Sunday 30 June 2013

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.
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 crisiswhich 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!

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