Macro and Credit - Mithridatism

"Many have said of Alchemy, that it is for the making of gold and silver. For me such is not the aim, but to consider only what virtue and power may lie in medicines." - Paracelsus

Watching with interest the tentative rebound in US equities on the back of hope for an agreement between China and the United States on trade, while listening to the "contrition" of French president Macron following the "tax" revolution, promising more spending aka more deficit and more debt, which should no doubt please his technocratic friends in Brussels, when it came to selecting our title analogy given the market gyrations surrounding liquidity withdrawal, we decided to go for "Mithridatism", being the practice of protecting oneself against a poison by gradually self-administering non-lethal amounts. 

The word is derived from Mithridates VI, the King of Pontus, who so feared being poisoned that he regularly ingested small doses, aiming to develop immunity. It has been suggested that Russian mystic Rasputin's survival of a poisoning attempt was due to mithridatism, but this has not been proven. It is important to note that mithridatism is not effective against all types of poison (immunity generally is only possible with biologically complex types which the immune system can respond to) and, depending on the toxin, the practice can lead to the lethal accumulation of a poison in the body. 

For example, the Australian Koalas' diet is so much toxic and poisonous that a normal mammal can't survive. It has also come to our attention that finally the long "immune" Australian housing market has come under pressure as of late as indicated by Cameron Kusher on his twitter feed on the 3rd of December:

Sydney dwelling values have been falling for 16 months and are down -9.5%, when Perth started to decline, 16 months in values were -5.3% lower, and in Darwin they were down -4.4% after 16 months. Is this an orderly slowdown?" - Cameron Kusher - Twitter feed 

While thanks to "Mithridatism", Australia's housing market had been spared for such a long time, it looks to us that finally it is coming under tremendous pressure. One of our French friends currently residing in Sydney suggests that the four big Australian banks were displaying classic 2007 US banks characteristics. Our friend Carl Hodson-Thomas Portfolio Manager at Prometheus Asset Management and based in Perth, would probably argue that QBE insurance company should be a prime candidate for a sizable "short" position given it, along with GMA, has the first-loss exposure to the riskiest mortgages in Australia through its lenders mortgage insurance... But, we digress.

In this week's conversation, we would like to look at what 2019 could entail in terms of risk given the most recent bout in widening credit spreads and with the ECB joining the tapering bandwagon on the back of Fed's ongoing QT.

Synopsis:

• Macro and Credit - 2019: When the central banks are no longer your "friends"...
• Final chart -  Did the Fed already break something?

• Macro and Credit - 2019: When the central banks are no longer your "friends"...

As we pointed out in our previous musing, credit markets and fund flows continue to be "wobbly" to say the least. We continue to monitor credit markets as yet another indication we are in the late stage of this credit cycle. As indicated by Lisa Abramowicz on her twitter feed, the recent credit selloff has been vast and furious in the US:

"The recent credit selloff has hit U.S. debt more than emerging-markets notes. Investors are now demanding the most extra yield to own U.S. junk bonds versus emerging-markets credit since April. (This is a comparison of spreads, as per BBG Barclays data)" - source Bloomberg - Lisa Abramowicz - twitter

Furthermore, more and more pundits are taking the short side of the credit markets and it's not only in the illiquid part of the market such as "leveraged loans" which have come to the attention of central bankers and others, as pointed out by the Wall Street Journal on the 11th of December in their article entitled "Investors Bet $10 Billion Against Popular Bond ETFs":

"Bond investors scrambling to protect themselves from losses are increasingly using bets against the largest junk-bond exchange-traded funds and derivatives that rise in value when corporate bonds lose ground. The popularity of such defensive trades could portend more pain for stock investors as corporate bonds, especially those with sub-investment grade, or junk, ratings, often pick up signs of economic stress before other assets.

The value of bearish bets on shares of the two largest junk-bond ETFs hit a record $10 billion in recent weeks, according to data from IHS Markit . Downbeat wagers on indexes of credit default swaps, or CDS, for junk bonds hit a four-year high in November, according to Citigroup .

Investors are turning to ETFs and derivatives as proxies for actual bonds because debt-trading activity, also called liquidity, has declined over the past decade as new regulations forced investment banks to pare risk-taking. Rising numbers of hedge-fund and mutual-fund managers, for example, are using ETFs to quickly take bearish and bullish positions on bond markets, making them early indicators of investor sentiment." - source WSJ

Over the last 7 days, the US leveraged loans market is down 1.1%. This is the steepest one-week drop since 2011 (per the S&P / LSTA Leveraged Loan Index) according to S&P Global Intelligence.  The S&P/LSTA US Leveraged Loan 100, which tracks the 100 largest loans in the broader Index, lost 0.38% on the 11th of December. Loan returns were –0.66% in the month to date and 2.38% in the YTD. You can expect an acceleration in the fall as we pointed out in our November conversation "Zollverein" particularly given their behavior in 2008 and the "illiquidity" premium discussed in our November conversation that needs to be factored in.

Cracks have started to show not only in supposedly "liquid" ETFs but, as well as in the CLO tranches market as pointed out by the Financial Times in their article entitled "Investors signal concerns with leveraged loans" (H/T Lisa Abramowicz):

"The difference between the interest rates on the highest-rated CLO tranches and three-month Libor has hit 121 basis points — the biggest risk premium since February 2017, according to Citigroup. As recently as November 2017, the spread was 90bp.

Lower-rated CLO tranches have also come under pressure. The spread between double-B tranches and three-month Libor rose 70bp in November to 675bp, the biggest monthly increase since early 2016, Citigroup said."

 - source Financial Times

There is more pain to follow we think in 2019. As we pointed out in our November conversation "Zollverein", US High Yield CCC rating bucket is seriously exposed to the Energy sector and to any fall in oil prices. Oil prices and US High Yield are highly connected (15% of US High Yield). As pointed by Lisa Abramowicz on twitter, no wonder some US oil drillers are starting to feel the "heat":

"An offshore driller, Parker Drilling, just filed for bankruptcy because oil prices aren't high enough to sustain its business model. It's bonds:

- source Bloomberg - Lisa Abramowicz - twitter

The big question one might rightly ask if indeed this is a start of a trend. Sure some pundits would like to point out about the current low default rates but that is akin to looking at the rear view mirror. We have indicated in numerous conversations that QT is accelerating the tightening in financial conditions, akin to some stealth rate hikes given the support provided by massive liquidity over the years. With credit spreads widening, so are financial conditions impacted for the leveraged weaker players.

In their most recent blog post on the 12th of December, DataGrapple is asking if indeed PKD is only the first shoe to drop in the Energy sector:

"SRAC (Sears) has been the first name to default in series 31 of CDX HY on October 15th, even though the auction that will help determine the payout of CDS contracts has still not been held. The second default happened overnight, as PKD ( Parker Drilling Company ) voluntarily filed for Chapter 11 protection under an agreement with a group of debtors that will allow it to quickly restructure. Drilling contractors have struggled to recover from a steep drop in oil prices which reached a trough in 2016. The recent step-down in crude levels – Brent lost roughly 30% since early October to close at $60/barrel tonight – threatens to derail a long-predicted recovery for off-shore companies, which typically handle more expensive projects that require higher energy prices to turn a profit. As recently as November, PKD warned its investors it might not be able to repay certain debts. Since then, its obligations have been trading at levels implying a near certain default and today’s announcement did not come as a big surprise to investors. The question is rather whether PKD is only the first shoe to drop and whether they should expect more decompression between the energy heavy CDX HY and other credit indices." - source DataGrapple

In true "Mithridatism" fashion one should indeed start to seriously reduce their credit "high beta" exposure while they can. It's not only a question of what is "illiquid" versus what is "liquid" given than contrary to 2007, dealers inventories are nowhere near to what they used to be.

The story of fund flows is clearly indicative of "crowding out" happening with appetite switching from credit markets towards US Treasury bills and the safety of the US front-end. As shown by Bank of America Merrill Lynch Follow The Flow note from the 9th of December entitled Back to pre-Qe levels, credit markets are under pressure:

"Outflows have now erased the QE flow

Outflows continued for another week in Europe. Cumulative outflows from IG and HY funds have now erased the inflow seen post QE.

The lack of yield and the lack of growth in Europe are pushing assets away. Risks remain to the downside as the buyer of last resort is stepping away and liquidity remains challenging. Spreads are prone of further widening, not due to weak fundamentals, but due to challenging liquidity and weakening macro backdrop.

Over the past week…

High grade funds recorded another large outflow this week. This has been the 17th week of outflows over the past 18 weeks. High yield funds also recorded another sizable outflow this week, the 10th in a row. Looking into the domicile breakdown, outflows were almost equally split between the three buckets we have: US-focused, Euro-focused and Global-focused funds have all lost similar amount of AUM. 

Government bond funds recorded a marginal inflow this week, putting an end to two consecutive weeks of outflows. Meanwhile, Money Market funds suffered again a large outflow, though half the size of last week’s.

European equity funds continued to suffer outflows for the 13th consecutive week, though this week’s outflow is meaningfully smaller than the ones observed in the 5 previous weeks. Still, during the past 39 weeks, European equity funds experienced 38 weeks of outflows.

Global EM debt recorded a large outflow this week, the 9th in a row, in sharp contrast
with the improving trend we saw during the past 7 weeks. Commodity funds recorded a
marginal outflow.
On the duration front, we saw outflows across the entire curve, though mid-term IG
funds led the trend by far." - source Bank of America Merrill Lynch

So yes, there is a "Great Rotation" from "growth" to "value" stocks in US equities, but, in credit land, there is as well a more defensive stance taking place and this doesn't bode well we think for 2019, particularly it could mean even more bad news for equities if one continues to believe that credit leads equities.

When it comes to the year ahead we read with interest Bank of America Merrill Lynch's take in their "The Inquirer" note from the 13th of December entitled "2019 - the year ahead: A Toxic Brew First, Monetary Elixir Later" that ties up nicely with our "Mithridatism" title:

"The Toxic Brew that threatens near term…

Three market drivers have turned hostile simultaneously. 1) The inflation-adjusted global monetary base was growing 10% YoY at the start of the year, and is now contracting 1%. Based on current Fed balance sheet contraction targets of USD472bn in 2019, and a flat ECB and BoJ balance sheet, it is projected to contract 4.6% by December 2019.

2) The breadth of global economic growth has collapsed – in January 2018, 26 of 38 i.e. 70% countries saw rising leading economic indicators, now only 6, or 16% are. This is close to the lowest decile of global economic breadth in the past 35 years.

3) Global equity market breadth has also collapsed. In January, 46 of 47 equity markets were above their 200-day moving averages, now only 6, or 13% are. Again, this is near the bottom decile. This triple toxic brew has percolated only three times in the past 35 years – in 1990, 1998 and 2001.

Each period was rough for risk assets, followed by central banks capitulating and easing monetary policy. Once the monetary elixir arrived, markets rallied hard, except in 2001, when it took longer to work off the TMT bubble valuations. We expect this time will be no different. While global monetary authorities currently plan to tighten, they are most likely to panic next year, and reverse themselves. Asia/EMs are poised to lift-off when that capitulation occurs." - source Bank of America Merrill Lynch

So global growth is indeed decelerating, credit markets are widening, the Fed blinked and it looks like many are hoping for China to come once again to the rescue and provide more Mithridatism it seems.


While Mithridatism being the practice of protecting oneself against a poison by gradually self-administering non-lethal amounts, it seems to us that ng the Fed with its QT is trying to gradually impose to markets more "price discovery" by administering non-lethal amount of rates hike and gradual liquidity withdrawal, a very difficult exercise indeed after years of repressed volatiliy. Our final chart below is asking if indeed the Fed already broke something or not.

• Final chart -  Did the Fed already break something?

Did the Fed recently blinked and December hike will need to a more data dependent Fed? This is the ongoing raging question everyone is wondering about. Clearly liquidity withdrawal has already blown in 2018 the house of straw of the short-vol pigs, the house of sticks of the Emerging Markets carry tourists, and it seems that as of late the house of bricks of the credit pigs have lost a few. The question that remains is if indeed in this cycle the Fed will break something else in 2019. The below chart comes from Bank of America Merrill Lynch "The Inquirer" note from the 13th of December entitled "2019 - the year ahead: A Toxic Brew First, Monetary Elixir Later" and displays the Fed's tightening in this cycle at 5.2% in total:

- source Bank of America Merrill Lynch

Given the above no wonder US based money market funds attracted $81 billion over the weekly period, the largest inflows on records dating to 1992 according to Lipper. It seems to us that some pundits don't believe that much in "Mithrandism" and its potential to protect from the "poison" of liquidity withdrawal but, we ramble again...

 "The true alchemists do not change lead into gold; they change the world into words."- William H. Gass

Stay tuned !

Australian Dollar, China and Iron Ore - What's behind the Aussie strength?

"It is in revolutionary periods that the culmination of previous trends and the beginning of new ones appear." - C. L. R. James, Trinidadian journalist. 

While in previous conversations we have discussed the link between China, Iron Ore and the Australian Dollar, we thought a, update was warranted given the continued strength in the Australian dollar.

Recently, China's government tightened housing market restrictions on March 1 in cities with "excessively fast" price gains.

Chinese commodities demand tends to weaken as property development slows. The Australian dollar has historically tracked the country's iron-ore exports to China - source Bloomberg:

The Australian dollar declined massively during the global financial crisis as Chinese demand fell for Australian iron ore. The currency then strengthened as exports of the commodity rebounded, coinciding with China's 4 trillion yuan ($643 billion) fiscal stimulus.


Iron ore is used to make steel, an essential material for housing development. Over the past year, as China has sought to curb housing prices, the Aussie has also tracked the relative performance of property stocks as indicated by Bloomberg.

Since June 2012, the Aussie has tended to move in tandem with the relative performance of the Chinese property sector.

Below you have the comparison between the AUD and the spread between the Shanghai Property Index and the Shanghai index - source Bloomberg:

Property stocks underperformed until March in anticipation of China's implementation of capital gains tax to cool the real estate frenzy. China's announcement of a 20 percent capital gains tax on home sales  on the 1st of March was less stringent than anticipated hence the rebound that followed. The Aussie had also fallen toward par against the U.S. dollar over the same period.

But what has been interesting has been the growing gap between the RBA's monthly commodity price index and the Australian dollar. The Australian dollar has been surprisingly resilient, as indicated by Bloomberg:

"The Reserve Bank of Australia’s decision to cut its key benchmark interest rate to a record low reflects the Australian dollar’s resilience to previous reductions and weaker commodity prices. 

The CHART OF THE DAY shows the RBA’s monthly commodity price index diverging from the local dollar by the most since the beginning of the nation’s China-fueled resource boom a decade ago. It also tracks the overnight cash-rate target that Governor Glenn Stevens and his board reduced to 2.75 percent yesterday, the lowest level since records began in June 1959. The exchange rate “has been little changed at a historically high level over the past 18 months, which is unusual given the decline in export prices and interest rates,” Stevens said in his 6th of May statement.

Stevens has reduced the cash rate by 2 percentage points in the past 19 months, a period when the currency has averaged more than $1.03, compared with 72 U.S. cents in the decade prior. The Aussie was at $1.0197 at 6 p.m. in Sydney yesterday. “It’s a balance between the interest rates being at record lows and the currency being high,” said Greg Gibbs, a Singapore-based senior currency strategist at Royal Bank of Scotland Group Plc. “While the currency remains unresponsive to commodity prices or interest-rate differentials, it increases the potential for rates to go lower.” Commodity prices have tumbled 21 percent from a peak in September 2011, the RBA’s gauge shows. The index “is intended to provide a timely indicator of the prices received by Australian commodity exporters,” according to the central bank’s website." - source Bloomberg

Could the reason behind the continuous resiliency in the Australian dollar due to a rebound in Iron Ore prices?

China imported 67.1 million tonnes of the steelmaking raw material in April, the third highest amount on record and up 4% from March it seems.

And, on Wednesday benchmark CFR import price of 62% iron ore fines at China's Tianjin climbed to $130.20 a tonne, up from its 2013 low of $128.10 reached last week according to Frik Els from Mining.com.

As far as inventories are concerned and as reported by Deutsche Bank in their latest Shipping Weekly from the 6th of May 2013, while inventories improved of their 1st quarter low, they remain below 2010 levels:

- source Deutsche Bank - Shipping Weekly - 6th of May 2013.

We do not think the resiliency of the Australian dollar is due to this rebound, there is, we think more to it and it has to do with two factors.

Factor 1 - Diversification of Central Banks FX Reserves:
The rebalancing of FX reserves as indicated by John Detrixhe in his Bloomberg article from the 3rd of April - Aussie to Loonie Equal Dollar in Attracting Reserves:

"For the first time, central banks are using their reserves to buy about the same amount of currencies from Canada to Australia as they are U.S. dollars in a sign that the pace of diversification is accelerating. Allocations to so-called non-reserve assets rose by $30.1 billion in the last three months of 2012, the most in a year, while those going to the dollar increased by $31.5 billion, according to International Monetary Fund data released on March 29. The $1.4 billion gap is the closest since at least 1999.

The changing makeup of reserve assets reflects the growing clout of second-tier nations as the major developed economies see a shrinking share of worldwide gross domestic product. The U.S., euro region, U.K. and Japan accounted for 52 percent of global GDP product in 2011, down from 69 percent a decade earlier, according to World Bank data. “The new money really got applied to the alternatives, Aussie and Canada, and it’s an ongoing trend,” Greg Anderson, the North America head of Group of 10 currency strategy at New York-based Citigroup Inc., said in a telephone interview. Those currencies have “better credit, higher yield. If you could, you’d probably put your whole portfolio there but they have a scale problem, you can’t do that,” he said.

A category the IMF calls “other currencies,” and which strategists say includes the Australian, New Zealand and Canadian dollars, soared to 6.1 percent of the $6.1 trillion in allocated global reserve assets from 1.8 percent at the end of 2007. The IMF calculates the share based on central-bank data. China, the world’s biggest reserve holder, doesn’t participate.

At the same time, the dollar percentage has shrunk to 61.9 percent from 64.1 percent, and the euro’s share has dwindled to 23.9 percent from 26.3 percent. The IMF said in November that it’s considering classifying the Australia and Canadian dollars as reserve currencies." - source Bloomberg

Factor 2 - Yuan-Aussie Trades:

As indicated in Jason Scott's Bloomberg article from the 11th of April, the Australian dollar cross-currency trading has been given a very big boost by the direct trading between the yuan and the Aussie which reached A$250 million on its first day   - Yuan-Aussie Trades Were A$250 Million on First Day:

"The People’s Bank of China approved Australia & New Zealand Banking Group Ltd. and Westpac Banking Corp. as market makers for the direct trading of the currencies that began yesterday, Gillard said at a press conference in Shanghai on April 8. Asia’s largest economy took about a third of Australia’s exports in February and is its major customer for iron ore and coal. The yuan gained 0.2 percent to 6.5167 per Australian dollar as of 2:32 p.m. in Beijing, according to data compiled by Bloomberg. The Australian dollar follows the greenback and the yen in being able to be directly traded with the yuan. Before the bilateral deal, cross-currency trading between the Aussie and the yuan was about A$20 million a day, according to data compiled by market participants, who asked not to be named." - source Bloomberg.

As far as the Yuan is concerned, you should watch what happens with the Yuan's trading range in the coming months because of the competitive devaluation taking place in Japan  - source Bloomberg:

"China won’t widen the yuan’s trading range for at least four months, as foreign inflows have pushed the currency near the upper end of the 1 percent daily limit, according to Australia & New Zealand Banking Group Ltd. “It would require an easing of capital inflows, or for the market to re-assess People’s Bank of China’s currency management” before the band is altered again, said Khoon Goh, a senior strategist at ANZ in Singapore. The central bank expanded the range from 0.5 percent in April 2012 after a stretch of at least 15 months during which the yuan hovered near the midpoint or tended to weaken. A change now would be an “effective revaluation” as other nations devalue their currencies, he said.
The CHART OF THE DAY shows the onshore yuan gained 3.4 percent against the dollar in the past nine months and has closed stronger than the reference rate since September. The lower panel shows the currency stayed near the maximum 1 percent above the fixing for the last seven months.
Speculation for a change was heightened on April 18 when PBOC Deputy Governor Yi Gang said the band would be widened “in the near future.” Based on the previous adjustment, the central bank probably won’t move “until the yuan is trading closer to the midpoint,” ANZ’s Goh said.
Yuan positions at Chinese financial institutions stemming from foreign-exchange transactions, a gauge of cross-border flows, rose by 1.22 trillion yuan ($197 billion) in the first three months of 2013, more than four times as much as in the same period last year. The inflows helped push the yuan to a 19- year high of 6.1723 per dollar on April 17." - source Bloomberg.

On Thursday the Yuan hit a record high of 6.1336 per dollar in morning Asian trade after the People's Bank of China (PBOC) fixed the yuan mid-point at the highest level since the 2005 revaluation.

What will be interesting to watch in relation to China and as reported by EJ Insight on the 8th of May is as follows:

"New forex position limits could tighten cash flow Starting June 10, banks in China are required to comply with new foreign exchange position limits. The State Administration of Foreign Exchange, the nation’s currency regulator, has linked the position limits to the banks’ foreign currency loan-deposit ratios.

Market analysts estimate the lenders need to buy as much as US$320 billion worth of US dollar to meet the new ratio. This could lead to tighter cash flow in the financial system and higher money rates for a short period. As a result, the central bank may keep a net cash injection via its open market operations.

On the other hand, the new measure, which is aimed at containing the influx of speculative capital, is timely and important at a time when other major economies are exercising monetary easing.

After Australia cut interest rates on Tuesday, South Korea’s central bank is likely to announce a long awaited cut today. According to official data, yuan positions at Chinese financial institutions from foreign exchange transactions rose by 1.22 trillion yuan (US$197 billion) in the first quarter."

And Korea did cut its interest rates by 25 bps. The race to the bottom is on and currency wars are indeed interesting to follow.


"The thing is to be able to outlast the trends." - Paul Anka, Canadian musician.

Stay tuned!

Chart of the Day - Chinese Iron Ore back to 2010 levels

"But it is possible that, in the days ahead, these years we have lived through may eventually be thought of simply as a period of disturbance and regression." - Hjalmar Branting, Swedish statesman 

Back in May 2012, we argued that Australia at some point could be facing the "Iron Ore" conundrum given its exposure to Iron Ore. Although we had it wrong in relation to our negative stance on the Australian dollar, the Australian dollar has been so far remarquably steady compared to the US dollar - source Bloomberg:

When ones look at the significant drop in Iron Ore inventory at port since 2009 coming back to 2010 levels, one can wonder what can be expected in 2013 for Chinese growth given the recent weakness seen in China's PMI - source Deutsche Bank, Shipping Weekly, 4th of March 2013:

While Chinese iron ore imports were up 21% y/y, they were down 4% m/m after a strong December according to Deutsche Bank:

Yet this recent rally can be challenged according to a recent Bloomberg article from the 7th of March - Iron Ore Surge Prompted by Demand, Speculation, China Says:

"A recent surge in iron ore prices was caused by changes in demand, market speculation and “unreasonable” pricing methods, China’s top planning body said. The biggest mining company said it hadn’t curbed supplies.
Chinese steelmakers re-stocked iron ore during the traditional “winter reserve” period and ramped up purchases as confidence in the economy improved, leading to an explosive increase in demand in the short term, the National Development and Reform Commission said in a statement on its website.

Chinese steelmakers re-stocked iron ore during the traditional “winter reserve” period and ramped up purchases as confidence in the economy improved, leading to an explosive increase in demand in the short term, the National Development and Reform Commission said in a statement on its website.
The three largest mining companies and certain traders either delayed or controlled deliveries to make up for their previous losses, creating a false impression of temporary short supply, according to the NDRC. Some mining companies also bought iron ore from the market to drive up prices, it said. - source Bloomberg

Iron ore exports to China from Australia are indeed a strong indicator of Chinese industrial activity, and given it fell by 14.8% in February from 18.38 million tonnes in January to 15.66 million tonnes in February, one can wonder if the Chinese holiday season or the cyclone disruptions are entirely responsible for the slowdown or if there is more to it given Korea data could indeed herald surprise China exports drop according to Bloomberg:

"South Korea’s biggest export drop in seven months suggests China will surprise the market and also report fewer shipments in February, lessening the case for monetary tightening in the world’s second-biggest economy, according to Nomura Holdings Inc. 
South Korea is the only one of Asia’s 10 biggest economies to report February trade data thus far. Given that China is its biggest export market, Korea’s sales drop signals that its larger neighbor is poised to report weaker-than-expected shipments, said Zhang Zhiwei, Nomura’s chief China economist. The CHART OF THE DAY tracks monthly changes in the two nations’ overseas sales since 2008. South Korea said exports in February declined 8.6 percent from a year earlier, the second drop in three months. Based on that result, Zhang predicts China will announce tomorrow a 10 percent decrease when February figures are released in Beijing. Nomura’s economist is among only six of 33 analysts surveyed by Bloomberg that predict a drop. The median estimate is for an 8.1 percent increase. “The data suggests China’s recovery is not so strong,” Hong Kong-based Zhang said. “We still call for the People’s Bank of China to tighten policies, hike interest rates and regulate shadow banking activities this year. But recent weak macro data will only make the central bank delay it.” 
China this week affirmed its 2013 growth target at 7.5 percent after the economy grew 7.8 percent in 2012, the slowest pace in 13 years. China will report a February trade deficit of $28.5 billion, according to Zhang. That would be the first shortfall in a year and compares with an average monthly surplus of $16 billion in the past three years. Growth rates for exports and imports in the first two months are distorted by changes in the timing of the weeklong Chinese New Year holiday, which fell in February this year and January in 2012. Nomura’s forecasts tie in with the new export orders component of China’s official Purchasing Managers’ Index, reported on March 1, which fell to a six-month low of 47.3 in February. The broader PMI sank to a five-month low of 50.1, according to data from the National Bureau of Statistics and China Federation of Logistics and Purchasing. A reading of 50 marks the divide between expansion and contraction." - source Bloomberg.

Could the recent slowdown and price manipulations for Iron Ore spell trouble as well for neighbor Australia given its dependency to Iron Ore exports? We wonder.

One thing for sure, the recent weakness in Korea's exports courtesy of Japan's agressive monetary stance has put the Japan-Korean risk gap near parity has indicated by Bloomberg:

"The push by Japan, the world’s most-indebted government, to weaken its currency to boost exports and end deflation may reduce its perceived default risk below South Korea’s, where won gains are having the reverse effect. The CHART OF THE DAY tracks the cost of insuring the five- year sovereign bonds of Japan and South Korea since August. Thespread between the two credit-default swaps fell to 1.2 basis points on Feb. 5, the narrowest since Oct. 11, the last time it was more expensive to insure against a Korean default, data compiled by CMA show." - source Bloomberg

Korea losing its competitive edge towards Japan thanks to a weakening Japanese yen could indicate weaker than expected Chinese growth as well as impacting Australia in the process.

"Worry is interest paid on trouble before it comes due." - William Ralph Inge, English clergyman



Stay tuned!

Australia and the Iron Ore conundrum

"The most fatal illusion is the narrow point of view. Since life is growth and motion, a fixed point of view kills anybody who has one."
Brooks Atkinson

Following up on our recent Shipping conversations ("Shipping is a leading credit indicator - A follow up"; "Shipping is a leading deflationary indicator"), we thought we would venture towards "Down Under", namely Australia given the recent weakness of Chinese Iron-Ore Inventory which have been declining for four weeks and are now below 2011 highs represent a serious conundrum for Australia's economic growth in general and AUD-USD in particular.

Source Deutsche Bank Shipping Weekly - 21st of May 2012

In fact since the beginning of the year both the Brazilian Real as well as the Australian Dollar have experienced a significant weakness versus the US Dollar - source Bloomberg.

While both commodities depending currencies had moved in synch versus the US dollar, the correlation between both broke last year leading to significant divergence between both currencies.

In a recent note entitled "Iron Ore Summer Slowdown" published by Deutsche Bank, their analysts indicated the following:

"Iron ore exports from Brazil have disappointed. Export levels have been poor due to various factors including adverse weather and infrastructure challenges. We expect that export levels are likely to exceed 25mt/month over the next couple of quarters. This normalisation of Brazilian exports could put additional pressure on the market as well.

Certainly we would expect that both Brazilian and Australian producers will be sensitive to the demand requirements of their customers, Europe and China principally, who we expect will be under considerable pressure over the summer slowdown period. On this basis one would expect that exports may drift lower in response to this. Nevertheless we believe that the ability of the key suppliers to ship tonnage to market will improve over this time-frame."

As Dylan Grice put it in his note "Australians be worried: someone is calling your country a miracle!" from the 25th of April:

"Australia's two biggest commodity exports are iron ore and coal. According to the RBA Australia has increased its iron ore capacity by 150Mtpa in the last five years, from 300Mtpa to 450Mpta. Planned capacity increases over the next five years amount to a further 200Mtpa (see chart below). Nearly all of it will go to China to feed the burgeoning steel industry there. But how healthy is China's iron ore demand? If its steel prospects were so attractive why does Wuhan Iron and Steel for one think pigs are the future? Why has the company recently announced plans to invest nearly $5bn over the next five years in industries in which it has no expertise, such as pig, fish and organic vegetable farming? Probably because steelmakers are now loss making and there is excess capacity. And if they have no confidence in the Chinese steel industry, why should Australia?"

In fact Deutsche Bank analysts in their note "Iron Ore Summer Slowdown" remain cautious near term:

"DB steel analysts in China are cautious near-term. After average daily production volumes reached 2.03mt/day in April, utilisation rates are now starting to moderate as end-use demand fails to materialise. In fact we understand that fabricators have high levels of finished inventories. Furthermore, steel inventories while falling are being drawn down at a slower rate than is usual for this time of year."

China growth cooling and implications for Iron Ore:

"Our China steel team expects that Chinese steel production growth will average nearly 4% YoY in 2012(reaching 710mt), as compared to 7.3% growth last year. Utilisation rates are forecast to fall to 86% in 2012.

However we anticipate that these figures may be downgraded if in fact a Chinese economic recovery is delayed or if GDP growth is lower than anticipated. We have concerns about the weakness of the three major fixed asset investment (FAI) pillars (infrastructure, real estate and manufacturing). As our team has indicated previously, excessive manufacturing growth in 2011(which was the highest since 2006) is worrying as it potentially sets the stage for a capex down-cycle for the sector in 2012. Of note, the aggregate capex for Chinese companies under DB analyst coverage is projected to decline in 2012." - source Deutsche Bank.

As indicated by Reuters on the 24th of May:

"Spot iron ore prices have fallen to a 6-1/2 month low below $130 a tonne this week, as steel mills in top consumer China deferred shipments and curbed fresh buying after domestic steel prices hovered near their cheapest in half a year.

Plummeting steel prices, which have shed 6 percent in May, coupled with doubts about domestic demand, are keeping China's army of steelmakers on edge, making them reluctant to commit to new orders.

With growing uncertainty over whether iron ore prices will continue to drop, Chinese steel mills have been picking up material they do need from ore piled at ports rather than making forward bookings with miners, which can take at least 20 days to arrive from Australia."

From the same article:
"If prices were to hit $120 a tonne, it could lead to the closure of some high-cost Chinese miners."

Source Deutsche Bank - "Iron Ore Summer Slowdown" - 17th of May 2012

It's still a game of survival of the fittest in this deflationary environment...

And as Dylan Grice put it in his note focusing on Australia:

"If Chinese resource demand holds up everything will probably be fine. But if it doesn't, well, everything won't be. In fact, there might be trouble anyway. The improvement in Australia's terms of trade (the ratio of its export prices to its import prices) has been spectacular thanks to the bull run in commodities. It should be running large current account surpluses, like Norway. But it isn't. It's running a deficit of 3%. So the AUD is overvalued and vulnerable."

Hence our negative view on Australian Dollar.

"All truth, in the long run, is only common sense clarified."
Thomas Huxley

Stay tuned!

Markets update - Credit - For whom the vol tolls and the return of FAS 159.

For whom the bell tolls
Definition: "An expression from a sermon by John Donne. Donne says that because we are all part of mankind, any person's death is a loss to all of us: “Any man's death diminishes me, because I am involved in mankind; and therefore never send to know for whom the bell tolls; it tolls for thee.”

Rest in peace Steve Jobs.

Today was clearly a day of volatility in the credit space.
Here is the overview.
The range for Itraxx Financial senior 5 year index was between 247 bps to 266 bps and the market closed around 253 bps.
For Itraxx Financial Subordinate 5 year index, the range was between 480 bps to 517 basis points intraday, closing at around 498 bps.

Although the markets in the credit space felt better, it clearly looked like a short covering move.
And my good credit friend to comment:
"Skew basis trades in the credit derivatives universe had for consequence a tightening of the credit indices versus single names (arbitrage selling the indices and buying the underlying single names components). Meanwhile, the cash market barely moved as we still see a lot of sellers and almost no buyers. The ratio seller to buyer was roughly 8:1, and the selling pressure was broad based. Financial bonds as well as corporate bonds are being offered relentlessly and the dislocation we saw in bank bonds and notes is spreading now to almost all issuers.

The name of the game remain Volatility..."

Yes, the markets expect a bazooka of some sort to relieve the pressure in the European space. The ECB's core mandate is price stability and given inflation has been creeping up recently at 3% in the euro zone, a rate cut, which many were expected today, did not materialise. Jean-Claude Trichet's last meeting, did not generate the bazooka, which the market is still hoping at some point.

Itraxx Credit Indices Market overview - Source Bloomberg

Itraxx Financial Senior 5 year CDS index versus Itraxx Europe Main (Investment Grade) 5 year CDS index - Source Bloomberg:

While volatility has been more muted in the CDS corporate space in recent months. The continuous pressure in the financial space means that volatility remains very high as indicated by the absolute spread between Itraxx Financial Senior 5 year CDS index and Itraxx Financial Subordinate 5 year CDS index - Source Bloomberg:

Spread between both indices still at the widest levels at around 245 bps. The unsecured funding market is still utterly shut and most issues coming to the markets from the financial space have been so far, covered bonds backed by pools of prime loans, apart from last week 2 year senior FRN (Floating Rate Note) issued by Deutsche Bank as discussed in previous post.
Access to capital is therefore still limited, no change there, with Nationwide Building Society (rating A+/Aa3/AA-) selling 1.5 billion euros of five-year covered bonds, priced to yield 130 bps than the benchmark mid-swap rate according to Bloomberg. We know from the post "Markets update - Credit - Crossing An Event Horizon", that
"Lenders, by using prime assets are willing to do whatever is necessary to get funding, as other sources, such as unsecured issuance have dried up, clearly reflected by the very high level reached by the Itraxx Financial Subordinate 5 year index."
We know ING sold AAA 10 year bonds at 80 bps over midswaps on the 24th of August, and Unicredit at 215 bps over midswaps on the 25th. It seems every new issue coming in the financial space is pricier than the previous one, and given covered bonds are the most senior guaranteed bonds you can find, senior unsecured bonds and subordinated are repriced accordingly in the process.

And although credit indices enjoyed a short squeeze tightening move, and ECB has pledged to buy 40 billion euros worth of covered bonds, to provide extra financing for banks, liquidity in the market, remains weak - Source Bloomberg:

ECB deposits still rising. But following today's ECB meeting, banks will be offered two additional unlimited loans of 12 and 13- month durations. Trichet in his last ECB meeting mentioned that the Central bank would continue to lend banks as much money as they need in its regular refinancing operations at least until July 2012 to alleviate current liquidity issues we previously discussed.

German 10 year Government yield, Eurostoxx, Itraxx Financial Senior 5 year CDS index and volatility - Source Bloomberg:

While volatility remains elevated, you can notice the correlation between the German 10 year bund yield and the Eurostoxx index.

In the Sovereign Index Space, SOVx Western Europe index (15 countries) is now tighter than the SOVx CEEMA (Central Eastern Europe, Middle-East and Africa) - source Bloomberg:

Confirming what we had discussed in "Markets update - the EM contagion" :

"The CHART OF THE DAY shows the Markit iTraxx SovX CEEMEA Index of credit default swaps on 15 governments in central and eastern Europe, the Middle East and Africa now exceeds a benchmark of western European creditworthiness by 14 basis points. Europe’s worsening deficit crisis is hurting manufacturers, eroding demand for commodities and undermining capital flows in developing economies. Investors are pulling money out of emerging-market bond and equity funds as the risk of a Greek default and losses on sovereign bond holdings mounts."

Meanwhile Ireland continues breaking away from Portugal, Sovereign 5 year CDS wise - Source Bloomberg:

While equity markets are enjoying a respite, we have yet to see a break upwards of the 2% yield for the German bond, still consistent with flight to quality in the European space - Source Bloomberg:

Truth is in the credit space, cash bonds felt weak today has commented by a market maker, with clients still reducing risks and selling bonds which, should not be a surprise given that corporate issuance is repricing credit curves. And cash bonds selling is not helping market makers given a lot of them have lost their risk appetite, as vol (volatility), in the credit space has indeed taken its toll.
Bloomberg - Bond Traders Left Adrift as Dealers Reduce Risk - Shannon D. Harrington and Sarah Mulholland - 6th of October 2010:
"Europe’s crisis of confidence is crippling credit-market trading as banks shrink bond inventories to the least since the depths of the last recession.
Federal Reserve data show U.S. primary dealers cut their holdings of corporate debt by 33 percent to $63.5 billion since May, bringing stockpiles to within $4 billion of the five-year low reached in April 2009. Trading in investment-grade company bonds has dropped 27 percent since February, according to Trace data compiled by Barclays Capital, and a measure of the cost to buy and sell debt is at the highest in more than two years."

and the two authors to add, in relation to liquidity in the credit space:
"Evaporating liquidity is contributing to the biggest junk-bond losses since the failure of Lehman Brothers Holdings Inc. three years ago as Europe’s leaders seek to prevent the region’s fiscal imbalances from infecting the global banking system and the U.S. economic recovery struggles to gain footing. Sales of new high-yield securities have all but disappeared and prices in debt markets are swinging by the most since 2008."
Volatility we have indeed and from the same article we learn that:
"Volatility is making it harder for Wall Street to underwrite loans, Julia Tcherkassova, a commercial-mortgage debt analyst based in New York at Barclays, said yesterday.“Originators need to see that stability.”It takes several months to accumulate mortgages to package for sale as bonds, and price swings on the debt mean that lenders may be stuck with unprofitable loans if values decline in the interim."

So dealers are as well de-risking and deleveraging, leading to wider bid-ask spreads, higher volatility and poorer liquidity, and we haven't seen complete capitulation yet as we saw in 2008.

So how do banks expect to sustain earnings in this difficult trading environment with less leverage, smaller balance sheet exposure, weak issuance and so forth?

Here comes again FAS 159!

In July 2010 I commented on the above: "Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008"
"Statement 159, adopted by the Financial Accounting Standards Board in 2007 allows banks to book profits when the value of their bonds falls from par. This rule expanded the daily marking of banks’ trading assets to their liabilities, under the theory that a profit would be realized if the debt were bought back at a discount."

Wall Street's tricky profits - CNN Money - Roddy Boyd:
"Here's how FAS 159 works: A company can assign a fair (or market) value to its financial assets and liabilities - such as bonds - in order to smooth out earnings. Say a bank sells debt, an IOU, at $1,000 par value. Because of broader credit-market concerns and a slowdown in earnings, that debt trades down to $800. The $200 differential, under standard 159, is allowed to be counted as mark-to-market income, without the bank having engaged in any business activity. The bank then details its use of the rule in footnotes to its regulatory filings."

And Roddy Boyd to add:
"Moody's Investors Services has also warned investors about FAS 159, noting that it risks giving false perceptions of a bank's financial strength. The agency says it "does not consider such gains to be high-quality, core earnings.""

So we have a similar pattern than what I discussed in 2010 namely that:
"With the recent increase in volatility in conjunction with a reduction in debt issuance in the second quarter, banks have had a hard time to reap in similar profits they made in Q1."

Bank Profits Depend on Debt-Writedown ‘Abomination’ in Forecast - Bloomberg July 2010:
“What’s on investors’ minds are the macroeconomic issues, as reflected by the interbank market in Europe, the very low yields on U.S. Treasuries and recent data on economic growth, jobs and housing,” Credit Agricole Securities USA analyst Michael Mayo said in an interview. “To the extent that the earnings power is less, the banks would not generate as much capital, so there’s less capital available to absorb future losses.”
Any similarities to today's situation are of course purely fortuitous.

And from the same article we learn:
"In practice, it’s an accounting “abomination” because fluctuations in the value of the debt don’t change the amount the banks owe, said Chris Kotowski, an analyst at Oppenheimer & Co. in New York."

And as David Hendler, Senior Analyst from CreditSights sums it up in the same Bloomberg article:
“When the prevailing winds of credit spreads tighten, they make a lot of money, and when spreads widen, they can’t make as much.”

So, when you have heightened volatility, FAS 159 and Debit Value Adjustment allows banks to increase earnings in bad times but when CDS spreads tighten it works the other way as discussed in "Credit Value Adjustment and the boomerang effect of FAS 159 accounting rules on Banks Earnings".

FAS 159 is the reason why UBS is expecting a "modest" net profit in the third quarter - Source Bloomberg - Elena Logutenkova - 4th of October 2011:
"UBS AG, Switzerland’s biggest bank, expects a “modest” net profit in the third quarter as gains from a widening of its credit spreads and the sale of bonds helped cushion the $2.3 billion loss from unauthorized trading.
The bank expects to book a fair-value gain of about 1.5 billion Swiss francs ($1.6 billion) as its credit spreads widened in the third quarter."

So, in coming bank earnings, you can expect more of the same, courtesy of the perfectly legal FAS 159 accounting trick which was as well very effective in 2008.

On a final note and as a follow up on our discussion about contagion to Emerging Markets and the Chinese slowdown, here is the updated picture for Australian Financials - Source data provider CMA:


"All of us might wish at times that we lived in a more tranquil world, but we don't. And if our times are difficult and perplexing, so are they challenging and filled with opportunity."
Robert Kennedy

Stay tuned!

Markets update - Credit - Rates - Equities - U can't touch this...Hammer time...

I told you homeboy u can't touch this
Yeah that's how we're livin' and you know u can't touch this
Look in my eyes man u can't touch this
You know let me bust the funky lyrics u can't touch this

MC Hammer - U can't touch this lyrics

Markets in a spin again, equities, you definitely can't touch this...It's hammer time in the markets!

10 year German Government Bund still experiencing flight to quality:

In the two year government bond space, Greece widening again:

In the Credit Space, credit indices widening as well:
Itraxx Crossover 5 year index:

Itraxx Financial Sub 5 year index (synthetic index comprising subordinated CDS levels of European Banks, the reference bonds in these CDS being subordinated debt):

and Italy's sovereign CDS and Government bond spreads an ongoing concern:

Italian Financial Senior 5 year CDS widening as well:

France 5 year Sovereign CDS is quoted at 135 bps.

Meanwhile the aggressive cut from the Swiss National Bank seemed to have had little effect on curtailing the EUR/CHF trend, here is the intraday picture:

Yen is still hanging at record low level suggesting Bank of Japan is on the lookout, we are at intervention levels but what kind of intervention?

Gold reaching a new record, here is the intraday move:

No more Ipads for the US consumer as per Bloomberg's Chart of the day:

And US consumption is 70% of US GDP. It is called deleveraging.

The other chart of the day, again from Bloomberg is more worrying as it shows the average Debt/Ebitda Ratio for closely held US companies, hold your breath it isn't pretty:

In relation to my previous post relating to the toxicity of stimulating high ownership rates, please find another "Chart of the day", from Bloomberg. As I mentioned in my post "Is the policy of achieving a high home ownership rate the biggest threat for an economy?", Australia is facing the same issues relating to its housing market as the UK have been facing and the US:

Yes indeed, house prices in Australia are over-valued and no, it's not different this time for housing and not different for LBO loan costs in Europe which, now exceeds Lehman crisis according to Bloomberg article from Patricia Kuo and Stephen Morris.

Private-Equity firms face funding costs for European LBO which exceeds even the aftermath of the Lehman collapse. Interests on loans to finance LBOs have risen to average 450 basis points more than benchmark since June, from 413 bps in the first five months. The record was at 437 bps following Lehman's demise.
But it is not LBOs that are in trouble to fund themselves. The recent rise in bond yields for Italy and Spain, spell similar funding issues.
According to Bloomberg, European leveraged loans fell to 91.08% of face value at the end of July, whereas in the US, leveraged loans stand at 94.41%. Leveraged loans are deemed High Yield and are rated below Baa3 by Moody's and lower than BBB- by S&P. The Itraxx Crossover index displayed previously is a good proxy.

The reality is slowly sinking in, everyone is competing for funding and costs will rise.

In the CMBS space, there is a disturbing trend as well:

Commercial-Mortgage Late Payments Increase to Record in July - Bloomberg

"Delinquencies on the debt jumped 51 basis points in July to a record 9.88 percent, according to real estate data provider Trepp LLC. The increase follows two months of declines, the New York-based firm said today in a statement. The jump is partly because of how loan servicers report mortgages that are in foreclosure, Trepp said."

This is very significant because it will have a very big impact on Banks level of provisions and will increase losses. It also justifies my previous stance on this blog, relating to US bank stocks and the reason to avoid them. For more on the subject, you can read what I have written on the subject: "Extend and Pretend" - Banks bloated balance sheets and the Impact of Real Estate crisis.

"Wall Street lenders may incur ”hundreds of millions of dollars” in losses as prices on commercial-mortgage bonds tumble, Barry Sternlicht, the chief executive officer of Starwood Capital Group LLC, said on a conference call with investors today for Starwood Property Trust, a unit of the firm."

And on the economic data, it was another disappointing day, Factory orders down 0.8% as durable goods decline (Highlighted above in one of the chart of the day) and ISM services slightly below consensus at 52.7, confirming the ongoing weakness in the US economy.

To be continued, now back to the bunker...