Macro and Credit - The Rebound effect

"Credibility is a basic survival tool." Rebecca Solnit, American writer

While listening to the somewhat "dovish" comments of Fed in chief Janet Yellen as of late, we reminded ourselves for our title analogy of the "Rebound effect", being the emergence or re-emergence of symptoms that were either absent or controlled while taking a medication, but appear when that same medication is discontinued (QE taper), or reduced in dosage. In the case of re-emergence, the severity of the symptoms is often worse than pretreatment levels, such as valuations we would argue which are somewhat rich according to Janet Yellen. Obviously in "Rebound effect" one could argue that "rich" valuations get richer even with discontinuation of sedative substances. It seems that Janet Yellen's words have fallen on deaf ears given her latest "dovish" comments have had no effect to the partygoers who have gotten seriously intoxicated on the Fed's punch bowl in recent years as indicated by the ultra-low levels of volatility reached in various indices (VIX, MOVE, to name a few). Even implied credit volatility is steering towards historical lows while inflows into Investment Grade credit in 2017 have been spectacularly strong. 

In this week's conversation, we would like to look at low volatility in the credit space as yet another sign of complacency. While everyone is basking in the sun, we think that a return in volatility is lurking in the shadows yet Goldilocks in credit, one would have to admit has been saved again by a more Dovish tone from Janet Yellen. We wonder if the Fed's chair is not more interested in preserving her legacy while still at helm, hence the more recent rhetoric but we digress.

Synopsis:

• Macro and Credit - Oh My God! They Killed Volatility!
• Final chart - Get over it, the Phillips curve is dead.

• Macro and Credit - Oh My God! They Killed Volatility!

One could easily opine that the biggest effect from overmedication from our "Generous Gamblers" aka our central bankers, has been the disappearance of volatility thanks to financial repression. As our tongue in cheek bullet point reference to the old South Park catch phrase, one might wonder if this low volatility regime will end, now that the narrative has been more hawkish somewhat as per our recent conversation "The Trail of the Hawk".

In similar fashion to Le Chiffre, aka Mario Draghi from the ECB, Janet Yellen has as well steered towards "Credit mumbo jumbo", which has had a much vaunted "Rebound effect", at least for US equities. Yet Janet Yellen's "rich" valuation word has been totally ignored by the leveraged and carry crowd, particularly in European High Yield seeing as well not only record issuance numbers but also loose covenants and record tight credit spreads as reported by Bloomberg on the 17th of July in their article entitled "Europe's Junk-Bond Boom Triggers Alarm as Safety Nets Weakened":

"The whole European junk bond market is on track for the busiest July on record, whereas issuance in the U.S. is waning. So far this month, sales swelled by 400 percent from the same period last July, while equivalent U.S. offerings dropped about 75 percent, Bloomberg data show.

- source Bloomberg

While we recently mused that gamma hedges in credit were cheap, while credit remains an attractive carry trade in this long in the tooth credit Goldilocks scenario, as we indicated last week, it's not only in the VIX that there has been systematic selling of volatility for income. The game has also been played in the credit world. The warnings sent by our central bankers have continued to fall on deaf ears and the "beta" game is continued to be played although, recently High Yield fund flows have been weaker. What goes up often goes down to paraphrase Mark Yusko from Morgan Creek's previous quarterly gravity parabola. We would add that what goes too tight often goes too wide in relation to credit spreads. That was at least the story for the second part of 2016 when it comes to the Energy sector. But, as we indicated recently, it seems to us that in terms of risk-reward, High Yield has moved from expensive or "rich" to super expensive and in particular Euro High Yield. On that note we agree with Richard Barley's article in the Wall Street Journal entitled "The Vanishing Reward for Buying High-Yield Bonds":

"The risk premia on high-yield bonds in the U.S. and Europe were negative in June, PPMG calculates. The extra yield wasn’t enough to compensate investors for the risk of owning them over time.

This has happened before, most recently in 2014. That was followed by a selloff that gathered pace in 2015 as the falling oil price hit energy-company balance sheets, most notably in the U.S. There may not be an immediate catalyst for the market to fall now. But for investors buying high-yield bonds, the risk-reward balance doesn’t look encouraging."  - source Wall Street Journal

Although oil prices have been under pressure in 2017, credit has been widening at a much slower pace than what we saw in early 2016. It seems to some instance that overmedication have led to some sort of permanent anesthetization and significant complacency although central bankers have started reducing in earnest the prescription drugs recently. Many pundits have been impressed by how resilient credit has been in the latest bout of Sovereign yields volatility. Everyone and their dog has been focusing on the low levels touched on VIX as indicative of the current complacency, but, if there is one asset class that has shown low volatility for different reasons than the equities space, it is in credit. On that subject we read with interest Morgan Stanley's take from their Credit Derivatives Research note from the 14th of July entitled Vol AWOL.

"Over the past year, we have analyzed credit valuations through several frameworks and found US credit markets to be rich most ways we slice them. Spread per leverage is close to all-time tights, and spread per duration has rarely been lower, while the quality of the IG market has deteriorated over time (see Investment Grade Research: Not Your Parents’ Market). The one exception is that credit spreads adjusted for the level of volatility still look attractive relative to history. In other words, if this low-vol environment persists, then credit may remain an attractive carry trade.

In our view, the recent bout of low volatility (implied and realized) is yet another sign of complacency in credit markets. And while volatility has been low this year, it is worth remembering that we have seen considerably higher return volatility in this cycle than in prior bull markets, with IG and HY spreads hitting ‘recessionary’ levels twice (2011, 2016).
Therefore, focusing on just the last 3-4 months misses the bigger picture. In our view, central banks have been somewhat successful in this cycle at responding to periods of tighter financial conditions, muting volatility in the process. We believe recent hawkish rhetoric out of many global central banks, on top of the Fed pushing ahead with its plan to continue hiking rates while shrinking the balance sheet is a clear catalyst for vol to again rise (see US Fixed Income Strategy: Trading the Fed's Balance Sheet). And when that happens, buying credit as a carry trade at very tight spread levels will no longer look as appealing.

Just as investors have reached for yield in this cycle, low implied volatility levels have also been driven by a search for income, a trend that has accelerated at tight spreads. We think both fundamental (central bank policy) and technical (systematic selling of vol for income) factors have driven volatility to these low levels, and an unwind of these dynamics could impact volatility in the other direction on the way down. In this week’s report, we dig into credit volatility in more detail.

Volatility and Valuations

We start by looking at the current level of volatility in credit markets on an absolute basis and in the context of credit valuations. In Exhibit 3 below, we show the level of 3M implied volatility for CDX HY.

Quite simply, implied volatility is close to historical lows across many asset classes. In the context of credit vol specifically though, we would note a few additional points. First, the repricing in credit implied volatility has been more meaningful when compared to prior lows. For example, CDX HY 3M implied vol recently hit a level of 3.5% vs. 5.2% at the tights in spreads in 2014. In comparison, 3M SPX implied vol hit a recent low of 9.6%, marginally below the lows of 2014. Second, on a historical basis, implied credit volatility trades closer to realized than in many other markets (Exhibit 4).

The importance of low volatility for credit markets should not be understated. Credit is a low-beta asset class and is inherently short volatility and tail-risk. At low yields and tight spread levels, the case for credit rests in part on attractive risk-adjusted returns. Low levels of volatility boost ‘carry’ trades, make fund Sharpe ratios look better and of course, are a general barometer of risk appetite. In Exhibit 6 below, we show trailing CDX IG spreads normalized by the level of 3M price volatility. Volatility-adjusted spreads clearly do not look as extreme as other metrics, like spreads adjusted for balance sheet leverage (Exhibit 5).

The risk with looking at spread/vol is that volatility is backward looking and is much less stable than a fundamental measure like leverage. For example, 3M realized price volatility in CDX IG would need to rise by just 0.3% for vol-adjusted spreads to trade back to historical averages. In addition, an ‘extreme’ level of spread/ volatility has not been a great predictor of future market performance. In Exhibit 7 below, we break-out the spread to volatility ratio into different buckets and show the average 1M forward index return and hit rate of performance (percentage of times returns are positive). Across both these metrics, we find that when spread/vol is high, returns going forward tend to be low and positive returns are less frequent.

Drivers of Low Realized Volatility

There are clearly many drivers of the current low vol environment. While we won’t spend much time on the fundamental elements, central banks have clearly played a role. As Exhibit 8 shows, this cycle has been characterized by elevated uncertainty and multiple growth scares. 

These environments have led to big waves of spreads widening. However, each of these episodes have also been followed by unprecedented levels of stimulus from the Fed as well as other global central banks. This ‘Fed’ put has no doubt muted volatility, at least for extended periods of time in this cycle.

Beyond central banks, portfolio dispersion has also played a role in low volatility levels this year. In fact, we think the current low level of volatility is masking some underlying dynamics in the CDX market. For example, dispersion in US credit is actually higher today than it was at the tights of the cycle in 2014. We try to show this using two charts: First, comparing the widest 10 names in the CDX IG index vs. the rest of the portfolio (Exhibit 9).

Second, we look at the standard deviation of weekly cross-sectional spread changes for the CDX IG constituents and normalize it by the level of volatility (Exhibit 10).

Both these metrics show that credit dispersion is higher today than it was at the tights of the cycle back in 2014. Effectively, this has played some role in keeping the index levels more range-bound and less volatile than may be the case otherwise.

In the equity market, very low levels of single-stock correlations have helped drive low realized volatility. In that sense, this dispersion dynamic in credit markets is not that unique. However, we would highlight an important distinction. The low correlation level in equities seems more about sector rotation (Tech unwind, value vs. growth) and certain sector-specific factors (Financials). In credit, the drivers of dispersion are mostly negative stories related to certain sectors that either face structural or fundamental challenges (e.g. Retail, Energy, Autos). As we have noted in the past, issues in credit tend to show up first in the most fundamentally stressed sectors, and are initially treated as idiosyncratic. Eventually, the stress spreads to the broader market as credit conditions tighten. As a result, we would not use the dispersion argument in credit to justify low volatility levels over a long period of time.

Drivers of Low Implied Volatility

Having discussed some of the drivers of low realized volatility, we now shift to the drivers of implied credit volatility. The first point we note is the move lower in implied is not just a function of low realized volatility. For example, at the tights of the cycle in June 2014, CDX HY 3M vol traded 1.45x 3M realized vol and CDX IG traded 1.29x 3M realized vol. Today, CDX HY vol trades 1.17x, whereas IG trades 1.19x. We see a similar trend of implied compressing to realized when comparing the credit and equity markets. However, historically, credit implied vol has traded at a larger premium to realized than the implied premium to realized in the equity market. In recent months, this relationship has flipped (i.e., a lower implied/realized ratio in credit than equities).

More specifically, looking just over the past 12 months, we have noticed a large pick-up in systematic selling of credit volatility. Anecdotally, these investors have been most active in shorter-dated expiries. In Exhibit 12, we show 1M and 3M implied volatility levels in CDX IG to highlight the importance of these flows. While 3M implied spread vol in IG is just ~3.5% below the average levels around cycle-tights (June 2014), 1M implied volatility has repriced even more meaningfully, lower by 5%.

Broadly, this selling of volatility in the credit options market, motivated by the same global reach for yield driving flows into US credit, has helped compress implied volatility to new cycle lows. Arguably, as credit valuations richened, these flows if anything strengthened as the relative benefit of selling options (vs. long spreads) became more attractive.

To the extent the selling of volatility is driven by an income-generating alternative to long carry via spreads, we think these flows may be reaching a limit. Implied volatility, when adjusted by historical index spreads levels, is already very low. We show this in Exhibit 13 below.

For example implied CDX HY spread vol today is around 27%, relative to a regression implied level of 36% based on the last 7 years of data. Also, as we mentioned earlier, historically, implied credit volatility used to trade richer to realized than many other asset classes. This is not the case today and hence selling credit volatility may not look as attractive on a cross-asset basis.

At the other end of the spectrum, demand for credit option hedges has also slowed down quite meaningfully. Large non-economic buyers of credit vol, such as banks, have been much less active this year relative to prior years. Anecdotally, the lower demand for credit hedging has been driven by expectations for easier capital requirements around less onerous stress scenarios.

Bigger picture, in our view, the conditions for volatility to remain low seem to be fading. For example, central bank rhetoric globally has turned hawkish at the margin, with the Fed seemingly more focused on financial conditions as well as risk-asset valuations. And when volatility does start picking up, some of the technicals noted above that have pushed it to such low levels, could exacerbate volatility on the way down. Just as strong and consistent flows have pushed spreads to very tight levels in this cycle multiple times, but when these flows turn the other way, weak liquidity has driven sharp moves in the other direction." - source Morgan Stanley

As we have reiterated recently, the credit mousetrap is coiled and has been set by our "Generous Gamblers". Of course flow wise the credit mouse trap continue to be coiled on a weekly basis, particularly in Investment Grade Credit according to Bank of America Merrill Lynch Follow The Flow note from the 14th of July entitled "Not giving into your (rates) tantrum":

"IG inflows are strong and stable

The high volatility in the rates markets has done little to deter the inflow stream into high grade funds. The resilience of the credit bull story (thanks for the backdrop of CSPP) is proving strong. This is evident in the divergence seen in fixed income flows, as IG credit fund flows remain high and positive, while government bond flows have moved into negative territory.

Over the past week…

High grade funds recorded another week of inflows; their 25th in a row and the third consecutive one above the $2bn mark. High yield fund flows remained negative for a third week and we note that the volume of the outflow has remained strong for a second week. Looking into the domicile breakdown, the aggregate number has been pulled down predominantly by European-focused funds, just as US focused funds flows were negative for the sixth consecutive week.

Government bond fund flows turned negative for the first time in six weeks. Overall, Fixed Income funds recorded their 17th consecutive inflow, again predominately driven by strong flows into IG credit funds." - source Bank of America Merrill Lynch

The Rebound effect is still going strong credit wise. Investors continue chasing yields, having both extended their duration and credit risk in recent years thanks to central banks meddling and selling volatility as well. No wonder volatility has been neutered. As we pointed out last week, there is a growing disconnect between fundamentals from the real economy and asset prices. We have used this analogy before of Disney's Fantasia movie and the sorcerer's apprentice. At some point having poured so much water (liquidity) our little apprentice finally loses control and eventually the old and wise wizard has to step in (BIS?). We are slowly but surely getting there. Are central bankers ready to take the proverbial credit punch bowl away? We wonder. 

Right now there are still a lot of buyers in credit with still so much liquidity sloshing around but clouds are gathering such as the US debt limit falling in the first half of October. To repeat ourselves, in the current Goldilocks scenario for credit, there is still room for further credit spreads tightening. With such strong inflows, unless we see some exogenous geopolitical factors coming into play, even with the most recent toned down rhetoric from Janet Yellen, it is hard to see just yet a change in markets volatility dynamics. As this long rally continues to be hated by so many, eventually Goldilocks will finally catch up with the three bears but it isn't the time yet. For now it is still yield chasing time but you would be well advise to start building up some "duration" and "credit" defenses while it is still cheap, just a thought. 

In our conversation "The Trail of the Hawk" we indicated that cheap gamma could be found in credit options and that in Investment Grade there were relatively cheap to own. You might already been wondering if there is a trade here. On that subject we read with interest Bank of America Merrill Lynch take in their Relative Value Strategist note from the 13th of July entitled "Volatility is low. In credit, especially so":

"Within credit, IG vol appears cheaper than HY

As we wrote recently, the plunge in oil prices and weakness in retail names have made HY quite vulnerable to macros risks. The implied vol premium in HY reflects that risk. However, the realised volatility of HY hasn’t really increased relative to IG. As a matter of fact, the beta is near its lows

Is there a trade here?

The divergence between credit volatility and comparable equity metrics has persisted for a while now. It is a symptom, we think, of the low volatility-high fragility regime that has characterized markets over the last couple of years.

We are reluctant to recommend a credit-equity relative value trade here for two (related) reasons. One, cross-asset beta has been very unstable and it is difficult to pick the ‘right’ value with any degree of confidence. Two, we suspect that unless the economic cycle turns, stocks are likely to respond more aggressively to shocks than credit i.e. the risk premium in equity vol is probably justified. All that said, for those looking for a low cost hedge, IG volatility appears to be the cheapest here, relative to equities and HY.

Why is credit volatility so low?

There are several explanations for this persistently low implied volatility. For one, there are simply more sellers than buyers. CDX options, unlike their counterparts in other asset classes, don’t enjoy a deep well of sponsorship among real money asset managers as a hedging tool. Among those who do employ derivatives, the bias has been towards selling volatility as a means to generate premium. This leaves banks as the sole structural buyers of index options. Secondly, implied volatility is low because realised volatility has remained persistently low. CDX IG has been realising less than 30% (annualised daily spread) volatility for a little over 6m now, longer than similar stretches in 2014 and 2015. Finally, economic data volatility has been subdued. While there have been some signs of weakness, the economic narrative hasn’t shifted dramatically. If economic volatility returns, either through the Fed committing a policy mistake or by falling behind the curve, we think credit volatility will follow suit." - source Bank of America Merrill Lynch

Whereas High Yield has remained more sensitive to macro risks such as the variation in oil prices, Investment Grade credit volatility has remained subdued hence its relative cheapness. Even in credit, when it comes to volatility, there is a simple rational behind the low level reached, there are simply more sellers than buyers as pointed out in Bank of America Merrill Lynch's note:

"Why is credit volatility so low?

The evident reason: more sellers than buyers CDX options, unlike their counterparts in other asset classes, don’t enjoy a deep well of sponsorship among real money asset managers as a hedging tool. While some may choose to hedge using the underlying index, the practice isn’t prevalent among a majority of money managers. Among those who do employ derivatives, the bias has been towards selling protection or selling volatility as a means to park incoming funds while ramping up the portfolio or simply to generate carry/premium. This is particularly true in CDX IG, where for several years now there has been a large non-dealer long base in the index.

The reluctance to hedge with derivatives can be attributed to a few factors. For many, it

may just stem from unfamiliarity with the product and never having used derivatives

before.

There is also the issue of mismatch between cash credit portfolios and CDX. CDX IG

doesn’t include any Banking names, which is the largest sector within High Grade.

Similarly, until recently CDX HY had very few Energy names even though the sector is

one of the largest in High Yield.

Corporate bond benchmarks and the portfolios that follow them are weighted by market capitalization, making them highly sensitive to the largest debt issuers. In contrast the CDX portfolio is equally weighted.

Beyond differences in portfolio construction, there is also the fundamental question of risk i.e. what is the exposure that needs to be hedged? CDX is a spread product, a vehicle to gain exposure to pure credit risk. However, most high yield accounts and more than half on the high grade side are ‘total return’ investors i.e. they are sensitive to both spreads and rates.

There is very little default risk in high grade portfolios and at the portfolio level there is perhaps more concern with hedging duration risk than credit risk. Also, since rates and spreads are negatively correlated, spread widening is often accompanied by lower rates, which softens the PnL impact.

In high yield, we also think there is some ‘hedge fatigue’. Because the CDX HY index did a poor job of representing the cash market in the past, it has not always held up as a good hedge for high yield bond portfolios. This issue has been corrected to some extent with changes in the index composition, but past experience perhaps continues to sting.

All this leaves banks as the sole structural buyers of credit options. They tend to buy low delta payers to hedge their loan books or origination activity or receive regulatory capital relief, among other things. What’s more, this technical is largely isolated to IG." - source Bank of America Merrill Lynch

So all in all, there much more concerns for investors with hedging duration risk rather than credit risk when it comes to Investment Grade credit. The risk of a "convexity event" with the perilous exercise of the reduction of the Fed balance sheet means that the focus should rather be on bond volatility and its indicator the MOVE index in the coming months. Obviously the recent dovish tone from Janet Yellen is we think representative of our "Generous gamblers" concerns with bond volatility given leveraged players and carry speculators, only love one thing and that's low rate volatility. Our central bankers are walking on a tight rope. After having coiled the volatility spring with their financial repression, they are trying to unwind it at a slow pace and avoid rocking the boat. It remains to be seen in the coming months how they are going to pull it off. 

While volatility seems to be at the moment "flatlining", so is the Phillips curve dear to the economists at the Fed, in true "Japanese" fashion as per our final chart. On a side note we have become more positive on gold and gold miners as of late thanks to Janet Yellen, therefore playing the "Rebound effect".

• Final chart - Get over it, the Phillips curve is dead.

Back in our May conversation "Wirth's law" we confided that we were part of the crowd claiming the death of the Phillips curve. As well, back in our January conversation "The Ultimatum game" we argued that the Phillips curve was dead because because the older a country's population gets, the lower its inflation rate in true "japanification" fashion. Our final chart comes from Deutsche Bank FX Daily note from the 14th of July entitled "When the Fed's punch bowl lacks punch" and displays the Phillips curve being flat on its back:

"From this we can conclude:

i) There is extreme inertia built in to inflation’s response to changes in economic activity, even if it is possible that the Phillips curve steepens in extreme circumstances of over and under capacity.

ii) The corollary is it is extremely difficult for the Fed to impact inflation through activity/growth measures. The Fed (and the Fed is not alone among Central Banks) has lost control over a half of its mandate.

iii) While doctrinaire goods and services inflation targeting persists, price cyclicality will be concentrated in larger asset price cycles. One difference between asset inflation compared with traditional goods & services inflation is that asset inflation also leads growth measures. The cycle then tends to show up as follows: asset inflation driving up capacity utilization, which does not show up meaningfully in traditional CPI measures, that leaves policy overly accommodative, that pumps up the asset cycle, until asset prices reach such extremes they turn on themselves.

iv) At least while the Phillips curve framework is being adhered to, the Fed will be very slow to ‘take away the punch bowl’.

v) The outstanding question for the Fed watchers is how will Fed deal with the status quo over the next year? IF inflation remains slightly below target, bonds handle the Fed balance sheet adjustment reasonably, risky assets remain strong, and growth remains at or above trend, will the Fed tighten in 2018? At least while the market cannot firmly answer in the affirmative, the USD is going to find limited support, especially against higher yielding currencies.

vi) The market assessment that there is more punch to be drunk, is probably correct. It still looks too early to bail-out of the positive risk story. In part because we have seen this narrative before in the late 1990s, asset froth in this cycle is prone to build more slowly and to lesser extremes. The Fed may have lost control, but the market will exert greater self-control. 

The optimistic risk conclusion is: drinking slowly from the punch bowl, extends the party – and should help with the hangover." - source Deutsche Bank

It looks to us that "The Rebound effect" is pushing towards a final melt-up regardless of the narrative of our "Generous Gamblers". For now, everyone keeps dancing, particularly in Investment Grade credit and in similar fashion to 2007, market makers keep getting hit on the bid, whether on CDS or Credit Options and continue to feel the pain of not being able to recycle effectively the relentless tightening seen in credit. As the sorcerer's apprentice in 1940 Disney's Fantasia movie, we would have to agree with Deutsche Bank, that the Fed has lost control and has tried too hard to exploit the Phillips curve as per Robert Lucas' critique. When unemployment becomes a target for the Fed, it ceases to be a good measure because like in Japan, over the years, wage growth - in both per worker and per hour terms - has become less responsive to changes in the unemployment rate. Subdued job switching is due to a mismatch between jobs and worker skills. To repeat ourselves, what matters is the quality of jobs but we should add that to ensure Americans are great again, they need to get better skills for the jobs being advertised and that goes through training. The Fed's models are built on past relationships. What these PhDs at the Fed need to understand is that these relationships change over time, making these models less reliable. At least you know that they will be slow in removing the punch bowl for the time being, that's a given. For more on the subject of the Phillips curve, we encourage you to read Hoisington Quarterly Review and Outlook for the Second Quarter 2017, a must read in our humble opinion. For now one could conclude from our conversation that "rich" valuations will get richer even with discontinuation of sedative substances. Sic transit gloria mundi...

"All things are only transitory." -  Johann Wolfgang von Goethe

Stay tuned!

Macro and Credit - The Ninth Wave

"Every wave, regardless of how high and forceful it crests, must eventually collapse within itself." - Stefan Zweig (1881-1942)

While chuckling about the gullibility of some investors pundits who were somewhat surprised by the Bank of Japan' latest move in implementing Negative Interest Rate Policy (NIRP), given as per the SNB move in 2015, they should know by now that central bankers always lie, we reminded ourselves The Third Wave experiment when thinking about our title analogy. While you might be already wondering why our title is the Ninth Wave and not the Third Wave experiment, it is fairly easy to explain. 

The Third Wave experiment was conducted by school history teacher Ron Jones during the first week of April 1967 in Palo Alto in California in order to explain his students how the German population came to accept the actions of the Nazi regime during World War II. Jones started a movement called "The Third Wave" and told his students that the movement aimed to eliminate democracy (in our central banks case: "interest paid"). Jones experiment (in similar fashion to current central banks experiments with QEs and NIRP) on the fourth day of the experiment quickly decided to terminate the movement because it was slipping out of his control. The experiment was all about explaining the rise of fascism. In our current environment, our central bankers "deities" are indeed experimenting with some form of "fascism" with their intent in imposing "financial repression" and discipline to the markets, we think.

So why our title?
Jones based the name of his movement, "The Third Wave", on the supposed fact that the third in a series of waves is the strongest, an erroneous version of an actual sailing tradition that every ninth wave is the largest hence our chosen title.

But, back in November 2011 we discussed a particular type of rogue wave called the 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 crisis In relation to our previous post, the Peregrine soliton, being an analytic solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), it is "an attractive hypothesis to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace" - source Wikipedia." - Macronomics - 15th of November 2011

We voiced our concerns in June 2013 on the risk of a rapid surging US dollar would cause with the Tapering stance of the Fed on Emerging Markets in our conversation "Singin' in the Rain":

"Why are we feeling rather nervous?

If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars? It is a possibility we fathom." - Macronomics - June 2013

At the time we stated that we were in an early stage of a dollar surge.

Back in December 2014 in our conversation "The QE MacGuffin" we added:

"The situation we are seeing today with major depreciation in EM currencies is eerily similar to the situation of 1998, with both China and Japan at the center of the turmoil."

What is of interest of course is that indeed the Third Wave experiment analogy has been somewhat validated by Goldman Sachs in a recent research report as per below chart:

- source Goldman Sachs.

This ties up nicely with our "reverse osmosis" theory we mentioned again in our previous conversation "Under pressure"(This global macro hypothesis was first described in our August 2013 conversation "Osmotic pressure").

But if the sailing tradition that every ninth wave is the largest is true, then again, our chosen title is the correct one.
The Ninth Wave happens to be as well a splendid painting from 1850 by Russian Armenian marine painter Ivan Aivazovsky. Overall, our title refers to the nautical tradition that waves grow larger and larger in a series up to the largest wave, the ninth wave, at which point the series starts again. This of course goes with our earlier quote from Stefan Zweig. Zweig's quote does ring eerily familiar with the reckless abandon in which central bankers of the world are engineering the biggest bond bubble (or wave) ever seen, and the Ninth Wave might eventually turn out to be Wave 3 squared result but we ramble again...

In this week's conversation we will once again reiterate our advice to start playing "defense" in credit and move higher into the capital structure and in the ratings spectrum. We will also look at the debilitating global growth outlook as well.

Synopsis:

• Credit - Time to play defense on any "relief" rally
• US Investment Grade Credit - Why you want to "front-run" Mrs Watanabe
• Macro -  Growth outlook? It's weaker than you think
• Final chart - Why a flatter yield curve is not good for the financial sector

• Credit - Time to play defense on any "relief" rally

As we pointed out recently, half the High Yield universe by market value today trades at 310bps, while the other half is at 1050bps. While the distressed list has a disproportionate representation of commodities (33%), this dispersion doesn't bode well for US High Yield, given default and distress ratios are increasing, even outside commodities. 

We commented recently that the higher the "distressed glut", the lower will be the recovery rate. Also, the number of distressed bonds is rising in Europe and of course our favorite "CCC credit canary" issuance levels has plummeted. When it comes to issuance levels and US High yield, year-to-date issuance is down by -16.3% according to SIFMA.

While looking more into issuance levels, we looked at the data provided by Dealogic through the blog Credit Market Daily from Dr Suki Mann, former UBS European Credit Market Strategist. When one looks at High Yield corporate bond issuance, one can clearly see that the issuance levels, given market gyrations have fallen from the proverbial cliff in January:

- graph source creditmarketdaily.com 

As we repeatedly pointed out in our missives, like any behavioral psychologist, we tend to focus on the process rather than on the content. Whereas every pundits and their dog focus these days on the correlation of oil and the relationship with equities, and fathom on a potential rebound of both, we prefer to stick to what we are seeing which is the evident deterioration in the broader credit picture and the implication for equities. The "process" is playing out we think. While yes we can expect indeed a short-term "Keynesian" rebound, we do remain medium to long term "Austrian" bearish and cautious in the grand scheme of things.

For instance, we reacquainted ourselves with what is happening in the Securitization world as of late, reading through Bank of America Merrill Lynch latest Securitization Weekly. We particularly read with attention their latest note from the 29th of January:

"Overview – Things are bad, at risk of getting worse

The bounce in oil should provide some near term upside/relief in securitized products (SP) credit, but will it last? Financial stress receded this week, but it is unprecedented for the Fed to be tightening at current elevated levels. As cheap as SP credit has gotten, we think additional downside risks are too high; stay long duration in agency MBS.

Last week, we compared the price pattern of ABX, the subprime index, back in 2007- 2009 with oil in 2014-2016 (Chart 1).

Our interest in oil stems from the correlation between securitized products credit prices and oil over the past year , as well as the correlation between oil and inflation breakevens, which underlies our recommendation to buy long duration agency MBS.

The ABX-oil comparison last week suggested to us that oil had the potential to decline down to the low 20s by March-April of this year. Naturally, oil rallied this week on that analysis, as news of some potential tightening of supply hit the market. Our experience with ABX tells us that these types of rallies are not unusual within the context of precipitous price declines and that fading the oil rally most likely makes sense. Given the correlations cited above, this suggests that selling or at least fully hedging riskier securitized products credit also makes. If oil goes lower, prices on mezzanine risk transfer, CMBS and CLOs are also likely to go lower, even though they are already at the cheapest levels in recent history.
To make matters worse, and to heighten the potential for some chaotic price declines, there is the matter of Fed policy. As we discuss next, given elevated levels of financial stress, we think the Fed’s decision to start tightening monetary policy in December created significant risks for financial markets. This week’s decision provided little indication to us that this risk will meaningfully alter policy decisions going forward. This suggests to us that downside risks for securitized products credit remain elevated, even after significant price declines in recent weeks and months.
This week’s rally in oil prices may be a precursor of some near term strength for mezzanine risk transfer, CLOs and CMBS, subject to the constraints mentioned above. We recommend either reducing or hedging exposures into such strength and moving up in quality to high quality, short spread duration sectors such as auto ABS. Meanwhile, we continue to recommend long duration agency MBS, with an added emphasis on prepayment protected stories with the 10yr yield dropping below 2.0%

Global financial stress on the rise

In Chart 5, we focus on the rise in financial stress since mid-2014, and show the 50-,
100- and 200-day moving averages.

The stress periods are seen as somewhat episodic, with stress rapidly elevating, and then subsiding, moving more or less back to the trend line defined by the 200-day moving average, which itself is steadily trending higher. The daily peak for the last two years was seen recently on January 20, and stress appears to now be subsiding, probably moving back to the 200-day moving average over the near term. Declining financial stress should be good for financial assets over the near term, including securitized products mezzanine credit. It probably will also give the Fed more comfort in hiking rates in March. This is where we see potential for additional downside in securitized products.

Consider the 2007-2009 experience for financial stress. Chart 6 shows a similar view to the ABX-oil view in Chart 1, benchmarking 2014-2016 versus 2007-2009.

The current cycle, where the January 20 peak was 0.65, appears benign relative to the super stressed levels of late 2008, when the GFSI hit a peak level of 3.01, almost 5x the current level. But just a week before the September 15, 2008 (the start of the global financial crisis), and for the prior year for that matter, the GFSI registered levels near 0.60, or right at about current levels. We have little reason to anticipate a shock to the financial system on the order of the financial disruptions during the GFC. But we think it is important to recognize that the pre-GFC financial stress is comparable to today’s levels, suggesting system vulnerability to shocks or policy errors.

It is in this context that we view the Fed’s tightening of monetary policy as very risky for financial assets. As Chart 7 shows, in 2007, with comparable levels of financial stress, the Fed was aggressively easing, not tightening; now, the Fed is tightening.

Tightening may be the correct policy for the Fed’s economic mandate, but that doesn’t mean financial assets will approve. Moreover, what makes matters more disconcerting for us this time is that, given the change in the political climate relative to the financial sector since 2008, it seems unlikely that there would be a strong (if any) policy response to financial system stress. The days of the Fed put, which arguably has been in effect since October 1987, appear to be over."

To get some sense of what might accompany higher levels of financial stress, we look at the relationship between oil and the GFSI over the past two years in Chart 8.

We actually show the inverse of oil, so oil in the 20-25 range corresponds to an inverse in the 0.4-0.5 range. Very roughly, Chart 8 suggests that if oil drops down to the 20-25 range, the GFSI could head up the 1.0 vicinity. This was the stress level last seen in 2011, which was “solved” by QE3. Would QE4 come in response to a return to comparable levels of financial stress? It’s possible, but given the recent track record, the Fed seems more likely to keep moving in the opposite direction of tightening. This scenario is not likely to be a good one for securitized products credit, in our view."- source Bank of America Merrill Lynch

While we agree with most of the points made by Bank of America Merrill Lynch made in their note, while we reading their interesting note a graph caught our attention, reminiscent of the heyday of 2007, namely the price action in both ABX prices and CMBX prices:

 - source Bank of America Merrill Lynch

Given all of the above, we strongly advocate selling "high beta" into strength and moving towards a more defensive position such as long duration and US high quality Investment Grade "domestically" exposed credit and/or very long dated US treasuries (30 years) or playing it via ETF ZROZ (for retail players).

If you want more compelling "arguments" validating our defensive stance we strongly recommend you read the latest note from Bahl & Gaynor - "It's not what you own that kills you… it's what you owe"

So, moving on to why US high quality Investment Grade credit is a good defensive play? Because of attractiveness from a relative value perspective versus Europe and as well from a flow perspective. The implementation of NIRP by the Bank of Japan will induced more foreign bonds buying by the Japanese Government Pension Investment Fund (GPIF) as well as Mrs Watanabe (analogy for the retail investors) through their Toshin funds. These external source of flows will induce more "financial repression" on European government yield curves, pushing most likely in the first place German Bund and French OATs more towards negative territory à la Swiss yield curve, now negative up to the 10 year tenor.

As per Bank of America Merrill Lynch Credit Market Strategist note from the 29th of January entitled "The great rotation into US credit", we agree with the points they are making:

"After the ECB meeting last week, and US data and BoJ this week, we think that the widening yield differential between US and foreign fixed income will re-ignite foreign demand, as US corporate bonds look increasingly relatively attractive (Figure 6).

Apart from the effects of US data strength, a lot of this relative re-pricing happened because actual and expected foreign monetary policy easing tends to widen yield differentials with US Treasuries (Figure 7).

Obviously it may take a little time before yield sensitive foreign investors transition from the initial stage of finding the new lower absolute yields unattractive, to appreciating that US corporate credit now looks much more attractive on a relative yield basis, and increase their buying (Figure 8).

Corporate yield differential between USD and EUR

While at the time of writing our index system had not updated for Friday’s market movements post the BoJ, as of yesterday (1/28) US and EUR 10-year corporate bonds yielded 4.10% and 1.94%, respectively, for a yield differential of 2.16% - up from 1.98% last week:

Post-BoJ Japanese corporate bond yields and spreads

Due to a favorable time zone our Japanese corporate bond index has in fact updated for the post-BoJ Friday session. We see that in reaction to BoJ negative interest rates, yields declined 6bps to 0.25% while spreads widened 1bp to 29bps (Figure 11).

In our experience Japanese investors have been heavy buyers of US corporate bonds since 2012 – initially mostly on a currency hedged basis but increasingly unhedged. Clearly we expect more buying, especially after the April 1st start of the new fiscal year in Japan. However, today’s -7.5bps move in the cross currency basis swap initial negates the additional yield advantage to US credit created by the BoJ’s action." - source Bank of America Merrill Lynch

If you want to somewhat "front-run" the GPIF and Mrs Watanabe, increasing allocation to US domestically exposed high quality Investment Grade credit makes sense as per Bank of America Merrill Lynch's note:

"US strength, global weakness. 

Our preliminary analysis of the 4Q earnings reporting season for US HG companies shows little evidence that the US economy is going into recession. Specifically for global high grade companies that derive more than 50% of revenue from abroad we are tracking -5% earnings growth for 4Q, a small deterioration from the actual reported number of -2% in 3Q. However, for domestic companies without foreign revenue earnings growth is tracking +8% in 4Q, which is strong even if down a bit from +10% in 3Q. In terms of topline growth we are tracking -5% for the global companies and +8% for their domestic counterparts – both numbers virtually unchanged from 3Q." - source Bank of America Merrill Lynch

Whereas we disagree with Bank of America Merrill Lynch is with their US economy views, we believe that the US economy is weaker than what meet the eyes and that their economists suffer from "optimism bias" we think (more on this in our third bullet point), but nonetheless high quality domestic issuers are definitely credit wise a more "defensive" play.

When it comes to following the flow and once again on why we focus on the process rather than the content, you have to "follow the flow" and when it comes to the implementation of NIRP, think clearly about the "implications".

• US Investment Grade Credit - Why you want to "front-run" Mrs Watanabe

Back in March 2015 in our conversation "Information cascade", we stressed the importance of following what the Japanese investors were doing in terms of flows:

"Go with the flow:
One should closely watch Japan's GPIF (Government Pension Investment Fund) and its $1.26 trillion firepower. Key investor types such as insurance companies, pension funds and toshin companies have been significant net buyers of foreign assets." - source Macronomics, March 2015

One should therefore not be surprised of the latest actions of the Bank of Japan in implementing NIRP which has already been implemented in various European countries and enforced as well by the ECB. As a reminder from last year conversation, this is the definition of "Information cascade":

"An information (or informational) cascade occurs when a person observes the actions of others and then—despite possible contradictions in his/her own private information signals—engages in the same acts. A cascade develops, then, when people “abandon their own information in favor of inferences based on earlier people’s actions”." - source Wikipedia

The Bank of Japan has merely engaged in the same acts as others. "Information cascade" is a trait of behavioral economics. You get our point when we state that we behave like behavioral psychologist when analyzing market trends and central banks "behavior".

When it comes to Mrs Watanabe, Toshin funds are significant players and you want to track what they are doing, particularly in regards to the so-called "Uridashi" funds. The Japanese levered "Uridashi" funds (also called "Double-Deckers") used to have the Brazilian Real as their preferred speculative currency. Created in 2009, these levered Japanese products now account for more than 15 percent of the world’s eighth-largest mutual-fund market and funds tied to the real accounted previously for 46 percent of double-decker funds in 2009 with close to a record 80% in 2010 and now down to only 22.8%.
As our global macro "reverse osmosis" theory has been playing out, so has been the allocation to the US dollar in selection-type Toshin as per Nomura JPY Flow Monitor report from the 15th of January 2016:

"We expect toshin momentum to remain strong in 2016, as suggested by the recent recovery. The maximum amount of risky asset investment under NISA per year has been raised since the beginning of the year. Risky asset investment via NISA tends to be especially strong in January, which will support toshin momentum in the near future. Risk sentiment among retail investors remains the key driver of toshin momentum too, and the latest Nomura Individual Investor Survey suggests a further recovery in retail investors’ appetite for risk assets. The survey also shows a strong preference for USD among foreign currencies, suggesting retail investors are likely to be dip buyers of USD assets via toshins.

The share of US assets in total foreign currency-denominated toshins continued to rise to 58.9% in December from 58.8% the previous month, the highest share since December 2001. US assets held via toshins declined to JPY17.1trn ($143bn), but non-US asset exposure declined more rapidly, especially exposure to EM assets. Interestingly, the share of EUR assets increased to 8.2% from 7.9% the previous month, while outstandings held in EUR-denominated assets inched up to JPY2.4trn ($20bn) from JPY2.3trn. November BoP data showed a recovery in Japanese investment in EUR-denominated securities, and the stabilisation in toshin companies’ exposure to EUR assets is worth monitoring, as it may show a gradual recovery in Japanese investors’ preference for EUR." - source Nomura.

Of course the woes of the Brazilian Real have been exacerbated by Mrs Watanabe and her growing dislike for her preferred carry trade since 2009...

Because GPIF and other large Japanese pension funds as well as retail investors such as Mrs Watanabe are likely to increase their portfolios into foreign assets, you can expect them to keep shifting their portfolios into foreign assets, meaning more support for US Investment Grade credit, more negative yields in the European Government bonds space with renewed buying thanks to a weaker "USD/JPY" courtesy of NIRP.

Whereas this is our assessment, when it comes to "front-running" the risk appetite of the Japanese crowd, although the "Ninth Wave" painting has warm tones in similar fashion than the upcoming "Japanese" allocation, which reduce the sea's apparent menacing overtones and tone of the market, the "macro" picture overall remains menacing as per our next bullet point.

• Macro -  Growth outlook? It's weaker than you think

We think that for "credibility" reasons, the Fed had no choice but to hike in December given the amount spent in its "Forward Guidance" strategy and in doing so has painted itself in a corner. We ended up 2015 stating that 2016 would provide ample opportunities in "risk-reversal" trades. The latest move by the Bank of Japan delivered yet another "sucker punch" to the long JPY crowd. Obviously, should the reverse decide to reverse course in 2016, there will be no doubt potential for significant rallies in "underloved" asset classes such as Emerging Market equities. But, for the time being, the macro picture is telling us, we think that regardless of how some pundits would like to spin it, not only is the credit cycle past "overtime" and getting weaker (hence our earlier recommendations in our conversation) but, don't forget that there is no shame in being long "cash". It is a valid strategy. Particularly given the messages sent by various markets as illustrated recently in Bank of America Merrill Lynch's GEMs Inquirer note from the 28th of January entitled "The Dark Messages of the Markets":

"Mkts consistent with a double digit contraction in EMs EPS

We respect the messages embedded in diverse markets. We highlighted the signals from Dr. Sotheby’s (BID), Dr. Haliburton (HAL), and Dr. Copper, all falling more than 50% from their recent highs – which could reflect weak demand from plutonomists (rich people), energy capex, and Chinese infrastructure – the key drivers of global growth in the past fifteen years.

Additionally, other indicators including transport stocks, the Baltic Dry Index, high yield bond spreads, the KOSPI, cubicle makers, shipping companies, palladium prices, the stock-bond ratio, are all suggesting a severe earnings recession in Asia and emerging markets. How severe? For EMs, USD EPS growth could contract about 15% in 2016. Consensus is at plus 8.4% EPS growth for 2016 for emerging markets (and 6.5% for Asia ex-Japan). (We combine all these growth-sensitive market prices into one indicator to divine EPS growth). Its message is consistent with Nigel Tupper’s global earnings revisions index. From these levels, both have been associated with policy easing, not tightening. We remain suspicious of cheerful consensus growth forecasts, which display a persistent upward bias, and are likely to be revised down. The Wu-Xia synthetic Federal funds rate (Bloomberg: WUXIFFRT Index) LEADS EM equities by 18 mths, and has been tightening since mid-2014, and the Fed forecasts further tightening by 100bps this year.

Valuations not close to cheap in Asia/EMs

Asia ex-Japan is trading at an EV/Net income of 19.9x, compared with an average of 21.7x over past 21 years. This is 0.2 standard deviations below the mean. At market lows, it normally gets to levels around 13x. We would caution against getting too excited by the 1.2x PB in ex-Japan Asia (and EMs) – the ROEs in both region are under pressure, and flattered by a rise in corporate leverage. We need to see a stand-still (or a reversal) of US monetary tightening for us to re-assess our negative views. And/or, much better value." - source Bank of America Merrill Lynch

The question therefore you need to ask yourself is if the FED is going to eventually "blink" during the course of 2016. Because, as put bluntly in Bank of America Merrill Lynch's note, all the Doctors put together do not point towards a "bullish" outcome for growth:

- source Bank of America Merrill Lynch

Financial conditions since mid 2014, that's what credit is telling you, that's what oil prices are telling you and that's what the 3 doctors have been telling you. The damage has been done and while we can understand why the FED has decided to defend its "credibility", we all know looking at the lofty valuations touched, that they should have tightened much earlier one rather than boosting further up "asset prices" for the "plutonomists" to paraphrase Bank of America Merrill Lynch.

In our conversation of November 2013 entitled "Squaring the Circle", we also argued that the performance of Sotheby’s, the world’s biggest publicly traded auction house was indeed a good leading indicator and has led many global market crises by three-to-six months. It has proved a timely indicator of potential global stock markets reversal. Whenever its price reached 50 or so with sky high valuations, a reversal has never been far away. 

Finally, when it comes to our positioning relative to the US recessionary crowd, we believe that a flattening of the US yield curve is never a good sign, particularly for the US financial sector which has been vaunted by some as a "compelling" buy. We will dispel this belief in our final chart.

• Final chart - Why a flatter yield curve is not good for the financial sector

We have been fairly vocal on our take on the direction that US long bonds would take given our deflationary incline. We have in fact hinted on numerous occasions that we had  been increasing our long duration exposure in conjunction with playing the rebound in gold miners (yes, disclosure we are as well, long ABX aka Barrick Gold). 

But if the 3 Doctors listed above don't tell you enough about the state of affairs, then, maybe the state of the US yield curve might tell you a little bit more. To that effect, we would like to point out the shape of the yield curve for our final chart extracted from Bank of America Merrill Lynch latest Securitization Weekly from the 29th of January:

"This week gave some indications of what this somewhat bleak view of ours might mean for rates and the yield curve (Chart 9): as of writing, the 10yr stands at 1.94, the lowest level since April 2015, and the 2yr-10yr spread of 115 bps is the lowest since early 2008. 

This is consistent with what we are looking for this year and why we have persistently recommended a long duration exposure in agency MBS, down in coupon (DIC) in passthroughs and Zs in CMOs. Following on the above discussion, we still see things as follows: the Fed likely will continue to push up short rates and thereby lower growth expectations, anchoring the back end of yields, and flatten the yield curve even more. The only change from this week is that, with new lows in treasury yields, we emphasize the need to own relatively stable long duration assets." - source Bank of America Merrill Lynch

Yes indeed, flatter is not good. And if, like us, you think that US Financials are the second derivative of an economy, meaning that putting on the "beta play" would only be justified by an acceleration of the growth outlook (loan growth) then, we think, there is nothing compelling in playing the "supposedly" value play in US Financials (When it comes to Europe, you already know our stance, stay out of it).

To complete our rebuttal of the "attractiveness" of US Financials, we would like to point out towards  Reorient Group strategist David Goldman's take in their note from the 21st of January entitled "Where to Hide?":

"Underperformance by the banking sector always is a bad sign for markets and the economy; it suggests that the credit mechanism is clogged, with knock-on effects for the rest of the economy. As we observed in our Jan. 18 Week Ahead report, the deterioration of credit conditions and the flattening of the yield curve have left the banks with sharply reduced earning potential. The banks invest more in Treasury securities than in business loans, and the flattening yield curve crushes the differential between their cost of funds and the yield they earn on Treasuries.

Banks’ net interest margin is already at the lowest level in history.

- source Reorient Group

So, before you decide to jump again on the "beta" wagon, think very clearly on how US Financials can be "profitable" in such a deflationary environment and a significant flattening of the yield curve.
There might be at least some solace in US Financials versus European Financials (in particular Deutsche Bank and Italian banks woes), but apart from that, we don't see any "screaming buy" in the former and "zero interest" in the latter.

"Growth is the only evidence of life." - John Henry Newman, British clergyman

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!