnect does not bode well for those that hedge with credit volatility products is not surprising to us. It validates our January 2013 take on the subject of the impact central banks play on volatility which we wrote about in our post "Volatility Regime Change and Central Banks - a key driver":

"One thing for sure, the on-going excessive search for yields could have a long-term impact (relative immunisation risk of credit versus equities)."

CITI also makes the following interesting point in their note on the correlation breakdown between index spreads and implied volatility being extremely weak:

"Furthermore, this is true across credit indices and option maturities – both 1M and 3M ATM implied volatility for CDX IG and HY indices exhibit the same behavior recently. At the same time, we find that the correlation between equity volatility (e.g. 3M ATM SPX volatility) and credit spreads does not suffer to this extent (see Figure2). 

Figure 2. In contrast to credit volatility, equity volatility shows stronger correlation to CDX IG index spreads in the post-Sep 2012 period (left). This is confirmed by regressions between 3M ATM SPX vol (X-axis) and CDX IG spreads (Y-axis) in the pre-Sep 2012 (top right) and post-Sep 2012

(bottom right) periods.

Does this mean that the credit volatility market has lost its signaling power as a

barometer of systemic risk? Further, are equity volatility markets a better barometer for credit risk itself?" - source CITI

Why  such a decoupling? It's the Low Spread Regime stupid! According to CITI:

Why are we seeing this apparent decoupling? After all, the only significant thing that happened in Sep 2012 was the OMT announcement from ECB president Draghi which did send spreads tighter, and volatility lower, across the board. However, while this announcement served to take tail risk off the table for most investors, it is unlikely that it would cause the correlation between spreads and volatility to break down in this spectacular fashion.

We believe that the reason is different, but related. Once systemic risk was off the table after the OMT announcement, there was a sustained rally in spreads that has more or less continued unabated to the present. For most of this period, CDX IG spreads have remained at relatively low levels (see Figure 1). As spreads have gone tighter, implied (spread) volatility levels have approached a floor.

Why did this happen? Remember that implied volatility for credit spreads is represented as a percentage of the underlying spot (spread) level. For example, when the CDX IG index is trading at 120bp, an implied spread volatility of 40% means that the index is expected to move around 3bp/day1. However, if the index spread falls to 60bp, the expected move falls to 1.5bp/day.

As spreads go tighter, the expected implied move in bp/day approaches a floor which is determined by the bid/ask spread for the index. In other words, in a tight spread regime, the implied volatility for the index cannot go below a floor that puts the corresponding expected index move in bp/day below the index bid/ask spread.

As we approach this implied (spread) volatility floor, the behavior of implied volatility begins to exhibit less sensitivity to spread moves, thus giving rise to convexity. This kind of behavior is a well-known phenomenon and can readily be seen in the relationships between other asset pairs, such as credit spreads and equity prices (e.g., CDX IG versus S&P 500), where credit spreads at very tight levels become de-sensitized to equity index moves." - source CITI

With so much "Greed" and no "Fear" thanks to the postponement of "tapering" in the near future, risky assets have rallied hard, as displayed in the rally seen in High Yield and the continuous rally in the S&P 500, but increasingly the performances for credit  investment grade is being "capped" due to the growing disconnect and correlation breakdown mentioned by CITI - graph source Bloomberg:

The correlation between the US, High Yield and equities (S&P 500) is back thanks to "no tapering". US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG.

The surge in risky assets is of course entirely driven by the fall in volatility as a whole in various asset classes as displayed in the below Bloomberg graph:

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

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

EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market currencies. The index is based on three-month at-the-money forward options, weighted by market turnover.

In true Anna Karenina principle, we think the rising disconnect and positive correlations are tantamount to rising instability in the system as a whole as posited by Gorban's work quoted by  the University of Leicester - Anna Karenina principle explains bodily stress and stock market crashes:

"Adaptation energy as described by Selye, represents physiological resources that can be drawn on when an organism is under biological stress. Gorban and colleagues have demonstrated that the same notion can be applied to financial systems.

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

The research was published in the August 15 issue of the journal Physica A, (Vol. 389, Issue 16, 2010, pp 3193-3217). A preprint is also available online: http://arxiv.org/abs/0905.0129"

The regime change in both lower volatility and lower yields is indicative of the adaptation of the financial system not under biological stress but under central banks "financial repression" that is:

"Many examples from human physiology support this observation: from the adaptation of healthy people to a change in climate conditions to the analysis of fatal outcomes in oncological and cardiological clinics.

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

In addition to the adaptation of the financial system under this time around "regulatory repression", the growing instability can be ascertained we think in "dwindling liquidity" as indicated in Bloomberg by Lisa Abramowicz on October 18th in her article entitled "Wall Street Dodging Bonds Lifts Risk in Tapering: Credit Markets":

"Wall Street’s biggest banks are demonstrating an unwillingness to wager on corporate debt in times of stress, raising concern that any losses will be magnified when the Federal Reserve tapers its record stimulus.

As speculation mounted in the two weeks ended Oct. 9 that the U.S. could default on its debt, the 21 primary dealers that trade directly with the central bank sold a net $180 million of investment-grade notes, Fed data show. The flight was bigger four months ago as the market spiraled into its worst performance since the financial crisis, with dealers slicing inventories by a net $4.77 billion.

Banks that traditionally sought to profit from debt-market dislocations now are shunning risk during periods of deteriorating sentiment as they eliminate proprietary trading groups and reduce leverage. Dealer reluctance to use balance sheets to absorb investment-grade credit amplified the 4.98 percent loss in May and June on the Bank of America Merrill Lynch U.S. Corporate Index as central bankers considered reducing the monthly bond purchases and Treasury yields soared toward a two-year high, New York Fed researchers wrote in an Oct. 16 report." - source Bloomberg.

The article also fuels our "liquidity" concerns which have been a regular feature in our numerous "credit" conversations. The increased volatility and sensitivity in bond prices are clearly for us an indication of the system adapting in true "Anna Kareninia principle" fashion leading to an overall significant build-up in "instability":

"Corporate-bond prices are experiencing bigger swings as policy makers debate slowing the economic stimulus that’s boosted the Fed’s balance sheet to $3.8 trillion. The central bank may start reducing bond purchases as soon as December, according to 59 percent of 41 economists in a Sept. 18-19 Bloomberg survey.

After cutting a broad measure of corporate and some asset-backed debt from a peak of $235 billion in October 2007, dealers pared investment-grade holdings to a net $11.5 billion as of Oct. 9, Fed data show. That’s down from $13.5 billion at the end of May, when Fed Chairman Ben S. Bernanke said sustainable labor-market progress could prompt a reduction in the $85 billion of monthly bond purchases through the quantitative easing program." - source Bloomberg

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

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

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

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

Of course when it comes to the "Anna Karenina principle" as well as Bayesian learning history shows the final phases of rallies have provided some of the biggest gains.

But we are drivelling again given in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":

"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

On a final note, given shipping has been our favorite deflationary indicator we give you the latest reading of the Drewry-Hong-Los Angeles container rate benchmark given it will be raised again by $400 USD on the 15th of November on all US destinations - graph source Bloomberg:

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

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

Stay tuned!

Credit - Alive and Kicking

"What you gonna do when things go wrong? 

What you gonna do when it all cracks up? 

What you gonna do when the Love burns down? 

What you gonna do when the flames go up? 

Who is gonna come and turn the tide? 

What's it gonna take to make a dream survive? 

Who's got the touch to calm the storm inside? 

Who's gonna save you? 

Alive and Kicking 

Stay until your love is, Alive and Kicking 

Stay until your love is, until your love is, Alive"

- Alive and Kicking - Simple Minds - 1985

Songwriters: Kerr, James / Macneil, Michael Joseph / Burchill, Charles

While enjoying the smoother driving commute to work courtesy of the summer lull, we listened to old classic 1985 "Alive and Kicking", from Scottish rock band Simple Minds, and some of the lyrics did struck a chord with the on-going central banks "kicking the can" game which has been increasing the correlation between asset classes and the levitation process. Therefore, in continuation to our previous use of musical references for our title analogy, we thought this week's title reflects our current interrogations on central banks abilities in dealing with the next burst of the asset bubble they have so aptly created thanks to their numerous and generous liquidity injections from the last couple of years.

In this week's conversation, we would like to focus our attention on the inherent "instability" which has been building up in all asset classes due to rising correlations, the consequences of negative real returns, and how to somewhat side-step negative convexity thanks to CDS. But, first, our usual market overview:

The volatility in the fixed income space has been receding during this on-going summer lull as displayed by the recent evolution of the Merrill Lynch's MOVE index falling from early May from 48 bps  towards the 75 bps level - 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.

A low volatility regime until May had benefitted the most carry trades such as Emerging Market Bonds as well as high carry Emerging Markets currencies. This was the direct consequence of negative interest rate of return on US Treasuries for the last couple of years due to "financial repression". Following the huge surge in volatility after the conflicting "tapering" signals sent out by the Fed that began in May, Emerging Market currencies should remain volatile and under pressure in the coming months as indicated by Bloomberg's "Chart of the Day" from the 5th of August displaying JP Morgan's Emerging Market Volatility Index:

"The CHART OF THE DAY shows JPMorgan Chase & Co.’s Emerging Market Volatility Index since Fed Chairman Ben S. Bernanke told Congress in May that policy makers may temper bond purchases that helped spur $3.9 trillion in capital flows to developing countries in the past four years. The gauge jumped to a one-year high of 11.8 percent June 21, before falling to 9.5 percent yesterday after the Fed said it will keep stimulus for now. The index’s 35 percent quarterly increase was the most since 2011.
Currencies in Brazil, India, South Africa, Turkey and Chile have fallen at least 7 percent since May 1 as higher Treasury yields lured investors away from emerging markets. Developing countries are paying for the Fed’s mixed signals and ministers from Chile to South Africa share India’s “unhappiness over the developments,” Indian Finance Minister Palaniappan Chidambaram said in an interview with the Times of India published July 31" - source Bloomberg.

A clear illustration of this surge in currency volatility can be seen in the depreciation of commodities linked currencies such as the Australian dollar and the Brazilian Real, which had been perfectly correlated since 2008 until the summer of 2011, which saw the start of some large unwinds from the Japanese levered "Uridashi" funds (also called "Double-Deckers") from their preferred speculative currency namely the Brazilian Real. Created in 2009, these levered Japanese products now account for more than 15 percent of the world’s eighth-largest mutual-fund market and funds tied to the real accounted for 46 percent of double-decker funds - graph source Bloomberg:

The Brazilian Real was one of the top "Double-Deckers" preferred currency play for its previous interesting carry. These funds represented 126 billion USD in asset in 2011:
"As we indicated in October 2011, in our conversation "Misery loves company", the reason behind the large depreciation of the Brazilian Real that specific year was because of the great unwind of the Japanese "Double-Decker" funds. These funds bundle high-return assets with high-yielding currencies. "Double Deckers" were insignificant at the end of 2008, but the Japanese being veterans of ultralow interest, have recently piled in again."

Following the violent surge of volatility in the fixed income space the recovery in Investment Grade credit indicated by the price action in the most liquid US investment grade ETF LQD and High Yield, as displayed by the lost liquid ETF HYG has been more muted in the US - source Bloomberg:

But as far as credit cash markets are concerned in the European space, European cash spreads are now within 5 bps of tights post the Great Financial Crisis, with the Iboxx Euro Corporate index, being one of the most used benchmark in European Investment Grade mutual funds tighter by 6 bps so far in August as indicated in a recent note by CITI "The Reluctant rally" from the 9th of August:
"In aggregate, the € iBoxx index has now taken back more than 80% of the widening in May and June – in other words, we're just 5bp from the tightest level credit has seen since 2008.
We're big advocates of leaning against the wind in the current range-bound market environment and have been suggesting taking profits at the margin where spreads have tightened the most. But we remain long. Why not be more resolute and go underweight here at these tight valuations? Sure, the European and US macro data is supportive but, after all, there's plenty of uncertainty in store in the autumn: the impact of actual Fed tapering, US debt ceiling discussions, European politics after the German elections, the German constitutional court ruling on the OMT, FTT negotiations, bank repositioning on the back of the latest Basel guidance, periphery politics, Chinese data, Middle East tensions to name a few.
Some of these issues may yet come back to haunt us but, at the moment, we struggle to see the vulnerability in the European cash credit market even at these tight levels." - source CITI

As far as credit markets are concerned, they are no doubt, "Alive and Kicking". And we agree with CITI, as the Simple Minds (like ours) song goes:
"Stay until your love is, until your love is, Alive"
So stay in credit until your love is alive, but get close to the exit as we move towards a heightened risk of a fall during the Fall (Autumn that is...).

It is a similar story for European Government Bonds yields as indicated in the below graph with German 10 year yields staying between the 1.60% / 1.70% level and French yields now around 2.26% flat from last week, with Italian and Spanish yield grinding tighter - source Bloomberg:

Moving on to the subject of rising correlations and the buildup in "instability", we agree with Martin Hutchinson's recent article "Forced Correlations" published in Asia Times:
"In 2009-10, ultra-low interest rates forced up commodity prices themselves, but since then new sources of supply have been forced onto the market, causing a reversal of the commodities bubble. In energy, fracking techniques caused a collapse of natural gas prices in 2011-12, but it's interesting to note that no such collapse has occurred in the oil market, presumably because the new supply sources are insufficient and have been offset by the artificially increased demand for automobiles in China and India especially. 

Interestingly, the rise in gold and silver prices caused by cheap money (if cash has a negative real return then gold and silver are ipso facto a good investment) has been suppressed over the last 18 months by the International Monetary Fund and the world's central banks, seeking to disguise the true effect of their monetary policies, but this effect may be wearing off. 

Finally, negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. 

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

Dollar index versus Gold - graph source Bloomberg:

While recently the dollar has been weakening so far against major currencies with a significant bounce from the Japanese yen and Australian dollar, should "risk-off" materialize during the Autumn, the dollar could significantly benefit yet again from a flight to safety.

The credit markets and equities are no exception to "rising forced correlations" as highlighted by CITI's recent note from the 9th August entitled "Forget the Great Rotation":
"Rotation – isn’t it obvious?
It's not hard to figure out why the 'Great Rotation' has been such a hot topic this year. It seems so intuitive: as yields rise over the next few years in response to a gradual economic recovery, total returns in fixed income will be weighed down, if not outright negative. The asset class that has the most to benefit from growth is equities.
For example, for the past year we have continuously highlighted the asymmetry in risk/reward between equities and credit. As illustrated in Figures 2 and 3, credit and equities have correlated closely over the last few years and almost in a constant ratio. We don't see why that wouldn't work in reverse also.

However, as credit spreads get closer and closer to the lower bound it becomes increasingly difficult for them to continue performing in the historical relationship with equities. The slight gap that appears to be opening up in both charts recently seems to bear that out.
In other words, to our minds there is an obvious long-equities-short-credit relative value trade insofar as credit has all the downside potential of equities, and much less of the upside." - source CITI

For us, there is no "Great Rotation" there are only "Great Correlations" and we have to confide that we agree with Martin Hutchinson's recent take on "Forced Correlations":
"The lack of a major banking crash and major job losses from the LTCM debacle, and the Fed's insistence on goosing the stock bubble yet further by reducing interest rates when LTCM collapsed, produced the moral hazard from which we are now suffering, and in the long run the correlations from which the more leveraged and better connected are currently profiting. 

However, the new correlations are - like LTCM's correlations in 1996-8 - entirely artificial and capable of reversing at any time. As we are seeing in the bond markets, where the Fed in spite of all its efforts is proving incapable of keeping interest rates to the level it wants, even the Fed does not have access to large enough printing presses to keep these correlations going once they start to turn negative. As with LTCM, the eventual reversal of the current correlations will within a few months cause gigantic losses and a major market crash. 

Only this time the loser will not be a single albeit bloated hedge fund but more or less the entire universe of investors, all of whom have become overextended in a market far above its fundamental value. With a crash so widespread, the losers will not be just too big to fail, they will be too big to bail out - an altogether more perilous state." - source Asia Times, Martin Hutchinson

"What you gonna do when things go wrong? 

What you gonna do when it all cracks up? 

What you gonna do when the Love burns down? 

What you gonna do when the flames go up? 

Who is gonna come and turn the tide? 

What's it gonna take to make a dream survive? 

Who's got the touch to calm the storm inside? 

Who's gonna save you?"

- Alive and Kicking - Simple Minds - 1985

But we are not there yet...

Moving on to the subject of convexity and bonds, how does one goes in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":
"CDS benefits from positive convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays

Convexity measures how duration changes as yields change. For a positively convex bond, the duration increases as the yield declines, and decreases as the yield rises. Positive convexity means that the price increase for a given decline in yields is greater than the price decrease for the same rise in yields. Non-callable bonds are positively-convex. Bonds with traditional call options, such as preferreds, and mortgage-backed securities, or some specific callable high yield notes are generally negatively convex. If you expect yields to rise, you should avoid bonds with long duration, such as those with longer maturities and lower coupons, and favor bonds that have shorter duration and higher yields. In periods were you can expect higher volatility in yields, you should avoid low or negative convexity bonds such as callable bonds in the High Yield space.

This is particularly true for callable high yield bonds such as Windstream:
"We can again use Windstream to illustrate this dynamic. Figure 5 shows the duration (OAD) and yield to worst of the WIN 7.5s of 2022 from May 10 to August 7. As the bond sold off from May 10 to June 24 (yields rose), the duration increased as well, due to the negative convexity of the bond.

The increase in duration resulted in larger losses for the bond relative to an equivalent non-callable bond and CDS. In the subsequent rally, duration declined, resulting in a smaller gain relative to a non-callable bond and CDS. The negative convexity of the bond enhanced the downside during the sell-off and limited the upside during the most recent rally. Remarkably, even though nearly three months have passed, duration remains toward the high end of the range. The holder of the bond not only suffered a mark-to-market loss, but now has to contend with a higher duration investment that continues to suffer from negative convexity." source Barclays

The illustration of the downside protection offered by the CDS market as well as the better liquidity provided by the CDS market can indeed mitigate the damages as illustrated by the Total Return performance on a callable High Yield bond suffering from negative convexity versus its CDS - graph source Barclays:

"CDS has outperformed the 2022s by more than 400bp in P&L terms (Figure 8) due to the rate exposure and duration extension of the bond." - source Barclays

Nota bene: Liquidity in the CDS market tends to be greatest at the 5 year point, making the 5 year single name CDS contract a more viable alternative than other CDS maturities.

Conclusion:
With positive convexity from using CDS, the sensitivity of the price to yield changes (i.e., duration) works in your favor whereas with negative convexity, duration works against you as the price of the bond is becoming more sensitive to yield changes. The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger...

On a final note, counter-intuitively, rising yields should benefit US companies suffering from ZIRP due to rising  Pension Funding Gaps which have not been alleviated by a rise in the S&P 500.

As a reminder from our conversation "Cloud Nine":
"If we look at GM and FORD which went into chapter 11 due to the massive burden built due to UAW's size of "unfunded liabilities", they are still suffering from some of the largest pension obligations among US corporations. Both said this week they see a significant improvement in their pension plans liabilities because of rising interest rates used to calculate the future cost of payments. When interest rates rise, the cost of these "promissory notes" fall, which alleviates therefore these pension shortfalls. So, over the long term (we know Keynes said in the long run we are all dead...), it will enable these companies to "reallocate" more spending on their core business and less on retirees. Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2."

We agree with Bloomberg that rising stock prices have done little to bolster the finances of corporate pension funds this year - graph source Bloomberg:

"Rising stock prices may do relatively little to bolster the finances of corporate pension funds this year, according to Tobias M. Levkovich, Citigroup Inc.’s chief U.S. equity strategist.
As the CHART OF THE DAY shows, the percentage gap between pension assets and obligations for companies in the Standard &Poor’s 500 Index widened last year, when the stock-market gauge increased 13 percent. The S&P 500 rose another 19 percent this year through yesterday.
Assets were 23 percent less than projected payouts at the end of 2012, according to data from S&P Dow Jones Indices that Levkovich presented in an Aug. 2 report. The shortfall was the biggest since at least 1991.
“Overall pension pressures have not eased” even though the S&P 500 has more than doubled since March 2009, when the current bull market began, Levkovich wrote. “The stock market is crucial to the asset side of the pension story.” Managers contributed to the wider funding gap with their reluctance to put more money into equities, the New York-based strategist wrote. Stocks amounted to 48.6 percent of assets at S&P 500 funds last year, down from 50.5 percent in 2009.
Surging obligations also played a role, according to S&P Dow Jones’s data, published last week. Projected distributions increased 38 percent, to $1.99 trillion, between 2007 and 2012. Assets rose just 2 percent, to $1.53 trillion, as the period began with the worst bear market since the Great Depression." - source Bloomberg

So much for the "Great Rotation" story. Oh well...

"At times it is folly to hasten at other times, to delay. The wise do everything in its proper time." - Ovid

Stay tuned!

Credit - Structural Instability

"The markets don't like instability and they don't like uncertainty." - Peter Mandelson

"In numerous fields of study, the component of instability within a system is generally characterized by some of the outputs or internal states growing without bounds. Not all systems that are not stable are unstable; systems can also be marginally stable or exhibit limit cycle behavior.

In control theory, a system is unstable if any of the roots of its characteristic equation has real part greater than zero (or if zero is a repeated root)." - source Wikipedia

Zero being a repeated root in terms of monetary interest rate policy (ZIRP) it is leading to "Structural Instability", we thought we would follow up on our recent computational analogy (Banker's algorithm) and delve into control theory this time around in our title analogy. The great Hyman Minsky thesis was "stability leads to instability", we would argue that dwindling liquidity and excessive spread tightening in core quality credit spreads courtesy of zero interest rates policy in both the US and Europe is extremely concerning and are already indicative of a great build up in structural instability. Back in July in our conversation "Hooke's law", we indicated that Hooke's law of elasticity says in simple terms that strain is directly proportional to stress: "The level of stress that can be ascertained from the level of core European yields making new record lows (Germany, France, Austria, Netherlands), which we think is indeed, directly proportional to the aforementioned stress. But it not only in Europe, we are seeing an extension of the "negative yield club", the United Kingdom as well poised for joining the club."

"In structural engineering, a structure can become unstable when excessive load is applied. Beyond a certain threshold, structural deflections magnify stresses, which in turn increases deflections. This can take the form of buckling or crippling. The general field of study is called structural stability." - source Wikipedia

Hence our title. But reading through Hyman Minsky's 1982 paper "Can "It" Happen Again? A reprise (H/T Zero Hedge), the roots of instability according to Hyman Minsky  are: "...velocity-increasing and liquidity-decreasing money-market innovations will take place. As a result, the decrease in liquidity is compounded. In time these compounded changes will result in an inherently unstable money market so that a slight reversal of prosperity can trigger a financial crisis".

The ever growing lack of "liquidity" in the secondary credit markets which we discussed at length in our previous conversation (Banker's algorithm), as well as the ever tightening spread levels of quality investment grade corporate bonds (-30 bps in August 2012 as per Iboxx Euro Corporate Index) is a cause for concern in relation to the "structural stability" of credit markets. For instance,  very high quality German corporate issuer Siemens (rated Aa3 by Moody's Investors Service Inc. and A+ by Standard & Poor's Corp) is paying investors 20 basis points over the reference midswap rate for its 7.5-year latest euro-denominated bond. To put that in perspective, French government bonds maturing in April 2020 are trading around 34 basis points over midswaps, and its 500 million euro 2 year bonds was issued at midswap rate -10 bps instead of the initial +5 bps guidance given the demand, equating to a coupon of 0.40%. With inflation coming at an annual pace of 2.6% in the Euro Zone, now you also have negative yield in the high quality corporate bond space. A negative yield means investors who hold these notes to maturity will receive less than they paid to buy them.

The proceeds of the new issues raised by Siemens will be used to buy-back up to 3 billion euros worth of shares. This is a negative development from a credit perspective indicative of this growing structural instability we think. In our previous "Hooke's law" ending remarks we argued:

"Given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates."

As indicated by John Glover and Andrew Reierson in their Bloomberg article - Europe Trounces U.S. as Corporate Gains Reach 9%":
"Corporate bonds in Europe last outperformed U.S. debt in 2008, when they lost 3.3 percent, less than the 6.8 percent drop in value of American company debt. Last year, Europe gained 1.99%, while the U.S. soared 7.51%."

 

Yes, one might argue that given the U.S. two-tear interest-rate swap spread, a measure of stress in debt markets has extended its third straight monthly decline to 16.46 bps, down from this year high of 48.32 bps on the third of January and returns in 2012 on Europe corporate bonds are on pace to total about 14 percent which would be exceeded only by the 14.9% gain in 2009 all is well and stable. We do not think this complacency or stability in "instability" can remain for an extended period of time.

"Measures showing U.S. financial market conditions have improved put little pressure on Federal
Reserve Chairman Ben S. Bernanke to signal added monetary stimulus this week, according to Credit Suisse Group AG. The CHART OF THE DAY shows the Bloomberg U.S. Financial Conditions Index moved above zero on July 27, a threshold that signals receding market risk. It was below negative 1 last year when Bernanke spoke at the Kansas City Fed’s annual economic symposium in Jackson Hole, Wyoming. The bottom panel shows the spread between the rate to exchange floating for fixed-interest payments and Treasury yields for two years, a gauge of investors’ perceived risk in the banking sector, fell yesterday to the lowest since May 2011. Bernanke speaks at this year’s Jackson Hole conference on Aug. 31." - source Bloomberg.

But, this false sense of "stability" is increasingly indicative of growing signs of "instability". Back in our July conversation "Hooke's law we argued: "The fall in interest rates increases bond prices companies have on their balance sheets, exactly like inflation (superior to what an increase of 2% to 3% of productivity and progress) destroys the veracity of a balance sheet for non-financial assets. The conjunction of low interest rates with higher taxations will undoubtedly damage companies, particularly in Europe, and in a country like France, for instance, where public expenditure as a % of GDP is much higher (56%) than in Germany (45%)."

 

We would like to use again a reference to Bastiat in relation to liquidity and Credit Markets (from our conversation "The Unbearable Lightness of Credit"): "That Which is Seen, and That Which is Not Seen"

 

In similar fashion to what Hyman Minsky posited, this  false sense of "stability" is in fact indicative of rising "instability" in the monetary system with the "improbable" being inaccurately priced in the US rates markets.  In Citi Research US Rates and MBS weekly note from the 30th of August, they indicated the following:

"Large Moves in a Low Yield Environment

Over the last three months, we have seen 10y swap rates move lower almost 40 bps within two months and subsequently move higher 40 bps over the following three weeks. Much of this movement was not driven by a slow grind, but rather through a series of violent single-day moves interspersed with a series of benign moves. We’ve also seen significant moves in volalitility vs rates, where implied vols tend to fall when yields fall."

- Source: Citi Research, Bloomberg. Average moves are calculated as avg(x|p) = sum(abs(x)|x>=p)/count(x|x>=p) for upper tails, and done similarly for lower tails., for a given data point x and a percentile p.

"Over the last several years, it is somewhat surprising to see that, despite the steady move lower in 10y swap rates, the magnitude of a single-day or a one-month tail event (as defined above) has stayed relatively constant, or has even become somewhat larger over time. In general, we would like to note that 10y swaps have moved at least 7bps/day 20% of the time (cumulative probability of the two extreme deciles). Similarly, they have generally moved at least 30bps per month, with a probability of 20% based on the past 22 years of data."

 

This growing false sense of stability is clearly indicated in the current US swaptions market given the "improbable" is currently "equally priced" by the market at the same level of the "probable" according to Citi:

"Here we can see that markets have priced in roughly a 30bp move/month with a 20% probability, which is in-line with historical levels. Indeed, we use this data to compare with realized tail moves to create an implied-to-realized ratio on 10% and 90% moves. In this case, we compare the market-implied moves given probabilities with historical percentiles of various time periods." - source Citi.

 

"The degree to which the implied/realized ratios tend towards one, especially using two-year realized percentiles, is quite surprising. Not only do we see that rate volatility in the past, where yield levels were as much as 200bps higher, to be good indicators for percentiles in the future, but also that considering implied levels of high and low strikes are similar, the market expects that the probability and magnitude of a large move higher are almost equivalent to that of one lower. In other words, the market implies that large moves in yield today are not impacted by the perceived lower bound on rates. A 30bp move higher is equally probable as a one move lower, regardless of whether current rate levels are at 2% or 4%. Even under more stringent criteria of a “tail” move, despite small differences between the implieds on high and low strikes, we see very similar results – the chances of a 50bp move higher or lower are roughly the same. It is equally surprising to see that implied/realized ratios still tend towards one.

Given this data, we can see that it is impossible to simultaneously have a bounded market where tail risk isn’t valued separately evaluated by its direction. In other words, one can only make one of the following two conclusions:

a) Market levels are incorrect, and a move in rates lower should be viewed differently from a move higher.

b) Market levels are correct, and the supposed lower bound on rates currently has no impact on the size and directionality of a move.

Given recent moves in the market, we are inclined to take the latter conclusion. Potential tail risk scenarios seem to abound, varying from Jackson Hole to the Grexit to a hard landing in China. In any of these scenarios, it is easy to imagine large rate moves higher or lower, regardless of current levels. As a result, we would be cautious in placing trades in duration based on beliefs that rate markets are bound, especially considering that it is not clear on what level that bound would come into play." - source Citi.

Our equities friends would be well advised to remain cautious September wise and take a few chips off the gambling table, September being statistically volatile (September: The Worst of Months - Cullen Roche - Pragmatic Capitalism). The lower earnings estimates will be the biggest risk to come in coming months as indicated by Bloomberg Chart of the day:

"Lower earnings estimates may be the biggest risk for stock investors in the next couple of months,
according to Barry Knapp, head of U.S. equity strategy at Barclays Plc’s securities unit.
As the CHART OF THE DAY shows, analysts lowered profit projections for companies in the Standard & Poor’s 500 Index more often than they raised them in the months of September and
October since 2000. The figures were compiled by Barclays and exclude periods in which the U.S. economy was in recession. October was the worst month for earnings revisions in the past 12 years, according to Barclays data. Based on the number of changes made by analysts, estimate cuts surpassed increases by 5.2 percentage points. September tied for the second-worst month with December. The gap between lower and higher estimates was 3.2 points on average. January was the only other month of the year in which reductions predominated." - source Bloomberg.

Back in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

Following our usual Credit Overview, we would like to turn our attention again between the relationship between credit and equities correlation given the significant outperformance of U.S. equities indices versus their European peers, whereas in contrast, European credit as indicated earlier, has been outperforming significantly U.S. credit. As a reminder, we already discussed the reasons behind the performance of the US economy versus Europe  back in May 2012 in our conversation - "Growth divergence between US and Europe? It's the credit conditions stupid...".

 The Itraxx CDS indices picture, ending this month on a weaker note in the credit derivatives space - source Bloomberg:

In similar fashion to last week, Credit indices were overall wider on Friday, ahead of the long week-end in the U.S but around the exact same levels as the previous week. Itraxx Crossover 5 year index (High Yield risk gauge based on 50 European entities). While Credit Indices have had a weaker tone in the last two weeks, cash credit has continued to perform, supported by a flurry of new issues which came to the market, quickly absorbed by yield starving investors in the need of placing their cash to work courtesy of dwindling liquidity and rarity of quality paper in the secondary corporate bonds market. For instance, although Cargill (A2/A/A), top trader in the commodity space as well as the leading food processor, grain and meat exporter reported an 82% drop of quarterly earnings on the 9th of August, making it the company's worst quarter in more than 20 years, it nevertheless managed to place its 500 million euros 7 year issue at mid-swap +57 bps equating to a meager coupon of 1.875%. A similar scenario consequent of the on-going "Yield-Famine" environment played out, namely that as the book grew in size (4 billion euros worth of orders), and the guidance was tightened, from mid-swap +70 bps to end up mid-swap +57 bps.

 

So what does that mean for credit? We would have to agree with UBS recent Credit Strategy morning comment from the 29th of August:
"We are downgrading our stance on corporate credit, moving to underweight in Europe and to neutral in the US. The prevailing lack of confidence among agents amounts to an uncertainty shock, one that is taking its toll on economic growth and appears unlikely to abate soon. Recent data points on the macro (Europe, China PMIs) and micro (guidance from Cisco, Caterpillar, Hewlett Packard) fronts suggest growth, particularly in Europe, is running at stall speed.
Risks to the outlook are skewed to the downside, in our opinion. A confluence of factors constrains the outlook for economic growth and corporate profitability, particularly in Europe. They include: the Eurozone crisis, the US fiscal cliff and election uncertainty, political instability in Greece and Italy, doubts over the vitality of the Chinese recovery and rising geopolitical tensions in the Middle East.
In the meantime, the susceptibility of markets to a downside shock is high in an environment of weak growth.
On the other hand, the prospects for policy upside appear constrained versus expectations. In Europe, we expect clarification on the tenor and timeline for bond purchases. However, additional details would run into two major obstacles. First, the Eurozone is a heterogeneous bloc; peripheral countries have disparate problems which require different solutions in terms of aid and conditions, making a “one size fits all” programme an ineffective remedy. Second, there is a moral hazard issue associated with a fully transparent programme; if the terms are too generous, the incentives to reform swiftly would vanish. In the US, we expect Chairman Bernanke to explain the mechanisms the Fed would use to ease further at Jackson Hole, but avoid promising easing is forthcoming. Our economists peg the odds of QE in September at roughly 50/50.
Credit valuations look extended, particularly in higher beta European corporates. Our regression models using economic indicators (Europe composite PMIs, global manufacturing PMIs) suggest iTraxx Xover spreads are c100bp rich to fair value (Chart 1). Given substantial, albeit well flagged, event risks in September, we recommend investors set shorts in higher-beta European credit and take some profits in credit globally."

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

As we posited in "Yield-Famine": "Credit is increasingly becoming a crowded trade, forcing yield hungry investors to get out of their comfort zone and reaching out for High Yield as well as Emerging Markets in the process. While everyone is happily jumping on the credit bandwagon in this "yield famine" environment, we would advise caution given liquidity, as we discussed on numerous occasions (and liquidity mattered a lot in 2011...), is an important factor to consider in relation to investor confidence and market stability."

Both the Eurostoxx and German 10 year Government yields are still moving in synch but most likely towards "Risk-Off" in the coming weeks with fast falling German Bund yields towards 1.30% yield level and a slightly weaker Eurostoxx 50 at the end of the week - 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:

Our "Flight to quality" picture marking pointing towards "Risk-Off" with Germany's 10 year Government bond yields falling again towards 1.30% and the 5 year CDS spread for Germany rising above 60 bps - source Bloomberg:

As far as the EUR/USD is concerned we told you in our conversation "Sting like a bee - The European fight of the Century" to watch out for political "sucker punches" during this summer "lull" because they do sting like a bee!  Friday's "sucker punch" on EUR/USD as displayed by the significant intraday move - source Bloomberg:

In relation to the European bond picture, Spanish 10 year yields climbing towards 6.70, slightly below 7% whereas Italian 10 year yields are still below 6% around 5.80% and German government yields fell towards 1.36% - source Bloomberg:

The recent rise in Spanish government yields is related to the recent request for bailout by three Spanish regions, Catalonia, Valencia and Murcia in quick successions. Catalonia asked for 5 billion euros, Valencia asked for an additional 3.5 billion euros and southeastern Murcia asked for 700 million. Valencia has already borrowed 25% of the 18 billion euro-bailout fund set up by Prime Minister Rajoy, amounting to 4.35 billion euros. The size of the bailout fund will soon prove to be insufficient. Catalonia region was subsequently cut to junk on Friday by Standard and Poor's with a negative outlook.

The regions were responsible in 2011 for most of Spain's overspending, 8.9% of GDP (unchanged from 2010) while the debt level of the regions as a percentage of GDP are still rising as indicated by Bloomberg:

"The total debt outstanding of Spain's 17 regions doubled from 4Q08 to 1Q12 and now stands at 145 billion euros, equivalent to 13.5% of GDP. With 15 billion euros of maturities due by year-end, the 18 billion fund announced in July to support the regions may prove insufficient, and addressing this will form a pivotal part of any Spanish request for a bailout." - source Bloomberg.

In addition to the rapidly debt picture, for the three Spanish regions asking for a rescue, unemployment has been rising as well in all three:

In addition to Regional woes, Spain has been busy as well with its banking sector woes this week, given Bankia Group announced 4.45 billion euros of losses for 1H2012 versus a 205 million profit in 2011 (year of its nicely priced IPO...). Bankia had 6.63 billion euros of provisions for 1H impairments costs, and its group clients funds fell 37.6 billion euros from December to 173.8 billion euros. Consequences for Bankia was that its banking rescue FROB has had to immediately inject capital given Bankia group's BIS II Core Capital ratio fell to 6.3% and its bad loans ratio jumped to 11% from 6.3% in 1H 2012.

During the same week, we had the secretary of state for the economy, Fernando Jiménez Latorre, telling us that there was no significant drop in Spain bank deposits. Reading the following comment from HSBC made us wonder about the delusional state of some members of the Spanish government:
"ECB deposit data out and the usual health warnings apply, for anyone of a remotely nervous disposition. This latest set of data show an alarming increase in the pace of deposit flight from Spain - see the graph below. After what appeared to be something of a moderation in June, with 'only' EUR8.6bn disappearing vs EUR30bn+ in both April and May, last month saw EUR74bn leave the Spanish financial system. This brings the YoY pace of decline to a rather Greek 12%. Deputy Finance Minister Latorre is on the tape this morning saying that there's no significant drop in deposits, which one would have to assume refers to this month, as the July data is alarming."

'Other financial institutions' are responsible for the bulk of the outflows, with 50% of the deposits being of an 'agreed maturity', so presumably these depositors are so keen to get their money out of the country that they'd take an early withdrawal penalty (which would presumably be cheaper than hedging any redenomination risk). Unless there was a large seasoning of term deposits in the numbers, but that seems an unlikely coincidence. Given that Spanish bond yields were getting a little hairy in July, this shouldn't be a huge surprise.
 
Since Draghi's verbal Chuck Norris intervention and subsequent spread tightening, however, one would imagine that the pace of deposit flight would moderate, so August's data should mellow. Yet the MoM flow in domestic govt bonds held by Spanish banks has been declining again, consistent with the trend this year since the LTRO induced peak. Makes you wonder who is there in the background buying these assets given the headlines and risks, as the domestic bank bid has been so supportive over the last few years.

Were the Spanish financial system capable of shedding assets at the same rate, or ideally, faster, all would be well. But look at the loans to deposits graph  below and note that the Spanish system LDR is still climbing. It's not as large a funding gap as you might see elsewhere in Europe (currently 117% LDR, vs e.g. Finland on 143%, Ireland on 129%, Italy on 122%, or the Netherlands on 120%), but more the trend that's concerning, as Spain belong to the unfortunate minority of countries where the funding gap is widening - Greece, Cyprus, and more recently, Portugal. No wonder there's a sense of urgency at the ECB these days." - source HSBC

Back in our conversation "Agree to Disagree" in June we wrote:
"If our European politicians had studied carefully what had happened in Argentina before their default in 2002, they would not be pressing for a "Banking Union" but should rather be more concerned about a deposit guarantee scheme if they are "really serious" about keeping Greece in the Euro. Back in March we argued the following in our conversation "Modicum of Relief":
"A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse). 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). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios.
Unless our European politicians rapidly introduce European laws guaranteeing depositors money ("insurance for depositors against the risk of euro exit" is qualitatively different from "deposit insurance"), capital flight might start in Spain as it has already in Greece."

As far as Spain is concerned, deposit outflows have been confirming our June call:
"The dangers of deposit outflows. While complacency is prevailing so far in relation to Spanish deposits, it cannot be taken for granted, as shown by the situation in Argentina which quickly spiraled out of control and led to its default in 2002:
"the most puzzling aspect of the crisis so far is the relative complacency of the public. This is starting to be tested." - CreditSights, 31st of July 2001 paper "Defining the Default Path".

We might be rambling again in our longer than usual conversation but we have long argued   the impact the LTRO has had on the Spanish banking system. amounted to "Money for Nothing":

 - source HSBC - Spain - Loans growth month to month.

 We hate sounding like a broken record but: no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits (All Quiet on the Western Front - April 2012):
"In August 2011 we wrote in our conversation "It's the liquidity stupid...and why it matters again...":
"Lack of funding means that bank will have no choice but to shrink their loan books. If it happens, you will have another credit crunch in weaker European economies, meaning a huge drag on their economic recovery and therefore major challenges for our already struggling politicians.

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.

"So austerity measures in conjunction with loan book contractions will lead unfortunately to a credit crunch in peripheral countries, seriously putting in jeopardy their economic growth plan and deficit reduction plans."- "Subordinated debt - Love me tender?" - Macronomics, October 2011

One can easily conclude that not only will the regional bail-out fund will need to be recapitalized but FROB as well given the Bankia group will certainly need additional capital injunctions as the economic outlook deteriorates further in Spain because no loan growth means no earnings, rising non-performing loans and rising deposit-outflows mean rising loan-to-deposits level. Capital injections mean additional strain on the budget with weaker tax receipts.

Back in our conversation "Modicum of Relief" we indicated the following:
"On the subject of systemic risk diagnosis, wholesale bank deposits flights and tracking the loan-to-deposit ratio of banks can be used as a simple gauge of risk profile. It is as well a good indicator of banks 'capacity in supporting lending in their respective economy. Maintaining lending and credit flows is paramount to avoid a credit crunch which would essentially impair GDP growth in the process (as per our "car" analogy used in our previous conversation)."
As far as similarities between Spain and Argentina and in relation to capital flight:
"the lack of liquidity in the system has forced the central banks to provide unprecedented level of repos to the system and also relax reserve requirements. The problem is that this is very unclear whether that additional liquidity is funding anything but capital flight at this point." - CreditSights 31st of July 2001 paper "Defining the Default Path"

Moving on to the subject of  the relationship between credit and equities correlation, the significant outperformance of U.S. equities indices versus their European peers, is interesting given the outperformance of European credit versus U.S. credit.

We have been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:

We have on various occasions discussed the relationship between credit and equities. Back in January 2011, in our credit conversation "A tale of two markets - Credit versus Equities", we indicated the following in relation to credit and the relationship with equity volatility:
"In theory Credit can be assimilated to a long OTM (Out of the Money) equity option. A Credit Default Swap (CDS) is a proxy for a Put Option on the Assets of a Firm. This means that by going long on bonds the bondholders are long the face value of the bond and short a put option on the assets of the firm with the strike price being the face value (principal) of the bonds.

In recent years, according to a research published by Morgan Stanley in March 2009 by Sivan Mahadevan, correlations between changes in credit spreads and changes in various implied volatility metrics, have been very similar to short-dated ATM (At The Money) equity options. Liquidity being an important factor and short-dated ATM being the most liquid in equities, whereas the 5 year point being the most liquid CDS point (Credit Default Swap). Given there is an extremely low probability of an entire equity index going bankrupt, Morgan Stanley's research team further comment that ATM volatility can be used to make comparisons between equity and credit. The cash equity/credit relationship is apparently less stable than the volatility/credit relationship according to Morgan Stanley's study."

We would like to go further given the R2 (coefficient of determination of a linear regression) between Credit/Spot equities and Credit/Equities Volatilities (ATM for At The Money) in both Europe and the U.S. tell a different story courtesy of our good cross-asset friend. An elevated R2 level indicates a significant relation. One can see in the below table the higher correlation between European Itraxx Credit indices (Itraxx Main Europe being the investment grade risk gauge and Itraxx Crossover being the European High Yield risk gauge) and the Eurostoxx 50 equity index. In the U.S. in the table below you can see the relationship between CDX IG (Investment Grade) and CDX HY (High Yield) with the Standard and Poor's 500 (SPX) and the Russell index.

The correlations between Credit Indices in Europe versus Spot equities remain very significant in Europe and in Japan but less so in the U.S. At current levels the relationship between the Standard and Poor's and Credit is weak, whereas the Russell Index is more positively correlated to Credit in the U.S. The fact that the Standard and Poor's volatility is strongly correlated to Credit is counterintuitive.

The overall underperformance of Japanese credit spreads which continue to weaken is at present the only notable disconnect between credit spreads and spot equities:

According to our good cross asset-friend, this weak Japanese relationship warrants monitoring and could be played by selling CDS and buying Nikkei Put Options, which benefit from absolute low volatility levels. Nikkei Index - 3 Month 100% Moneyness Implied Vol versus Japan 5 year CDS since March 2010 until the 21st of August 2012 - source Bloomberg:

Monitoring levels of correlation in the short-term is fundamental if you are looking at adding relative value positions or if you would like using historical signals to position yourself on either credit or equities.

"If you want stability, prepare for instability" - Martin T - Macronomics.

Stay tuned!