Credit - Mack the Knife

"Oh the shark has pretty teeth dear,
And he shows them pearly white
Just a jack-knife has Macheath dear
And he keeps it out of sight." - The Threepenny Opera 1954

Watching with interest the on-going carnage in the commodity space in conjunction with the current sell-off in US High Yield in true "convexity" fashion seeing significant fall in cash prices at a rapid pace spelling the return of strong deflationary forces, we reminded ourselves of Mack the Knife, a song composed by Kurt Weill with lyrics by Berthold Brecht for their music drama known as "The Threepenny Opera". Mack the Knife is a "moritat", a murder ballad, from mori meaning "deadly" and tat meaning "deed".  In a "moritat", the lyrics form a narrative describing the events of a murder. In our case, we are witnessing the "murder" of the commodity sphere. The murderer is indeed "Mack the Knife" aka the King Dollar also known as the Greenback in conjunction with US real interest rates swinging in positive territory hence the pressure on gold prices marking the return of the Gibson paradox which we mused about in our October 2013 conversation:

"When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact." - Macronomics

Of course what is happening in the commodity space as well as in the Emerging Markets space is of no surprise to us given we mused on Emerging Markets risks in our conversation "The Tourist trap" back in September 2013:

"Of course if Bernanke is serious about initiating his "tap dancing" following "twist", this might spell out the "last tango" for Emerging Markets, and as we posited in a previous conversation (Singin' in the Rain), we might get another "dollar" crisis on our hands:
"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: Wave number 1 - Financial crisis Wave number 2 - Sovereign crisis Wave number 3 - Currency crisisIf the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?"

It might not be a "last tango" but, it looks more and more to us as "Murder ballad" à la Mack the Knife. Therefore, in this week's conversation we will look at the significant ripple effect "Mack the Knife" aka King Dollar is having on the EM tourists and carry players alike in his murderous ballad.

Synopsis:

• The return of Gibson's paradox and our "macro osmosis" theory are playing out
• Hypertonic surrounding in Emerging Markets prevents them from stemming capital outflows - the case of China
• High Yield and the scary CCC credit canary
• For High Yield, default matters particularly with contagion risk from commodity
• EM credit spreads and oil prices are highly correlated
• Final chart: Big gap between debt and equity

• The return of Gibson's paradox and our "macro osmosis" theory are playing out

While we won't bother going into much the details of Alfred Herbert Gibson's 1923 theory of the negative correlation between gold prices and real interest rates, we will simply look at the relationship of the return of Gibson's paradox with an illustration provided by Barclays from their most recent Commodities Weekly note from the 27th of July entitled "The collapse continues":

"Gold as a currency: Macro headwinds
Gold can be viewed as a currency and its price is affected by three main factors: the real interest rate, US dollar strength, and safe-haven demand. We believe that the real interest rate is the most important macro factor for gold prices. Figure 1 shows that, empirically, the US real rate has been the main driver for gold prices moves in recent years; while academic papers (Barsky, Summers, 1988) have given theoretical support. 

We are near the beginning of the rate raising cycle and our economists expect the Federal Reserve to have first rate hike in September. The rate hike expectation is likely to continue weigh on gold prices.
Gold is unlikely to gain any support from the dollar or safe-haven demand either, in our view. Our FX team continues to think that the dollar will strengthen (Global FX Quarterly: In the dollar we trust , June 2015), which is negative for gold. Two main risk events, the Greek crisis and the Chinese stock rout, have entered a calmer phase, implying limited safe-haven demand.

Gold as a commodity: Where does the gold go?
Monday’s sell off follows lower-than-expected Chinese central bank purchases data, which turned people’s attention to the gold physical balance sheet. Figure 2 plots total fabrication demand against three main channels of physical gold supply: mine production, scrap, and central banks’ selling.

Global fabrication demand has declined the since mid 1990s and there is a sizable gap between physical supply and fabrication demand since 2000, even with central banks gradually becoming net buyers." - source Barclays

Real interest rate, US dollar strength have indeed been the "out-of sight" jack-knife of our Mack the Knife's murder of gold prices. That simple.

When it comes to the acceleration of flows out of Emerging Markets and growing pressure on their respective currencies, it is, we think a clear illustration of our "macro theory" of reverse osmosis playing as we have argued in our conversation "Osmotic pressure" back in August 2013:

"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013

The mechanical resonance of bond volatility in the bond market in 2013 (which accelerated again in 2015) started the biological process of the buildup in the "Osmotic pressure" we discussed at the time:

"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - Macronomics, August 2013.

More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike.

• Hypertonic surrounding in EM prevents them from stemming capital outflows - the case of China

A good illustration of our "reverse osmosis" and "hypertonic surrounding in our macro theory playing out in true Mack the Knife fashion has been China with the acceleration in capital outflows put forward by many pundits. 

Nota bene: Hypertonic

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

What we are seeing in true "biological" fashion is indeed tendency for capital outflows to flow out of an Emerging Market country in order to balance the concentration not of solutes, but in terms of "real interest rates" (US vs China). On that note we read with interest Bank of America Merrill Lynch's China in Focus note from the 29th of July entitled "Capital outflows: how to measure and what to watch":

"We estimate China’s capital outflows widened to US$92bn in 1H15 from US$30bn in 2014, and the pressure could continue in the near term. While some capital outflow is unlikely to harm China’s external position materially, careful liquidity management is required for growth and market stability. There is ample policy room for further RRR cuts and targeted liquidity injections, and we believe the PBoC will take necessary actions.

Capital outflows: how to measure and what to watch
Market concerns about China’s capital flight are on the rise. In our view, capital flow conditions are becoming more volatile in 2015, and outflow pressures could rise in 2H15. Externally, the likely Fed rate hike and continued USD strength could result in capital outflows from emerging economics including China. In China, relatively weak market confidence in CNY-denominated assets amid the recent stock market turmoil and talks of potential CNY-trade band widening may lead to bigger RMB depreciation expectations. Beyond the short term, with China’s more balanced but still positive current account and policymakers’ FX reform efforts towards a more flexible CNY and less FX intervention, a small deficit of capital and financial accounts could be the new norm for China.
Some capital outflow is unlikely to harm China’s external stability materially, due to China’s sustained current account surplus (~2.9% GDP in 2015), low foreign debt (15% 2015 GDP) and large FX reserves (US$3.7tn at end-2Q15).
However, it’s necessary for the PBoC to manage domestic liquidity condition carefully to avoid possible RMB liquidity drain when economic growth momentum is still soft. It has a big room to inject liquidity by cutting RRR, which is currently at around 18.0%, if capital outflow risks the stability of interbank liquidity and base money supply. Other measures may also be taken to improve liquidity and credit supply for the real economy such as medium term lending facility (MLF) and pledged supplementary lending (PSL). We expect the PBoC will continue opening up China’s capital account in a controlled and prudent manner to manage capital-flight risks.

Measuring capital outflows: US$92bn in 1H vs US$30bn in 2014
We estimate that capital outflow could be around US$102bn in 2Q. In 1H15, it could be US$92bn, widening from US$30bn in 2014. As such, the total capital outflow since the start of 2014 could be US$122bn, far lower than some of the popular estimates in the markets. We take a simplified approach, described in “Estimating China’s capital flow and estimate”, 8 April 2014, to roughly estimate a “portfolio and other unexplained capital flow” to capture the “hot money” nature of some cross-border flows. In a nutshell, we take the change of the
FX purchase position and FX deposits as the aggregate inflow, deducting flows by trade surplus in both goods and services and net inflows of direct investment from the aggregate inflows, leaving the remainder as portfolio and unexplained capital flow. Moreover, we adjust for the impact of RMB international trade settlements.
Why some popular estimates exaggerate capital outflows
In comparison, a popular estimation method would be taking the difference of change in FX purchase position and current account balance and net FDI. However, as we pointed out in our previous reports, this measure could significantly exaggerate the magnitude of capital outflows when the market expects RMB depreciation. This is because: (1) it fails to take into account the impact of currency choices for trade settlement with RMB trade settlement facilities on FX purchase and FX reserves, which could in turn lead to overestimation of capital outflow. More foreign exporters would demand USD payment while foreign importers may pay for goods with RMB, resulting in lower FX purchases; and (2) it overlooks the increase in domestic banks and other institutions’ FX holdings, which will lead to a drop in FX purchases without capital flowing across the border.

Capital flow indications
To gauge capital flow momentum on a high-frequency basis, we could monitor the following two sets of data for some clues. First, we could track the trend of CNY/USD appreciation/depreciation expectations and USD strength. When CNY/USD depreciation expectation rises or USD strengthens, there will likely be more pressures on capital outflows if other macro factors remain relatively stable.

Second, RMB asset performances matter too. While a complete data set on cross-border portfolio investment is not available, we could watch net inflows/outflows under the Shanghai-HK stock connect for some indication of portfolio investment sentiment.

 - source Bank of America Merrill Lynch

Emerging Markets including China are in an hypertonic situation, therefore the tendency is for capital to flow out. In conjunction with capital outflows from exposed "macro tourists" playing the carry trade for too long, the recent price action in US High Yield and the convexity risk we warned about as well as the CCC bucket being the credit canary are all indicative of the murderous proficiency of "Mack the Knife" (King Dollar + positive real US interest rates).

• High Yield and the scary CCC credit canary

Of course we were way in advance in sounding a warning on that subject in our conversation "The False Alarm" in October 2013 where we stated:

"If we take CCC Default Rate Cyclicality as an early indicative of a shorter credit cycle, then it is the rating bucket to watch going forward
Why the CCC bucket? Because there has been this time around a very high percentage of CCC rated issuers accessing the primary market in High Yield.
A rise in defaults would likely be the consequences of a deterioration in credit availability. Credit ratings are in fact a lagging indicator." - source Macronomics

We will re-iterate our 2013 advice for credit investors, watch CCC default rate going forward. Because it matters, more and more.

Our cause for concerns has been validated recently given the on-going sell-off in the US High Yield bond markets. On that subject we read with interest UBS's take in their Global Credit Comment from the 27th of July entitled "The scary reality":

"High yield: The scary reality
The current sell-off in US high yield bond market appears controlled based on the consistent but moderate declines in daily cash bond index prices, but underneath the hood several participants are characterizing the price action as carnage. At an index level the average HY bond has fallen about 2 points week-over-week, but index data is notoriously stale and lagging; there are numerous examples of issues down 5, 7 or 10 points on light volumes despite no direct exposure to commodity prices and no material firm specific news. In our view, recent market behavior has exposed several hidden fragilities in the market ecosystem.
First, too many investors were overweight heading into the sell-off, in particular in the energy complex. The plunge in oil and commodity prices following the Iran deal and Chinese demand fears has intensified the potential fundamental stress in resource related sectors, and this outcome was not anticipated by the consensus. Anecdotally we've heard several credit funds have raised cash balances, but there are two problems with this thesis: one, the rise is arguably structural as outflow risks rise in an environment of tighter monetary policy, rising credit risks and lackluster performance. Two, many of those who raised cash we believe added beta to continue producing above-benchmark returns and limit tracking error. This strategy fails in a decompression scenario where low quality and illiquid credit underperforms.
Second, the sensitivity of energy firms to oil prices is not linear anymore- at depressed levels what would be considered 'normal' levels of commodity price volatility can have outsized effects on fundamentals and market prices. Simply put, the risk symmetry in stressed sectors is to the downside for bondholders. The rub is central bank quantitative easing drove traditional investors seeking mid-to-high single digit yields out of investment grade/ crossover credit into high yield, loan and emerging market debt to satisfy yield bogeys. The problem, however, is some of the tourists underappreciate the exponential loss and mark-to-market functions for low quality high yield assets. As we have noted previously when the credit cycle turns annual triple C default rates can surge from 5% to 30% while average triple C prices can fall into the $40 - $50 range (versus $83 currently) - especially given expected recoveries average in the $20 - $25 context. The scary reality is those investors in triple Cs are seeking high single digit returns when they are likely to end up with negative total returns over the next several years (if our view of the credit cycle proves correct).
Third, the perceived illiquidity in the marketplace at present is due not only to seasonal and month-end effects as well as regulation; the phenomenon also has its roots in uncertainty bred on information gaps and asymmetry. It is well known that the overall HY market has doubled in size; sectors that witnessed more buoyant issuance in recent years like energy and metals mining have seen debt outstanding triple or quadruple. And the number of new names and issues has grown a commensurate amount. The reality is that resources in many segments of the market have not kept up.

Simply put, the growth of the credit markets have not been matched by the addition of research resources (e.g., credit analysts) in many of the silos. Global banks are an obvious example, but a quick graph of employee growth across US banks, brokers, asset managers and rating agency types illustrates the reality that some investors have not added the resources necessary to do the fundamental credit work for today's bloated HY market (Figure 1).

Admittedly employee growth is not shown for the HY credit businesses specifically; however, anecdotes are plentiful enough. For example, high yield managers with one energy analyst responsible for covering 200bn in debt outstanding across 300 issues, or total return funds that bought energy in Q1 which have no dedicated credit research team- only a couple credit PMs/ generalist analyst types.

This would not be a problem if street and rating agency resources were adequate. But they are simply not. The overwhelming majority has been swimming in the opposite direction; nearly all sell side analysts have been asked to cover more names with less support, and the dynamic is similar at rating agencies. In our view, this is a problem as the smaller issues pose more significant credit risks. For example, splitting the overall HY index universe by issuer size (greater, less than 1bn in total debt) we find a considerably higher concentration of single B and triple Cs among the smaller issuers (Figures 2, 3).

And we observe a similar dynamic for the energy and metals/mining segments (Figure 4, 5).

Moreover, the small issuer cohort still accounts for one-quarter of the total HY index universe. In summary, the lowest of the junk rated bond market pose more elevated default risks- yet this cohort is where there is less research coverage, fewer banking relationships, limited trading volumes and very little liquidity. And when defaults start rising some of the tourists may not have the resources necessary to explain the losses in their portfolios when their proverbial shoulders get tapped." - source UBS

Indeed, not only have the macro tourists been "carried away" and are becoming easy preys for our "Mack the Knife" but, High Yield tourists, particularly in the CCC bucket will as well face at some point the jack-knife of our murderous "beta slaughterer", yet another unintended consequences of higher regulatory pressure and dwindling liquidity. Make no mistake, during the next credit downturn, you can expect much lower recovery values, making CDS 40% recovery value assumption for senior debt dubious at best. Negative convexity of callable High Yield bonds is enhanced during sell-off periods and not only does a bondholder suffers from mark-to-market loss but also has to contend with a higher duration investment in most cases as he reaches out for yield and seeks outperformance of his benchmark.

As a reminder, in the current low yield environment, both duration and convexity are higher, therefore the price movement lower will be larger. And, as per our "Blue Monday" conversation earlier in July, convexity has started to bite credit in earnest:

"Over the course of the summer we expect credit spreads to widen, particularly in the High Yield space" - Macronomics, 4th of July 2015

• For High Yield, default matters particularly with contagion risk from commodity

When it comes to the murderous spirit of our "Mack the Knife it has been more akin to a serial killer working overtime when it comes to the significant price movement seen in the High Yield energy and basic material sectors. On the murderous impact of "Mack the Knife" on the sector, we have read with interest CITI's take in their note from the 30th of July entitled "What Credit to Buy if You're Bearish":

• Overview — Bonds in the HY energy and basic materials sectors are down as much as 27 pts this month, but despite lower levels credit investors seem more biased to sell than buy. In this article we first outline fundamental and technical reasons to be bearish in the period ahead. Of course, most PMs have to hold something in these sectors, and in this regard we also introduce a framework for quantifying the risk / return profile of various issuers.

• Fundamentals Prospects — Near-term, we are bearish on the fundamentals.

• There are a number of factors that will weigh on underlying commodity market fundamentals, ranging from falling shale well costs to higher rig counts. Fundamentals for specific issuers in the energy and basic materials sectors face a variety of challenges, as evidenced by the fact that the stock price for 12% of our sample set now trades below $1.

• Technicals Prospects — Flow and positioning data suggest that the technical backdrop could exacerbate any negative fundamental developments."

 - source CITI

When it comes to the High Yield energy sector and Basic Materials, "Mack the Knife" has indeed been very swift with his blade.

But, for High Yield valuations default risk matters and matters a lot. High Yield is a more default sensitive asset and given the "murderous" impact of Mack the Knife on the commodity sphere, there is indeed a default risk spillover in the High Yield sector according to UBS from their 30th of July Global Credit Comment entitled "Credit contagion: why commodity defaults could spread":

"Credit contagion: why commodity defaults could spreadIn the wake of the commodity price swoon one of the recurring questions is will the stress in commodity markets spillover to other sectors? We have already noted some tentative signs that the selloff is beginning to spread as HY energy contributed less to the overall HY market widening last week (12% vs 53% from Jun 3 - Jul 20). However, a few weeks does not make a trend. To answer this question we revisit our outlook for potential defaults in the commodity sectors and discuss the primary channels of plausible contagion to the broader market.
First, regular readers will recall our HY energy default forecast of 10-15% through mid-2016. Simply framed, the commodity related industries total 22.8% of the overall HY market index on a par-weighted basis. In our view, sectors most at-risk for defaults (defined as failure to pay, bankruptcy and distressed restructurings) total 18.2% of the index and include the oil/gas producer (10.6%), metals/mining (4.7%), and oil service/equipment (2.9%) industries. Within these three B/CCC exposure in these industries comprise 10.2% of the index (6%, 3% and 1.2%, respectively). In our view, defaults in the B/CCC categories would be severe at current commodity prices; roughly 25% default rates annually for this cohort seems reasonable given past precedent and a sanity check from our single name specialists. A few investors have suggested our projections may prove conservative as distress could reach some of the higher-quality (BB) issuers in the at-risk sectors given structural/cyclical headwinds.

With that said, how large are contagion risks to the broader HY market? And what are the transmission channels? Historically, investors in the limited contagion camp would probably point to the early 1980s. In this cycle commodity price defaults spiked with the drop in oil prices yet average default rates (IG & HY) increased only moderately amidst a favorable economic environment. In our view, however, the parallels in terms of the credit and asset price cycles are a stretch versus the current context. In the last three cycles, commodity price defaults have either led or coincided with a broader rise in corporate default rates (Figure 2).

More broadly, we find high degrees of correlation between industries with above and below average default rates (e.g., the 25th and 75th percentiles) since the early 1990s (Figure 3).

 

And, not surprisingly, associations between HY spreads in the lower and upper quartiles also appear quite robust (Figure 4).

But why should there be contagion from commodity sectors to other segments?
Academic literature offers up a host of plausible theories. There is a clear pattern of default correlation dependent on fluctuations in national or international economic trends. Commodity price weakness is symptomatic of weak economic growth in China and emerging markets – with possible spillover risks for commodity related sovereigns (oil exporters) and corporates.

In addition, distress in one sector affects the perceived creditworthiness as well as profits and investment of related firms in the production process. For example, exploration and production firm defaults could negatively affect suppliers and customers which would include oil equipment and service, metals, pipeline, infrastructure, and engineering firms.

Furthermore, related literature points to the significance of the supply/demand balance for distressed debt; our theory is that there is a relatively finite pool of capital for distressed assets, implying greater supply of distressed paper pushes down valuations of like assets. Unfortunately, a rise in the supply of stressed bonds typically coincides with a decline in demand for such assets. This self-reinforcing dynamic historically leads to a re-pricing in lower quality segments. Moreover, regulation and market structure increase the risk that investors will absorb fund outflows and mark-to-market losses by selling similar assets if liquidity in stressed issues dries up. And finally, one of the looming technical risks for HY credit markets, in our view, is fallen angels; there is about $400bn of BBB- and $400bn of BBB rated debt outstanding in US high grade indices, of which 30-35% is energy related and much of it is longer duration. In summary, we believe the evidence argues strongly in support of the thesis that commodity defaults could cause broader HY default and spread contagion. So for those in the decoupling camp, you've gotta ask yourself one question: "Do I feel lucky?"" - source UBS

When it comes to High Yield, it looks indeed that Mack the Knife's jack-knife blade while still
out of sight is ready to strike our "credit/macro" tourist in earnest...but we ramble again...

Not only US High Yield and Investment Grade in commodity sectors are at risk but EM credit spreads are also in the target line given the correlation between EM credit spreads and oil.

• EM credit spreads and oil prices are highly correlated

Given the exposure of some sovereigns and quasi sovereigns to the oil sector it doesn't come as a surprise to see additional pressure not only in the FX sphere but as well on EM credit spreads to the evolution of oil prices. This relationship is clearly highlighted in CITI's EM Strategy report from the 29th of July 2015: 

"EM credit spreads and oil prices are highly correlated — Given the renewed collapse in Brent to levels below $54, broad EM corporate spreads should widen a further 10-30bps on top of the 10bps of widening over the past three weeks. Obviously, credits directly involved in the oil business should experience greater widening. Tight market technicals and poor liquidity may prevent this from being fully materialized.

Commodities bite EM again, while Brazil gets kicked around a bit more
The week began with another leg down in commodity prices, combined with heightened anxiety about Brazil’s status as an investment grade credit. We see the two dynamics as being interrelated, as Brazil, while diversified across its commodity basket, very much remains a commodity dependent economy and is highly subject to the polar vortex hitting markets at the end of the commodity super cycle.
We maintain that oil prices are the most important commodity driving EM credit, given that oil is the largest sector by issuance after financials, and it is the bellwether commodity in the world. For EM specifically, iron ore and copper are also important commodities. In figures 3-12, we update and expand the charts we published on July 6 in our Oil tumble a bigger concern than Greece report. In that report we recommended to buy on weakness if Brent prices fell below $60 and broad EM spreads widened by 20-40bps. 

They have widened by only 10bps, so we see another 10-30bps of widening needed to abide by our original recommendation before buying should commence. Given the greater than anticipated drop in oil, as well as the negative ratings actions in Brazil, we believe the wide side of this range should be reached at the least." - source CITI.

Of course when it comes to correlation with oil prices and as shown in CITI's report EM currencies have been first in the line when comes to feeling the heat from falling oil prices:
"EM currencies remain highly correlated to oil

EM currencies are much more liquid than hard currency debt, and therefore reflect price movements fairly quickly. We can see this in figures 11-12. 

The point we are making here is that weaker currencies can offset some of the commodity price pressures oil and mining credits are experiencing. In several past reports that focused on Brazilian and Russian corporates, the main commodity producers in EM, we showed through our scenario analysis that weaker currencies tended to benefit the export sector. PETBRA, as usual, was the exception, given its BRL priced gasoline policy.

Our Broad Recommendations
We believe broad EM corporate credits spreads will cheapen out another 10-30bps because of the price oil until we would come in and buy. For Brazil, we anticipate its corporates will be negatively impacted by any potential downgrade and anticipate 50-75bps of relative spread widening as they converge with Russia. We do not believe this move is fully price in despite recent weakness. Russian corporates have lagged the move down in Brent while the RUB has done much to offset the decline in commodities and have kept the country competitive. We doubt this can be sustained, and if Brazil overshoots Russian spreads, we believe Russian corporates may re-correct back to Brazil. Of single name credits, PETBRA bears mentioning as being at risk of downgrade by S&P as the agency has already stated PETBRA remains IG due to implied sovereign support. As we mentioned last week, we believe Brazil’s subordinated bank debt from BANBRA, BRADES and ITAU is subject to a ratings downgrade. We continue to dislike iron ore as a sector." - source CITI

Looks like Mack the Knife has indeed a little more to carve-out from the already wounded EM crowd and its macro tourists cohort....

Whereas credit and in particular High Yield has been weakening, there is indeed a growing disconnect between equities and debt markets.

• Final chart: Big gap between debt and equity

Whereas last week we pointed out the growing disconnect in terms of flows in both asset classes, there is a well a growing disconnect between high grade credit spreads and equity volatility which continues to be subdued. This has been clearly pointed out by Bank of America Merrill Lynch in their Situation Room report from the 28th of July entitled "Equity meet debt, debt meet equity":

 "Equity meet debt, debt meet equityGiven the large disconnect between the two markets we thought we should make the introduction. Over the past roughly three months (since April 22st) high grade credit spreads from our bond index have widened 23bps, or about 18%, while equity volatility has declined 1 percentage point, or approximately 6% (Figure 1). 

While already a sizable gap notice that the underlying pricing in bond indices tends to be rather stale – thus we point out that a basket of spreads for a limited number of liquid 10-year non-financial, non-energy, nonmaterials bond spreads we track has widened 39% over the same period of time. While from a theoretical perspective credit spreads and equity volatilities are comparative measures of risk associated with a given company when capital structures are constant, clearly they are now sending vastly different messages. This difference in perspectives measured from different parts of the capital structures may reflect a number of factors including differences in sector composition of the two markets, different horizons, changing correlations, expected re-leveraging associated with the acceleration of the M&A cycle, etc.

However, clearly most of the difference between the messages sent by the debt and equity sides results as the former asset class has begun to price in the coming Fed rate hiking cycle. As we discussed in our weekly piece (see: Policy matters) that re-pricing took place in part as issuers accelerated supply ahead of Fed liftoff, and as deteriorating returns significantly reduced retail demand. That leaves HG credit spreads around the cheapest level relative to equity vol we have seen outside the financial crisis (Figure 2). 

Obviously either market could be correct – although clearly we are biased given our underweight stance on credit. It is also fair to expect that credit will be more adversely affected by the tightening monetary policy that equity. However, at the very least it is worth noting that standing just six weeks prior to expected Fed liftoff HG credit spreads are 9.5bps per percentage point of equity vol, or twice the 4.7bps/% we saw six weeks prior to the 2004-06 rate hiking cycle." - source Bank of America Merrill Lynch

Are equities priced for perfection or is credit already reflecting the tightening stance of the Fed? The jury is out there...

"A sword never kills anybody; it is a tool in the killer's hand." - Lucius Annaeus Seneca

Stay tuned!

Chart of the Day - US High Yield issuance and debt outstanding

"Resilience is all about being able to overcome the unexpected. Sustainability is about survival. The goal of resilience is to thrive." - Jamais Cascio, American writer

We came across a very interesting note from UBS - Macro Keys entitled "Is the surge in US high yield issuance sustainable?"

The Chart of the Day comes from this UBS report  and display US High Yield issuance and debt outstanding (bn):

- source UBS

We often hear about strong balance sheets of US corporates and their "cash" levels as the second main driver (after the Fed) for the current low volatility environment. It is indeed the case but, one must not forget about the on-going massive releveraging taking place, notably to fund buybacks via debt issuance.

As long as cash flows and margins stay on current levels, the rising gross debt levels on balance sheets do not affect ratios such as Debt/Ebitda as per the below graph from the same UBS report:

- source UBS

But, should the US experience a strong economic slowdown, you have to remember that this high level of debt can back and haunt you, particularly in the High Yield segment as in the period 2002-2003.

As a rough estimate, the US High Yield market is as big as it has ever been (superior to 1 trillion $) as per the Chart of the Day above! 

In Europe, the situation is different, where the explosion in growth in the High Yield market comes from substitution from corporate loans to bond issuance due to the disintermediation on the back of bank deleveraging (which by the way is way behind the US). Existing loans in Europe are getting refinanced therefore via new High Yield issuance in the bond market, which implies that there is no significant releveraging as seen in the US so far.

So enjoy the "carry" trade but don't get "carried" away as US corporate leveraging has been on the increase due to buybacks, as shown by US equities rising strongly courtesy of multiple expansion in many instances. 

We agree with UBS' concluding remarks in the sense that liquidity challenges in the High Yield space will indeed ultimately be tested should the market turn South at some point:

"In concluding, in the short run, it is possible that US corporate earnings could climb moderately, sustaining the HY market. However, over the long run, predictions for further increases would seem to be predicated on irrational expectations. We continue to believe that the corporate profit cycle is more advanced than the economic cycle, and, in turn, the fundamental underpinnings of the HY market are rather precarious. Credit investors care principally about the evolution of leverage, i.e., the outlook for profits and debt. If corporate profits prove resilient, then debt issuance will continue at will – likely resulting in an increase, albeit modest, in corporate leverage. However, if – or shall we say when – corporate profits turn lower, the increase in corporate leverage will be more pronounced, and the ability to service that debt will become a burden. The impact on issuance is less clear cut; if profits modestly decline, supply could remain frothy as companies turn to financial engineering to boost earnings. However, if the drop is severe enough, capital market conditions may deteriorate and issuance could adjust lower. Historically, credit spreads also react to large shifts in corporate leverage – quite abruptly as one would expect (Figure 4). 

And, as we wrote back in August 3, the risk is that a severe downturn in credit fundamentals sparks a real panic in the US high yield market, which will likely trigger an exodus from non-institutional and crossover investors. Then, and only then, will we know the true extent of the high yield bond market's liquidity challenges." - source UBS

"The first rule of sustainability is to align with natural forces, or at least not try to defy them." - Paul Hawken, American environmentalist.

Stay tuned!

Credit - The Monkey's paw

"'It had a spell put on it by an old fakir,' said the sergeant-major, 'a very holy man. He wanted to show that fate ruled people's lives, and that those who interfered with it did so to their sorrow.'" - The Monkey's paw - Horror short story by W.W. Jacobs published in 1902

After some R&R (Rest and Recuperation), our reconnection to the credit markets validated even further our long standing assertion of a "japonification" process taking place in the credit space in particular and in world growth in general (IMF lowered its 2014 US growth prospect forecast to 2% from 2.4%). 

Of course, all of this is part of the deflationary pressure we have been discussing and highlighting throughout our numerous posts. For illustration purposes we have used the shipping industry to support our deflationary stance and used what was happening with the Drewry Container Rates as an illustration of the tremendous deflationary forces at play. Container lines have made eight general rate increases and one peak season surcharge totaling $3,000 on Asia-U.S. routes since June 2013 and there have been four general increases this year - graph source Bloomberg:

Every single time, the increases have failed to hold because of excess capacity and a sluggish global economy. The benchmark Hong Kong-Los Angeles rate has fallen 7% this year through June 4 and is down 11% yoy. In our Bear Case scenario, slack capacity will continue undermining efforts to raise rates during 2014. Rates have been below $2000 in 16 of the past 17 weeks.

Looking at the growing build up in liquidity concerns which have been stressed on many occasions by market practitioners, it is interesting to see that finally some of the "omnipotent" deities in central banking are waking up to the wonders of the "practice" of their magician tricks given that Federal Reserve officials have discussed whether regulators should impose exit fees on bond funds to avert a potential run by investors, underlining concern about the vulnerability of the $10tn corporate bond market as reported in the Financial Times.

While we previously used many references to the magic tricks used by a "Central Banks" world which was dominated by the "Sorcerer's apprentice" aka Dr Ben Bernanke before his replacement by Janet Yellen, and our "Generous Gambler" aka Mario Draghi in Europe, we thought this time around in continuation to "failing magic trick" references and on-going deception we would use in our title a reference to the Monkey's paw. 

The story is based on the famous "setup" in which three wishes are granted. In the story, the paw of a dead monkey is a talisman that grants its possessor three wishes, but the wishes come with an enormous price for interfering with fate (deflation). In similar fashion the wishes of our central bankers have come with an enormous price tag for interfering with the most important price of all, the price of money with their ZIRP experiment. Of course the recurring liquidity risk in credit markets has been amplified by the acceleration in disintermediation as well as the reduction in market making activities due to regulatory pressures, deleveraging and balance sheet constraints, leading of course to a growing sense of a nasty build-up in "instability" in true Minsky fashion but we digress.

So in this week conversation we will look again at liquidity constraints as well as interesting development in the subordinated space which so far has been disregarded by credit investors given the appetite for yield has clearly made them forget the notion of "risk".

The "japonification" process and the growing risk posed by "positive correlations" is a subject we touched in our conversation "Misstra Know-it all" back in September 2013 and we referred to Martin Hutchinson's take on these correlations:

"Negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. 

Since central banks worldwide are now pursuing the same easy-money policies as the Bernanke Fed, the same correlations are appearing elsewhere, with the exception of the majority of emerging markets, where economic reality remains in play." - source Asia Times, Martin Hutchinson

We commented at the time that the credit markets and equities markets were no exception to "rising forced correlations". In recent years, credit and equities have correlated closely, but, as credit has moved towards a lower bound, Investment Grade for instance have become even more sensitive to interest rates movement, making it incredibly likely that any rate rises will have a large impact given the disappearance of the interest rate risk buffer in the asset class given the on-going spread compression supported by large inflows into the asset class. An illustration of the "positive correlations" we are discussing can be seen, we think in the strong convergence we have seen between the CDX index in the US representative of Investment Grade credit risk and its European counterpart the Itraxx Main Europe 5 year CDS index - graph source Bloomberg:

In August 2013 in our conversation "Alive and Kicking" we argued the following:

For us, there is no "Great Rotation" there are only "Great Correlations" and we have to confide that we agree with Martin Hutchinson's recent take on "Forced Correlations":

"The lack of a major banking crash and major job losses from the LTCM debacle, and the Fed's insistence on goosing the stock bubble yet further by reducing interest rates when LTCM collapsed, produced the moral hazard from which we are now suffering, and in the long run the correlations from which the more leveraged and better connected are currently profiting. 

However, the new correlations are - like LTCM's correlations in 1996-8 - entirely artificial and capable of reversing at any time. As we are seeing in the bond markets, where the Fed in spite of all its efforts is proving incapable of keeping interest rates to the level it wants, even the Fed does not have access to large enough printing presses to keep these correlations going once they start to turn negative. As with LTCM, the eventual reversal of the current correlations will within a few months cause gigantic losses and a major market crash. 

Only this time the loser will not be a single albeit bloated hedge fund but more or less the entire universe of investors, all of whom have become overextended in a market far above its fundamental value. With a crash so widespread, the losers will not be just too big to fail, they will be too big to bail out - an altogether more perilous state." - source Asia Times, Martin Hutchinson

It seems to us the central bank "deities" are in fact realising the dangers of using too much the "Monkey's paw" in the sense that the Fed paved the way for "mis-allocation" and the rise in inflows into the credit space, but that even the Fed's generosity cannot offset the rising risks of a broad exit in a disorderly fashion in credit funds given that the Fed's role is supposedly one of "financial stability". To illustrate further the growing liquidity risks posed by central banks actions, please see the below graphs from Bank of America Merrill Lynch recent situation room from the 16th of June entitled "Geopolitical risk in the Middle-East" displaying the evolution of the capacity for market makers in providing two way markets since 2005:

- source Bank of America Merrill Lynch

Another illustration of the growing risk posed by the gigantic growth of the credit space can be seen in another graph coming from the same Bank of America Merrill Lynch report:

- source Bank of America Merrill Lynch

In this note Bank of America Merrill Lynch made the following interesting comments:

"Just to re-iterate our concern – the Fed’s rate hiking cycle tends to be associated with wider credit spreads (Figure 9). 

Three developments make us concerned that it may actually be much worse this time. 

1) The Fed’s zero interest rate policy has led to an unprecedented reach for yield for more than five years – when the Fed hikes rates the “un-reach” for yield is going to be unprecedented as well. 

2) Dealers have little ability to act as buffer in a sell-off this time, as balance sheets have collapsed due to new regulation (Figure 5 above ). And finally 

3) The mutual fund/ETF ownership share of the corporate bond market is much higher than we have seen in the past – and this is the “hot money” in the corporate bond market (Figure 6 above). However, in the short term we still view the initial increase in interest rates over the past two weeks as modestly bullish for credit spreads, as institutional investors come out and retail flows react to returns only with a lag." - source Bank of America Merrill Lynch

Higher interest rates so far in June have indeed highlighted rising interest rate risk for US high grade spreads and the lack of a significant buffer to counteract rising rates. Back in August 2013 in our conversation "Alive and Kicking" we argued the following when it comes to convexity and bonds:

Moving on to the subject of convexity and bonds, how does one goes in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":
"CDS benefits from positive convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays

As a reminder:
Convexity measures how duration changes as yields change. For a positively convex bond, the duration increases as the yield declines, and decreases as the yield rises. Positive convexity means that the price increase for a given decline in yields is greater than the price decrease for the same rise in yields. Non-callable bonds are positively-convex. Bonds with traditional call options, such as preferreds, and mortgage-backed securities, or some specific callable high yield notes are generally negatively convex. If you expect yields to rise, you should avoid bonds with long duration, such as those with longer maturities and lower coupons, and favor bonds that have shorter duration and higher yields. In periods were you can expect higher volatility in yields, you should avoid low or negative convexity bonds such as callable bonds in the High Yield space.

We concluded at the time:

"With positive convexity from using CDS, the sensitivity of the price to yield changes (i.e., duration) works in your favor whereas with negative convexity, duration works against you as the price of the bond is becoming more sensitive to yield changes. The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..."

Of course another issue to take into account is the liquidity in the CDS space which has been affected as well by the new regulatory environment.

Moving on to the subordinated space which has been a pet subject of ours in recent years (as we predicted in timely fashion skip of calls, bond tenders, and debt to equity swaps in the European banking space - see our conversations "Subordinated debt - Love me tender?" and "Goodwill Hunting Redux"), the new TLTRO set by the ECB is preventing additional liability management taking place in the subordinated space. As we argued in our previous conversation, what European banks lack is not liquidity but lack of capital. Liability management exercises meaning buying back or exchanging subordinated debt usually well below par value took place before the introduction of the LTRO in December 2011. These exercises provided some support for subordinated bond prices at the time. On the back of the ECB's support most prices of Tier 1 subordinated bonds rallied hard closer to par for most in 2013 given the liability exercises took place in 2011 and 2012 and for some peripheral banks took place at a later stage in 2013. 

What has been interesting indeed is the convergence we have seen between the Itraxx Financial Senior 5 year CDS index with the Itraxx Financial Subordinated 5 year CDS index - graph source Bloomberg:

This convergence can indeed be explained by the central banks support which has so far prevented further liability management exercises by providing more than enough liquidity to provide additional support in the on-going deleveraging process and capital raising exercise taking place in the European banking space.

Again, the use of the Monkey paw by central bankers has indeed clearly created mis-pricing and induced mis-allocation as indicated by the induced compression between financial senior risk and subordinated risk we think. For instance a recent example of the mis-perception and mis-pricing of risk in the subordinated space has been highlighted by the threat of the Austrian government towards subordinated creditors of Austrian distressed real estate bank Hypo Alper-Adria-Bank (HAA). The Austrian government in this specific case is trying to pass a law to impose haircuts on investors who thought were insured given the bonds have deficiency guarantee from the state of Carinthia in Austria. This is in effect putting into a new perspective regional government guarantees. The spillover effect of the HAA story had of course some impact on the Austrian financial sector and led S&P on the 10th of June to put the ratings of seven Austrian banks and four Austrian states under review for downgrade. As reported by CreditSights in their Euro Financial Movers report of the 15th of June:

"The government is also proposing to cancel loans of €800 mn provided by the bank's former owner Bayerische Landesbank (BayernLB), while a further €1.5 bn of loans from BayernLB will not be repaid or paid interest until June 2019 at the earliest. BayernLB has reacted angrily, not unexpectedly (see Bayerische Landesbank: HAA Bail-in Challenge), as this move could hit its capital ratios and potentially might require it to take further provisions or impairment charges." - source CreditSights

This illustrates not only the unpredictability of government action but also the mis-pricing of risk in the subordinated space we think, particularly in the light of the upcoming revamp of the CDS market in September 2014 with the new design for CDS contracts which should lead to a significant widening of subordinated spreads to reflect the changes in the new contracts. The lower recovery rate expectations in the new European bank CDS contracts will widen spreads but should end of the day benefit the protection buyer as the sub-level events given successor provisions which will be introduced mean that senior and sub debt will be tracked separately to determine successors meaning it reduces orphaning risk (lack of deliverable bonds). As a reminder in the experience of Bankia/BFA sub debt moved to BFA, but the majority of senior debt and sub and senior CDS moved to Bankia.

In relation to the widening expected, Barclays in their note from the 6th of June 2014 entitled "Implied valuations of '14 bank CDS definitions" expect a widening of 50 bps:

"We expect sub CDS to be up to 50bp wider, on average, with senior CDS 15bp tighter. Though September is a few months away, two trading implications that are relevant right now are to sell sub protection in names with positive CDS-cash basis and to own (or not be underweight) LT2 bonds in tier 2 banks." - source Barclays

Therefore the Bloomberg graph above displaying the on-going relationship between Itraxx Financial Senior with Itraxx Financial Subordinated 5 year CDS index is somewhat an anomaly which has been induced by investors once again over-reaching for yield in their buying spree.

On a final note as always, regardless of the final melt up in asset prices, credit prices will indeed be giving clues for a stock market correction as indicated by Bank of America Merrill Lynch in the below graph from their recent Thundering Word note from the 12th of June entitled "The Greatest Risk of All":

"We are a buyer of vol into fall when correction risks rise significantly: either Q3 growth is +3% confirming recovery and cause rates to rise or speculative excesses appear causing central banks to start "talking down" asset prices. Clues to stock market correction include rising gold prices and decline in credit prices (as in 1987 –Chart 1)." - source Bank of America Merrill Lynch

The Monkey's paw story is as follows:

" The story involves Mr. and Mrs. White and their adult son, Herbert. Sergeant-Major Morris, a friend of the Whites who has been part of the British Army in India, introduces them to the monkey's paw, telling of its mysterious powers to grant three wishes and of its journey from an old fakir to his comrade, who used his third wish to wish for death.

Sergeant-Major Morris, having had a bad experience upon using the paw, throws the monkey's paw into the fire but White quickly retrieves it. Morris warns White, but White, thinking about what the paw could be used for, ignores him.

Mr. White wishes for £200 to be used as the final payment on his house. The next day his son Herbert leaves for work. Some time later, the young man is killed by machinery at the factory where he works, and the couple receives compensation of £200 from his employer.

Ten days after the funeral, Mrs. White, almost mad with grief, asks her husband to use the paw to wish Herbert back to life. Reluctantly, he does so. Shortly afterwards there is a knock at the door. Mrs. White fumbles at the locks in an attempt to open the door. Mr. White knows, however, that he cannot allow their revived son in, as his appearance will be too hideous. Mr. White was required to identify the body, which had been mutilated by the accident. It has now lain buried for more than a week. While Mrs. White tries to open the door, Mr. White makes his third wish, and the knocking stops. Mrs. White opens the door to find no one there." - source Wikipedia

Maybe Mr Central Banker, in similar fashion to Mr White knows that he cannot allow a fast revival of normal interest rates as the re-appearance will be "too hideous" for risky asset prices as a whole.

As far as we are concerned we have our doubts in the much vaunted "recovery" story but do agree that vol's cheapness is indeed inversely correlated to the rising "complacency" making new highs on a regular basis in the market place.

From Monkey's paw to Monkey business...

"An American monkey, after getting drunk on brandy, would never touch it again, and thus is much wiser than most men." - Charles Darwin

Stay tuned!

Chart of the day, or "dislocation of the year"? S&P 500 vs US 10 year

"I believe in social dislocation and creative trouble." - Bayard Rustin

The S&P 500 vs US 10 year bonds - Graph source Bloomberg:

We discussed this topic with our good cross-asset friend and fellow "Macronomics" blogger "Sormiou". We thought this time around we would entertain you with some interesting points he made and add our comments as well:

"The dislocation that started mid-April is becoming more and more "puzzling":

Noise 1: on-going Chinese Treasuries buying, through Belgium, cf the on-going CNY slide and Belgium Treasuries holdings stats strangely exploding

Noise 2: simply short covering on T-Note

Or bond markets sending alarming growth/inflation message, that equity markets do not want to hear?"

As we posited in our last post "The Vortex Ring", the upcoming re-allocation process from Japanese behemoth GPIF, will continue to put additional downward pressure on core government bonds. For instance the pressure can already been seen coming from Japanese investors as indicated by Nomura in their latest "Summary of Japanese investment in April". While banks have been shedding foreign assets, key investor types such as insurance companies, pension funds and toshin companies have been significant net buyers of foreign assets:

"Insurance companies: Insurance companies accelerated their investment in foreign bonds, while slowing their investment in JGBs (Figure 1). 

They purchased JPY633bn ($6.2bn) in foreign bonds, and there has been net buying of foreign bonds by insurance companies for three months in a row. Major lifers. financial results show they increased their exposures in EUR-denominated assets aggressively in FY2013, and they are likely

to keep adding exposures in EUR-denominated assets in April, as the share of EUR in total foreign assets remains lower than before the Euro crisis. While the strong investment in foreign bonds was partly owing to the beginning of the new fiscal year, we expect lifers to be more positive on foreign bond investment as Japanese yields are still low. In fact, insurance companies. superlong JGB investment slowed to JPY226bn ($2.2bn), the smallest amount since April 2013. Their investment in JGBs also slowed to its smallest amount since May 2012 (JPY567bn or $5.5bn). The liquidation of domestic equity exposures continued at a moderate pace (-JPY35bn or $0.3bn).

Banks: Banks sold JGBs at the highest pace since April 2012 (-JPY2632bn or $25.7bn), while also selling foreign bonds at a high pace (-JPY2021bn or $19.7bn. This was the fifth month in a row of banks. foreign bond selling, while recent MOF weekly datasuggest their selling of foreign bonds has been slowing lately.

Pension funds: Pension funds accelerated their investment in foreign assets in April. They purchased JPY510bn ($5.0bn) of foreign bonds, the biggest amount since 2005 when data begun (Figure 3).

The biggest pension fund, GPIF, is expected to change its target portfolio to add more foreign assets, and smaller pension funds may have already started increasing foreign asset exposures ahead of the expected GPIF announcement. Pension funds continued selling domestic equities, albeit by a small amount (-JPY94bn or $0.9bn)." - source Nomura

Another illustration from the bond buying spree from Japanese investors can be seen below coming from the same Nomura report:

As per our last post "The Vortex Ring":

"It is worth noting Japanese have bought a record $86 billion of US treasuries in the last 12 months according to Bloomberg data. It is important to note as well that for the Japanese investors, adjusted for living expenses, US treasuries still yield more this year than Japanese government debt than at any time since 1998,  as per monthly data compiled by Bloomberg showed recently. So if the GPIF starts deploying its "allocation firepower" in June, maybe you ought to cling to your US treasuries a little bit longer, and maybe after all the Belgian central bank is just a very "astute" investor after all..."

We still sit tight in the deflationary camp, meaning you should go with the "flow" and expect further compression in core government yields and spread in this "japonification" process. 

Key take aways from our last post "The Vortex Ring"  are as follows:

-Don't sell your US Treasuries yet (you might want to "front run Godzilla", namely Japan's GPIF),

-Play the rebound of the Nikkei with weakening yen again in June (but first short term pain has been and is on the cards)

-Don't expect QE yet in Europe.

"We spend more time developing means of escaping our troubles than we do solving the troubles we're trying to escape from." - David Lloyd, British artist.

Stay tuned!

Credit - Cloud Nine

cloud nine: "A state of happiness, elation or bliss".

Following up from our previous conversation where we made a previous "meteorology" veiled reference in our chosen title, looking at the "improved" European data and markets in conjunction with the European weather, we thought we would continue with this line of referencing in this week's conversation.

For now, in Europe, looks like there is indeed a state of elation or "Cloud Nine", at least in the credit space. There is some form of normalization in spreads, having seen this week the Iboxx Euro Corporate index, being one of the most used benchmark in European Investment Grade mutual funds, tightening by 5 bps in the cash market to 153 bps, also with High Yield debt issuance surging again, signaling the busiest July on record from an issuance perspective as reported by Bloomberg with the average yield investors demand to hold junk bonds falling 42 basis points so far this month to 5.68 percent, near the lowest in seven weeks, Bank of America Merrill Lynch index data show.

Indeed, the credit markets are back into "Cloud Nine" following the devastation from May and June thanks to the QE tapering bomb, which we previously nicknamed the "Daisy Cutter". 

No doubt the latest PMI releases point to some form of stabilization or respite for the time being in the European space as indicated by the improving PMI data.

US PMI versus Europe PMI from 2008 onwards. Graph - source Bloomberg:

But stabilization, doesn't equate expansion, and while the latest European PMI read has scrapped back just above the 50 line, this near term comfort or "cloud nine" moment, is only a respite given nothing has really materially change in the European space. 

So in this week's conversation we would like to focus our attention again on the elusive credit growth plaguing European economies due to encumbered European banks balance sheet with legacy assets as well as why we think it is in the interest of the US to start normalizing rates, therefore tapering.

The elusive credit growth:

Yes, we hate sounding like a broken record but Europe in our views is still a story of broken credit transmission to the real economy. 

On that point we agree with Bank of America Merrill Lynch's take on the Europe story so far from their note from the 9th of July entitled "European banks: it's tough out there":

"Not enough credit in the system

What Europe is struggling with is a lack of lending. This is in different countries driven by a fear of new regulation; a need to bring funding structures into line with new expectations; provisioning shortfalls; or new business margins being unattractive. Obvious undercapitalisation is rare; indeed, it has almost been driven underground. But there is no point regulators tightening the rules overall if

they are not universally applied. They will not achieve what is sought. The AQR* is an opportunity – already being applied in an unnecessarily leisurely fashion – to finally get ahead.

2013 – or perhaps 2014 as well

With it, 2013 is a lost year for lending. If it is not rigorous enough, 2014 will be lost too. It seems difficult to imagine that the political agenda will last that long." - source Bank of America Merrill Lynch

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

Should the AQR indicate a shortfall in capital, then there is potential for bail-in rules to be applied as indicated by Bank of America Merrill Lynch's note:

"Bail-in would be painful but would position Spain for sustained recovery 

Should the AQR indicate a shortfall in capital, we believe it may be that the EU’s proposed bail-in rules would need to be applied. With many Spanish banks having run down subordinated debt through exchanges over recent years and having very limited amounts of senior debt outstanding after years of difficult funding markets, the risk of depositor bail-in could rapidly loom large.

The challenge in potentially bailing in banks that were declared well capitalised by the current authorities would in our view be a political challenge of significant proportion. However, we see it as likely to be necessary if the aim is to build a banking system that will lend to solvent borrowers at reasonable prices. We do not believe that even the major Spanish banks are well positioned to do this at present, with high loan to deposit ratios, or their capital tied up overseas or in equity holdings.

We believe that the price would be worth paying, as a banking system that had truly put all its legacy issues behind it would be best placed to restart lending, which would avoid the creation of new bad debts through weak economic performance and unnecessary company and individual bankruptcies. We discuss recent meetings in Spain and our conclusion that credit withdrawal from the economy is likely to be ongoing later in this report." - source Bank of America Merrill Lynch.

We agree with Bank of America's take, namely that until the AQR is completed and capital shortfalls identified and remedied, you cannot expect a significant pick up in lending. 

So while credit markets are basking in "cloud nine" as displayed by the recovery in spreads over this week and the re-opening of the issuance market, the latest lending survey data coming out of the ECB point to much different picture as indicated by Jeff Black in Bloomberg on the 25th of July in his article "ECB Says Bank Loans to Private Sector Shrink Most on Record":

"Lending to companies and households in the 17-member euro area fell the most on record in June in a sign the region is still struggling to shake off its longest-ever recession.

Loans to the private sector dropped 1.6 percent from a year earlier, the Frankfurt-based European Central Bank said today. That’s the 14th monthly decline and the biggest since the start of the single currency in 1999.

“The weak economy is still weighing on demand for loans and the ECB needs to figure out how to support that,” said Annalisa Piazza, a fixed-income analyst at Newedge Group in London. “There are still substantial reasons for the ECB to maintain the current accommodative stance.” 

ECB President Mario Draghi pledged last month to keep interest rates low for an extended period of time amid a subdued economic outlook and “weaker and weaker” credit flows. While euro-area banks loosened credit standards for loans to consumers in the three months ended June for the first time since the end of 2007, they continued to tighten them for corporate and home loans, an ECB report showed yesterday.

The rate of growth in M3 money supply, which the ECB uses as an indicator for future inflation, fell to 2.3 percent in June from 2.9 percent in May, according to today’s data. That’s below all 30 estimates in a Bloomberg survey of economists.

M3 grew 2.8 percent in past three months from the same period a year earlier. M3 is the broadest gauge of money supply and includes cash in circulation, some forms of savings and money-market holdings." - source Bloomberg

No loan, no growth, no growth, no reduction of budget deficits.

Is lending going to improve in Europe going forward?

We do not believe it will and so does Bank of America Merrill Lynch in their 9th of July paper on European banks:
"While funding markets are open, high debt costs compared with realisable margins on new business mean that banks have made little use of the term markets. With all the pressures from regulators to fund more conservatively, a lack of term issuance has to be in our view a lead indicator of further balance sheet shrinkage. Without a significant change in new business spreads which remains elusive (Chart 20), we believe that banks will be shrinking across the euro area for some time to come. This will naturally be deflationary for the economy.

Is it going to be possible to get around the banks and provide credit to the economy through other channels? We believe not. - source Bank of America Merrill Lynch.

Last week we made the following point:
While the ECB has recently tweaked its collateral framework as additional policy support, as part of the intent towards re-launching the ABS market to improve SME funding conditions, we think it is too little, too late and that the credit transmission mechanism has been broken in Europe, leading to a surge in bankruptcies as well as unemployment.

The credit transmission mechanism channel is broken as indicated by Bank of America Merrill Lynch graph depicting euro area loans to the private sector adjusted for sales and securitization:

"Schemes to kick-start securitisation of small business loans will in our view struggle to gain traction. Given high levels of non-performing loans in the SME sector, a government-backed or ECB “first loss” piece would likely have to be over 20% of the principal extended, a figure too high for northern European support to be forthcoming." - source Bank of America Merrill Lynch.

Encumbered European banks balance sheet with legacy assets:
Problems on European banks balance sheet, not only have not gone away but in some cases have yet to peak, so while credit markets are enjoying a "cloud nine" respite, the deleveraging of European banks balance sheet has much further to go as displayed by Bank of America Merrill Lynch's graph depicting the list of potentially troubled credit ranging from  13% of loans on banks' books to 40% in Ireland:

"On this basis, all the southern economies have double-digit proportions of their balance sheets in need of close attention. Given ongoing economic weakness in the region, we believe this will tend to create pressure on banks to shrink, in order to conserve capital ratios." - source Bank of America Merrill Lynch.

Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments as per Bank of America Merrill Lynch's graph below:
"Foreign ownership of the debt has stabilised but YTD has risen only marginally. Spanish banks have taken up the majority of the increase in recent months, continuing a trend since 2008 (Chart 28).

In addition, regions and municipalities have taken significant amounts of loans from the banks, as have the various funds set up to pay off arrears accumulated by parts of government. These collectively saw banks’ exposures to government rise by a further €20 billion in 2012; more lies ahead in our view.
Crowding out is likely to continue, for two reasons. First, the pretax margin available in taking government exposure is potentially equivalent to, or above, that of lending because there is almost no marginal cost, credit losses are likely assumed to be zero. Furthermore, a government bond position can be repo funded with a 5% or less haircut even for longer dated exposures. This is a fraction of the discount required to repo fund mortgage or SME exposures, even when such finance is available.
Leverage ratios may bind here too
The trade off between loans and government exposures is also set to be intensified with the introduction of leverage ratios. The zero risk weighting of government bonds made them 'free' from a capital perspective, but a 3% leverage constraint implies an equivalent 30% risk weight based on a target common equity tier. One ratio of 10%. based on the proposed 8% of liabilities bail-in requirement, the effective risk weight would likely be higher."  - source Bank of America Merrill Lynch.

Where we disagree with Bank of America Merrill Lynch's recent note is on their take about the recent improvement in the Macro Data in Europe which according to them could lead to potential increase in credit demand. We do agree though that banks are a leveraged play on recovering economy (so far US banks have outperformed both equity wise and credit wise):
"Macro data in Europe has been, at least, less bad in recent months. Banks are, always and everywhere, leveraged macro plays. This predisposes us to be more positive on the European banking system. Better GDP improves potential credit demand and drives higher asset prices, a key contributor to bad debt charges.
However, better GDP is a necessary but not sufficient condition for a more positive view. There remain several constraints :
- Legacy assets. We believe these are likely to be dominant issues for many banks in Spain and Portugal. The past is not yet behind them
- Non-performing loan generation has been elevated recently in Italy and Spain. While the pace should slow with sustained GDP recovery, provision coverage has lagged new NPL formation, suggesting that more recent problem loans will also need to be addressed
- Returns are not sufficiently high to encourage banks to grow."  - source Bank of America Merrill Lynch.

So far the ECB has limited the surge of European Government Bonds yields as indicated in the below graph with German 10 year yields staying around the 1.60% level at 1.64% and French yields now around 2.25% slightly higher from last week - source Bloomberg:

But how long can the summer lull last?

Probably until the fall, where there is a significant possibility of seeing renewed political risk in conjunction with austerity fatigue. On that note we agree with Nomura's take from the 25th of July from their geopolitics not entitled "Red October":
"- In contrast to 2012, markets have been barely troubled by political risk this year, with the focus very much on the fundamentals and, latterly, the Federal Reserve together with monetary tightening in China.
- However, the autumn (or "fall", as the Americans would have it) may see politics-related risk rising in several geographies, notably the eurozone but also East Asia, the Middle East and the US.
- Although we see a systemic event as a tail risk, we still think that politics has the potential to move markets non-negligibly in the coming weeks, with October currently looking particularly risky." - source Nomura

While the summer lull and "cloud nine" seems to be prevailing, as we argued last week, in conjunction with our friends from Rcube latest call on global weakening earnings momentum, there are significant indicators that are starting to flash warning signs, at least credit wise we think from a European perspective as like anyone else we look at PMIs in Europe but we prefer to focus on credit availability and financing conditions.

First, Europe's largest engineering company Siemens has cuts its profitability forecast amid market slowdown and won't achieve its 2014 margin target of at least 12%, leading for an early exit of its CEO Peter Löscher.

Second, one particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. As indicated in our conversation "The European crisis: The Greatest Show on Earth", :

"When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys."

One particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. The latest survey published on the 12th of July points to a deterioration in the Terms of Payments:

The monthly question asked to French Corporate Treasurers is as follows:

Do the delays in receiving payments from your clients tend to fall, remain stable or rise?

Delays in "Terms of Payment" as indicated in their July survey have been reporting an increase by corporate treasurers. Overall +27.6% of corporate treasurers reported an increase compared to the previous month, a clear deterioration in the trend. The record in 2008 was 40%.

On top of that French treasurers are clearly indicating in the latest report a deterioration in their operating cash flow position in the latest AFTE report:

The monthly question asked to French Corporate Treasurers is as follows:

How do you assess the current situation of the operating cash flow of your business:

easy, normal or difficult?

A deterioration that does not bode well for France's level of unemployment which should continue to rise given a deterioration of operating cash flows could lead to a rise in the number of bankruptcies in France which continue to rise as per the below graph from Natixis:

So we recommend continuing to monitor closely the French corporate treasurers' survey in the coming months.

Moving on to the subject of why we think it is in the interest of the US to start normalizing rates, therefore tapering, we have long argued that we have more issue with ZIRP policies than QE.

Let us explain.

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

The only way the Fed can start raising interest rate is by first starting its "tapering" dance (following its "twist"...). To do that you need to contract the monetary base first, which is not trivial to say the least.

Looking at the recent bout of volatility with the ML MOVE index jumping from early May from 48 bps to a record 117 bps in a couple of weeks which crushed the fixed income space, it will not be an easy exit for sure - graph source Bloomberg:

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

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

On a final note, we recently took the liberty of plotting not only the rise of the S&P index (blue) versus NYSE Margin debt (red) but we also added S&P EBITDA growth (yellow) as well as the S&P buyback  index (green) since 2009 - graph source Bloomberg:

The much vaunted stability courtesy of Bernanke's wealth effect looks to us increasingly unstable.

Sometimes when we look at the chosen path taken by our central bankers, thinking they can "print" their way out of trouble and the pernicious destructive effects ZIRP policies have on capitalism (lack of a price for capital therefore it cannot be "efficiently" deployed but only mis-allocated) and labor, we sometimes feel like Zweig must have felt in Petropolis...

Oh well...

"Every wave, regardless of how high and forceful it crests, must eventually collapse within itself."  

Stefan Zweig (1881-1942)

Stay tuned!