Credit - The Runaway Horse

"One way to stop a runaway horse is to bet on him." - Jeffrey Bernard, British journalist.

Looking at the trouble brewing in Emerging Markets, fuelled by outflows from "tourist" investors, as well by political turmoil, our chosen title is of course a reference to the Chinese New Year, placed under the sign of the "Wood Horse" which according to feng shui experts could be a "combustible" year. 

But, being movie "aficionados", our chosen title is as well a reference to 1907 early movie "The Runaway Horse". In this 7 minutes short movie a laundry man parks his horse-drawn cart to make a delivery. While he is inside, his horse sees a bag of oats and starts to eat them. By the time the man comes back outside, the horse has eaten a whole bag of oats, and has so much energy that he begins to race out of control. Of course any reference to the "unfortunate" emerging markets inflows/outflows courtesy of ZIRP/QE induced policies introduced by the FED and now leading to "reverse osmosis" in truly cinematic lingo would be truly fortuitous. 

The film "The Runaway Horse" was produced by Société Pathé Frères, a company created by four brothers in 1896 dealing with motion picture production and the distribution business. The two brothers also created Pathé records and both companies would become a dominant international force in their respective industries. Pathé became the world's largest film equipment and production company, as well as a major producer of phonograph records before the founders sold their international businesses in 1929. The company went bankrupt in 1935 under new ownership but we ramble again...

In this week's conversation we will focus on the contagion in Emerging Markets, which, in earnest has indeed increased as seen in the latest outflows coming out from the asset class in true "Runaway Horse" fashion we think. 

We did remind ourselves last week our musings from our previous conversation entitled "Misstra Know-it-all" that, when it comes to undoing the great "destabilizing" work from Ben Bernanke (aka "The Departed"), rising volatility would lead to re-calibration of risk exposure:

"Of course given volatility is on the rise and that VaR (Value at risk) has risen sharply from a risk management perspective, re-calibrating risk exposure could indeed accentuate the on-going pressure of reducing exposure to Emerging Markets, triggering to that affect additional outflows in difficult illiquid markets to make matters worse."

When it comes to volatility, Emerging Market VIX has indeed surged the most in two years as reported by Nikolaj Gammeltoft and Callie Bost from Bloomberg on the 27th of January 2014 in their article "Emerging-Market VIX Surges Most in Two Years on Selloff":

"Equity volatility from India to Brazil and Turkey jumped the most in two years as turmoil spread across global markets amid a selloff in developing-country currencies and growing concern over China’s economy.

The Chicago Board Options Exchange Emerging Markets ETF Volatility Index rose 40 percent to 28.26 last week, the biggest increase since September 2011, according to data compiled by

Bloomberg. Bearish bets outnumber bullish ones on the underlying exchange-traded fund by the most since July with about 60 percent more puts than calls. Developing-nation stocks extended declines from a 4 1/2-month low today, with MSCI’s Emerging-Markets Index losing 1.2 percent by 1:09 p.m. in Hong Kong.

The devaluation of Argentina’s peso, data signaling a possible contraction in China’s factory output and declines from the Turkish lira to the South African rand shook investor confidence. Emerging-market equities have tumbled since the Federal Reserve signaled in May that it could start scaling back bond purchases that boosted demand for higher-yielding assets.

“There’s concern that the downtrend may continue,” Walter “Bucky” Hellwig, who helps manage $17 billion at BB&T Wealth Management in Birmingham, Alabama, said by phone Jan. 24. “Protection is being purchased or bets are being made that it will.”

The MSCI emerging-markets gauge fell 2.3 percent to 949.90 last week, extending this year’s slump to 5.3 percent. The European equity benchmark lost 3.3 percent, while the Dow Jones Industrial Average sank 3.5 percent for the biggest weekly decline since May 2012." - source Bloomberg

In last week's conversation we also underlined what Nomura indicated at the time of our September 2013 "Misstra Know-it-all" conversation, the risk of the situation turning nasty for lack of liquidity is significant:

"Bad liquidity markets saw asset swaps widen considerably (making swap paying less of a hedge) and start to trade like credit products. This phenomenon, if it continues, could result in a lot of proxy hedging through FX, FX vol, buying CDS and, at a more serious stage, selling what investors could unwind."

According to Bloomberg, investors traded almost 600,000 puts on the iShares MSCI Emerging Markets ETF on Jan. 24, three times the average from the past 20 days, data compiled by Bloomberg show. About 150,000 calls changed hands, 45 percent more than the mean.

One space though where volatility has not been contained has been of course in the bond space, as depicted by the significant evolution of the MOVE index in 2013. But what we have seen in Emerging Markets currencies in early 2014 has indeed been in the rapid surge of the EM VYX index, following the Fed's tapering stance:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market currencies. The index is based on three-month at-the-money forward options, weighted by market turnover.

So what you have in Emerging Markets is the above playing out: namely proxy hedging in the first place and additional "de-risking" taking place as indicated by Bank of America Merrill Lynch's note on the 30th of January 2014 entitled "First Signs of Panic", the stampede in Emerging Markets has somewhat started in earnest, validating amply our chosen title:

"Largest EM equity fund outflows since Aug’11 ($6.4bn); $15bn outflows over next 2-3 weeks triggers contrarian “buy” signal from our EM Flow Trading Rule (Chart 1).

Largest EM debt fund outflows since Jun’13 ($2.7bn); selling concentrated in LDM (local debt markets).

EM debt & equity funds see combined outflows of $9.1bn; magnitude almost rivals outflows during Taper (May’13), Debt Ceiling (Aug’11) & Lehman (Sep’08) (Chart 2).

$6.4bn outflows from EM equity funds (largest since Aug’11) (14 straight weeks of outflows = tied for longest outflow streak on record.

4-week outflows from EM equities = 1.4% of AUM; another $15bn outflows over next 2-3 weeks would trigger contrarian “buy” signal from our EM Flow Trading Rule (3.0% is threshold)

- source Bank of America Merrill Lynch.

Of course, the use of our Jeffrey Bernard as our "commencing" quote, is by no way innocent. 

While it is too early to become "contrarian", we will be patiently monitoring the EM space waiting for the herd of "runaway horses" (namely tourists) to vacate the place as no doubt, opportunities will materialise eventually. 

On that subject we agree somewhat on the subject with Skagen AS, the Norwegian fund top Emerging Markets manager, as reported by Jonas Bergman in Bloomberg on the 29th of January in his article "Emerging Market Bull Who Beat Wall Street Sees Rout Passing":

"Skagen AS, the Norwegian fund manager who has outperformed some of Wall Street’s biggest banks over the past decade, is urging clients to sit out the turmoil gripping developing nations.

Kristoffer Stensrud, whose 50 billion-krone ($8 billion) Kon-Tiki A emerging market fund has returned an annualized 14 percent over the past 10 years, said there’s “nothing new really” in the recent turbulence, in an e-mailed reply to questions. He characterized the moves as “some contagion” in Latin America from Argentina, while reactions in the east remained “calm.”

“Emerging market economies hit by currency falls will probably be more competitive going forward,” according to 60-year-old Stensrud, who started Skagen in 1993. A lack of inflationary pressure from commodities will also be “positive,” giving a longer period with “low inflation and low interest rates in developed markets than generally perceived presently,” he said." - source Bloomberg.

Skagen AS are not the only ones taking the long term "macro" views, for instance legendary Mark Mobius chairman of Templeton Emerging Markets Group is also sitting in the "contrarian" camp as indicated by Jaco Viser in Bloomberg on the 29th of January in his article "Mobius Sees Money Flowing Back Into Emerging Markets on Growth":

"Mark Mobius, chairman of Templeton Emerging Markets Group, said inflows into developing nations will resume later this year following a selloff triggered by the Federal Reserve tapering monetary stimulus.

“People are enjoying what they see as a bull market in the U.S.,” he said in an interview in Johannesburg today. “As we go forward, we’re going to see a lot of overweight positions in the U.S. So, given the fact that emerging markets are still growing fast, given that they have low debt-to-GDP ratios, given that they have high foreign-exchange reserves, we believe that money will be flowing back in again to emerging markets.”

Investors sold $1.87 trillion in stocks worldwide in the week to Jan. 27 ahead of the Fed’s two-day meeting, which ends today, where the central bank will announce reducing bond purchases by a further $10 billion next month, according to the median estimate of 78 economists surveyed by Bloomberg. The selloff spurred a rout in emerging-market currencies with central banks in Turkey, India and South Africa unexpectedly

increasing benchmark interest rates.

The effectiveness of higher interest rates “depends on the country and it depends on the degree,” Mobius, 77, said. “In India it is working OK. The jury is still out on Turkey. The picture becomes a little complicated in certain countries because of upcoming elections. Despite the rise in interest rates, you’re not going to see a big, big flow back in, but it will eventually come.”" - source Bloomberg

We might be short-term pessimists, but, overall we remain long term optimists for Emerging Markets. 

After all, as we did indicate back in March 2012, that, when it comes to "Equities, there is life (and value) after default!". Russia, Argentina, Iceland, and as of late Greece are all living proofs that there life (and value!) after a default.  It turns out that our "early call" on Greece based on our long-term macro analysis rewarded handsomely investors in 2013 as presented by Namitha Jagadeesh in Bloomberg in October 2013 in his article "Greek Recovery Makes Stocks World’s Best as Paulson Buys":

"Since June 5, 2012, two weeks before MSCI Inc. gave notice it may reclassify Greece as an emerging market, the country’s ASE Index (ASE) has surged 146 percent, trimming the decline from its 2007 peak to 79 percent. The gains topped all 94 national benchmarks globally in the period, except Venezuela, according to data compiled by Bloomberg. Yields on Greece’s 10-year government bonds have dropped to 8.31 percent from a peak of 33.7 percent in March 2012." - source Bloomberg.

When it comes to opposing credit to equities, we have also argued in 2013 in our conversation "Credit versus Equities - a farming analogy", the following:

"-Bonds = Tenant farming

-Equities = Metayage

Therefore when ones look at credit volumes, you need to not only include the total of financial claims but as well equities.

When there is a recession or even worse a depression, equities will fall towards zero, in the case of bankruptcy. It is a very painful but it is a very fast adjustment.

The increasing recourse towards bond issuing by companies will be increasing "difficulties" at the end of the on-going credit cycle, when entering a recession or depression.

What has made the resounding success of the US economy throughout many decades was its capitalistic approach and recourse to equities issuance for financing purposes rather than bonds.

We believe the global declines in listings is indicative of growing instability in the financial system and increasing risk as a whole." - Macronomics - 15th of October 2013

So before betting on the "runaway horse", you need to see a clear "restructuring" such as what happened with Greece, or Russia, before setting up a hugely profitable "contrarian" bet but currency hedged we think.

When it comes to "true" returns, of course, one need to take into account the currency effect. 

"Big in Japan", yes we had "lift-off in risky assets" or "Risk-On" that is, in Japan in 2013, as indicated in the below graph where we have been monitoring the USD/JPY exchange rate, the Nikkei index and the credit risk Itraxx Japan CDS spread (inverted) - source Bloomberg:

While we recommended last year to go long Nikkei in euro terms, a similar strategy would have been successful with countries such as Argentina as displayed in Bloomberg's recent Chart of the Day displaying 105% stock gain as long as you ignore inflation and depreciation of the currency:

"Argentine stocks posted some of the best returns in the world in President Cristina Fernandez de Kirchner’s second term, as long as you ignore inflation and depreciation. In reality, they were among the worst.

The CHART OF THE DAY shows that while the Merval index doubled in peso terms since her re-election Oct. 24, 2011, the shares lost 15 percent once returns were converted to dollars at the rate investors use to avoid currency controls. While the 105 percent local-currency return was the fifth-biggest among 94 indexes globally during the period, the drop in dollar terms made the gauge the world’s 12th-worst performer.

“Argentina is a high-risk, high return market and there has been more risk than return lately,” said Eric Conrads, a money manager who helps oversees $750 million of Latin American stocks at ING Investment Management in New York. He said he sold the last of his Argentine shares last year.

Fernandez devalued the peso last week in a bid to shore up foreign reserves that sunk to a seven-year low amid a surge in government spending, inflation estimated at about 30 percent and declining prices for the country’s soy and wheat exports.

Restrictions on dollar purchases mean investors use the so-called blue-chip swap, under which local assets are sold abroad for foreign currency at a discount to the official exchange rate of 8.0177 per dollar.

The blue-chip rate of 11.5697 pesos per dollar has depreciated 58 percent since the election, more than the 47 percent drop in the official rate and the worst among 31 major dollar counterparts. “The intelligent people in Argentina invest in property,” Conrads said." - source Bloomberg

When it comes to Argentina's woes, Bank of America and Moody's suggest that only 40% interest rate can arrest Peso's fall as reported by Katia Porzecanski and Camila Russo on the 30th of January in their article "Only 40% Interest Rate can Arrest Peso's Swoon":

"Argentina’s decision to ratchet up interest rates to 24 percent is failing to convince Bank of America Corp. and Moody’s Analytics Inc. the nation can stem demand for dollars in the wake of the peso’s devaluation.

Argentina needs to offer 37.5 percent to attract enough investors to halt peso losses, according to the average of five forecasters surveyed by Bloomberg News, even after the nation’s benchmark deposit rate surged 2 percentage points this week to a five-year high. Bank of America says a rate of 40 percent is needed to effectively compensate for consumer prices rising an estimated 28 percent annually.

 While the devaluation was intended to bolster the nation’s foreign reserves that were depleted as the central bank sold dollars to support the peso’s official rate, Argentina faces the prospect of savers dumping a currency that has lost more value than any time in a decade. Higher interest rates would mirror increases by developing nations such as Turkey, which doubled its benchmark rate to shore up the lira, as the Federal Reserve fuels a rout in emerging-market currencies by paring stimulus.

“Argentina’s got to do something similar,” Daniel Kerner, an analyst at political consultancy Eurasia Group, said in a telephone interview from Washington. “I get the feeling they don’t have a clear strategy, they don’t really understand the problem and they don’t believe in incentives.” Kerner said Argentina needs to lift its deposit rate to 40 percent to boost demand in the peso, which has lost 18.5 percent this year." - source Bloomberg.

Unfortunately, this time "it's different" we think. As it seems in Argentina, not only FX reserves have been disappearing fast, but confidence in the currency as well has completely vanished, meaning Argentina is experiencing yet again another bout of hyperinflation in the process. In that context, the "runaway horse" has further to go, given that ZIRP, and QEs have led to increased connectivity and positive correlations and therefore negative feedback loops. We agree with Nomura's recent take on Argentina from the 24th of January entitled "Argentina: Bowing to the inevitable":

"Devaluation of the Argentinean peso this week, in our view, is the inevitable result of an unsustainable mix of monetary and fiscal policies. The move is probably intended to preserve falling reserves, yet greater exchange rate volatility could open up a series of political and economic uncertainties. Developments in Argentina have generated knockon effects in Brazil, and the risk of contagion across EM has now become more real." - source Nomura

When it comes to rising risks, negative feedback loops and positive correlations, its biggest trading partner Brazil is in the front line according to Nomura's note:

"The events in Argentina have generated knock-on effects across the region, especially for Brazil, which has Argentina as its third largest trading partner after China and the United States (Figure 7). 

In terms of real exchange rates, ARS has grown steadily stronger than BRL since mid-2011 (Figure 8). 

Given the expanding current account deficits in Brazil, there is a risk of BRL suffering in sync with a weaker ARS." - source Nomura

Given that in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off, no wonder Brazil will suffer from the "competitive" sudden devaluation from its largest trading partner.

In blue the Brazilian real versus the US dollar, in red the Australian dollar versus the US dollar, as one can see the correlation between the Australian currency and the Brazilian real broke down spectacularly in 2011- source Bloomberg:

In similar fashion to Brazilian woes stemming from Argentina's devaluation, Australia is exposed clearly to China's tightening stance and commodities slowdown.

If all is well when it comes to the world growth outlook, maybe someone can tell us why Copper futures are headed for the longest slump in 15 months? In similar fashion all is not well for Iron Ore, as displayed in the below graph from Bloomberg:

Or maybe our preferred credit and deflationary indicator, namely shipping and the Baltic Dry Index, recent weakness is only a "temporary" blip in the much vaunted "recovery"? Graph source Bloomberg:

Our biggest concerns doesn't lie much in sovereign woes but much more to surging defaults risks in the corporate space, given since May 2011, Brazilian companies have sold the most junk bonds on record and accounted for 81% of Brazil's corporate debt sales versus 34% globally, another consequences of ZIRP on "mis-allocation" of capital. The recent default of OGX in Brazil on $3.6 billion of bonds is a stark reminder of default risk in the Emerging Corporate sector.

Of course it interesting to read that the Brazilian oil company OGX has been delaying a restructuring for a second week in after BlackRock and Blackstone Group pulled out of the deal as reported by Bloomberg.

It reminds us of one of our quotes:

"He who rejects restructuring is the architect of default." - Macronomics.

What is of interest to us of course is that what credit investors forget in this deflationary environment, is that, as we argued in November 2011 in a low yield environment, defaults tend to spike and it should be normally be your concern credit wise (in relation to upcoming defaults) for High Yield, not inflation. A rise in defaults would likely be the consequences of a deterioration in credit availability. Credit ratings are in fact a lagging indicator.

When it comes to European exposure to Emerging Markets, Nomura in another note entitled "Assessing the linkages between EM and the euro area" published on the 27th of January, gives us more insight:

"After reviewing the trade and financial linkages, we conclude that a protracted slowdown in these countries would shave around 0.1 percentage point (pp) from euro area GDP growth. This compares to the 0.3pp reduction observed in the China/Asia slowdown simulation that we conducted last summer.

-Unsurprisingly, Spain and its banking sector are most exposed. However, it is important to note that these subsidiaries across LatAm operate as fully independent entities, supported by capital retained at the local level and funding that is independent from the parent company. As a result, most of the risk to BBVA and Santander stem from the potential lower earnings contribution.

-Among the Spanish banks, we believe BBVA is most at risk to FX markets given its greater exposure to Argentina, Venezuela and Turkey. While this is partly reflected in our earnings estimates, it may not be reflected in the consensus.

-In our view, risks to the euro area do not stem from a country-specific bout of volatility in select emerging markets, like the one taking place in Argentina, but rather from a broad-based EM slowdown, which would have potential to threaten the region's recovery. In this sense, we view the past week as more of a warning should contagion become more entrenched and broad-based across EM." - source Nomura

In terms of banking exposure, Spain is the most exposed according to Nomura's note:

"Financial channels: The bank exposure channel – the case of Spain

European banks are known to be significantly exposed to Latin America. Figure 7 shows that European banks had EUR564bn of claims against Latin American countries and EUR136bn of claims against Turkey.

When looking at the various European countries, Spain is clearly most exposed, with around EUR160bn of claims against stressed countries or about 5% of its total banking assets. Importantly, these subsidiaries across LatAm operate independently from the parent, with capital retained at the local level and independent funding from the parent company. As a result, most of the risk to BBVA and Santander stems from the potential for a lower earnings contribution." - source Nomura

On a final note, Oil and Mining Stocks are the most exposed to Emerging Currency risk as displayed by Bloomberg's Chart of the Day from the 30th of January:

"Energy and raw-material producers may have the most at stake among U.S. stocks as emerging-market currencies fall, according to Gina Martin Adams, a Wells Fargo & Co. strategist.

The CHART OF THE DAY shows the relationship between the MSCI Emerging Markets Currency Index and the Standard & Poor’s 500 Energy Index since March 2009, when the shares began their

current bull market.

MSCI’s index dropped this week to its lowest reading since September as the Russian ruble, South African rand, Turkish lira and other currencies tumbled against the dollar. Each currency’s weight matches the country’s proportion of the MSCI emerging-market stock index.

“High correlations between emerging-market currencies and commodity prices suggest commodity-sensitive sectors in the S&P 500 are likely to suffer most” as the decline worsens, Martin Adams wrote in a Jan. 24 report.

Oil and gas stocks were the most closely linked to the foreign-exchange index among 64 industry groups in the S&P 500, according to data that the New York-based strategist cited. The correlation was 0.94 since January 1999, when MSCI started its calculations. Comparable figures for chemicals and mining were 0.87 and 0.66, respectively. The highest potential reading was 1, showing the currency and stock indexes moved in lockstep.

China’s yuan, South Korea’s won and the Taiwan dollar account for about half of the MSCI index’s value, the report said. Argentina’s peso is excluded because MSCI classifies the country as a frontier market, not an emerging market. The peso was devalued by 15 percent last week." -source Bloomberg

In relation to gold, once forced liquidation hits EM and wipe out leveraged players and "carry" tourists, gold could go lower first for these simple 3 reasons:

"-He who has the gold, does not always make the rules.

-The market does not learn for long.

-Human nature does not change."

"When you have got an elephant by the hind legs and he is trying to run away, it's best to let him run." - Abraham Lincoln

Stay tuned!

Credit - Osmotic pressure

"We want a story that starts out with an earthquake and works its way up to a climax." - Samuel Goldwyn 

Looking at the continued sell-off in Emerging Markets currencies with the Indian Rupee touching a record low level of 65.56 before bouncing back by 2.1%, on Friday the biggest move since June 2012 and the Brazilian Real which continued its slide before bouncing back as well 3.7% to 2.3488 following a 60 billion US dollar central bank pledge, made us venture towards our distant memories, in similar fashion like our previous posts made us revisit our musical souvenirs from the 80's.

Emerging Currencies "tapering" in true MMA fashion since Bernanke started mentioning "tapering" its QE programme, graph source Thomson Reuters Datastream / Fathom Consulting / Macronomics:

So why "Osmotic pressure" as our chosen title you might rightly ask?

This time around, our chosen title is directly linked to capital flows we are seeing, with the outflows from Emerging Markets towards Developed Markets. 

As the Osmosis definition goes:

"When an animal cell is placed in a hypotonic surrounding (or higher water concentration), the water molecules will move into the cell causing the cell to swell. If osmosis continues and becomes excessive the cell will eventually burst. In a plant cell, excessive osmosis is prevented due to the osmotic pressure exerted by the cell wall thereby stabilizing the cell. In fact, osmotic pressure is the main cause of support in plants. However, if a plant cell is placed in a hypertonic surrounding, the cell wall cannot prevent the cell from losing water. It results in cell shrinking (or cell becoming flaccid)." - source Biology Online.

Nota bene: Hypertonic

"Hypertonic refers to a greater concentration. In biology, a hypertonic solution is one with a higher concentration of solutes on the outside of the cell. When a cell is immersed into a hypertonic solution, the tendency is for water to flow out of the cell in order to balance the concentration of the solutes." - source Wikipedia

So the reasoning behind our chosen title is linked to our past "biology" classes of course, given since 2009, the effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility.

We did send a warning in June in our conversation "The Daisy Cutter":

"If you think rising yields are only putting global trade at risk, think as well how it will ripple through in various sectors and countries." - source Macronomics 

This is what we envisaged in our conversation "Singin' in the Rain" as well:

"If the dollar goes even more in short supply courtesy of Bernanke's "Tap dancing" with his "Singin' in the Rain", could it mean we will have wave number 3 namely a currency crisis on our hands? We wonder..."

The mechanical resonance of bond volatility in the bond market started the biological process of the buildup in the "Osmotic pressure" we think and bond volatility has yet to recede. 

The volatility in the fixed income space has remained elevated as displayed by the recent evolution of the Merrill Lynch's MOVE index rising from early May from 48 bps  towards the 100 bps level again, whereas the VIX, the measure of volatility for equities is finally reacting - graph source Bloomberg:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

Of course, what we have been tracking with interest is the ratio between the ML MOVE index and the VIX which remains elevated from an historical point of view if we look back since October 2000 - graph source Bloomberg:

With VIX picking up, no wonder the ratio between the MOVE index and VIX has fallen from last week 7.06 level towards 6.10 as the contagion in the equities space is finally picking up. Hence, last week our "Fears for Tears" concerns for our equities friend as the "tapering" noise increases as we move towards September.

As a reminder, we started pondering about the potential end of the goldilocks period of "low rates volatility / stable carry trade environment in June:

"As pointed out by Bank of America Merrill Lynch's note stable carry thrives in low rates volatility environment, the recent spike in US bonds volatility has had some devastating effect in high yielding assets:

"Carry trades love low risk-free interest rates, but they love low interest rate volatility even more. This is why over the past three years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving their risk premiums to abnormally low levels."

So what we are witnessing right now is indeed "reverse osmosis" in Emerging Markets, and the osmotic pressure which has been building up is no doubt leading to an "hypertonic solution" when it comes to capital outflows in Emerging Markets.

Let us explain:

In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment.

So in this week's conversation, as we moved towards the "interesting" month of September we will revisit some of our thoughts from our conversation "Singin' in the Rain" and look at the risk and opportunities lying ahead.

As a reminder from our June conversation:

"We got seriously wrong-footed by the market's reaction to the "tapering QE" scenario and we still think at some point the Fed will maybe redirect its buying towards MBS, given that rising rates could seriously dent any hope of a "housing recovery" should the move continue at a rapid pace like it has this week."

The "housing recovery is indeed at risk - graph source Thomson Reuters Datastream / Fathom Consulting:

As indicated by Prashant Gopal on the 22nd of August in Bloomberg in his article "U.S. Mortgage Rates Jump to Two-Year High With 30-Year at 4.58%": 

"The average rate for a 30-year fixed mortgage rose to 4.58 percent this week from 4.4 percent, Freddie Mac said in a statement today. The average 15-year rate climbed to 3.6 percent from 3.44 percent, the McLean, Virginia-based mortgage-finance company said. Both were the highest since July 2011.

Homebuyers are rushing to take advantage of historically low borrowing costs before they increase any more. Existing-home sales in July jumped 6.5 percent to the second-highest level in six years, the National Association of Realtors reported yesterday. Those transactions largely reflect closings of contracts signed a month or two earlier, when mortgage rates were just beginning to edge up." - source Bloomberg

From the same article:

"The Mortgage Bankers Association’s index of applications to lower monthly payments fell 7.7 percent in the week ended Aug. 16, the 10th straight decline. A measure of purchases rose 1.2 percent, the trade group said yesterday.

The 30-year fixed mortgage rate is well below its average of about 6.3 percent for the past 20 years, according to data compiled by Bloomberg. The 20-year average for a 15-year loan is about 5.83 percent." - source Bloomberg

Yes but, there is indeed a "convexity issue at play" given the US average Maturity of Fixed Rate Mortgages has been steadily increasing in the last decades - graph source Thomson Reuters Datastream / Fathom Consulting:

 And as our very wise credit friend former head of credit research said on the subject of convexity in June in our conversation "Singin' in the Rain":

"Convexity is a bigger issue in all the pensions + fixed income funds. That's one reason mortgages have been whacked. the Fed will basically have to do a ECB - stop buying USTs and start buying RMBS. But pensions (or Fannie / Freddie) do not hedge MBS with USTs - they do it with LIBOR"

At the time we argued:

"The Fed is likely to step in and actually increase QE to try and hold rates down, because mortgage rates have spiked substantially over the last month from a low of around 3.5% to around 4.3%, we have to agree with our friend that a "new dance" routine from the Fed might be coming." 

Central Banks Assets - graph source Thomson Reuters Datastream / Fathom Consulting:

Why the Fed might indeed increase QE? 

Point number 1:

Because the Fed is facing a raft of sellers and the economy is not as strong as it seems.

For instance, China’s holdings in May were $1.297 trillion, less than the $1.316 trillion reported by the Treasury last month. China’s stake dropped by $21.5 billion in June, or 1.7 percent according to Bloomberg as per Treasury Department data released on the 14th of August. On top of that US Commercial Banks as well have been selling as indicated by Bloomberg Chart of the Day from the 19th of August - graph source Bloomberg:

"U.S. commercial banks are dumping Treasuries at the fastest pace in a decade and boosting loans, helping make the debt securities the world’s worst performers as the economy gains momentum.

The CHART OF THE DAY shows banks’ holdings of U.S. Treasury and agency debt tumbled $34.7 billion to $1.81 trillion in July, the biggest monthly decline in 10 years, according to the Federal Reserve. The level dropped to $1.79 trillion in the first week of August, Fed data showed on Aug. 16. Also tracked are 30-year bond yields climbing to a two-year high. The lower panel records commercial and industrial loans as they surged to $1.57 trillion, the highest since 2008.

Bank sales of Treasuries accelerated after Federal Reserve Chairman Ben S. Bernanke said on June 19 policy makers may reduce the bond-buying program they use to support the economy. Concern the Fed will trim its $85 billion a month of Treasury and mortgage purchases helped send notes and bonds due in a decade or longer down 11 percent in the past 12 months. It was the biggest loss of 174 debt indexes tracked by Bloomberg and the European Federation of Financial Analysts Societies." - source Bloomberg.

Point number 2:

Our "omnipotent" magicians are desperately trying to "bend" the velocity curve and anchor higher inflation expectations. On that note we read with interest Professor Rogoff comments in Bloomberg article by Aki Ito and Michelle Jamrisko on the 12th of August - "Rogoff Saying This Time Different Calls for Reflation":

"Rogoff is espousing aggressive monetary stimulus, even at the cost of moderate price increases. At a time of weak global inflation, higher prices may even help the U.S. economy by lowering real interest rates and reducing debt burdens, he said.

“In more normal times, you’re looking for the central banker to be an anchor against high inflation expectations and to assure investors that inflation will stay low and stable to keep interest rates down,” Rogoff, co-author with Carmen Reinhart of the 2009 book “This Time Is Different: Eight Centuries of Financial Folly,” said in an interview. Now “we’re in this situation where many of the central banks of the world need to convince the public of their tolerance for inflation, not their intolerance.”

G-7 Inflation

Central banks across the developed world are struggling with inflation that’s too low. Consumer price increases in all but one of the Group of Seven economies are currently running under 2 percent, which has become the standard goal in recent years for monetary authorities. Two years ago, deflationary Japan was the only country struggling with below-target inflation."  - source Bloomberg.

The only issue is once 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”

While the recent jump in interest rates, has created an "hypertonic surrounding" in the reverse osmosis plaguing Emerging Markets, it has had some positive effect somewhat for the insurance sector as well as the Auto Industry given that it has provided some relief in terms of "reserve adequacy" for insurers and a relief on "reinvestment rates" to plug the growing gap in pensions liabilities hindering the allocation of capital for the Car industry giants.

As a reminder from our conversation "Cloud Nine": 

"If we look at GM and FORD which went into chapter 11 due to the massive burden built due to UAW's size of "unfunded liabilities", they are still suffering from some of the largest pension obligations among US corporations. Both said this week they see a significant improvement in their pension plans liabilities because of rising interest rates used to calculate the future cost of payments. When interest rates rise, the cost of these "promissory notes" fall, which alleviates therefore these pension shortfalls. So, over the long term (we know Keynes said in the long run we are all dead...), it will enable these companies to "reallocate" more spending on their core business and less on retirees. Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2."

But, of course, what matters is indeed the "velocity" of the movement, and the intensity. So far we have avoided a major sell-off in credit. 

As indicated by Megan Hickey and Zachary Tracer in their Bloomberg article from the 1st of August commenting on US insurer's Metlife's results entitled "Metlife Says $10.9 billion of Bond Gain Erased, More Than Crisis", what matters is the pace of the rise in interest rates:

"MetLife Inc., the largest U.S. life insurer, saw $10.9 billion in bond gains wiped out in the three months ended June 30 as interest rates rose, exceeding the decline in any quarter of the financial crisis.

Net unrealized gains narrowed to $20.9 billion on the portfolio of available-for-sale fixed-maturity securities, from $31.8 billion three months earlier. The tumble helped cut MetLife’s bond holdings about 4.8 percent to $356.5 billion." - source Bloomberg

They also added the following comments from a Fitch Ratings analyst:

"Losses tied to deterioration in the creditworthiness of issuers are more worrisome than the more recent fluctuations related to interest rate movements, said Douglas Meyer, an analyst at Fitch Ratings. He said higher rates can help increase investment income at insurers and improve profitability on some products.

“The jump in interest rates, the way we look at it, it has a positive impact on the industry,” he said. “This will provide relief in terms of reserve adequacy, it will provide relief on reinvestment rates.”

An extreme spike in rates of more than 5 percentage points could hurt insurers, he said. Clients might redeem products that offered lower yields, forcing insurers to sell securities at a loss to meet withdrawal demands, he said." - source Bloomberg.

We quoted our fellow blogger and friend Martin Sibileau back in June in "Singin' in the Rain" on the risk ahead for credit:

"If Ben triggers a sell off in credit with the insinuation of tapering, the dealers on the other side, making the bid for the investors, will be forced to do the rate hedge their investors did not do, because they must be interest rate neutral! That means selling US Tsys for an average of 85% and 50% of positions in HY and IG respectively! In other words, the potential sell-off tomorrow may trigger a surprising self-feeding convexity. How are precious metals to react in such scenario?" - Martin Sibileau

And as we discussed above, "macro" osmosis has led to "positive correlations". When it comes for risks ahead, we share CITI's Matt King views from his European Credit Weekly, namely that after a pleasant summer for credit, it might be time indeed to continue to reduce exposure to neutral:

"Dominoes

One of my favourite games as a child was always dominoes. No, not the rather tedious business of laying tiles end to end and trying to match up their spots.

Rather, the much more thrilling challenge of creating long and winding lines before knocking them over, and being amazed at the far-reaching devastation which could be caused with a single flick of the finger.

European credit feels at present to us like the last asset in a similarly long chain – seemingly remote from the problem of higher UST yields, almost immune to date to the outflows starting to occur elsewhere, and yet nevertheless with an intricate linkage to other assets which belies its apparent distance.

Ironically, our best guess has been and remains that the domino run will not quite get started in the first place – or, at a minimum, that some benign and omnipotent central banker will reach in to remove a domino or two and stop any run before it reaches us. Our house forecasts show the UST backup abating, show credit spreads remaining tight, and the EM sell-off remaining contained to mid-2014.

Moreover, it is striking just how well spreads have generally performed in the face of the backup in UST yields to date. EM hard currency mutual funds, for example, have lost nearly one-third of the last three years’ cumulative inflows (Figure 2), against which the backup in EM spreads, while notable, is hardly cataclysmic. 

The outflows from credit funds have been tiny by comparison, and in Europe have been almost negligible. Unless outflows pick up very significantly, there is every reason to think € spreads remain resilient." 

Besides, in many respects the risks as we head into September seem rather obvious. Tapering has been extremely well flagged. The Fed minutes suggest it will happen this year, but did not seem overly attached to our view of a September start.

German elections have been talked about a great deal, but seem ever less likely to bring about a significant change in the political landscape. Conscious corporate releveraging seems largely confined to the US. Supply is likely to pick up significantly, but is likely to have been widely anticipated. Above all, we have little sense of any build-up in complacent longs during the summer in the way we earlier feared, as is vouched for by the lack of outperformance of most high-beta names.

And yet despite all this, we still recommend reducing any remaining longs in € credit to neutral." - source CITI

CITI's Matt King also added:

"When playing dominoes, it usually takes a few goes before the run really gets started (unless, of course, you didn’t mean for it to start, in which case there’s no stopping it). Our best guess is likewise that, despite the somewhat precarious lineup, not a great deal happens over the next few weeks, and that spreads trade more or less sideways.

But that’s a bit like leaving the room and hoping that when you come back later you’ll still find all the dominoes standing just as you left them. As those with younger brothers will know, you ought to be okay – but at this point we just don’t think you’re being paid for it." - source CITI

The issue for us is that from a "macro" perspective, if the reverse "osmosis" has truly started and with "positive correlations" still in place, there is indeed not only heightened risk from the continuation of the sell-off in Emerging Markets which could affect Developed Markets in the process, but, exogenous factors with political tensions and agendas could indeed roil further risky asset classes.

The $3.9 trillion of cash that flowed into emerging markets over the past four years has started to reverse, indicative of the "Osmotic Pressure" and "reverse osmosis" process taking place.

As we posited back in June for Emerging Markets:

"Why are we feeling rather nervous?

If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?" - source Macronomics, June 2013, "Singin' in the Rain"

Moving back to our friend Martin Sibileau's June question on "precious metals":

"In other words, the potential sell-off tomorrow may trigger a surprising self-feeding convexity. How are precious metals to react in such scenario?"

At the time we argued that precious metal had further to fall and they did.

But, as we move towards September and what has already started is a bounce back. In similar fashion to what we confided in our January conversation "If at first you don't succeed...", we have once again put in practice the effect of our magicians ("omnipotent" central bankers practicing their "secret illusions") by starting being long gold miners via ETF GDX and some selected miners as well.

The S&P 500, the US 10 year breakeven, please note we have added Gold into our previous Chart,  graph source Bloomberg:

Once again we have broken our Magician's Oath:

"As a magician I promise never to reveal the secret of any illusion to a non-magician, unless that one swears to uphold the Magician's Oath in turn. I promise never to perform any illusion for any non-magician without first practicing the effect until I can perform it well enough to maintain the illusion of magic."

What is the rationale behind our call? We once again come back to our June conversation "Singin' in the Rain" where we quoted David Goldman's article about Gold and Treasuries and bonds in general which he wrote in August 2011 (the former global head of fixed income research for Bank of America):

"Why should gold and Treasury bonds go up together? Gold is an inflation signal and bonds are a deflation hedge. At first glance it seems very strange for both of them to rise together. Why should this be happening?

 The answer is simple: bonds are an option on the short-term interest rate, and gold is a perpetual put option on the dollar. Both rise with volatility.

 It’s like the old joke about the thermos bottle: “How does it know if it’s hot or cold?” If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. By put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

Our thermos bottle is lately behaving accordingly because the YTD movements in 5 year forward breakeven rates is falling again, which is indicative of the strength of the deflationary forces at play - source Bloomberg:

The 5 year forward breakeven was at 2.56% on the 21st of August but it has been breaking lower as per the most recent reading - graph source Thomson Reuters Datastream / Fathom Consulting:

QE and the US Dollar - graph source Thomson Reuters Datastream / Fathom Consulting:

Dollar index versus Gold - graph source Bloomberg:

So far we have bought the put leg of the put-call parity strategy and we are indeed thinking of adding the call leg shortly. That's all for magic tricks. We enjoy your company, dear readers, but we should not be breaking our Magician Oath too often as you haven't sworn to uphold the Magician's Oath in turn yet...

On a final note, in true Pareto efficient economic allocation, while some pundits wager about simultaneous developments having contributed to the weakness in Emerging Market equities, for us Emerging Markets have been simply the victims of currency wars ("Have Emerging Equities been the victims of currency wars?"), "Abenomics", and of course "reverse osmosis" courtesy of positive real interest rates in the US. It is therefore not a surprise to see that the biggest beneficiary of "reflationary"policies have indeed been the Japanese as displayed in Bloomberg's Chart of the Day from the 22nd of August displaying the Earnings Per Share for 6 regions:

"Prime Minister Shinzo Abe’s policies to lower the yen and end deflation are already paying off for corporate earnings, with Japanese companies’ profits outpacing the rest of the world.

The CHART OF THE DAY shows earnings per share in six regions tracked by Bloomberg rebased to 100 at the end of June 2011. Profits for the Topix climbed the most, rising 32 percent as companies in Japan’s equity benchmark recovered from the March 2011 earthquake that damaged large parts of the country’s north east. The lower panel of the chart shows the yen’s decline against nine other world currencies.

“Japan has been through a full earnings cycle over the past two years,” said Mert Genc, a London-based strategist at Citigroup Inc., which composed the graph. “First, largely as a result of the earthquake, earnings halved. But then they doubled again, with the latest boost coming from weakness in the yen and improving economic performance.”

Japanese exports jumped by the most since 2010 in July, showing the economy has benefited from the yen’s 22 percent slide against the dollar since the end of 2011. Earnings in the U.S. have climbed 16 percent since June 2011 as the Federal Reserve’s bond-purchasing program helped to stimulate growth. Profits in the U.K., the euro area, emerging markets and Australia have declined in the same period.

Analysts estimate earnings in the Topix will grow 11 percent in 2014, according to Bloomberg data, in line with the average for the other regions in the chart of the day." - source Bloomberg.

The MSCI Emerging Markets Index has declined 12 percent this year, compared with a 12 percent gain for the MSCI World Index of companies in advanced economies.

"Remember, the storm is a good opportunity for the pine and the cypress to show their strength and their stability." - Ho Chi Minh 

Stay tuned!

Credit - Fears for Tears

"A person's fears are lighter when the danger is at hand." - Lucius Annaeus Seneca

In continuation to our musical title analogies and given we have been revisiting old classic "New Wave" music from the 80's while enjoying the quiet daily commute, looking at the continuation of the build in risk (US equities making new highs using margin debt, the great return of covenant-light loans, etc.), we thought this week, we would use a somewhat veiled reference to UK group Tears for Fears for our chosen title, given this year was the 30 year anniversary since the release of their first debut album "The Hurting" (released on the 7th of March 1983). Looking at the increasing risks of a Fed "Tapering" and the poor liquidity experienced in the secondary space during the previous bout of bond volatility, we thought using "Fears for Tears" as a title would conveniently illustrate our growing "fears" concerns that could no doubt led to "tears" and to large inflicted "hurting" in risky assets.

Of course, some will describe us as being outright "bearish" given everyone is vaunting the much improved economic data in the US as well as in Europe. As we pointed out last week, there are indeed a few clouds gathering on the horizon thanks to rising "forced correlations" which could lead to some  additional repricing, and not only in the equities space.

In this week's conversation, we will focus on these risks as well as what capital shortfalls entails in the credit space for subordinated bond holders, which have become again quite complacent on the matter.

We have been tracking with interest not only the rise of the S&P index (blue) versus NYSE Margin debt (red) but we also added S&P EBITDA growth (yellow) as well as the S&P buyback  index (green) since 2009 - graph source Bloomberg:

Of course this only telling half the liquidity induced rally courtesy of our "omnipotent" central bankers and their wealth effect strategy, leading to the use of leverage of any kind, which, leading to some "risk parity" strategic users to rediscover with much "hurting" the inherent risk in too much leveraged risk piled into interest rate sensitive asset which our friends at Rcube Global Macro Research have been discussing as of late. We will touch more on liquidity further in our conversation.

Some argue that concerns on the record amount of borrowing for US stocks are misplaced because, lower interest rates have made the borrowing much less expensive, as illustrated by Bloomberg in a recent Chart of the Day (15th of August):

"Concern that a record amount of borrowing to buy U.S. stocks foreshadows an end to the current bull market is misplaced, according to Michael Shaoul, chairman and chief executive officer at Marketfield Asset Management.

The CHART OF THE DAY illustrates why the issue has emerged in the top panel, which compares total margin debt at New York Stock Exchange member firms with the value of the Standard & Poor’s 500 Index. April’s debt was a record $384.4 billion, according to the exchange.

Lower interest rates have made the borrowing much less expensive -- and less significant -- than it was when the last two bull markets concluded in 2000 and 2007, Shaoul wrote in an e-mailed note yesterday.

Investors are paying about 72 percent less interest than they were at the 2007 peak, as displayed in the chart’s bottom panel. This estimate was calculated by multiplying margin debt by the broker call rate, charged by banks on similar loans to securities firms, as Shaoul did in his note.

Companies’ rising earnings also suggest borrowing is far from excessive, the e-mail said, because they have made stocks more valuable. By this yardstick, the amount of margin debt has to climb 40 percent to reach an equivalent to the two previous market peaks, even if S&P 500 company profit stays unchanged.

“Margin debt expansion will remain in place until corporate earnings falter” or the Federal Reserve raises its target interest rate significantly, the New York-based investor wrote. “We do not expect to see either of these take place for a number of quarters.”" - source Bloomberg.

But corporate earnings are, we think exposed, and the rally has been as well sustained by multiple expansions and very significant stock buy-backs.

Reading through CLSA's weekly Greed & Fear note from the 15th of August, written by Christopher Woods, we could not agree more with his comments, where he indicated that risks on the S&P 500 are rising:

"What does all this mean for the American stock market? Well in one paradoxical sense if growth in the US is not as robust as hoped for, that means quanto easing continues which should support the equity market. Still at some point common sense takes over and a lack of growth is plain bearish for equities, most particularly in the context of an American stock market which in recent months has been driven far more by multiple expansion rather than earnings growth. Thus, the S&P500 trailing PE has risen from 15.6x in late December to 18.4x" - source CLSA - Greed & Fear, 15th of August 2013.

For illustrative purposes, we have been plotting the growing divergence between the S&P 500 and trailing PE since January 2012 - graph source Bloomberg:

On top of that multiple expansion and the induced rally by central banks liquidity injections have been boosted as well by a reduction in denominator via stock buy-backs. The complacency in the equity space is starting to raise our "fears" for "tears" as displayed by Deutsche Bank's US equity strategist at Deutsche Bank graph indicating the price-earnings ratio for the Standard & Poor's 500 with the VIX:

"Investors are becoming overly content about the prospects for stocks after more than four years of gains, according to David Bianco, chief U.S. equity strategist at Deutsche Bank AG.

The CHART OF THE DAY shows how Bianco reached his conclusion: by comparing the price-earnings ratio for the Standard & Poor’s 500 Index with this quarter’s average close for the Chicago Board Options Exchange Volatility Index. The latter gauge, known as the VIX, is based on S&P 500 options.

Bianco’s P/E-VIX ratio closed yesterday at 1.20. At that level, a lack of concern that share prices may fall starts to supplant “realistic and disciplined” investing, he wrote in an Aug. 9 report.

“This complacency signal may pertain more to the derivatives market than the equity market,” he wrote. This quarter’s closing VIX average as of yesterday was 13.59, just above the first-quarter figure of 13.53. The latter reading was the lowest since 2007, when a five-year bull market came to an end, according to data compiled by Bloomberg.

While stocks have room to extend their advance since March 2009, increased volatility is likely to accompany any further gains, he wrote. This would allow stocks to rise relative to earnings without sending another warning sign, the New York-based strategist wrote.

Bianco expects the index to end next year at 1,850, which is 9.2 percent higher than yesterday’s close. His projection for the end of this year is 1,675, in line with the average among 17 strategists in a Bloomberg survey." - source Bloomberg.

Whereas the volatility in the fixed income space has remained elevated as displayed by the recent evolution of the Merrill Lynch's MOVE index falling from early May from 48 bps  towards the 87 bps level, the VIX, the measure of volatility for equities has remained fairly muted - graph source Bloomberg:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

Of course when ones look at European government yields and in particular peripheral yields, both Italy and Spain are trading towards the lowest level since 2011 relative to German government yields - graph source Bloomberg:

While the German 10 year government bond has moved in sympathy with the 10 year US treasuries breaking its 1.60% - 1.70% range towards 1.90%, Spanish and Italian yields have so far remained fairly muted. 

In relation to our "Fears" for "Tears", we share the same views as Morgan Stanley, from their Credit Strategy note from the 16th of August entitled "Working Through Our Worries", namely that Europe remains on our top concern list:

"Why Europe is the risk we’d stay focused on

We’re relatively relaxed about higher rates and the EM slowdown, but it’s the risk of renewed volatility in the eurozone that causes us the most discomfort. This may sound odd, given that Spanish sovereign spreads are at their year-to-date tights, but is based on a couple of factors unique to this risk.

First, it enjoys especially high uncertainty: One can look to Fed speeches and US data to inform a view of ‘tapering’. One can follow EM currencies or commodity prices to get a sense of regional stress. No similar metric exists for measuring the cohesion of the Italian government or the likelihood of a rating agency downgrade.

Second, it can strike with high intensity: The large rate move since May has so far been weathered well. No more than a handful of European corporates are experiencing serious credit trouble from a sharper China slowdown.

Sovereign weakness, in contrast, has repeatedly shown the ability to drive severe, broad-based weakness in our market.

Third, while it is not our base case, there are plausible reasons why a eurozone crisis could re-emerge: Improving economic data in Europe are encouraging. Yet the ratings of nearly all eurozone sovereigns remain on negative outlook. Debt/GDP will likely rise and unemployment should stay high well into 2014, even if growth ‘improves’ to ~1%. The eurozone’s ability to backstop a crisis remains hamstrung by the continued lack of a banking union, an OMT programme that our economists believe will be difficult to activate, and a continued reluctance by the ECB to use QE." - source Morgan Stanley

Yes, we all know that Mario Draghi's OMT "nuclear deterrent" has yet to be tested. But what we are concerned about is, as we indicated in our conversation "Cloud Nine", is the lack of credit growth in peripheral countries which are most likely to be exacerbated by the upcoming AQR 

As a reminder: AQR = Asset Quality Review, planned for 1st Quarter 2014 as a prelude to the ECB becoming the Single Supervisor for large euro area banks in 2H 2014. The AQR's intent is to review banks challenged loan portfolios and the need for capital increase.

"Until the AQR is completed and capital shortfalls identified and remedied, you cannot expect a significant pick up in lending." 

One of main reason of the relative calm in the European government bond market has been the "crowding out" of the private sector.

"Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments"

It is fairly simple, in effect while the deleveraging runs unabated for European banks, most European banks have been playing the carry trade and in effect boosting their sovereign holdings by 30% since 2011 to record as displayed in the below table by Bloomberg:

"Euro zone financial institutions' sovereign holdings totaled 1.78 trillion euros in June, up from 1.4 trillion euros in December 2011. In efforts to maintain asset values and lower auction costs, banks have increasingly supported their sovereigns by purchasing sovereign debt, which may stop their own associated CDSs and funding costs from rising aggressively. Over-exposure to sovereign debt (and loans) can threaten solvency should conditions deteriorate enough." - source Bloomberg.

In that sense the European Banking Union is more akin to a Government/Bank Union when it comes to sovereign bonds holdings.

As we indicated back in our conversation "Cloud Nine", indeed the government is the preferred borrower when it comes to lending as displayed in Bloomberg Chart of The Day from the 13th of August:

"Italian banks are increasingly using liquidity to buy more profitable sovereign debt, reducing loans to companies and households, as Italy’s longest recession in 20 years makes lending more risky.

The CHART OF THE DAY compares the banks’ purchase of Italian government bonds and loans made to the private sector.

Italian banks increased their holdings of the country’s debt by almost 100 billion euros ($133 billion) in the 12 months ended June 30 to a record 402 billion euros. In the same period, loans decreased by 55 billion euros, or 3.3 percent, to 1.63 trillion euros.

“There’s a crowding-out effect,” said Carlo Alberto Carnevale Maffe, professor of business strategy at Milan’s Bocconi University. “The public debt is soaking up resources from the private sector, offering higher yields on capital and a lower investment risk, at a time in which companies and families are struggling to repay their debt.”

Italian banks, which have borrowed more than 255 billion euros from the European Central Bank’s longer-term refinancing program, are investing part of the liquidity obtained at lower interest rates in short-term government bonds that offer higher yields. That’s favored by Italy’s government, which is seeking domestic buyers to replace lower purchases from foreign investors so it can cover a monthly average issuance of 40 billion euros in securities to finance its $2.7 trillion debt. At the same time, banks are more reluctant to lend as a recession saddles them with mounting bad loans." - source Bloomberg

Should Mario Draghi feel the urge to trigger is "nuclear" device, it will have to be "Brighter than a Thousand Suns", to quote, J. Robert Oppenheimer...

Oh well...

So when it comes to our "Fears for Tears", liquidity has always been our top concern, credit wise.

As we posited in "The Unbearable Lightness of Credit":
“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“

The recent surge in the fixed income space of May and June have indeed been very stark reminder of the importance of liquidity. On that subject we came across a Risk.net article entitled "The great unwind: Buy-side fears impact of market-making constraints" which struck as a perfect illustration of Roger Lowenstein's quote:

"At the start of May, as prices for US agency bonds reached what would later prove to be a peak, one New York-based hedge fund decided to sell its portfolio of roughly $100 million in AAA-rated mortgage-backed securities. The fund’s senior trader expected to be out of the position in a day, or even less. If it had gone to plan, it would have been beautifully timed, but it didn’t go to plan.

“You’re talking about AAA agencies – OK, with some callable features – and you don’t expect there would be no liquidity for that kind of instrument. The only reason I allowed us to carry that position is that, in my mind, you should be able to blow out of it in basically a day, or even an hour for that kind of size. But the reality was it took us a month,” he says.

The fund initially turned to a single dealer, which bought less than $10 million of the bonds upfront, promising to take the rest as and when it could find bids from other clients. Over the course of the next four weeks, the position shrank slowly, and the price of the bonds steadily slipped. The trader declines to say how much value was given up, but he admits the fund’s hedges did not work perfectly, and says it lost money on the portfolio during the month. Eventually, losing patience, the fund brought in a second bank to speed up the process.

“Effectively, there was no liquidity for that stuff. The discrepancy between the expectation and the actual liquidity was one of the largest I’ve ever experienced,” he says.

This fund was one of the lucky ones, selling the bulk of its portfolio before bond market jitters turned into a full-scale rout in the last week of May. The sell-off was triggered by the fairly innocuous statement from Federal Reserve chairman, Ben Bernanke, that the central bank might rein in its programme of quantitative easing. As fixed-income investors sought to pare back the huge positions they have built up in recent years, prices moved dramatically, triggering further waves of selling – yields on 10-year US Treasury bonds leapt 80 basis points in six weeks to close at 2.73% on July 5, but everything from emerging market sovereign debt to corporate bond exchange-traded funds (ETFs) was hit.

“I’ve never seen markets move so far on so little news,” says one senior, London-based trader – a sentiment shared by many other market participants.

Some banks, plus buy-side firms including BlackRock, Deutsche Asset & Wealth Management and Fortress Investment Group, now explain this episode in the same way: the problem was illiquidity, and the cause was bank regulation.

New capital, liquidity and leverage rules are making it more expensive to carry inventory, they say, meaning banks have less capacity to take principal risk. The consequence is that market-makers were not initially willing to absorb the supply of securities: orders were broken into smaller clips, bid-offer spreads exploded, in some cases even enquiries had the power to move markets. Once prices had collapsed, demand strengthened, enabling bank trading desks to match up buyer and seller more rapidly, and stabilising the market.

Or so the argument goes, and there is a lively debate, particularly among dealers, about how important these factors were. But the bigger question is what happens next. As interest rates normalise, investors that have gorged on fixed-income securities will all be trying to cut their exposure – a prospect the chief risk officer at one US bank’s asset management arm calls “the great unwind”. With market-makers unable to provide the kind of liquidity many investors are used to, he predicts a period of sustained, savage volatility, and the head of rates distribution at one UK bank agrees: “We’ve just had a 30-second trailer for the full movie.”

For now, there is little science to back up these scary predictions, but there are anecdotes, intuition, a lot of first-hand experience – and some numbers.

“There’s never been a wider gap between the amount of overall product out in the market versus dealer balance sheets. When you start looking at the size of the institutional market and daily turnover as a function of the dealer balance sheet, you get some pretty horrific stats,” says Richard Prager, head of trading and liquidity strategies at BlackRock in New York.

Others see it the same way. “There is a pent-up mismatch that has been built as real-money asset managers have swelled in size while dealers have reduced their inventories, and there is a real risk that some investors may not understand the effect this structural imbalance has on the underlying liquidity of some of those portfolios,” says Randy Brown, co-chief investment officer at Deutsche Asset & Wealth Management in London.

According to data compiled by the Federal Reserve Bank of New York, the inventory of corporate bonds held by primary dealers plunged from a high of $235 billion on October 17, 2007 to just $55.9 billion as of March 27 this year. An even bigger drop has been seen in holdings of agency debt, which fell from a high of $69 billion in May 2008 to $6.8 billion by March 27 – a decline of 90%.

The same trend has been seen in corporate bonds, according to Peter Duenas-Brckovich, global co-head of credit flow trading at Nomura in London. “If, 10 years ago, the Street was willing to hold 4.5 to 5% of the outstanding debt, that number is now only 0.5%,” he says.

Constraint

The major constraint has been the introduction of the Basel Committee on Banking Supervision’s new trading book capital rules – known as Basel 2.5 – which has forced dealers to hold more capital against trading book assets through the use of a general market risk charge measured using a 10-day value at risk at a 99% confidence interval, a stressed VAR charge and, for banks that model specific risk, an incremental risk charge (IRC) (see box, The roots of the problem). But banks also face a new leverage ratio and structural restrictions on their ability to take proprietary trading positions – however those are defined.

“Post-crisis, the proportion of inventory held by dealers has diminished dramatically; collectively, dealers’ inventory is a tenth of what it once was,” says Chris Murphy, global head of rates and credit at UBS, and a member of the bank’s investment bank executive committee. “Banks were complacent about housing inventory in the pre-crisis years, and balance sheets were out of whack with the industry’s real risk-bearing capacity. That has been corrected by the Basel capital overlay, where warehousing credit products in the lower-rated space – like high-yield or emerging markets – is extremely punitive. And banks also have to comply with leverage ratios, which act as a major constraint on balance sheet size.”

Large asset managers agree on both the cause and the effect. “Holding securities longer term has always been challenging for dealers. Today, constraints on funding cash inventory are even more pronounced because of new regulations, lower credit ratings for most dealers, and mark-to-market concerns if credit spreads widen. Dealers will assume positions temporarily while trying to place bonds elsewhere, but I would not expect them to offer significant additional longer-term capacity,” says Hilmar Schaumann, chief risk officer of Fortress Investment Group in New York.

What this means, simply put, is that markets are likely to move further and faster when clients are selling – and traders say the reaction to Bernanke’s comments is the perfect example.

“He basically said, ‘At some point in the future, there is a possibility we might think about maybe – maybe – not doing quite as much bond buying’. And we still had a complete meltdown. That’s a lot of movement for not a lot of news. Imagine if they’d actually changed rates,” says the London-based head of European fixed-income trading at one large European bank.

Another example is the reaction to the July 1 resignation of the Portuguese finance minister. By July 3, the country’s 10-year bonds had jumped from 6.38% to 7.46%. The price of the bonds fell around five points – or 5% of par.

“It’s a peripheral credit that is expected to have problems, but a five-point drop? I’ve been doing this for 20 years – the news does not justify the move. This is not a corporate where the head of accounting quit because of accounting fraud. This is highly suggestive of poor liquidity in the market,” says Nomura’s Duenas-Brckovich." - source Risk.net

Moving on to the subject of complacency in the subordinated bond space, we eagerly await the results of the AQR tests which will be conducted by the ECB and we agree with CITI's take from their credit note from the 13th of August:

"European Union finance ministers recently reached an agreement on several topics which should form the backbone of the European bail-in legislation (expected to be implemented from 2015): e.g. the priority of payments in the event of a bail-in and the creation of national based resolution funds. Essentially, the agreement specifies a list of liabilities which will not be bailed-in (e.g. guaranteed deposits); this list excludes equity, sub and senior debt, i.e. they are “bail-inable”.

According to our interpretation of the draft directive, national authorities will only have the ability to inject “public” money into a bailed-in bank once losses of 8% of total assets have already been absorbed. In other words, for sub or senior debt not to be bailed-in, other (presumably more junior obligations like equity) securities would have to have already absorbed (i.e. bailed-in) 8% of the total liabilities of the bank. What does this mean (to us at least)?

-If the equity to total liabilities ratio in a bank were more than 8%, there would be a chance that sub debt may not be bailed-in. However, the average equity to total liabilities ratio in European banks is 5% and very rarely exceeds 8%, which means that sub bail-ins appear very likely.

-The ratio of equity plus subordinated debt to total liabilities for the average European bank is around 7%, which means that national authorities would pretty much be forced to “fully” bail-in equity and subordinated bondholders. Figure 4 shows the distribution of the ratio of equity plus subordinated debt to total liabilities across European banks.

In many cases, the ratio is below 8%. Even if the ratio is above 8%, sub debt would likely be bailedin if losses are above that level and/or national authorities want the post “bailined” bank to have a meaningful capital base

-What about senior debt? In the average European bank, equity plus subordinated debt will make up around 7-8% of total liabilities, which means that national authorities will likely have discretion not to bail-in senior debt.

National authorities will, in our view, make use of bail-in legislations when dealing with distressed banks going forward. We expect that bail-ins will trigger restructuring credit events in current CDS contracts, as was the case in SNS and Bankia, and “bail-in” credit events in the new CDS contract."  - source CITI

Of course we have long voice our "Fears for Tears" for the subordinated bond holders and it has been a recurring subject in our numerous credit conversations. It support our long standing views expressed in our post "Peripheral Banks, Kneecap Recap, Kneecap Recap":

"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

Back in our conversation "The Week That Changed The CDS World", we indicated that the recent SNS case has derailed the auction process and the validity of the current CDS subordinated contract. In the case of SNS, because the auction used senior bonds, the recovery was around 95.5 for the bucket at 2.5 years and 85.5 for other maturities segment. Given the payout equates to par minus recovery, a CDS subordinated bondholder only received 14.5 (100-85.5)....so much for taking a CDS in the first place...

1. 
   The issue was that the auction could not operate due to lack of deliverable, it reminds us of a similar case with Delphi Automotive when a market maker had squeezed the market and cornered the bonds which had led to a higher recovery rate and smaller payout to the CDS holders. The markets then moved towards cash settlement to avoid some players to rig on purpose the auction process.
   
   In the case of the SNS expropriation, the CDS mechanism has derailed somewhat the auction process, hence the need to ensure with the new contracts a smoother payout mechanism. Obviously going forward Sub CDS protection should trade wider. 
   
   
   One of our prime candidate for "Fears for Tears" and for failing the upcoming AQR tests in relating to the subordinated bond holders risks, is troubled Italian bank MPS (Montei Dei Paschi). We agree with Bank of America Merrill Lynch's recent note on MPS from the 14th of August entitled "Defusing the capital problem" about the increasing probability of a debt-to-equity swap for the Italian lender:
   "A sub-debt-to-equity swap could help MPS’s capital position

   In our view, an effective solution to the capital issue could be a subordinated debt to equity swap. This is not without recent precedents (Commerzbank, Portuguese banks). Some issues may arise in connection with the Italian rules on dedicated capital increases and pre-emptive rights, but we do not think that these are insurmountable. Incidentally, Banco Popolare has a convertible outstanding which allows the bank to trigger anticipated conversion effectively at a discount to market value (bondholders will receive the face value plus 10%)". Besides, according to new EC rules “state aid must not be granted before equity, hybrid capital and subordinated debt have fully contributed to offset any losses”. If our interpretation is correct, this may imply that ahead of conversion of the state aid into equity, current shareholders and sub-bond holders might have to bear the losses. In our view, this should be a good enough reason for bondholders to accept trading out of (relatively illiquid) bonds into shares. In July 2012, MPS launched a senior-to-sub swap, which was a wasted opportunity as MPS realised just a modest capital gain. A sub-debt-to-equity swap would have the advantage of moving the full sub-debt balance exchanged for equity (rather than just the delta between market price and tender in a cash-to-debt deal).

   MPS has relatively limited options with respect to using its subordinated debt to recapitalise the bank because of the relatively high cash prices that many of the bonds trade at. In some other examples, banks have been able to take advantage of the discount at which their bonds trade to par and monetise this – this seems less clearly an option here given that many bonds trade in the 90s or even higher. We do not exclude that cash prices could fall in the coming months of course but our assessment is that MPS sub bond prices have been surprisingly resilient in the face of the bad news emanating from the bank on the one side and a clearly underperforming sub CDS which is currently indicated at well over +1,000bps on the other side. This is a level that we’d generally associate with very high default risk. There is a big disconnect between MPS cash bonds and its CDS. The latter is implying that there is a high likelihood of a Credit Event. 

   We think this is most likely to be a Restructuring Credit Event rather than a Failure to Pay. We estimate that MPS has subordinated debt with a face value of about €5.3bn, not including the FRESH, all of which essentially could be made available to recapitalise the bank if there was a debt-for-equity swap. In our view, the bank could offer to buy back its subordinated bonds for shares, albeit that this would be very dilutive given that MPS’s current market value is around €2.5bn. Even if the bank decided to focus on the more subordinated parts of its capital structure (T1 and UT2), there would still be potentially €3bn that could be raised in this way. Part of the capital raised would be the gain from taking out any liabilities below par but most of the capital would come from a straight swap of the liabilities for equity. "- source BAML

   
   

   But there is a catch for the holders of the current CDS subordinated contract as pointed out by CITI:
   "Under the current CDS contract, if sub debt is converted into equity before the auction date there will be no subordinated deliverables for the auction, as was the case in Bankia." - source CITI

"Fears for Tears"...

On a final note, German exporters should start to have as well their "Fears for Tears" given the Chinese slowdown will continue to weigh on German output as indicated by Bloomberg Chart of The Day:

"China’s credit squeeze is signaling a downturn in German manufacturing, according to ING Groep NV.

The CHART OF THE DAY shows that Germany’s factory output as gauged by a manufacturing purchasing-managers’ index has mirrored Chinese bank-lending growth since a credit boom that began in 2008. As China’s Communist Party seeks to rein in lending on concern that wasteful investment will threaten

longer-term growth, Germany’s export-oriented manufacturers are poised to suffer.

“China’s economy is shifting from domestic investment to more of a domestic consumption model,” said Martin van Vliet, senior euro-zone economist at ING in Amsterdam. “If you’re a German exporter selling machinery, that’s bad news.” China will start a nationwide audit of public-sector debt this week as the government pressures banks to better manage their balance sheets after the record surge in credit. The nation’s economic growth slowed for a second quarter to 7.5 percent in the three months ended June and the government has set a target of 7 percent a year for the five years through 2015. China hasn’t expanded at a slower than 7.6 percent pace

since 1990.

A reduction in debt-fueled Chinese investment spending may hurt German machinery orders in particular. Machinery sales to China last year were valued at 16.9 billion euros ($22.5 billion), accounting for more than a quarter of total shipments to the country, according to the Federal Statistics Office in Wiesbaden.

German exports to China have increased at an average rate of 15.8 percent a year since 1995, more than twice as fast as the total gain. That’s helped Germany weather the effects of the euro-area’s sovereign debt crisis, now in its fourth year." - source Bloomberg.

"Prosperity is not without many fears and distastes; adversity not without many comforts and hopes." -Francis Bacon 

Stay tuned!