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.

Synopsis:

• 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!