Sunday 26 March 2017

Macro and Credit - Outflow boundary

"It was one of those March days when the sun shines hot and the wind blows cold: when it is summer in the light, and winter in the shade." -  Charles Dickens
Watching with interest the inflows pouring into short term Investment Grade credit funds, somewhat validating, the defensive posture we have been discussing as of late, we reminded ourselves for our title analogy of the concept of "Outflow boundary". An "Outflow boundary" also known as a gust front, is a storm-scale or mesoscale boundary separating thunderstorm-cooled air (outflow) from the surrounding air, similar in effect to a cold front. While outflows boundaries can persist for 24 hours or more after a thunderstorm, with passage marked by a wind shift and usually a drop in temperature and a related pressure jump, in similar fashion outflows in funds can persist for a specific amount of time. Also "Outflow boundaries" do create low-level wind shear which can be hazardous during aircraft takeoffs and landings, so if you are indeed piloting in similar "market conditions", you need to be extra cautious, and probably embrace somewhat a contrarian stance, at least from a long duration perspective we think.

In this week's conversation we would like to look at the oil fueled decompression in credit, and why we are turning more positive when it comes to going long US duration, which will be supported flow wise by a return of the Japanese crowd thanks to better cross-currency basis.

  • Macro and Credit - Front-running our Japanese friends?
  • Final chart - Beware of "credit" repatriation

  • Macro and Credit - Front-running our Japanese friends?
While we have long argued that in recent years you had to focus on what our Japanese friends such as GPIF, Lifers and Mrs Watanabe were doing in terms of allocations, given we are moving towards the end of the Japanese fiscal year, we are wondering if we are close to the "Outflow boundary" as many of them have shun foreign bonds lately. Could this time be different? 

It was only a matter of time before the weakness in oil translated into a weakness in credit, hence the fund outflows we have discussing about in our recent musing and our argument relating to High Yield being "priced to perfection" hence our recommendation to seek refuge in US Investment Grade. This outperformance of Investment Grade credit in conjunction with the weakness in oil has been clearly described by DataGrapple in their recent blog posting from the 24th of March entitled "Oil-Fueled Decompression":
"After a few months a stability, oil experienced a tumultuous month of March. Over the last four weeks, it has slid more than 10% amid supply woes. Russia’s policy makers are leaning on the cautious side. They said they were using below consensus estimates - $50/barrel on average in 2017, falling to $40/barrel at the end of 2017 and then staying near that level during the 2 following years – to establish growth forecasts in an economy still driven by oil to a large extent, adding to the market nervousness in doing so. That certainly goes a long way in explaining the underperformance of the energy heavy CDX HY compared to its investment grade benchmark equivalent, CDX IG. Since the 24th February, CDX IG series 27 – series 28 did not exist at the time – has tightened by 3bps to 60bps, while CDX HY series 27 has widened by 7bps to 327bps. Using a standard beta and thus assuming 1bp of CDX IG is equivalent to 5bps of CDX HY, it means HY has underperformed IG by almost 1 percentage point in cash price over the last 4 weeks." - source DataGrapple
In terms of oil and US High Yield with a correlation of 0.72, it makes sense from a Total Return perspective to see a relationship, particularly given the significant weight of the Energy sector in US High Yield indices:
- source MacroCharts

Of course flow wise, recent weeks saw a defensive rotation on the back of the weakness in oil prices as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 24th of March entitled "Rising risk of outflows out of short-term funds":
"Forsaking duration vs reaching for yield
Despite the significant risk-on we have seen across risky assets in the past weeks, inflows continue to pile into short-term IG funds. Total returns are turning negative over the past weeks (chart 1), and this increases the risk of outflows hitting IG funds in Europe. 2y bund yields have re-priced significantly higher since late February. The flattening of the yield curve is not supportive either. EM debt funds continue to attract interest as dollar slips lower.

Over the past week…
High grade funds flows remain on the positive side for the ninth week in a row. Even though flows are still strong, the pace is weakening lately. High yield funds flow remained negative for a second week, however the outflow was less more than halved w-o-w. Looking into the domicile breakdown, as charts 13 and 14 show, the largest part of the outflow came from euro-focused and US-focused HY funds. The globally focused funds were almost flat last week.

Government bond funds flows remained on negative territory for the fourth consecutive week, recording over $3.5bn of outflows over that period. Money market funds weekly flows remained positive for a third week, but the inflow was marginal. Overall, fixed income funds flows flipped back to positive territory after a brief week of outflows. European equity funds flows were negative for a second week, with outflows picking up w-o-w. However these outflows are significantly smaller than what we have experienced in 2016.
Global EM debt fund flows continued on a positive trend for an 8th week. The latest inflow was the highest in 34 week as dollar continued to weaken. Commodities funds recorded their second week of inflows.
On the duration front, strong inflows continued in short-term IG funds for the 14th week in a row recording the biggest inflow in this part of the curve since July ‘14. Mid-term funds posted a second outflow in a row, the largest outflow in four weeks. Flows in long-term funds remained slightly positive for a second week." - source Bank of America Merrill Lynch
When it comes to oil woes and High Yield weakness, it remains to be seen if indeed we are going through an "Outflow boundary". As pointed out by Deutsche Bank's US Credit Strategy Sector Themes from the 24th of March, High Yield's weakness apart from outflows, seems to be continuing and worth monitoring given its correlation with equities (more on this below):
"HY weakness persists, despite slower issuance, stable oil
The HY bond market has repriced noticeably this month, having seen its spread widening from the lows of 368bps reached on March 2 to 423bp today. It started with weakness in the higher-quality segments of the index, before extending itself down the quality spectrum. At the end, CCCs have lost 2.6% in excess return, compared to 1.4% in BBs in March, while maintaining about a 2pt lead for the year.
A record-setting streak of eight-day outflows from ETFs earlier this month claimed 7.2% of their AUM, compared to 6.7% in withdrawals in the immediate aftermath of the Third Ave fund failure in Dec 2015. Eventually the outflows extended to broader fund space, claiming a couple of $1bn+ days of heavy withdrawals, which continue to this day.
Issuance has slowed down noticeably in recent days, after breaking some records leading to the Fed meeting. This suggests it only had a limited contribution to HY weakness at that point in time. Similarly, HY temporary bounce a week ago was happening in the background of WTI trading close to its recent lows, also supporting our view that oil had only a limited impact on spread widening. We think it is mostly about repricing longer-term rates and growth expectations. IG spreads remained broadly unchanged March, oscillating around 120bp.
The global yield environment is shifting fast
The yield on Bloomberg’s Global Agg index has jumped by 20bps between late February and the Fed’s meeting, reaching 1.75% at its peak before giving back a few basis points since then. To put things into perspective, these 20bps represent 2/3rds of its increase between the US election and year-end. We think this datapoint is a key aspect of what drove HY weakness in recent weeks, as the reach for yield trade can only survive in the environment of lack of global yield opportunities, and every basis point of increase in that benchmark’s yield equals $4.6 of incremental income produced in a year. In an average month, global HY market produces $12bn of income, and in the middle of last year this number stood for a quarter of total income produced by the Global Agg. At any point in time between Brexit vote last June and US election in November, investors were willingly accepting lower yields on their EU IG holdings than they can currently get in the German 10yr bund." - source Deutsche Bank
As we pointed out recently, the performance for High Yield since the "Trumpflation"trade has been impressive to say the least. This is also pointed out by Deutsche Bank's report:
"HY vs IG
HY spreads have tightened dramatically post the US election, setting a low print of 368bp in early March, or almost 150bp below their level on Nov 8. In the meantime, IG spreads have only tightened by 20 bps to 118bps. The 1:7.5x relationship between IG and HY we experienced over the past few months breaks the historical norm of around 1:3.5x between these two asset classes.

A tight relationship that exists between these two asset classes has been pushed to the limit in early March, as Figure 2 demonstrates.

This resulted in the error term (actual vs estimated HY spread based on regression vs IG) of -75bps, matching its cyclical tights.
Going forward, we expect this tight relationship (85% r-squared) to reassert itself, resulting in relative excess return underperformance in HY. While the normal historical spread beta between IG and HY spreads is 1:3.5x, the excess return beta is only 1:1.5x (a function of shorter HY effective duration). As such, we use this 1.5x beta as the weighting for the IG leg of this positioning recommendation. One easy way to execute on this trade would by using ETFs: LQDH is a rates-hedged version of LQD, and HYGH is an equivalent in HY. We recommend shorting $1 of HYGH vs going long $1.5 of LQDH.
HY CDX is trading much closer to IG CDX based on a similar regression analysis, implying little potential value in replicating this trade there. Also, an extension of this recommendation to total returns is challenging, given our expectations for higher rates. IG is more likely to underperform HY in total return terms in that scenario." - source Deutsche Bank
We agree with the above, namely that the weakness in US High Yield is likely to persist further. and, this represents as well some headwind for our equities friends out there. Why is so, just a simple correlation close to 1:
- source MacroChart

In case you are asking, it just shows you that High Yield, isn't that much of an "alternative" asset class, as put forward by some pundits. So really please tell us where your potential for diversification is? Because,  when it comes to High Yield, we do not see it hence our "Outflow boundary"analogy.

But, the big question, as we await the allocation decision from our Japanese friends, if there will be enticed again by foreign bonds like they have in recent years. The weakness seen since the beginning of the year has reduced the cost of dollar funding, and with US policy in turmoil in conjunction with prospects for slower US growth than anticipated, there is a chance to "make duration great again" we think in the current "Outflow boundary" environment. This is as well put forward by Bank of America Merrill Lynch in their Credit Market Strategist note from the 24th of March entitled "Hedging costs in the driver seat":
"Hedging costs in the driver seat
We feel increasingly confident about our bullish outlook for high grade credit spreads, as well as our 10s/30s spread curve flattener. But our 5s/10s flattener is challenged. Volatility from policy risks aside the technicals of the high grade corporate bond market are about to improve. This is because of sharp further declines in the cost of dollar funding for foreign investors (Figure 1), as US policy gridlock dampens the outlook for accelerating economic growth.

Recently this has been particularly pronounced for Japanese investors – perhaps due to liquidation of foreign assets toward the end of their fiscal year (March 31st, Figure 2).

This, along with the shift higher in US interest rates and continued decline in interest rate risk (Figure 3), come conveniently just ahead of the new Japanese fiscal year where their foreign bond buying steps up significantly.
Higher inflows …
That also means continued strong inflows to high grade bond funds and ETFs, as we have argued these are presently driven by foreign investors. This is because we are seeing record inflows in a time with poor bond price performance, which contrasts with the typical historical pattern where bond fund inflows are driven by retail investors chasing performance (Figure 4).

Furthermore the acceleration in inflows began at the time dollar funding costs declined early this year, and further accelerated after the Chinese New Year.
… but in the curve
While our bullish outlook for credit spreads welcomes the decline in the cost of dollar funding, as inflows accelerate, our 5s/10s spread curve flattener does not. This is because of the high degree of yield sensitivity of foreign demand, which means that the cost of dollar funding is a prime determinant of how far out the steep maturity curve they must reach. Hence the declining cost of dollar funding this year is allowing many foreign investors to reach their yield bogeys at shorter maturities in the US corporate bond market this year compared to the last part of last year. This is why the dealer-to affiliate volumes show a large increase in 3-7 year foreign buying this year, which is the key reason for the steepening bias in 5s/10s spread curves (Figure 5).

However, as foreign inflows accelerate we expect the cost of dollar funding to rebound and again send foreign investors out the curve, generating flatter 5s/10s curves." - source Bank of America Merrill Lynch
Obviously the big question coming up is relative to Japanese foreign bond buying. Is this time different? Are we going to see them return in drove to US Investment Grade?

On this very subject we read with interest Nomura's take from their Japan Navigator note number 713 entitled "Buying lower-rated credit instruments or adding currency-market exposure?":
"On supply and demand, we believe domestic investors are unlikely to aggressively add duration in determining their FY17 portfolios, either in yen or (currency-hedged) foreign bonds, in light of substantial losses that they incurred in these markets in FY16.

For these investors, increasing purchases in foreign credit markets may be an option. Assuming this, the recent narrowing of USD/JPY basis may look positive for their flows into these markets, but this is also a result of the narrowing difference between credit spreads in the US and Japan (Figure 2), which makes their aggressive (currency-hedged) buying of US corporates unlikely, particularly as the Fed hike will likely prompt a widening of the difference between short-term rates in the US and Japan (Figure 3).

This leaves Japanese investors options of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During the previous 2004-06 Fed rate hiking cycle, life insurers lowered the ratio of currency hedged investments (Figure 4).
Currency hedging costs and Japanese foreign bond investment
More investors appear to be converting USD to JPY USD basis has been tightening, not only to JPY but also to all key currencies, meaning the tightening of USD/JPY basis is not specific to JPY (Figure 5).

We also note that USD/JPY has tightened more in short-term tenors (Figure 6), which we attribute to a reversal of the sharp widening into end-2016.

USD funding tightened on MMF reforms in the US and concerns over Fed hikes. We believe the widening trend has been reversed as the market has recognized there is greater USD supply than expected. In addition, the recovery in EM currencies likely lowered the need for USD (Figure 7).

Coupled with the recent tightening of supply and demand in short and intermediate tenors of the JGB market (Figure 8), these factors suggest to us a wider range of investors are converting USD into JPY for yen bond purchases.

Basis swaps appear to provide global investors one of the few opportunities to earn low-risk returns now that central bank tightening has reduced the range of such options. This explains why USD/JPY basis has not widened to the extent we saw in late 2016, even as the Fed continued to lay the foundation for a March hike. Investors looking to buy currency-hedged foreign bonds may well take this opportunity.

Cheaper USD may not lead to an increase in Japanese investor flows into foreign bonds
That said, Japanese investor flows into foreign bonds are unlikely to pick up just because of cheaper USD funding, as the recent tightening of USD basis – particularly in long tenors – reflects the narrowing difference between credit spreads in the US and Japan (Figure 2). Specifically, the difference between the spreads of A-rated corporates in the US and Japan has narrowed to levels that no longer cover USD-hedging costs.
In addition, we believe the recent narrowing of USD/JPY basis likely reflects a decline in Japanese investors’ appetite for foreign bond investments, as the difference between short-term rates in the US and Japan is widening while the Fed is increasingly likely to hike more aggressively than was initially expected." - source Nomura

If indeed the Fed decides to have a more aggressive tightening stance, as we posited in our last conversation when it comes to our Swiss Wall analogy and path outcomes, then indeed Nomura could be right. But, as we stated in our last conversation, the dovish tone of the Fed might be linked to the recent weakness related to Commercial and Industrial lending (C&I). This is worth monitoring from a "credit impulse" perspective.

In relation to Nomura's take on the recovery in EM currencies lowering the need for USD, we will closely be watching oil prices and its relation with Asian currencies in particular. There is a significant correlation over time. Where oil goes, Asian currencies follow:
- source MacroCharts

Now, if US long bonds yields such as 30 years continue receding, then indeed our contrarian stance of once again dipping our toes in long duration exposure (ETF ZROZ - TLT) and adding to Investment Grade credit with higher duration as well could be tactically enticing. We are watching closely the 3% level on the 30 year.

One thing that appears clear to us is that in recent years, USD corporate credit in recent years has been supported by a large contingent of foreign investors. It remains to be seen how long the ECB and the Bank of Japan (BOJ) will remain accommodative when the Fed is about to take a way the punch bowl as per our final chart below.

  • Final chart - Beware of "credit" repatriation
While we do think renewed signs of volatility could impact High Yield, we agree with most sell-side pundits that a move towards "quality" could be warranted and therefore US Investment Grade could provide some buffer. Our final chart comes from Wells Fargo Global Corporate Credit Outlook for Q2 2017 published on the 24th of March and entitled "Hope is not a strategy". This final chart displays Non-US Demand for US Credit and clearly highlights the risk of "repatriation", if there is a trend reversal for US credit demand from foreign investors:
"If the ECB and others start to follow the Fed's lead and move away from their extraordinarily easy monetary policies and front-end yields start to move toward a positive rate, then global flows could shift dramatically. We estimate that about 40% of the $8.5 trillion USD corporate credit market is held by non-U.S. investors with about 30% held in Europe and 10% held in Asia. For these investors, price sensitivity is determined by creditworthiness, interest rate movements and foreign exchange movements. If interest rates start to rise and the USD weakens, then non-U.S. investors would experience material mark-to-market losses and may start to repatriate their funds. Admittedly, this is more likely a risk for the second half of this year, but given the dramatic inflows into USD credit from overseas investors over the past several years, a reversal of the trend could be quite jarring to the market." - source Wells Fargo
For now the "Outflow boundary" seems to hold (low level wind), for the second part of the year, we do remain relatively cautious, yet, tactically we think adding duration is starting to become enticing on a risk of renewed turbulences and volatility in the short term.

"Political language... is designed to make lies sound truthful and murder respectable, and to give an appearance of solidity to pure wind." - George Orwell

Stay tuned!

Monday 20 March 2017

Macro and Credit - The Swiss Wall

"When things are steep, remember to stay level-headed." - Horace

Looking at the consequences of a finally Dovish Fed leading to a significant rise in gold and gold miners, with a continuation of the rally in risky assets, given we have been vacationing in the French Alps, it reminded us, this time around for our title analogy about a steep and difficult piste in the Portes du Soleil ski area, on the border between France and Switzerland called Le Pas de Chavanette, also called the Swiss Wall. 

This particular slope is classified in the Swiss/French difficulty rating as orange, which means that it is rated as too difficult to fit in the standard classification of green (very easy), blue (easy), red (intermediate) and black (difficult). It has a length of 1 kilometre and a vertical drop of 331 metres, starting at 2,151 metres above sea level. In similar fashion, if indeed the Atlanta Fed's Q1 US GDP estimate is estimated at 0.9% and the Fed continues with its "normalization" process, while there are some early signs of credit slowing, then in similar fashion to those who have experienced skiing on the much dreaded Swiss Wall (like ourselves) will know that this particular "slope" or normalization process, can quickly become hazardous, to say the least. The scary Swiss Wall starts in a narrow pass on the mountain top with an inclination of 40 degrees. The initial 50 metres have to be skied or boarded by everyone taking Le Pas de Chavanette. Especially without fresh snow, the slope gets icy quickly, turning the area between moguls into ice sheets. Not making a turn in these situations means that you miss the next mogul, and pick up too much speed to make the next one after that, starting off a tumble that ends a couple of hundred metres down the slope, while hitting a few dozen icy bumps in the course. By having kept interest rates, too low for too long, and given the Fed's propensity of being often behind the curve (or the slope), means, when it comes to our chosen analogy that markets could potentially tumble, hence the defensive outflows seen as of late from High Yield where the punters (or skiers) are aware of the difficulties that lie ahead of them. In similar fashion, on the Swiss Wall, after the initial very steep stretch, the choice can be made, up until the rocky passage in the direct path, to escape to the less steep left hand side of the slope, where a stumble is less dangerous. The direct path down Le Pas de Chavanette, to the right hand side and down the rocky passage, should only be taken by very experienced skiers and riders who know how to handle moguls, as it is effectively a continuation of the first 50 metres. As the slope eases out, it is easier to negotiate the moguls and make a single run down to the end, although the inclination and bumps still call for significant dexterity and physical strength. It remains to be seen, which path the Fed will decided to take and how experienced skiers they are when it comes to take the very slippery slope of the interest rate normalization process. In similar fashion to skiers venturing on the Swiss Wall, wearing protective gear like a helmet and a back protector is highly recommended. Same things goes in these "inflated" markets we think.

In this week's conversation we would like to look at how global financial risks can be driving spreads, in conjunction with near term political risks.

  • Macro and Credit - Taking the Investment Grade path where a stumble is less dangerous
  • Final chart - USD likely to weaken given current position in historical tightening cycle

  • Macro and Credit - Taking the Investment Grade path where a stumble is less dangerous
While there has been a continuation in the performance of risky assets and in particular equities on the back of the Fed's rate hike and a somewhat more dovish tone, in terms of outflows, there has been a continuation of a defensive stance building up in credit, leading to a rotation from High Yield towards Investment Grade. We do remain short term "Keynesian" when it comes to credit and in particular Investment Grade, yet we are cautious on a longer time frame due to the leverage accumulated thanks to cheap credit which funded buybacks on a grand scale, weakening in the process corporates' balance sheets. In similar fashion to skiers on the Swiss Wall, as of late investors have chosen to take the less steep left hand side of the slope, where a stumble is less dangerous. This can be seen in fund flows as reported by Bank of America Merrill Lynch from their Follow the Flow note from the 17th of March 2017 entitled "Quality yield inflows as political risks near":
"Cautious flows 
Heading to the Dutch elections, investors preferred to look for quality yield. Inflows into high grade bonds strengthened considerably, while outflows hit HY funds particularly hard. Equity funds suffered light outflows, as equity investors wanted to be light heading to the Dutch elections. However, we feel that post the strong risk-on moves yesterday, part of these flows should reverse back to high yield and equity portfolios. 
Over the past week… 
High grade funds continued on the same positive trend of late for the eighth week in a row; and recorded an inflow as strong as the one a week ago. Monthly data reveal that February flows were the strongest in 6 months. High yield funds flow dipped into negative territory; making last week’s outflow the largest in 32 weeks. Looking into the domicile breakdown, among the European HY domiciled funds the ones that focus on US and European HY were the ones that recorded the vast majority of the outflows, while outflows from globally-focused funds were marginal. HY monthly flows remained positive for a third month in a row. 
Government bond funds flows remained on negative territory for another week, recording a sizable outflow, the largest in 12 weeks. Money market funds weekly flows remained positive for a second week. Overall, fixed income funds flows flipped back to negative after 11 weeks of inflows. However February data reveal that FI funds recorded the strongest inflow in six months. European equity funds flows flipped back to negative territory, recording relatively mild weekly outflows. Monthly flows remained relatively muted in February for a third month in a row for the asset class.

Global EM debt fund flows continued on a positive trend for a 7th week. The asset class has seen ~$14bn of inflows YTD. Commodities funds flows flipped back to positive. On the duration front, strong inflows continued in short-term IG funds for the 13th week in a row. Mid-term funds posted a small outflow, while flows in long-term funds flipped to a marginal positive figure after three weeks of notable outflows. " - source Bank of America Merrill Lynch
There has been definitely a scare in The Swiss Wall of investing when it comes to High Yield as reported by Bank of America Merrill Lynch in their High Yield Flow Report entitled "The outflows continue":
"Largest outflows from HY since Ukraine; 3rd largest ever 
US HY recorded a $4.06bn (-1.7%) net outflow last week, the largest since August 2014 and 3rd largest of all time. This brought the YTD total back into negative territory at - $3.3bn (-0.9%) through Wednesday. Whereas last week’s $2.8bn in redemptions were driven mostly by HY ETFs, open-ended funds bore the brunt of this session’s outflows with a $3.1bn (-1.6%) net loss. Similar to the aggregate high yield figure, this was the largest outflow from open-ended funds since the Ukrainian plane crash in the summer of 2014.

Although there has not been one cataclysmic event to cause the recent burst of outflows, they have likely been driven by a combination of higher rates, renewed fears over another dip in oil prices, and a fatigued rally that pointed towards a reluctance to continue investing in high yield. These withdrawals have pulled down returns in March, which currently stand at -1.4% through the 15th. Non-US HY also recorded a sizeable outflow totaling -$1.64bn (-0.6%) last week, their first period of net redemptions since November." - source Bank of America Merrill Lynch
If indeed investors (or skiers) have been on the cautious side prior to the FOMC rate hike decision, hence their rotation towards a more defensive position, we are awaiting to see if the Japanese investors crowd such as the gigantic GPIF and Lifers will come back to play with their foreign bonds allocations as they should be enticed by higher yielding US investment grade once more. What we also find of interest relating to our analogy is that investors and skiers alike, given the Fed's dovish tone, are encouraged by some sell-side pundits to take the right hand side and down the rocky passage of the Swiss Wall of investing namely in "equities". So far this year as indicated by Bank of America Merrill Lynch in their Fixed Income Weekly Strategy note from the 17th of March, this strategy has been vindicated:

 - source Bank of America Merill Lynch

Yet, from a valuation perspective and given current US valuation levels reached, from a skiing perspective and thanks to the Fed's dovish tone as of late, we would therefore rather go for EM equities if we had to make this choice down the slope of the Swiss Wall of investing. The bullish "skiing" stance down the Swiss Wall of investing is as well put forward by Bank of America Merrill Lynch in their Relative Value Strategist note from the 13th of March entitled "In the realm of diminishing returns":
"Don’t be a hero 
Despite the wobble in risk assets over the last week, credit indices are close to their post-crisis tights. And after the strong jobs report, we think the near-term path of spreads is likely to lead them further towards these lows, post-FOMC and the March CDX roll. That said, in our view credit as an asset class is now past its prime; at these valuations, we believe we are entering a realm of diminishing returns. In fact, as our analysis shows, returns in either direction aren’t likely to be large enough to warrant significant, outsized positions. In our view, if there ever was a time to step back, clip coupon, accumulate small gains and focus more on avoiding blow-ups, it is now. 
Great or not, the rotation is here 
If you’re bullish, we think the risk-return payoff in equities is far more compelling than in credit. In particular, we like being long S&P 500 vs. short in a HY cash index product (hedged for rates). Over the last 7y, in excess return terms, corporate bonds have failed to consistently generate returns that would overcome the losses during bad times. The upside vs. downside payoff looks far better in equities and CDX than in corporate bonds. Going forward, if the economy remains on this trajectory, the equity market is likely to continue outperforming credit. The prospect of higher rates is more favourable to equities, while in HY, negative convexity will likely cap any significant capital appreciation here on. On the downside, certain tax policy proposals which aren’t being priced in, namely borderadjustment tax and the elimination of interest-rate deductibility, are likely to have a significant negative impact on both equities and credit if implemented. Within credit, we think high yield companies are more susceptible than HG names and a short in HY cash is likely to provide a good offset to a SPX long from a policy risk perspective. 
Upside, downside, and in between 
For those looking for a credit long, medium/long term, we think CDX HY is a good candidate. While this may seem non-intuitive at first glance, we think technical issues with the index will continue to mean that it is often less volatile than either IG or its cash counterpart. Over the last 7y it has provided better risk-adjusted returns than either. For those bearish credit in the near-term (3-6m), we think it best to wait to set CDX shorts (IG or HY), at wider levels, just as the sell-off begins to gain momentum. Historically, shorts at current levels haven’t had a significant pay-off over 3m, despite wider spreads. Finally, we reiterate our preference for positive basis positions i.e. long CDX or synthetics over cash indices/bonds." - source Bank of America Merrill Lynch
We do agree with Bank of America Merrill Lynch, that, for bolder skiers, going for the synthetic option for playing High Yield makes sense first because of the liquidity factor provided by the index, second because of the lower duration factor compared to cash.

Of course, like any difficult slope, it can always get trickier on the ever changing Swiss Wall of investing. The rally can continue thanks to a dovish tone from the Fed which would be supportive of EM asset classes and put pressure on the crowded long US dollar positions. When it comes to credit, we do agree with Bank of America Merrill Lynch's take, that we are getting closer to the lower bounds of credit spread, even with the technical support of lower supply in the primary markets:
"In the realm of diminishing returns 
Credit spreads, unlike stock prices, have a lower bound (notwithstanding the recent spurt of negative spread bonds in Europe). We’re aware that we trot this statement out every now and then, as credit benchmarks approach previous tights, but it is a point worth bearing- the payoff in credit becomes more asymmetrical at tighter spread levels. Despite the wobble in risk assets over the last week, credit indices are close to their post-crisis tights, reached in June of 2014. And after the strong jobs report for February, the near-term path of spreads is likely to lead them further towards these lows. Over the coming weeks, we think there is potential for spread compression, post-FOMC and also into the March CDX roll. 
In last week’s HY Wire, we noted the similarities between now and the first half of 2014. Of course, back then geopolitics and oil prices poured cold water on the rally by the third quarter and that set the stage for high volatility and poor returns for the next two years. For this year too we think the second half has the potential to turn sour as disappointment with legislative progress in Congress starts weighing on the market. As we wrote last month, it seems as if all the good has already been priced in, with little to account for the bad. That said, it is difficult to pinpoint what will eventually make the market turn and more importantly, when. There’s also the possibility, that the underlying strength in the economy and confidence keeps risk assets buoyed for much longer
In our view what is perhaps more certain, is that credit is now past its prime; at these valuations, we think we are entering a realm of diminishing returns. In fact, as our analysis shows, returns in either direction aren’t likely to be large enough to warrant significant, outsized positions. This is well reflected in our HY returns forecast for the year – around 6% - and even better in our year ahead title – ‘Don’t be a hero’. If there ever was a time to step back, clip coupon, accumulate small gains and focus more on avoiding blow-ups, we think it is now. 
  • If you’re bullish, we think the risk-return payoff in equities is far more compelling than in credit – consider long S&P 500 vs. short in HY cash.
  • For those looking for a credit long, medium/long term, we think CDX HY is a good candidate. While this may seem non-intuitive at first glance, we think technical issues with the index will continue to mean that it is often less volatile than either IG or its cash counterpart. Over the last 7y it has provided better risk-adjusted returns than either.
  • For those bearish credit in the near-term (3-6m), we think it best to wait to set CDX shorts (IG or HY), at wider levels, just as the sell-off begins to gain momentum. Historically, shorts at current levels haven’t had a significant pay-off over 3m, despite wider spreads.
  • Finally, we reiterate our preference for positive basis positions i.e. long CDX or synthetics over cash indices/bonds." - source Bank of America Merrill Lynch
In our Swiss Wall of investing, when there is plenty of snow, the path downhill is easier on both side of the slope. But, as conditions changes and when the snow melts away at the end of the season, leading to some icy parts forming, not only it gets trickier even for the experienced skier like ourselves, but you need to chose your path more wisely according to the weather conditions. At this stage of the credit cycle, it becomes easier we think to stumble, no matter how experienced you think you are. What we have learned from both our investing experience and skiing the Swiss Wall is the need to stay humble and avoid being overconfident. From one day to the next, the Swiss Wall is never the same slope, this is why it makes it very challenging at this stage of the credit cycle. Even if Emerging Markets (EM) looks currently more enticing from an allocation perspective compared to Developed Markets (DM), as put forward by Bank of America Merrill Lynch in their EM Corporate Weekly note from the 14th of March 2017 entitled "Beware of fat tails", "Global financial risk" is the most important short term driver of spreads (icy patches):
"Global financial risk most important ST driver of spreads 
Ahead of the upcoming risk events (FOMC, Dutch & French Elections), we analyze past short-term drivers of EM credit spreads. Using a simple econometric model, we find that changes in UST yields, commodity prices, and global financial stress are able to explain more than half of the variation in credit spreads. Changes in BofAML’s Global Financial Stress Index (GFSI) are the most important driver (a one standard deviation increase in the GFSI is associated with +6 bps wider EMCB OAS). The second most important factor is changes in UST yields, followed by commodities. Our analysis also finds that these three factors can only explain 84 bps of spread tightening for our EMCB index since July 1st, compared to an actual tightening of 111 bps. This residual can likely be explained by technical factors which we do not explicitly include in our model. 
In Focus: quantifying the drivers behind spreads 
EM corporates are facing two different currents: on the one hand, technicals remain strong and credit fundamentals are improving on the back of higher commodities and GDP growth. On the other hand, valuations look expensive and a rise in external risks could lead to a re-pricing of credit spreads. In an attempt to quantify the historical impact of external factors on spreads, we run a simple multivariate linear regression model. We gathered weekly data from Jan 2012-Mar 2017 for our EM corporate indices as well as several external factors. Our baseline specification is the following:
Where UST5Y is the weekly bp change in 5Y UST yields, Commodities is the weekly percentage change in the S&P GSCI index, and GFSI is the weekly unit change in BofAML’s Global Financial Stress Index which is a measure of global cross-asset risk. 
Global financial risk biggest driver of spreads 
Results from our model suggest that BofAML’s GFSI index has the biggest impact on spreads: a three standard deviation weekly increase in the GFSI index is associated with spreads widening by 18 bps. EM HY is more correlated with changes in the GFSI than EM IG: a 3SD increase is associated with +36 bps of widening for EM HY vs. +12 bps for EM IG. LatAm is more correlated with the GFSI than other regions (Chart 3) with an est. spread widening of 25 bps given a 3SD move compared to +11 bps for Asia.

By sector Basic Materials and Real Estate are most correlated with the GFSI while Capital Goods are the least (Chart 4).
The last time the GFSI index rose by 3SD was February 12th 2016 (China and commodity selloff). Note that the GFSI has a correlation of 0.67 with the VIX. The latter did not show as much explanatory power in our regressions, which is why we prefer the GFSI. It is also a broader measure of risk appetite. 
Higher commodities associated with tighter spreads 
As expected, a 10% (4 SD) increase in commodity prices is associated with spreads tightening by 10 bps, holding other factors constant. EM HY is more sensitive to changes in commodities than EM IG, while LatAm is more sensitive than other regions given the larger share of commodity issuers (47%). On a sector basis, Energy, Basic Materials, and Transportation are most negatively correlated with commodity prices. 
EM HY has most negative correlation with UST yields 
In contrast to the positive correlation between the GFSI and spreads, changes in UST yields are negatively correlated with changes in spreads. A 50 bps (4.7 SD) weekly increase in 5Y UST yields is associated with OAS spreads tightening by 16 bps (beta of - 0.33), holding other factors constant (Chart 3). This implies that average yields would rise by 34 bps if 5Y UST yields rise by 50 bps. We also tested to see whether is a difference in the estimated beta depending on whether UST yields are rising or falling, but didn’t find any statistical significance. EM HY has a more negative beta than EM IG (-0.6 vs. -0.3) while Asia has the least negative beta across the regions (-0.2 vs. -0.4 for LatAm and EEMEA). On a sector basis, energy and consumer goods have the most negative beta, meaning spreads stand to tighten the most in a rising UST environment. 
Spreads have tightened more than predicted since July 
This regression also allows us to check whether the 111 bps tightening in EMCB spreads since July 1st 2016 is justified based on the actual changes in UST yields, commodity prices, and global financial stress. We find that the 103 bps increase in UST yields can explain 30 bps of the tightening in spreads, the 5% rise in commodities can explain 8 bps of tighter spreads, and lower financial stress can explain 46 bps of spread tightening. In total, our model calculates that EM spreads should have tightened by 84 bps since July 1st, implying that spreads overshot by 27 bps. However, the three variables in our model explain only 53% of the total variation in spreads, so it is possible that other factors which we don’t account for, such as technical factors or EM specific news account for the remaining spread tightening. High frequency data on technical factors are difficult to come across but we will explore this topic in future research." - source Bank of America Merrill Lynch
Now, if you remember our February 2016 conversation "The disappearance of MS München", we quoted Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis, when it comes to assessing warning signals that could weight on spreads:
"Depending on the type of crisis, there are different warning signals, such as significant current account imbalances (foreign debt crisis), inefficient currency pegs (currency crisis), excessive lending behavior (banking crisis), and a combination of excessive risk taking and asset price inflation (systemic financial crisis). A financial crisis is costly, as they are fiscal costs to restructure the financial system. There is also a tremendous loss from asset devaluation, and there can be a misallocation of resources, which in the end, depresses growth. A banking crisis is considered to be very costly compared with, for example, a currency crisis.We classify a credit crisis as something between a banking crisis and a systematic financial crisis. A credit crisis affects the banking system or arises in the financial system; the huge importance of credit risk for the functioning of the financial system as a whole bears also a systematic component. The trigger event is often an exogenous shock, while the pre-credit crisis situation is characterized by excessive lending, excessive leverage, excessive risk taking, and lax lending standardsSuch crises emerge in periods of very high expectations on economic development, which in turns boosts loan demand and leverage in the systemWhen an exogenous shock hits the market, it triggers an immediate repricing of the whole spectrum of credit-risky assets, increasing the funding costs of borrowers while causing an immense drop in the asset value of credit portfolios." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis - Macronomics, February 2016
In world where positive correlations have been rising as discussed in last year's conversation and where global economies are much more intertwined, we have noticed in recent years much larger standard deviation moves, which have had significant large impacts on a very short period of time in various asset classes. In fact what is of interest from the quoted EM report from Bank of America Merrill Lynch comes from the volatility of spreads and kurtosis:
- source Bank of America Merrill Lynch

In similar fashion to the Swiss Wall of investing, as we move towards the end of the credit cycle, kurtosis is showing up, meaning that bursts of volatility can be faster and shorter in terms of time frame as we saw in the first part of last year with the Energy sector and spreads blowing out initially, and outperforming in the second part of the year. We continue to be very wary of the second part of 2017 which could play out as the reverse of 2016, namely we could move from "good performance" to "bad performance". The rally so far this year for many asset classes has been significant.

One thing appears clear to us is that the dovish tone of the Fed might indeed be linked to the recent weakness we mentioned last week in Commercial & Industrial (C&I) lending:
"Given C&I loans are strongly related to what the "real" economy does, this warrants we think close monitoring in the coming months, to assess if it is only a short blip or if there is indeed something more sinister going on (slowing credit growth)." - source Macronomics, March 2017 
This "dovish" respite most likely explains the rebound in the Euro versus the crowded long US dollar and is providing an additional boost for EM asset classes in the process. Yet, we think the trend in C&I lending is worth following very closely. This is as well highlighted by Bank of America Merrill Lynch Credit Market Strategist note from the 17th of March entitled "HG sector outlook: long beta, leverage and inflows":
"Soft data is hard, hard data soft 
The Fed’s patience makes sense as hard economic data outside the labor market has been relatively soft. As we have highlighted (see: Situation Room: In wait and see mode 07 February 2017), loan demand has been soft recently – C&I lending for example has been flat since October while consumer loans on bank balance sheets have risen just 4% (Figure 36, Figure 37).

Clearly everybody is in wait and see mode pending details of actual fiscal policy expansion from the new administration – including especially tax reform. Until they deliver – and that is not a small task – it would be counterintuitive to see a marked hawkish shift at the Fed. In the meantime we remain bullish on high grade credit spreads." - source Bank of America Merrill Lynch.
We agree with the above, namely that before taking the more difficult path of the the Swiss Wall of investing with its normalization process, the Fed is clearly awaiting for more clarity from the new US administration. On a side note, we were quite surprised by the strong rally in gold/gold miners following the FOMC as we were expecting a more hawkish tone from the Fed on the back of ADP/NFP data releases.

From our continued contrarian position and Swiss Wall of investing perspective, we believe that the US dollar is likely to weaken further, contrary to the herd mentality, which has been taking a different path on this slope and a significant long position on the "greenback" as per our final chart below.

  • Final chart - USD likely to weaken given current position in historical tightening cycle
While the trade war rethoric seems to be still in play following the most recent G20 meeting, we still believe as per our early 2017 conversations that the path on the Swiss Wall of investing is lower, not higher in the current environment. This is as well highlighted in our final chart from Barclays note Thoughts for the Week Ahead entitled "The Fed says carry on":
"We expect further near-term USD weakness, concentrated primarily against high-yielding currencies. History suggests that this point in the Fed’s tightening cycle is typically followed by further near-term USD weakness, stable equity prices and lower 10y UST yields (Figure 1). 

Although low-yielding G10 and EM currencies will likely struggle to materially strengthen further against the USD, the drop in cross-asset volatility (Figure 2) will likely support high yielders, particularly the ones with positive idiosyncratic stories (RUB, INR, IDR and BRL), in our view.

Additional USD consolidation is also likely, amid still elevated long USD and short UST positioning, according to CFTC data (Figure 3). 
- source Barclays

One could argue that, if everyone is thinking the same, no one is really thinking, because, if indeed the Fed's recent caution on the Swill Wall of investing appears to be warranted in the light of the recent Atlanta Fed 1st quarter GDP projection and slowing credit growth, there is indeed a possibility for our "bold skiers" to "tumble" if one takes into account their current stretched positioning but, we ramble again...

"Tis one thing to be tempted, another thing to fall." - William Shakespeare

Stay tuned!

Saturday 11 March 2017

Macro and Credit - The Endless Summer

"The fact that logic cannot satisfy us awakens an almost insatiable hunger for the irrational." - A. N. Wilson, English writer

Watching with interest the continuation in the "Trumpflation" trade with equities pushing higher, credit going tighter and USD suddenly going stronger with real rates (pushing us to significantly curtail our gold mining exposure), we reminded ourselves for our title analogy of the 1966 worldwide release of surf movie "The Endless Summer". Its title comes from the idea, expressed at both the beginning and end of the film, that if one had enough time and money it would be possible to follow the summer up and down the world, making it endless (like the perfect asset allocator...). In similar fashion, the global reflationary trend witnessed so far thanks to central banks support, like the tide, has lifted all boats overall. From real estate to stock markets reaching in the US for some instance "lofty" valuations levels, given the recent strong macro data from PMIs to the latest ADP/NFP release in the US, we are indeed wondering if this credit cycle, while being long in the tooth, doesn't amount to "The Endless Summer". So if surfing the "wealth effect" seems so far appropriate for our title and markets analogy, we are wondering where the next big wave could be coming, given we recently pointed out that in many instances High Yield had been "priced" to perfection and the rally had been significant.

In this week's conversation we would like to look at the ebb and flow in the credit markets which could determine departure times from various asset classes as we move towards the Fed's hike decision.

  • Macro and Credit - Caesar, beware the ides of March
  • Final charts - Are Boomers "Bust" ?

  • Macro and Credit - Caesar, beware the ides of March
In modern times, the Ides of March is best known as the date on which Julius Caesar was assassinated in 44 BC which corresponds, dear readers to the 15th of March and equating to the next FOMC meeting of the US Federal Reserve bank. As we pointed out on numerous occasions we tend to look not only like any good pundits in the positioning of the players (such as the overstretched position in oil longs for instance...), but we do also look at the flows which could also be indicative in the changes in allocations.  As we pointed out in our most recent musing, so far this year High Yield fund inflows have remained strong in conjunction with the performance, making it look like an "Endless Summer" given the very significant performance of the asset class since the second part of 2016. Yet, it seems that as of late, it looks like some players have been trimming their sails. While next rate hike seems to be "baked in the cake", it remains to be seen how hawkish the tone will be at the next FOMC meeting. Many analysts are pointing out that the Fed is behind the curve, we have on numerous occasions joked with other macro rates pundits that the curve is behind the Fed. In relation to the risk of a more hawkish bias, we read with interest Bank of America Merrill Lynch's take from their Securitized Products Strategy weekly note from the 10th of March:
"Turning negative
Fed rate hike odds for next week are now almost 100%, up from the mid-30s just two weeks ago. The hawkish shift by the Fed has already been reflected in corporate credit spreads and real interest rates: IG and HY CDX spreads were as much as 5 bps and 30 bps wider in the past week, respectively, while the real 10yr yield is up by over 25 bps in the last two weeks. As usual, securitized products spreads have lagged the corporate and rate market action for the most part, as technical support for securitized products, especially credit, remains very strong.
What we’ve seen over the past two weeks is a mini-version of what we expect for 2017 overall. There is still plenty of time left in the year, so no doubt there will be continued swings in both directions on rates and spreads. But the big development in the past two weeks is the rapid hawkish shift in Fed rhetoric. We see potential for additional hawkish shifts in rhetoric going forward, including discussion of normalizing the balance sheet quicker than the market anticipates, and are in the camp that thinks the Fed is behind the curve on tightening monetary policy. If economic/inflation data forces the Fed to start tightening policy more aggressively, we think the market will eventually re-price equilibrium spread levels wider.
In short, the securitized products view is turning more and more into a view on how hawkish this tightening cycle will be for the Fed. Fed accommodation, and QE in particular, has unequivocally benefitted what we think of as the benchmark sector for securitized products, agency MBS. If the Fed is finally embarking on a sustained, hawkish tightening cycle, where their ownership of agency MBS is “normalized,” the path of least resistance for securitized products spreads is likely to be wider. Meanwhile, spread tightening potential, or at least justification for it, has become limited in our
view. Asymmetry on spreads is not a good thing.
Below, we examine the data connecting the Fed's MBS portfolio size to housing inventory, and rent and home price inflation. We believe the case can be made that reducing the portfolio sooner rather than later is warranted due to inflationary pressures in the housing market, although we recognize that this is probably a deep out-of-the money view at this point. Meanwhile, for the near term, the inflationary pressures in housing are a positive for residential mortgage credit.
We retain our neutral view on securitized products credit. There are positives on the technical and even fundamental front for the sector, except perhaps for CMBS, but our concerns about a looming hawkish shift by the Fed make us wary about chasing spreads tighter. Neutral balances it out for us. We turn underweight agency MBS, where we see enough negatives to outweigh the positives on the technical side. Specifically, we see seasonal supply pressures picking up and recognize that agency MBS are likely to be the first sector adversely impacted by any talk of accelerated balance sheet normalization.
Two indicators of why the Fed is/may be (way) behind on tightening 
We look at data that shows that the Fed is or may be way behind on tightening monetary policy, both in terms of raising rates and reducing its MBS portfolio. We are well aware that to date, both the Fed and the market have shown little concern over, or perhaps even awareness, of the analysis we present. As a result, it’s probably too early to think about it having a market impact. However, at a minimum, we think the data highlight the risk that the Fed somewhat abruptly shifts to a much more hawkish policy position.
In particular, unless mortgage rates are increased, by signaling accelerated MBS portfolio reduction, we think excessive home price and rent inflation looms on the horizon. Some have asked whether losses on portfolio sales would deter the Fed from selling. Losses might be a deterrent, but if rent and home price inflation spiral out of control, the Fed may not have a choice. Before considering the balance sheet, we focus on rate hikes as a policy tool.
1. Fed Funds and the Taylor Rule
Stanford’s John Taylor of Taylor Rule fame will be the featured speaker at the BofAML 2017 Residential & Housing Finance Conference this coming Tuesday, March 14, 2017. We'll wait for that session for guidance on the appropriateness of the Taylor Rule Fed Funds level versus the current Fed Funds level. Here, we simply present the historical data in Chart 1 (the two time series) and Chart 2 (Fed Funds – Taylor Rule) and leave it to the reader to decide if he or she thinks the Fed is possibly behind the curve. Currently, Fed Funds is roughly 300 basis points (twelve 25 basis point hikes!) below the Taylor Rule level.
The last time a disparity this large was seen was in 1974-1975, during a period of extraordinary rate volatility, when Fed Funds went from 13% to 5.5% in a matter of months. In a period of such high volatility, short term dislocation between an actual value and a model value can be expected. Now, with Fed Funds barely budging in eight years, the volatility explanation of the discrepancy does not apply. Rather, it appears as if the “Rule” is simply being ignored. As a result, after 40 years of roughly moving together, with the Taylor Rule level exhibiting less volatility than actual Fed Funds, they have decoupled.
Two possibilities emerge:
1. The Rule no longer applies and the decoupling will be permanent.
2. The Rule still applies and, as has been the case in the past, economic data inevitably force the humans setting the Fed Funds level to follow the Rule.
As a simple observation on the historical data, possibility #2 seems more reasonable to us, suggesting the Fed is way behind on tightening. Others can choose possibility #1.
2. The Fed balance sheet and home price and rent inflation
Here we consider the histories of existing home sales, housing inventory (measured as months supply, the number of homes for sale relative to the annual sales rate), Case Shiller home price appreciation (HPA), rent inflation and the Fed’s MBS portfolio size. We suggest that the Fed’s MBS ownership is creating home price and rent inflation, and that may not necessarily be a good thing.
Chart 3 starts with a look at existing home sales. January’s 5.69 million rate was the highest level since early 2007. That is also the level of early 2002, just before the housing bubble period commenced. Sales are seen on a steady uptrend since the end of 2008, when the Fed began buying MBS.
Chart 4 shows existing home sales versus Case Shiller HPA. Not surprisingly, the two series tend to move together. Policymakers and homeowners may be pleased that YOY HPA is reasonably strong, 5.85% for 2016. But what if it trends higher, along with existing home sales, as it did in the early 2000s? Is there a level of home price inflation that makes policymakers uncomfortable? What about the 36% of the population that do not own homes? Are they priced out of homeownership? Does strong HPA get passed through to rents?
Chart 5 suggests the answer on rents is yes. 5%-10% HPA may be great for homeowners but do policymakers really want to see rent inflation continue the steady rise that began in 2010, a year and a half after the Fed began purchasing MBS? Chart 6 shows that, two years after the Fed stopped increasing its MBS portfolio size, rent inflation appears to be accelerating. Similar to existing home sales, rent inflation is at the highest level since 2007.

Chart 7 shows the history of housing inventory. At 3.6 months, supply is back down to the record lows seen at the height of the housing bubble in 2005. Many will say that the low inventory is because builders are not building new homes. That may be true, but does that preclude the possibility that Fed MBS purchases may also be a factor, by artificially setting mortgage rates too low? The answer, in our view, is no, Fed balance sheet holdings cannot be ruled out as a driving force. Moreover, even if the Fed is responsible for low housing inventory, why is that a problem? Well, as we will see, it leads to home price inflation, which, as noted above, leads to rent inflation, which we think is a problem.
To help show these connections, we do a mathematical trick and invert the housing inventory and compare the inverted level to the Fed MBS holdings (Chart 8) and to HPA (Chart 9).

Similar to rent inflation, Chart 8 shows that the inverted housing inventory number bottomed in 2010, about a year and a half after the Fed started buying MBS, and has been trending higher ever since, meaning that inventories have been moving steadily lower. Chart 9 shows that this inverted inventory number tends to move in synch with or in advance of HPA, ie as a leading indicator. For anyone long housing, or residential mortgage credit, this looks like very good news for 2017. The data suggest that, due to record low inventories, the risk for HPA in 2017 is to the upside. The comparison of inverted inventory levels and rent inflation in Chart 10 shows a similar story for rent inflation: upside risk in 2017.
For a policymaker whose job is to maintain price stability, escalating rent inflation is not good news. There is a simple policy “cure” for this situation: raise mortgage rates by reducing the Fed MBS portfolio. Is the Fed anywhere near reaching this conclusion? Maybe not, but it probably should be, and if there is a rapid policy shift on this issue, we will not be surprised." - source Bank of America Merrill Lynch
There you go. While the Fed has been behind most of the "Endless Summer", one could argue that the Fed is not behind the curve, but, the curve is behind the Fed. Put it more simply, the Fed is the credit cycle, so, as the Fed starts to tighten in earnest financial conditions, the credit cycle will turn and rest assured it will entail some significant repricing at some point.

To that effect we agree with Jeff Gundlach from Double Line's recent take, namely that the Fed will hike until something breaks. It is bound to happen as the Fed has once again maintained rates too low for too long, which has led to some complacency in various asset classes and lofty valuations in many instances. This is as well the feeling in credit land as per recent investors' survey where there is a feeling of overvaluation.

This has been leading to some flow rotation with a more pronounced defensive stance leading to a reduction in both credit risk (from High Yield to Investment Grade) and a reduction in duration risk. This is clearly indicated in Bank of America Merrill Lynch latest Follow The Flow note from the 10th of March entitled "Shunning duration, adding yield":
"Reaching for yield, but cutting on duration
Higher yields and tighter spreads continue to benefit IG bond funds in Europe, recording a very strong inflow last week. Equities flows are back to positive with a $1bn inflow last week as economics data are strengthening. Duration is still under attack as IG investors are cutting back with rates moving higher. The reach for yield trade is in vogue with inflows into EM debt funds doubling w-o-w.
Over the past week…
High grade funds continued on a positive trend for the seventh week in a row; and recorded the highest inflow in 18 weeks. High yield funds inflows slowed down significantly last week, but still posted their 14th consecutive week of positive flows. Looking into the domicile breakdown, European-focused funds were the ones that recorded inflows, while outflows hit US and globally-focused funds.
Government bond funds flows remained on negative territory as rates moved higher. Money market funds weekly flows are back to positive after three weeks of outflows. Overall, fixed income funds flows remained strong and positive for the eleventh consecutive week; with more than $33bn of inflows over that period.
European equity funds flows flipped back to positive territory. So far this year the asset class has recorded inflows in seven out of ten weeks. Note that in 2016 the asset class recorded only eight weeks of inflows during the entire year.
Global EM debt fund flows continued on a positive trend for a sixth week, while flows more than doubled w-o-w. Almost $13bn of AUM has been added in the asset class YTD. Commodities funds flows flipped back to negative after seven weeks of consecutive inflows as oil prices dipped lower.
On the duration front, strong inflows continued in short-term IG funds for the 12th week in a row. Mid-term funds also posted a strong week of inflows; the second in the row. Flows into long-term funds remained negative for a third week in a row." - source Bank of America Merrill Lynch
Now if indeed there is added caution and a "Great Rotation" to quality (Investment Grade), one might wonder if indeed this time around credit will be leading equities and mark an end or a pause to the "Endless Summer". We looked at the below chart from Lawrence McDonald on our twitter feed and wondered:
- source Lawrence McDonald - Bloomberg/Twitter feed

Also on our Twitter feed which caught our attention was Bloomberg Lisa Abramowicz comments relating to the outflows in the ETF HYG on the 8th of March:
"Yesterday saw the biggest one-day outflow from the biggest junk-bond ETF since the U.S. election." - source Lisa Abramowicz - Bloomberg
As pointed out by a credit market pundit on Twitter as well (H/T Fil Zucchi) $5 billion worth of new issues were bought in the cash markets. One has to remember that, when it comes to keeping it's cool under pressure, the retail crowd is much more feeble than the institutional crowd. Where we slightly disagree with Fil Zucchi is that there has been a very significant growth in passive management and in particular bonds ETFs. So while tracking bonds ETFs is of interest, it is of course not the best great gauge of real health in credit markets. Yet, in the European High Yield complex, this week has seen some heavy trading in the cash space thanks to growing redemptions in High Yield credit ETFs. So all in all, tracking flows in ETFs is necessary but, not always enough to gauge the state of the market. But, from a short term perspective, it might indicate some weakness in the near term.

Another cause for concern has been the recent sucker punch delivered in very short order to the very crowded long oil community, which once again is going to weight on credit spreads and in particular the Energy sector which have been on a tear in the second part of 2016, leading to a significant outperformance of the sector. This, we think is worth monitoring, given the correlation between oil prices and High Yield as displayed in the below chart from Tom McClellan on his twitter feed:
- source Tom McClellan - Twitter feed

So if it is indeed you are wondering when "The Endless Summer"  will end and if you are a "big wave surfer" like Bohdi in Point Break meaning you are waiting for the "50-Year Storm" and "big waves" à la Nazaré in Portugal you need to start asking yourself how will this credit cycle end. On that specific point we read with interest Société Générale's take from their Credit Market Wrap-up from the 6th of March entitled "How will this credit cycle end":
"Market thoughts
For the past two years (and most recently in “The big hangover, Part II”), we have argued that the credit cycle has become shorter since the global financial crisis. Based on data going back to the 1920s, we have noted that the typical credit cycle lasts eight years, with a bear phase, a bull phase, and a phase of broad stability. But as Chart 1 shows, in the past eight years this traditional stability phase has disappeared. The average life of a credit cycle has shrunk to three years, and we have had three full credit cycles.

Chart 2 shows that there is a historical precedent for this type of rapid cycling credit market. While the cycles of the 1980s and 1990s (and a fortiori the 1940s to mid-1960s) were relatively long, the late 1960s to late 1970s saw three cycles in the space of a decade.
Beards and flares may be back in fashion, but the current disinflationary world seems very different from the high inflation of the 1970s. Yet there is one similarity: real bond yields. Chart three shows credit spreads and US 10yr bond yields minus average CPI over the previous three years. In both the 1970s and the past ten years, US real yields were low, often negative, and always volatile. By contrast, real yields in the long 1980s and 1990s cycles were positive and well behaved. Negative real yields do seem to make credit cycles faster.

So if real rates rise as quantitative easing ends, credit cycles should lengthen again. But how would this rapid cycle phase end? The 1970s example is worrying, for the biggest spike in yields took place at the end of the period. Moreover, it’s worth noting that balance sheet leverage has been much stickier through this cycle than in the 1970s. Chart 4 shows the nonfinancial debt/assets ratio from two series from the Federal Reserve of Saint Louis, plotted against spreads.
The correlation between spreads and balance sheet leverage looks weak, as leverage was falling during the rapid cycles of the 1970s, rose during the long cycles of the 1980s (as academics convinced corporates of the value of tax shields), fell after the telecoms crisis and has risen again since nominal and real yields started to fall after the financial crisis. But the more important and worrying point is that balance sheet leverage is high now compared to history, and this may end up amplifying the impact of a crisis if one is triggered by the end of low real yields.
So to sum up, the history of the 1970s is worrying for two reasons. First, it shows that the switch from a negative real yield regime to a more normal, positive real yield regime might spark a big non-financial credit crisis. Second, this crisis could be amplified by the fact that there has been no real balance sheet deleveraging during this period of spread volatility (unlike the 1970s). The end of this credit cycle may be far off in the future – indeed further off than we might have thought at the start of this year. When it comes, however, it may be very messy indeed." - source Société Générale
Until then you might enjoy the summer lull and complacency of the credit markets, but one thing for certain is that the end of this particularly long credit cycle will see much lower recovery rates, for us that's a given.

If indeed corporate leverage is higher than in the previous cycle as pointed out by Société Générale, there also a phenomenon that needs to be taken into account and it is that the current Boomers are more leveraged than previous generations were ahead of retirement as per the final points below

  • Final charts - Are Boomers "Bust" ?
While the developed world in many parts is clearly in a state of over indebtedness, what is of interest as well is that the Baby Boomers generations that benefited from many golden years and the generosity from both governments and central banks in recent years do face some challenges as per our final charts from Wells Fargo Economics Group note from the 9th of March entitled "Till Debt Do Us Part: How Leveraged Is the Typical Boomer?":
"The Boomers are more leveraged than previous generations were ahead of retirement.
We examine the liabilities side of the balance sheet for this group and explore some of the challenges they may face.
The Borrowing Boomers
Unsurprisingly, the Baby Boomers have less debt than younger generations who are currently in their prime working years and still climbing the ladder of life. However, the typical Boomer has more debt at this point in their life relative to previous generations. As of 2013, 79 percent of households age 55-64 and 66 percent of those age 65-74 had debt of some kind (top chart).

The long-run trend in the top chart signals a rising share of each successive generation approaches the traditional retirement age with debt of some sort. In addition, not only do more Boomers hold debt, the typical value in real dollars has also risen. The Great Recession pushed debt holdings for this age bracket even higher in 2010 than the bubbly 2007 period. Real debt holdings for the typical boomer receded markedly in 2013, although this in part reflects a decline in homeownership.
Like the asset side of the balance sheet, housing comprises the bulk of debt for the average Boomer. A bit under half of Boomers hold debt secured by their primary residence (middle chart), with the median value for Boomers age 55-64 amounting to about $100,000. Credit card balances and installment loans (for vehicles for example) are also common, but median balances are a relatively manageable $3,000 and $12,000, respectively. Mean debt holdings are more than double the median, however, suggesting that some Boomers are significantly more leveraged than their peers.

Old School Not So Funny for the Boomers
Student loan debt has emerged as a hot button issue for some Boomers. A recent report by the Government Accountability Office (GAO) drew attention to this issue, highlighting the number of people whose Social Security checks are being reduced to pay off delinquent student debt.* The report found that there were 114,000 people age 50 or older in fiscal year 2015 who had their benefits reduced by about $140 a month for unpaid student loans. As the bottom chart illustrates, student loan debt has increased in size and prevalence for older individuals.

We caution, however, about overstating the pervasiveness of the problem; according to Survey of Consumer Finances data, only 12 percent of 55-64 year olds have some form of student debt, with older Boomers having an even smaller share. In addition, the 114,000 individuals age 50+ from the GAO study represent less than 0.5 percent of Social Security beneficiaries. This suggests that most Boomers are not grappling with a crushing student loan burden as they enter their golden years. That said, the GAO report found that a sizable share of those who had their Social Security benefits reduced were either pushed below/pushed even further below the poverty line. Further, if the trend of growing educational debt continues, the problem will likely increase in scope over time and create further challenges for Boomers who are already struggling with retirement preparedness." - Source Wells Fargo
Although "The Endless Summer" has created a significant windfall for the holders of financial assets, it looks to us increasingly that in many ways the average US consumer is somewhat "maxed out". It remains to be seen how many hikes it will take before the Fed finally breaks something, but, we ramble again...

"Things as certain as death and taxes, can be more firmly believ’d." - Daniel Defoe, The Political History of the Devil, 1726.

 Stay tuned!
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