Macro and Credit - Fuel dumping

"One of the tests of leadership is the ability to recognize a problem before it becomes an emergency." -  Arnold H. Glasow, American author

Looking at the Dow Jones and the S&P 500 having their worst month since 1931, with cracks clearly showing up in credit markets with weaker oil and outflows from Leveraged Loans, with the Fed hiking by another 25 bps, leading to markets being dazed and confused, when it came to selecting our title analogy, given our fondness for aeronautics ("Dissymmetry of lift" in August 2018, "The Coffin corner" in April 2013, the other being "The Vortex Ring" in May 2014), when it came to our title analogy we decided to go for "Fuel dumping". "Fuel dumping" (or a fuel jettison) is a procedure used by an aircraft in certain emergency situation before a return to the airport shortly after takeoff, or before landing short of its intended destination (or inflation target...) to reduce the aircraft's weight (the Fed's balance sheet with its QT policy, now up to $50 billion per month). 

Aircraft have two major types of weight limits: the maximum takeoff weight and the maximum structural landing weight, with the maximum structural landing weight almost always being the lower of the two. This allows an aircraft on a normal, routine flight to take off at the higher weight, consume fuel en route, and arrive at a lower weight. If a flight takes off at the maximum takeoff weight and then faces a situation where it must return to the departure airport (due to certain mechanical problems, or a passenger medical problem for instance), there will not be time to consume the fuel meant for getting to the original destination, and the aircraft may exceed the maximum landing weight to land at the departure point. If an aircraft lands at more than its maximum allowable weight it might suffer structural damage, or even break apart on landing. At the very least, an overweight landing would require a thorough inspection for damage. 

As a matter of fact, long range twin jets such as the Boeing 767 and the Airbus A300, A310, and A330 may or may not have fuel dump systems, depending upon how the aircraft was ordered, since on some aircraft they are a customer option. As a rule of thumb for the Boeing 747, pilots quote dump rates ranging from a ton per minute, to two tons per minute, to a thumb formula of dump time = (dump weight / 2) + 5 in minutes. In similar fashion, when it comes to the Fed's QT, there is no real rule of thumb when it comes to the pace of the reduction of its balance sheet. We read with interest Stanley Druckenmiller and Kevin Warsh's take on the Fed's policy in the Wall Street Journal yet it seems that as we pointed out in our October conversation "Explosive cyclogenesis":

"As we concluded our previous post, beware of the velocity in tightening conditions. Both Morgan Stanley and as well Goldman Sachs, indicates that given the large sell-off seen in October, investors perceptions have been changing, and that maybe  we have a case of "reflexivity" one might argue. Goldman Sachs Financial Conditions Index shows the equivalent of a 50-basis-point tightening in the past month, two-thirds of which is due to the selloff in equity markets. Early February this year financial conditions tightened about 80bp over a two week period akin to "Explosive cyclogenesis" aka a "weather bomb".

But, the difference this time around we think, even if many pundits are pointing that forward price/earnings ratio of the S&P 500 has tumbled to 15.6 times expected earnings, from 18.8 times nine months ago, making it enticing for some to "buy" the proverbial dip. We think that the Fed's put strike price is much lower than many thinks.

Sure "real rates" have been driving the sell-off but we think many more signs are starting to show up in the big macro picture pointing towards the necessity to start playing "defense". "- Macronomics, October 2018

The big question we think when it comes to Fed having both QT and rate hikes at the same time aka "Fuel dumping" is can you allow interest rates to rise without contracting the monetary base? Clearly the Fed put is still way "out of the money".

In this week's conversation, we would like to reflexionate more on 2019 given the Fed has been clearly telling you, it hasn't got your back anymore and you are on your own...

Synopsis:

• Macro and Credit - 2019: "Mean" mean reversion?
• Final charts  - What the Fed see and what they don't...  

• Macro and Credit - 2019: "Mean" mean reversion?

In our previous conversation we pointed out the weakness seen in credit, given the rise in dispersion witnessed during the course of 2018, leading to cracks showing up in cyclicals and with now leveraged loans weaknesses under scrutiny. Like any behavioral psychologist we indicated in numerous conversations that we would rather focus on the "flows" than on the "stock" given in our credit book, liquidity is what "matters" and when it comes to fund flows, in some segments of the credit markets "outflows" have been significant.

In our credit book, "flows" matter and when it comes to fund flows in credit land there has been plenty of "fuel dumping" as reported by Bank of America Merrill Lynch in their Follow The Flow report from the 14th of December entitled "The CSPP party is definitely over":

"More outflows and no more CSPP

Only three weeks to go before the end of the year, and outflows continued in Europe. Last week we saw a significant risk reduction across European IG, HY and Equity funds. Investors reached for safer assets with strong inflows in Govies and Money Markets. Even Global EM debt funds recorded outflows amid the recent sell off. It seems that this year will end on a negative note as investors are cutting positions across risk assets amid uncertainty around the macro and trade wars front. Italian politics are not helping either, contributing in a flight away from credit and equity funds.

Over the past week…

High grade funds suffered their largest outflow of the year, making this week the 18th week of outflow over the past 19 weeks. High yield funds also recorded a sizable outflow as well, the 11th in a row. Looking into the domicile breakdown, Euro-focused funds led the negative trend, followed closely by Global-focused funds. US focused funds experienced a more moderate outflow.

Government bond funds recorded an inflow this week, the 2nd in a row. Meanwhile, Money Market funds saw a large inflow, putting an end to 4 consecutive weeks of outflows.

European equity funds recorded a sizable outflow, in sharp contrast with the moderate outflow recorded last week, and making it the 14th consecutive week of outflows. During the past 40 weeks, European equity funds experienced 39 weeks of outflows.

Global EM debt recorded an outflow this week, the 10th in a row. Commodity funds recorded a marginal inflow.

On the duration front, mid-term IG funds led the negative trend by far, short-term funds also suffered, while the deterioration was more moderate for the long-end of the curve." - source Bank of America Merrill Lynch

 When the trend in outflows is not your friend...

As per our November conversation "Zollverein", when we talked about the vulnerability of leveraged loans, clearly they have been under the spotlight and some credit investors have indeed resorted in "fuel dumping" so to speak. As per LeveragedLoan.com outflows have been significant and accelerating in the asset class:

"Leveraged loan funds log record $2.53B outflow

U.S. loan funds reported an outflow of $2.53 billion for the week ended Dec. 12, according to Lipper weekly reporters only. This is the largest weekly outflow on record for loan funds, topping the prior mark of negative $2.12 billion from August 2011.

This is also the fourth consecutive week of withdrawals, totaling a whopping $6.63 billion over that span. With that, the four-week trailing average is now deeper in the red than it’s ever been at $1.66 billion, from negative $1.01 billion last week.

Mutual funds were the catalyst in the latest period as investors pulled out a net $1.82 billion, the most since August 2011. Another $704.9 million of outflows from ETFs was the most ever.

Outflows have been logged in six of the last eight weeks and that has taken a big bite out the year-to-date total inflow, which has slumped to $3.7 billion after cresting $11 billion in October.

The change due to market conditions last week was a decrease of $1.231 billion, the largest drop for any week since December 2014. Total assets were roughly $99.3 billion at the end of the observation period and ETFs represent about 11% of that, at roughly $10.9 billion. — Jon Hemingway" - source LeveragedLoan.com

If this isn't "fuel dumping" then we wonder what it is:

"In just the past four trading days, investors have pulled $2.2 billion from all loan mutual funds and exchange-traded funds. That brings withdrawals from the asset class to almost $9 billion since mid-November" - source Bloomberg 

- graph source Bloomberg

It looks like more and more to us the "credit aircraft" may have exceeded the maximum landing weight to land at the departure point given the posture of the Fed with its hiking stance and with its QT on "autopilot".

For Bank of America Merrill Lynch in their Weekly Securitization Overview note from the 14th of December entitled "Mission accomplished; damage assessment", the price action in Leveraged Loans should be watched closely and we agree as we posited back in our November conversation "Zollverein":

"We consider the recent free fall price action for leveraged loans (Chart 5) underlying collateral of CLOs and specifically noted in the FOMC’s September minutes as posing “possible risks to financial stability.” The end result of the Fed’s hawkishness is that less, not more, rate hikes are now expected than in September (see below), so the interest in floating rate instruments such as leveraged loans, and CLOs, has declined. That explains part of the weakness. Another important part of the latest sharp re-pricing of loans is simply that they had lagged the spread widening/risk re-pricing seen in other sectors. This week saw some major catch-up." - source Bank of America Merrill Lynch

 Clearly some pundits are concerned about the "liquidity" factor of Leveraged Loans and decided that "Fuel dumping" was the right strategy given the growing cracks seen in credit with the significant underperformance of US High Yield thanks to weaker oil prices and its exposure to the Energy sector (we have touched on this subject in recent posts). No surprise to see Lisa Abramowicz on her twitter feed commenting on US High Yield spread blowing out today:

"U.S. high-yield bond spreads rose yesterday the most on a percentage basis since August 2011."

- source Bloomberg - Lisa Abramowicz - twitter

Obviously with its QT akin to "Fuel dumping", the Fed has been successful in tightening further financial conditions.

But in relation to Leveraged Loans and the deterioration in both price and flows, comes the question about its impact on the US economy as a whole. On that point we read with interest Wells Fargo's take from their Economics Group note from the 18th of December entitled "Leveraged Loans - A Deathknell for the US Economy?":

"Executive Summary

The leveraged loan market, where the bank debt of non-investment grade companies is traded, has experienced rapid growth over the past few years. But weakness in the market in recent weeks may bring back unpleasant memories of the sub-prime loan debacle a decade ago. Does this recent weakness in the leveraged loan market have negative implications for the macro U.S. economy?

In our view, the leveraged loan market, taken in isolation, is not likely to bring the economy to its knees anytime soon. But its recent weakness may reflect a broader economic reality about which we have been writing. Namely, the overall financial health of the non-financial corporate sector has deteriorated modestly over the past few years. If the Fed continues to push up interest rates and if corporate debt continues to rise, then financial conditions would tighten further, which could eventually lead to a sharper slowdown, if not an outright downturn, in economic growth

Stress Appears in the Leveraged Loan Market

The leveraged loan market in the United States has mushroomed to more than $1 trillion today from only $5 billion about 20 years ago (Figure 1).

 Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

Growth has been especially marked in the past two years with the amount of leveraged loans outstanding up more than 30% since late 2016. But the market has weakened recently. The amount of leveraged loans outstanding declined by nearly $20 billion between late November and mid-December, while prices of loans fell about 2 points over that period (Figure 2).

Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities 

Before discussing macroeconomic implications, we first offer a quick primer on the leveraged loan market. A leveraged loan is a loan that is made to a company with relatively high leverage (i.e., companies with high debt-to-cash flow ratios). Usually, these companies are rated as less than- investment grade. Years ago, banks would hold these loans on their balance sheets, but in the  past few decades an active market has developed in which these loans are bought and sold. Often, an investment bank will buy leveraged loans from commercial banks to bundle them into structured financial instruments that are known as collateralized loan obligations (CLOs). CLOs trade like bonds, and they improve the liquidity in the leveraged loan market.

Leveraged loans are floating-rate financial instruments, so investors piled into the market over the past two years when the Fed was in rate-hiking mode. However, some investors have started to sell their holdings of leveraged loans recently as doubts have risen about how much higher short-term interest rates actually will rise. Moreover, the evident deceleration occurring in the economy could negatively affect the ability of some highly levered companies to adequately service their debt obligations, which has also contributed to some nervousness in the leveraged loan market. Could the recent weakness in the leveraged loan market have implications for the U.S. economy?

Does the Leveraged Loan Market Have Broader Macro Implications?

When banks sell their leveraged loans, they then have room on their balance sheets to make new loans. If weakness in the leveraged loan market negatively affects the ability of commercial banks to offload their leveraged loans, then growth in bank lending could slow. Everything else equal, slower growth in bank lending could lead to slower economic growth, which could then lead to further weakness in the leveraged loan market, etc. In short, a vicious circle could be set in motion. Is there any evidence to support the notion that weakness in the leveraged loan market has led to slower growth in bank lending?

Figure 3 plots the leveraged loan price index which was shown in Figure 2 along with the year-over-year growth rate in commercial and industrial (C&I) loans.

Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

The price of leveraged loans collapsed in 2008, and C&I loan growth subsequently nosedived as well. But the U.S. economy at that time was beset by the deepest financial crisis and recession it had experienced in more than 70 years. The weakness in the leveraged loan market in 2008 may have contributed to the swoon in C&I lending that transpired in 2008-2009, but there probably were more important factors that were causing the sharp drop in C&I lending at that time. 

Indeed, over the past two decades there have been two episodes of weakness in the leveraged loan market that have not been associated with marked deceleration in C&I lending. Between early 1997 and late 2000, prices of leveraged loans fell about 10 points. But growth in C&I lending held up reasonably well during that period, before turning negative as the economy fell into recession in early 2001.

Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

More recently, leveraged loan prices fell 8 points between May 2015 and February 2016. Growth in C&I lending edged down a bit, but we would not characterize that episode as one of “significant” deceleration in C&I lending. In short, there does not appear to be overwhelming evidence to support the notion that weakness in the leveraged loan market leads to significantly slower growth in C&I lending.

C&I lending accounts for less than 20% of total bank credit. Perhaps other components of bank credit, such as the securities holdings of banks, residential and non-residential real estate lending or other types of consumer lending, may show more sensitivity to the leveraged loan market than C&I lending. However, Figure 4 shows that growth in overall bank credit generally has had a low degree of correlation with prices of leveraged loans as well.

 Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

Although we acknowledge that the weakness in the leveraged loan market has the potential to eventually weigh on bank credit, there appears to be very little fallout thus far. Indeed, the amount of C&I loans outstanding as well as total bank credit have both risen in recent weeks.

In our view, the weakness in the leveraged loan market at present reflects a broader economic reality about which we have been writing in recent months. That is, the overall financial health of the non-financial corporate sector has deteriorated over the past few years. The phenomenal growth in the leveraged loan market since 2016 reflects both demand-side and supply-side factors. In terms of demand, investors have been attracted to the relatively high returns that leveraged loans and CLOs offer. On the supply side, the marked increased in leveraged loan issuance over the past few years speaks to the steady rise in non-financial corporate debt, especially among non-investment grade businesses, that has occurred.

Taken in isolation, the leveraged loan market is not likely to bring the economy to its knees anytime soon. But recent weakness in the leveraged loan market may be symptomatic of rising concerns that investors may be having about the outlook for the financial health of the business sector. Spreads on speculative-grade corporate bonds have widened in recent weeks, and investment grade spreads have also pushed out. As we have written previously, we do not view the overall financial health of the American business sector as “poor” at present. But investors apparently are starting to react to its modest deterioration. If the Fed continues to push up interest rates and if corporate debt continues to rise, which would put upward pressure on spreads, then financial conditions would tighten further, which could eventually lead to a sharper slowdown, if not an outright downturn, in economic growth." - source Wells Fargo

After the Great Financial Crisis (GFC), many banks retreated from the Leveraged Loans business thanks to heightened regulatory oversight. In this context, Nonbank direct lenders, business development companies as well as collateralized loan obligation funds and private equity affiliated debt funds all stepped in and funded acquisitions and private-equity buyouts as the M&A market rebounded in recent years. US banks one would argue are in a much healthier "leverage" situation than their European peers, though when it comes to the Leveraged Loan market both in the United States and Europe have seen the rise of "disintermediation" aka shadow banking stepping in. Where we slightly disagree with Wells Fargo's take is indeed the rise in "disintermediation" as banks have been facing rising competition from even "new" competitors entering the private lending space.

Yet, when it comes to C&I loans, change in the last three months have been significant we think:

- graph source Bank of America Merrill Lynch

As we mused in our conversation "Ballyhoo" in October, using a more real-time look at financial conditions points towards a higher velocity in the tightening trend of financial conditions. We argued that the velocity seen in greater tightening of financial conditions could be seen as a case of "Reflexivity", being the theory that a two-way feedback loop exists in which investors' perceptions affect that environment, which in turn changes investor perceptions hence the outflows and the acceleration in "Fuel dumping" or outflows from "credit" to the benefit of the US long end of the yield curve as well as US money market funds, in essence some good old "crowding out".

This velocity we think is important given the combination of rates hike and balance sheet reduction given many pundits are already talking about "policy mistake" being made by the Fed. The whole question is about the transmission of the velocity of tightening financial conditions towards the real economy. We have already seen significant weakness in various US cyclicals (Housing, autos, etc.). On the subject of this transmission mechanism we read with interest Bank of America Merrill Lynch's take in their US Economic Watch note from the 19th of December entitled "Fed up":

"Getting ahead of the shocks

One of the many factors the Committee has considers in their policy reaction function is the impact of financial conditions on the real economy. As was clear from the press conference, “The additional tightening of financial conditions we have seen over the past couple of months along with signs of somewhat weaker growth abroad have also led us to mark down growth and inflation growth a bit.”

To understand the transmission of financial conditions onto the economy, we run various financial shocks through FRB/US, the Federal Reserve Board’s large-scale general equilibrium macroeconomic model. These shocks are 100bp increase in the conventional mortgage rate, 100bp increase to the interest rate on new car loans, 50bp increase in credit spreads (proxied by an 50bp increase in BBB term premium) and a 10% decline in household equity wealth. Note that the shocks to the mortgage rate, car loan rate, and BBB term premium have been approximately calibrated to the moves seen since the start of the year while the equity shock has been roughly calibrated to the decline since peak of the equity market over the summer (Chart 1 and Chart 2).

The shocks are run individually through FRB/US and sustained through the simulation period.

The results of the stylized exercise are presented in Table 1. There are several points worth noting:

• Financial conditions work through the economy with a lag. With the exception of the mortgage rate shock, the peak drag to growth from tighter financial conditions hits the economy 2 to 3 quarters after the initial shock.
• The impact of the individual shocks is fairly muted. For example, a 10% decline in household equity would roughly translate to less than 0.1pp drag to growth in the 2H of year 1 after the shock hits. But add up the multiple shocks, there’s a meaningful slowdown in growth that leads to higher unemployment rate and lower core inflation.
• Higher borrowing costs for businesses have the greatest and most persistent impact on the economy. A 50bp widening in the credit spread acts as a roughly 0.1pp drag in year 1 and 0.1-0.2pp in year. This is consistent with Fed research which shows that the primary transmission of tighter financial conditions works through weaker business fixed investment.2
• The cumulative tightening we’ve see over the past year is roughly equivalent to 33bp of Fed tightening. Another way to interpret these results is tighter financial conditions would prescribe the Fed to ease up on the pace of rate hikes by roughly one fewer hike, consistent with the latest median dots.

What about weaker global growth? The direct impact should be fairly muted given that the external macro linkages are only a small share of the US economy. However, weaker global conditions will filter through tighter financial markets, primarily through higher borrowing rates for businesses and to a lesser extent a decline in household equity wealth that will act as a headwind for the economy." - source Bank of America Merrill Lynch

While global trade has been decelerating thanks to the trade war narrative, the spike in "real rates" in early October triggered the repricing of US equities. Our timing using another "aeronautics" on the first of October in our post "The Amstrong limit" was probably lucky:

"Watching with interest the Japanese Nikkei index touching its highest level in 27 years at 24,245.76 points, with US stock indices having rallied strongly against the rest of the world during this year, and closing towards new highs, when it came to selecting our title analogy we decided to go for another aeronautic analogy "The Armstrong limit". The Armstrong limit also called the Armstrong's line is a measure of altitude above which atmospheric pressure is sufficiently low that water boils at the normal temperature of the human body. Humans cannot survive above the Armstrong limit in an unpressurized environment." - source Macronomics, October 2018.

We wondered at the time if we had reached the "boiling point". In retrospect we did.

The big question many pundits are asking is should the bold pilots at the Fed continue with QT on autopilot. Back in February 2013 in our conversation "Bold Banking" we used another aeronautics reference:

"While 1994, was the year of a big sell-off in many risky assets courtesy of a surprise rate hike, 1994 was as well the year of the demise of "Czar 52" on the 24th of June 1994 which saw the tragic crash of a Boeing B-52H "Stratofortress" assigned to 325th Bomb Squadron at Fairchild Air Force Base during practice maneuvers for an upcoming airshow. The demise of the BUFF (the nickname among pilots for the B-52 meaning Big Ugly Fat Fellow) was due to Colonel Bud Holland's decision to push the aircraft to its absolute limits. He had an established reputation for being a "hot stick".

So what is the link, you might rightly ask, between "bold banking" and "bold piloting"?

A subsequent Air Force investigation found that Colonel Bud Holland had a history of unsafe piloting behavior and that Air Force leaders had repeatedly failed to correct Holland's behavior when it was brought to their attention (not  French president Hollande in that instance but we digress...).

When it comes to "reckless banking" and "reckless piloting", we found it amusing that current leaders have repeatedly failed to correct central bankers' policies, like the ones pursued by former Fed president Alan Greenspan and current Fed president Ben Bernanke, or, the ones pursued by Japan. These policies are instigating, bubbles after bubbles at an inspiring rate." - Macronomics, February 2013

For now the pilots once again at the Fed seem pretty confident in the strength of the US economy, on our side we do not think their optimism is warranted as per our final charts.

• Final charts  - What the Fed see and what they don't...  

With Philadelphia Fed manufacturing index undershooting in similar fashion to the New York Fed released this week as well, one might indeed be wondering if "Fuel dumping" is warranted given the heavy load of the US airplane in terms of corporate debt binge. Our final charts comes from Wells Fargo Economics Group note from the 19th of December entitled "Where the Fed May Be wrong" and in their note they are pondering whether or not the Fed is making a "policy mistake":

"Caught Between A Rate Hike and A Hard Place

Recessions are typically triggered by policy mistakes and the Federal Reserve may very well be on the road to making one. The policy statement that accompanied the Fed’s latest rate hike attempted to allay fears the Fed would tighten too much by acknowledging the economic outlook has diminished and that the balance of risks was now roughly even. FOMC participants also slightly lowered their expectations for the federal funds rate and now call for just two rate hikes in 2019 and one more after that, while the drawdown of the Fed’s balance sheet is expected to remain on auto-pilot at $50 billion a month in 2019.

The financial markets provided some powerful real-time feedback to the Fed. Stocks had rallied just before the Fed’s decision was released, gave back their gains after digesting the policy statement and then sold off heavily during Chairman Powell’s testimony. The yield curve also flattened further and remains inverted between the two- and five-year notes. The markets shot down the Fed’s dovish tightening because they feel economic growth may not be as strong as the Fed believes and is certainly not strong enough to hold to the notion that monetary policy, in its entirety, remains short of neutral.

Economic growth may not be as ‘strong’ as the Fed believes. The strength in the U.S. economy has been narrowly focused, with the energy and technology booms accounting for a disproportionate share of economic growth. Both sectors now appear to be slowing, with the former struggling under the weight of sluggish global economic growth and lower oil prices, while the latter is facing an onslaught of government oversight concerning privacy concerns and anti-trust matters. Growth in the more cyclical parts of the economy is also slowing, with demand for home sales and capital goods flagging for the past few months.

The Fed’s confidence about the strength of the economy may be grounded in the satisfaction that the unemployment rate remains so low at just 3.7%. The unemployment rate is a lagging indicator, however, and monetary policy works with a long and variable lag. Moreover, the IT revolution and growth in online job search platforms have likely changed the way job seekers interact with the labor force. This may help explain why the surge in job openings has not led to a resurgence in wage increases.

The Fed may also be underestimating the impact the drawdown of the Fed’s balance sheet and continuation of enhanced forward guidance are having on global liquidity. Both policies were projected to have strong positive effects when they were implemented. Why wouldn’t they have an equally strong impact now that they are headed in the other direction? Moreover, the high degree of certainty the Fed has displayed that these policies will continue, effectively on auto-pilot at a time that growth is decelerating, has sent a foggy message to the financial markets, which has likely increased uncertainty— hence the rush out of stocks and into bonds and the dollar." - source Wells Fargo

It might be the case that the pilots at the Fed are slightly over-relying on "auto piloting" QT aka "Fuel dumping" while interpreting incorrectly the readings from their pilot cabin's instruments, but we ramble again...

We wish you all a Merry Christmas and a Happy New Year. Don't hesitate to reach out to us in 2019, a year in which we hope to celebrate the 10 year anniversary of this very blog. Thank you for your praise and support.

as the old pilot saying goes:

"There are old pilots and there are bold pilots; there are no old, bold pilots!" 

Stay tuned !

Credit - The Departed

"Faithless is he that says farewell when the road darkens." -  J. R. R. Tolkien 

We have long posited that by suppressing interest rates through ZIRP, the Fed has allowed risks to be "mis-priced" leading to global aggressive "mis-allocation" of capital in the search for returns. This week's chosen title is not only a reference to departing Fed chairman Ben Bernanke, but as well a reference to Martin Scorsese movie masterpiece "The Departed". In the final scene, a rat is seen on the window ledge, symbolizing according to Scorsese "the quest for the rat", which we can ascertain today in the strong sense of distrust towards the actions of the US central bank and in relation to our chosen analogy. We could ramble further and quote Don Delillo's 2003 Cosmopolis: "A rat became the unit of currency".

Under Ben Bernanke's guidance, there has been a growing disconnect between Wall Street and Main Street as displayed by Bank of America Merrill Lynch graph displaying the evolution of Wall Street versus Main Street:

From its 2009 lows the US economy has grown by $1.3 trillion while the US stock market has grown by $12.0 trillion.

No doubt to us that the 2013 performance of the US stock market has been artificially "boosted" by "de-equitization", namely the reduction of the number of shares courtesy of buybacks thanks to increase leverage given many corporates have issued bonds to finance their buybacks program as displayed by the graph below displaying the growing divergence between the S&P 500 and trailing PE since January 2012  - graph source Bloomberg:

 The S&P 500 trades at 25x cyclically adjusted PE ratio (CAPE), exceeding the highs reached in 1901 and 1966. In 1929 CAPE reached 33x and in 2000 44x. 

Our "Departed" strategy has relied heavily on the "Cantillon Effects". The rise of the Fed's Balance sheet coincided with the rise of the S&P 500, and boosted as well by the rise of buybacks. The greatest failure of "the Departed" can be clearly seen in the fall in the US labor participation rate (inversely plotted) - source Bloomberg:

In red: the Fed's balance sheet

In dark blue: the S&P 500
In light blue: S&P 500 buybacks
In purple: NYSE Margin debt
In green: inverse US labor participation rate.

What the "Departed" aka Ben Bernanke as achieved is as follows:

More liquidity = greater economic instability once QE ends

No surprise therefore that the $4 trillion of flows which have been going towards Emerging Markets have been impacted by the return of US rates into positive real yields territory 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 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."

Of course, what we are seeing right now in Emerging Markets is the continuation of "reverse osmosis".

So in this week's conversation, we will look at the growing downside risk posed by some Emerging Markets, the implication for European stocks, and our growing uneasiness with the credit risks being taken and the deflation build-up we are seeing.

We already discussed EM troubles brewing in our conversation "Misstra Know-it-all" relating to the great work from Ben Bernanke aka "The Departed":

"Of course given volatility is on the rise and that VaR (Value at risk) has risen sharply from a risk management perspective, re-calibrating risk exposure could indeed accentuate the on-going pressure of reducing exposure to Emerging Markets, triggering to that affect additional outflows in difficult illiquid markets to make matters worse."

And as posited by Nomura at the time of our September 2013, the risk of the situation turning nasty for lack of liquidity is significant:

"Bad liquidity markets saw asset swaps widen considerably (making swap paying less of a hedge) and start to trade like credit products. This phenomenon, if it continues, could result in a lot of proxy hedging through FX, FX vol, buying CDS and, at a more serious stage, selling what investors could unwind."

We also added at the time:

"Misstra Know-it'all has indeed played a quick hand, lifting stock prices, playing on the wealth effect game and exporting "hot money" flows in Emerging Markets"

In the same conversation we also indicated an interesting trade we particularly like and enjoy today:

"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. By put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up." - David Goldman's article about Gold and Treasuries and bonds in general written in August 2011 (the former global head of fixed income research for Bank of America)

This is exactly what is happening at the moment from a tactical point of view we think and at least the gold leg of the put-call parity, has indeed been performing in this fashion year to date while Emerging Markets currencies have been on the receiving end of the sell-off - graph source Bloomberg:

Interestingly, when it comes to Japan and the crowded trade in JPY (which we have been playing since late 2012) appears to us overly crowded and the risk of a strong reversal cannot be ignored anymore, making as well the Nikkei vulnerable in the short-term (we admitted in 2013 that we enjoyed being long Nikkei hedged in Euro). The USD/JPY exchange rate, the Nikkei index and the credit risk Itraxx Japan CDS spread (inverted) - source Bloomberg:

When it comes to credit and spread tightening, the above significant correlation between rising equities and tighter credit spreads is clearly explained by the wealth effect induced by the Japanese QE.

But, the recent rise in the Nikkei 3 month 100% Moneyness Implied Volatility could indicate a potential near term rise in the Itraxx Japan, representative of the credit risk perception for corporate Japan. It has stayed at record low levels for many months and could easily climb back towards the 100 bps level we think - graph source Bloomberg:

Given the recent bout of volatility, which has been caused from the "Great Rotation" from Emerging Markets aka the "Tourist Trap" (a tourist trap being an establishment, that has been created or re-purposed with the aim of "attracting tourists" and their money), when it comes to playing "defense", Consumer staples offer partial crash protection. On that subject see our April 2013 post - "Equities, playing defense - Consumer staples, an embedded free "partial crash" put option".  From a contrarian stand-point, Consumer Staples, as displayed by Bank of America Merrill Lynch January 2014 Long & Shorts summary, appears extremely underweight:

When it comes to equities and credit sensitivity to Emerging Markets turmoil, Europe is more sensitive to China/EM weakness as indicated by the below chart from Bank of America Merrill Lynch from their note from the 25th of January entitled "Love EM or Hate EM" displaying the massive underperformance in Europe main investment grade risk perception indicator namely Itraxx Main (125 European investment grade entities):

We already touched on the sensitivity of equity index earnings versus FX sensitivity on the 21st of March 2013 in our conversation "Have Emerging Equities been the victim of currency wars?":
"For some countries, the major equity indices can be much more heavily affected by foreign earnings than by domestic earnings." - source BNP Paribas

No wonder the IBEX is on clearly on the receiving end of the latest sell-off. In similar fashion peripheral issuers such as Santander, Mapfre and BBVA in the credit space have not been spared either. The underperformance of the IBEX - graph source - stockcharts.com:

Credit wise, "The Departed" has indeed pushed "mis-allocation" to deep instability level, you would have thought the prime role of a central bank was financial stability, but then again, looking at the recent developments, one might wonder about the "unintended consequences" which increased the instability of the system were worth the efforts put on in over-reflating financial markets.

Recent examples abound to show the increasing risks taken by brazen investors moving clearly outside there comfort zone.

For instance investors are dipping their toes back into illiquid investments as reported by Lisa Abramowicz in Bloomberg on the 23rd of January 2013 in her article "Hard-To-Sell Junk Debt Lure Oaktree to JP Morgan":
"Bond investors are losing their aversion to difficult-to-trade corporate debt that handed them some of the biggest losses in the credit crisis.
The extra yield note buyers demand to own older, smaller junk bonds that trade infrequently has shrunk to an average 0.25 percentage point this month from more than 1 percentage point a year ago, according to Barclays Plc data. JPMorgan Chase & Co. money manager Jim Shanahan said he’s preferring “good credit quality and less liquidity” when picking bonds, while Howard Marks, the head of distressed debt investor Oaktree Capital Group LLC, said he’s finding bigger potential gains in private, less-traded debt.
The evaporating premium for illiquid assets is showing the depths to which money managers are reaching to boost returns after a five-year rally that pushed relative yields on junk bonds to the least since August 2007. With Federal Reserve monetary policies suppressing interest-rate benchmarks for a sixth year, credit buyers are showing more concern that they’ll miss out on a continued rally than get stuck with debt that lost 26 percent during the market seizure in 2008.
“For the past several years, people have been concerned about liquidity,” said Eric Gross, a credit strategist at Barclays in New York. “Now we’re hearing more about people seeking out illiquid bonds.”

Fragile Market

Such debt tends to be more vulnerable to price swings when market sentiment deteriorates, because there are fewer buyers to bid on it when investor withdrawals force money managers to sell. Those risks intensified after stricter banking rules accelerated a pullback by Wall Street dealers that used their own money to facilitate trading.
Primary dealers that trade directly with the Fed cut their holdings of corporate bonds by 76 percent to $56 billion after peaking at $235 billion in 2007, Fed data through March show. After the central bank changed the way it reported the holdings in April, net speculative-grade bond holdings fell as much as 24 percent to a low of $5.63 billion in May before rising to $7.7 billion on Jan. 8.
Investors are demanding an average yield of 5.94 percent to own bonds sold at least 18 months ago in batches of less than $250 million, Barclays data show. That compares with an average 5.7 percent for newer debt offerings of at least $500 million.
The gap, which averaged 0.5 percentage point last year and 0.92 percentage point in 2012, reached as much as 1.95 percentage points at the peak of the financial crisis in March 2009."  - source Bloomberg.

Just a thought for our confident credit investors:
"Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth - - they trust, instead, on their supposed ability to exit."
Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” - "Corzine Forgot Lessons of Long-Term Capital"

Another example as well to the extreme the "Departed" has pushed investors is the return of the old credit binge instruments such as "PIKs" bonds (Payment in Kind) as discussed by Sarika Gangar in Bloomberg on the 24th of January in her article "No-interest Junk Bonds Make Comeback With Twist":
"The riskiest types of corporate bonds are getting a makeover, providing more protection for investors while showing the limits of a rally in junk-rated debt that pushed yields to a record low.
Issuers from Neiman Marcus Group Ltd., which sold $600 million of notes in October that allow it to make interest payments in more debt instead of cash, to Jacksonville, Florida-based Bi-Lo Holdings LLC led $14.8 billion of payment-in-kind offerings in the U.S. last year, the most since 2008, according to data compiled by Bloomberg and Fitch Ratings. The 36 issues were a record.
While the bonds became popular during the last credit boom before the downturn, the new generation of securities are smaller in size, come from companies with less leverage and some compel borrowers to pay interest in cash unless they violate certain financial targets. These protections show that investors are treading carefully even as they search for additional yield amid unprecedented central bank stimulus measures that pushed interest rates to all-time lows.
“The issuance of PIK tends to move the same way as the credit cycle and credit has been loosening,” Sharon Bonelli, a managing director at Fitch in New York, said in a telephone interview. Still, “the market is not as aggressive as it was.” Sales of PIK-bonds were the third most on record last year, behind the $16.2 billion in 2007 and $14.9 billion in 2008." - source Bloomberg.

Kuddos to the "Departed", the Fed's ZIRP since 2008 has forced investors into riskier securities to get extra payouts. But, there is a catch we have repeatedly pointed out:
Definition of Credit Market insanity - "Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."

When it comes to credit risk and luck, recently some investors in hybrid securities learned the hard way when ArcelorMittal called early some subordinated bonds at 101 when they had been trading recently around 108.96 cents, a good sucker punch for some unwary investors as indicated by Alastair March in Bloomberg on the 21st of January in his article entitled "Arcelor Mittal's Hybrid Bonds Slump on Early Redemption Call":
"ArcelorMittal’s $650 million of hybrid bonds slumped 6.8 percent after the steelmaker said it would redeem the notes early because of changes to the way the securities are treated by Moody’s Investors Service.
ArcelorMittal will buy back the subordinated securities on Feb. 20 and pay investors 101 percent of their principal, the Luxembourg-based company said in a statement. The notes, which combine elements of debt and equity, were trading at 101.55 cents on the dollar at 11:05 a.m. in London after closing on Friday at 108.96 cents. Moody’s said on July 31 that it would consider hybrids of speculative-grade companies to be entirely debt, rather than half equity as is now the case for all issuers. ArcelorMittal’s move to call the securities early “shocked the market” and highlights the vulnerability of hybrid bonds to ratings changes, ING Groep NV analysts led by Mark Harmer wrote in a note to investors." - source Bloomberg

When the facts change, which they did in July last year, as a credit investor, change your facts or face the consequences.

We are nearing a top in the gentle credit cycle and no doubt there will be a second distressed wave in the not so distant future, rest assured.

This is what Bethany McLean, known for her work on the Enron scandal and the 2008 financial crisis, wrote back in 2011 - Corporate Subprime - The default crisis that never happened:
"Armageddon never arrived. The Federal Reserve slashed interest rates, helping to spark a huge rebound in the price of risky debt. According to S&P, during the past five years cov-lite debt returned a total of 33 percent, versus 31 percent for standard loans with covenants. Companies that were running into trouble were able to raise more money in the markets. Corporate default rates stayed very low. And it all happened so quickly that the protection afforded by the covenants, or the lack thereof, never seriously got tested." - Bethany McLean - The default crisis that never happened.

She also added in her 2011article:
"The fact that the Fed rode to the rescue doesn't necessarily mean that cov-lite loans were a good risk to begin with."

Another interesting development in the desperate search for yields at any risk by credit investors, has been in the the speculative loan space as indicated by Sridhar Natarajan in Bloomberg on the 22nd of January in his article "Loan Surge Above Par Putting Investors at Risk":
"More speculative-grade U.S. loans are trading above par than at any time since May, exposing investors who are funneling record amounts of cash into the debt to greater risks as rising prices encourage borrowers to refinance at lower interest rates. 
Spanish-language broadcaster Univision Communications Inc. and KKR & Co.-controlled First Data Corp. are among at least 30 companies seeking to reduce rates on $31 billion of bank debt as more than 80 percent of leveraged-loan prices exceed 100 cents on the dollar, according to JPMorgan Chase & Co. That’s up from 40 percent at the beginning of October, according to a report from the New York-based lender last week. “Loans are trading well above their call prices because the investor community is reaching out for existing loans, "Jonathan Kitei, head of U.S. loan distribution at Barclays Plc in New York, said in a telephone interview. “You will see more loans getting repriced.”
Investors last year deposited about $63 billion into loan funds that invest in debt with rates that rise with benchmarks and have limited restrictions on early repayment. Banks from Barclays Plc to JPMorgan and Citigroup Inc. expect loans to underperform compared with 2013 as the Federal Reserve begins to taper its bond purchases, paving the way for an increase in rates that have been kept near zero for the last five years.

Limited ‘Protection’

“Whenever loans are trading above par, you introduce an additional risk element as there is limited call protection,” David Breazzano, president of DDJ Capital Management LLC, which manages more than $7 billion in high yield assets, said in a telephone interview. “Value in loans has dissipated a bit in the last couple of months.” Companies reduced borrowing costs on $281 billion of speculative-grade loans last year, or almost 4 times more than 2012, according to Standard & Poor’s Capital IQ Leveraged Commentary and Data." - source Bloomberg.

The divergence of growth between the US economy and the European economy has been indeed reflected in credit prices such as the US leveraged loan cash price index versus its European peer. - source Bloomberg:

While both the PMIs and Leveraged loan prices cratered in 2008, you can see the impressive rebound in 2009, leading in the rapid surge in cash prices for leveraged loans and the increasing divergence in cash prices as indicated by the growing spread between US leveraged loan prices and European leveraged loan prices now at only 3 points apart.

The divergence of loan growth has indeed explained the divergence of economic expansion between Europe and the US. The divergence between US and European PMI indexes - source Bloomberg:

The growth differential between both economies is due to credit conditions. You can clearly notice the uncanning similarity with leveraged loans prices in both regions.

Moving on to the growing deflationary risk we have been warning about for some time, Europe seems indeed to be sleepwalking into a deflationary trap as pointed at recently by Christopher Woods from CLSA in his recent Greed & Fear note:
"At some point the equity market must surely focus on the reality that this market action reflects an increasingly deflationary environment in the Eurozone which is fundamentally equity negative. In this respect it is worth noting that 20% of the items in the Eurozone’s CPI inflation basket are now in deflation, with an average 2.2%YoY decline in December, contributing a negative 45bps to the Eurozone CPI inflation." - CLSA, Christopher Woods

Europe is indeed turning Japanese. It's D,  D for deflation. German 2 year notes versus Japan 2 year notes going down again and indicative of the deflationary forces at play we have been discussing over and over again - source Bloomberg:

In similar fashion to QE2, QE3 triggered a significant rise in Inflation Expectations, since the beginning of the year, 5 year forward breakeven rates have been falling, indicative of the strength of the deflationary forces at play - source Bloomberg

Every time over the past several years when inflation expectations have eased significantly stocks have declined and credit spreads widened meaningfully.

Another sign of the many failures of the "Departed": Inflation is nowhere to be seen but in rising asset prices, which are more and more grossly disconnected from reality. QE was supposed to create inflation. It hasn't been the kind of inflation the "Departed" was hoping for.

On a final note, of course one of the main culprits in 2013 which we have discussed at length has been Japan which has been exporting deflation on a large scale and the US has not been immune. It is still the "D" world (Deflation - Deleveraging). On that point we agree with Albert Edwards from Société Générale on the deflation risk, as displayed in a recent Chart of the Day graph from Bloomberg:

"The CHART OF THE DAY shows annual rates of inflation excluding food and energy, based on indicators that Edwards cited in a similar chart two days ago. It tracks the monthly changes in a consumer-spending deflator compiled by the U.S. Commerce Department and a price index from Eurostat.
The U.S. deflator rose 1.1 percent for the 12 months ended in November. The increase was smaller than the 1.7 percent gain for the core consumer price index that month, which was matched in December. Last month’s reading for the euro-region gauge was 0.7 percent, the lowest on record.
“Investors have yet to react to the deflationary threat,” wrote Edwards, a London-based strategist who says stocks are in a multiyear bear market that he calls the Ice Age. “They simply do not believe a recession that would trigger outright deflation is on the horizon.”
International Monetary Fund Managing Director Christine Lagarde highlighted the risk of falling prices two days ago during a speech in Washington. She urged policy makers in the U.S. and other advanced economies to avert deflation, which would hamper a “feeble” economic recovery.
“If U.S. growth in 2014 proves as disappointing as in previous years, then there should be a large market reaction as inflation expectations get pegged back closer to euro-zone levels,” Edwards wrote.
Economists expect gross domestic product to rise this year by 2.8 percent, exceeding last year’s 1.9 percent, according to the average estimate in a Bloomberg survey. They also expect a bigger increase in the deflator for core consumer spending, to 1.6 percent from 1.3 percent." - source Bloomberg.

To conclude on Ben Bernanke's legacy, we quite enjoyed Doug Noland recent take on the subject in his column entitled "The Departing Bernanke on Macro-Prudential":
Q&A from the National Association of Business Economics conference, Philadelphia, January 3, 2014: William Nordhaus, Yale University economics professor and chairman of the Federal Reserve Bank of Boston: “I asked my students if they had a question for [Bernanke]. And there were a number of them, one which I won’t ask is ‘what about bitcoin?’ – which I know he knows about. But I thought a really interesting one was this: ‘If you knew in 2006 what you know now, what step or steps would you have taken then to prevent or ameliorate the financial crisis and subsequent severe downturn?’” 

Bernanke: “Well that’s a really unfair question. I mean, the reality is that everybody – every policymaker has to make – this is the nature of policy – it has to be made in very, very foggy conditions with very imperfect information – a lot of uncertainty. So, in order to do anything, I think I would not only have to know everything in advance, everyone else would have to know I knew everything in advance. In other words, if I went out and started saying – all of the sudden I’m arbitrarily raising capital requirements by five percentage points, the banks would say ‘What!’ and it would be very difficult to get Congress and the other regulators and so on and so on to agree. I mean I think the crisis was very complex, involved many many issues. One of the concerns, I want to respond indirectly to a point…, the usefulness of macro-prudential-type measures. I think one of the practical questions is, even if you think you’ve got macro-prudential measures that work, can you put them in place quickly enough and responsibly enough, preemptively enough.

"To know and not to act is not to know." - Cosmopolis - Don Delillo

So long "Departed".

Stay tuned!

Credit - Fears for Tears

"A person's fears are lighter when the danger is at hand." - Lucius Annaeus Seneca

In continuation to our musical title analogies and given we have been revisiting old classic "New Wave" music from the 80's while enjoying the quiet daily commute, looking at the continuation of the build in risk (US equities making new highs using margin debt, the great return of covenant-light loans, etc.), we thought this week, we would use a somewhat veiled reference to UK group Tears for Fears for our chosen title, given this year was the 30 year anniversary since the release of their first debut album "The Hurting" (released on the 7th of March 1983). Looking at the increasing risks of a Fed "Tapering" and the poor liquidity experienced in the secondary space during the previous bout of bond volatility, we thought using "Fears for Tears" as a title would conveniently illustrate our growing "fears" concerns that could no doubt led to "tears" and to large inflicted "hurting" in risky assets.

Of course, some will describe us as being outright "bearish" given everyone is vaunting the much improved economic data in the US as well as in Europe. As we pointed out last week, there are indeed a few clouds gathering on the horizon thanks to rising "forced correlations" which could lead to some  additional repricing, and not only in the equities space.

In this week's conversation, we will focus on these risks as well as what capital shortfalls entails in the credit space for subordinated bond holders, which have become again quite complacent on the matter.

We have been tracking with interest 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:

Of course this only telling half the liquidity induced rally courtesy of our "omnipotent" central bankers and their wealth effect strategy, leading to the use of leverage of any kind, which, leading to some "risk parity" strategic users to rediscover with much "hurting" the inherent risk in too much leveraged risk piled into interest rate sensitive asset which our friends at Rcube Global Macro Research have been discussing as of late. We will touch more on liquidity further in our conversation.

Some argue that concerns on the record amount of borrowing for US stocks are misplaced because, lower interest rates have made the borrowing much less expensive, as illustrated by Bloomberg in a recent Chart of the Day (15th of August):

"Concern that a record amount of borrowing to buy U.S. stocks foreshadows an end to the current bull market is misplaced, according to Michael Shaoul, chairman and chief executive officer at Marketfield Asset Management.

The CHART OF THE DAY illustrates why the issue has emerged in the top panel, which compares total margin debt at New York Stock Exchange member firms with the value of the Standard & Poor’s 500 Index. April’s debt was a record $384.4 billion, according to the exchange.

Lower interest rates have made the borrowing much less expensive -- and less significant -- than it was when the last two bull markets concluded in 2000 and 2007, Shaoul wrote in an e-mailed note yesterday.

Investors are paying about 72 percent less interest than they were at the 2007 peak, as displayed in the chart’s bottom panel. This estimate was calculated by multiplying margin debt by the broker call rate, charged by banks on similar loans to securities firms, as Shaoul did in his note.

Companies’ rising earnings also suggest borrowing is far from excessive, the e-mail said, because they have made stocks more valuable. By this yardstick, the amount of margin debt has to climb 40 percent to reach an equivalent to the two previous market peaks, even if S&P 500 company profit stays unchanged.

“Margin debt expansion will remain in place until corporate earnings falter” or the Federal Reserve raises its target interest rate significantly, the New York-based investor wrote. “We do not expect to see either of these take place for a number of quarters.”" - source Bloomberg.

But corporate earnings are, we think exposed, and the rally has been as well sustained by multiple expansions and very significant stock buy-backs.

Reading through CLSA's weekly Greed & Fear note from the 15th of August, written by Christopher Woods, we could not agree more with his comments, where he indicated that risks on the S&P 500 are rising:

"What does all this mean for the American stock market? Well in one paradoxical sense if growth in the US is not as robust as hoped for, that means quanto easing continues which should support the equity market. Still at some point common sense takes over and a lack of growth is plain bearish for equities, most particularly in the context of an American stock market which in recent months has been driven far more by multiple expansion rather than earnings growth. Thus, the S&P500 trailing PE has risen from 15.6x in late December to 18.4x" - source CLSA - Greed & Fear, 15th of August 2013.

For illustrative purposes, we have been plotting the growing divergence between the S&P 500 and trailing PE since January 2012 - graph source Bloomberg:

On top of that multiple expansion and the induced rally by central banks liquidity injections have been boosted as well by a reduction in denominator via stock buy-backs. The complacency in the equity space is starting to raise our "fears" for "tears" as displayed by Deutsche Bank's US equity strategist at Deutsche Bank graph indicating the price-earnings ratio for the Standard & Poor's 500 with the VIX:

"Investors are becoming overly content about the prospects for stocks after more than four years of gains, according to David Bianco, chief U.S. equity strategist at Deutsche Bank AG.

The CHART OF THE DAY shows how Bianco reached his conclusion: by comparing the price-earnings ratio for the Standard & Poor’s 500 Index with this quarter’s average close for the Chicago Board Options Exchange Volatility Index. The latter gauge, known as the VIX, is based on S&P 500 options.

Bianco’s P/E-VIX ratio closed yesterday at 1.20. At that level, a lack of concern that share prices may fall starts to supplant “realistic and disciplined” investing, he wrote in an Aug. 9 report.

“This complacency signal may pertain more to the derivatives market than the equity market,” he wrote. This quarter’s closing VIX average as of yesterday was 13.59, just above the first-quarter figure of 13.53. The latter reading was the lowest since 2007, when a five-year bull market came to an end, according to data compiled by Bloomberg.

While stocks have room to extend their advance since March 2009, increased volatility is likely to accompany any further gains, he wrote. This would allow stocks to rise relative to earnings without sending another warning sign, the New York-based strategist wrote.

Bianco expects the index to end next year at 1,850, which is 9.2 percent higher than yesterday’s close. His projection for the end of this year is 1,675, in line with the average among 17 strategists in a Bloomberg survey." - source Bloomberg.

Whereas the volatility in the fixed income space has remained elevated as displayed by the recent evolution of the Merrill Lynch's MOVE index falling from early May from 48 bps  towards the 87 bps level, the VIX, the measure of volatility for equities has remained fairly muted - 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.

Of course when ones look at European government yields and in particular peripheral yields, both Italy and Spain are trading towards the lowest level since 2011 relative to German government yields - graph source Bloomberg:

While the German 10 year government bond has moved in sympathy with the 10 year US treasuries breaking its 1.60% - 1.70% range towards 1.90%, Spanish and Italian yields have so far remained fairly muted. 

In relation to our "Fears" for "Tears", we share the same views as Morgan Stanley, from their Credit Strategy note from the 16th of August entitled "Working Through Our Worries", namely that Europe remains on our top concern list:

"Why Europe is the risk we’d stay focused on

We’re relatively relaxed about higher rates and the EM slowdown, but it’s the risk of renewed volatility in the eurozone that causes us the most discomfort. This may sound odd, given that Spanish sovereign spreads are at their year-to-date tights, but is based on a couple of factors unique to this risk.

First, it enjoys especially high uncertainty: One can look to Fed speeches and US data to inform a view of ‘tapering’. One can follow EM currencies or commodity prices to get a sense of regional stress. No similar metric exists for measuring the cohesion of the Italian government or the likelihood of a rating agency downgrade.

Second, it can strike with high intensity: The large rate move since May has so far been weathered well. No more than a handful of European corporates are experiencing serious credit trouble from a sharper China slowdown.

Sovereign weakness, in contrast, has repeatedly shown the ability to drive severe, broad-based weakness in our market.

Third, while it is not our base case, there are plausible reasons why a eurozone crisis could re-emerge: Improving economic data in Europe are encouraging. Yet the ratings of nearly all eurozone sovereigns remain on negative outlook. Debt/GDP will likely rise and unemployment should stay high well into 2014, even if growth ‘improves’ to ~1%. The eurozone’s ability to backstop a crisis remains hamstrung by the continued lack of a banking union, an OMT programme that our economists believe will be difficult to activate, and a continued reluctance by the ECB to use QE." - source Morgan Stanley

Yes, we all know that Mario Draghi's OMT "nuclear deterrent" has yet to be tested. But what we are concerned about is, as we indicated in our conversation "Cloud Nine", is the lack of credit growth in peripheral countries which are most likely to be exacerbated by the upcoming AQR 

As a reminder: 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.

"Until the AQR is completed and capital shortfalls identified and remedied, you cannot expect a significant pick up in lending." 

One of main reason of the relative calm in the European government bond market has been the "crowding out" of the private sector.

"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"

It is fairly simple, in effect while the deleveraging runs unabated for European banks, most European banks have been playing the carry trade and in effect boosting their sovereign holdings by 30% since 2011 to record as displayed in the below table by Bloomberg:

"Euro zone financial institutions' sovereign holdings totaled 1.78 trillion euros in June, up from 1.4 trillion euros in December 2011. In efforts to maintain asset values and lower auction costs, banks have increasingly supported their sovereigns by purchasing sovereign debt, which may stop their own associated CDSs and funding costs from rising aggressively. Over-exposure to sovereign debt (and loans) can threaten solvency should conditions deteriorate enough." - source Bloomberg.

In that sense the European Banking Union is more akin to a Government/Bank Union when it comes to sovereign bonds holdings.

As we indicated back in our conversation "Cloud Nine", indeed the government is the preferred borrower when it comes to lending as displayed in Bloomberg Chart of The Day from the 13th of August:

"Italian banks are increasingly using liquidity to buy more profitable sovereign debt, reducing loans to companies and households, as Italy’s longest recession in 20 years makes lending more risky.

The CHART OF THE DAY compares the banks’ purchase of Italian government bonds and loans made to the private sector.

Italian banks increased their holdings of the country’s debt by almost 100 billion euros ($133 billion) in the 12 months ended June 30 to a record 402 billion euros. In the same period, loans decreased by 55 billion euros, or 3.3 percent, to 1.63 trillion euros.

“There’s a crowding-out effect,” said Carlo Alberto Carnevale Maffe, professor of business strategy at Milan’s Bocconi University. “The public debt is soaking up resources from the private sector, offering higher yields on capital and a lower investment risk, at a time in which companies and families are struggling to repay their debt.”

Italian banks, which have borrowed more than 255 billion euros from the European Central Bank’s longer-term refinancing program, are investing part of the liquidity obtained at lower interest rates in short-term government bonds that offer higher yields. That’s favored by Italy’s government, which is seeking domestic buyers to replace lower purchases from foreign investors so it can cover a monthly average issuance of 40 billion euros in securities to finance its $2.7 trillion debt. At the same time, banks are more reluctant to lend as a recession saddles them with mounting bad loans." - source Bloomberg

Should Mario Draghi feel the urge to trigger is "nuclear" device, it will have to be "Brighter than a Thousand Suns", to quote, J. Robert Oppenheimer...

Oh well...

So when it comes to our "Fears for Tears", liquidity has always been our top concern, credit wise.

As we posited in "The Unbearable Lightness of Credit":
“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“

The recent surge in the fixed income space of May and June have indeed been very stark reminder of the importance of liquidity. On that subject we came across a Risk.net article entitled "The great unwind: Buy-side fears impact of market-making constraints" which struck as a perfect illustration of Roger Lowenstein's quote:

"At the start of May, as prices for US agency bonds reached what would later prove to be a peak, one New York-based hedge fund decided to sell its portfolio of roughly $100 million in AAA-rated mortgage-backed securities. The fund’s senior trader expected to be out of the position in a day, or even less. If it had gone to plan, it would have been beautifully timed, but it didn’t go to plan.

“You’re talking about AAA agencies – OK, with some callable features – and you don’t expect there would be no liquidity for that kind of instrument. The only reason I allowed us to carry that position is that, in my mind, you should be able to blow out of it in basically a day, or even an hour for that kind of size. But the reality was it took us a month,” he says.

The fund initially turned to a single dealer, which bought less than $10 million of the bonds upfront, promising to take the rest as and when it could find bids from other clients. Over the course of the next four weeks, the position shrank slowly, and the price of the bonds steadily slipped. The trader declines to say how much value was given up, but he admits the fund’s hedges did not work perfectly, and says it lost money on the portfolio during the month. Eventually, losing patience, the fund brought in a second bank to speed up the process.

“Effectively, there was no liquidity for that stuff. The discrepancy between the expectation and the actual liquidity was one of the largest I’ve ever experienced,” he says.

This fund was one of the lucky ones, selling the bulk of its portfolio before bond market jitters turned into a full-scale rout in the last week of May. The sell-off was triggered by the fairly innocuous statement from Federal Reserve chairman, Ben Bernanke, that the central bank might rein in its programme of quantitative easing. As fixed-income investors sought to pare back the huge positions they have built up in recent years, prices moved dramatically, triggering further waves of selling – yields on 10-year US Treasury bonds leapt 80 basis points in six weeks to close at 2.73% on July 5, but everything from emerging market sovereign debt to corporate bond exchange-traded funds (ETFs) was hit.

“I’ve never seen markets move so far on so little news,” says one senior, London-based trader – a sentiment shared by many other market participants.

Some banks, plus buy-side firms including BlackRock, Deutsche Asset & Wealth Management and Fortress Investment Group, now explain this episode in the same way: the problem was illiquidity, and the cause was bank regulation.

New capital, liquidity and leverage rules are making it more expensive to carry inventory, they say, meaning banks have less capacity to take principal risk. The consequence is that market-makers were not initially willing to absorb the supply of securities: orders were broken into smaller clips, bid-offer spreads exploded, in some cases even enquiries had the power to move markets. Once prices had collapsed, demand strengthened, enabling bank trading desks to match up buyer and seller more rapidly, and stabilising the market.

Or so the argument goes, and there is a lively debate, particularly among dealers, about how important these factors were. But the bigger question is what happens next. As interest rates normalise, investors that have gorged on fixed-income securities will all be trying to cut their exposure – a prospect the chief risk officer at one US bank’s asset management arm calls “the great unwind”. With market-makers unable to provide the kind of liquidity many investors are used to, he predicts a period of sustained, savage volatility, and the head of rates distribution at one UK bank agrees: “We’ve just had a 30-second trailer for the full movie.”

For now, there is little science to back up these scary predictions, but there are anecdotes, intuition, a lot of first-hand experience – and some numbers.

“There’s never been a wider gap between the amount of overall product out in the market versus dealer balance sheets. When you start looking at the size of the institutional market and daily turnover as a function of the dealer balance sheet, you get some pretty horrific stats,” says Richard Prager, head of trading and liquidity strategies at BlackRock in New York.

Others see it the same way. “There is a pent-up mismatch that has been built as real-money asset managers have swelled in size while dealers have reduced their inventories, and there is a real risk that some investors may not understand the effect this structural imbalance has on the underlying liquidity of some of those portfolios,” says Randy Brown, co-chief investment officer at Deutsche Asset & Wealth Management in London.

According to data compiled by the Federal Reserve Bank of New York, the inventory of corporate bonds held by primary dealers plunged from a high of $235 billion on October 17, 2007 to just $55.9 billion as of March 27 this year. An even bigger drop has been seen in holdings of agency debt, which fell from a high of $69 billion in May 2008 to $6.8 billion by March 27 – a decline of 90%.

The same trend has been seen in corporate bonds, according to Peter Duenas-Brckovich, global co-head of credit flow trading at Nomura in London. “If, 10 years ago, the Street was willing to hold 4.5 to 5% of the outstanding debt, that number is now only 0.5%,” he says.

Constraint

The major constraint has been the introduction of the Basel Committee on Banking Supervision’s new trading book capital rules – known as Basel 2.5 – which has forced dealers to hold more capital against trading book assets through the use of a general market risk charge measured using a 10-day value at risk at a 99% confidence interval, a stressed VAR charge and, for banks that model specific risk, an incremental risk charge (IRC) (see box, The roots of the problem). But banks also face a new leverage ratio and structural restrictions on their ability to take proprietary trading positions – however those are defined.

“Post-crisis, the proportion of inventory held by dealers has diminished dramatically; collectively, dealers’ inventory is a tenth of what it once was,” says Chris Murphy, global head of rates and credit at UBS, and a member of the bank’s investment bank executive committee. “Banks were complacent about housing inventory in the pre-crisis years, and balance sheets were out of whack with the industry’s real risk-bearing capacity. That has been corrected by the Basel capital overlay, where warehousing credit products in the lower-rated space – like high-yield or emerging markets – is extremely punitive. And banks also have to comply with leverage ratios, which act as a major constraint on balance sheet size.”

Large asset managers agree on both the cause and the effect. “Holding securities longer term has always been challenging for dealers. Today, constraints on funding cash inventory are even more pronounced because of new regulations, lower credit ratings for most dealers, and mark-to-market concerns if credit spreads widen. Dealers will assume positions temporarily while trying to place bonds elsewhere, but I would not expect them to offer significant additional longer-term capacity,” says Hilmar Schaumann, chief risk officer of Fortress Investment Group in New York.

What this means, simply put, is that markets are likely to move further and faster when clients are selling – and traders say the reaction to Bernanke’s comments is the perfect example.

“He basically said, ‘At some point in the future, there is a possibility we might think about maybe – maybe – not doing quite as much bond buying’. And we still had a complete meltdown. That’s a lot of movement for not a lot of news. Imagine if they’d actually changed rates,” says the London-based head of European fixed-income trading at one large European bank.

Another example is the reaction to the July 1 resignation of the Portuguese finance minister. By July 3, the country’s 10-year bonds had jumped from 6.38% to 7.46%. The price of the bonds fell around five points – or 5% of par.

“It’s a peripheral credit that is expected to have problems, but a five-point drop? I’ve been doing this for 20 years – the news does not justify the move. This is not a corporate where the head of accounting quit because of accounting fraud. This is highly suggestive of poor liquidity in the market,” says Nomura’s Duenas-Brckovich." - source Risk.net

Moving on to the subject of complacency in the subordinated bond space, we eagerly await the results of the AQR tests which will be conducted by the ECB and we agree with CITI's take from their credit note from the 13th of August:

"European Union finance ministers recently reached an agreement on several topics which should form the backbone of the European bail-in legislation (expected to be implemented from 2015): e.g. the priority of payments in the event of a bail-in and the creation of national based resolution funds. Essentially, the agreement specifies a list of liabilities which will not be bailed-in (e.g. guaranteed deposits); this list excludes equity, sub and senior debt, i.e. they are “bail-inable”.

According to our interpretation of the draft directive, national authorities will only have the ability to inject “public” money into a bailed-in bank once losses of 8% of total assets have already been absorbed. In other words, for sub or senior debt not to be bailed-in, other (presumably more junior obligations like equity) securities would have to have already absorbed (i.e. bailed-in) 8% of the total liabilities of the bank. What does this mean (to us at least)?

-If the equity to total liabilities ratio in a bank were more than 8%, there would be a chance that sub debt may not be bailed-in. However, the average equity to total liabilities ratio in European banks is 5% and very rarely exceeds 8%, which means that sub bail-ins appear very likely.

-The ratio of equity plus subordinated debt to total liabilities for the average European bank is around 7%, which means that national authorities would pretty much be forced to “fully” bail-in equity and subordinated bondholders. Figure 4 shows the distribution of the ratio of equity plus subordinated debt to total liabilities across European banks.

In many cases, the ratio is below 8%. Even if the ratio is above 8%, sub debt would likely be bailedin if losses are above that level and/or national authorities want the post “bailined” bank to have a meaningful capital base

-What about senior debt? In the average European bank, equity plus subordinated debt will make up around 7-8% of total liabilities, which means that national authorities will likely have discretion not to bail-in senior debt.

National authorities will, in our view, make use of bail-in legislations when dealing with distressed banks going forward. We expect that bail-ins will trigger restructuring credit events in current CDS contracts, as was the case in SNS and Bankia, and “bail-in” credit events in the new CDS contract."  - source CITI

Of course we have long voice our "Fears for Tears" for the subordinated bond holders and it has been a recurring subject in our numerous credit conversations. It support our long standing views expressed in our post "Peripheral Banks, Kneecap Recap, Kneecap Recap":

"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

Back in our conversation "The Week That Changed The CDS World", we indicated that the recent SNS case has derailed the auction process and the validity of the current CDS subordinated contract. In the case of SNS, because the auction used senior bonds, the recovery was around 95.5 for the bucket at 2.5 years and 85.5 for other maturities segment. Given the payout equates to par minus recovery, a CDS subordinated bondholder only received 14.5 (100-85.5)....so much for taking a CDS in the first place...

1. 
   The issue was that the auction could not operate due to lack of deliverable, it reminds us of a similar case with Delphi Automotive when a market maker had squeezed the market and cornered the bonds which had led to a higher recovery rate and smaller payout to the CDS holders. The markets then moved towards cash settlement to avoid some players to rig on purpose the auction process.
   
   In the case of the SNS expropriation, the CDS mechanism has derailed somewhat the auction process, hence the need to ensure with the new contracts a smoother payout mechanism. Obviously going forward Sub CDS protection should trade wider. 
   
   
   One of our prime candidate for "Fears for Tears" and for failing the upcoming AQR tests in relating to the subordinated bond holders risks, is troubled Italian bank MPS (Montei Dei Paschi). We agree with Bank of America Merrill Lynch's recent note on MPS from the 14th of August entitled "Defusing the capital problem" about the increasing probability of a debt-to-equity swap for the Italian lender:
   "A sub-debt-to-equity swap could help MPS’s capital position

   In our view, an effective solution to the capital issue could be a subordinated debt to equity swap. This is not without recent precedents (Commerzbank, Portuguese banks). Some issues may arise in connection with the Italian rules on dedicated capital increases and pre-emptive rights, but we do not think that these are insurmountable. Incidentally, Banco Popolare has a convertible outstanding which allows the bank to trigger anticipated conversion effectively at a discount to market value (bondholders will receive the face value plus 10%)". Besides, according to new EC rules “state aid must not be granted before equity, hybrid capital and subordinated debt have fully contributed to offset any losses”. If our interpretation is correct, this may imply that ahead of conversion of the state aid into equity, current shareholders and sub-bond holders might have to bear the losses. In our view, this should be a good enough reason for bondholders to accept trading out of (relatively illiquid) bonds into shares. In July 2012, MPS launched a senior-to-sub swap, which was a wasted opportunity as MPS realised just a modest capital gain. A sub-debt-to-equity swap would have the advantage of moving the full sub-debt balance exchanged for equity (rather than just the delta between market price and tender in a cash-to-debt deal).

   MPS has relatively limited options with respect to using its subordinated debt to recapitalise the bank because of the relatively high cash prices that many of the bonds trade at. In some other examples, banks have been able to take advantage of the discount at which their bonds trade to par and monetise this – this seems less clearly an option here given that many bonds trade in the 90s or even higher. We do not exclude that cash prices could fall in the coming months of course but our assessment is that MPS sub bond prices have been surprisingly resilient in the face of the bad news emanating from the bank on the one side and a clearly underperforming sub CDS which is currently indicated at well over +1,000bps on the other side. This is a level that we’d generally associate with very high default risk. There is a big disconnect between MPS cash bonds and its CDS. The latter is implying that there is a high likelihood of a Credit Event. 

   We think this is most likely to be a Restructuring Credit Event rather than a Failure to Pay. We estimate that MPS has subordinated debt with a face value of about €5.3bn, not including the FRESH, all of which essentially could be made available to recapitalise the bank if there was a debt-for-equity swap. In our view, the bank could offer to buy back its subordinated bonds for shares, albeit that this would be very dilutive given that MPS’s current market value is around €2.5bn. Even if the bank decided to focus on the more subordinated parts of its capital structure (T1 and UT2), there would still be potentially €3bn that could be raised in this way. Part of the capital raised would be the gain from taking out any liabilities below par but most of the capital would come from a straight swap of the liabilities for equity. "- source BAML

   
   

   But there is a catch for the holders of the current CDS subordinated contract as pointed out by CITI:
   "Under the current CDS contract, if sub debt is converted into equity before the auction date there will be no subordinated deliverables for the auction, as was the case in Bankia." - source CITI

"Fears for Tears"...

On a final note, German exporters should start to have as well their "Fears for Tears" given the Chinese slowdown will continue to weigh on German output as indicated by Bloomberg Chart of The Day:

"China’s credit squeeze is signaling a downturn in German manufacturing, according to ING Groep NV.

The CHART OF THE DAY shows that Germany’s factory output as gauged by a manufacturing purchasing-managers’ index has mirrored Chinese bank-lending growth since a credit boom that began in 2008. As China’s Communist Party seeks to rein in lending on concern that wasteful investment will threaten

longer-term growth, Germany’s export-oriented manufacturers are poised to suffer.

“China’s economy is shifting from domestic investment to more of a domestic consumption model,” said Martin van Vliet, senior euro-zone economist at ING in Amsterdam. “If you’re a German exporter selling machinery, that’s bad news.” China will start a nationwide audit of public-sector debt this week as the government pressures banks to better manage their balance sheets after the record surge in credit. The nation’s economic growth slowed for a second quarter to 7.5 percent in the three months ended June and the government has set a target of 7 percent a year for the five years through 2015. China hasn’t expanded at a slower than 7.6 percent pace

since 1990.

A reduction in debt-fueled Chinese investment spending may hurt German machinery orders in particular. Machinery sales to China last year were valued at 16.9 billion euros ($22.5 billion), accounting for more than a quarter of total shipments to the country, according to the Federal Statistics Office in Wiesbaden.

German exports to China have increased at an average rate of 15.8 percent a year since 1995, more than twice as fast as the total gain. That’s helped Germany weather the effects of the euro-area’s sovereign debt crisis, now in its fourth year." - source Bloomberg.

"Prosperity is not without many fears and distastes; adversity not without many comforts and hopes." -Francis Bacon 

Stay tuned!