This week's long-form credit kung-fu cross-post from Macronomics delves deeper into the follow-up of tapering, from initial pressure on the emerging markets to back the source.
Credit - Osmotic pressure
"We want a story that starts out with an earthquake and works its way up to a climax." - Samuel Goldwyn
Looking at the continued sell-off in Emerging Markets currencies with
the Indian Rupee touching a record low level of 65.56 before bouncing
back by 2.1%, on Friday the biggest move since June 2012 and the
Brazilian Real which continued its slide before bouncing back as well
3.7% to 2.3488 following a 60 billion US dollar central bank pledge,
made us venture towards our distant memories, in similar fashion like
our previous posts made us revisit our musical souvenirs from the 80's.
Emerging Currencies "tapering" in true MMA fashion since Bernanke
started mentioning "tapering" its QE programme, graph source Thomson
Reuters Datastream / Fathom Consulting / Macronomics:
This time around, our chosen title is directly linked to capital flows
we are seeing, with the outflows from Emerging Markets towards Developed
Markets.
As the Osmosis definition goes:
"When an animal cell is placed in a hypotonic surrounding (or higher
water concentration), the water molecules will move into the cell
causing the cell to swell. If osmosis continues and becomes excessive the cell will eventually burst. In
a plant cell, excessive osmosis is prevented due to the osmotic
pressure exerted by the cell wall thereby stabilizing the cell. In fact, osmotic pressure is the main cause of support in plants. However, if a plant cell is placed in a hypertonic surrounding, the cell wall cannot prevent the cell from losing water. It results in cell shrinking (or cell becoming flaccid)." - source Biology Online.
Nota bene: Hypertonic
"Hypertonic refers to a greater concentration. In biology, a hypertonic solution is one with a higher concentration of solutes on the outside of the cell. When
a cell is immersed into a hypertonic solution, the tendency is for
water to flow out of the cell in order to balance the concentration of
the solutes." - source Wikipedia
So the reasoning behind our chosen title is linked to our past "biology" classes of course, given since
2009, 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.
We did send a warning in June in our conversation "The Daisy Cutter":
"If you think rising yields are only putting global trade at risk,
think as well how it will ripple through in various sectors and
countries." - source Macronomics
This is what we envisaged in our conversation "Singin' in the Rain" as well:
"If the dollar goes even more in short
supply courtesy of Bernanke's "Tap dancing" with his "Singin' in the
Rain", could it mean we will have wave number 3 namely a currency crisis
on our hands? We wonder..."
The mechanical resonance
of bond volatility in the bond market started the biological process of
the buildup in the "Osmotic pressure" we think and bond volatility has
yet to recede.
The volatility in the fixed income space has remained elevated as displayed by the recent evolution of the Merrill Lynch's MOVE index rising from early May from 48 bps towards the 100 bps level again, whereas the VIX, the measure of volatility for equities is finally reacting - 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, what we have been tracking with interest is the ratio between
the ML MOVE index and the VIX which remains elevated from an historical
point of view if we look back since October 2000 - graph source
Bloomberg:
With VIX picking up, no wonder the ratio between the MOVE index and VIX
has fallen from last week 7.06 level towards 6.10 as the contagion in
the equities space is finally picking up. Hence, last week our "Fears for Tears" concerns for our equities friend as the "tapering" noise increases as we move towards September.
As a reminder, we started pondering about the potential end of the goldilocks period of "low rates volatility / stable carry trade environment in June:
"As pointed out by Bank of America Merrill Lynch's note stable carry
thrives in low rates volatility environment, the recent spike in US
bonds volatility has had some devastating effect in high yielding
assets:
"Carry trades love low risk-free interest rates, but they love low interest rate volatility even more. This
is why over the past three years, billions of dollars have poured into
high yielding assets like risky corporate bonds, emerging market
currencies, and dividend paying stocks, driving their risk premiums to
abnormally low levels."
So what we are witnessing right now is indeed "reverse osmosis"
in Emerging Markets, and the osmotic pressure which has been building
up is no doubt leading to an "hypertonic solution" when it comes to
capital outflows in Emerging Markets.
Let us explain:
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.
So in this week's conversation, as we moved towards the "interesting"
month of September we will revisit some of our thoughts from our
conversation "Singin' in the Rain" and look at the risk and opportunities lying ahead.
As a reminder from our June conversation:
"We got seriously wrong-footed by the market's reaction to the
"tapering QE" scenario and we still think at some point the Fed will
maybe redirect its buying towards MBS, given that rising rates could
seriously dent any hope of a "housing recovery" should the move continue
at a rapid pace like it has this week."
The "housing recovery is indeed at risk - graph source Thomson Reuters Datastream / Fathom Consulting:
As indicated by Prashant Gopal on the 22nd of August in Bloomberg in his article "U.S. Mortgage Rates Jump to Two-Year High With 30-Year at 4.58%":
"The average rate for a 30-year fixed mortgage rose to 4.58 percent
this week from 4.4 percent, Freddie Mac said in a statement today. The
average 15-year rate climbed to 3.6 percent from 3.44 percent, the
McLean, Virginia-based mortgage-finance company said. Both were the
highest since July 2011.
Homebuyers are rushing to take advantage of historically low
borrowing costs before they increase any more. Existing-home sales in
July jumped 6.5 percent to the second-highest level in six years, the
National Association of Realtors reported yesterday. Those transactions
largely reflect closings of contracts signed a month or two earlier,
when mortgage rates were just beginning to edge up." - source Bloomberg
From the same article:
"The
Mortgage Bankers Association’s index of applications to lower monthly
payments fell 7.7 percent in the week ended Aug. 16, the 10th straight
decline. A measure of purchases rose 1.2 percent, the trade group said
yesterday.
The
30-year fixed mortgage rate is well below its average of about 6.3 percent for
the past 20 years, according to data compiled by Bloomberg. The 20-year average
for a 15-year loan is about 5.83 percent." - source Bloomberg
Yes but, there is indeed a "convexity issue at play" given the US
average Maturity of Fixed Rate Mortgages has been steadily increasing in
the last decades - graph source Thomson Reuters Datastream / Fathom Consulting:
And as our very wise credit friend former head of credit research said on the subject of convexity in June in our conversation "Singin' in the Rain":
"Convexity is a bigger issue in all the pensions + fixed income
funds. That's one reason mortgages have been whacked. the Fed will
basically have to do a ECB - stop buying USTs and start buying RMBS. But
pensions (or Fannie / Freddie) do not hedge MBS with USTs - they do it
with LIBOR"
At the time we argued:
"The
Fed is likely to step in and actually increase QE to try and hold rates down,
because mortgage rates have spiked substantially over the last month from
a low of around 3.5% to around 4.3%, we have to agree with our friend that a
"new dance" routine from the Fed might be coming."
Central Banks Assets - graph source Thomson Reuters Datastream / Fathom Consulting:
Why the Fed might indeed increase QE?
Point number 1:
Because the Fed is facing a raft of sellers and the economy is not as strong as it seems.
For instance, China’s holdings in May were $1.297 trillion, less than
the $1.316 trillion reported by the Treasury last month. China’s stake
dropped by $21.5 billion in June, or 1.7 percent according to Bloomberg
as per Treasury Department data released on the 14th of August. On top
of that US Commercial Banks as well have been selling as indicated by
Bloomberg Chart of the Day from the 19th of August - graph source
Bloomberg:
"U.S. commercial banks are dumping Treasuries at the fastest pace in a
decade and boosting loans, helping make the debt securities the world’s
worst performers as the economy gains momentum.
The CHART OF THE DAY shows banks’ holdings of U.S. Treasury and
agency debt tumbled $34.7 billion to $1.81 trillion in July, the biggest
monthly decline in 10 years, according to the Federal Reserve. The
level dropped to $1.79 trillion in the first week of August, Fed data
showed on Aug. 16. Also tracked are 30-year bond yields climbing to a
two-year high. The lower panel records commercial and industrial loans
as they surged to $1.57 trillion, the highest since 2008.
Bank sales of Treasuries accelerated after Federal Reserve Chairman
Ben S. Bernanke said on June 19 policy makers may reduce the bond-buying
program they use to support the economy. Concern the Fed will trim its
$85 billion a month of Treasury and mortgage purchases helped send notes
and bonds due in a decade or longer down 11 percent in the past 12
months. It was the biggest loss of 174 debt indexes tracked by Bloomberg
and the European Federation of Financial Analysts Societies." - source Bloomberg.
Point number 2:
Our "omnipotent" magicians are desperately trying to "bend" the velocity
curve and anchor higher inflation expectations. On that note we read
with interest Professor Rogoff comments in Bloomberg article by Aki Ito
and Michelle Jamrisko on the 12th of August - "Rogoff Saying This Time Different Calls for Reflation":
"Rogoff is espousing aggressive monetary stimulus, even at the cost
of moderate price increases. At a time of weak global inflation, higher
prices may even help the U.S. economy by lowering real interest rates
and reducing debt burdens, he said.
“In more normal times, you’re looking for the central banker to be an
anchor against high inflation expectations and to assure investors that
inflation will stay low and stable to keep interest rates down,”
Rogoff, co-author with Carmen Reinhart of the 2009 book “This Time Is
Different: Eight Centuries of Financial Folly,” said in an interview.
Now “we’re in this situation where many of the central banks of the
world need to convince the public of their tolerance for inflation, not
their intolerance.”
G-7 Inflation
Central banks across the developed world are struggling with
inflation that’s too low. Consumer price increases in all but one of the
Group of Seven economies are currently running under 2 percent, which
has become the standard goal in recent years for monetary authorities.
Two years ago, deflationary Japan was the only country struggling with
below-target inflation." - source Bloomberg.
The only issue is once the "Inflation Genie" is Out of the Bottle" as
warned by Fed's Bullard in 2012, it is hard to get it back under
control:
“There’s some risk that you lock in this policy for too long a
period,” he stated. ”Once inflation gets out of control, it takes a
long, long time to fix it”
While the recent jump in interest rates, has created an "hypertonic
surrounding" in the reverse osmosis plaguing Emerging Markets, it has
had some positive effect somewhat for the insurance sector as well as
the Auto Industry given that it has provided some relief in terms of
"reserve adequacy" for insurers and a relief on "reinvestment rates" to
plug the growing gap in pensions liabilities hindering the allocation of
capital for the Car industry giants.
"If we look at GM and FORD which went into chapter 11 due to the
massive burden built due to UAW's size of "unfunded liabilities", they
are still suffering from some of the largest pension obligations among
US corporations. Both said this week they see a significant improvement
in their pension plans liabilities because of rising interest rates used
to calculate the future cost of payments. When
interest rates rise, the cost of these "promissory notes" fall, which
alleviates therefore these pension shortfalls. So, over the long term
(we know Keynes said in the long run we are all dead...), it will enable
these companies to "reallocate" more spending on their core business
and less on retirees. Charles Plosser, the head of
Philadelpha Federal Reserve Bank, argued that the Fed should have
increased short-term interest rates to 2.5% in 2011 during QE2."
But, of course, what matters is indeed the "velocity" of the movement,
and the intensity. So far we have avoided a major sell-off in credit.
As indicated by Megan Hickey and Zachary Tracer in their Bloomberg
article from the 1st of August commenting on US insurer's Metlife's
results entitled "Metlife Says $10.9 billion of Bond Gain Erased, More Than Crisis", what matters is the pace of the rise in interest rates:
"MetLife Inc., the largest U.S. life insurer, saw $10.9 billion in
bond gains wiped out in the three months ended June 30 as interest rates
rose, exceeding the decline in any quarter of the financial crisis.
Net unrealized gains narrowed to $20.9 billion on the portfolio of
available-for-sale fixed-maturity securities, from $31.8 billion three
months earlier. The tumble helped cut MetLife’s bond holdings about 4.8
percent to $356.5 billion." - source Bloomberg
They also added the following comments from a Fitch Ratings analyst:
"Losses tied to deterioration in the creditworthiness of issuers are
more worrisome than the more recent fluctuations related to interest
rate movements, said Douglas Meyer, an analyst at Fitch Ratings. He said
higher rates can help increase investment income at insurers and
improve profitability on some products.
“The jump in interest rates, the way we look at it, it has a positive impact on the industry,” he said. “This will provide relief in terms of reserve adequacy, it will provide relief on reinvestment rates.”
An extreme spike in rates of more than 5 percentage points could hurt insurers,
he said. Clients might redeem products that offered lower yields,
forcing insurers to sell securities at a loss to meet withdrawal
demands, he said." - source Bloomberg.
We quoted our fellow blogger and friend Martin Sibileau back in June in "Singin' in the Rain" on the risk ahead for credit:
"If Ben triggers a sell off in credit
with the insinuation of tapering, the dealers on the other side, making
the bid for the investors, will be forced to do the rate hedge their
investors did not do, because they must be interest rate neutral! That
means selling US Tsys for an average of 85% and 50% of positions in HY
and IG respectively! In other words, the potential sell-off tomorrow may
trigger a surprising self-feeding convexity. How are precious metals to react in such scenario?" - Martin Sibileau
And as we discussed above, "macro" osmosis has led to "positive
correlations". When it comes for risks ahead, we share CITI's Matt King
views from his European Credit Weekly, namely that after a pleasant
summer for credit, it might be time indeed to continue to reduce
exposure to neutral:
"Dominoes
One of my favourite games as a child was always dominoes. No, not the rather tedious business of laying tiles end to end and trying to match up their spots.
Rather, the much more thrilling challenge of creating long and winding lines before knocking them over, and being amazed at the far-reaching devastation which could be caused with a single flick of the finger.
European credit feels at present to us like the last asset in a similarly long chain – seemingly remote from the problem of higher UST yields, almost immune to date to the outflows starting to occur elsewhere, and yet nevertheless with an intricate linkage to other assets which belies its apparent distance.
Ironically, our best guess has been and remains that the domino run will not quite get started in the first place – or, at a minimum, that some benign and omnipotent central banker will reach in to remove a domino or two and stop any run before it reaches us. Our house forecasts show the UST backup abating, show credit spreads remaining tight, and the EM sell-off remaining contained to mid-2014.
Moreover, it is striking just how well spreads have generally performed in the face of the backup in UST yields to date. EM hard currency mutual funds, for example, have lost nearly one-third of the last three years’ cumulative inflows (Figure 2), against which the backup in EM spreads, while notable, is hardly cataclysmic.
The outflows from credit funds have been tiny by comparison, and in Europe have been almost negligible. Unless outflows pick up very significantly, there is every reason to think € spreads remain resilient."
Besides, in many respects the risks as we head into September seem rather obvious. Tapering has been extremely well flagged. The Fed minutes suggest it will happen this year, but did not seem overly attached to our view of a September start.
German elections have been talked about a great deal, but seem ever less likely to bring about a significant change in the political landscape. Conscious corporate releveraging seems largely confined to the US. Supply is likely to pick up significantly, but is likely to have been widely anticipated. Above all, we have little sense of any build-up in complacent longs during the summer in the way we earlier feared, as is vouched for by the lack of outperformance of most high-beta names.
And yet despite all this, we still recommend reducing any remaining longs in € credit to neutral." - source CITI
CITI's Matt King also added:
"When playing dominoes, it usually takes a few goes before the run
really gets started (unless, of course, you didn’t mean for it to start,
in which case there’s no stopping it). Our best guess is likewise that,
despite the somewhat precarious lineup, not a great deal happens over
the next few weeks, and that spreads trade more or less sideways.
But that’s a bit like leaving the room and hoping that when you come
back later you’ll still find all the dominoes standing just as you left
them. As those with younger brothers will know, you ought to be okay –
but at this point we just don’t think you’re being paid for it." - source CITI
The issue for us is that from a "macro" perspective, if the reverse
"osmosis" has truly started and with "positive correlations" still in
place, there is indeed not only heightened risk from the continuation of
the sell-off in Emerging Markets which could affect Developed Markets
in the process, but, exogenous factors with political tensions and
agendas could indeed roil further risky asset classes.
The $3.9 trillion of cash that flowed into emerging markets over the
past four years has started to reverse, indicative of the "Osmotic
Pressure" and "reverse osmosis" process taking place.
"Why are we feeling rather nervous?
If the Fed starts draining liquidity, some "big whales" might turn up
belly up. Could it be Chinese banks defaulting? Emerging Markets
countries defaulting as well due to lack of access to US dollars?" - source Macronomics, June 2013, "Singin' in the Rain"
Moving back to our friend Martin Sibileau's June question on "precious metals":
"In other words, the potential sell-off tomorrow may trigger a surprising self-feeding convexity. How are precious metals to react in such scenario?"
At the time we argued that precious metal had further to fall and they did.
But, as we move towards September and what has already started is a
bounce back. In similar fashion to what we confided in our January
conversation "If at first you don't succeed...",
we have once again put in practice the effect of our magicians
("omnipotent" central bankers practicing their "secret illusions") by
starting being long gold miners via ETF GDX and some selected miners as
well.
The S&P 500, the US 10 year breakeven, please note we have added Gold into our previous Chart, graph source Bloomberg:
Once again we have broken our Magician's Oath:
"As a magician I promise never to reveal the secret of any illusion
to a non-magician, unless that one swears to uphold the Magician's Oath
in turn. I promise never to perform any illusion for any non-magician
without first practicing the effect until I can perform it well enough
to maintain the illusion of magic."
What is the rationale behind our call? We once again come back to our June conversation "Singin' in the Rain" where we quoted David Goldman's article about Gold and Treasuries and bonds in general which he wrote in August 2011 (the former global head of fixed income research for Bank of America):
"Why should gold and Treasury bonds go up together? Gold is an inflation signal and bonds are a deflation hedge. At first glance it seems very strange for both of them to rise together. Why should this be happening?
The answer is simple: bonds are an option on the short-term interest rate, and gold is a perpetual put option on the dollar. Both rise with volatility.
It’s like the old joke about the thermos bottle: “How does it know if it’s hot or cold?” 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."
Our thermos bottle is lately behaving accordingly because the YTD
movements in 5 year forward breakeven rates is falling again, which is
indicative of the strength of the deflationary forces at play - source
Bloomberg:
The 5 year forward breakeven was at 2.56% on the 21st of August but it has been breaking lower as per the most recent reading - graph source Thomson Reuters Datastream / Fathom Consulting:
QE and the US Dollar - graph source Thomson Reuters Datastream / Fathom Consulting:
Dollar index versus Gold - graph source Bloomberg:
So far we have bought the put leg of the put-call parity strategy and we
are indeed thinking of adding the call leg shortly. That's all for
magic tricks. We enjoy your company, dear readers, but we should not be
breaking our Magician Oath too often as you haven't sworn to uphold the
Magician's Oath in turn yet...
On a final note, in true Pareto
efficient economic allocation, while some pundits wager about
simultaneous developments having contributed to the weakness in Emerging
Market equities, for us Emerging Markets have been simply the victims
of currency wars ("Have Emerging Equities been the victims of currency wars?"), "Abenomics",
and of course "reverse osmosis" courtesy of positive real interest
rates in the US. It is therefore not a surprise to see that the biggest
beneficiary of "reflationary"policies have indeed been the Japanese as
displayed in Bloomberg's Chart of the Day from the 22nd of August
displaying the Earnings Per Share for 6 regions:
"Prime Minister Shinzo Abe’s policies to lower the yen and end
deflation are already paying off for corporate earnings, with Japanese
companies’ profits outpacing the rest of the world.
The CHART OF THE DAY shows earnings per share in six regions tracked by Bloomberg rebased to 100 at the end of June 2011. Profits
for the Topix climbed the most, rising 32 percent as companies in
Japan’s equity benchmark recovered from the March 2011 earthquake that
damaged large parts of the country’s north east. The lower panel of the chart shows the yen’s decline against nine other world currencies.
“Japan has been through a full earnings cycle over the past two
years,” said Mert Genc, a London-based strategist at Citigroup Inc.,
which composed the graph. “First, largely as a result of the earthquake,
earnings halved. But then they doubled again, with the latest boost
coming from weakness in the yen and improving economic performance.”
Japanese exports jumped by the most since 2010 in July, showing the
economy has benefited from the yen’s 22 percent slide against the dollar
since the end of 2011. Earnings in the U.S. have climbed 16 percent
since June 2011 as the Federal Reserve’s bond-purchasing program helped
to stimulate growth. Profits in the U.K., the euro area, emerging markets and Australia have declined in the same period.
Analysts estimate earnings in the Topix will grow 11 percent in 2014,
according to Bloomberg data, in line with the average for the other
regions in the chart of the day." - source Bloomberg.
The MSCI Emerging Markets Index has declined 12 percent this year,
compared with a 12 percent gain for the MSCI World Index of companies in
advanced economies.
"Remember, the storm is a good opportunity for the pine and the cypress to show their strength and their stability." - Ho Chi Minh
Stay tuned!