Sunday, 29 April 2018

Macro and Credit - The Seventh-inning stretch

"It's easier to resist at the beginning than at the end." -  Leonardo da Vinci

Watching with interest the better than expected US 1st quarter GDP print up 2.3%, vs 2.0% expected despite a slowdown in consumer spending, with wages and salaries up 2.7 percent in the 12 months through March compared to 2.5 percent in the year to December, and (PCE) price index excluding food and energy increasing at a 2.5% being the fastest pace since the fourth quarter of 2007, leading many pundits to usher more and more the dreaded "stagflation" growth (real negative growth), when it came to selecting our title analogy we decided to tilt our choice towards a baseball one given the growing signs of the lateness of the credit cycle. The Seventh-inning stretch is a tradition in baseball in the United States that takes place between the halves of the seventh inning of a game. Fans generally stand up and stretch out their arms and legs and sometimes walk around. As to the name, there appears to be no written record of the name "seventh-inning stretch" before 1920, which since at least the late 1870s was called the "Lucky Seventh", indicating that the 7th inning was settled on for superstitious reasons. While all thirty Major League franchises currently sing the traditional "Take Me Out to the Ball Game" in the seventh inning, several other teams will sing their local favorite between the top and bottom of the eighth inning. In the current state of affairs of the credit cycle, as we pointed out in our last musing, the debate on where we stand in regards to the credit cycle is still a hotly debated issue particularly with the US 10 year Treasury Notes passing the 3% level before slightly receding as of late.

In this week's conversation, we would like to look at potential headwinds for credit markets in the second half of 2018 given the markets have become much more choppier in 2018 thanks to higher volatility and rising yields. 

  • Macro and Credit - Switching beta for quality? 
  • Final chart -  More and more holes in the safe haven status of the CHF cheese

  • Macro and Credit - Switching beta for quality? 
As we pointed out in our early April conversation "Fandango" when we quoted our friend Edward J Casey, Flows and outflows matter more and more as many are dancing closer and closer towards the exit it seems in this gradually tightening environment thanks to the Fed's hiking path. Rising rates volatility have whipsawed credit markets in 2018, upsetting therefore the prevailing "goldilocks" environment which had been leading for so long in credit markets thanks to repressed volatility on the back of central bankers meddling with asset prices. With rising dispersion as we have pointed out in our recent musings, credit markets have become more choppy and less stable to that effect, more a traders market one would opine. It has become therefore more and more important as pointed out by our friend to monitor fund outflows but as well foreign flows coming from Japanese investors to gauge the appetite of investors for specific segments of the credit markets. It appears to us more and more that there is somewhat a growing rotation from high beta towards more quality, moving up the ratings spectrum that is.

When it comes to assessing flows, we read with interest Bank of America Merrill Lynch's Follow The Flow note from the 27th of April entitled "Pressure On, Pressure Off":
"Another week of the same? Not exactly.
While HY and equity flows remained on the negative side it seems that the "risk off" flows trend is turning. Last week’s outflow from government bond funds was the first in 15 weeks.

Note that the asset class has seen a significant inflow trend so far this year on the back of the rise in yields and but more importantly on the back of a bid for "safety". With rates vol still close to the lows and spread trends improving on the back of a more moderate primary and with geopolitical risks and trade war risks moderating, we think that high grade fund flows trends are set to continue to improve.
Over the past week…
High grade fund flows were positive over last week after a brief week of outflows.
High yield funds continued to record outflows (24th consecutive week). Looking into the domicile breakdown, US and Globally-focussed funds have recorded the vast majority of the outflows, while the European-focussed funds flow was only marginally negative.
Government bond funds recorded their first outflow in 15 weeks and the second of the year. All in all, Fixed Income funds flows were negative for a second week.
European equity funds continued to record outflows for a seventh consecutive week. Over those seven weeks, the total withdrawal from the asset class funds was close to $19bn.
Global EM debt funds saw outflows for the first time in four weeks. Commodity funds on the other hand continued to see strong inflows for a fourth week.
On the duration front, long-term IG funds were the ones that suffered the most last week, as outflows were recorded on that part of the curve. Mid-term and short-end funds both recorded inflows." - source Bank of America Merrill Lynch
Are we seeing the start of a risk-reduction trend in high beta namely high yield in favor of quality, namely investment grade thanks to the support of foreign flows following the end of the Japanese fiscal year with investors returning to US shores on an unhedged currency risk basis? We wonder.

It would be hard not to take into account the change in the narrative given the Fed is clearly becoming less supportive, though we would expect Mario Draghi to remain on the accommodative side until the end of his tenure at the head of the ECB. While clearly credit markets investors have recently practiced a "Seventh-inning stretch" as we pointed out last week, we do not think the credit cycle will be decisively turning in 2018 given financial conditions remain overall still very loose.

But, no doubt that the credit game is running towards the last inning with leverage above average and credit spreads at "expensive" levels particularly in Europe where as of late Economic Surprises have experienced a significant downturn. On the subject of leverage and inflows into credit markets we also read with interest Société Générale's Equity Strategy note entitled "Rising yields and debt complacency spell trouble for equity markets" from the 23rd of April:
"Leverage is high as spreads have narrowed substantially
Both in Europe and in the US we observe that leverage levels are above their respective historical averages. While on a net debt to EBITDA ratio, US companies (1.6x) appear less leveraged than European companies (2.0x), both regions are at levels only seen during the worst of the TMT bubble (2001-03), or the financial crisis (2008-09). Indeed, it seems as though companies have tried to take advantage of the low yield environment by leveraging their balance sheets (Apple is good example of this). However, while the balance sheet of an IT company is not significantly at risk from higher bond yields (cash rich), some other segments of the market may be more at risk.
Since 2009, the corporate bond market has benefited from massive inflows. Despite the change of volatility regime and releveraging of corporate balance sheets, credit spreads are still ultra low. SG credit strategists expect more challenging conditions for the credit market in the second half of the year, with the end of the EU’s Corporate Sector Purchase Programme (CSPP) and rising government yields.
Mutual Fund Watch - exceptional outflows from credit
The latest outflows from European credit funds are exceptional in the sense that they mark a clear break from previous trends. This is easily observed in the charts below: the four-week trailing series are well below zero (overall net outflows over the last four weeks) and have crossed the lower band of two standard deviations below the long-term average. That is exceptional, especially given that we find the same picture in the US.
The outflows from European credit funds follow a similar pattern to that seen in the US. The four-week trailing series for the US have also fallen below zero (overall net outflows over the last four weeks) and have crossed the lower band of two standard deviations below the long-term average. In the case of investment grade (IG) credit funds in the US and Europe, the turnaround comes after a prolonged period of strong cumulative net inflows. The series therefore appears to be peaking at very high levels.
- source Société Générale

As we discussed on many occasions on this very blog, when it comes to US credit markets foreign flows matter, particularly flows coming from Japan. During the hiking period of the Fed in 2004-2006, Japanese Lifers and other investors gave up FX risk and took one more credit risks. Given the start of the new fiscal year in Japan, it is paramount to find out their intentions in relation to their foreign bond appetite. On this particular point we read another Bank of America Merrill Lynch note from their Credit Market Strategies series from the 27th of April entitled "Drinking from the firehose":
"Unhedged foreign bonds for life
Every six months Japanese life insurance companies update on their investment plans for the half of their fiscal years that just started. Hence we have now heard plans for the fiscal first half that began April 1st (Figure 10).

The color is very much consistent with last year and our discussion above – to reduce yen holdings in favor of foreign holdings and alternative investments (see our most recent updates: Foreign bonds for life 26 April 2017, Lifers on the hedge 24 October 2017).
Increasingly Japanese lifers plan to directly reduce currency-hedged foreign holdings, explicitly due to the rising cost, which should lead to more selling of shorter-maturity US corporate bonds (than have rolled down). That translates into increasing currency-unhedged holdings of foreign assets, which means an up-in-quality shift in Japanese
Reaching for investors
The recent spike in interest rates to 3% on the 10-year is the bond market reaching for investors (Figure 11).

While we have no real-time information on domestic insurance and pension buying – which we expect is increasing - we have detected a significant acceleration in foreign buying the past seven business days (Figure 12).

On April 17th our measure of foreign buying was down 59% year-to-date compared with the same period last year - but by now the decline is just 46%. In fact foreign buying over the past seven days is the strongest we have seen since February last year (Figure 13).

Of course, since a lot of this foreign money is likely currency unhedged (see: Unhedged foreign bonds for life 23 April 2018), which comes from a smaller budget, there is a limit to how long this pace can persist. However, increased yield-sensitive buying gives hope that the market is going to be better able to absorb the big seasonal increase in supply volumes we expect in May. This especially if inflows to bond funds/ETfs do not continue to deteriorate (Figure 14).
Defensive flows
US high grade fund and ETF flows weakened for risk assets such as stocks, high yield and EM bonds this past week ending on April 25. On the other hand inflows increased for safer asset classes such as high grade and government bonds. The overall impact on overall fixed income was a decline in inflows to $3.12bn from $4.36bn. For stocks flows turned negative with a $2.43bn outflow following two weeks of inflows, including a $6.23bn inflow in the prior week (Figure 15).

Inflows to high grade increased to $3.33bn from $0.86bn the week before. Inflows increased across the maturity curve, rising to $1.16bn from $0.26bn for short-term high grade and to $2.17bn from $0.60bn outside of short-term. Most of the increase was from ETFs that tend to be dominated by institutional investors. ETF inflows rose to $2.48bn from $0.38bn. Inflows to funds increased more modestly, rising to $0.85bn from $0.47bn (Figure 16).

Inflows to government bond funds were higher as well, coming in at $1.66bn this past week, up from a $0.85bn inflow in the prior week. High yield, on the other hand, had the largest outflow since February of $1.60bn, compared to a $2.67bn inflow the week before. Similarly inflows to leveraged loans weakened, decelerating to $0.16bn from $0.49bn, while global EM bond flows turned negative with a $0.72bn outflow following a $0.61bn inflow a week earlier. The net flow for munis was flat, up from a $0.68bn outflow in the prior week. Finally, money market funds had a $3.16bn inflow this past week after a $31.57bn outflow a week earlier." - source Bank of America Merrill Lynch
If the trend is "your friend" then it seems that it is becoming more defensive in credit markets, with rising dispersion on the back of investors becoming more discerning when it comes to their credit risk exposure. We might have seen a "Seventh-inning" stretch, but when it comes to earnings for Investment Grade credit, the results so far have pointed towards a notable acceleration in earnings growth, supported as well by a weaker US dollar benefiting the global players. 

The big question on our mind in continuation to what we posited last week is relating to the might overstretched short positioning in US 10year notes. We indicated in our previous musing "The Golden Rule" the following when it comes to our MDGA (Make Duration Great Again) stance:
"We don't think yet with have reached the "trigger point" making us bold enough to dip our investing toes into the long end of the US yield curve particularly as we are getting closer to the 3% level on the 10y Treasury yield" - source Macronomics, 22nd of April 2018
We continue to watch this space very closely, given the short-end of the US yield curve is becoming more and more enticing with the return of "Cash" being again an asset in a more volatile environment, we continue that the Fed's control of the long end is more difficult to ascertain. The most important question that will be coming in the next quarters as the Fed continues its hiking path will be about substituting credit risk for interest risk. Bank of America Merrill Lynch in their High Yield Strategy note from the 27th of April entitled "When Rates Arrive, Credit Risk Leaves":
"This week marks the second time in this credit cycle that the 10yr Treasury yield has touched on 3%. The previous instance was in Dec 2013, when the benchmark peaked at 3.02%, before turning the other way and rallying all the way to 1.36% by mid-2016. We continue to believe that the 10yr yield struggles to go higher from these levels and remain willing holders of some incremental duration risk.
One of the arguments around rates here with the 10/2yr yield curve at 50bps is that historically the Federal Reserve has refrained from intentionally inverting yield curve into deeply negative territory. We can observe such a behavior in Figure 1 on the left, where we plot the fed funds rate against the 10yr Trsy yield, or Figure 2 on the right where the former is plotted against the 10/2yr yield curve itself.

Regardless of the angle we take, the picture appears to be convincing in that over the past three policy tightening cycles, the Fed tried hiking once, or at most twice into a flat yield curve, and then it would cease further action. We think it is both natural and reasonable to expect this behavior to be repeated in the current policy tightening episode.
And if that is the line the Fed is unlikely to cross then our distance to that line could be only 3-4 hikes away from here, with the benefit of doubt that the curve does not flatten basis point for basis point of each hike. In this case, the Fed’s own longer-term median dot projection, at 2.75% or 4 hikes from here, may be closer to reality than it gets credit from consensus, which prices in 5-6 hikes.
A different aspect of the question on positioning between credit vs interest rate risk could be gleaned from Figure 3 and Figure 4 below.

These two graphs help us contrast the opposite extremes on the risk spectrum: the one on the left plots proportion of total BB yield contributed by its rates component, while the one on the right shows proportion of CCCs OAS coming from distressed credits. The two datasets are naturally inversely correlated (r = -30%), although they measure non-overlapping parts of the credit space.
Extreme observations on these graphs help us calibrate our risk allocation scale between heavily weighting rate duration risk or credit risk. Naturally, there is rarely a choice that includes both simultaneously, except for valuation deviations in smaller market segments. In the grand scheme of things, investors are mostly facing a choice of one over another.
So for example, between 2009 and 2016, rates represented only a modest part of overall BB yield, suggesting that their proportion could increase through either rising rates into stable spreads or tightening spreads into stable rates. In either case investors would be better off by overweighting credit over interest rate risk exposures.
Figure 4 further provides an additional layer of precision by highlighting extreme peaks of distressed contributions to CCCs spreads, which occurred in early 2009, late 2011, and early 2016. In all three cases, of course, an overweight in credit risk was the optimal strategy.
The opposite was true in early 2007 or late 2000, when both lines were at the other end of their historical range (i.e. an outsized contribution from rates to BB yields and modest contribution from distressed to CCC spreads). With the benefit of hindsight, both extremes provided clear signals to overweight the rate over credit risk.
Even when the lines were not at their extremes, in early 2011 or late 2014, they were leaning on the side of being long rates over credit. In other words, when rate risk dominates the picture, credit risk tends to fall into obscurity. Our preference is to lean against such consensus views, all else being equal, i.e. we would be inclined to take on relatively more risk that is on everyone’s mind, and take less risk that is out of scope and thus probably underpriced.
Today, both lines are tilted on the same side of distribution, i.e. rates contribute relatively more than their historical average and distressed contributes relatively little. While levels are far from supporting any extreme positioning tilts, they do point towards modest overweight in rates over credit risk. Our preference for excess returns in BBs with some element of total return exposure fits this description well. We continue to maintain a market weight in CCCs, although we are watching the deterioration in our default rate estimates closely. Any further increases in expected defaults could lead us to take a more defensive view on lower quality." - source Bank of America Merrill Lynch
Sure by all means, massive increase of US government supply represents a serious headache for a bold contrarian investor, yet we do think that we are getting very closer to the points where the US long end of the curve will start to be enticing from a carry and roll-down perspective, particularly when inflation expectations are surging and negative real US GDP growth might provide support the dreaded "stagflation" word. In our book, flat or inverted yield curves never last for a very long time, and often appear near the peaks of economic cycles. Sure we are marking a pause similar to a "Seventh-inning stretch" but, this is the direction the Fed is clearly taking. In this Fed hiking context, rising interest rates has favored a Barbell strategy because reinvestments are implemented at regular times, which allowed you to benefit from higher rates. Once the yield curve is almost flat, the Barbell strategy will become meaningless and the time will come to reconsider your asset allocation policy and to lean toward the median part of the yield curve (belly). As discussed in our conversation "Rician fading" from December the question is whether we are in a in a bull flattening case or in a bear flattening case: 
  • In a Bull Flattener case, the shape of the yield curve flattens as a result of long term interest rates falling faster than short term interest rates.  This can happen when there is a flight to safety trade and/or a lowering of inflation expectations.  It is called a bull flattener because this change in the yield curve often precedes the Fed lowering short term interest rates, which is bullish for both the economy and the stock market.
  • In a Bear Flattener case short term interest rates are rising faster than long term interest rates.  It is called a bear flattener because this change in the yield curve often precedes the Fed raising short term interest rates, which is  generally seen as bearish for both the economy and the stock market
In the case of bear flattening, Japanese lifers tend to gravitate towards foreign bond investment. Bull flattening encourages Japanese lifers to move away from foreign bonds and they are left with no choice but to park their money in yen bonds. To that extent, we think that the ongoing "Bear Flattener" is still supportive of US credit, but most likely towards quality, being Investment Grade that is. During the bear flattening in 2013-14 (as the taper tantrum subsided), Japanese lifers accelerated their UST investment. This could certainly push us in short order to put back our MDGA hat on and dip our toes into the US long end part of the curve but we ramble again...

Given ongoing volatility brewing in the US yield curve and the dreaded 3% level touched by the US 10 year Treasury Notes, the world is turning towards alternative “safe havens”…instruments that act as a store of value in volatile times, instruments that can be used as collateral to raise funding and post margin in derivatives transactions and instruments that lubricate the financial system. For years, the US Treasury bond has been seen as the safe haven - a high-quality asset that rally in times of market stress and offer diversification for investors’ risky portfolios. Obviously 2018 has shown growing pressure on the "safe haven status" coming from the Fed's balance sheet reduction, higher US Libor rates and the jump in the US budget deficit. The supply of Treasuries that the private sector will need to digest will be much greater than during the Fed’s QE mania. Could Japanese investors come to again to the rescue given they sold a record amount of U.S. dollar bonds in February as the soaring cost of currency-hedging undercut yields? We wonder as it seems their appetite seems to be more credit related eg non-government bonds related. For now cash in the US seems to have been emerging as a safe haven according to Bank of America Merrill Lynch European Credit Strategist note from the 26th of April entitled "What is the safest asset of them all?":
"Cash as an emerging asset class in the USRalf Preusser, our global rates strategist, makes an excellent point, namely that the typical haven characteristic of Treasury debt is being hindered by the appealing rates of return on cash in the US. As Ralf points out, historically during periods of market turbulence, money would flow from risky assets (such as stocks) into US Treasury bonds. But with $ Libor at 2.36%, support for Treasury debt is diminishing (consider that 5yr Treasury yields are 2.84%). In other words, the rise of “cash” as an asset class is altering the traditional allocation decisions of multi-asset investors in times of market stress.
Chart 5 highlights this point. We show the rolling 1yr correlation between total returns on 10yr Treasury bonds and the total returns on the Dow Jones stock index (daily returns). We overlay this with the evolution of 3m $LIBOR.

As can be seen, a decade ago the correlation between Treasury bond returns and stock returns was significantly negative (-60%). Treasuries performed their function as a place of safe harbor, and a store of value, around the time of the Global Financial Crisis. But since then the negative correlation has dwindled and is now just -28%.
Moreover, the chart shows that the changes in Treasury/stock correlation have closely followed the evolution of 3m $LIBOR, as Ralf has pointed out. Higher LIBOR rates have coincided with weaker Treasury/stock correlations. In other words, “cash” has started to become an attractive place to park money in times of market stress, and especially so since mid ’17 – when $LIBOR began to rise more vigorously.

In addition, Chart 8 above shows that the rolling 1y beta between Treasury bond returns and stock returns has also declined since the start of 2017, highlighting the reduced sensitivity of US rates to fluctuations in the stock market.
The competition from “cash”, therefore, seems to be challenging the traditional safe harbor characteristics of US Treasuries." - source Bank of America Merrill Lynch
Or put it simply when the king of the last decades, balanced funds are becoming "unbalanced" thanks to rising positive correlations we have been discussing many times. As we move towards the second part of 2018, it seems to us that clearly any tactical rally/relief should entice an investor in reducing his beta exposure and adopt overall a gradual more defensive stance credit wise. Safe havens it seems, and even the US dollar have so far been more elusive in 2018 apart from the "barbaric relic" aka gold's performance during the first quarter of this year.  Talking of "safe havens" as per our final chart below, even the defensive nature of the Swiss currency CHF has become questionable.

  • Final chart -  More and more holes in the safe haven status of the CHF cheese
Given the aggressive nature of central banking interventions in recent years, the SNB has also shown in its nature by becoming somewhat a very large hedge fund, particularly in the light of its large equities portfolio. It is therefore not really a surprise given the aggressive stance of the SNB to expect further intervention on its currency, preventing in effect its safe haven magnet status of the past. Our final chart comes from another Bank of America Merrill Lynch report World at a Glance entitled "After 3%" and displays how the CHF have lost its safe haven allure:
"CHF is certainly finding no friends at the SNB and during this latest bout of weakness, board members have shown little appetite to prevent further losses. Indeed, at the time of writing, SNB President Jordan has stated that a move above 1.20 in EUR/CHF “goes in the right direction”. The SNB’s motivations are clear – they still see CHF as highly valued and in our view want to see EUR/CHF trade meaningfully and sustainably above 1.20 before changing their characterization of the currency. Against the backdrop of the protectionism and trade wars, “vigilant” and “fragile” have been key buzzwords used by the SNB and they remain concerned that CHF may succumb to safe haven inflows on geopolitical tremors.
We would challenge the SNB assertion that the CHF is a safe haven currency. As the chart below highlights, CHF has meaningfully under-performed the two other major safe haven assets (gold and JPY) over the past 15 months.

We believe the existence of the SNB put will likely prevent sustained CHF appreciation during risk-off periods as the SNB continues to make it clear that it is prepared to use intervention as a tool in order to prevent sustained CHF appreciation." - source Bank of America Merrill Lynch
Whereas we have seem in credit recently a short term bounce, in this "Seventh-inning stretch", we think that gradually one should adopt a more cautious stance in regards to credit markets and be more discerning at the issuer level given rising dispersion. The change of narrative also means that "cash" in the US is back in the asset allocation toolbox after years of financial repression thanks to QE, ZIRP and NIRP. It remains to be seen if 2020 will mark the 9th inning or if it will be early 2019, as far as we are concerned, the jury is still out there.

"Switzerland is a country where very few things begin, but many things end." - F. Scott Fitzgerald
Stay tuned!

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