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. 

Synopsis:

• 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!

Macro and Credit - Structured Criticality

"Bright light is injurious to those who see nothing." -  Prudentius

Looking at the relief rally that followed the tragedy that followed the "first to default" wipe-out of large swaths of the short volatility complex and given that we think that a large part of the continuation in the rally in equities is supported by the $171 billion in YTD stock buyback announcements, when it came to selecting our title analogy we reminded ourselves of "Structured Criticality" which is a property of complex systems such as financial markets. In complex systems such as financial markets, a small event may trigger larger events due to subtle interdependencies between elements. In our previous conversation we mentioned the pile of sand analogy with the additional grain of sand that triggers the avalanche as per the demise of the "first to default" or equity tranche short-volatility complex in the capital structure (or cone shape) of financial markets. Though the pile has retained its shape following the avalanche which has caused some number of grains to slide down the side of the cone (short volatility funds blowing up), it is nearly impossible to predict if the next grain of sand will cause an avalanche and where this avalanche will occur on the pile and how many grains of sand will be involved (risk parity, vol control products?). However, the aggregate behavior of avalanches can be modeled statistically with some accuracy. For example, some can reasonably predict the frequency of avalanche events of different sizes. The avalanches are caused when the impact of a new grain of sand is sufficient to dislodge some group of sand grains. If that group is dislodged then its motion may be sufficient to cause a cascade failure in some neighboring groups, while other groups that are nearby may be strong enough to absorb the energy of the event without being disturbed. Each group of sand grains can be thought of as a sub-system with its own state, and each sub-system can be made up of other sub-systems, and so on. In this way you can imagine the sand pile (or financial markets) as a complex system made up of sub-systems ultimately made up of individual grains of sand (yet another sub-system). Each of these sub-systems is more or less likely to suffer a cascade failure. Those that are likely to fail and reorganize can be said to be in a critical state. Put another way, the likelihood that any particular sub-system will fail (or experience a particular event) can be called its criticality. So then, the pile of sand (or financial markets) can be viewed as a network of interconnected systems, each with its own criticality. The relationships between these groups impose a structure on this network which has a profound effect on the probability and scope of a cascade failure in response to some other event. In other words - structured criticality. Given most buybacks have been funded by debt, we wonder when the next grain of sand will trigger the next avalanche. For now the complex system is benefiting from an unhealthy support coming from the flurry of buybacks announcements we think so caveat emptor ("let the buyer beware") with U.S. stocks recording the strongest weekly performance since at least 2013.

In this week's conversation, we would like to look at how volatility is the enemy of leverage and the on-going repricing of financial markets including volatility forcing markets to re-adjust to a loosening of financial repression and what it entails. There are as well many young market practitioners today that have never traded through a rising rates environment or seen what renewed inflationary pressure means for risky asset prices. 

Synopsis:

• Macro and Credit - Volatility is the enemy of leverage
• Final charts - US Dollar ? Twin deficits and inflation matter

• Macro and Credit - Volatility is the enemy of leverage

As we pointed out in our previous conversation "Harmonic tremor", the regime change in volatility and the effect of "Who's Afraid of the Big Bad Wolf?" aka "inflation expectations" thanks to rising wage inflation expectations have already claimed the small fishes such as some players in the short volatility leveraged and crowded complex. Leverage and rising positive correlations not only reduces the benefit from diversification but the jump in global risk premiums meant that the sell-off episode has shown us that this time was indeed different in the sense that what could be seen as "antifragile" havens in a true Taleb fashion such as US long bonds, gold and Swiss franc did not played their defensive purposes, only cash mattered, or having had sufficient downward protection strategies in this small avalanche that clearly put into the limelight the brewing instability in market structures. 

Whereas recently the markets have rebounded significantly thanks to the impressive support from additional buyback announcements, one should clearly be wised in  trying to understand the "Structured Criticality"  and vulnerabilities which have been highlighted by the VIX episode. The anomaly was obvious to many, namely that financial repression has led to volatility being repressed beyond anything reasonable thanks to central banking intervention. Repricing was way due for a reality check and of course as one might correctly opine, volatility is always the enemy of leverage (ask LTCM). It should not come as surprise therefore with the return of volatility to a more normal stage to see Global Macro Hedge Funds staging a comeback. As we pointed out in our November 2012 conversation "Why have Global Macro Hedge Funds underperformed", the main culprit was the lack of volatility. 

Obviously the biggest question following the "repricing" of volatility to a more "normal" state after many years of "financial repression" led by central banks is the risk in the change in the narrative we warned about in so many conversations. This is leading to unpredictability making a return into what have been "predictable" markets for so many years. On this subject we read with interest Deutsche Bank's Special Report from the 16th of February entitled " Undoing the unstrange  - The problem of re-emancipation of the markets" which we think is a great illustration of the change in the narrative we are seeing first hand:

"After years of calm and predictable markets, suddenly there seems to be many things going on at the same time. As recently as early January, the incoming vol supply could not find a buyer as vol selling and carry trade remained the dominant themes. This changed practically overnight as rates broke through significant technical levels, which triggered a spike in gamma, which quickly spread across all market sectors. With every new installment of stimulus unwind, it seems as if things are moving in reverse, but not to where we left them, rather towards what appears to be an unknown and unfamiliar destination. This is proving to be a highly unconventional tightening cycle and recovery. After years of forced hibernation, brought about by suspension of traditional trading rules by the central banks, the markets are facing a painful process of re-emancipation. This is causing considerable confusion and anxiety. Last time we saw a recovery from a conventional recession was about 14 years ago (for many, this is longer than their entire professional career). Things are different this time. Both the 2008 financial crisis and subsequent policy response were highly unconventional, and therefore there is no reason to expect that recovery and unwind of the policy response should be conventional either. We believe that the following three observations summarize the ongoing complications associated with stimulus unwind and the conflicts they create in the context of economic recovery.

1) Unwind of stimulus is a mirror image of the QE trade. It is a de-risking mode and, as such, it goes against the grain of recovery. This is in sharp contrast with conventional unwind of the recession trade, which is the risk-on mode.

2) Risk is asymmetrically distributed between rates and risk assets. There are two distinct paths to higher rates (through higher real rates or wider breakevens). They mean two different things for bonds and stocks. For bonds, the distinction between these two paths is a matter of degree between a mild and a moderate selloff. For equities (and USD), on the other hand, the effect is binary – it means a difference between a modest rally and a substantial selloff.

3) Volatility plays an essential role in the policy unwind. It is one of the key decision variables in the process of portfolio risk rebalancing -- higher volatility causes complications. However, unlike traditional recoveries, which are collinear with the unwind of the recession trade -- and, as such, volatility-reducing – the unwind of financial repression is withdrawal of convexity supply and a vol-enhancing mode.

The main diagonal: Conventional recovery from a conventional recession

To visualize the problem, we start with a figure that illustrates how recoveries from conventional recession used to play out in terms of the interplay between yields and equities. We start at point 1: Recession typically begins with a steep decline in risk assets and allocation to bonds. Monetary policy intervenes with rate cuts, which slows the selloff in risk, with rate cuts continuing until the economy stabilizes and the market turns around (2).

The recession-recovery path in the figure moves along the main diagonal (between the 1st and 3rd quadrants) -- recovery is a mirror image of the recession. As the defensive position (long bonds/short risk) is rebalanced, it moves the market naturally into the risk-on region (3) with more aggressive allocation to risk assets and underweight in bonds continuing typically until rate hikes slow the rise in equities (4). Unwind of the recession trade (in the conventional setting) goes along the grain of the market trade – its inertia leads naturally into the recovery trade. Because of this, past recoveries have been generally accompanied with lower volatility.

The agony of the off-diagonal: Rise of the unconditional

The current policy unwind is qualitatively different from traditional recoveries. The underlying complications can be traced back to the later installments of QE, around 2011, which signaled the beginning of a new regime of market functioning, an utterly new mode rarely seen to persist beyond transient episodes. The figure illustrates a longer history of the three assets in question, USD (in terms of TWI index), S&P levels and 10Y UST yield, indexed to their Jan-200 levels.

The letters S and W stand for strong and weak. Typically, stocks, bonds and currency cannot all rally at the same time for a prolonged period of time. Generally, they support each other conditionally: For two of them to rally, one has to sell off (and the other way around). This is seen in the picture during first decade of this century. 2011 signals a structural shift to a new regime: Between 2011 and 2016, the three assets supported each other unconditionally – they rallied simultaneously. This was a result of continued QE against the background of threat of sovereign risk overseas, which created positive externalities for both USD and US stocks, and it represents the other side of the state of exception created by the extended influence of central banks.

This outlines the essence of the problem of policy unwind. While central banks actions and the market environment had clearly created optimal conditions where, for many years, every asset class made money at the same time, the natural question one had to ask is: What to expect after that? If unwind of the stimulus is its mirror image, where does one go when everything sells off?

Monetary policy pharmakon of why does it hurt when we unwind?

The figure below illustrates the recession-recovery path post-2008. It starts, as usual, with a selloff in risk assets and a rally in bonds (1 & 2), but as the crisis deepens and QE gets deployed (3), the action moves (and stays) on the off-diagonal where both bonds and equities rally. Unwind of QE now becomes essentially a de-risking move -- it goes against the grain of recovery.

Currently, we are heading towards point 4, beginning to catch sight of the bifurcation point (5) from which the market could either sink into the “stagflationary” trap (6: everything: stocks bonds and currency, sell off) or move to the 1st quadrant if the Fed and Congress manage to engineer a turnaround and we get catapulted towards what looks like a traditional recovery. This is the biggest challenge for the Fed at the moment, which is further complicated by the ongoing rise in volatility. This complication, which appears to come naturally in this context, is further amplified by the Fed’s negative convexity exposure to inflation.

Inflation is producing an Icarus effect: Although negative convexity of inflation is a far OTM risk, it is significant even at remote distances from the strike, due to its enormous size. The accumulation of relatively illiquid long-dated bonds on retail balance sheets is at toxic levels and a substantial rise in inflation, to which there is no adequate policy response, could threaten to trigger a bond unwind that the market would be unable to absorb.

Locally, the main problem for risk assets is a rise in real rates: Having UST bonds with strong dollar or high real yields will be more attractive than holding US stocks, which means accelerated de-risking and higher volatility in the stock market. Higher inflation, on the other hand, would be supportive for equities and could cause another leg of selloff in bonds. What complicates things is that the behavior of real rates at this point is also a function of expected inflation: Higher inflation warrants a more hawkish Fed and therefore pricing in higher real rates. The reaction of stocks is a non-linear function of inflation – although risk assets might “like” higher inflation, this would remain true only up to a certain point.

Unwind of financial repression: Volatility is the key variable

Traditional recoveries have not been very sensitive to volatility behavior. In fact, volatility showed a tendency to decline in those cases. This follows almost automatically because of collinearity of recession unwind with the risk-on trade. The role of volatility in the current context is a novelty. An exit from almost a decade of financial repression has another dimension defined by volatility. This is a consequence of both the nature and the duration of the stimulus and subsequent  addiction liability that central banks run at the moment. The subsequent three figures illustrate how volatility enters the play during different stages of stimulus and its withdrawal.

Step 1: The recession starts at elevated volatility levels. The solid line represents the efficient frontier of a portfolio on the risk-return plane. Changing the risk causes a repricing of the frontier. This is shown by the dashed lines which reflect the levels of the existing market volatility. The two-sided arrow represents the risk limits of a given portfolio. This is kept constant through different stages of rebalancing. For a given risk limit, one finds a place on the frontier that fits inside the dashed lines (“VaR limits”).

Step 2: Response to crisis through QE consists of constraining the rates at the long end and therefore reducing the market volatility. As volatility resets lower, investors can afford to move further out along the risk curve until their risk limits are compatible with new volatility levels. This is the asset misallocation trade (one does things that one regrets later). This persists for years after the initial decline of volatility from crisis levels in late 2009. The new position is shown with the red double-sided arrow (the initial one is shaded).

Step 3: Unwind of stimulus and Fed exit is also a withdrawal of convexity supply. This implies higher volatility, which means that the prior portfolio is now operating above the risk limits. As a consequence we have a risk rebalancing towards the left (point 3 or the green arrow).

In the subsequent months, a particular pattern of volatility, in terms of its breakdown across different assets, will determine the mode of risk rebalancing. In that context, volatility will play a decisive role in determining the success and timing of the recovery and a particular economic trajectory.

Trades

Money market repricing

Inflation or no inflation in the short run, with continued push towards easy fiscal policy, financial conditions are unlikely to tighten. In that context, inflation risk could become more acute than currently perceived. At least, this is what history  would suggest. When markets operate close to full employment, further easing of financial conditions could create an explosive response in the economy. In that environment, the Fed is likely to stay the course and continue to hike, especially in light of the realization of the actual threat of inflation getting out of hand. In the meantime, the question is more about the Fed path rather than about its stance. A possibility of frontloading some of the hikes implies a flattening between the red and green sectors of the money market curve. This mode is not yet being priced in by the curve and vol. We are buyers of conditional bear flatteners at the short end of the curve." - source Deutsche Bank

As we pointed out in our previous conversation, there lies the risk ahead for financial markets when it comes to "inflation expectations", "realized inflation" could prove to be a significant grain of sand in terms of "Structured Criticality" particularly with a potential acceleration in trade wars and geopolitical exogenous factors coming into play (both are bullish gold by the way):

"Believing that the spread between implied and realized volatility would persist has indeed been a dangerous proposal with rising positive correlations. In similar fashion believing that "implied inflation" could persist remaining below "realized inflation" could become hazardous in the coming months, particularly with growing geopolitical exogenous risks around. Whereas QE was deflationary, QT could prove to be inflationary but we ramble again..." - source Macronomics, February 2018

Also, what we re-iterated in our conversation "Who's Afraid of the Big Bad Wolf?", with inflation, the only issue is when the "Inflation Genie" is "Out of the Bottle" as warned by Fed's Bullard in 2012, it is hard to get it back under control:

“There’s some risk that you lock in this policy for too long a period,” he stated.  ”Once inflation gets out of control, it takes a long, long time to fix it”

As pointed out by Christopher R. Cole, CFA from Artemis Capital Management latest note entitled "Volatility and the Alchemy of Risk - Reflexivity in the Shadows of Black Monday 1987",  the rise of the Big Bad Wolf aka inflation was what started a liquidity fire in credit that spread to equities before the 1987 volatility explosion. As we pointed out in our recent musings, when it comes to "Structured Criticality", for a "bear market" to materialize, you would indeed need a return of the Big Bad Wolf aka "inflation", being probably one of the most dangerous grain of sand around when it comes to "avalanches" in the conic structure of financial markets we think. If volatility is the enemy of leverage, then again, inflation is the enemy of volatility. 

If indeed as pointed out by Christopher Cole, volatility is the brother of credit and volatility regime shifts are driven by the credit cycle, we have yet to see in earnest a significant tightening in financial conditions, yet from the buybacks frenzy to the current M&A craze, everything points towards a late credit cycle in our playbook. Yet when it comes to pressure on credit spreads, as seen during the energy crisis with the fall in oil prices leading to the blow-out in credit spreads, things can turn "south" as for the short-vol sellers faster than a rat on roller skates. What we think is of interest is that finally the much vaunted "Great Rotation" by some sell-side pundits, has finally somewhat started to materialize slowly in terms of fund outflows but this time where all the "fun" has been running thanks to low volatility and low interest rates, namely in the bond markets thanks to "goldilocks" environment enabling the "beta game" for the carry tourists. Fund outflows also point towards "Structured Criticality" in the sense that the shape of the conic structure in credit has been heavily skewed in recent years by the significant inflows into corporate bonds including the ETF complex. On the subject of fixed income outflows and the growing importance of the ETF complex we read with interest Bank of America Merrill Lynch's take from their Situation Room note from the 15th of February entitled "Position reduction":

"Following the recent equity market correction and equity and rates vol spike, investors reduced positioning in risk assets across the board this past week ending on February 14th. Outflows from equities continued for a second week at $3.55bn from $29.54bn. US-domiciled high grade bond funds and ETFs reported the first weekly outflow since December 2016 at $1.52bn, following a $5.28bn inflow the week before. HG funds had an outflow of $0.28bn after an inflow of $4.54bn, and HG ETFs had a $1.25bn outflow – highest since June 2013 – following a $0.74bn inflow one week earlier. Short-term HG held up comparatively well with an inflow of $0.12bn, down from $2.15bn the week before, while HG outside-of-short-term lost $1.65bn after gaining $3.13bn the prior week.

High yield also experienced a flows exodus of $6.33bn – the second highest weekly outflow on record – after a $2.34bn outflow the prior week, with HY funds and ETFs losing $3.58bn and $2.75bn in redemptions (-$1.37bn and -$0.97bn one week ago), respectively. Leveraged loans also had an outflow of $0.27bn from an inflow of $0.50bn the week before. Global EM reported an outflow of $2.87bn following an almost flat prior week of $0.02bn inflow. Outflow from munis accelerated to $0.66bn from $0.47bn, while inflow to money market funds slowed to $0.02bn from $27.80bn. Mortgages experienced a $0.18bn outflow following a $0.08bn inflow one week ago. On the other hand, government bonds continued to report decent inflows at $1.73bn this past week following a $1.75bn inflow the week before. The net effect on the all fixed income category was a significant $8.21bn outflow from a $4.02bn inflow a week earlier.

IG ETFs vs. bond funds

ETFs are becoming increasingly important vehicles in fixed income and inside we provide a discussion of trading volumes relative to the IG corporate bond market. Today we fielded a number of questions about yesterday’s record ~$924mn outflow from the largest IG corporate bond ETF (LQD) and whether we are concerned about it. We are not as, while the importance of ETFs in IG credit is growing, they are still relatively small. About 20% of US corporate bonds (IG+HY) are held by bond funds and ETFs (Figure 13), which applied to the size of the index eligible IG market comes out to $1.27tr.

However, we estimate that ETFs hold only $190bn of IG corporate bonds, or 2.9% of the market (Figure 16). Hence bond funds – not ETFs – are the elephant in the room as they hold more than six times as many IG corporate bond assets relative to ETFs. Even with the more recent shift to passive investment (see piece below) inflows to HG bond funds were four times ETF inflows in 2017.

The particular ETF in question (LQD) had about $34bn of assets – or 0.5% of the size of the IG market - before suffering a 2.6% outflow, which is a drop in the bucket. This ETF has suffered outflows all year totaling about $4.7bn as bond prices declined (entirely due to higher interest rates as credit spreads are flat on the year), which is normal (Figure 11).

However, we estimate that high grade bond funds and ETFs overall (a category that includes LQD) have seen inflows of $47bn this year. Hence the big story is one of very large inflows as opposed to ETF outflows. Now most IG bond funds/ETFs buy other IG assets in addition to corporate bonds - such as Treasuries, mortgages, etc. Focusing on dedicated corporate bond IG funds/ETFs (again including LQD) we estimate a $1bn inflow this year.

Recent daily outflows from HG bond funds/ETFs

However, we are starting to see small daily outflows from high grade bond funds and ETFs recently – specifically Friday-Wednesday (Figure 14).

This is to be expected given that the three main drivers of inflows to high grade bond funds/ETFs are 1) good total return performance (instead IG corporate bonds have lost 2.74% so far this year), low interest rate vol (Instead the move index has jumped to 70bps from 47bps) and equity outperformance (instead stocks corrected recently). For more details see: Inflows to taper 26 January 2018. For us to be concerned about large overall HG outflows – i.e. from bond funds as well - we need to see a much bigger increase in interest rates.

ETF liquidity injection

Fixed income ETFs are getting increasingly popular and, as a result, are adding liquidity to the mostly illiquid corporate bond market. In particular dedicated IG corporate bond ETF trading volumes are about 5.6% of cash bond trading volumes LTM – on adding the corporate bond portion of fixed income ETFs with broader mandates – such as agg-type funds - that number increases to 7.5% (Figure 15).

Trading activity in IG corporate bond ETFs is highly concentrated with the largest fund accounting for about 60% of volumes (Figure 17).

Trading volumes for the most active bonds in the corporate bond market are comparable, although slightly lower (Figure 18). In terms of AUM ETFs rose from 0.9% of the high grade index market value in January 2010 to 2.9% currently (for both corporate and high grade bond ETFs, adjusting for the share of corp. bonds, Figure 16)." - source Bank of America Merrill Lynch

While the slow movement in outflows has not reached the "Structured Criticality" level that would mean another "avalanche, these grains of sand do start to add up. Whereas foreign investors were responsible for the big acceleration in HG bond fund/ETF inflows in recent years thanks to a big decline in the cost of dollar hedging, retail in many instances have taken over from these foreigners particularly in the High Yield ETF space, rendering them more prone to volatility thanks to the feeble nature of these investors. While tracking bonds ETFs is of interest, it is of course not the best great gauge of real health in credit markets we must confess, though from a short term perspective, it might indicate some weakness in the near term. The correlation between oil prices and High Yield is much more interesting from a "monitoring" perspective. What you should be concerned about is that the switch from a negative real yield regime to a more normal, positive real yield regime might spark a big non-financial credit crisis because this time around leverage is higher now compared to history. If you believe in a "stagflationary" scenario unfolding à la 70s, the major difference is that leverage was falling during the rapid credit cycles of the 70s, with the biggest spikes in yields taking place at the end of the period.  There also a phenomenon that needs to be taken into account and it is that the current Boomers are more leveraged than previous generations were ahead of retirement as per the final points we have shown in our March 2017 conversation entitled "The Endless Summer". We concluded our missive at the time asking ourselves how many hikes it would take before the Fed finally breaks something.

But before your worries get ahead of you, in terms of credit matters, from an allocation perspective, if indeed slowly but surely rising outflows pressure from the Fixed Income space, we got interest by the suggestion made by Deutsche Bank in their Credit Bites note from the 16th of February entitled "The Resilience of Loans":

"In the aftermath of the recent inflation induced spike in volatility we analyse the impact it has had on the relative performance of HY bonds and leveraged loans. One of our key relative value views in our 2018 outlook is that loans would fare better than bonds if we did indeed see an inflation/rising yields led move higher in volatility that puts pressure on credit spreads.

When we published our outlook back in November one of our key relative value views was that loans would fare better than bonds if we did indeed see an inflation/rising yields led move higher in volatility that puts pressure on credit spreads. Given recent events we thought it would be worthwhile taking stock of where we stand and how the recent bout of volatility has impacted the relative returns between loans and bonds.

In Figure 1 we look at the cumulative YTD returns for the HY bond and leveraged loan indices.

We can see that in the early weeks of the year with spreads generally trending sideways to tighter bonds had fared fairly well. However with Bund yields generally moving higher from the second week of January loan returns started to bridge the performance gap. Then the inflation induced spike in volatility pushed credit spreads wider and helped to accelerate this trend. At the time of publication loans have outperformed bonds by 1-1.5% across the rating bands as we can see in the right hand chart of Figure 1.
 

In Figure 2 we run the same analysis for the USD market. We can see the relative performance dynamics are very similar to what we have already shown for the EUR market.

After the initial spread tightening and associated outperformance of bonds, the combination of higher bond yields and the spike higher in volatility has seen loans notably outperform. In fact the level of outperformance is slightly more impressive in the USD market. At the time of publishing loans had outperformed bonds (at an index level) in the 1.5-2% range across the rating bands (right hand chart of Figure 2).

We would additionally argue that it is not just the obvious outperformance of loans that has been impressive but also the general stability of loan returns. This highlights a key factor in why we think loans will outperform this year as they are generally less susceptible to day to day market volatility as well as having negligible exposure to rates duration.

If spread weakness in 2018 is driven by macro factors such as higher inflation and rising bond yields leading to higher volatility and wider spreads then the recent trend in performance makes us more comfortable with the view that loans will outperform bonds this year. We would be more concerned about this view if spread widening were to be driven by fundamental credit factors that pushed us towards the next default cycle.

Near-term we might see some reversal of this loan outperformance if volatility continues to settle down, equities continue to rebound from the recent correction and credit spreads continue to reverse some of the recent widening. However over the medium term we expect higher inflation and yields to keep volatility elevated above the lows of 2017 and therefore credit spreads to maintain a widening bias which should benefit loans over bonds." - source Deutsche Bank

What we don't like right now in the Leveraged Loans market is that Lower-rated deals (and covenant-lite transactions) are driving it at the moment. As indicated by S&P Leveraged Loans:

"There's $970B of outstanding US Leveraged Loans and more than 75% of that is covenant-lite" - source S&P LCD News

It might be more appropriate from a defensive perspective to play the Leveraged Loans game through large "Senior Tranches" in CLOs, ensuring you have a high attachment point, should defaults make a return at some point. Yet no doubt the low volatility of the asset class is compelling. Also in the US, managers of open-market CLOs have received a waiver from retention risk from the part of the US Court of Appeals for the DC circuit recently. This decision opens the door to other markets such as RMBS, CMBS and ABS to issue with the new rule in place. With a slower pace of issuance taking place over the next few months following the ruling, the asset class could benefit from a "technical bid". 

While many continue to be puzzled by the weakness in the US Dollar as per our final charts, we do think that when it comes to the long term direction of the currency, the twin deficits matter, and matter a lot.

• Final charts - US Dollar ? Twin deficits and inflation matter

Economies that have both a fiscal deficit and a current account deficit are often referred to as having "twin deficits." The United States has fallen firmly into this category for years. According to Nomura FX Insights report from the 16th of February entitled "Twin deficits + inflation = weak dollar, current account balances are good explainers for FX performance. Both the Twin deficits in the US in conjunction with rising inflation expectations are good reasons to put forward for the weakness in the US dollar according to their report:

"USD/JPY’s plunge to levels last seen in late 2016 has caught many by surprise, but it fits neatly into a dollar downtrend narrative. Indeed, EUR/JPY has broadly been in a range since September last year, suggesting that we are not seeing a yen- or euro-specific move, but rather a dollar move. Remember, the euro is also seeing new highs – it has recently touched its highest level since late 2014.

We wrote recently that growing twin deficits in the US typically see the correlation between yields and the dollar breakdown and also that the dollar fares poorly during actual hiking phases. Another way of looking at this is correlations of G10 FX performance against current accounts or shifts in interest rates. Here we find that current account balances have asserted themselves as the best explainer of relative FX performance just as monetary policy has lost its grip on markets (Figure 1).

As for inflation, we also have written that the current combination of higher US inflation and loss of momentum in US growth surprises should weigh on the dollar. This has panned out. Again looking at correlations across a range of indicators, we find that FX is now negatively correlated with inflation levels.

In a world where twin deficits and inflation matter, the yen stands out. Japan has the lowest expected inflation in the G10 world. Core inflation is currently an anemic 0.1% compared with the recent 1.8% in the US. Japan is running a sizeable current account surplus and its fiscal balance is improving. Meanwhile, the US’s trade deficit is widening fast and the US is set to see its worst deterioration in its fiscal balance outside of a recession in modern history. All this suggests that dollar weakness could continue. We need to monitor the pace of the move, and Fed actions (more tightening to slow the economy) or even BoJ/ECB actions, but for now we’d look for USD/JPY to breach 100 and the euro to breach 1.30 in coming months." - source Nomura

In addition to the above interesting points made by Nomura, if the US dollar tends to weaken when inflation worsen, it also tends to strengthen when oil prices fall. When it comes to "Structured Criticality", the rapid fall in oil prices in 2015 was the grain of sand that led to the "avalanche" in risk-off and the significant widening in credit spreads that led to the weakness seen in equities in early 2016. Right now, the market has regained some posture thanks to financial engineering in the form of renewed buybacks and a strong M&A pipeline, until we get another unforeseen grain of sand, but that's a story for another day it seems.

"The epitaph on the grave of our democracy would be: They sacrificed the long-term for the short-term, and the long-term arrived" - Sir James Goldsmith

Stay tuned !