Macro and Credit - White noise

"The real man smiles in trouble, gathers strength from distress, and grows brave by reflection." -Thomas Paine

Watching with interest, the return of volatility and consequent rise in Italian Government bond yields, in conjunction with trouble brewing yet again in Spain, following the continuous pressure and Turkey and other Emerging Markets, when it came to selecting our title analogy we decided to go for a signal processing analogy namely "White noise". In signal processing, white noise is a random signal having equal intensity at different frequencies, giving it a constant power spectral density. The term is used, with this or similar meanings, in many scientific and technical disciplines, such as physics, acoustic engineering, telecommunications, and statistical forecasting. White noise refers to a statistical model for signals and signal sources, rather than to any specific signal. White noise draws its name from white light, although light that appears white generally does not have a flat power spectral density over the visible band. White noise is as well interesting thanks to its statistical properties. Being uncorrelated in time does not restrict the values a signal can take. Any distribution of values is possible and even a binary signal such as the ones currently being given by European Peripheral bond markets (risk-off). In statistics and econometrics one often assumes that an observed series of data values is the sum of a series of values generated by a deterministic linear process, depending on certain independent (explanatory) variables, and on a series of random noise values. Then regression analysis is used to infer the parameters of the model process from the observed data, e.g. by ordinary least squares, and to test the null hypothesis that each of the parameters is zero against the alternative hypothesis that it is non-zero. Hypothesis testing typically assumes that the noise values are mutually uncorrelated with zero mean and have the same Gaussian probability distribution – in other words, that the noise is white. If there is non-zero correlation between the noise values underlying different observations then the estimated model parameters are still unbiased, but estimates of their uncertainties (such as confidence intervals) will be biased (not accurate on average). This is also true if the noise is heteroskedastic – that is, if it has different variances for different data points. While causation of Emerging Markets sell-off can be attributed to  "Mack the Knife" aka rising US dollar and positive US real rates, it doesn't imply correlation with the sudden surge in Italian government bond yields, following the rise of a so called "populist" government at the helm of Italy. It is not that Italian issues went away, it is that there were just hiding in plain sight thanks to the strong support of the ECB with its QE program. Now that a less accommodative government has been elected in Italy, the status quo of the sustainability of the European project and European debt are being questioned again. The constant power spectral density of the ECB's QE is fading, hence the aforementioned reduction in the "White noise" and stability in European yields we think. We recently argued the following on our Twitter account: 

"Both rising US dollar and Gold may mean we have entered a period where non-yielding assets are preferable to assets such as some sovereign debts promising a yield yet future size of payment and or return of principal are starting to become "questionable". - source Macronomics, 24th of May.

As the central banks put is fading, what basically has been hiding in plain sight, has been the sustainability of the European project. Investors are therefore moving back into assessing the "return of capital" rather than the "return on capital". It seems to us that the "White noise" which in effect had hidden the reality of "risk" thanks to volatility being repressed thanks to central banking meddling is indeed making somewhat a comeback to center stage yet again given the recent bout of volatility seen on Italian bond prices and yields. When it comes to Italy's latest political turmoil we have to confide that we are not surprised whatsoever. We warned about this playing out exactly last year during our interview on "Futures Radio Show" hosted by Anthony Crudele:

"The biggest risk in Europe is still Italy because the growth is not there" - source Macronomics, May 2017 on Futures Radio Show.

On the anniversary of us voicing our concerns on Italy in this week's conversation, we would like to look at debt sustainability with rising rates as well as the risk of deceleration we are seeing in global growth as of late. 

Synopsis:

• Macro and Credit -  Solvency of the issuer ultimately determines allocation of capital 
• Final chart - Decline in PMI's doesn't bode well for the US bond bears

• Macro and Credit -  Solvency of the issuer ultimately determines allocation of capital 

The latest ructions in both Emerging Markets and Italian Government bond yields are a reminder that once "White noise" starts to dissipate with QT and a fading central banks put, then indeed solvency issues can return with a vengeance, such is the case with Turkey and fears on Italian debt sustainability. It is a subject we already touched in a long conversation we had back in September 2011 in our post "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portolio Theory and more!". In this conversation we quoted the work of Dr Jochen Felsenheimer, prior to set up "assénagon" and now with XAIA Asset Management, was previously head of the Credit Strategy and Structured Credit Research team at Unicredit and co-author of the book "Active Credit Portfolio Management:

"Competing systems between countries in a world of globalisation and fully integrated capital markets restrict a country's room for manoeuvre in that mobile factors of production seek out the state infrastructure which give them the best possible reward. The state can only counter the migration of workers and relocation of whole production sites with economic measures, for example the creation of an effective infrastructure (e.g. education) or tax incentives. Accordingly, a government's outgoings - and also its income - are not just determined by domestic economic developments, but also by other countries' economic strategies. Countries are in competition with each other - just like companies. And this is particularly true within a currency union, which is fully reflected in the different tax policies of the individual member states." - Dr Jochen Felsenheimer.

At the time we added that the name of the current game was maintaining, at all cost, rates as low as possible, to avoid government bankruptcies hence the ECB's QE. Dr Jochen Felsenheimer which we quoted at the time also made the following comments in the letter we quoted extensively in our conversation in 2011:

 "In terms of global competing systems, we can view countries like companies. The difference is that they only refinance through debt. Even if this refinancing option does not appear unattractive in view of the low interest rate, even cheap money has to be paid back sometimes. And that is exactly what is becoming increasingly unlikely." - Dr Jochen Felsenheimer

The ECB has been able to provide protection against a run, alas temporarily. While the ECB acted as a lender of last resort, doing so exacerbated political tensions and is not a lasting solution as we can see unfolding right now in Italy. 

The concept of "solvency" is very sensitive to the government’s cost of funding (Turkey), and therefore to swings in market confidence.  A government with even a very large level of debt can appear entirely solvent if funded cheaply enough, which is the case for various European countries we think. There is no reassurance that solvent government will always be kept liquid, forget "leverage", end of the day in credit markets "liquidity" matters and we should all know by now that "liquidity" is indeed a "coward". We commented at the time in 2011 that liquidity, matters, because the major implication of the disappearance of risk-free interest rates is that it weakens in the process the quality of the "fiscal backstop" enjoyed by banks, particularly in peripheral countries which have extensively played the "carry trade". Therefore the sovereign/banks nexus has not been reduced by the ECB's actions, on the contrary. Net Interest Margins (NIM) for peripheral banks has been replaced by "carry trades" thanks to the ECB. There is a direct relationship between the credit quality of the government and the cost and availability of bank funding. You probably understand more our Twitter quote from above regarding the risk for the "return of principal" when it comes to some sovereign debt which again are starting to become "questionable" hence the "repricing" for some Emerging Markets and Italy as well.

If indeed we are moving towards a repricing of risk on the back of "solvency" issues it is because the "risk-free" status of some European government bonds is coming back into center stage. We can see it in the credit markets as pointed out by Bank of America Merrill Lynch European Credit Strategist note from the 24th of May entitled "Corporates safer than governments":

"The not so dolce vita

2017 was a year of “buy the dip” galore in Euro credit markets. Few of the risks that bubbled to the surface last year caused spreads to sell-off for any notable length of time. In fact, the longest consecutive streak of spread widening in 2017 was a mere 3 days (Aug 9th – 11th). What held the market together so well? The constant stream of retail investor inflows into European credit (IG inflows in 49 out of 52 weeks).

This year, however, it’s been more of an uphill struggle for spreads. “Buy the dip” behaviour has been decidedly absent whenever risks have weighed on the market (note that spreads widened for 7 consecutive days in March). And new issuance continues to knock secondary bonds, something that was rarely seen last year.

What happened to TINA (There Is No Alternative)?

What’s changed, then, from 2017 to now? Simply, that the retail inflows in Europe have been much more muted over the last few months…and these were the “glue” of the credit market last year. What about TINA…and the reach for yield? We think the Euro credit inflow story is partly being disrupted by the attractive rates of return available on “cash” proxies in the US market. As Chart 1 shows, given the cheapening in the frontend of the US fixed-income market, US bill yields now offer more attractive returns for investors than the dividend yields on US stocks – something that has not been the case for over a decade.

Accordingly, we think some European retail inflows may be leaking into the US market at the moment, especially given the recent USD strength.

QE…and a classic liquidity trap?

But we don’t think this dynamic will stymie the inflow story forever. In fact, we remain confident that retail inflows into European credit funds will pick up steam over the weeks ahead.

As Chart 2 shows, domestic savings rates across major Euro Area countries have been rising noticeably of late, while declining in other countries such as the US and UK. Even with all the restorative work that Draghi and the ECB have done, European consumers’ penchant for conservatism and saving has not moderated.

In a classic “liquidity trap” scenario, we wonder whether low/negative rates in the Euro Area may simply be encouraging a greater effort by consumers to save for the future (and note that the Fed and BoE never cut rates below zero).

Whatever the driver, more money is being saved in Europe, and yet the prospect of material rate increases by the ECB remains a distant thing: the market has pushed back lately on rate hike expectations, with cumulative ECB depo hikes of 40bp now seen in over 2yrs time.

In this respect, Draghi is still fighting a “war on cash” in Europe. We believe this was the pre-eminent reason retail inflows into credit were so consistent last year…and we believe that this story is far from over.

The not so Dolce Vita

The ructions in Italy have contributed to another dose of high-grade spread widening over the last week: 8bp for high-grade and almost 20bp for high-yield. Testament to the weaker inflows at present, the move in credit is larger than that seen last March, pre the French Presidential election. Back then, the market was also on tenterhooks given Marine Le Pen’s manifesto pledge to redenominate France’s debt stock into a new currency, and to hold a referendum on EU membership.

5% of high-grade

For now, the ink isn’t yet dry on Italy’s first populist government – there are still the hurdles of designating a Prime Minister (at the time of writing), the President’s “blessing” on the government programme, and confidence votes in the Italian parliament. But assuming a 5-Star/Lega coalition government takes power, is this a source of systemic risk for Euro credit? We think not for the high-grade market. While Italy has a larger outstanding stock of sovereign debt than France, the picture is much different when it comes to high-grade. In fact, Italian IG credit represents just 5.4% of the market now…and that number continues to shrink as Italian corporates remain focused on deleveraging.

Where systemic risk from Italy may be of greater concern is in high-yield, as Italian credit represents 17% of ICE BofAML’s Euro high-yield index (we elaborate more on this here).

The plunge protection team

And true to form, the sell-off in the corporate bonds over the last week has been a much shallower version of what historically one would have expected to see. Chart 4 shows corporate bond spreads for peripheral financials versus 10yr BTP spreads.

They have been well correlated since early 2011. But credit spreads have moved much less over the last week than the move in BTPs would imply (and see here for a similar picture for Itraxx Main).

Populism…for real

The Le Pen populism experience quickly came and went for credit markets last year. Her insistence on drastic ideas such as “Frexit” appeared to stymie her support heading into the first round of the French Presidential elections. Her policies did not resonate with a French electorate that were broadly in favour of the EU and its institutions.

But political uncertainty, and populist sentiment in Italy, is likely to have longevity in our view. The hallmarks of populism – voter frustration and wealth inequality – are clear to see. Strong and stable governments have not been a hallmark of Italian politics since the proclamation of the Italian Republic in 1946: the country has had 65 governments.

The hallmarks of populism

Although the Italian economy has returned to growth over the last few years the magnitude of the recovery is still tepid. The IMF forecast Italy to grow at 1.5% this year, one of the lowest growth rates among Advanced Economies (the UK’s projected growth rate is 1.6% this year and Japan is forecast to grow at just 1.2%, according to the IMF).

In fact, the Italian electorate has seen little in the way of wealth gains since the creation of the Eurozone. Chart 5 shows GDP per capita trends for Italy and Germany. While GDP per capita is much higher in Germany, for Italy it remains marginally below where it was upon the creation of the Euro.

According to Eurostat, almost 29% of the Italian population were at risk of poverty or social exclusion in 2015 (and almost 34% of children were at risk). Hence the Citizenship Income mentioned in the 5-Star/Lega Government Contract.

Successive governments, of late, have focused on the fiscal side of the economy with less emphasis on structural reforms to unlock Italy’s growth potential. This has hindered private entrepreneurialism and the expansion of the corporate sector. As Chart 6 shows, Italy still has a large number of SMEs (and “micro firms”) making up its industrial base.

Sluggish long-term investment has partly contributed to this state of affairs. As Chart 7 highlights, capex intensity in Italy remains well below the levels seen between 2000- 2005, while the capex recovery has been a lot healthier in France and Germany.

A vibrant banking sector – that supports SME lending – is of course a prerequisite for greater levels of credit growth in Italy. And while Italian banks have made a lot of progress in reducing their NPLs recently (especially over the last few quarters), Chart 8 shows that there is still work to be done.

Italian banks continue to have the largest stock of non-performing loans across the European banking space. For more on the structural challenges facing Italy see our economists’ in-depth note here.

Such a backdrop is fertile ground for populist politics. Unlike in France, however, populist narratives are likely to fall on more receptive ears in Italy. As the charts below show, the Italian electorate is much less enamored with the EU than in other Eurozone countries.

Companies safer than governments?

The unknown in all of this will be the ECB. QE has been a powerful tool at controlling spreads and yields in the European fixed-income market over the last few years. But Draghi has not had to buy debt securities when Euro Area member countries have been less committed to fiscal consolidation.

And as Chart 11 shows, the ECB has been almost the only net buyer of Italian sovereign debt over the last 12m. Their impetus remains crucial.

Will higher political uncertainty in Italy alter the balance of the ECB’s asset purchases from here until year-end? Time will tell. However, in the credit market we’ve been struck by the extreme relative value gap that’s opened up between Italian credit and Italian sovereign debt during the last week. Italian credit spreads have held up incredibly well vis-à-vis BTPs, amid the volatility.

Chart 12 shows the volume of French, Italian and Spanish credits that are currently yielding less than their respective, maturity-matched, sovereign debt. Notice for Italy that close to a staggering 90% of credits now yield less than BTPs.

And while in periods of political uncertainty the market has often taken that view that corporates are “safer” than governments, this is by far a historical high for Italy (and for any Eurozone country for that matter). Moreover many Italian companies are actually “domestic” and thus have little in the way of a safety net from foreign revenues.

CSPP > PSPP?

How has there managed to be such a substantial outperformance of Italian credits over the last few weeks? We believe a large part of this is because the ECB has upped the intensity of its CSPP purchases lately, especially with regards to Italian issuers. This gives us confidence that the ECB remains committed to buying corporate bonds for as long as politically possible. See our recent note for more of our thoughts on CSPP, the “stealth” taper, and the programme’s longevity.

Yet, Chart 12 also suggests that credit investors should tread carefully with respect to Italian credits at present. While corporate credit richness versus government debt can persist, we learnt during the peripheral crisis of 2011-2012 that eventually tight credits will reprice wider vs. govt debt (the best example of this was Telefonica).

As a guide for investors, Tables 1 and 2 at the end of the note highlight which Italian credits trade the richest versus BTPs.

Respect the law

For the last year, the Euro credit market has not had to worry about the risk of Eurozone breakup. That ended last week, as the first draft of the 5-Star/Lega Contratto contained a reference to a Euro exit mechanism. However, in subsequent versions this was removed.

Nonetheless, as the front-page chart highlights, the market still appears nervous with regards to Eurozone break-up risk. Note the spread between 2014 and 2003 sovereign CDS contracts (The ISDA “basis”) remains high for Italy, and has ticked up again for Spain and France lately.

The 2014 sovereign CDS contracts provide greater optionality for protection buyers, relative to the 2003 contracts, both in terms of whether the CDS contracts trigger upon a redenomination event and also in terms of their expected recovery rates.

Know your bond

If redenomination concerns remain, what should credit investors look for in terms of Italian corporate bonds? In the charts below, we run a simple screen from Bloomberg on the governing law of corporate bonds in our high-grade and high-yield indices. Chart 13 shows the analysis by country and Chart 14 shows the analysis by Italian credit sector.

We rank Chart 13 by the country with the highest share of foreign law bonds (to the left) to the lowest share of foreign law bonds (to the right).

For Italy, the Bloomberg screen suggests that just 10% of Italian corporate bonds (IG and HY combined) are domiciled under domestic law (Chart 13). This is a very different situation to last March when around 60% of French corporate bonds were domiciled under domestic law.

While a legal analysis of the redenomination risks of Italian corporate bonds is outside the scope of this note, what we learnt from the Greek crisis in 2011 and 2012 was that investor focus gravitated towards the governing law of bonds (where foreign law bonds were perceived by the market to be more secure)." - source Bank of America Merrill Lynch

Of course, as everyone know and given the latest news on the Italian front, the European technocrats in Brussels have shot themselves in the foot by interfering with Italian democracy which will led to bolster even more anti-european sentiment. In October 2016 in our conversation "Empire Days" we pointed out that the statu quo was falling in Europe and we also reminded ourselves what we discussed in our November 2014 "Chekhov's gun" the 30's model could be the outcome:

"Our take on QE in Europe can be summarized as follows: 

Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). 

“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?
Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)" - source Macronomics November 2014

It seems to us increasingly probable that we will get to the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…) hence the reason for our title analogy as previous colonial empire days were counted, so are the days of banking empires and political "statu quo" hence our continuous "pre-revolutionary" mindset as we feel there is more political troubles brewing ahead of us." - source Macronomics, October 2016

Obviously the path taken has been the road to growth / disillusion / social tensions and short-term road to heaven for financial assets as well as goldilocks period for credit. Now we are moving towards longer-term violent social wake-up calls in various parts of Europe. 

We really enjoyed our friend Kevin Muir latest excellent musing on Italian woes on his blog The Macro Tourist. He made some very interesting points in his must read note and we really enjoyed his bar-fighting economics analogy:

"Total French, Italian and Spanish assets are multiples of German assets. Italian Government BTPs are almost 400 billion and there are another 200 billion of other Italian debt securities. 600 billion represents almost 20% of German GDP. And that’s only Italy. What are the chances that an Ital-exit is confined to one nation?

Remember back to the 1930s. Nations that devalued early and aggressively generally did better economically during the ensuing depression - I like to call this bar-fighting economics - hit first and hit hard.

The ECB’s balance sheet expansion has put Germany in an extremely difficult place. They cannot afford to cut back on the expansion for fear of another Euro-crisis, yet the more QE they do, they more Germany is on the hook.

I hate to break it to Germany, but it’s even worse than it looks.

Don’t forget that ECB balance sheet expansion is only one the methods that imbalances within the European Union are stabilized. There is another potentially even more scary mechanism that occurs behind the scenes without much fanfare. Although the ECB is Europe’s Central Bank, each member nation still has their own Central Bank. Since monetary policy is set for the Union as a whole, there are times when capital leaves one European nation in favour of another. Individual Central Banks cannot raise rates to counter these flows, so the ECB stands in as an intermediary.
Let’s say capital flees Italy and heads to Germany, to facilitate the flows, the Italian Central Bank borrows money from the ECB while the German Central Bank deposits excess reserves with the GDP, thus allowing it all to balance. The individual country net borrowing/lending amounts are known as Target 2 Reserves." - source  The Macro Tourist, Kevin Muir

Target 2 issues have been a subject which has been well documented and discussed by many financial pundits. We won't delve more into this subject. But, as pointed out by Kevin Muir in his very interesting note, as a creditor Italy and being a very large one, Italy is in a much better position than the arrogant technocrats in Brussels think it is. In our book, it is always very dangerous to have a wounded animal cornered, it's a recipe for trouble. The latest European blunder thanks to the Italian president most likely instructed by Brussels to muddle with the elections result will likely lead to a more nefarious outcome down the line. Charles Gave on French blog "Institut des Libertés" made some very interesting comments when it comes to Italy's macro position:

• Italy now runs a current account surplus of 3.5% of GDP, 

• Italy has a primary surplus of 2 % of GDP, 

• Italy has extended the duration of its debt in the last few years and so is less vulnerable to a rise in long rates, 

• 72% of Italian debt is now owned by Italian entities

There has never been a better time for Italy to quit the euro. Come the autumn a fresh euro crisis is possible." - source Institut des Libertés - Charles Gave

Another expression we could propose relating to the excellent bar-fighting economics analogy from Kevin Muir and Target 2 would be as follows:

 "He who leaves the bar early doesn't pick up the bar tab" - source Macronomics

It is always about first mover advantage anyway, hence our previous positive stance on Brexit from a macro perspective when everyone and their dog were predicting a calamitous fall in growth following the outcome of the referendum.

When it comes to credit and Italian troubles, European High Yield needs to be underweight as it is at risk as pointed out by UBS in their Global Macro Strategy note from the 23rd of May entitled "How big a risk to EUR, credit and stocks":

"Credit: HY more exposed than IG to Italian stress

Italy is a risk but more so for HY cash vs. IG, in our view, where the Italian exposure is about 20% vs. 5%. As long as the risk of Italy challenging the integrity of Eurozone remains low (i.e. higher risk premium but no crisis scenario), we think the disruption in credit should remain mostly contained to Italian corps.

In a scenario of modest additional stress (c. 40bps BTP spread widening), we estimate that EUR IG and HY should widen 5-10bps and 25-30bps respectively from here, based on our fair value models and the recent performance. Our models are based on multi-linear regressions which also take into account other factors such as global growth, credit risk and conditions, as well as the ECB's CSPP.

In fact, peripheral spread widening of 30-40bps is likely the threshold when the relationship between corporate credit and peripheral spreads becomes non-linear, in our view (see Figure 5 and Figure 6). This is the threshold beyond which Italian risk should also affect EUR corporate credit markets more significantly outside of Italian issuers.

Given the uncertainties, we shift our preference for EUR HY vs. IG to neutral and prefer exposure to HY via its CDS index (Xover) which has a much lower Italian exposure at 7%. We recommend investors underweight Italian corps in IG and HY financials (largely Italian banks) and move up the HY curve from single B names to BB non-fins." - source UBS

We have recommended in our recent musings to reduce your beta exposure and to adopt a more defensive stance. If high beta is a risk and you don't like volatility, then again you are much better-off favoring non-financials over financials and you should probably maintain very low exposure to subordinated debt from peripheral financial issuers. At our former shop, a large European Asset Manager we recommended launching a Euro Corporate Bond Funds ex Financials. While the fund unfortunately did not gathered much attention AUM wise, performance wise it has been very good thanks to its low volatility profile and solid credit management. It is still boasting 4 stars according to Morningstar most recent ranking. Should Italian woes escalate high beta exposure will be hit much more, particularly financials. In that instance, for a long term credit investor, having less exposure to financials makes much more sense and we are not even discussing recovery values at this stage.  

Don't ask us about our opinion on having exposure to European banks equities again, because you will get the same answer from us. From a risk-reward perspective and long term investment prospect, it's just doesn't make sense whatsoever to get exposed to them regardless of the cheap book value argument put forward by some snake-oil sell-side salesman. You have been much more rewarded by sticking to credit exposure on European banks, rather than equities in Europe. End of the rant.

As well, we also pointed out in recent conversations that US cash had made a return into the allocation tool box and given the rise in political uncertainties and volatility, one should think about rising its cash level for protective measure. Cash can be "king" particularly with rising US yields and a strengthening US dollar marking the return of "Mack the Knife". Gold continue with it's safe harbor status. As we indicated in our earlier quoted tweet, both the dollar and gold can rise when we move in a situation where investors are moving from being more concerned about "return of capital". One would also be wise to seek refuge again in the Swiss franc (CHF) we think particularly versus the Euro (EUR). As well, a short covering on 10 year US Treasury Notes could be in the making (in size...). Watch that space because we think long end is enticing even zero coupon 25 years plus (ETF ZROZ) should we see an acceleration in the "risk-off" environment.

Moving back to "solvency" risk and sustainability of debt, namely "return of capital", as pointed out corporate credit in many instances could be "safer" than "sovereign" risk. Back in our conversation  "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portolio Theory and more!" we quoted again Dr Jochen Felsenheimer on macro and credit (our focus):

"In the end, all investors face the same problem - the whole world is a credit investment. And it is difficult to negotiate this problem with the classical theory of economics. Short selling bans, Eurobonds and ratings agency bashing will not provide a remedy here either." - Dr Jochen Felsenheimer

We added at the time that confidence is the name of the game and the perception of the risk-free interest rates, namely a solvency issue is at the heart of the ongoing issues. This brings us to the trajectory of European debt in general and Italy in particular. On this very subject we read Deutsche Bank's Euroland Strategy note from the 25th of May entitled "Pricing debt (un)sustainability" with great interest:

"Default risk pricing and bond relative value

Rising concerns over Italy’s debt sustainability can also be seen in the spreads between high coupon and low coupon bonds on the BTP curve. Over periods of stress, high coupon bonds which typically trade at a higher cash price tend to underperform lower coupon neighbours. One potential explanation for this is the risk that upon a hypothetical default the recovery rate will be based on the par value of the bond rather than the cash price an investor paid. Related to this, lower coupon, more recently issued bonds are also more likely to have CAC clauses compared to neighbours issued pre-2013.

Moreover, in times of stress participants seeking to release cash (for example insurers or pension funds with broad portfolios) might prefer to reduce holdings of higher price bonds (high coupon). Finally, even in normal times higher cash bonds may trade at a slight discount, reflecting the lower liquidity in some of these issues.

This effect is apparent in the charts below showing the positive correlations of z-spread (left) and yield differentials (right) between high and low coupon bond pairs and the IT-DE 10Y spread (which proxies for market pricing of BTP risk). As the BTP Bund spread has widened, high cash bonds across the curve (but particularly from 10Y+) have underperformed.

The non-linear dynamics of some of the bond pairs as spreads have widened are noteworthy. At the the 30Y point, the 44s-47s spread had remained elevated into the latest stress, with the 44s only beginning to underperform after the initial widening move. This may partially reflect the relatively large maturity gap between the two bonds, with 10s30s flattening at first outweighing the high cash price/low cash price effect on the bond spread.

- source Deutsche Bank

From a convexity perspective we find it very amusing that "yield hogs" when facing "redenomination/restructuring risk" see their high coupon bonds underperforming lower coupon neighbours, or to put it simply when non-linearity delivers a sucker punch to greedy investors...

While the "risk-off" mentality is prevailing thanks to Italian woes, confidence matters when it comes to "solvency" and debt "sustainability" yet, given the overstretched positioning in US Treasury Notes, if there is a continuation of troubles in European bond markets, then again, it will be interesting to see what our Japanese friends will do when it comes to their bond allocation. Our final chart deal with the current slowdown in the global economy which represents for us a clear threat to the US bond bears current positioning.

• Final chart - Decline in PMI's doesn't bode well for the US bond bears

While we have been reluctant so far to dip our toes back into the long end of the US yield curve, given the most recent surge in European woes and extreme short positioning, we think there is a potential for a violent short covering move. Our final chart comes from CITI Global Economic and Strategy Outlook note from the 23rd of May and displays the decline from recent peak in Manufacturing PMI pointing towards a slowdown:

There is more evidence that global economic growth is slowing. Some of the drags are likely temporary, such as some payback from unusually fast growth in H2 2017 (e.g. real retail sales in the US grew by 8% annualized in Q4), and adverse weather impacts across Western Europe, Japan and the US, while the positive effects of fiscal stimulus in the US will ramp up over the course of the year. But declining business sentiment, some tightening of financial conditions and the rise in oil prices are likely to have a more persistent (if moderate) dampening effect on global growth, notably on moderating momentum in business capex (Figure 2)." - source CITI

As far as White Noise is concerned, being uncorrelated in time does not restrict the values a signal can take (Italy back in crisis mode + slowing global economic growth). Any distribution of values is possible and even a binary signal such as the ones currently being given by European Peripheral bond markets (risk-off) can makes confidence turn on a dime. For financial markets as well as consumers, end of the day "confidence matters" for credit growth. Have we reached peak consumer confidence?

"What we obtain too cheap, we esteem too lightly; it is dearness only that gives everything its value. " - Thomas Paine

Stay tuned!

Macro and Credit - The Golden Rule

"After World War II, there were a lot of pension funds in Europe that were fully funded, but they were pressured to hold a lot of government debt. There was a lot of inflation, and the value of all those assets fell. Those pension funds couldn't honor their promises to the people." -  Edward C. Prescott, American economist and Nobel Prize in Economics.

Looking at the technical "relief rally" in all things "beta" including US High Yield thanks to the tone down in the geopolitical narrative but with the pickup of the trade war rhetoric between the United States and China, when it came to selecting our title post analogy, we reminded ourselves of the "Golden Rule". The Golden Rule (which can be considered a law of reciprocity in various religions) is the principle of treating others as one would wish to be treated. It is a maxim found in most religions and cultures:

• One should treat others as one would like others to treat oneself (positive or directive form).
• One should not treat others in ways that one would not like to be treated (negative or prohibitive form).
• What you wish upon others, you wish upon yourself (empathic or responsive form).

The concept occurs in some form or another in nearly every religion and ethical tradition and is often considered as the central tenet of "Christian ethics".  It can also be explained from the perspectives of psychology, philosophy, sociology, human evolution, and of course economics hence our reference in relation to growing trade tensions. 

In this week's conversation, we would like to look again at where we are within the credit cycles, given as we pointed out in recent musings cracks have started to show in some parts and everyone is asking oneself when the downturn is given the relentless flattening of the US yield curve.

Synopsis:

• Macro and Credit - Have we reached the end of the credit cycle yet?
• Final charts -  The return of Macro to the forefront thanks to higher interest rates

• Macro and Credit - Have we reached the end of the credit cycle yet?

We have been discussing at length like many various pundits about the credit cycle and the fact that it was slowly but surely turning thanks to the Fed's change of narrative. We even posited that the Fed is the credit cycle in one of our musings. Back in October in our conversation "Who's Afraid of the Big Bad Wolf?", we indicated that for a "bear market" to materialize, you would indeed need a return of the Big Bad Wolf aka "inflation". With the continuing surge in oil prices in conjunction with commodities prices, we also pointed out as well in this prior conversation that credit cycles die because too much debt has been raised and therefore it remains to be seen if rising "inflation expectations" could indeed be the match that lights the ignite the explosion of the credit bubble hence the importance of gauging where we stand in this credit cycle. The increasing trade war narrative has proven in the first quarter to be "bullish" gold as we anticipated thanks to the "Golden Rule" being put forward between the United States and China. Following years of financial repression the house of straw of the short-vol pigs was blown off by the explosion of volatility following the Fed's decision to put a lower strike on its "put" for asset prices, which had been a deliberate part of their move in recent years. We have become increasingly wary of the situation of the US consumer hence us adopting more scrutiny on the rising price at the gas pump with an already strained US consumer balance sheet thanks to rising rents and healthcare and slowly rising wages with dwindling savings and rising usage of credit cards to maintain the lifestyle. 

So, one might rightly ask oneself, when does it all end given that as per the below recent Bloomberg chart, displaying US Economic Surprise indexes for both hard data and soft data trending lower:

- source Bloomberg

Many wonder if this time it will be different with the continuing flattening of the US yield curve. On this subject we read with interest Bank of America Merrill Lynch's Securitized Products Strategy Weekly note from the 20th of April,. First here is the summary of their findings:

"This time is different: late cycle mortgage lending, higher rates, and a flatter curve

This week’s yield curve flattening, to a post-crisis low of 43 bps on the 2yr-10yr spread, is raising concerns that the current cycle is coming to an end and recession is now on the not too distant horizon. It’s more than 9 years since the stock market low of March 2009, so it is clearly late in the cycle. However, we continue to believe that this cycle has at least a couple of more years before it ends and credit spreads, along with securitized products spreads (see “Bullish for Q2” for corporate-securitized products correlation discussion), widen materially.

In fact, although the path for spreads will be bumpier than what was seen in 2017, we think there is potential for spreads to tighten further in Q2 and beyond. As discussed last week, we think the 10yr breakeven inflation rate is likely to head higher in Q2, moving above 2.20% or even 2.30%, as oil experiences upward seasonal pressure. Given correlations, we see this as good news for securitized products spreads. (This week’s jump to an intraday high of 2.19% on the breakeven rate suggested that 2.20%-2.30% is not a particularly aggressive target.)

We acknowledge the tightness of spreads, but we caution against being too early to position for major spread widening in the near future. Although we see tightening potential for spreads, due to the tightness of spreads, we maintain our neutral view for securitized products.

We compare this cycle to the last cycle on two fronts:

First, and more broadly, we consider metrics such as the 2yr-10yr spread, the BofAML Global Financial Stress Indicator and the BofAML Liquidity Stress Indicator: all three indicators suggest little imminent stress. We see the current period as similar to May 2005. As a reminder, that was 2 years before credit spreads began to widen and over 3 years before full blown crisis and recession. Given the slow pace of monetary policy tightening in this cycle, we think the risk is that this cycle takes longer to end than the last one did when at a comparable point on the metrics just mentioned.

Second, and more specific to mortgages, we compare today’s mortgage lending environment to what was seen in the pre-crisis period and in the aftermath of the massive 2003 refi wave. The changes are dramatic. Non-bank lenders’ market presence is on the rise while banks are retreating; another refi wave has ended but primary secondary spreads are generous relative to 2005; most importantly, there is little to no evidence of a meaningful shift to the risky mortgage lending practices that precipitated the 2008 crisis. At a minimum, this cycle has a notable absence of the primary driver of what caused the crisis in the last cycle. If there is a trigger event for another broader downturn, it will have to come from a sector other than mortgages and housing. Perhaps it will be the corporate sector or the government sector but we would not dismiss the economic robustness derived from an exceptionally healthy mortgage market. Again, we think the risk is that years of healthy and disciplined mortgage lending prolongs this economic cycle."  -source Bank of America Merrill Lynch

We would have to agree, if indeed there is a trigger event for another broader downturn, then indeed, this time it will be different in the sense that it won't be coming from the housing sector and the mortgage markets. Many like ourselves are pointing out towards the excess leverage building up in the corporate sector thanks to a credit binge tied up to ZIRP and NIRP policies and credit markets. If US High Yield can be seen as being relatively expensive then European High Yield is a base case definition of what "expensive" can be defined as. We are closely monitoring fund flows given as of late there has been some rotation from credit funds towards government bonds funds as described by Bank of America Merrill Lynch in their Follow the Flow note from the 20th of April entitled "Trade wars flows":

"Rising geopolitical risk is pushing more money into govies

Over the past couple of months government bond funds in Europe have recorded sizable inflows. We think trade wars and rising geopolitical risk has been translated into deflationary pressures that feed primarily into a bid for “risk free” assets. IG fund flows in Europe have been slower to improve because of the trade uncertainties. However, inflows into Euro only IG funds over the last week were nonetheless positive.

Over the past week…

High grade fund flows were negative over last week after two weeks of inflows. While the breakdown by currency shows a marginally positive number for the eurofocussed funds, the dollar ones have driven the overall trend. Monthly data also were negative for a second month, March figures show.

High yield funds continued to record outflows (23rd consecutive week), and similarly the monthly data also displayed a fifth consecutive month of outflows. Looking into the domicile breakdown, US and Globally-focussed funds have recorded outflows, while the European-focussed funds flow was slightly positive. Note that this was the first week of inflows into euro-focused funds after 13 weeks of outflows.

Government bond funds recorded their 14th consecutive week of inflows just as the monthly data were rolling on to the fifth consecutive month of positive flows. All in all,
Fixed Income funds flows were on negative territory last week. Monthly data reveal that just like February, March was also characterised by outflows.

European equity funds continued to record outflows for a sixth consecutive week; driving the year-to-date cumulative flows below zero. The trend also transpired on the March number, which was the most negative since August ‘16." - source Bank of America Merrill Lynch

While it has been difficult to "Make Duration Great Again" given the recent rise in the 10 year yield in US Treasury Notes, from a contrarian perspective and given the significant short positioning in the long end, there will come a point when fundamentals might reverse the confidence in this overstretched positioning which would entail significant short covering. We are not there yet. 

Returning on Bank of America Merrill Lynch note on the relationship between a flattening yield curve and credit spreads, here is what they had to say on the subject:

"Yield curve flattening and credit spreads

The 2yr-10yr spread narrowed to a post-crisis low of 43 bps this week, raising concerns that the current cycle is coming to an end and recession is on the not too distant horizon. We see the recent flattening of the yield curve as consistent with expectations laid out in our 2018 Year Ahead outlook, published in November 2017. We expect the 2yr-10yr spread to reach zero and turn negative in the first half of 2019, and recession and material credit spread widening to occur 12-18 months later, in other words, mid to late 2020. Given the slow pace of monetary policy tightening in this cycle, we think the risk is that the process takes longer than we expect.

Chart 1 and Exhibit 1 provide some perspective on this view.

Chart 1 shows that today’s 2yr-10yr spread level of roughly 45 bps was observed in May 2005. We also see that today’s asset swap spread of roughly 300 bps on the ICE BofAML High Yield Index (H0A0) is comparable to the index spread in May 2005. (We use this high yield index for our securitized products discussion just because it allows us to make the longer term comparison.) The takeaway from this chart is that it took approximately two years for the curve to first fully flatten and then re-steepen. Similarly, it took approximately two years before credit spreads finished tightening, reaching a tight of 185 bps (over 100 bps tighter than the May 2005 level!), and began cyclical widening.

This is the primary basis for our view that material spread widening in the current cycle won’t occur until at least approximately mid-2020. In other words, we place a heavy weight on the yield curve as an indicator of where we are in the credit cycle. The first significant event that we would need to see for us to become more cautious on spreads is to have the curve fully flatten or invert. But even then, the 2005-2007 experience tells us that it could take over a year after flattening or inversion occurs before spreads materially widen.

Exhibit 1 shows a view of yield curve movements relative to the Fed Funds rate, along with rough projections. The primary observation for this cycle relative to the last cycle is that the Fed is tightening at about half the rate of the last cycle. Given this, we think the risk for this cycle is that the flattening and re-steepening/spread widening process takes longer than the last cycle.

Yield curve flattening and financial and liquidity stress indicators

Chart 2 and Chart 3 provide an additional view of today’s world relative to 2005, using the BofAML Global Financial Stress IndicatorTM and the BofAML Liquidity Stress IndicatorTM.

Both Global Financial Stress and Liquidity Stress are negative (indicating below average risk), have been trending lower since early 2016, and are currently comparable to the levels of May 2005. Both indicators moved up substantially only when the yield curve re-steepened in late 2007. Our takeaway here is that the low levels on the Stress Indicators are confirming our view that a 2yr-10yr spread of roughly 50 bps is  not necessarily indicating imminent stress. In other words, there is still ample monetary policy accommodation.

Mortgage lending in this cycle: low risk lending and the rise of non-bank lenders

While broad macro developments are currently similar to 2005, the mortgage market, arguably the trigger of the 2008 recession and crisis, is very different. In particular, mortgage market risk is far lower today than it was 13 years ago. To at least partly understand pre-crisis developments in mortgage lending, it’s useful to recall the role played by the massive 2003 refinancing wave.

Chart 4 shows the MBA refinancing index along with the primary-secondary spread back to 2000.

In some respects, the great refi wave of 2003 was the genesis of the mortgage crisis that followed. Lending capacity rapidly expanded to respond to the opportunity presented in 2003: refinancing volumes were unprecedented and margins, as measured by the primary-secondary spread (30yr mortgage rate-FNMA MBS current coupon yield) that peaked at 60 bps, were relatively attractive. When mortgage rates moved higher in 2004, refinancing volumes – and margins – collapsed. With massive capacity and minimal volume/margin in higher quality lending, the industry turned to higher margin, riskier lending as the alternative; we’ll come back to that in a moment.

But first, fast forward to 2018 in Chart 4 After years of low interest rates in the post crisis period, most that could refinance have refinanced: the MBA refi index is now at the lowest levels of the millennium. Chart 5 shows that purchase lending activity is on the rise, although it is still well below the levels of the pre-crisis era.

Going back to the primary-secondary spread in Chart 4, although it’s declined in recent years, we see a still relatively high margin on this low volume lending activity: currently about 75 bps, well above the levels of the pre-crisis period. The margin suggests no need to stretch on lending standards, but the volumes suggest that bankers have to work hard to get their share of the pie.

Next, consider some of the changes that have taken place or are underway.

Chart 6 and Chart 7 show the composition of lending in 2005 and 2017, respectively.

In 2005, 54% of production was ARMs, 36% was “expanded credit,” and 43% was government/conventional. In 2017, the composition shifted to 12% ARMs, 2% “expanded credit,” and 80% government/conventional lending. Clearly, the post-crisis regulatory changes and financial penalties associated with pre-crisis lending practices have changed lending behavior to higher credit quality.

Table 1 shows a lending and servicing snapshot for 2017, including YOY changes. Bank lenders experienced above average declines in lending volumes in 2017 while a number of the top 10 non-bank lenders actually experienced growth in originations.

On servicing, the shift away from the banks to the non-banks is even more pronounced. Bank servicing portfolios declined in aggregate while non-banks experienced double digit or even higher growth rates. Banks are conceding market share.

Overall, while the post-crisis refinancing lending opportunity has passed, and non-bank lenders are increasing their presence in the market, lending standards remain strong. The Urban Institute aggregate measure of the risk of loans closed shows that although credit risk has been rising in recent years, especially in the GSE segment, it remains well below pre-crisis levels (Chart 8).

If there is a trigger for the next crisis or even mild recession, we do not see it coming from the mortgage market. Similar to the indications from the Global Financial Stress and Liquidity Stress Indicators, there are no indications of current stress potential coming from the mortgage market." - source Bank of America Merrill Lynch

We would like to make a couple of remarks on the above. The shift to non-bank eg the "Shadow banking" has been significant. Banks have been less active in that space. Banks under higher regulatory pressure and oversight have reduced their activity and focused mainly on the higher quality segment of the mortgage market.  Also following the housing bust, US Homeownership Rates have come down significantly from a peak of 68% meaning US households could less afford buying a new home and have resorted to renting. Both Healthcare and rents now take a large chunk of the average American household income on a monthly basis. So, overall mortgage activity has become more muted for large banks. As always, there is risk you see and what you don't see to paraphrase Bastiat. It works as well for the US Mortgage market as indicated by the Brookings Institute in their article from the 8th of March entitled "The mortgage market risk no one’s talking about, plus a proposal to redesign the system":

"Nonbank mortgage originators and servicers—i.e.  independent  mortgage companies that are not subsidiaries of a bank or a bank holding company—are  subject to far greater liquidity risks  but  are  less  regulated than bank-lenders and servicers.  As of 2016, non-bank financial institutions originated close to  50 percent of  all  mortgages  and 75 percent of  mortgages with explicit government backing.

...
The research also  suggests that mortgages originated by nonbanks are of lower credit quality than those originated by banks, making nonbank lenders more vulnerable to  delinquencies triggered by a fall in house prices through  the  higher costs of servicing delinquent loans.  A  larger fraction  of  nonbank originations are insured by the Federal Housing Administration (FHA) or Department of Veterans Affairs (VA), which tend to be more likely to default than other types. Among  mortgages  in  Ginnie  Mae  pools, the data  indicate that mortgages originated  by nonbanks are twice as likely as bank-originated mortgages to be two  or  more  months  delinquent."  -source Brookings

Basically, as a reference to Nassim Taleb's latest book, banks have less skin in the game today in the mortgage market than they used to. So if housing is less the issue than in the prior cycle, then what is and what should we watch for when it comes to assessing the state of the credit cycles? 

On this matter we read with interest UBS Global Macro Note  "Credit Perspectives - Caution or Carry?" from the 19th of April in particular relating to the more advanced stage in the US of the credit cycle:

"Q: Where are we in the US credit cycle?

The US credit cycle is later-stage, but unlikely to end in 2018. Later-stage credit indicators are present. Corporate leverage is very high, covenant protections are very loose, lower-income consumer balance sheets are weak, and NYSE margin debt is elevated. But the market trades off changes in conditions, not levels. To this point, we do not see an inflection to suggest the credit cycle is turning. Our latest credit-recession model pegs the probability of a downturn at 5% through Q4'18. Corporate EBITDA growth is running at 5-8% Y/Y, enough to keep leverage and interest coverage from deteriorating. Lending standards and defaults are only tightening and rising, respectively, in select pockets, and the scale of tightening is not enough to engineer broad stress. Last, but not least, a quick shot to growth from significant fiscal stimulus in 2018 should keep the cycle supported.

Q: How will demand for US corporate credit evolve?

We expect overall US credit demand to slow, with an up-in-quality bias developing and continued demand for floating-rate product (leveraged loans, IG floaters). Rising USD funding costs are reducing the appeal of US credit to European and Asian investors. These funding costs are now 2.5% for Japanese investors and 2.8% for European investors (3 month FX swaps). With 3 more Fed hikes in 2018, these hedging costs will climb to 3-3.25% by year-end. We do not expect supportive unhedged foreign flows to materialize due to significant US policy uncertainty, higher capital charges on unhedged positions (especially Solvency II), and regulatory pressure (Taiwan). US IG is better positioned than US HY, as current yields of 3.8% should attract some additional domestic insurer and pension interest. Modestly rising credit risk in HY may also divert some flows back into IG. But US HY outflows are likely to continue, given Fed hikes, tight spreads, below average earnings growth, and declining equity valuations of HY-rated companies.

Q: How will Fed hikes impact the US credit cycle?

4 Fed hikes in 2018 will age the credit cycle and create pockets of volatility. The increase in LIBOR is resetting interest rates higher on $3.2tn of US business loans (1/3 of the total stock) and is reducing the appeal of US fixed-income to non-US investors. Higher interest rates are filtering through to US consumer loans; they are raising funding costs for non-bank lenders who utilize floating-rate bank credit to facilitate lower-quality auto and mortgage lending. But in the context of still strong US growth, the cycle has a buffer. Floating-rate leveraged loan issuers have interest coverage ratios still above 3x (EBITDA/Interest expense) and can withstand 3 additional Fed hikes in 2018. A strong job market will keep consumer delinquencies contained to the subprime space. And rising LIBOR is currently a benefit to large US banks, which can still access cheap funding via retail deposits, while receiving a higher interest rate on their loan portfolios.

We prefer US IG over US HY on a total and excess return basis. US HY spreads of 323bps are expensive vs. our blended model estimate of 429bps, while IG spreads are more aligned (105bps current vs. our blended model estimate of 116bps). We have a slight preference for BBB credit, given higher carry, and also that a declining non-US bid will hurt A-rated demand, while domestic demand could support BBBs. In US HY, we maintain our preference for B-rated credit. CCC's are vulnerable given declining equity valuations, while BB HY will struggle with higher duration fears. We prefer US leveraged loans over US high-yield given our call for 6 Fed hikes by 2019, and much stronger demand for loans and CLOs from US and non-US investors alike. By tenor, we prefer 5- 10yr IG, acknowledging slightly better valuations in the short-end than before. We still believe it is too early to position in 1-5yr IG credit, given lower carry, additional Fed hikes and negative repatriation technicals around large buyback/M&A announcements. We are also cautious on 10+ US IG credit, particularly in higher quality names, given very flat curves relative to expectations.

We understand the levels of conditions are weak, but the changes are critical to capturing inflection points. US earnings momentum, lending standards (C&I, consumer), and consumer defaults will be on our radar. The Fed and BOJ will be important. A Fed more tolerant on inflation will boost our view on risky credit; a change in the BOJ's yield target would be a negative for US credit. The resolution of the ATT/TWX antitrust case will also set the tone for future M&A supply.

A cyclical recovery won't be enough to tighten spreads. For US IG, spreads near current levels (105bps) are justified largely by "soft data", in particular strong ISMs. With a fading foreign bid, increasing duration fears and more M&A activity on the horizon, we think IG spreads will widen to 115bps in the near-term. The one positive is that US IG has already cheapened YTD, which will attract domestic investor interest and reduce material downside.

US HY now screens expensive, as spreads at 323bps are inconsistent with both structural credit risks and increased equity volatility. In addition, we believe significant outflows YTD have whittled down cash balances for fund managers. Aggregate fundamentals remain stable, but tenuous at lower ratings, with leverage elevated and interest coverage weak. We expect HY spreads to shift wider to 400bps.

The credit cycle isn't turning yet. Our credit-based recession gauge highlights a 5% chance of recession through Q4'18, far from the 40-50% that signals a red flag. Earnings growth, lending standards, and bank NPL trends are "good enough" to sustain the cycle. However, interest coverage will likely become less favourable as 3 more Fed hikes in '18 and '19 will flow through to $3tn in floating-rate business debt.

Fixed-rate US HY coupons are stable as firms are not yet refinancing into higher rates. For floating rate leveraged-loans, coupon payments have been range bound, as re-pricings and tighter spreads have offset higher LIBOR. But we expect higher interest payments for loan issuers later in 2018, as the Fed hikes 3 more times, and spreads can't tighten as much to offset higher LIBOR.

Despite rising interest costs, floating-rate US loans have resilient enough interest coverage to sustain 3 more Fed hikes in 2018. This dynamic, plus growing demand for floating-rate credit, underlies our preference for US Loans over US HY. 3 additional Fed hikes in 2019 will prove more problematic. This will push loan coverage ratios to low levels (inferior to 3x) for B-rated firms and pressure free cash flow. Earnings growth will need to rise to reduce this future risk.

US leveraged loan supply hit $500bn in 2017, over 50% for M&A and LBOs, and reported 1st lien leverage is 3.9x – the highest on record. EBITDA add-backs averaged 20-21% in 2017, and are averaging 26% for large PE sponsor deals YTD – suggesting leverage is underreported and rising. A conservative view would push average 1st lien leverage closer to 5x on M&A deals.

The non-US bid into US IG credit will slow in 2018. Non-US investors are paying 2.5% (Japan) & 2.8% (Europe) to hedge their US fixed-income allocations. We do not believe foreign investors will remove FX hedges, given broad uncertainty on the trajectory of the US dollar. As the Fed keeps hiking, these costs will rise further and US IG will become less attractive than long-duration sovereign alternatives and even EU IG credit by year-end.

Slower demand is one part of the equation, but we still expect IG supply to be robust in 2018 (+2.5% Y/Y). The M&A pipeline is large, and we expect more issuance could hit the market, conditional on favourable antitrust outcomes which have lowered closing rates. High multiples and still low rates suggest firms will finance with debt. Offshore repatriation may reduce issuance on the margin, but most IG firms do not have significant cash, either overseas or on balance sheets, to utilize.

The savings from corporate tax reform will only modestly delever capital structures, even assuming firms utilize 25% of their tax windfall to pay down debt. More importantly, credit spreads have already priced this; spreads per unit of net leverage are at all-time tights. Bottom-line, earnings growth needs to be much stronger to de-lever capital structures.

HY spreads have remained very resilient. Despite significant outflows in Q1, HY spreads were effectively unchanged. We believe Dec'17 coupon reinvestments and low issuance YTD (-22%) had replenished cash buffers. But given the outflows of Q1'18, cash buffers are low once again. We expect HY spreads to widen more aggressively if volatility picks up anew." - source UBS

As we pointed out recently, rising dispersion means that at the current stage of the credit cycle in the US, credit investors are becoming more discerning in their issuer process selection, meaning overall that active credit manager should continue to outperform as the credit cycle is gradually turning on the back of the Fed continuing its hiking trajectory. Sure, "beta" has rallied hard recently, but, one should think about gradually adopting a more defensive stance by starting to reduce high beta exposure towards safer places. While we pointed out in our conversation "Fandango" that some positioning appears to be stretched such as short the long end of the US yield curve, we don't think yet with have reached the "trigger point" making us bold enough to dip our investing toes into the long end of the US yield curve particularly as we are getting closer to the 3% level on the 10y Treasury yield. We are certainly watching any signs that would point out that the recent weaknesses seen in hard and soft US data has been temporary or not. 

While the "Golden Rule" is being vindicated by the Trump administration for the growing use of trade war measures, boosting gold price in the process, 2018 seems to be marking the return of "Macro" as a strategy following the unfortunate demise of many Hedge Fund players after years of financial repression thanks to lack of cross-asset volatility. As per our last charts below, Global Macro is making a come back thanks to rising volatility and dispersion across asset classes it seems.

• Final charts -  The return of Macro to the forefront thanks to higher interest rates

The final removal of the lid on volatility which has prevailed thanks to the strong central banking narrative has been fading and marked earlier on this year by the explosion of the short-vol pig house of straw that built up during many years. Our final charts come from Bank of America Merrill Lynch from their Global Liquid Markets Weekly note entitled "The gold big bang theory" from the 16th of April 2018 with one of the charts displaying the spike in vix which can be linked to the rising rate environment:

"Tighter Fed policy is helping lift OIS and LIBOR

We first argued in September 2017 (see Mind the unwind) that risk assets could suffer as a Fed balance sheet compression added on top of an already steady pace of US interest rate hikes. Six months later, the effects of tighter US monetary policy are starting to become visible in a number of markets and returns across major asset classes are negative for the year. The Fed has already been hiking rates at a steady pace for 9 quarters now (Chart 1).

Looking forward, with a tight labor market backdrop and rising commodity prices, our economics team believes that the Fed will likely complete three more hikes this year. In addition, we believe that Fed balance sheet tapering (see Missing the BEAT) has been an important contributor to the rapid widening in the 3m LIBOR-OIS spread (Chart 2).

In turn, higher interest rates are pushing up vol...

Just like ultra loose monetary policy was a balm for asset markets, this combination of rising rates and balance sheet tightening could well be having the opposite effect on bond and equity markets. As we have previously explained, rising interest rates tend to put upward pressure on macro volatility (Table 1).

This effect is often lagged but quite persistent, and macro volatility has been on the rise for some time now. In our view (see Forward vol looks cheap to carry as long as you believe markets are late cycle), the spike in the VIX can be partly traced to the rising interest rate environment (Chart 3).

But higher interest rates are not the only source of uncertainty at the moment for global markets.

...as US fiscal policy is entering a slippery slopeIn fact, just as monetary policy has tightened, the US Federal budget deficit is poised to balloon (Table 2) over the coming 24 months.

Our economists have previously argued (see Fiscal injection: round 2), that the US Federal government could face the worst cyclically adjusted fiscal deficit as a 5.1% of GDP in 2019 because of the continuous fiscal stimulus: tax reform, increase in budget caps, and greater infrastructure spending. Less bond demand from the Fed and a tightening interest rate path is meeting looser fiscal policy. And as the Fed stops reinvesting its bond proceeds, the market will have to absorb more US Treasuries (Chart 4).

Recent tax changes have also reduced the demand for dollar commercial paper from US corporates abroad.

Inflation is trending higher helped by oil prices

Of course, the tighter monetary policy path in the US and the normalization of interest rates is informed by the rising inflation pressures across the economy. On the one hand, the decline in the unemployment rate will likely support a steady increase in core inflation (Chart 5).

On the other hand, rising oil prices are already feeding into an increase in headline inflation (Chart 6).

Because we now expect Brent crude oil prices to hit $80/bbl over the coming months (see The ruble drop is bullish for oil) and US job growth is poised to remain steady, the Fed will likely continue to tighten policy.

Naturally, cross-asset info ratios have fallen

Tighter money policy will continue to impact macro volatility. With volatility on the rise, info ratios across major asset classes could well continue to roll over (Chart 7) in the coming months.

In our view, equities and bonds are unlikely to see the stellar rolling Sharpe ratios of the past few years as the Fed continues to drain liquidity. Moreover, we would argue that a tighter US monetary policy outlook is already acting as a drag on asset values. Year to date, cash returns of 0.4% compare favorably to S&P returns of -1.2%, Eurostoxx returns of -2.0%, or 10 year treasury returns of -2.1% (Chart 8).

So is the Fed ready to switch course? Not yet

True, leading indicators such as PMIs remain in positive territory across all major economies and inflation is on the rise. So the Fed is unlikely to change Yellen’s preset course for now under the new leadership of Powell. Yet, as money supply around the world continues to roll over on the back of tighter policy, asset returns could struggle (Chart 9).

The market is perhaps right to expect the Fed to hike interest rates roughly as scheduled (Exhibit 1).

 

But we still believe that escaping zero interest rate policy (ZIRP) will not result in a smooth path for asset markets." - source Bank of America Merrill Lynch

Back in November 2012, in our conversation "Why have Global Macro Hedge Funds underperformed?" we posited that when volatility across all asset classes crashes, global macro strategies tend to suffer on both an absolute and relative basis. If indeed we are moving from a cooperative world to a noncooperative world based on the Golden Rule in conjunction with a return of volatility then one should be wise to dust up the Global Macro playbook we think... 

"Monetary policy causes booms and busts." - Edward C. Prescott, American economist and Nobel Prize in Economics.

Stay tuned !