Sunday, 13 October 2013

Credit - The Rebel Yell

"Those who excel in virtue have the best right of all to rebel, but then they are of all men the least inclined to do so." - Aristotle 

While watching the continuation of the US political stand-off, which as we argued last week, turned out to be more of a "False Alarm" than anything else when one takes into account the rally witnessed at the end of the week in most risky assets, we thought we would play with your mind again using a dual reference in this week's chosen title.

The first reference is a music reference from our beloved musically creative 80s period, namely Billy Idol's famous 1983 hit album Rebel Yell as we believe that, when it comes to the debt ceiling and Billy Idol's lyrics from the famous song, in the end, US politicians "in the midnight hour will cry- 'more, more, more' ", when it comes to raising the debt ceiling and issuing more debt in the process.

The second reference is more historical. The rebel yell was a battle cry used by Confederate soldiers during the American Civil War. Confederate soldiers would use the yell during charges to intimidate the enemy and boost their own morale in similar fashion to today's Republicans stand-off, although the yell had many other uses....but we ramble again. 

Some pundits have recently argued that the US government shutdown was a demonstration that the United States of America had never been more divided. On that point we agree with the recent rant of our old friend and mentor Anthony Peters in his column in IFR entitled "On civil wars". This kind of comments on how the United States of America is divided today is utter nonsense:
"Sometimes I feel like screaming. This morning it was a report on the wireless which quoted a newspaper dubbing the US government shutdown as demonstration that the country has never been more divided. I challenge this piece of nonsense on two counts.

The first count is that, as a keen student of the American Civil War (1861-1865) which over four years ended the life of around one in ten of the nation’s male population and which culminated with the assassination of the President, I find it hard in any way to hold up the events of 150 years ago against the petty posturing on Capitol Hill in 2013 and to see any measurable comparisons.

The second is that it is not the nation which is divided but the politicians who eat and sleep pork barrel politics and who do not seem to give a fig for the wellbeing of any citizen who is not a member of their respective parochial electorate.

In fact, if one takes a disciplined approach to American politics, it is not a polarisation of political opinion which is prevalent but a vicious, no holds barred, cat fight for the middle ground which is the cause of much of the current problem. It brings with it one very important question and one which is taxing the minds of both John Boehner, the Republican Speaker of the House, and of the President which is whether ultimate power should be vested in the legislature or with the executive." - Anthony Peters, SwissInvest Strategist.

Therefore in this week's conversation we will discuss the "Rebel Yell" and the US version of the "Scheduled Chicken" for the US Debt Ceiling but also look more into the implications for the future "tapering" stance of the Fed under the new leadership of "Chairwoman" Janet Yellen. 

While in recent years we have been more accustomed to European politicians playing the game of "Scheduled Chicken" on so many occasions that our head hurts, it is interesting to see the contagion spreading to the US with the senseless fear of impeding default. As the wise Lucius Annaeus Seneca" once said:"Every man prefers belief to the exercise of judgment."

As put it recently by Nomura in their recent special report from the 10th of October entitled "US Debt Ceiling: Countdown to Default?", here comes the US version this time around of the aforementioned "Scheduled Chicken":
"As the US government shutdown drags into a second week, the markets are now starting to take notice of the sobering reality that this impasse will most likely go down to the wire. Complicating the situation is the near-exhaustion of the extraordinary measures being used by the Treasury to avoid crossing over the debt-ceiling limit. Given that there is over a week to go until October 17 – the critical cross-over date at which when Treasury cash-flow management becomes less predictable – key aspects of the funding markets are experiencing a more pronounced move than during the 2011 debt ceiling run-up." - source Nomura

More pronounced? At least not in the CDS space.

It was interesting this week to watch the US 1 year CDS surge to 55 bid on the 10th of October before seeing it tighten by 25 bps the next day when the 5 year CDS level was flat at 34 bps on the bid side. So much for default risk...

When it comes to politicians shenanigans, the move seen as of late on the US sovereign CDS space has indeed been much benign than two years ago as indicated by the recent Bloomberg Chart of the Day:
"Investors appear less concerned about the wrangling over the U.S. government’s budget and debt ceiling than they were two years ago, according to Barry Knapp, Barclays Plc’s chief U.S. equity strategist.
The CHART OF THE DAY tracks one indicator that Knapp used to draw his conclusion, presented in an Oct. 4 report: the cost of credit-default-swap contracts that insure against default on U.S. Treasury securities.
Last week’s closing rate of 45.5 basis points was well below a peak of 64.4 basis points in July 2011, the last time the federal debt limit was almost breached, according to data compiled by McGraw Hill Financial Inc.’s CMA unit. Every basis point is equivalent to $1,000 a year for a contract protecting $10 million of debt." - source Bloomberg.

In continuation to the US CDS signals following the "Rebel Yell", Bank of America Merrill Lynch in their note entitled "The declining duration of fiscal concerns" from the 11th of October added the following in relation to volume in the US CDS sovereign space:
"The weekly DTCC data shows a fair amount of trading supporting the widening of CDS spreads on the US sovereign we have seen recently, as 1-year spreads widened to 60bps from less than 10bps. Specifically the net position in CDS increased by about $250mm during each of the past two weeks to about $3.6bn as of last Friday. That corresponds to about a third of the typical trading volume (not changes in net notional) in the most liquid corporate names. As trading volumes most likely exceed changes in net notional, clearly US sovereign CDS contracts have been fairly liquid over the past two weeks and the widening of spreads reflects real risk taking as opposed to a lack of liquidity. Note that the net notional is still dwarfed by what we saw in 2011, while spreads are similar. 
Assuming a 90% recovery in a CDS auction on the sovereign, at 60bps buyers of protection would need to assess a default probability higher than 6% over the next year to expect a profitable trade." - source Bank of America Merrill Lynch

Arguably the "Rebel Yell" has had more terrifying effect on the 1 month TED and in the T-bill volatility space, as displayed by Nomura in their recent special note:
"Stresses have begun to show across various subsectors of the money markets. One need not look further than the extreme moves in the 1m TED spread which inverted this past week (Figure 3). The pressure sitting on the very front end of the T-bill curve remains a function of fear over owning securities that are in the “default window.” The quick spike higher in the front end after quarters of stability is also showing up in the rolling realized vol of 1m T-bills (Figure 4)." - source Nomura

Of course the consequences of the "Cantillon effects" and the surge in all risky asset prices with dwindling liquidity on banks books, have led to consequently much more risk for heightened volatility as illustrated by not only the violent surge in T-bills volatility but no doubt in the spike in 1 month bill yields as illustrated by Bank of America Merrill Lynch in their note from the 8th of October entitled "From financial to fiscal crisis":
"The more idiosyncratic concerns this time about being repaid by US Treasury was highlighted by the huge jump today in 1-month Treasury yields to 34bps, more than double yesterday’s level of 16bps as Treasury sold $30bn of new 1-month bills (Figure 4). Clearly, given the political circumstances, the likelihood of being repaid a 1-month maturity by the private sector may well exceed the likelihood of being repaid by the public sector (though both probabilities are very high). However, in the unlikely event that it really came to a public sector default we doubt the financial sector would continue to outperform – despite banks having finally recovered from the financial crisis - amid potential systemic concerns. Such concerns include liquidity and haircut requirements of Treasury collateral supporting the short term market. This perhaps explains the small spike in FRA-OIS the past two days (Figure 1)."
- source Bank of America Merrill Lynch

After all, it does seem that, courtesy of Central Banks' generosity we do live in a Bayesian world: "For subjectivists, probability corresponds to a 'personal belief'"- source Wikipedia

Like the wise Seneca, we prefer the exercise of judgment. On that sense we agree with the comments from Bank of America Merrill Lynch from their note from the 10th of October 2013 entitled "No Apocalypse Now":
"While we have recently suggested (see "Get CRASHy") that investor behavior is becoming more exuberant, right now there are two factors that we believe reduce the risk of a major market decline in coming weeks.
First, investors have already taken out substantial protection against a sharp debt-default inspired decline in equities in the form of SPX puts and VIX calls.
Second, in a classic debt default crash, the value of equities, bonds as well as the currency is simultaneously impacted. In our view a US apocalypse trade in October would require lower equities (in particular bank stocks), a lower US dollar and higher bond yields. We believe that combination would suggest investors are questioning the credit-worthiness of the US government and/or expecting inflationary consequences of QE4 (i.e. another liquidity policy response by the Fed) and a devaluation of the US dollar. Should the Fed be forced to "extend" or "magnify" liquidity and bond yields rise, in our view risk assets would likely be severly impacted.
Despite the debt ceiling situation, both inflation expectations and interest rates do not appear to be acting in an apocalyptic manner. Aside from a sharp move higher in the 1-month T-bill, fixed income markets have been very well behaved and volatility in both stocks and currencies has been low. And Washington is now piecing together a plan to extend the debt ceiling for up to 6 weeks." - source Bank of America Merrill Lynch

So if you still want to play the "Bayesian subjectivist" here comes from Bank of America Merrill Lynch note, another bout of  "Scheduled Schedule" for you to peruse:
"-As of Monday, October 7th, the Treasury had $35 billion of cash and $92 billion in debt maneuver capacity, giving the government $127 billion in cash to deal with upcoming liabilities.
-October 17th is the date specified by the US Treasury that debt capacity will run out (BofAML estimates that payment capacity will still be $70bn).
-October 31st a $6bn coupon payment is due (BofAML estimates payment capacity at that date will have fallen to $22bn).
-November 1st the payment capacity completely runs out due to large Social Security, Medicare, defense, & veterans payments of $67bn (BofAML estimates only half payments could be made).
-November 15th a further $31bn coupon payment is due and a potential default could then be announced if the debt ceiling is not raised before this date." - source Bank of America Merrill Lynch

Moving on to the subject of the potential "tapering stance" of the new "Chairwoman" Janet Yellen, back in June 2013 in our conversation "Lucas critique" we argued:
"QE tapering"soon? We do not think so. Markets participants have had much lower inflation expectations in the world, leading to a significantly growing divergence between the S&P 500 and the US 10 year breakeven, indicative of the deflationary forces at play".

The divergence between the S&P 500 and the US 10 year breakeven, graph source Bloomberg:

The correlation between the US, High Yield and equities (S&P 500) since the beginning of the year has weakened dramatically. US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG  - source Bloomberg:

In addition to inflations expectations, shipping has always been for us, the best significant example of the reflationary attempts of our "omnipotent" central bankers. For instance, containership lines have announced 6 rate increases in 2013, but have failed to maintain the momentum because of the weak global economy and the excess capacity which has yet to be cleared in similar fashion to the housing shadow inventory plaguing US banks balance sheet, graph source Bloomberg:
"The Drewry Hong Kong-Los Angeles container rate benchmark fell 5.3% to $1,786 in the week ended Oct. 9, the lowest level since March 2012 ($1,771). This marks the 13th week in 2013 that rates are below $2,000. Rates are about 29% lower than the July 2012 high of $2,519. Even with six increases in 2013, rates are 34.1% lower yoy and down 19.3% ytd, as slack capacity continues to pressure pricing." - source Bloomberg.

Weak global economy, with weak global demand as illustrated by shipping rates as indicated by data from the World Container Index data - source Bloomberg:
"Shipping rates for 40-foot containers (FEU) fell 3.8% sequentially to $1,601 for the week ending Oct. 3, the fourth straight decline, according to World Container Index data.
Weakness continues to be driven by Asia, as rates from Shanghai to Rotterdam fell 7.3%, followed by Shanghai to Los Angeles (down 4.8%), Shanghai to Genoa (4.7% lower) and Shanghai to New York (down 3.2%) routes. Rates rose for Rotterdam to Shanghai (4.7%) and to New York (1.6%)." - source Bloomberg.

While the recent range break-out in the Baltic Dry Index is supposedly indicative of a strong economic rebound, we think the respite is temporary - graph source Bloomberg:

Some pundits as well have become more upbeat on iron-ore freight and scrapping levels as indicated in the below Chart of the Day from Bloomberg depicting fleet expansion versus ships' scrapping. We remain wary given the deflationary forces at play - graph source Bloomberg:
"The biggest rally in iron-ore freight costs since 2009 is prompting shipowners to end the industry’s biggest scrapping program in at least three decades as older vessels bring in more money.
The CHART OF THE DAY shows how rates, in blue, for Capesize ships hauling 160,000 metric tons of iron ore rose to a 34-month high of $42,211 a day on Sept. 25. Scrapping levels are in red.
Owners have paid off debt used to buy older vessels, making them cheaper to run, so they won’t opt for scrapping as long as the rally allows them to profit from the ships, according to Erik Nikolai Stavseth, an analyst at Arctic Securities ASA in Oslo. Chinese investment in rail, buildings and infrastructure will rise 20 percent this year, creating demand for another 135 million tons of steel, Shanghai-based Citic Securities Co. says. That would require 200 million tons of iron ore, used to produce the alloy, enough to fill 180 Capesizes, according to Fearnley Consultants A/S, a research company in Oslo. Capesize fleet capacity is up 75 percent since 2008, says IHS Maritime, a Coulsdon, England-based maritime researcher. “Freight rates are expected to return to profitable levels- even for older tonnage,” said Stavseth, whose recommendations on shipping company shares returned 26 percent in the past year.
“This will potentially lead to higher net fleet growth.” World trade in iron ore will grow 6 percent to 1.17 billion tons this year, with China taking two-thirds, according to Clarkson Plc, the biggest shipbroker. Earnings for Capesize carriers sailing to China from Brazil at a $40,000 daily rate assuming a voyage time of 45 days will equate to $1.8 million, spurring owners to keep trading their ships, Stavseth said." - source Bloomberg

We remain wary because we have yet to see a clear reduction in the number of ships being broken-up - graph source Bloomberg:

We remain wary because we have not seen a confirmed rebound in Chinese Iron Ore imports which are correlated to the Australian dollar - graph source Bloomberg:

As displayed in Deutsche Bank weekly Shipping note from the 7th of October 2013, Chinese Ore Inventory remains well below 2012 levels:
- source Deutsche Bank

But there are some improvements in monthly Chinese Iron Ore Imports as indicated by Deutsche Bank:
"August iron ore imports declined by 5.6% m/m, but is still up 7.2% y/y. Given recent chartering trends, we expect to see improved imports in September." - source Deutsche Bank

We have already touched on "the link between consumer spending, housing, credit growth and shipping":
"If there is a genuine recovery in housing driven by consumer confidence leading to consumer spending, one would expect a significant rebound in the Baltic Dry Index given that containerized traffic is dominated by the shipping of consumer products."

The worry for us as of late is that consumer sentiment in the US has fallen in October to a 9th month low making us questioning the strength of the rebound in shipping, as per Ben Schenkel's article from the 11th of October entitled "Consumer Sentiment in U.S. Fell in October to Nine-Month Low":
"Consumer sentiment in the U.S. fell in October to a nine-month low as the government’s partial shutdown and the debt-ceiling debate caused outlooks to sour.
The Thomson Reuters/University of Michigan preliminary consumer sentiment index of decreased to 75.2 this month from 77.5 in September. Economists in a Bloomberg survey projected a drop to 75.3, according to the median estimate.
Households are becoming pessimistic about the economy as the shutdown heads into a third week and the deadline looms for raising the debt limit and avoiding a default. Nonetheless, improved stock values and home prices have lent support to balance sheets, especially for wealthier Americans.
“Since the shutdown began, consumer sentiment has taken a hit,” Brian Jones, senior U.S. economist for Societe Generale in New York, said before the report. “The average person is sensitive to the headlines about the debt ceiling and the adverse impact of a technical default.” Projections of the 68 economists surveyed by Bloomberg ranged from 65 to 80. The index averaged 89 in the five years leading up to the economic slump that began in December 2007, and 64.2 during the 18-month recession that ensued." - source Bloomberg.

This leads us not to believe the Fed will "taper" in 2013. For 2014, we are not too sure either...That's our own "Rebel Yell".

"What is a rebel? A man who says no." - Albert Camus 

Stay tuned!

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