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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