Macro and Credit - Ballyhoo

"Chaos is inherent in all compounded things. Strive on with diligence." - Buddha

Watching with interest recent market gyrations, with the intervention of China in the mix to calm down the turmoil in its equities market, when it came to selecting this week's title analogy, we decided to go for the word "Ballyhoo":

1. : a noisy attention-getting demonstration or talk
2. : flamboyant, exaggerated, or sensational promotion or publicity
3. : excited commotion

A "Ballyhoo" is as well a "publicity, hype" from circus slang, "a short sample of a sideshow" used to lure customers (1901), which is of unknown origin. The word seems to have been in use in various colloquial senses in the 1890s.  In nautical lingo, ballahou or ballahoo (1867, perhaps 1836) was a sailor's contemptuous word for any vessel they disliked. There is as well a 2009 book entitled "Heroes and Ballyhoo" by Michael K. Bohn about sports stars during the period 1919-30s an "era of wonderful nonsense", when sport-crazed public demanded spectacles instead of just matches. Given this golden crazy age lasted 12 years long and many pundits are indicating that a recession in the United States could happen in the next two years, we are indeed wondering when this period of "irrational exuberance" to paraphrase former Fed supremo Alan Greenspan will end. On a side note, for sports fanatics out there, baseball legend Babe Ruth personified the Golden Age of the roaring "Ballyhoo" twenties, a close second was the boxer Jack Dempsey. 

In this week's conversation, we would like to look at housing as yet another sign that we think we have reached "peak" US economic activity.

Synopsis:

• Macro and Credit -  The real state of Real Estate in the US and the consequences
• Final chart - Beware of the velocity in tightening conditions

• Macro and Credit -  The real state of Real Estate in the US and consequences

Back in April 2012 we indicated the following relationship with the housing bubble: 

"The surge in the Baltic Dry Index before the start of the financial crisis was a clear indicator of cheap credit fueling a bubble, which, like housing, eventually burst. In the chart below, you can notice the parabolic surge of the index in 2006 leading to the index peaking in May 2008 at 11,440; with the index touching a low point of 680 in January 2012"  - source Macronomics, April 2012

- source Macrobond

The Baltic Dry Index, a gauge of rates to transport dry-bulk commodities including grains and coal by sea. Dry bulk cargo represents the largest part of the $380 billion shipping industry. Container shipping traffic is driven by consumer spending as it is dominated by consumer products. Container volumes to the United States are dependent on the housing market. Furniture and appliances are some of the top freight categories imported in both the United States but, in Europe as well from Asia. 

Any changes in consumer spending trends are depending on the health of the housing market:

- source Macrobond

With the Fed on its hiking mission, house affordability is being impacted through rising mortgage rates. Housing is getting more expensive in conjunction with labor shortages and rising costs linked to some extent to tariffs such as those on imported steel.

Basically it seems that the housing market in the United States seems to be stalling as affordability is becoming an issue:

- source Macrobond

Making a quick detour to shipping, there are as well signs that global trade is indeed cooling off. 

Another indicator other than the BDY is the Harpex Shipping Index. It is considered a good indicator of global economic fleet shipping activity since it tracks changes in freight rates for container ships over broad categories. It is slightly different than the BDY. Harpex weights average daily charter rates across eight size classes of vessels to formulate its index. A vessel containing dry bulk generally transports a single load type. Containers ship, by comparison, usually transport a wider variety of finished goods, which makers therefore the Harpex Shipping index a more accurate indicator for measuring global trade:

- source Macrobond

We can clearly see a deceleration in global trade happening at the moment thanks to this index.

But, let's return to US Housing. 

The housing market has clearly been the weak spot in the “strong economy” narrative. The Fed’s hiking path is leading to rising 30 year fixed mortgage rate towards 4.90%, the highest level touched since April 2011:

- graph source Macrobond

Single-family homebuilding is the largest share of the US housing market and fell by 0.9%. Housing affordability is becoming a challenge. 

At the same time, US housing prices are now 6.3% higher than their peak in July 2006 and 46% above their trough in February 2012:

- graph source Macrobond

On the subject of housing being a cause for concern, we read with interest Bank of America Merrill Lynch's US Economic Weekly note from the 19th of October entitled "Will housing hurt?":

"Will housing hurt?

• We have made a number of changes to our housing forecasts to reveal a weaker trajectory of sales, starts and home prices amid rising rates.
• We think home price appreciation is set to slow but not fall negative absent a recession in the overall economy.
• Housing is no longer a tailwind for the economy, but the headwinds are blowing very gently.

Home prices: from boom to bust

Home prices nationally, as measured by the S&P CoreLogic Case-Shiller index are running at 6.0% yoy as of the latest data in July. Assuming some modest slowing into the end of the year, we believe we are on track for home prices to end up 5.0% this year, as measured by 4Q/4Q change. As we look ahead into next year, we expect the slowing in home prices to persist, leaving home price appreciation (HPA) of 3% at the end of 2019 (Chart 1).

Thereafter we expect home price appreciation to hold at that 3.0% pace in 2020.

Back to econ 101, home prices should be a function of housing supply and demand. As we argued in Home sales: the peak has been reached, we think existing home sales peaked at the very end of last year and have since been moving sideways in a choppy fashion. This is a function of affordability which has been challenged from rising mortgage rates and elevated home prices. Inventory levels have remained extremely low, but since we look for some continued growth in single family housing starts but little change in home sales, we could start to see the supply of homes increase. The modest shift in the demand curve and out of the supply curve naturally implies slower  home price appreciation. As Chart 2 shows home price appreciation typically peaks along with the peak in home sales.

With mortgage rates heading higher, the challenges with affordability will continue. As a simple rule of thumb based on the NAR’s affordability index, we find that a 50bp increase in mortgage rates would need about a 5.5% offsetting drop in home prices in order to keep affordability unchanged. Of course, this does not account for the rise in income which provides an additional modest offset. Plugging in forecasts for mortgage rates based on our rates strategy call for the 10 year to end this year at 3.25% and 3Q 2019 at 3.35% – which implies close to 5.15% and 5.25%, respectively, for the 30-year fixed-rate mortgage – we would see affordability continue to slip lower (Chart 3). 

While affordability would still be above the historical average, it would still be more challenging than the past several years.

Another important aspect when thinking about the trajectory of home prices is an idea called “mean reversion”. Home prices are ultimately anchored to a fair value which is a function of income growth. Based on the OECD’s methodology, we compare nominal Case-Shiller home prices with disposable income per capita, indexed to 100 in 1Q 2000 (Chart 4) which shows the overvaluation during the housing bubble given the irrational exuberance in the market and easy credit conditions.

The housing bust left prices to tumble back below fair value. Based on our calculation, prices are once again overvalued on a national level, albeit not nearly as much as during the bubble period. Over time the overvaluation can be solved in two ways: 1) home prices grow at a rate below income for a period of time to close the gap; 2) home prices decline to correct the valuation difference. The pull to fair value can be quite strong.

Regional realities

We have been discussing the national outlook for the housing market but the dynamics will vary on a regional basis. Focusing on the top 20 metropolitan statistical areas (MSAs), we find that all 20 are still witnessing positive YOY home price appreciation, ranging from a low of 2.8% in Washington DC to a high of 13.7% in Las Vegas.

Generally speaking the West Coast has seen stronger home price appreciation relative to other regions. This reflects the fact that the West has enjoyed robust economic growth, supported by the thriving tech sector, which has led to greater income and wealth creation. This subsequently feeds into housing demand and a bid on prices (Chart 5).

At the same time, the West has also suffered from greater building constraints and a more severe housing shortage, owing to restrictive land-use regulations and zoning laws. This has contributed to home prices well outpacing income growth. Unsurprisingly, a regional analysis of price/income ratios finds the greatest levels of overvaluation in  Western MSAs (Chart 6).

Conversely, the Midwest cities were generally undervalued.

The higher prices rise in overvalued regions, the harder they may fall. So outright price declines could be seen as demand pulls back, though as discussed earlier we think this is less likely for aggregate national prices. Meanwhile, more affordable areas should continue to see price gains assuming healthy regional economic growth.

Sales and starts are a bit weaker

While existing home sales have peaked and will continue to hold around 5.5 million through next year, we see further upside for new home sales, albeit only modest. We forecast new home sales to edge up to 665K next year from our forecast of 640K this year, which is up from 612K last year. Why would new home sales increase while existing home sales move sideways? The recovery in new home sales was much slower since builders were hesitant to add supply to a challenged market, particularly in the early stages of the recovery.

We have revised down our forecast for starts this year and next. We expect 1.260 million starts this year and 1.30 million next year. The gain will be entirely in single family construction as multifamily has little upside.

- source Bank of America Merrill Lynch 

While we expect single family starts to edge higher – consistent with continued elevated levels of NAHB homebuilder sentiment and low levels of inventory – we think builders will be cautious in the face of rising mortgage rates." - source Bank of America Merrill Lynch

Unfortunately we do not share Bank of America Merrill Lynch's optimistic view. That would not make us "perma-bears" but we do not fall easily prey to "Ballyhoo" games namely sensational promotion.

No offense to Bank of America Merrill Lynch but, Main Street has had a much better record when it comes to calling a housing market top in the US than Wall Street. 

If you want a good indicator of the deterioration of the credit cycle, we encourage you to track the University of Michigan Consumer Sentiment Index given the proportion of consumers stating that now is a good time to sell a house has been steadily rising:

- graph source Macrobond

Maybe after all, they are spot on and now is a good time to sell houses in the US? Just a thought. Main Street was 2 years ahead of the 2008 Great Financial Crisis (GFC) as a reminder. Many pundits are predicting a recession in the US economy in the next two years.

As we have stated before, the Fed will continue its hiking path, until something breaks, and we have already seen some small leveraged fish coming belly up when the house of straw build up by the short-vol pigs blew up and when during the summer the house of sticks of the macro tourist carry pigs blew up (Turkey, Argentina, etc.). We keep pounding this but, Fed's quarterly Senior Loan Officer Opinion Survey (SLOOs) will be paramount to track going forward as the credit noose tightens.

Furthermore, it’s isn’t only residential housing which is a concern, in recent years Commercial Real Estate prices have gone through the proverbial “roof”:

- graph source Macrobond 

We think that "housing is no longer a tailwind for the economy" and that "headwinds are blowing very gently" is in this case a "Ballyhoo".

If one looks at US Homebuilders index versus the S&P500 that cyclicals matter when it comes to assessing the rising probabilities of a US recession:

- graph source Macrobond

This is telling you that housing activity is leading overall economic activity, housing being a sensitive cyclical sector. We have reached "peak" everything when it comes to US economic activity. It might be very well all downhill from there. We are already seeing signs in Europe with the latest PMIs of global trade deceleration, and not only from shipping mentioned above.

Also, if one looks at the S&P500 versus US Regional banks, one could conclude that "misery loves company":

- graph source Macrobond

The Regional Banks index has fallen 16.58% from its high back in early June and has fallen 7.05% since the start of October. Bank OZK’s stock dropped nearly 24% on the 19th of October after Commercial Real Estate (CRE) write-offs. The Arkansas-based bank is one of the largest condo construction lenders in Miami, NYC and LA. You would be wise thinking about selling your condo in Miami according to Main Street's predictive history.

As indicated by Bank of America Merrill Lynch in their weekly Securitized Products Strategy weekly note from the 22nd of October, bank stocks and MBS basis have a strong relationship since 2015:

"How Q3 bank earnings inform us

Domestic bank demand is key to agency MBS valuations; one simple relationship we have ascribed to is the strong relationship between bank equity valuations and the current coupon mortgage basis. Even recently, lower bank stock valuations have coincided with the basis widening. The underlying logic tying these two together is the outlook for bank balance sheets, reflected in stock prices, suggesting a technical backdrop for bank demand for agency MBS.

Many individual moving parts, however, come into play on the various pieces of bank balance sheets. For example, theory suggests deposits are impacted by the Fed’s balance sheet runoff. Appetite for securities relies on tolerance for capital volatility related to AOCI (all other comprehensive income), which changes with rate views and duration appetite. Finally, loans funded vary based on credit risk appetite and industry competitiveness, such as non-bank participation and accessibility to the high grade, high yield markets. These moving parts change, dampening or expanding bank demand for securities. We leverage the 3Q18 earnings call transcripts of the largest banks to extract takeaways on driving factors influencing these trends.

Lower tolerance for incurring AOCI risks – Tax reform, lower tax rates specifically, has reduced bank tolerance for incurring AOCI risks. AOCI losses have led to a larger tax deductible historically than what the current lower tax regime offers. The outlook for higher rates this year, and the potential for even higher rates ahead, has dampened enthusiasm for banks to take duration risk.

Cash is king, a compelling alternative, only getting better– Cash yielding 2+% compared to a post-crisis era of offering nothing raises the bar for investing in securities and taking on duration risk. Projecting returns on cash, along the forward path, only further stands to enhance the appeal of this strategy. Indeed, this is how the Fed’s tightening of policy works its way through banking channels, essentially raising the risk-free rate!

Yes, higher base case NIMs, but a few IF’s echoed – The selloff in rates highlights better NIM opportunities presented today, as deposit rates undershoot model forecasts. However, it is far from being just this simple. Convexity concerns and volatility ahead pose risks, along various forward paths. The outlook for loan growth, hinging on whether the economy keeps expanding, dictates securities demand, be it for HQLA/LCR reasons or for NIM/earnings.

The big question is can the US economy continue to expand as such a pace when housing is already struggling and even if FICO scores get lowered to facilitate credit card use by a pressurized US consumer?

There are indeed some implications down the line as highlighted by Bryce Coward from Knowledge Leaders Capital in his blog post from the 19th of October entitled "More evidence of a slowing housing market, and its implications":

"The slowdown housing activity leads overall economic activity by eighteen months. Housing, being one the most cyclically sensitive sectors of the economy, often feels the impact of higher rates well before other areas. This alone implies a peaking of economic activity right about now, leading to persistently slower growth rates through Q1 2020. 

Not coincidentally, a peaking of economic activity about now is also consistent with the 1.2% fiscal stimulus boost we’re getting in 2018. Incremental stimulus for 2019 drops to .4%, with the potential of that entire stimulus being negated by dead weight losses from tariffs, but that is a topic for another day." - source Knowledge Leaders Capital

This ties up nicely we think with Main Street sanguine view of the housing market, namely that it's less and less the time to buy a house and more and more the case of selling a house as per the previous credit cycle call Main Street made. The credit cycle is no doubt turning regardless of the "Ballyhoo" put forward by some pundits.

Sure overall, the latest quarterly Fed Senior Loan Officer Opinion Survey (SLOOs) points towards gradual tightening of financial conditions overall, yet the recent move based on the sensitivities of major market variables points towards an accelerating trend as per our final chart.

• Final chart - Beware of the velocity in tightening conditions

Our final chart comes from Morgan Stanley US Economics note from the 11th of October and indicates how using a more real-time look at financial conditions points towards a higher velocity in the tightening trend of financial conditions:

"An updated view on financial conditions indices shows a mixed picture, with the
Chicago Fed’s FCI actually easing further in the week ending October 5, while other alternative financial conditions metrics show a more considerable tightening in recent days.

The Chicago Fed updated its weekly FCI this morning. The latest update covers through last Friday, October 5, so it’s quite lagged. Somewhat surprisingly, the index eased 0.026 points – the largest one-week easing since the week ending August 10 and the 13th consecutive week of easing for the index.

The index now stands at a level of -0.76, a low since July 2015, driven by lower readings on the risk, credit, and leverage subcomponents. 49 underlying indicators tightened in the last week and 56 loosened – some of the biggest contributions to easier conditions were the Markit IG 5-yr senior CDS index, HY 5-year senior CDS index, and the 3-month TED spread.

An alternative metric that we look at for a more real-time look at financial conditions has shown a greater tightening in financial conditions so far this week. This metric tracks financial conditions based on the sensitivities of major market variables in the Fed’s FRB/US macro model, and we express it in a fed funds rate equivalent.

By this approach, financial conditions have tightened about 10bp from last Friday and about 50bp from the end of September. That compares with the experience from early February this year when financial conditions tightened about 80bp over a two week period." - source Morgan Stanley

Is this velocity seen in greater tightening of financial conditions a case of "Reflexivity", being the theory that a two-way feedback loop exists in which investors' perceptions affect that environment, which in turn changes investor perceptions, or is it simply a case of "Ballyhoo" at play? We wonder...

"Civilization begins with order, grows with liberty and dies with chaos." - Will Durant, American historian

Stay tuned!

Macro and Credit - The Endless Summer

"The fact that logic cannot satisfy us awakens an almost insatiable hunger for the irrational." - A. N. Wilson, English writer

Watching with interest the continuation in the "Trumpflation" trade with equities pushing higher, credit going tighter and USD suddenly going stronger with real rates (pushing us to significantly curtail our gold mining exposure), we reminded ourselves for our title analogy of the 1966 worldwide release of surf movie "The Endless Summer". Its title comes from the idea, expressed at both the beginning and end of the film, that if one had enough time and money it would be possible to follow the summer up and down the world, making it endless (like the perfect asset allocator...). In similar fashion, the global reflationary trend witnessed so far thanks to central banks support, like the tide, has lifted all boats overall. From real estate to stock markets reaching in the US for some instance "lofty" valuations levels, given the recent strong macro data from PMIs to the latest ADP/NFP release in the US, we are indeed wondering if this credit cycle, while being long in the tooth, doesn't amount to "The Endless Summer". So if surfing the "wealth effect" seems so far appropriate for our title and markets analogy, we are wondering where the next big wave could be coming, given we recently pointed out that in many instances High Yield had been "priced" to perfection and the rally had been significant.

In this week's conversation we would like to look at the ebb and flow in the credit markets which could determine departure times from various asset classes as we move towards the Fed's hike decision.

Synopsis:

• Macro and Credit - Caesar, beware the ides of March
• Final charts - Are Boomers "Bust" ?

• Macro and Credit - Caesar, beware the ides of March

In modern times, the Ides of March is best known as the date on which Julius Caesar was assassinated in 44 BC which corresponds, dear readers to the 15th of March and equating to the next FOMC meeting of the US Federal Reserve bank. As we pointed out on numerous occasions we tend to look not only like any good pundits in the positioning of the players (such as the overstretched position in oil longs for instance...), but we do also look at the flows which could also be indicative in the changes in allocations.  As we pointed out in our most recent musing, so far this year High Yield fund inflows have remained strong in conjunction with the performance, making it look like an "Endless Summer" given the very significant performance of the asset class since the second part of 2016. Yet, it seems that as of late, it looks like some players have been trimming their sails. While next rate hike seems to be "baked in the cake", it remains to be seen how hawkish the tone will be at the next FOMC meeting. Many analysts are pointing out that the Fed is behind the curve, we have on numerous occasions joked with other macro rates pundits that the curve is behind the Fed. In relation to the risk of a more hawkish bias, we read with interest Bank of America Merrill Lynch's take from their Securitized Products Strategy weekly note from the 10th of March:

"Turning negative

Fed rate hike odds for next week are now almost 100%, up from the mid-30s just two weeks ago. The hawkish shift by the Fed has already been reflected in corporate credit spreads and real interest rates: IG and HY CDX spreads were as much as 5 bps and 30 bps wider in the past week, respectively, while the real 10yr yield is up by over 25 bps in the last two weeks. As usual, securitized products spreads have lagged the corporate and rate market action for the most part, as technical support for securitized products, especially credit, remains very strong.

What we’ve seen over the past two weeks is a mini-version of what we expect for 2017 overall. There is still plenty of time left in the year, so no doubt there will be continued swings in both directions on rates and spreads. But the big development in the past two weeks is the rapid hawkish shift in Fed rhetoric. We see potential for additional hawkish shifts in rhetoric going forward, including discussion of normalizing the balance sheet quicker than the market anticipates, and are in the camp that thinks the Fed is behind the curve on tightening monetary policy. If economic/inflation data forces the Fed to start tightening policy more aggressively, we think the market will eventually re-price equilibrium spread levels wider.

In short, the securitized products view is turning more and more into a view on how hawkish this tightening cycle will be for the Fed. Fed accommodation, and QE in particular, has unequivocally benefitted what we think of as the benchmark sector for securitized products, agency MBS. If the Fed is finally embarking on a sustained, hawkish tightening cycle, where their ownership of agency MBS is “normalized,” the path of least resistance for securitized products spreads is likely to be wider. Meanwhile, spread tightening potential, or at least justification for it, has become limited in our
view. Asymmetry on spreads is not a good thing.

Below, we examine the data connecting the Fed's MBS portfolio size to housing inventory, and rent and home price inflation. We believe the case can be made that reducing the portfolio sooner rather than later is warranted due to inflationary pressures in the housing market, although we recognize that this is probably a deep out-of-the money view at this point. Meanwhile, for the near term, the inflationary pressures in housing are a positive for residential mortgage credit.

We retain our neutral view on securitized products credit. There are positives on the technical and even fundamental front for the sector, except perhaps for CMBS, but our concerns about a looming hawkish shift by the Fed make us wary about chasing spreads tighter. Neutral balances it out for us. We turn underweight agency MBS, where we see enough negatives to outweigh the positives on the technical side. Specifically, we see seasonal supply pressures picking up and recognize that agency MBS are likely to be the first sector adversely impacted by any talk of accelerated balance sheet normalization.

Two indicators of why the Fed is/may be (way) behind on tightening 

We look at data that shows that the Fed is or may be way behind on tightening monetary policy, both in terms of raising rates and reducing its MBS portfolio. We are well aware that to date, both the Fed and the market have shown little concern over, or perhaps even awareness, of the analysis we present. As a result, it’s probably too early to think about it having a market impact. However, at a minimum, we think the data highlight the risk that the Fed somewhat abruptly shifts to a much more hawkish policy position.

In particular, unless mortgage rates are increased, by signaling accelerated MBS portfolio reduction, we think excessive home price and rent inflation looms on the horizon. Some have asked whether losses on portfolio sales would deter the Fed from selling. Losses might be a deterrent, but if rent and home price inflation spiral out of control, the Fed may not have a choice. Before considering the balance sheet, we focus on rate hikes as a policy tool.

1. Fed Funds and the Taylor Rule

Stanford’s John Taylor of Taylor Rule fame will be the featured speaker at the BofAML 2017 Residential & Housing Finance Conference this coming Tuesday, March 14, 2017. We'll wait for that session for guidance on the appropriateness of the Taylor Rule Fed Funds level versus the current Fed Funds level. Here, we simply present the historical data in Chart 1 (the two time series) and Chart 2 (Fed Funds – Taylor Rule) and leave it to the reader to decide if he or she thinks the Fed is possibly behind the curve. Currently, Fed Funds is roughly 300 basis points (twelve 25 basis point hikes!) below the Taylor Rule level.

The last time a disparity this large was seen was in 1974-1975, during a period of extraordinary rate volatility, when Fed Funds went from 13% to 5.5% in a matter of months. In a period of such high volatility, short term dislocation between an actual value and a model value can be expected. Now, with Fed Funds barely budging in eight years, the volatility explanation of the discrepancy does not apply. Rather, it appears as if the “Rule” is simply being ignored. As a result, after 40 years of roughly moving together, with the Taylor Rule level exhibiting less volatility than actual Fed Funds, they have decoupled.

Two possibilities emerge:

1. The Rule no longer applies and the decoupling will be permanent.
2. The Rule still applies and, as has been the case in the past, economic data inevitably force the humans setting the Fed Funds level to follow the Rule.

As a simple observation on the historical data, possibility #2 seems more reasonable to us, suggesting the Fed is way behind on tightening. Others can choose possibility #1.

2. The Fed balance sheet and home price and rent inflation

Here we consider the histories of existing home sales, housing inventory (measured as months supply, the number of homes for sale relative to the annual sales rate), Case Shiller home price appreciation (HPA), rent inflation and the Fed’s MBS portfolio size. We suggest that the Fed’s MBS ownership is creating home price and rent inflation, and that may not necessarily be a good thing.

Chart 3 starts with a look at existing home sales. January’s 5.69 million rate was the highest level since early 2007. That is also the level of early 2002, just before the housing bubble period commenced. Sales are seen on a steady uptrend since the end of 2008, when the Fed began buying MBS.

Chart 4 shows existing home sales versus Case Shiller HPA. Not surprisingly, the two series tend to move together. Policymakers and homeowners may be pleased that YOY HPA is reasonably strong, 5.85% for 2016. But what if it trends higher, along with existing home sales, as it did in the early 2000s? Is there a level of home price inflation that makes policymakers uncomfortable? What about the 36% of the population that do not own homes? Are they priced out of homeownership? Does strong HPA get passed through to rents?

Chart 5 suggests the answer on rents is yes. 5%-10% HPA may be great for homeowners but do policymakers really want to see rent inflation continue the steady rise that began in 2010, a year and a half after the Fed began purchasing MBS? Chart 6 shows that, two years after the Fed stopped increasing its MBS portfolio size, rent inflation appears to be accelerating. Similar to existing home sales, rent inflation is at the highest level since 2007.

Chart 7 shows the history of housing inventory. At 3.6 months, supply is back down to the record lows seen at the height of the housing bubble in 2005. Many will say that the low inventory is because builders are not building new homes. That may be true, but does that preclude the possibility that Fed MBS purchases may also be a factor, by artificially setting mortgage rates too low? The answer, in our view, is no, Fed balance sheet holdings cannot be ruled out as a driving force. Moreover, even if the Fed is responsible for low housing inventory, why is that a problem? Well, as we will see, it leads to home price inflation, which, as noted above, leads to rent inflation, which we think is a problem.

To help show these connections, we do a mathematical trick and invert the housing inventory and compare the inverted level to the Fed MBS holdings (Chart 8) and to HPA (Chart 9).

Similar to rent inflation, Chart 8 shows that the inverted housing inventory number bottomed in 2010, about a year and a half after the Fed started buying MBS, and has been trending higher ever since, meaning that inventories have been moving steadily lower. Chart 9 shows that this inverted inventory number tends to move in synch with or in advance of HPA, ie as a leading indicator. For anyone long housing, or residential mortgage credit, this looks like very good news for 2017. The data suggest that, due to record low inventories, the risk for HPA in 2017 is to the upside. The comparison of inverted inventory levels and rent inflation in Chart 10 shows a similar story for rent inflation: upside risk in 2017.

For a policymaker whose job is to maintain price stability, escalating rent inflation is not good news. There is a simple policy “cure” for this situation: raise mortgage rates by reducing the Fed MBS portfolio. Is the Fed anywhere near reaching this conclusion? Maybe not, but it probably should be, and if there is a rapid policy shift on this issue, we will not be surprised." - source Bank of America Merrill Lynch

There you go. While the Fed has been behind most of the "Endless Summer", one could argue that the Fed is not behind the curve, but, the curve is behind the Fed. Put it more simply, the Fed is the credit cycle, so, as the Fed starts to tighten in earnest financial conditions, the credit cycle will turn and rest assured it will entail some significant repricing at some point.

To that effect we agree with Jeff Gundlach from Double Line's recent take, namely that the Fed will hike until something breaks. It is bound to happen as the Fed has once again maintained rates too low for too long, which has led to some complacency in various asset classes and lofty valuations in many instances. This is as well the feeling in credit land as per recent investors' survey where there is a feeling of overvaluation.

This has been leading to some flow rotation with a more pronounced defensive stance leading to a reduction in both credit risk (from High Yield to Investment Grade) and a reduction in duration risk. This is clearly indicated in Bank of America Merrill Lynch latest Follow The Flow note from the 10th of March entitled "Shunning duration, adding yield":

"Reaching for yield, but cutting on duration

Higher yields and tighter spreads continue to benefit IG bond funds in Europe, recording a very strong inflow last week. Equities flows are back to positive with a $1bn inflow last week as economics data are strengthening. Duration is still under attack as IG investors are cutting back with rates moving higher. The reach for yield trade is in vogue with inflows into EM debt funds doubling w-o-w.

Over the past week…

High grade funds continued on a positive trend for the seventh week in a row; and recorded the highest inflow in 18 weeks. High yield funds inflows slowed down significantly last week, but still posted their 14th consecutive week of positive flows. Looking into the domicile breakdown, European-focused funds were the ones that recorded inflows, while outflows hit US and globally-focused funds.
Government bond funds flows remained on negative territory as rates moved higher. Money market funds weekly flows are back to positive after three weeks of outflows. Overall, fixed income funds flows remained strong and positive for the eleventh consecutive week; with more than $33bn of inflows over that period.
European equity funds flows flipped back to positive territory. So far this year the asset class has recorded inflows in seven out of ten weeks. Note that in 2016 the asset class recorded only eight weeks of inflows during the entire year.

Global EM debt fund flows continued on a positive trend for a sixth week, while flows more than doubled w-o-w. Almost $13bn of AUM has been added in the asset class YTD. Commodities funds flows flipped back to negative after seven weeks of consecutive inflows as oil prices dipped lower.
On the duration front, strong inflows continued in short-term IG funds for the 12th week in a row. Mid-term funds also posted a strong week of inflows; the second in the row. Flows into long-term funds remained negative for a third week in a row." - source Bank of America Merrill Lynch

Now if indeed there is added caution and a "Great Rotation" to quality (Investment Grade), one might wonder if indeed this time around credit will be leading equities and mark an end or a pause to the "Endless Summer". We looked at the below chart from Lawrence McDonald on our twitter feed and wondered:

- source Lawrence McDonald - Bloomberg/Twitter feed

Also on our Twitter feed which caught our attention was Bloomberg Lisa Abramowicz comments relating to the outflows in the ETF HYG on the 8th of March:

"Yesterday saw the biggest one-day outflow from the biggest junk-bond ETF since the U.S. election." - source Lisa Abramowicz - Bloomberg

As pointed out by a credit market pundit on Twitter as well (H/T Fil Zucchi) $5 billion worth of new issues were bought in the cash markets. One has to remember that, when it comes to keeping it's cool under pressure, the retail crowd is much more feeble than the institutional crowd. Where we slightly disagree with Fil Zucchi is that there has been a very significant growth in passive management and in particular bonds ETFs. So while tracking bonds ETFs is of interest, it is of course not the best great gauge of real health in credit markets. Yet, in the European High Yield complex, this week has seen some heavy trading in the cash space thanks to growing redemptions in High Yield credit ETFs. So all in all, tracking flows in ETFs is necessary but, not always enough to gauge the state of the market. But, from a short term perspective, it might indicate some weakness in the near term.

Another cause for concern has been the recent sucker punch delivered in very short order to the very crowded long oil community, which once again is going to weight on credit spreads and in particular the Energy sector which have been on a tear in the second part of 2016, leading to a significant outperformance of the sector. This, we think is worth monitoring, given the correlation between oil prices and High Yield as displayed in the below chart from Tom McClellan on his twitter feed:

- source Tom McClellan - Twitter feed

So if it is indeed you are wondering when "The Endless Summer"  will end and if you are a "big wave surfer" like Bohdi in Point Break meaning you are waiting for the "50-Year Storm" and "big waves" à la Nazaré in Portugal you need to start asking yourself how will this credit cycle end. On that specific point we read with interest Société Générale's take from their Credit Market Wrap-up from the 6th of March entitled "How will this credit cycle end":

"Market thoughts

For the past two years (and most recently in “The big hangover, Part II”), we have argued that the credit cycle has become shorter since the global financial crisis. Based on data going back to the 1920s, we have noted that the typical credit cycle lasts eight years, with a bear phase, a bull phase, and a phase of broad stability. But as Chart 1 shows, in the past eight years this traditional stability phase has disappeared. The average life of a credit cycle has shrunk to three years, and we have had three full credit cycles.

Chart 2 shows that there is a historical precedent for this type of rapid cycling credit market. While the cycles of the 1980s and 1990s (and a fortiori the 1940s to mid-1960s) were relatively long, the late 1960s to late 1970s saw three cycles in the space of a decade.

Beards and flares may be back in fashion, but the current disinflationary world seems very different from the high inflation of the 1970s. Yet there is one similarity: real bond yields. Chart three shows credit spreads and US 10yr bond yields minus average CPI over the previous three years. In both the 1970s and the past ten years, US real yields were low, often negative, and always volatile. By contrast, real yields in the long 1980s and 1990s cycles were positive and well behaved. Negative real yields do seem to make credit cycles faster.

So if real rates rise as quantitative easing ends, credit cycles should lengthen again. But how would this rapid cycle phase end? The 1970s example is worrying, for the biggest spike in yields took place at the end of the period. Moreover, it’s worth noting that balance sheet leverage has been much stickier through this cycle than in the 1970s. Chart 4 shows the nonfinancial debt/assets ratio from two series from the Federal Reserve of Saint Louis, plotted against spreads.

The correlation between spreads and balance sheet leverage looks weak, as leverage was falling during the rapid cycles of the 1970s, rose during the long cycles of the 1980s (as academics convinced corporates of the value of tax shields), fell after the telecoms crisis and has risen again since nominal and real yields started to fall after the financial crisis. But the more important and worrying point is that balance sheet leverage is high now compared to history, and this may end up amplifying the impact of a crisis if one is triggered by the end of low real yields.

So to sum up, the history of the 1970s is worrying for two reasons. First, it shows 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. Second, this crisis could be amplified by the fact that there has been no real balance sheet deleveraging during this period of spread volatility (unlike the 1970s). The end of this credit cycle may be far off in the future – indeed further off than we might have thought at the start of this year. When it comes, however, it may be very messy indeed." - source Société Générale

Until then you might enjoy the summer lull and complacency of the credit markets, but one thing for certain is that the end of this particularly long credit cycle will see much lower recovery rates, for us that's a given.

If indeed corporate leverage is higher than in the previous cycle as pointed out by Société Générale, 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 below

• Final charts - Are Boomers "Bust" ?

While the developed world in many parts is clearly in a state of over indebtedness, what is of interest as well is that the Baby Boomers generations that benefited from many golden years and the generosity from both governments and central banks in recent years do face some challenges as per our final charts from Wells Fargo Economics Group note from the 9th of March entitled "Till Debt Do Us Part: How Leveraged Is the Typical Boomer?":

"The Boomers are more leveraged than previous generations were ahead of retirement.

We examine the liabilities side of the balance sheet for this group and explore some of the challenges they may face.

The Borrowing Boomers

Unsurprisingly, the Baby Boomers have less debt than younger generations who are currently in their prime working years and still climbing the ladder of life. However, the typical Boomer has more debt at this point in their life relative to previous generations. As of 2013, 79 percent of households age 55-64 and 66 percent of those age 65-74 had debt of some kind (top chart).

The long-run trend in the top chart signals a rising share of each successive generation approaches the traditional retirement age with debt of some sort. In addition, not only do more Boomers hold debt, the typical value in real dollars has also risen. The Great Recession pushed debt holdings for this age bracket even higher in 2010 than the bubbly 2007 period. Real debt holdings for the typical boomer receded markedly in 2013, although this in part reflects a decline in homeownership.
Like the asset side of the balance sheet, housing comprises the bulk of debt for the average Boomer. A bit under half of Boomers hold debt secured by their primary residence (middle chart), with the median value for Boomers age 55-64 amounting to about $100,000. Credit card balances and installment loans (for vehicles for example) are also common, but median balances are a relatively manageable $3,000 and $12,000, respectively. Mean debt holdings are more than double the median, however, suggesting that some Boomers are significantly more leveraged than their peers.

Old School Not So Funny for the Boomers

Student loan debt has emerged as a hot button issue for some Boomers. A recent report by the Government Accountability Office (GAO) drew attention to this issue, highlighting the number of people whose Social Security checks are being reduced to pay off delinquent student debt.* The report found that there were 114,000 people age 50 or older in fiscal year 2015 who had their benefits reduced by about $140 a month for unpaid student loans. As the bottom chart illustrates, student loan debt has increased in size and prevalence for older individuals.

We caution, however, about overstating the pervasiveness of the problem; according to Survey of Consumer Finances data, only 12 percent of 55-64 year olds have some form of student debt, with older Boomers having an even smaller share. In addition, the 114,000 individuals age 50+ from the GAO study represent less than 0.5 percent of Social Security beneficiaries. This suggests that most Boomers are not grappling with a crushing student loan burden as they enter their golden years. That said, the GAO report found that a sizable share of those who had their Social Security benefits reduced were either pushed below/pushed even further below the poverty line. Further, if the trend of growing educational debt continues, the problem will likely increase in scope over time and create further challenges for Boomers who are already struggling with retirement preparedness." - Source Wells Fargo

Although "The Endless Summer" has created a significant windfall for the holders of financial assets, it looks to us increasingly that in many ways the average US consumer is somewhat "maxed out". It remains to be seen how many hikes it will take before the Fed finally breaks something, but, we ramble again...

"Things as certain as death and taxes, can be more firmly believ’d." - Daniel Defoe, The Political History of the Devil, 1726.

 Stay tuned!

Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008.

Statement 159, adopted by the Financial Accounting Standards Board in 2007 allows banks to book profits when the value of their bonds falls from par. This rule expanded the daily marking of banks’ trading assets to their liabilities, under the theory that a profit would be realized if the debt were bought back at a discount. How convenient...

I commented previously about the first quarter being the perfect game, the second quarter will be seriously different for Banks profits this time around.

A fast and furious tightening of credit spreads allowed Banks to publish record profits for 2009.

With the recent increase in volatility in conjunction with a reduction in debt issuance in the second quarter, banks have had a hard times to reap in similar profits they made in Q1.

As per below's Bloomberg article, Banks are now using the same accounting trick they used previously to boost their profits in a difficult trading environment.

http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=a3Eg4vzAbneA

“What’s on investors’ minds are the macroeconomic issues, as reflected by the interbank market in Europe, the very low yields on U.S. Treasuries and recent data on economic growth, jobs and housing,” Credit Agricole Securities USA analyst Michael Mayo said in an interview. “To the extent that the earnings power is less, the banks would not generate as much capital, so there’s less capital available to absorb future losses.”

The capital buffer is shrinking...and the DVA (Debt Valuation Adjustments) are returning with a vengeance.

DVA Gains:

"Including Bank of America, the four banks probably had debt-valuation adjustments, or DVAs, amounting to an average of 18 percent of pretax income, based on Citigroup Analyst Keith Horowitz’s estimates."

Accounting ‘Abomination’

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

David Hendler, Senior Analyst from CreditSights Inc. sums it up nicely in the Bloomberg article quoted above:

“When the prevailing winds of credit spreads tighten, they make a lot of money, and when spreads widen, they can’t make as much,”

Hence the recourse to DVA accounting practices.

When the game is not going your way, just change the rules...

Another nice move from FASB in 2007.

FAS 157 was reviewed in 2009 to allow more flexibility and issued in September 2006.

http://en.wikipedia.org/wiki/Mark-to-market_accounting

"On March 9, 2009, In remarks made in the Council on Foreign Relations in Washington, Federal Reserve Chairman Ben Bernanke said, "We should review regulatory policies and accounting rules to ensure that they do not induce excessive (swings in the financial system and economy)". Although he doesn't support the full suspension of basic proposition of Mark to Market principles, he is open to improving it and provide "guidance" on reasonable ways to value assets to reduce their pro- cyclical effects.

On March 16, 2009, FASB proposed allowing companies to use more leeway in valuing their assets under "mark-to-market" accounting, a move that could ease balance-sheet pressures many companies say they are feeling during the economic crisis. On April 2, 2009, after a 15-day public comment period, FASB eased the mark-to-market rules. Financial institutions are still required by the rules to mark transactions to market prices but more so in a steady market and less so when the market is inactive. To proponents of the rules, this removes the unnecessary "positive feedback loop" that can result in a deeply weakened economy.

On April 9, 2009, FASB issued the official update to FAS 157 that eases the mark-to-market rules when the market is unsteady or inactive. Early adopters were allowed to apply the ruling as of March 15, 2009, and the rest as of June 15, 2009. It was anticipated that these changes could significantly boost banks' statements of earnings and allow them to defer reporting losses. The changes, however, affected accounting standards applicable to a broad range of derivatives, not just banks holding mortgage-backed securities.

In January 2010, Adair Turner, Chairman of the UK's Financial Services Authority, said that marking to market had been a cause of inflated bankers' bonuses. This is because it produces a self-reinforcing cycle during a rising market that feeds into banks' profit estimates."

Basically, FAS 157 enabled banks to boost earnings in good times and pay themselves record bonuses and suffer catastrophic losses during the credit crisis, generating excessive margin calls on derivatives trades.
At the same time FAS 159 for DVA, enables banks to increase earnings in bad times.

The issue was anyway excessive leverage in conjunction with inappropriate accounting principle FAS 157, which led to seismic losses in US banks. Whereas in Canada bank leverage was capped to around 20 times. The capital buffer was therefore more significant. RBC still boast a AAA Rating.

The shadow inventory of REOs (Real Estate Owned, following rises in foreclosures) is putting additional strains on banks earnings. Inevitable adjustments to interest rates would as well put additional pressure on Banks Balance sheets. The current steep yield environment is helping tremendously banks in shoring up capital, provided their play is short duration (2 to 4 years). The risk is higher for Banks if they start buying longer duration trades on MBS (Mortgage Backed Securities). MBS are more abundant than US treasuries or short term liquid investments and are also offering higher yields as well. The temptation is there...and the risks are real if there is a sudden rise in interest rates.