Macro and Credit - Fuel dumping

"One of the tests of leadership is the ability to recognize a problem before it becomes an emergency." -  Arnold H. Glasow, American author

Looking at the Dow Jones and the S&P 500 having their worst month since 1931, with cracks clearly showing up in credit markets with weaker oil and outflows from Leveraged Loans, with the Fed hiking by another 25 bps, leading to markets being dazed and confused, when it came to selecting our title analogy, given our fondness for aeronautics ("Dissymmetry of lift" in August 2018, "The Coffin corner" in April 2013, the other being "The Vortex Ring" in May 2014), when it came to our title analogy we decided to go for "Fuel dumping". "Fuel dumping" (or a fuel jettison) is a procedure used by an aircraft in certain emergency situation before a return to the airport shortly after takeoff, or before landing short of its intended destination (or inflation target...) to reduce the aircraft's weight (the Fed's balance sheet with its QT policy, now up to $50 billion per month). 

Aircraft have two major types of weight limits: the maximum takeoff weight and the maximum structural landing weight, with the maximum structural landing weight almost always being the lower of the two. This allows an aircraft on a normal, routine flight to take off at the higher weight, consume fuel en route, and arrive at a lower weight. If a flight takes off at the maximum takeoff weight and then faces a situation where it must return to the departure airport (due to certain mechanical problems, or a passenger medical problem for instance), there will not be time to consume the fuel meant for getting to the original destination, and the aircraft may exceed the maximum landing weight to land at the departure point. If an aircraft lands at more than its maximum allowable weight it might suffer structural damage, or even break apart on landing. At the very least, an overweight landing would require a thorough inspection for damage. 

As a matter of fact, long range twin jets such as the Boeing 767 and the Airbus A300, A310, and A330 may or may not have fuel dump systems, depending upon how the aircraft was ordered, since on some aircraft they are a customer option. As a rule of thumb for the Boeing 747, pilots quote dump rates ranging from a ton per minute, to two tons per minute, to a thumb formula of dump time = (dump weight / 2) + 5 in minutes. In similar fashion, when it comes to the Fed's QT, there is no real rule of thumb when it comes to the pace of the reduction of its balance sheet. We read with interest Stanley Druckenmiller and Kevin Warsh's take on the Fed's policy in the Wall Street Journal yet it seems that as we pointed out in our October conversation "Explosive cyclogenesis":

"As we concluded our previous post, beware of the velocity in tightening conditions. Both Morgan Stanley and as well Goldman Sachs, indicates that given the large sell-off seen in October, investors perceptions have been changing, and that maybe  we have a case of "reflexivity" one might argue. Goldman Sachs Financial Conditions Index shows the equivalent of a 50-basis-point tightening in the past month, two-thirds of which is due to the selloff in equity markets. Early February this year financial conditions tightened about 80bp over a two week period akin to "Explosive cyclogenesis" aka a "weather bomb".

But, the difference this time around we think, even if many pundits are pointing that forward price/earnings ratio of the S&P 500 has tumbled to 15.6 times expected earnings, from 18.8 times nine months ago, making it enticing for some to "buy" the proverbial dip. We think that the Fed's put strike price is much lower than many thinks.

Sure "real rates" have been driving the sell-off but we think many more signs are starting to show up in the big macro picture pointing towards the necessity to start playing "defense". "- Macronomics, October 2018

The big question we think when it comes to Fed having both QT and rate hikes at the same time aka "Fuel dumping" is can you allow interest rates to rise without contracting the monetary base? Clearly the Fed put is still way "out of the money".

In this week's conversation, we would like to reflexionate more on 2019 given the Fed has been clearly telling you, it hasn't got your back anymore and you are on your own...

Synopsis:

• Macro and Credit - 2019: "Mean" mean reversion?
• Final charts  - What the Fed see and what they don't...  

• Macro and Credit - 2019: "Mean" mean reversion?

In our previous conversation we pointed out the weakness seen in credit, given the rise in dispersion witnessed during the course of 2018, leading to cracks showing up in cyclicals and with now leveraged loans weaknesses under scrutiny. Like any behavioral psychologist we indicated in numerous conversations that we would rather focus on the "flows" than on the "stock" given in our credit book, liquidity is what "matters" and when it comes to fund flows, in some segments of the credit markets "outflows" have been significant.

In our credit book, "flows" matter and when it comes to fund flows in credit land there has been plenty of "fuel dumping" as reported by Bank of America Merrill Lynch in their Follow The Flow report from the 14th of December entitled "The CSPP party is definitely over":

"More outflows and no more CSPP

Only three weeks to go before the end of the year, and outflows continued in Europe. Last week we saw a significant risk reduction across European IG, HY and Equity funds. Investors reached for safer assets with strong inflows in Govies and Money Markets. Even Global EM debt funds recorded outflows amid the recent sell off. It seems that this year will end on a negative note as investors are cutting positions across risk assets amid uncertainty around the macro and trade wars front. Italian politics are not helping either, contributing in a flight away from credit and equity funds.

Over the past week…

High grade funds suffered their largest outflow of the year, making this week the 18th week of outflow over the past 19 weeks. High yield funds also recorded a sizable outflow as well, the 11th in a row. Looking into the domicile breakdown, Euro-focused funds led the negative trend, followed closely by Global-focused funds. US focused funds experienced a more moderate outflow.

Government bond funds recorded an inflow this week, the 2nd in a row. Meanwhile, Money Market funds saw a large inflow, putting an end to 4 consecutive weeks of outflows.

European equity funds recorded a sizable outflow, in sharp contrast with the moderate outflow recorded last week, and making it the 14th consecutive week of outflows. During the past 40 weeks, European equity funds experienced 39 weeks of outflows.

Global EM debt recorded an outflow this week, the 10th in a row. Commodity funds recorded a marginal inflow.

On the duration front, mid-term IG funds led the negative trend by far, short-term funds also suffered, while the deterioration was more moderate for the long-end of the curve." - source Bank of America Merrill Lynch

 When the trend in outflows is not your friend...

As per our November conversation "Zollverein", when we talked about the vulnerability of leveraged loans, clearly they have been under the spotlight and some credit investors have indeed resorted in "fuel dumping" so to speak. As per LeveragedLoan.com outflows have been significant and accelerating in the asset class:

"Leveraged loan funds log record $2.53B outflow

U.S. loan funds reported an outflow of $2.53 billion for the week ended Dec. 12, according to Lipper weekly reporters only. This is the largest weekly outflow on record for loan funds, topping the prior mark of negative $2.12 billion from August 2011.

This is also the fourth consecutive week of withdrawals, totaling a whopping $6.63 billion over that span. With that, the four-week trailing average is now deeper in the red than it’s ever been at $1.66 billion, from negative $1.01 billion last week.

Mutual funds were the catalyst in the latest period as investors pulled out a net $1.82 billion, the most since August 2011. Another $704.9 million of outflows from ETFs was the most ever.

Outflows have been logged in six of the last eight weeks and that has taken a big bite out the year-to-date total inflow, which has slumped to $3.7 billion after cresting $11 billion in October.

The change due to market conditions last week was a decrease of $1.231 billion, the largest drop for any week since December 2014. Total assets were roughly $99.3 billion at the end of the observation period and ETFs represent about 11% of that, at roughly $10.9 billion. — Jon Hemingway" - source LeveragedLoan.com

If this isn't "fuel dumping" then we wonder what it is:

"In just the past four trading days, investors have pulled $2.2 billion from all loan mutual funds and exchange-traded funds. That brings withdrawals from the asset class to almost $9 billion since mid-November" - source Bloomberg 

- graph source Bloomberg

It looks like more and more to us the "credit aircraft" may have exceeded the maximum landing weight to land at the departure point given the posture of the Fed with its hiking stance and with its QT on "autopilot".

For Bank of America Merrill Lynch in their Weekly Securitization Overview note from the 14th of December entitled "Mission accomplished; damage assessment", the price action in Leveraged Loans should be watched closely and we agree as we posited back in our November conversation "Zollverein":

"We consider the recent free fall price action for leveraged loans (Chart 5) underlying collateral of CLOs and specifically noted in the FOMC’s September minutes as posing “possible risks to financial stability.” The end result of the Fed’s hawkishness is that less, not more, rate hikes are now expected than in September (see below), so the interest in floating rate instruments such as leveraged loans, and CLOs, has declined. That explains part of the weakness. Another important part of the latest sharp re-pricing of loans is simply that they had lagged the spread widening/risk re-pricing seen in other sectors. This week saw some major catch-up." - source Bank of America Merrill Lynch

 Clearly some pundits are concerned about the "liquidity" factor of Leveraged Loans and decided that "Fuel dumping" was the right strategy given the growing cracks seen in credit with the significant underperformance of US High Yield thanks to weaker oil prices and its exposure to the Energy sector (we have touched on this subject in recent posts). No surprise to see Lisa Abramowicz on her twitter feed commenting on US High Yield spread blowing out today:

"U.S. high-yield bond spreads rose yesterday the most on a percentage basis since August 2011."

- source Bloomberg - Lisa Abramowicz - twitter

Obviously with its QT akin to "Fuel dumping", the Fed has been successful in tightening further financial conditions.

But in relation to Leveraged Loans and the deterioration in both price and flows, comes the question about its impact on the US economy as a whole. On that point we read with interest Wells Fargo's take from their Economics Group note from the 18th of December entitled "Leveraged Loans - A Deathknell for the US Economy?":

"Executive Summary

The leveraged loan market, where the bank debt of non-investment grade companies is traded, has experienced rapid growth over the past few years. But weakness in the market in recent weeks may bring back unpleasant memories of the sub-prime loan debacle a decade ago. Does this recent weakness in the leveraged loan market have negative implications for the macro U.S. economy?

In our view, the leveraged loan market, taken in isolation, is not likely to bring the economy to its knees anytime soon. But its recent weakness may reflect a broader economic reality about which we have been writing. Namely, the overall financial health of the non-financial corporate sector has deteriorated modestly over the past few years. If the Fed continues to push up interest rates and if corporate debt continues to rise, then financial conditions would tighten further, which could eventually lead to a sharper slowdown, if not an outright downturn, in economic growth

Stress Appears in the Leveraged Loan Market

The leveraged loan market in the United States has mushroomed to more than $1 trillion today from only $5 billion about 20 years ago (Figure 1).

 Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

Growth has been especially marked in the past two years with the amount of leveraged loans outstanding up more than 30% since late 2016. But the market has weakened recently. The amount of leveraged loans outstanding declined by nearly $20 billion between late November and mid-December, while prices of loans fell about 2 points over that period (Figure 2).

Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities 

Before discussing macroeconomic implications, we first offer a quick primer on the leveraged loan market. A leveraged loan is a loan that is made to a company with relatively high leverage (i.e., companies with high debt-to-cash flow ratios). Usually, these companies are rated as less than- investment grade. Years ago, banks would hold these loans on their balance sheets, but in the  past few decades an active market has developed in which these loans are bought and sold. Often, an investment bank will buy leveraged loans from commercial banks to bundle them into structured financial instruments that are known as collateralized loan obligations (CLOs). CLOs trade like bonds, and they improve the liquidity in the leveraged loan market.

Leveraged loans are floating-rate financial instruments, so investors piled into the market over the past two years when the Fed was in rate-hiking mode. However, some investors have started to sell their holdings of leveraged loans recently as doubts have risen about how much higher short-term interest rates actually will rise. Moreover, the evident deceleration occurring in the economy could negatively affect the ability of some highly levered companies to adequately service their debt obligations, which has also contributed to some nervousness in the leveraged loan market. Could the recent weakness in the leveraged loan market have implications for the U.S. economy?

Does the Leveraged Loan Market Have Broader Macro Implications?

When banks sell their leveraged loans, they then have room on their balance sheets to make new loans. If weakness in the leveraged loan market negatively affects the ability of commercial banks to offload their leveraged loans, then growth in bank lending could slow. Everything else equal, slower growth in bank lending could lead to slower economic growth, which could then lead to further weakness in the leveraged loan market, etc. In short, a vicious circle could be set in motion. Is there any evidence to support the notion that weakness in the leveraged loan market has led to slower growth in bank lending?

Figure 3 plots the leveraged loan price index which was shown in Figure 2 along with the year-over-year growth rate in commercial and industrial (C&I) loans.

Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

The price of leveraged loans collapsed in 2008, and C&I loan growth subsequently nosedived as well. But the U.S. economy at that time was beset by the deepest financial crisis and recession it had experienced in more than 70 years. The weakness in the leveraged loan market in 2008 may have contributed to the swoon in C&I lending that transpired in 2008-2009, but there probably were more important factors that were causing the sharp drop in C&I lending at that time. 

Indeed, over the past two decades there have been two episodes of weakness in the leveraged loan market that have not been associated with marked deceleration in C&I lending. Between early 1997 and late 2000, prices of leveraged loans fell about 10 points. But growth in C&I lending held up reasonably well during that period, before turning negative as the economy fell into recession in early 2001.

Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

More recently, leveraged loan prices fell 8 points between May 2015 and February 2016. Growth in C&I lending edged down a bit, but we would not characterize that episode as one of “significant” deceleration in C&I lending. In short, there does not appear to be overwhelming evidence to support the notion that weakness in the leveraged loan market leads to significantly slower growth in C&I lending.

C&I lending accounts for less than 20% of total bank credit. Perhaps other components of bank credit, such as the securities holdings of banks, residential and non-residential real estate lending or other types of consumer lending, may show more sensitivity to the leveraged loan market than C&I lending. However, Figure 4 shows that growth in overall bank credit generally has had a low degree of correlation with prices of leveraged loans as well.

 Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

Although we acknowledge that the weakness in the leveraged loan market has the potential to eventually weigh on bank credit, there appears to be very little fallout thus far. Indeed, the amount of C&I loans outstanding as well as total bank credit have both risen in recent weeks.

In our view, the weakness in the leveraged loan market at present reflects a broader economic reality about which we have been writing in recent months. That is, the overall financial health of the non-financial corporate sector has deteriorated over the past few years. The phenomenal growth in the leveraged loan market since 2016 reflects both demand-side and supply-side factors. In terms of demand, investors have been attracted to the relatively high returns that leveraged loans and CLOs offer. On the supply side, the marked increased in leveraged loan issuance over the past few years speaks to the steady rise in non-financial corporate debt, especially among non-investment grade businesses, that has occurred.

Taken in isolation, the leveraged loan market is not likely to bring the economy to its knees anytime soon. But recent weakness in the leveraged loan market may be symptomatic of rising concerns that investors may be having about the outlook for the financial health of the business sector. Spreads on speculative-grade corporate bonds have widened in recent weeks, and investment grade spreads have also pushed out. As we have written previously, we do not view the overall financial health of the American business sector as “poor” at present. But investors apparently are starting to react to its modest deterioration. If the Fed continues to push up interest rates and if corporate debt continues to rise, which would put upward pressure on spreads, then financial conditions would tighten further, which could eventually lead to a sharper slowdown, if not an outright downturn, in economic growth." - source Wells Fargo

After the Great Financial Crisis (GFC), many banks retreated from the Leveraged Loans business thanks to heightened regulatory oversight. In this context, Nonbank direct lenders, business development companies as well as collateralized loan obligation funds and private equity affiliated debt funds all stepped in and funded acquisitions and private-equity buyouts as the M&A market rebounded in recent years. US banks one would argue are in a much healthier "leverage" situation than their European peers, though when it comes to the Leveraged Loan market both in the United States and Europe have seen the rise of "disintermediation" aka shadow banking stepping in. Where we slightly disagree with Wells Fargo's take is indeed the rise in "disintermediation" as banks have been facing rising competition from even "new" competitors entering the private lending space.

Yet, when it comes to C&I loans, change in the last three months have been significant we think:

- graph source Bank of America Merrill Lynch

As we mused in our conversation "Ballyhoo" in October, using a more real-time look at financial conditions points towards a higher velocity in the tightening trend of financial conditions. We argued that the velocity seen in greater tightening of financial conditions could be seen as a case of "Reflexivity", being the theory that a two-way feedback loop exists in which investors' perceptions affect that environment, which in turn changes investor perceptions hence the outflows and the acceleration in "Fuel dumping" or outflows from "credit" to the benefit of the US long end of the yield curve as well as US money market funds, in essence some good old "crowding out".

This velocity we think is important given the combination of rates hike and balance sheet reduction given many pundits are already talking about "policy mistake" being made by the Fed. The whole question is about the transmission of the velocity of tightening financial conditions towards the real economy. We have already seen significant weakness in various US cyclicals (Housing, autos, etc.). On the subject of this transmission mechanism we read with interest Bank of America Merrill Lynch's take in their US Economic Watch note from the 19th of December entitled "Fed up":

"Getting ahead of the shocks

One of the many factors the Committee has considers in their policy reaction function is the impact of financial conditions on the real economy. As was clear from the press conference, “The additional tightening of financial conditions we have seen over the past couple of months along with signs of somewhat weaker growth abroad have also led us to mark down growth and inflation growth a bit.”

To understand the transmission of financial conditions onto the economy, we run various financial shocks through FRB/US, the Federal Reserve Board’s large-scale general equilibrium macroeconomic model. These shocks are 100bp increase in the conventional mortgage rate, 100bp increase to the interest rate on new car loans, 50bp increase in credit spreads (proxied by an 50bp increase in BBB term premium) and a 10% decline in household equity wealth. Note that the shocks to the mortgage rate, car loan rate, and BBB term premium have been approximately calibrated to the moves seen since the start of the year while the equity shock has been roughly calibrated to the decline since peak of the equity market over the summer (Chart 1 and Chart 2).

The shocks are run individually through FRB/US and sustained through the simulation period.

The results of the stylized exercise are presented in Table 1. There are several points worth noting:

• Financial conditions work through the economy with a lag. With the exception of the mortgage rate shock, the peak drag to growth from tighter financial conditions hits the economy 2 to 3 quarters after the initial shock.
• The impact of the individual shocks is fairly muted. For example, a 10% decline in household equity would roughly translate to less than 0.1pp drag to growth in the 2H of year 1 after the shock hits. But add up the multiple shocks, there’s a meaningful slowdown in growth that leads to higher unemployment rate and lower core inflation.
• Higher borrowing costs for businesses have the greatest and most persistent impact on the economy. A 50bp widening in the credit spread acts as a roughly 0.1pp drag in year 1 and 0.1-0.2pp in year. This is consistent with Fed research which shows that the primary transmission of tighter financial conditions works through weaker business fixed investment.2
• The cumulative tightening we’ve see over the past year is roughly equivalent to 33bp of Fed tightening. Another way to interpret these results is tighter financial conditions would prescribe the Fed to ease up on the pace of rate hikes by roughly one fewer hike, consistent with the latest median dots.

What about weaker global growth? The direct impact should be fairly muted given that the external macro linkages are only a small share of the US economy. However, weaker global conditions will filter through tighter financial markets, primarily through higher borrowing rates for businesses and to a lesser extent a decline in household equity wealth that will act as a headwind for the economy." - source Bank of America Merrill Lynch

While global trade has been decelerating thanks to the trade war narrative, the spike in "real rates" in early October triggered the repricing of US equities. Our timing using another "aeronautics" on the first of October in our post "The Amstrong limit" was probably lucky:

"Watching with interest the Japanese Nikkei index touching its highest level in 27 years at 24,245.76 points, with US stock indices having rallied strongly against the rest of the world during this year, and closing towards new highs, when it came to selecting our title analogy we decided to go for another aeronautic analogy "The Armstrong limit". The Armstrong limit also called the Armstrong's line is a measure of altitude above which atmospheric pressure is sufficiently low that water boils at the normal temperature of the human body. Humans cannot survive above the Armstrong limit in an unpressurized environment." - source Macronomics, October 2018.

We wondered at the time if we had reached the "boiling point". In retrospect we did.

The big question many pundits are asking is should the bold pilots at the Fed continue with QT on autopilot. Back in February 2013 in our conversation "Bold Banking" we used another aeronautics reference:

"While 1994, was the year of a big sell-off in many risky assets courtesy of a surprise rate hike, 1994 was as well the year of the demise of "Czar 52" on the 24th of June 1994 which saw the tragic crash of a Boeing B-52H "Stratofortress" assigned to 325th Bomb Squadron at Fairchild Air Force Base during practice maneuvers for an upcoming airshow. The demise of the BUFF (the nickname among pilots for the B-52 meaning Big Ugly Fat Fellow) was due to Colonel Bud Holland's decision to push the aircraft to its absolute limits. He had an established reputation for being a "hot stick".

So what is the link, you might rightly ask, between "bold banking" and "bold piloting"?

A subsequent Air Force investigation found that Colonel Bud Holland had a history of unsafe piloting behavior and that Air Force leaders had repeatedly failed to correct Holland's behavior when it was brought to their attention (not  French president Hollande in that instance but we digress...).

When it comes to "reckless banking" and "reckless piloting", we found it amusing that current leaders have repeatedly failed to correct central bankers' policies, like the ones pursued by former Fed president Alan Greenspan and current Fed president Ben Bernanke, or, the ones pursued by Japan. These policies are instigating, bubbles after bubbles at an inspiring rate." - Macronomics, February 2013

For now the pilots once again at the Fed seem pretty confident in the strength of the US economy, on our side we do not think their optimism is warranted as per our final charts.

• Final charts  - What the Fed see and what they don't...  

With Philadelphia Fed manufacturing index undershooting in similar fashion to the New York Fed released this week as well, one might indeed be wondering if "Fuel dumping" is warranted given the heavy load of the US airplane in terms of corporate debt binge. Our final charts comes from Wells Fargo Economics Group note from the 19th of December entitled "Where the Fed May Be wrong" and in their note they are pondering whether or not the Fed is making a "policy mistake":

"Caught Between A Rate Hike and A Hard Place

Recessions are typically triggered by policy mistakes and the Federal Reserve may very well be on the road to making one. The policy statement that accompanied the Fed’s latest rate hike attempted to allay fears the Fed would tighten too much by acknowledging the economic outlook has diminished and that the balance of risks was now roughly even. FOMC participants also slightly lowered their expectations for the federal funds rate and now call for just two rate hikes in 2019 and one more after that, while the drawdown of the Fed’s balance sheet is expected to remain on auto-pilot at $50 billion a month in 2019.

The financial markets provided some powerful real-time feedback to the Fed. Stocks had rallied just before the Fed’s decision was released, gave back their gains after digesting the policy statement and then sold off heavily during Chairman Powell’s testimony. The yield curve also flattened further and remains inverted between the two- and five-year notes. The markets shot down the Fed’s dovish tightening because they feel economic growth may not be as strong as the Fed believes and is certainly not strong enough to hold to the notion that monetary policy, in its entirety, remains short of neutral.

Economic growth may not be as ‘strong’ as the Fed believes. The strength in the U.S. economy has been narrowly focused, with the energy and technology booms accounting for a disproportionate share of economic growth. Both sectors now appear to be slowing, with the former struggling under the weight of sluggish global economic growth and lower oil prices, while the latter is facing an onslaught of government oversight concerning privacy concerns and anti-trust matters. Growth in the more cyclical parts of the economy is also slowing, with demand for home sales and capital goods flagging for the past few months.

The Fed’s confidence about the strength of the economy may be grounded in the satisfaction that the unemployment rate remains so low at just 3.7%. The unemployment rate is a lagging indicator, however, and monetary policy works with a long and variable lag. Moreover, the IT revolution and growth in online job search platforms have likely changed the way job seekers interact with the labor force. This may help explain why the surge in job openings has not led to a resurgence in wage increases.

The Fed may also be underestimating the impact the drawdown of the Fed’s balance sheet and continuation of enhanced forward guidance are having on global liquidity. Both policies were projected to have strong positive effects when they were implemented. Why wouldn’t they have an equally strong impact now that they are headed in the other direction? Moreover, the high degree of certainty the Fed has displayed that these policies will continue, effectively on auto-pilot at a time that growth is decelerating, has sent a foggy message to the financial markets, which has likely increased uncertainty— hence the rush out of stocks and into bonds and the dollar." - source Wells Fargo

It might be the case that the pilots at the Fed are slightly over-relying on "auto piloting" QT aka "Fuel dumping" while interpreting incorrectly the readings from their pilot cabin's instruments, but we ramble again...

We wish you all a Merry Christmas and a Happy New Year. Don't hesitate to reach out to us in 2019, a year in which we hope to celebrate the 10 year anniversary of this very blog. Thank you for your praise and support.

as the old pilot saying goes:

"There are old pilots and there are bold pilots; there are no old, bold pilots!" 

Stay tuned !