Macro and Credit - The Zimmermann Telegram

"No matter what political reasons are given for war, the underlying reason is always economic." - A. J. P. Taylor, British historian

Looking at the evolution of the trade war rhetoric in conjunction with cold war 2.0 heating up following the events in London as of late, as well as the weakness in risky asset prices and issues surrounding FANG stocks darling Facebook, when it came to selecting our title analogy we reacquainted ourselves with the "Zimmerman Telegram". The Zimmermann Telegram was a secret diplomatic communication issued from the German Foreign Office in January 1917 that proposed a military alliance between Germany and Mexico in the prior event of the United States entering World War I against Germany. Mexico would recover Texas, Arizona, and New Mexico. The proposal was intercepted and decoded by British intelligence. Revelation of the contents enraged American public opinion, especially after the German Foreign Secretary Arthur Zimmermann publicly admitted the telegram was genuine on March 3rd 1917, and helped generate support for the United States declaration of war on Germany in April 1917. The decryption was described as the most significant intelligence triumph for Britain during World War I, and one of the earliest occasions on which a piece of signals intelligence influenced world events. One could indeed make a parallel and wonder if the latest disclosure on privacy issues relating to Facebook will not mark a turning point for the strong winners (FANG stocks) of the rally seen in recent years in equities.

In this week's conversation, we would like to look at the US dollar funding pressure which has been highlighted by many pundits particularly given that the Libor-OIS spread, has more than doubled since the end of January to 55 basis points, a level unseen since 2009 reflecting an increasing scarcity of dollar funding it seems with large implications as per the below Bloomberg charts as well as US corporate leverage:

- source Bloomberg

Synopsis:

• Macro and Credit - Libor and leverage, my dear Watson...
• Final charts - Dispersion matters 

• Macro and Credit - Libor and leverage, my dear Watson...

No doubt the returns on everything beta including the Russell 2000 since Trump's election in the US has been stellar but, we are seeing it seems a change in the narrative since early 2018 with the continuous hiking pattern of the Fed, making markets more prone to heightened volatility and questioning the continuation of the "goldilocks environment" which had prevailed so far in credit markets. One most sensitive candidate we think for a "short" bias when the markets will eventually turn in the footsteps of the Fed's hiking course that will in the end "break something" is the Russell 2000 small cap index we think. Given that more than 40 percent of debt issued by Russell 2000 companies is floating, they are therefore susceptible to the rise in the benchmark rate namely our old friend Libor. While the CFOs of some of these firms have made good use of derivatives to effectively swap from floating-rate into fixed obligations, these companies are still more interest-rate sensitive than their larger counterparts that have embarked on a bond-issuance frenzy in recent years particularly so with a significant amount of leverage. At the end of 2017 around 34% of the Russell 2000 was made up of loss-making companies with an average LT debt to Capital of around 35% versus 29% in 2007. In our book higher leverage and rising Libor even if some smart CFOs have swapped some exposure from floating to fixed doesn't look too promising when the market will finally turn to a bearish stance (we are not quite there yet).

On the pressing subject of Libor and OIS rates, we read with interest UBS Global Macro Strategy note from the 2nd of March entitled "USD Funding Pressures: Myth and Reality:

"Here's what's happening

Some investors are worried about the rising gap between LIBOR and OIS rates (Figure 1) as being indicative of a nascent funding problem.

At the root of this widening is an increase in T-bill rates; as Fed funds and T-bill yields rise, so does the cost of unsecured LIBOR funding. The gap between T-bills and LIBOR rates, the Ted spread, has not changed much. Bill rates have been rising particularly sharply since early February, as Congress agreed on further fiscal spending (we estimate net bill issuance in '18 at $475bn vs $200bn in '17). Supply is in play here, not credit issues. The gap between LIBOR and Fed funds rate is hardly out of line with previous hiking cycles (Figure 2).

Will this widening between LIBOR and OIS persist?

If we're right about T-bills being the real driver of this move, then LIBOR-OIS should not widen much more. The spread between T-bills and OIS is now positive (Figure 3), and this has typically been a limit in the widening.

Note that when funding stresses have risen in the past because of credit reasons, the T-bill to OIS spread has gone the other way. What we're witnessing today is higher rates, not a clogging of financial plumbing. 

Distinguish between the price of funding and access to funding

It is undeniable that higher US rates will have an impact on the 'price' of funding, perhaps globally, and that this will have consequences. But 'access' to funding is a completely different story. We see few signs of this having been compromised thus far. 

Neither credit nor currency markets suggest funding is becoming a problem

As we have argued, the underbelly of the risk trade – the weakest rating buckets in the US HY – are actually outperforming on a beta-adjusted basis. Spreads are remarkably stable in the context of higher front end rates and equity volatility (Figure 4).

Issuance and demand for paper have not been a problem. In currency markets, basis swaps (Figure 5) (difference between local currency and $ funding), risk reversals (the price of a $ call vs a $ put), and volatility are showing no signs of stress.

So, is there nothing to see here? Does the cost of funding not matter at all?

It does. But instead of LIBOR–OIS widening, which is likely a red herring, we need to focus on the right channels to assess changes in market trends. First, watch the hit from yields to floating rate HY credit. We estimate floating rate loans at $2.2tn, of which $1.1tn of loans ($690bn of leveraged loans, $459bn of bank C&I loans) have been extended to issuers rated below BB-. Our recent analysis shows leveraged loan issuers fundamentally will remain resilient to the next 75-100bp increase in Fed Funds rates, but further rises could elevate funding vulnerabilities. Second, watch US growth surprises relative to those in the rest of the world. Widening front end rate differentials will become more meaningful for currency trends if mirrored in growth differentials. We would pay particular attention to China, where data has been mixed to weak. The EM currency complex, thus far calm, may begin to weaken if growth here softens in backdrop of higher US rates (Figure 6).

Third, and most importantly, we would watch term premium in the US. Markets have been worried about the impact of higher rates, but thus far US rates volatility itself hasn’t risen meaningfully, and shouldn't do so unless term premium rises sharply (Figure 7). We have argued against a big shift here.

Where does this leave us?

We are positioned defensively on US HY credit, and are looking for modest trade weighted weakness in EM currencies (Figure 8).

However, we think back-end rates are likely more range-bound here and, based on the facts today, are not inclined to take a negative view on US stocks. We would be watching the three channels above to reassess our view." - source UBS

Obviously when it comes to the LIBOR-OIS widening more, UBS hasn't got it entirely right given, it Libor has been rising for 31 days in row so far. Is it a case of "reflexivity"? We wonder. One thing for certain, we have noticed since the beginning of the year a weaker tone in fund flows, particularly in US High Yield, which, we think could be indicative of the start of the end of the "Goldilocks environment" in credit markets which had still been prevailing in 2017 in the beta part of the market, with the CCC rating bucket posting some strong returns (Russell 2000 as well...).

While recently we have touched on the "hidden" leverage in the US consumer in our conversation "Intermezzo", if Libor is indeed a growing concern for some credit market and sell-side pundits then obviously one need to take into account "leverage". As per the explosion of the yield pig's short vol straw house in February akin to the equity tranche in the capital structure of our complex markets, identifying the leveraged players is essential as the credit cycle shows clear signs of fatigue and the start of tightening thanks to the hiking path of the Fed (and QT). On that particular question about leverage we read with interest UBS Global Credit Strategy note from the 19th of March entitled "Is US corporate leverage higher than reported?" and below is the summary before we go into their detailed note:

"Key questions

The state of US corporate balance sheets and the outlook is one of the key debates for fixed income investors. The consensus is, while we are in the later stages of the US credit cycle, a recession is not on the horizon. We agree. But we believe identifying those pockets within credit markets where credit and leverage growth has been excessive is crucial to capturing a potential inflection point in the credit cycle early and to calibrating the extent of the fallout.

Where are US corporate credit market excesses? A focus on loans

Our view is there are three corporate credit market imbalances in this cycle. First, the rise in lower-rated, longer dated investment grade debt1; second, a 100% increase in the number of triple C rated issuers to over 1,400, many of which have floating-rate liabilities; and third, excessive debt growth in the technology, electronics and pharmaceutical sectors. Our focus here is on US leveraged loans (LL), where $1.1tn in lower rated, spec grade loans is more vulnerable to our house view for 7 Fed hikes and a material flatting in the US yield curve through '19.

Leverage is high. After normalizing for addbacks, it is even higher.

US leveraged loan gross issuance hit $500bn in 2017, with 60% used for M&A, LBOs or recapitalizations. Total leverage on new deals is 5x, and near 5x since 2014, while 1st lien leverage is 3.9x, the highest in two decades. But are these figures understated? EBITDA add-backs are rampant and material, averaging 20-21% for M&A related deals in 2017 and 26% for large sponsor deals YTD (largest in the tech, metals and food sectors). The jury is still out on add-back realization rates, but a conservative view would push average total/ 1st lien leverage to 6.2x and 5x, respectively, on M&A deals.

What are the early warning signals and current prognosis?

Corporate leverage is therefore a structural risk. But are we at an inflection point in the credit cycle? Leveraged loans (1.35%) have outperformed high yield bonds (-0.52%) YTD even as LL default rates have risen moderately to 2.2% (from 1.4% in Q3 '17). First, we have created a proprietary non-bank LL liquidity indicator to assess if lenders are beginning to ration loan supply. This metric led spread widening in '15 and '07, but currently the indicator is at -2%, indicative of slight easing and a stable backdrop. Second, the key demand source for LL is collateralized debt obligations (CLOs), and portfolio concentrations are highest in technology (13-15%), healthcare (11-12%) and cable/media (8-9%). Our recent flows analysis suggests rising USD hedging costs and duration concerns are driving more foreign investors into loans. And while total returns in the above sectors are lagging the LL index, they remain in positive territory.

How to position credit portfolios?

Overall bank and non-bank lending standards are not showing signs of tightening credit, our credit-based recession gauge is at a modest 13% through Q3 '18 and broad US credit valuations are moderately overvalued. With the house view calling for materially higher short rates but a modest rise in long end yields and USD depreciation, we favour EM over DM corporate credit and US leveraged loans over US high yield. Our HY spread target remains 380bp vs 341bp current. We maintain the view that corporate credit markets can absorb the next several rate hikes, but spread tightening is over and investors should be more cautious as the hiking cycle matures. And we remain structurally underweight healthcare and tech across credit portfolios for 2018." - source UBS

We do agree with the above, namely that we would favor EM over DM in corporate credit. The recent outperformance of local-currency emerging-markets credit has been impressive, with the debt returning 2.4% so far this year while U.S. IG credit has lost 2.5%. If indeed the weaker tone in the US dollar continues its course, then again having exposure to Emerging Markets Local Currency debt is still an enticing proposal, even in the light of recent outperformance of the asset class. Regardless of some Zimmermann Telegram and Cold War 2.0 narrative, Russian debt continues to be appealing we think, and much more appealing than dangerously overpriced European Government bonds which in fact, like the German bund as of late, are barely trading in similar fashion to what happened with Japanese Government Bonds market (which in effect has ceased to trade). Getting Japanese? We really think so: Private investors hold only 10% of German government bonds. It’s impressive that this market functions at all.

- source IMF and ECB

But moving back to our US leverage story, UBS looks into details about the state of the US corporate leverage:

"Is US corporate leverage higher than reported?

The health of corporate balance sheets, particularly speculative grade and private firms, was one of the key thematic debates during our client visits in London. We break down the genesis of the questions into three sub-themes: first, within the US corporate credit markets where are the excesses? Second, how concerned are you about levels of leverage, and to what extent are earnings add-backs hiding risks? And third, what early warning signals are you monitoring and what is the current outlook?

Where are corporate credit market excesses?

We have previously outlined three corporate credit market imbalances that bear close tracking, with the latter two in focus in this piece3. First, in high grade the rise in lower-rated, longer dated issuance with the ratio of BBB/BB 10yr+ debt rising from 4.8x to 13.3x. Second, in speculative grade a doubling in the number of triple C rated issuers to over 1,400 (US corporate debt: revisiting financial stability concerns). A majority of these issuers have funding in the US leveraged loan market, issuing secured loans to boost issue level ratings; B-rated loans outstanding have risen from $195bn to $467bn since 2012 (Figure 1).

And third, above average debt growth in the technology, electronics and pharmaceutical sectors; for US leveraged loans specifically this thesis is evident in the growth of the broad manufacturing and sectors which have grown from $117 to $295bn and $256 to $448bn, respectively, since 2012 (Figure 2).

By sub-industry growth, manufacturing has been primarily electronics ($124bn from $52bn). In services, business services ($98bn from $77bn) and lodging/ leisure ($87bn vs. $52bn) have led the increase.

More recently, we have discussed lower rated firms as structurally more vulnerable to rising interest rates with near-peak leverage and relatively low interest coverage (Lesson Learned: The Underbelly of US Tightening). And we argued that $1.1trn of lower rated, spec grade loans were the fulcrum – i.e., more vulnerable to our house interest rate outlook characterized by aggressive Fed rate hikes (7 through '19) but significant yield curve flattening (with 5yr Treasuries projected to remain below 3% through '19). Our analysis suggested these issuers would be resilient to 3-4 Fed rate hikes, but 4 more would lower coverage ratios near pre-crisis ('06) levels (A deeper dive into US credit markets more vulnerable to aggressive Fed hikes).

How concerning are leverage levels, and are earnings add-backs hiding risks

US leveraged loan gross issuance hit a record of approximately $500bn in 2017, with about 60% of use of proceeds for leveraged buyouts (LBOs), M&A/acquisition or recapitalizations (Figure 3).

While the theme of LBOs is less prevalent this cycle vs the prior, M&A has been a more persistent theme – primarily between private/sponsor firms. The market has been a sellers/borrowers market in recent months, in part driven by duration concerns which are fueling inflows into floating rate products (The Technical Pulse: Where will yield-hungry investors next leave their global footprint?), the perceived safety of secured debt and financial deregulation (with bank adherence to the 2013 Leveraged Lending Guidance fading). While median total leverage metrics have declined from peak levels of 5x to 4.5x post-crisis, they are still above the 4.25-4.5x pre-crisis. In addition, the negative tail remains fatter as the proportion of issuers with leverage above 6x is 29% (vs a post-crisis high of 35%, and 19% pre-crisis).

To reiterate, these figures represent the median leverage for public leveraged loan issuers outstanding (i.e., leverage on the stock of public issuer loans). But 65% of the lev loans are actually from private firms. While we do not have median leverage data on the stock of private issuer loans outstanding, credit metrics are available on all new deals – public and private (i.e., the flow). This data shows average total leverage for all deals at 5x, with private leverage running at 5.2x (c1x higher than on new public deals). Total leverage on new private deals has been running above 5x on average since early 2014; in the last cycle, average leverage above 5x was seen from Mar '07 to Mar '08 (Figure 4).

Across the capital  structure, however, leverage through the 1st lien for all new deals is at 3.9x, and has been running higher than prior peaks since 2013 – one key reason why lev loan investors have heightened recovery rate concerns in this cycle (Figure 5).

But what if leverage (and coverage) figures are wrong? The issue of earnings adjustments (or engineering) has consistently reared its ugly head in our client discussions for several years, and it is certainly not confined to US leveraged loans – but the rhetoric from leveraged finance/distressed credit investors has grown stronger. Market participants suggest nearly every acquisition-related deal now has its share of EBITDA add-backs, and a number of long term investors have suggested this cycle is unlike any others they have witnessed. Figure 6 depicts our best estimate of the average EBITDA add-back (expressed as a turn of total leverage) for M&A deals over time.

We would posit that the phenomenon of EBITDA add-backs is partly an unintended consequence of macroprudential regulation. The 2013 Leveraged Lending Guidelines (not enforced until late 20147) capped pro forma leverage at 6x (and required 50% debt amortization within 5-7 years8), incentivizing issuers to manage pro forma EBITDA such that leverage would remain below the 6x threshold. Rising add-backs are likely also a byproduct of low interest rates and QE, which have pushed up asset valuations and M&A deal multiples and contributed to reach-for-yield behaviour and material easing in lending standards.

Aggregate data on the magnitude of EBITDA add-backs is not easily sourced. For this we have leveraged the work of Covenant Review, and more specifically data from their CR Trendlines Topical Reports. Their work suggests that EBITDA addbacks for M&A - related deals across sponsor/ non-sponsor deals in 2017 were approximately 20-21% of Pro Forma Adjusted EBITDA. In 2017, the tendency seemed to be greater add-backs appeared first among large sponsor deals, and then spread across mid-sized and non-sponsored loans. And in 2018 this seems to be taking shape again, as EBITDA add-backs for M&A-related deals for large sponsors are averaging 26% of Pro Forma Adjusted EBITDA – suggesting another "high water mark" for EBITDA add-backs is attempting to take shape now (as addbacks for mid-sized sponsored/ non-sponsored loans remain at 20 – 21%).

Finally, in terms of sector outliers, the magnitude of EBITDA add-backs is more aggressive in electronics, software, metals/mining and food/food services (ranging from 24 – 29%). Are the add-backs being realized? The verdict is still out. First, it is difficult to monitor the aggregate credit fundamentals for the stock of private loans post-deal. Second, the credit agreement and covenants typically allow borrowers 24 months or more to realize a majority of the add-backs, in part a function of the significant easing in lending standards post-crisis (consistent with the shift from covenant to covenant-lite loans, 75% in '17 vs. 29% in '07; Figure 7).

For illustrative purposes, if one assumes a liberal view that all add-backs are realized then leverage levels are unchanged; however, if one takes a conservative view and excludes add-backs, total and 1st lien new deal leverage would increase to 5.0x and 6.2x, respectively, on average from 3.9x and 4.9x, respectively (Figure 8).

What early warning signals are you monitoring and what is the prognosis?

At this point, we don't see an inflection in the credit cycle. First, leveraged loans (1.35%) have outperformed high yield bonds (-0.52%) year-to-date amid higher rate and equity volatility, and LL spreads remain firm at 368bp (4yr discounted spread) even as LL default rates tick up moderately to 2.2% from a low of 1.4% in August (Figure 9).

Second, we have also created a proprietary non-bank LL liquidity indicator, following the methodology of our non-bank liquidity indicator (Credit Cycle Turning? Non-bank Liquidity Hits Multi-Year Lows), which calibrates changes in net loan issuance for low quality credits to determine if lenders are starting to ration their existing liquidity to higher quality borrowers. Historically, this proxy proved to be a warning signal in Q3 2007 and Q4 2014 when net tightening in lending standards reached +5 to 10% while spreads were still relatively tight (Figure 10).

Currently the indicator is at -2%, indicative of net easing and a constructive backdrop in the LL primary market.

Third, in terms of market structure and sector risks, the key demand source in terms of flow and stock of LL is collateralized debt obligations (CLOs, Figure 11).

And CLO portfolio exposures can be quite diverse, suggesting investors should pay attention to concentration risks. In this respect, we are focused on the outlook for technology (13-15% average exposure in CLOs), mainly software given robust debt growth, M&A activity and EBITDA add-backs and, secondarily, the healthcare (11-12%) and cable/media (8-9%) industries10. YTD total returns in these sectors are lagging the overall index modestly (electronics 0.90%, healthcare 1.12%, cable television 0.86%), but remain positive overall. 

Lastly and more broadly, bank and non-bank lending standards are not showing signs of tightening credit, our proprietary credit-based recession gauge is a modest 13% through Q3 '18, and broader US credit valuations look 0.8 standard deviations rich (vs. 2 standard deviations back in Q2 '07; Where are we in the credit cycle?)." - source UBS

One thing for certain is that the M&A wave we foresaw for 2018 has been staggering and as a late cycle red flag it is as clear as you can get with global deal making this year crossing the $1tn mark on Tuesday, the fastest it has ever reached that level, as a wave of consolidation spreads across the US and activity in the UK, China, Germany and Japan accelerates. You don't need no Zimmermann Telegram to tell you this but it certainly feels like late 2007 all over again and even early 2008 one could posit given we are seeing the return of Mega M&A deals as indicated by Wells Fargo in their Credit Spotlight note from the 15th of March entitled "Mega Deals Strike Back":

"Animal spirits continue to swirl in corporate boardrooms as evidenced by the recently announced Cigna/Express Scripts and Comcast/Sky proposed acquisitions. Industry consolidation is clearly en vogue across a range of sectors, and with debt markets willing to finance mega debt cap-structures, it seems unlikely to stop anytime soon. As a result, despite a healthy economic backdrop, credit investors need to tread cautiously as they navigate an upsurge of idiosyncratic risk, and for index oriented investors, what you don’t own could be just as important as what you do when it comes to performance.

We expect a record amount of M&A in 2018. This should result in another year of record bond issuance in the IG market.

M&A Update – Continue to Expect a Record Year

Mega Cap M&A continues to be a key driver of U.S. credit markets, both as a driver of leverage and a driver of bond issuance. We continue to expect M&A in 2018 to move to a new all-time high and lead to increased bond issuance in the IG market. There has been more than $387 billion of M&A announced so far in 2018, on pace to be the largest first quarter of M&A announcements on record. In fact, M&A is currently on pace to reach $1.8 trillion, breaking the previous record of $1.7 trillion from 2015.

We expect M&A to be the main driver of increased bond issuance in 2018 as we expect M&A-related funding to rise from $175 billion to $250 billion, accounting for substantially all of our increase in net supply for the year. We expect the Consumer Non-Cyclical sector to be the primary driver as M&A heats up in each of the Health Care, Pharmaceutical, Food & Beverage and Consumer Products subsectors. The rising M&A and issuance need are the key drivers of our Underweight recommendation on the sector.

The mega deals have really been the driver of increased M&A over the past few years. In each of 2016 and 2018 over 20% of the total M&A volume has come from deals over $40 billion. In addition, with the exception of 2017 over 40% of the M&A volume has come from deals in excess of $10 billion.

The increase in the propensity of these larger deals also has increased the funding need in the IG bond market and has led to a significant increase in the size of the average capital structure within the market. These large cap structures are now nearly on par with the mega banks in terms of index weightings." - source Wells Fargo.

The return of large M&A mega deals is clearly as stated a late cycle behavior we think akin to what we saw in 2007. If indeed the credit amplifier is still going to 11 in true spinal tap fashion, then again a flattening US yield curve and the rise in the front end, will make Investment Grade credit less and less alluring we think from a pure allocation perspective in the current environment. No doubt overall the liquidity picture is changing and you should take notice and start to be more defensive in regards to "cyclicals" at least, even if the FOMC shows greater "optimism" on the economic cycle.


In November in both our conversations "Stress concentration" and "The Roots of Coincidence" we argued that we were starting to see cracks in the credit narrative thanks to rising dispersion at the issuer level as well as growing negative basis credit index wise. We added that rising dispersion meant better alpha generation from pure active credit players, particularly in the light of rising M&A activity in 2018 and the need to reach for your LBO screener to avoid potential sucker punches in the form of sudden credit spreads blowing out in your face. As we pointed out in our previous conversations, dispersion is indicative of the lateness in the credit cycle and the beta game, and it means, as we posited that active managers should outperform in 2018. In our final point below, we would like to look again at dispersion given rising dispersion in our book amounts to credit deterioration.

• Final charts - Dispersion matters 

Normally, higher dispersion should drive eventually spreads wider. Since 2013, balance sheet leverage has been widening, therefore on top of Libor woes building up, investors should be wise in tracking leverage ratios in 2018. One of our final charts comes from Barclays note from the 16th of March 2018 entitled "Lessons in Leverage" and displays the history of the US High Yield Index spread versus the dispersion of net leverage at the single name level (ex-financials):

"Figure 5 overlays the history of the US High Yield Index spread versus the dispersion of net leverage at the single name level (ex-financials), with dispersion measured as the difference in turns of net leverage between the 80th and 20th percentiles of high yield credits at any point in time. While there are many drivers of spreads, we could expect at least a reasonable relationship between the dispersion of leverage and the overall market spread - namely , high and increasing dispersion likely coincides with periods of credit deterioration derived from macro challenges, and vice versa. Note that the dispersion of leverage remains reasonably far above the 2014 lows (given the drivers and observations noted above), while the high yield market spread is less dislocated. That may suggest that any credit improvement that might occur in 2018 (particularly for lower-quality segments) has already largely been factored in and that a further tightening of credit risk premia would have to be sourced from other drivers besides fundamentals" - source Barclays

This trend of rising dispersion can also be seen in the synthetic derivatives part in the US credit market namely in the CDX HY index where dispersion is also on the rise as indicated by CITI in their Global Credit Strategy Focus note from the 15th of March entitled "What is happening with CDX IG volatility?":

"There are several reasons why CDX HY may not be a good tail risk hedge at the moment. First, the default environment is expected to remain benign going forward. In addition to the decline in HY defaults over the past year, Moody’s is expecting the HY default rate to fall even further over the next year. Second, two other metrics of HY cash portfolios also provide reasons for optimism.
The maturity distribution for the Bloomberg Barclays cash HY index indicates that less than 5% of the entire portfolio by notional will mature over the next 2 years, out of which less than 1% is expected to mature in the next year. In other words, even if rates were to rise, the total amount of HY debt coming up for refinancing is quite small. there is a fairly limited overlap between CDX HY constituents and the Bloomberg Barclays cash HY index. We find only 35% of the total notional in the cash index corresponds to the names in the CDX HY index (see Figure 4 (left)). Given that a significant component of tail risk in HY is a pick-up in defaults, using CDX HY as a hedge against cash HY portfolios would leave a large portion of the average cash HY portfolio exposed.
All of these reasons have contributed to investors currently staying away from using CDX HY payers as a tail risk hedge. Instead, what we are observing at the moment in HY hedging is investor activity targeted at individual names, which has also caused dispersion to rise in the CDX HY portfolio (see Figure 4 (right)).

In contrast to CDX HY which is more sensitive to (idiosyncratic) default risk, CDX IG is more sensitive to macro risks. One of the major tail risks on investors’ radar is rising inflation. As investors digest the effects of the newly instituted tariffs on aluminum and steel, the rising risk from potential trade war scenarios and the overall wealth effects from tax cuts, we are seeing inflation tick higher, as evidenced by the rise in 5y inflation breakevens.

Our analysis of data during a past rising rate environment (1963-1981) has shown that higher inflation can potentially drive credit spreads wider (see Figure 5 right), and here) for a more detailed discussion. Such dynamics would make CDX IG spreads an appropriate choice for inflation-driven tail risk for credit investors.

At the current time, markets are pricing in roughly 3 (25bp) rate hikes over the next year, which is also the base case projection from Citi economists (see here). However, a 4th rate hike has not been completely ruled out, and if it were to materialize, we could see another sell-off in credit spreads, especially concentrated in IG since IG credit is more sensitive to duration risk." - source CITI

Rising credit dispersion, rising inflation and a potential trade war means that no matter how you look at your Zimmermann Telegram from the credit markets, the Goldilocks narrative which has been prevailing for so long look to us increasingly at risk in 2018.

"Like most of those who study history, he (Napoleon III) learned from the mistakes of the past how to make new ones." -  A. J. P. Taylor, British historian

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 !