Sunday, 22 April 2018

Macro and Credit - The Golden Rule

"After World War II, there were a lot of pension funds in Europe that were fully funded, but they were pressured to hold a lot of government debt. There was a lot of inflation, and the value of all those assets fell. Those pension funds couldn't honor their promises to the people." -  Edward C. Prescott, American economist and Nobel Prize in Economics.
Looking at the technical "relief rally" in all things "beta" including US High Yield thanks to the tone down in the geopolitical narrative but with the pickup of the trade war rhetoric between the United States and China, when it came to selecting our title post analogy, we reminded ourselves of the "Golden Rule". The Golden Rule (which can be considered a law of reciprocity in various religions) is the principle of treating others as one would wish to be treated. It is a maxim found in most religions and cultures:
  • One should treat others as one would like others to treat oneself (positive or directive form).
  • One should not treat others in ways that one would not like to be treated (negative or prohibitive form).
  • What you wish upon others, you wish upon yourself (empathic or responsive form).

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

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

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

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

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

Many wonder if this time it will be different with the continuing flattening of the US yield curve. On this subject we read with interest Bank of America Merrill Lynch's Securitized Products Strategy Weekly note from the 20th of April,. First here is the summary of their findings:
"This time is different: late cycle mortgage lending, higher rates, and a flatter curve
This week’s yield curve flattening, to a post-crisis low of 43 bps on the 2yr-10yr spread, is raising concerns that the current cycle is coming to an end and recession is now on the not too distant horizon. It’s more than 9 years since the stock market low of March 2009, so it is clearly late in the cycle. However, we continue to believe that this cycle has at least a couple of more years before it ends and credit spreads, along with securitized products spreads (see “Bullish for Q2” for corporate-securitized products correlation discussion), widen materially.
In fact, although the path for spreads will be bumpier than what was seen in 2017, we think there is potential for spreads to tighten further in Q2 and beyond. As discussed last week, we think the 10yr breakeven inflation rate is likely to head higher in Q2, moving above 2.20% or even 2.30%, as oil experiences upward seasonal pressure. Given correlations, we see this as good news for securitized products spreads. (This week’s jump to an intraday high of 2.19% on the breakeven rate suggested that 2.20%-2.30% is not a particularly aggressive target.)
We acknowledge the tightness of spreads, but we caution against being too early to position for major spread widening in the near future. Although we see tightening potential for spreads, due to the tightness of spreads, we maintain our neutral view for securitized products.
We compare this cycle to the last cycle on two fronts:
First, and more broadly, we consider metrics such as the 2yr-10yr spread, the BofAML Global Financial Stress Indicator and the BofAML Liquidity Stress Indicator: all three indicators suggest little imminent stress. We see the current period as similar to May 2005. As a reminder, that was 2 years before credit spreads began to widen and over 3 years before full blown crisis and recession. Given the slow pace of monetary policy tightening in this cycle, we think the risk is that this cycle takes longer to end than the last one did when at a comparable point on the metrics just mentioned.
Second, and more specific to mortgages, we compare today’s mortgage lending environment to what was seen in the pre-crisis period and in the aftermath of the massive 2003 refi wave. The changes are dramatic. Non-bank lenders’ market presence is on the rise while banks are retreating; another refi wave has ended but primary secondary spreads are generous relative to 2005; most importantly, there is little to no evidence of a meaningful shift to the risky mortgage lending practices that precipitated the 2008 crisis. At a minimum, this cycle has a notable absence of the primary driver of what caused the crisis in the last cycle. If there is a trigger event for another broader downturn, it will have to come from a sector other than mortgages and housing. Perhaps it will be the corporate sector or the government sector but we would not dismiss the economic robustness derived from an exceptionally healthy mortgage market. Again, we think the risk is that years of healthy and disciplined mortgage lending prolongs this economic cycle."  -source Bank of America Merrill Lynch
We would have to agree, if indeed there is a trigger event for another broader downturn, then indeed, this time it will be different in the sense that it won't be coming from the housing sector and the mortgage markets. Many like ourselves are pointing out towards the excess leverage building up in the corporate sector thanks to a credit binge tied up to ZIRP and NIRP policies and credit markets. If US High Yield can be seen as being relatively expensive then European High Yield is a base case definition of what "expensive" can be defined as. We are closely monitoring fund flows given as of late there has been some rotation from credit funds towards government bonds funds as described by Bank of America Merrill Lynch in their Follow the Flow note from the 20th of April entitled "Trade wars flows":
"Rising geopolitical risk is pushing more money into govies
Over the past couple of months government bond funds in Europe have recorded sizable inflows. We think trade wars and rising geopolitical risk has been translated into deflationary pressures that feed primarily into a bid for “risk free” assets. IG fund flows in Europe have been slower to improve because of the trade uncertainties. However, inflows into Euro only IG funds over the last week were nonetheless positive.

Over the past week…
High grade fund flows were negative over last week after two weeks of inflows. While the breakdown by currency shows a marginally positive number for the eurofocussed funds, the dollar ones have driven the overall trend. Monthly data also were negative for a second month, March figures show.
High yield funds continued to record outflows (23rd consecutive week), and similarly the monthly data also displayed a fifth consecutive month of outflows. Looking into the domicile breakdown, US and Globally-focussed funds have recorded outflows, while the European-focussed funds flow was slightly positive. Note that this was the first week of inflows into euro-focused funds after 13 weeks of outflows.
Government bond funds recorded their 14th consecutive week of inflows just as the monthly data were rolling on to the fifth consecutive month of positive flows. All in all,
Fixed Income funds flows were on negative territory last week. Monthly data reveal that just like February, March was also characterised by outflows.
European equity funds continued to record outflows for a sixth consecutive week; driving the year-to-date cumulative flows below zero. The trend also transpired on the March number, which was the most negative since August ‘16." - source Bank of America Merrill Lynch
While it has been difficult to "Make Duration Great Again" given the recent rise in the 10 year yield in US Treasury Notes, from a contrarian perspective and given the significant short positioning in the long end, there will come a point when fundamentals might reverse the confidence in this overstretched positioning which would entail significant short covering. We are not there yet. 

Returning on Bank of America Merrill Lynch note on the relationship between a flattening yield curve and credit spreads, here is what they had to say on the subject:
"Yield curve flattening and credit spreads
The 2yr-10yr spread narrowed to a post-crisis low of 43 bps this week, raising concerns that the current cycle is coming to an end and recession is on the not too distant horizon. We see the recent flattening of the yield curve as consistent with expectations laid out in our 2018 Year Ahead outlook, published in November 2017. We expect the 2yr-10yr spread to reach zero and turn negative in the first half of 2019, and recession and material credit spread widening to occur 12-18 months later, in other words, mid to late 2020. Given the slow pace of monetary policy tightening in this cycle, we think the risk is that the process takes longer than we expect.
Chart 1 and Exhibit 1 provide some perspective on this view.
Chart 1 shows that today’s 2yr-10yr spread level of roughly 45 bps was observed in May 2005. We also see that today’s asset swap spread of roughly 300 bps on the ICE BofAML High Yield Index (H0A0) is comparable to the index spread in May 2005. (We use this high yield index for our securitized products discussion just because it allows us to make the longer term comparison.) The takeaway from this chart is that it took approximately two years for the curve to first fully flatten and then re-steepen. Similarly, it took approximately two years before credit spreads finished tightening, reaching a tight of 185 bps (over 100 bps tighter than the May 2005 level!), and began cyclical widening.
This is the primary basis for our view that material spread widening in the current cycle won’t occur until at least approximately mid-2020. In other words, we place a heavy weight on the yield curve as an indicator of where we are in the credit cycle. The first significant event that we would need to see for us to become more cautious on spreads is to have the curve fully flatten or invert. But even then, the 2005-2007 experience tells us that it could take over a year after flattening or inversion occurs before spreads materially widen.

Exhibit 1 shows a view of yield curve movements relative to the Fed Funds rate, along with rough projections. The primary observation for this cycle relative to the last cycle is that the Fed is tightening at about half the rate of the last cycle. Given this, we think the risk for this cycle is that the flattening and re-steepening/spread widening process takes longer than the last cycle.
Yield curve flattening and financial and liquidity stress indicators
Chart 2 and Chart 3 provide an additional view of today’s world relative to 2005, using the BofAML Global Financial Stress IndicatorTM and the BofAML Liquidity Stress IndicatorTM.

Both Global Financial Stress and Liquidity Stress are negative (indicating below average risk), have been trending lower since early 2016, and are currently comparable to the levels of May 2005. Both indicators moved up substantially only when the yield curve re-steepened in late 2007. Our takeaway here is that the low levels on the Stress Indicators are confirming our view that a 2yr-10yr spread of roughly 50 bps is  not necessarily indicating imminent stress. In other words, there is still ample monetary policy accommodation.
Mortgage lending in this cycle: low risk lending and the rise of non-bank lenders
While broad macro developments are currently similar to 2005, the mortgage market, arguably the trigger of the 2008 recession and crisis, is very different. In particular, mortgage market risk is far lower today than it was 13 years ago. To at least partly understand pre-crisis developments in mortgage lending, it’s useful to recall the role played by the massive 2003 refinancing wave.
Chart 4 shows the MBA refinancing index along with the primary-secondary spread back to 2000.

In some respects, the great refi wave of 2003 was the genesis of the mortgage crisis that followed. Lending capacity rapidly expanded to respond to the opportunity presented in 2003: refinancing volumes were unprecedented and margins, as measured by the primary-secondary spread (30yr mortgage rate-FNMA MBS current coupon yield) that peaked at 60 bps, were relatively attractive. When mortgage rates moved higher in 2004, refinancing volumes – and margins – collapsed. With massive capacity and minimal volume/margin in higher quality lending, the industry turned to higher margin, riskier lending as the alternative; we’ll come back to that in a moment.
But first, fast forward to 2018 in Chart 4 After years of low interest rates in the post crisis period, most that could refinance have refinanced: the MBA refi index is now at the lowest levels of the millennium. Chart 5 shows that purchase lending activity is on the rise, although it is still well below the levels of the pre-crisis era.

Going back to the primary-secondary spread in Chart 4, although it’s declined in recent years, we see a still relatively high margin on this low volume lending activity: currently about 75 bps, well above the levels of the pre-crisis period. The margin suggests no need to stretch on lending standards, but the volumes suggest that bankers have to work hard to get their share of the pie.
Next, consider some of the changes that have taken place or are underway.
Chart 6 and Chart 7 show the composition of lending in 2005 and 2017, respectively.

In 2005, 54% of production was ARMs, 36% was “expanded credit,” and 43% was government/conventional. In 2017, the composition shifted to 12% ARMs, 2% “expanded credit,” and 80% government/conventional lending. Clearly, the post-crisis regulatory changes and financial penalties associated with pre-crisis lending practices have changed lending behavior to higher credit quality.
Table 1 shows a lending and servicing snapshot for 2017, including YOY changes. Bank lenders experienced above average declines in lending volumes in 2017 while a number of the top 10 non-bank lenders actually experienced growth in originations.

On servicing, the shift away from the banks to the non-banks is even more pronounced. Bank servicing portfolios declined in aggregate while non-banks experienced double digit or even higher growth rates. Banks are conceding market share.
Overall, while the post-crisis refinancing lending opportunity has passed, and non-bank lenders are increasing their presence in the market, lending standards remain strong. The Urban Institute aggregate measure of the risk of loans closed shows that although credit risk has been rising in recent years, especially in the GSE segment, it remains well below pre-crisis levels (Chart 8).

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

"Nonbank mortgage originators and servicers—i.e.  independent  mortgage companies that are not subsidiaries of a bank or a bank holding company—are  subject to far greater liquidity risks  but  are  less  regulated than bank-lenders and servicers.  As of 2016, non-bank financial institutions originated close to  50 percent of  all  mortgages  and 75 percent of  mortgages with explicit government backing.
The research also  suggests that mortgages originated by nonbanks are of lower credit quality than those originated by banks, making nonbank lenders more vulnerable to  delinquencies triggered by a fall in house prices through  the  higher costs of servicing delinquent loans.  A  larger fraction  of  nonbank originations are insured by the Federal Housing Administration (FHA) or Department of Veterans Affairs (VA), which tend to be more likely to default than other types. Among  mortgages  in  Ginnie  Mae  pools, the data  indicate that mortgages originated  by nonbanks are twice as likely as bank-originated mortgages to be two  or  more  months  delinquent."  -source Brookings
Basically, as a reference to Nassim Taleb's latest book, banks have less skin in the game today in the mortgage market than they used to. So if housing is less the issue than in the prior cycle, then what is and what should we watch for when it comes to assessing the state of the credit cycles? 

On this matter we read with interest UBS Global Macro Note  "Credit Perspectives - Caution or Carry?" from the 19th of April in particular relating to the more advanced stage in the US of the credit cycle:
"Q: Where are we in the US credit cycle?
The US credit cycle is later-stage, but unlikely to end in 2018. Later-stage credit indicators are present. Corporate leverage is very high, covenant protections are very loose, lower-income consumer balance sheets are weak, and NYSE margin debt is elevated. But the market trades off changes in conditions, not levels. To this point, we do not see an inflection to suggest the credit cycle is turning. Our latest credit-recession model pegs the probability of a downturn at 5% through Q4'18. Corporate EBITDA growth is running at 5-8% Y/Y, enough to keep leverage and interest coverage from deteriorating. Lending standards and defaults are only tightening and rising, respectively, in select pockets, and the scale of tightening is not enough to engineer broad stress. Last, but not least, a quick shot to growth from significant fiscal stimulus in 2018 should keep the cycle supported.
Q: How will demand for US corporate credit evolve?
We expect overall US credit demand to slow, with an up-in-quality bias developing and continued demand for floating-rate product (leveraged loans, IG floaters). Rising USD funding costs are reducing the appeal of US credit to European and Asian investors. These funding costs are now 2.5% for Japanese investors and 2.8% for European investors (3 month FX swaps). With 3 more Fed hikes in 2018, these hedging costs will climb to 3-3.25% by year-end. We do not expect supportive unhedged foreign flows to materialize due to significant US policy uncertainty, higher capital charges on unhedged positions (especially Solvency II), and regulatory pressure (Taiwan). US IG is better positioned than US HY, as current yields of 3.8% should attract some additional domestic insurer and pension interest. Modestly rising credit risk in HY may also divert some flows back into IG. But US HY outflows are likely to continue, given Fed hikes, tight spreads, below average earnings growth, and declining equity valuations of HY-rated companies.
Q: How will Fed hikes impact the US credit cycle?
4 Fed hikes in 2018 will age the credit cycle and create pockets of volatility. The increase in LIBOR is resetting interest rates higher on $3.2tn of US business loans (1/3 of the total stock) and is reducing the appeal of US fixed-income to non-US investors. Higher interest rates are filtering through to US consumer loans; they are raising funding costs for non-bank lenders who utilize floating-rate bank credit to facilitate lower-quality auto and mortgage lending. But in the context of still strong US growth, the cycle has a buffer. Floating-rate leveraged loan issuers have interest coverage ratios still above 3x (EBITDA/Interest expense) and can withstand 3 additional Fed hikes in 2018. A strong job market will keep consumer delinquencies contained to the subprime space. And rising LIBOR is currently a benefit to large US banks, which can still access cheap funding via retail deposits, while receiving a higher interest rate on their loan portfolios.
We prefer US IG over US HY on a total and excess return basis. US HY spreads of 323bps are expensive vs. our blended model estimate of 429bps, while IG spreads are more aligned (105bps current vs. our blended model estimate of 116bps). We have a slight preference for BBB credit, given higher carry, and also that a declining non-US bid will hurt A-rated demand, while domestic demand could support BBBs. In US HY, we maintain our preference for B-rated credit. CCC's are vulnerable given declining equity valuations, while BB HY will struggle with higher duration fears. We prefer US leveraged loans over US high-yield given our call for 6 Fed hikes by 2019, and much stronger demand for loans and CLOs from US and non-US investors alike. By tenor, we prefer 5- 10yr IG, acknowledging slightly better valuations in the short-end than before. We still believe it is too early to position in 1-5yr IG credit, given lower carry, additional Fed hikes and negative repatriation technicals around large buyback/M&A announcements. We are also cautious on 10+ US IG credit, particularly in higher quality names, given very flat curves relative to expectations.
We understand the levels of conditions are weak, but the changes are critical to capturing inflection points. US earnings momentum, lending standards (C&I, consumer), and consumer defaults will be on our radar. The Fed and BOJ will be important. A Fed more tolerant on inflation will boost our view on risky credit; a change in the BOJ's yield target would be a negative for US credit. The resolution of the ATT/TWX antitrust case will also set the tone for future M&A supply.

A cyclical recovery won't be enough to tighten spreads. For US IG, spreads near current levels (105bps) are justified largely by "soft data", in particular strong ISMs. With a fading foreign bid, increasing duration fears and more M&A activity on the horizon, we think IG spreads will widen to 115bps in the near-term. The one positive is that US IG has already cheapened YTD, which will attract domestic investor interest and reduce material downside.
US HY now screens expensive, as spreads at 323bps are inconsistent with both structural credit risks and increased equity volatility. In addition, we believe significant outflows YTD have whittled down cash balances for fund managers. Aggregate fundamentals remain stable, but tenuous at lower ratings, with leverage elevated and interest coverage weak. We expect HY spreads to shift wider to 400bps.
The credit cycle isn't turning yet. Our credit-based recession gauge highlights a 5% chance of recession through Q4'18, far from the 40-50% that signals a red flag. Earnings growth, lending standards, and bank NPL trends are "good enough" to sustain the cycle. However, interest coverage will likely become less favourable as 3 more Fed hikes in '18 and '19 will flow through to $3tn in floating-rate business debt.
Fixed-rate US HY coupons are stable as firms are not yet refinancing into higher rates. For floating rate leveraged-loans, coupon payments have been range bound, as re-pricings and tighter spreads have offset higher LIBOR. But we expect higher interest payments for loan issuers later in 2018, as the Fed hikes 3 more times, and spreads can't tighten as much to offset higher LIBOR.
Despite rising interest costs, floating-rate US loans have resilient enough interest coverage to sustain 3 more Fed hikes in 2018. This dynamic, plus growing demand for floating-rate credit, underlies our preference for US Loans over US HY. 3 additional Fed hikes in 2019 will prove more problematic. This will push loan coverage ratios to low levels (inferior to 3x) for B-rated firms and pressure free cash flow. Earnings growth will need to rise to reduce this future risk.
US leveraged loan supply hit $500bn in 2017, over 50% for M&A and LBOs, and reported 1st lien leverage is 3.9x – the highest on record. EBITDA add-backs averaged 20-21% in 2017, and are averaging 26% for large PE sponsor deals YTD – suggesting leverage is underreported and rising. A conservative view would push average 1st lien leverage closer to 5x on M&A deals.

The non-US bid into US IG credit will slow in 2018. Non-US investors are paying 2.5% (Japan) & 2.8% (Europe) to hedge their US fixed-income allocations. We do not believe foreign investors will remove FX hedges, given broad uncertainty on the trajectory of the US dollar. As the Fed keeps hiking, these costs will rise further and US IG will become less attractive than long-duration sovereign alternatives and even EU IG credit by year-end.
Slower demand is one part of the equation, but we still expect IG supply to be robust in 2018 (+2.5% Y/Y). The M&A pipeline is large, and we expect more issuance could hit the market, conditional on favourable antitrust outcomes which have lowered closing rates. High multiples and still low rates suggest firms will finance with debt. Offshore repatriation may reduce issuance on the margin, but most IG firms do not have significant cash, either overseas or on balance sheets, to utilize.
The savings from corporate tax reform will only modestly delever capital structures, even assuming firms utilize 25% of their tax windfall to pay down debt. More importantly, credit spreads have already priced this; spreads per unit of net leverage are at all-time tights. Bottom-line, earnings growth needs to be much stronger to de-lever capital structures.
HY spreads have remained very resilient. Despite significant outflows in Q1, HY spreads were effectively unchanged. We believe Dec'17 coupon reinvestments and low issuance YTD (-22%) had replenished cash buffers. But given the outflows of Q1'18, cash buffers are low once again. We expect HY spreads to widen more aggressively if volatility picks up anew." - source UBS
As we pointed out recently, rising dispersion means that at the current stage of the credit cycle in the US, credit investors are becoming more discerning in their issuer process selection, meaning overall that active credit manager should continue to outperform as the credit cycle is gradually turning on the back of the Fed continuing its hiking trajectory. Sure, "beta" has rallied hard recently, but, one should think about gradually adopting a more defensive stance by starting to reduce high beta exposure towards safer places. While we pointed out in our conversation "Fandango" that some positioning appears to be stretched such as short the long end of the US yield curve, we don't think yet with have reached the "trigger point" making us bold enough to dip our investing toes into the long end of the US yield curve particularly as we are getting closer to the 3% level on the 10y Treasury yield. We are certainly watching any signs that would point out that the recent weaknesses seen in hard and soft US data has been temporary or not. 

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

  • Final charts -  The return of Macro to the forefront thanks to higher interest rates
The final removal of the lid on volatility which has prevailed thanks to the strong central banking narrative has been fading and marked earlier on this year by the explosion of the short-vol pig house of straw that built up during many years. Our final charts come from Bank of America Merrill Lynch from their Global Liquid Markets Weekly note entitled "The gold big bang theory" from the 16th of April 2018 with one of the charts displaying the spike in vix which can be linked to the rising rate environment:
"Tighter Fed policy is helping lift OIS and LIBOR
We first argued in September 2017 (see Mind the unwind) that risk assets could suffer as a Fed balance sheet compression added on top of an already steady pace of US interest rate hikes. Six months later, the effects of tighter US monetary policy are starting to become visible in a number of markets and returns across major asset classes are negative for the year. The Fed has already been hiking rates at a steady pace for 9 quarters now (Chart 1).

Looking forward, with a tight labor market backdrop and rising commodity prices, our economics team believes that the Fed will likely complete three more hikes this year. In addition, we believe that Fed balance sheet tapering (see Missing the BEAT) has been an important contributor to the rapid widening in the 3m LIBOR-OIS spread (Chart 2).
In turn, higher interest rates are pushing up vol...
Just like ultra loose monetary policy was a balm for asset markets, this combination of rising rates and balance sheet tightening could well be having the opposite effect on bond and equity markets. As we have previously explained, rising interest rates tend to put upward pressure on macro volatility (Table 1).
This effect is often lagged but quite persistent, and macro volatility has been on the rise for some time now. In our view (see Forward vol looks cheap to carry as long as you believe markets are late cycle), the spike in the VIX can be partly traced to the rising interest rate environment (Chart 3).

But higher interest rates are not the only source of uncertainty at the moment for global markets. US fiscal policy is entering a slippery slopeIn fact, just as monetary policy has tightened, the US Federal budget deficit is poised to balloon (Table 2) over the coming 24 months.

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

Recent tax changes have also reduced the demand for dollar commercial paper from US corporates abroad.
Inflation is trending higher helped by oil prices
Of course, the tighter monetary policy path in the US and the normalization of interest rates is informed by the rising inflation pressures across the economy. On the one hand, the decline in the unemployment rate will likely support a steady increase in core inflation (Chart 5).

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

Because we now expect Brent crude oil prices to hit $80/bbl over the coming months (see The ruble drop is bullish for oil) and US job growth is poised to remain steady, the Fed will likely continue to tighten policy.
Naturally, cross-asset info ratios have fallen
Tighter money policy will continue to impact macro volatility. With volatility on the rise, info ratios across major asset classes could well continue to roll over (Chart 7) in the coming months.

In our view, equities and bonds are unlikely to see the stellar rolling Sharpe ratios of the past few years as the Fed continues to drain liquidity. Moreover, we would argue that a tighter US monetary policy outlook is already acting as a drag on asset values. Year to date, cash returns of 0.4% compare favorably to S&P returns of -1.2%, Eurostoxx returns of -2.0%, or 10 year treasury returns of -2.1% (Chart 8).
So is the Fed ready to switch course? Not yet
True, leading indicators such as PMIs remain in positive territory across all major economies and inflation is on the rise. So the Fed is unlikely to change Yellen’s preset course for now under the new leadership of Powell. Yet, as money supply around the world continues to roll over on the back of tighter policy, asset returns could struggle (Chart 9).

The market is perhaps right to expect the Fed to hike interest rates roughly as scheduled (Exhibit 1).
But we still believe that escaping zero interest rate policy (ZIRP) will not result in a smooth path for asset markets." - source Bank of America Merrill Lynch
Back in November 2012, in our conversation "Why have Global Macro Hedge Funds underperformed?" we posited that when volatility across all asset classes crashes, global macro strategies tend to suffer on both an absolute and relative basis. If indeed we are moving from a cooperative world to a noncooperative world based on the Golden Rule in conjunction with a return of volatility then one should be wise to dust up the Global Macro playbook we think... 
"Monetary policy causes booms and busts." - Edward C. Prescott, American economist and Nobel Prize in Economics.
Stay tuned !

Friday, 13 April 2018

Macro and Credit - Dyslipidemia

"You can stroke people with words." -  F. Scott Fitzgerald

While learning that Global debt had reached a record $237 trillion in 2017 which is more than 327% of global GDP and that since 2007 global debt has increased by $68 trillion, when it came to selecting our title analogy for this week's musing, we reminded ourselves of the medical term "Dyslipidemia". "Dyslipidemia" is an abnormal amount of lipids (e.g. triglycerides, cholesterol and/or fat phospholipids) in the blood (such as global debt). In developed countries, most dyslipidemias are hyperlipidemias; that is, an elevation of lipids in the blood such as debt levels in comparison to many Emerging Market countries. This "abnormality" level is often due to diet and lifestyle. "Dyslipidemia" can lead to cardiovascular disease, which can be symptomatic but we ramble again...

In this week's conversation, we would like to look at cracks showing up in the "growth" narrative put forward by many pundits. 

  • Macro and Credit - Mirror global growth beautiful?
  • Final charts -  Confidence can turn on a dime

  • Macro and Credit - Mirror global growth beautiful?
As we concluded our previous conversation about some stretched positioning such as long oil, short US Treasury Notes, to name a few, the recent weakness in macro data seems to point somewhat to a different story painted by the rosy tainted narrative of strong global growth which has been prevailing in recent months. As we also pointed out in our last musing, on top of weakening macro data, fund outflows have been increasing, particularly from credit funds. We also argued that the "goldilocks" narrative which had prevailed in credit markets in general and Investment Grade in particular has been changing since the beginning of the year. This is particularly due to the "technical bid" from central banks which has been prevailing for so long, on top of significant issuance levels. Yet, it seems to us that with the central banking put slowly but surely fading, rising dispersion as pointed out as well in numerous conversations is a sign of the lateness in the credit cycle given investors are becoming much more discerning at the issuer level. This also why we advised for a reduction in beta exposure as well as the need to raise cash levels, moving towards a more defensive position. 

When it comes to global data and our "Mirror Mirror", they have started to turn negative. On this subject we read with interest Bank of America Merrill Lynch's take from their Global Liquid Markets Weekly note from the 9th of April entitled "Synchronized cracks":
"Global data surprises turn negative
Synchronized global growth was the buzzword of 2017 and generally expected to continue into 2018. However, global data surprises have turned negative for the first time since mid-2017, potentially due to forecasts being optimistic in the first place. While trade tensions have been widely cited as the reason for the drop in global equities, the realized weakness in global data may be a more straightforward explanation. Chart 1 depicts the stable relationship between MSCI World returns and global data surprises over the past five years.

Markets are assuming Euro zone data deterioration will be transitory
The immediate focus in terms of weaker data is the Euro zone, where data surprises are now the most negative since the peripheral crisis. There are two unknowns here – how much of this weakness is related to weather disruptions and how much reflects a convergence of soft survey data with the reality of weaker hard data. However, this also means the typical rationale for mean reversion in data surprises (economists revising projections) is unlikely to apply here if the weakness is being attributed to temporary factors. Upcoming data, particularly the April PMIs, will be crucial and the fact that EUR has been resilient to the data deterioration suggests the pain trade for markets will be if the weakness persists.
While seasonal distortions mean China slowdown is a blind spot
The relative blind spot in our view is China. With investors mostly looking past the distortions of the Jan-Feb Chinese data, the March numbers should help provide more clarity. Our economists expect a broad deterioration in the official numbers that begin releasing this week (China Economic Watch: Preview of March and 1Q macro data: Softer activity growth momentum 05 April 2018), while some of the higher frequency indicators warrant caution as well.
• Shipments of iron ore to China’s key ports has been weakening in both annual and sequential terms (Chart 3).

The latest March data show the biggest YoY decline since 2015 in both value and volumes. This may partly reflect the very high level of inventories at Chinese ports but at least partly symptomatic of a weaker demand trend.
• Steel production data, particularly for key factories, is less sensitive to inventory swings and supply adjustments, therefore providing some indication of the state of domestic investment, particularly property and infrastructure. Data including the first 20 days of March shows production is still positive YoY but rolling over recently (Chart 4).

• Chinese asset prices are reflecting a growing sense of unease, with a simultaneous drop in commodity prices, domestic rates and equities in recent months (China – sensing the unease 21 March 2018). While this may partly reflect risk premium associated with US-China trade tensions, the fact that even non-tradeable sectors such as real estate have been hit point to domestic demand concerns as well.
Market implications
If Euro zone and China growth moderate, the assumption of synchronized global growth could be challenged. While US Treasuries are becoming desensitized to equity swings (see Rates section), economic data still matter and would temper the upside for US rates. The US dollar would benefit against high-beta commodity and EM FX, but also against the EUR where the divergence with data is extreme. Finally, we are bearish thermal coal relative to forwards (see Commodities section)." - source Bank of America Merrill Lynch
As we have hinted on many occasions, when everyone is thinking the same (in terms of the consensus positioning being very stretched), one might indeed wonder if everyone is thinking. As the central banking "technical bid" is fading, fundamentals matter more than ever. Given rising geopolitical tensions in conjunction with the trade war rhetoric seen lately, one might wonder whether this is sufficient enough to put a further dent into confidence, which has shown in the past its capacity to turn on a dime. For us the short positioning on the 10 year part of the US curve appears to us stretched. Sure the trade war narrative doesn't seem to provide some support to increase the duration exposure, though we think possible further deterioration of fundamentals could eventually cost the bond bears crowd. 

On the subject of the rates story we read with interest Bank of America Merrill Lynch "Rates" segment of their "Synchronized cracks" note:
"• Levered funds' record short positioning remains, and still a risk for bond bears.
• Unlike 2017, asset managers did most of the buying in the rally; unlike 2015-16, USTs pale vs. cash in a risk-off.
• Looking ahead, economic data hold the key for the direction of rates more than equity markets.
This time is different
In our view, the impact of trade tensions ultimately translates into higher rates. As we detail here, the market is only reacting to the growth impact of tariffs but not the inflation impact with both real rates and breakevens lower since February.
In terms of flows, the two biggest differences in this rally compared to recent history are: 1) most of the UST buying came from asset managers, not short covering from levered funds; 2) the rise of cash as a Treasury alternative in risk-off moves. The former suggests economic data hold the key for the direction of rates, more so than risk-off flows; the latter is a confirmation of our view that cash as the new ‘safe haven’ asset threatens the stock/bond correlation.
Levered funds positioning risk remains
Despite the 10% equity market correction and the 20bp rally in 10y rate from February highs, levered funds community stood firm with their net short positions in the futures market. According to CFTC data, the week following the March FOMC meeting did see some profit taking, especially in the 2-year contract. However, overall positioning among levered funds barely budged from the record shorts reached a few weeks ago (Chart 5).

While we have seen evidence of UST short positioning unwind among European investors, the risk of a rally led by positioning unwind remains.
Asset managers did most of the buying since Feb, unlike 2017
Compared to a year ago, this time is different. Much of the buying over the last two months came from asset managers – Treasury futures market saw about $70bn (in 10y equivalent terms) increase in net long positions from this community, whereas levered funds saw $13bn increase in net shorts over the same period. A year ago, the month after March 2017 FOMC meeting saw over 40bp rally in 10y Treasuries and levered funds bought the most, with almost $40bn reduction in net shorts (Chart 6).

The asset manager demand recently was likely propelled by the volatility in risk assets, whereas the levered funds buying in 2017 was driven by a slowdown in tax reform progress and disappointing economic data after Q1.
Cash is now a competing asset
The other interesting development in this risk-off move was the rise of cash as an asset class, threatening rate/equity correlation. Unlike what we were used to seeing, government bond fund inflows in recent weeks were almost negligible compared to historical episodes, especially funds investing in medium and long maturity securities (Chart 7).

At the same time, evidence from money market fund flows reflects greater interest in cash. Seasonally, Q1 tended to see outflows from these funds largely due to anticipation of tax-related withdrawals. However, February and March saw almost $30bn inflows, compared to the average of $40bn outflows from 2012 to 2017 (Chart 8).

Holding cash in the MMF now seems to be a much better alternative for many investors than holding Treasuries with much bigger duration risk.
Watch what the data say, not just what the stocks do
The fact that levered funds are willing to shrug off the risk-off moves in the equity market and trade discussions suggest to us that the driver behind the market volatility is more important than the volatility itself. While we have seen sporadic weaker economic data prints in the US from the consumer side, it’s not enough to convince investors the growth momentum has run its course. The risk-off move could certainly put pressure for rates to move higher, the ultimate test though comes down to the data." - source Bank of America Merrill Lynch

Mirror, Mirror...indeed, watch the data more and more, because it matters. We do agree with Bank of America Merrill Lynch that it is becoming more important than volatility itself. Sure, investors are not convinced yet the growth momentum has run its course, but, as per confidence, the stretched positioning seen on the long end of the US yield curve has the potential to change rapidly should the growth narrative appears to what it seems to us, namely, slowing. No offense to the bond bears out there but even in this much vaunted global synchronized recovery narrative, yield can and will move lower as shown in the below chart from Bank of America Merrill Lynch The Flow Show note from the 12th of April entitled "Gold-ishocks":
"Buried Treasuries: record pace of YTD US Treasury inflows ($18.6 YTD, $3.4 this week); global synchronized recovery, record profits, low unemployment, massive fiscal stimulus, Fed selling, $70 oil…yet 10-year USTs still unable to break >3% and equities (homebuilders down, utilities up – Chart 3) confirm yields can move lower.
- source Bank of America Merrill Lynch

If you want to play the "bond bears" at some point down the credit cycle road then obviously, you should look at credit markets. As we posited in our previous musing, given the size of the ETF complex in that space and dwindling inventories since the Great Financial Complex, you don't need to be a genius to figure out, that the ETF Fixed Income complex dwarfs the "exit" door. 

As a reminder:
“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
This is what we wrote in our November 2017 conversation "The Roots of Coincidence":
"When it comes to the paranormal phenomena of the low volatility regime instigated by our central bankers, no offense to their narrative" but modern physics still works and normalisation of interest rates should lead to some repricing and a less repressed volatility in conjunction to a fall in the "free put" strike price set up by our central planners in 2018. You probably do not want to hold on too long on "illiquid parts" of your portfolio going forward, given, as many knows, liquidity is indeed a coward.
As we move towards 2018, the big question on everyone's mind should be the sustainability of the low volatility regime which has been feeding the carry trade and the fuel for the beta game" - source Macronomics, November 2017
If liquidity is a coward, then obviously reducing the illiquid beta part of your portfolio would be a sensible thing to do. While we have seen some flows return to High Bonds according to Bank of America Merrill Lynch to the tune of $0.4 billion which has been the first inflow for the last 13 weeks and with some rebound as well in Investment Grade with $3.8 billion inflows (66 fund inflows of past 68 weeks), the narrative we think is slowly changing for "goldilocks" in the credit space. This is probably tied up to lower volatility in interest rate volatility and it remain to be seen if the important Japanese investing crowd will return in the coming weeks to US credit markets shores. So yes we could see short term some sort of "relief rally" but we don't expect this to last medium term.

As we pointed out earlier on in our conversation, the central banking technical bid is fading and fundamentals are starting to matter more again. On that note we read with interest Société Générale's note from the 11th of April entitled "The Sword of Damocles - 2Q18 Outlook - Why spreads should widen and how to protect your portfolio":

  1. The real worry is whether growth will slow in 2019, and defaults rise in 2020.
  2. We see a return to late 2015 levels on this fear.
  3. Avoid high beta credits and cyclicals. Be defensive.
  1. The market is expensive
  2. And valuations are the mother of returns
  3. Asset allocators may switch credit for cash and equities (though it is slow to do)
The worst combination would be higher inflation and weaker growth. Yet it is not impossible.
Conclusion on technicals:
  1. Supply has been low but should accelerate.
  2. ECB demand will decline (as we all know).
  3. Which means Europe will follow the US, and it is too expensive." - source Socété Générale
In our credit book as well, increase dispersion, should eventually drive spreads wider particularly in the light of our recent comments surrounding the rise in leverage and the fall in credit quality overall. For the moment, dispersion are coming from single names rather than sectors such as we have seen in the past with the energy sector credit woes in 2016 and recent credit woes in the retail sector. We expect dispersion to rise and impact more sectors going forward. Of course the usual suspects in the US are where the "leverage" is namely tech and healthcare but, that's not a secret. 

If inflation is indeed accelerating and growth is slowing, then again, the dreaded "stagflation" word comes to mind as we posited also in past musings. Back in October in our conversation "Who's Afraid of the Big Bad Wolf?", we indicated that for a "bear market" to materialize, you would indeed need a return of the Big Bad Wolf aka "inflation. Sure the explosion of the pigs' short-vol house of straw was triggered by sudden fear of rising wage inflation, but, we continue to believe that a sudden burst of inflation, would no doubt take down their "credit" houses of straw and twigs:
"If as indicated by Christopher Cole, volatility is the brother of credit, then obviously assessing the longevity of the credit cycle is paramount. We do agree with Christopher that, for the time being, we do not see the credit stress required for a sustained expansion of volatility. It's only when the Big Bad Wolf will rear its ugly face that we will change our "Practical yield pigs" stance. But if indeed the credit cycle matters from an Ouroboros perspective, then obviously one has to wonder how the death of the credit snake comes about" - Macronomics
We pointed out as well in this prior conversation that credit cycles die because too much debt has been raised in the final point of this long conversation. Yet another veiled reference to "Dyslipidemia" one could point out. 

 Some might point out, it could be too early to see the fear of trade wars sapping "confidence" in the growth outlook, but we do think as per our last point, that when it comes to "growth" and "stability" in complex structures such as financial markets, confidence matters.

  • Final charts -  Confidence can turn on a dime
While geopolitical tensions are quite palpable, the increasing trade war narrative has proven in the first quarter to be "bullish" gold as we anticipated. We believe that for a continuation of the global growth narrative to prevail, confidence matters and matters a lot. We continue to see cracks in the macro narrative on both the hard side as well as a weaker tone now in soft data such as consumer confidence. Our final charts come from Bank of America Merrill Lynch Global Economic Weekly note from the 13th of April entitled "Fear factor" and display the reaction of various equity markets since the announcement of steel and aluminum tariffs as well as the Global PMI Manufacturing New Export Orders and Volume of world merchandise trade:
"Fear factor
One of the striking developments in the last two years is how investors, consumers and business leaders have learned to shrug off confidence shocks. The result is not only a steady pick-up in confidence indicators, but a pick-up in growth as well. In recent weeks, however, the markets seem to have found something they can’t dismiss: the prospect of trade wars. Here we argue that the way this “war” is developing, the US is the most exposed, followed by China and then relatively open economies around the world. This is because the US is looking to change its relationship with all of its major trading partners, with a particular focus on China. In other words, while most countries are “fighting” on only one front, the US is fighting on many fronts.
Let’s take a look at signs of confidence effects thus far, and what to watch if the “war” escalates.
First responder: global equity markets
It is much too early for fears of trade wars to impact hard data. In the meantime, equity markets are the best canary in this coal mine. Chart 1 shows the change in equity prices since the day before the steel and aluminum tariffs were announced for the US and the countries the Trump Administration is targeting.

Not surprisingly, the US (S&P 500) and China (Shanghai Composite Index) markets have dropped the most over this period.
Thus far the equity market seems to be pricing in a high probability of a benign outcome, with small drops in response to major threats and then rebounds on more assuring comments. The market response to the US-Korea trade deal is also telling. Korea made concessions on autos, steel and currency manipulation, but there was virtually no response for stock prices of the impacted companies. For example, Korea agreed to raise its quota on US car imports from 25,000 to 50,000. However, the “big three” US companies only shipped 19,911 cars to Korea last year. Not surprising the stock price of US and Korean car companies shrugged off the news.
Second responder: confidence surveys
A similar story applies for confidence indicators. As Michelle Meyer and team show, there are early hints that trade war fears are impacting confidence indicators in the US, particularly for manufacturing firms. Canadians are also growing concerned. The latest Business Outlook Survey from the Bank of Canada found that “while firms’ expectations for US economic growth have strengthened further, some cited rising protectionism and reduced competitiveness as factors limiting the impact on their sales.” The survey also shows a shift toward negative views of US policy overall. Asked how US policies had impacted “your business”: a year ago 11% said favorably and 10% unfavorably while in the latest survey 8.8% said favorably and 20.1% unfavorably. Confidence in Mexico dipped sharply in response to the initial threats to NAFTA, but has rebounded recently on hopes of minor changes to the treaty.
Outside of the NAFTA region, only Germany seems worried. Here are some representative thoughts from our regional economists:
  • Germany: According to the latest IFO survey, “the threat of protectionism is dampening the mood in the German economy.”
  • UK: The local press has generally reported this as something that is happening elsewhere rather than to the UK.
  • Japan: Our equity analysts say firms don’t seem overly concerned about trade wars.
  • Australia: At this stage, the press has focused on the opportunities these frictions presents for Australian exporters, particularly in agriculture. Perhaps the most important hint of global risk comes from Purchasing Managers reports. The global index of manufacturing export orders dipped in February and March (Chart 2). 
Two months does not make a trend, and the level of the index is still healthy, but this bears watching.
The biggest loser(s)
It is not surprising that even a small probability of an outright trade war is resonating in the markets. After all, the main battle involves the two most important economies in the world. It also comes at a time when stronger trade is underpinning global growth. The World Trade Organization reports that the growth in global merchandise trade volumes accelerated from 1.8% in 2016 to 4.7% last year. Hence, after a period of weakness, trade is again significantly outgrowing GDP. Looking ahead, they expect 4.4% growth this year, but also present a downside scenario in which trade volumes drop (Chart 3).
- source Bank of America Merrill Lynch

For us, stretched positioning in conjunction with geopolitical risks are major looming threats. That simple. This could lead to a "hot summer" indeed. Sell in May and go away? As say the old adage, in the current case of "Dyslipidemia", high cholesterol and high blood pressure do not mix well, in similar fashion, high debt level (leverage) and volatility do not either...

"Confidence is contagious. So is lack of confidence." - Vince Lombardi
Stay tuned !
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