Saturday 22 June 2013

Credit - Singin' in the Rain

"You learn to know a pilot in a storm." - Lucius Annaeus Seneca 

Looking at the epic bloodbath this week which started with the mechanical resonance of bond volatility in the bond market which we cautioned about recently, with carry trades in FX and High Yield ETFs (HYG) taken to the cleaners, and with equity starting to feel the spillover heat, you might think our title this week is a little bit "over the top" as far as sarcasm is concerned and you might not at first glance see the irony in it.

The epic bloodbath caused by a surge in bond volatility. The MOVE and CVIX indices rising contagion spilling to the equities sphere. We have added the VIX index as well - 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.

Let us explain our title choice. While "Singin' in the Rain" is a 1952 American musical comedy film directed by Gene Kelly, it does involve "Tap Dancing". In similar fashion to Gene Kelly's routine in the movie, credit investors have been "tap dancing" to the Fed's liquidity "rain" for the last couple of years until the music stops 'in true Citigroup - Chuck Prince fashion ("As long as the music is playing, you've got to get up and dance"). Well, it looks to us that the music has indeed stopped. After all, should be we surprised that "Tap dancing" follows "Operation Twist"?

On a side note, we would have used "Spinal Tap" as a title, in reference to this cult movie but it had already been used two days ago by the WSJ, and by Jeremy Warner in the Telegraph in December 2012 and in many other instances.

Therefore in this week's conversation, while we will review some of the market action driven by liquidity issues, we will ponder what the implications are for some risky assets and the underlying issue of "convexity".

As we posited in the conversation "The Unbearable Lightness of Credit":
Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital

The correlation between the US, High Yield and equities (S&P 500) since the beginning of the year is broken. US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG  - source Bloomberg:
We got seriously wrong-footed by the market's reaction to the "tapering QE" scenario and we still think at some point the Fed will maybe redirect its buying towards MBS, given that rising rates could seriously dent any hope of a "housing recovery" should the move continue at a rapid pace like it has this week.

The name of the game, we have kept saying is as follows:
"It is all about capital preservation rather than a hunt for yield".

As we have argued in our March 2012 conversation "Modicum of relief":
"In relation to systemic risk, credit risk conditions can significantly and persistently be decoupled from macro-financial fundamentals as indicated by Bernd Schwaab, Siem Jan Koopman and André Lucas in their December 2011 paper "Systemic risk diagnostics: coincident indicators and early warning signals":
"We demonstrate that a decoupling of credit risk conditions from macro financial fundamentals has preceded financial and macroeconomic distress in the past with non-negligible lead time (about four quarters)."

Looking at the market reaction with liquidity withdrawal, makes us indeed feeling rather nervous as we have long posited that liquidity crisis always lead to financial crisis:
"So as credit investors, yes we are indeed still dancing as the music is playing, but, given the liquidity levels closer to 2002 than 2007, we'd rather be dancing close to the exit door" - Macronomics - Pain & Gain

Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:
"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely:
 Wave number 1 - Financial crisis
 Wave number 2 - Sovereign crisis
 Wave number 3 - Currency crisis
 In relation to our previous post, the Peregrine soliton, being an analytic solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), it is "an attractive hypothesis to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace" - source Wikipedia." - Macronomics - 15th of November 2011

Why are we feeling rather nervous?

If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?

It is a possibility we fathom. 

Here is why:

As indicated by Andrea Wong in Bloomberg on the 21st of June, Asian countries have been on the receiving end of the Fed's latest "Tap dancing" - Asian Currencies Tumble Most in 21 months on Fed Exit Outlook
“The prospect of less quantitative easing has caused outflows and selloffs in Asian assets,” said Tobby Lin, a fixed-income trader at Yuanta Securities Co. in Taipei. “The countries that had experienced the most inflows, like South Korea and Southeast Asian nations, are being hit the most.” More than $19 billion has been withdrawn from funds investing in developing-nation assets in the three weeks to June 12, the most since 2011, according to data from EPFR Global. The Dollar Index, which tracks the greenback against six major counterparts, was up 1.3 percent for the week, while the MSCI Asia Pacific Index of shares slumped 3.4 percent." - source Bloomberg

As we indicated back in May 2012 in our conversation "Risk-Off Correlations - When Opposites attract":
"When investors are most concerned about risk, “positive correlation between growth assets is most notable. Everyone is looking at the same threats to growth, and so they are all selling together.” - Shane Oliver, head of investment strategy at AMP Capital Investors
"In fact, the only commodity that appears to be running scarce in "Risk-Off" periods appears to be the dollar" .

Dollar index versus Gold - graph source Bloomberg:
Looking at the ongoing predicament in the markets, in similar fashion to our May 2012, the Greenback remains the only place to hide as confirmed by Lu Wang, Inyoung Hwang and John Detrixhe in Bloomberg in their 21st of June article - Nowhere to Hide as Dollar Posts Only Gains Amid Stock, Bond Drops:
"The dollar is proving to be investors’ only haven as stocks, commodities, bonds and other currencies fall in unison for the first time since 2011.
Concern governments will curtail aid to economies pushed the MSCI All-Country World Index down 3 percent, spurred declines of 2.5 percent or more in gold, copper and crude oil, and sent bonds of all types to losses of 0.4 percent this week, according to Bank of America Merrill Lynch’s Global Broad Market Index. Currencies from Australia to Mexico slipped against the dollar.
Rallies that have lifted everything from Japanese banks to Italian government debt during a four-year global expansion are being revalued amid signs central bank stimulus through quantitative easing, or QE, is poised to slow. Global equities posted the biggest two-day retreat in 19 months after Federal Reserve Chairman Ben S. Bernanke said he may phase out stimulus and China’s cash crunch worsened.
The old risk on/risk off trade is broken,” said Walter “Bucky” Hellwig, who helps manage $17 billion at BB&T Wealth Management in Birmingham, Alabama. “The stress in the markets as the result of the pullback in QE and concurrent higher rates is causing the unwind of many kinds of trades. The liquidation and the deleveraging forces more unwinding as asset prices decline and the dollar strengthens.” The world’s 10 biggest equity markets slumped yesterday, according to data compiled by Bloomberg. They have fallen in sync three times in the past two months, accounting for half of the occurrences over five years." - source Bloomberg.

Indeed the old risk on / risk off trade is broken, we have to agree and we had no choice but to shelve our beloved indicator which we had been monitoring, namely the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes - source Bloomberg:
In "Risk Off" periods we noticed that the 120 days correlation was close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation was falling to significantly lower level.  The correlation between both the German Bund and US 10 year note is not telling us anything anymore. 
Nota Bene: ("Risk On" refers to a period of time in which investors are putting money into risky assets such as stocks, commodities, etc. "Risk Off" meaning the exact opposite with investors putting money into safe haven assets such as cash and treasuries or German Bund). 
Bye bye indicator...

According to John Detrixhe from Bloomberg on the 29th of May 2012:
"The dollar is proving scarce, even after the Federal Reserve flooded the financial system with an extra $2.3 trillion, as the amount of the highest-quality assets available worldwide shrinks."

Could the reason behind the "Tap Dancing"stance from the Fed be coming from the increasing shrinkage of the highest-quality assets available worldwide and in particular US Treasuries because the Fed's vacuum cleaner had been running on full steam with its QE program has posited by Zero Hedge in their recent note "Is This The Chart That Scared Bernanke Straight"?

And 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...

We have to agree with Barclays recent note on FX trends entitled "Let the tapering begin". The genie is out of the bottle as far as the dollar is concerned:
"• A robust recovery in the US is leading to repricing of market expectations of future Fed asset
• Higher risk premia typically lead to lower prices for risky assets and higher volatility.
In FX, this implies weakness in high-carry and EM currencies versus the USD.
• A broader USD rally, which would include low-yielding currencies, however, will have to wait for expectations of rate hikes to be priced.
• The broad resurgence in the USD is likely to gain strength as H2 progresses.
• It is likely that the Fed will attempt to smooth market expectations of a premature exit. However, it
is unlikely that it will be able to put the genie of an eventual exit from unconventional monetary policy back in the bottle.
• Recommendations:
• We favor being long USD versus JPY, CHF and EUR.
• Additionally, we remain out of USD funded carry trades despite the recent selloff." - source Barclays

We do agree with Barclays that we are in an early stage of dollar strengthening as well:
"• Markets have been given a little taste of how tricky the Fed’s exit from extraordinarily loose
monetary policy will be in the months and years ahead.
• Even at its near-term peak, the USD saw muted gains of about 2% on a broad basis; however,
the average rise in the USD against risky currencies has been much larger, at more than 8%."
- source Barclays

As per Lu Wang, Inyoung Hwang and John Detrixhe Bloomberg's article published on the 21st of June entitled "Nowhere to Hide as Dollar Posts Only Gains Amid Stock, Bond Drops", outflows in funds have been significant in recent weeks:
"More than $19 billion left funds investing in developing-nation assets in the three weeks to June 12, the most since 2011, according to EPFR Global. Foreign investors dumped an unprecedented $5.6 billion of Brazilian stocks and $3.4 billion of Indian bonds this month, exchange data show. The MSCI Emerging Markets Index slid 4 percent yesterday while the rupee and Turkish lira hit record lows." - source Bloomberg

Basically "carry monkeys investors" as described by Macro-Man in his recent post "Beatings will continue until morale improves"  have been hammered. All the investors that piled in high beta trade, namely High Yield, Emerging Debt Bonds and Emerging Currencies are being hit hard. They thought they were "smart investors", playing "alpha", when it was a pure beta play. 

"As pointed out by Bank of America Merrill Lynch's note stable carry thrives in low rates volatility environment, the recent spike in US bonds volatility has had some devastating effect in high yielding assets:
"Carry trades love low risk-free interest rates, but they love low interest rate volatility even more. This is why over the past three years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving their risk premiums to abnormally low levels."

Why the move could potentially accelerate?

Because of real yields...graph source Bloomberg:
"U.S. government debt is the cheapest in more than two years with inflation not a threat as the Federal Reserve provides a timetable for the eventual end of its bond-buying program.
The CHART OF THE DAY shows the difference in U.S. Treasury 10-year note yields and the annual inflation rate, known as the real yield, rose past 1 percent for the first time since March 2011 this week after Fed Chairman Ben S. Bernanke said the central bank may start reducing bond purchases later this year and end them by mid-2014. Consumer inflation climbed 1.4 percent in the 12 months to May, less than the Fed’s 2 percent goal. Benchmark yields touched 2.47 percent yesterday, the highest level since October 2011.
“The 2.40 percent 10-year is a very good buying opportunity,” Guy LeBas, chief fixed-income strategist in Philadelphia at Janney Montgomery Scott LLC, said in the telephone interview. “For the first time in a couple years, there’s good value in the current level of interest rates.” Higher real yields tend to attract foreign investors to a country’s bonds. Rising yields, along with unprecedented easing by major and emerging-market countries, have contributed to the dollar outpacing all but two of the 31 currencies tracked by Bloomberg over the last five days. Easing refers to a country’s central bank purchasing assets from commercial banks to increase the monetary base." - source Bloomberg.

This is what happens when you take the proverbial punch bowl away. Volatility which has been repressed by Central Banks meddling with setting up the price of risk by artificially suppressing up interest rates movements via the increase in M (Money Supply). MV = PQ as per the great Irving Fisher's equation. (Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.)

Let's move on to the underlying issue of "convexity":

Like a spring severely coiled, when volatility is released, the destructive energy is massive because of convexity as indicated by our friend Martin Sibileau on his Popular Macro blog:
"Technical aspects that may matter tomorrow: While the Bank of Japan seems to have failed to control market forces, the Fed appears to have won the repression battle. However, there is an aspect that may be out of their reach: Convexity. The reach for yield (i.e. greed) has been such a powerful force that the rumor is that approx. only 15% in High Yield and 50% in Investment Grade portfolios are rate hedged.

Remember: When an investor wants to be long credit risk only, as the yield is driven by: US Treasury yield + swap rate + credit spread or Libor+ credit spread, said investor will buy the credit (i.e. bond, loan) and sell the rate, to keep only the credit spread. 

But if only 15% and 50% of positions in HY and IG are rate hedged, if Ben triggers a sell off in credit with the insinuation of tapering, the dealers on the other side, making the bid for the investors, will be forced to do the rate hedge their investors did not do, because they must be interest rate neutral! That means selling US Tsys for an average of 85% and 50% of positions in HY and IG respectively! In other words, the potential sell-off tomorrow may trigger a surprising self-feeding convexity. How are precious metals to react in such scenario?" - Martin Sibileau, Popular Macro blog

So all in all this is the perfect storm because market makers are running inventories at 2002 levels and they are always interest rates neutral...You buy a bond from a mutual fund, you sell treasuries, feeding even more the rising pressure on treasuries yield to rise further.

There is no place to hide except cash at the moment and in dollars...(or shorting treasuries for the  short term tactical braves out there...we like the ETF TBT out there as of late...)

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).

The S&P 500 and the US 10 year breakeven, indicative of the deflationary forces at play,  graph source Bloomberg (21st of June 2013):
As indicated above, we got seriously wrong-footed (long US bonds) by the market's reaction to the "tapering QE" scenario, because as per "The Night of the Yield Hunter" and David Goldman article about Gold and Treasuries and bonds in general he wrote in August 2011 (the former global head of fixed income research for Bank of America):
"Why should gold and Treasury bonds go up together? Gold is an inflation signal and bonds are a deflation hedge. At first glance it seems very strange for both of them to rise together. Why should this be happening?
 The answer is simple: bonds are an option on the short-term interest rate, and gold is a perpetual put option on the dollar. Both rise with volatility.
 It’s like the old joke about the thermos bottle: “How does it know if it’s hot or cold?” If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. By put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

So not only our Risk-On / Risk-Off indicator is broken, but our thermos bottle is lately behaving strangely (could it be caused by global warming we wonder) because central bankers have been busy trying to ignite inflationary expectations with various QE programs, but the YTD movements in 5year forward breakeven rates is still  falling are indicative of the strength of the deflationary forces at play - source Bloomberg:
So we will patiently monitor 5 year breakeven given last time the Fed put on its dancing shoes and started "Twisting" again, it was when we hit the 2% level.

When it comes to credit, at the moment, we are happy to sit on the sidelines and enjoy the show given poor liquidity, convexity issues, and rising yields do not mix very well with "total return" or preservation of capital that is. After all Shares of BlackRock Inc.’s $21 billion investment-grade bond ETF have plunged 3.7 percent this month as of 11:58 a.m. in New York, the biggest decline for a month since February 2009, according to data compiled by Bloomberg. Shares have dropped the furthest below corporate-bond prices since August 2011, signaling that the fund may reduce holdings to lower its net asset value, the data show according to Bloomberg.

As Friday came to a closure after an eventful week where market participants age in dog years, clearly there was a weaker tone by the end of the day as indicated by a market maker in the cash market:
"While holding stable for the most part of the day we saw a proper collapse into the close in corp cash bonds. Market depth is basically non existent with no place to hide at the moment it seems. The pain is coming from everywhere being it wider swap spreads, wider indices or weaker stocks. With swap spreads moving wider so will new issue spreads vs bunds if and when. It feels a bit overdone at current levels and I would advise to hold things near the ground since there is also the possibility of a strong squeeze back in but going into the weekend it feels very weak out there. Low beta bonds close between 2-6 bps wider again with the bid side the tough one to trade. Not all is panicky in the market though with still the strong low beta names holding well compared. Have a nice weekend." - source undisclosed market maker.

And when you come under pressure, with outflows due to heavy redemptions and with poor liquidity you sell the good liquid stuff first, and the illiquid stays at the bottom. 

So all in all the quality of the leftovers such as in a leveraged loans mutual fund for instance is not optimal to say the least as indicated by Sridhar Natarajan in Bloomberg in his article - Loans Penalized as Funds Attempt to Stem Losses:
"Leveraged loan prices are dropping from a six-year high on speculation managers of high-yield funds are discarding the floating-rate debt to contain steeper losses from junk bonds amid record redemptions.
The average price for the 100 largest, most liquid loans declined 1.22 cents to 97.66 through yesterday from 98.88 cents on the dollar on May 22, the highest level since July 2007, according to the Standard & Poor’s/LSTA U.S. Leveraged Loan 100 index. Bonds sold by speculative-grade companies fell 4.53 cents to 102.06 cents from 106.6 cents, Bank of America Merrill Lynch index data show.
Investors pulled $9.4 billion from high-yield funds since May 22, including two weeks of record outflows, according to a June 13 report from Bank of America Corp., as Federal Reserve officials signaled they may pare back their extraordinary stimulus measures this year. Loans have held up better because they have rates that fluctuate, offering some defense against higher borrowing costs.
High-yield fund managers who sought the rate protection of senior loans to reduce their duration risk earlier this year and last year were now forced to sell those very instruments to meet the deluge of investors running for the exit,” said Bill Housey, a Wheaton, Illinois-based money manager at First Trust Advisors LP. “It really comes down to prices as loans are holding up better” than bonds, he said." source Bloomberg.

From the same article:
"“It is counterintuitive that they’d be selling off the loans, but yet they are because it’s the best place for them to fund the redemptions without having to realize much of a loss,” said Alex Jackson, the head of the bank loan group in Armonk, New York at Cutwater Asset Management, which manages about $30 billion in fixed-income assets. “It is better to sell off a loan with a one point loss rather than take a bigger hit on a similar quality bond.” "- source Bloomberg

On a final note, we discussed "convexity" with a very wise credit friend former head of credit research and this is what he had to say on the subject:
"Convexity is a bigger issue in all the pensions + fixed income funds. That's one reason mortgages have been whacked. the Fed will basically have to do a ECB - stop buying USTs and start buying RMBS. But pensions (or Fannie / Freddie) do not hedge MBS with USTs - they do it with LIBOR"

US 5 year Swap spreads - graph source Bloomberg:

All in all, as we indicated last week in our conversation "Lucas critique", while it did cost us not to believe in  the "Tap Dancing" skills of Ben Bernanke and given Mr. Jeff Gundlach's opinion is that the Fed is likely to step in and actually increase QE to try and hold rates down, because mortgage rates have spiked substantially over the last month from a low of around 3.5% to around 4.3%, we have to agree with our friend that a "new dance" routine from the Fed might be coming. 
As recently commented by Marc Faber"I am tempted to buy a 10 year treasury at a yield of 2.5%. I think we will rebound in the treasury market. Yields will go down first, and if they go up further, it will kill the economy including the housing market." 

There is indeed a risk for the Fed, and like our wise credit friend said, the Fed might do a ECB in the end. Should we call that new dance "B-boying"? We wonder...and keep "Singin' in the Rain".

"If you are caught on a golf course during a storm and are afraid of lightning, hold up a 1-iron. Not even God can hit a 1-iron." - Lee Trevino 

Stay tuned!

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