Monday, 23 June 2014

Credit - Deus Deceptor

"The senses deceive from time to time, and it is prudent never to trust wholly those who have deceived us even once." - Rene Descartes, French philosopher

Watching with interest the EONIA index posting new lows (1.5 bps) in the European space, spelling "death by a thousand rate cuts" for European money markets funds, meaning so far that they are only managing to survive by taking increasing interest rate exposure through Euribors, we decided to use another reference to central bankers' deception tricks in our chosen title this time around namely Deus Deceptor being a "deceptive god". 

Evolution of the Eonia index - graph source Bloomberg:

We had already used a reference to a great text from French poet Charles Baudelaire "Generous Gambler" aka Mario Draghi, but, this week we decided to refer to French philosopher René Descartes given he was accused of blasphemy by Protestants in 1643 and 1647 as he was positing an omnipotent God of malevolent intent (could we use this as an analogy to the central bankers of today?). 

The evil demon, sometimes referred to as the evil genius is a concept in Cartesian philosophy:
"In his 1641 Meditations on First Philosophy, René Descartes hypothesized the existence of an evil demon, a personification who is "as clever and deceitful as he is powerful, who has directed his entire effort to misleading me."" - source Wikipedia

Most Cartesian scholars opine that the evil demon is also "omnipotent" (hence the blasphemy as god is only considered as being "omnipotent"), and thus capable of altering mathematics and the fundamentals of logic. In Cartesian philosophy, sensation and the perception of reality are thought to be the source of untruth and illusions, with the only reliable truths to be had in the existence of a metaphysical mind. 

In similar fashion we already touched on the "Omnipotence Paradox" back in November 2012:
"1. A deity is able to do absolutely anything, even the logically impossible, i.e., pure agency.
2. A deity is able to do anything that it chooses to do.
3. A deity is able to do anything that is in accord with its own nature (thus, for instance, if it is a logical consequence of a deity's nature that what it speaks is truth, then it is not able to lie).
4. Hold that it is part of a deity's nature to be consistent and that it would be inconsistent for said deity to go against its own laws unless there was a reason to do so.
5. A deity is able to do anything that corresponds with its omniscience and therefore with its worldplan." - source Wikipedia.

But in terms of blasphemy and the "evil" intent of the central bankers both Descartes and the Cartesian scholars were wrong for the simple reason that central bankers are not omnipotent. Although, our "Deus Deceptors" of the central banking world, have indeed managed to altering mathematics (probability of default risk for the time being) and the fundamentals of logic, no doubt about that. 

"The gazing populace receives greedily, without examination, whatever soothes superstition and promotes wonder". - David Hume

Back in 2012 in our conversation we also argued:
"The "unintended consequences" of the zero rate boundaries being tackled by our "omnipotent" central banks "deities" is that capital is no longer being deployed but destroyed (buy-backs being a good indicator of the lack of investment perspectives)."

In this week's conversation we will look at the development in the credit space, which is a continuation of the "japonification" process with continued spread compression as the "yield frenzy" goes on as we move towards the close of the 1st semester of 2014 as well as some perspectives for the second semester 2014. 

Our take on Credit:
Credit, no doubt has had yet another great run in the first half of 2014, which comes to us as no surprise given the performance of credit in a deleveraging environment as it happened before in Japan.

In similar fashion to what we wrote about Japan in general and credit versus equities in particular in our April 2012 conversation "Deleveraging - Bad for equities but good for credit assets":
"Financial credit may be the next big opportunity
The build-up of corporate leverage in the 2000s was confined to financials which, unlike other corporates, had escaped unscarred from the 2001 experience. However, this changed in 2008. Judging by the experience of G3 (US, EU, Japan) non-financial corporates, there should be significant deleveraging in banks going forward. Indeed, regulatory pressures are also pushing in that direction. All else being equal, this should be bullish for financial credit." - source Nomura

The "japonification" process in the government bond space continues to support the bid for credit, with the caveat that for the investment grade class, there is no more interest rate buffer meaning investors are "obliged" to take risks outside their comfort zone (in untested areas such as CoCos - contingent convertibles financials bonds).

"Japonification" illustrated with German 2 year yields versus Japan coming close to negative again - graph source Bloomberg:

The strong convergence between the CDX index in the US representative of Investment Grade credit risk and its European counterpart the Itraxx Main Europe 5 year CDS index - graph source Bloomberg:

And the same picture since 2006 - graph source Bloomberg:
Could we go back to negative territory in terms of spread difference between Europe Investment Grade risk and the US like we did previously? We certainly can and will, given that back in January we expected more M&A and LBOs to materialise in 2014 as we move towards a later stage in the cycle we expect the US  to releverage at a faster pace.

Credit is far less volatile than equities, some leverage is sensible. Even leveraged credit can be less risky than unleveraged equities.

When it comes to High Yield and volatility, the spread compression has followed the compression in Eurostoxx Implied volatility as displayed in the below Bloomberg graph:
Of course there is more compression to come in both as ample central bank liquidity thanks to our "Deus Deceptors" who have managed to suppressed volatility and led to yield starvation meaning investors are reaching out for yield by taking additional risks down the credit quality spectrum.

But, when it comes to US High Yield, as far as we are concerned, it is "priced to perfection" and we cannot see the risk justifying the rewards anymore as displayed in the below Bloomberg graph illustrating the average High Yield Spread to Treasuries (Option Adjusted Spread - OAS):

Credit wise we agree with Société Générale weekly credit strategy note from the 20th of June when it comes to additional performance from the credit space and prefer European High Yield therefore to US High Yield which appears to us somewhat "richer" in terms of valuation.
"Credit fundamentals should remain strong (corporates are now in much more solid shape than pre-2008), and technicals supportive. That means that credit stands to gain further particularly HY, even if most market participants feel the asset class (IG and HY) is too rich. After all, it’s the bund’s fault as spreads remain much wider than pre-crisis (in IG, less so in HY). High yield names, corporate hybrids and AT1/Cocos stand to be the outperformers. After all, finding investments that yield over 5% are becoming increasingly rare, not even the recent issues by Greece or Cyprus (out this week) paid that. The great credit run is far from over, but even if the pace has slowed down, we expect the rally to continue with further compression between high and low beta names and sectors." -source Société Générale

Our take on US treasuries:
From a tail risk perspective and as a hedge with decent carry, we are staying long duration, a position we have taken on the ETF ZROZ - PIMCO 25+ Year Zero Coupon US Treasury Index Exchange-Traded Fund, a position we entered around 90 in terms of price level early in 2014 - graph source Bloomberg:
The contrarian 10% trade which we discussed in January.

Those who listened to us have done well so far in 2014 given we hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed":
"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. Buy put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."
We do indeed learn a lot from our "Deus Deceptors and their magic tricks... 

While every sell-side and most buy-side strategists and their dogs expect US 10 year yields to end 2014 at a level of around 3.25%, we are more incline to be contrarian on that matter for now until the facts change, before we change our facts to paraphrase Keynes. So we disagree with the consensus and agree at least with Nomura's take on UST as posited in their latest Japan Navigator from the 23rd of June:
"UST rates remain low but for different reasons
Many investors see low UST rates as reflecting economic weakness
We held a seminar primarily for equity investors in Tokyo this week. In a questionnaire given to seminar participants, we asked about the main factors to which they attribute the decline in UST rates since January. We also gave the same questionnaire to bond investors on our website. The results are shown in Figure 3.
More bond investors chose the second answer, which suggests that they consider low UST rates as being caused by structural reasons. Although fewer stock investors chose the second answer, over a half of respondents chose either the first or second answers in both groups. To the extent that these answers refer to slowing growth and/or slowing inflation, they are consistent with a weak stock market. In contrast, the third and fourth answers imply that yields are kept unjustifiably low relative to economic and inflation outlooks. They look consistent with a strong stock market.

We believe UST rates have been kept low for different reasons after mid-April
UST rates have remained low since January, but for different reasons before and after mid-April, in our opinion. Considering that the S&P 500 trended below end-2013 levels until mid-April, we believe UST rates were kept down largely by factors [1] and/or [2] until then. However, as stock prices continued to set new highs subsequently, we believe rates remained low more because of factors [3] and [4].

Considering that the strong bond and stock trend was more pronounced following the ECB announcement of a rate cut and the possibility of additional easing, and that the UST yield curve priced in a rate hike that was later than Fed guidance and lower neutral policy rates, factor [4] may have had a greater impact, in our view. As the ECB and BOJ continue to supply long-term funds at low rates, carry flows from the euro area and Japan into the UK, US and Oceania are likely to have a more material impact on these markets, in our view." - source Nomura

Welcome to a "Macro World"...

Our take on EUR/USD:
In terms of our take on the Euro currency's strength, in our conversation in early January 2014 entitled "Third time's a charm" we argued the following:
"As we move into 2014, our chosen title reflects the third time strategists put forward the case for a weaker euro. So could indeed 2014 see finally the much anticipated weaker euro forecasted by so many pundits?

In terms of our prognosis in both 2012 and 2013, we did not believe in a weakening of the Euro versus the dollar and we reiterated our stance in numerous occasions such as in our conversation from April 2013 "Big in Japan":
"In terms of the EUR/USD, we still think in the second quarter that it should remain in the 1.30 region versus the US dollar, which were our views for the 1st quarter. As we posited in January 2012, when most strategists were bearish on the EUR/USD, the Fed swap lines in conjunction with the FOMC decisions at the time did put a floor to the euro and are delaying a painful adjustment in Europe. The latest decision by Japan will as well prolong the European agony. In the process the European recession can only be prolonged and the European economy will continue to suffer (unemployment rate now at 12%)."

We also added:
"Unless Mario Draghi unleashes in Europe QE to fight off the growing deflationary risks we have been tracking and warning about, we do not see a weakening of the Euro in 2014."

Arguably in recent months, thanks to the US Fed tapering, the 1 year/1 year forwards for the US dollar and the Euro have increasingly diverged as displayed in the below Bloomberg chart:
This seems to indicate that the market clearly anticipates at some point some "nuclear" action from the ECB and also indicative of the tapering effect on the US dollar versus the Euro we think.

For us the divergence is as well an illustration of the difference in the inflation outlook between the US and Europe as shown in the below Bloomberg graph:

While many pundits point out to the interest rate differential which should lead therefore going forward to a lower euro. We disagree and expect Euro to strengthen during the second part of 2014 towards 1.40 (we therefore share the same views as Steen Jakobsen Chief Economist & CIO, Saxo Bank A/S). A very interesting explanation on why the Euro appears to be the new "widow maker" (in similar fashion to the short JGB trade) comes from Paul Donovan, senior economist at UBS as reported in the Jakarta Post:
"A key part of the explanation for the Euro’s defiance of divergent monetary policy lies in a revolution that has taken place in the world economy. Put simply, globalization has collapsed dramatically since 2007, and that collapse in globalization has profound implications for financial markets

The collapse in globalization is nothing to do with global trade. Global exports (as a share of the world economy) are at a higher level than they were in 2007 — here there has been a complete recovery. Instead the collapse has taken place in the realm of global capital flows. Global capital flows (again as a share of the world economy) are running at roughly a third of their pre-crisis peak, and around half the levels seen in the decade before the global financial crisis

The collapse of global capital flows has been brought about by several factors coming together. Investors, in particular banks, are more regulated than before the crisis. With that regulation has come about a bias to investment in domestic markets — in some cases as an unintended consequence of regulation, in some cases as a direct policy objective. In addition the more political nature of several developed financial markets has acted as a deterrent to international investors, who are likely to have less understanding of politics in remote markets. 

When capital flows were abundant, an economy with a current account deficit did not have too many problems finding the capital inflows necessary to finance the current account position. Only a tiny proportion of the huge amount of capital sloshing around the world had to be diverted to provide the funding. Now, with capital flows reduced to a thin trickle, a current account deficit country has to work a lot harder to attract the capital that they need. Crudely put, it is three times more difficult to finance a current-account deficit, now that capital flows are one third their pre-crisis levels. 

This helps to explain the Euro. The Euro area is a current account surplus area. The United States is a current-account deficit area. The interest rate differential argues for a weaker Euro. The current account position argues for a stronger Euro. These two forces battle it out in the foreign exchange markets, and the result is less Euro weakness than many had expected. 

This new model for foreign exchange has implications that reach far beyond the errors of Euro/dollar forecasting. Reduced capital flows means reduced capital inflows into Asian markets — something that has already slowed the pace of foreign exchange reserve accumulation. Reduced capital flow may mean a less efficient global allocation of capital resources. Global capital flows have been hidden from the headlines, but the collapse of globalization may turn out to be one of the most important economic changes of the past decade." - source Paul Donovan, senior economist UBS - the Jakarta Post.

Given that Europe's current-account balance, a broad measure of an economy's international financial position, increased in adjusted terms to a surplus of 21.5 billion euros ($29.26 billion) in April, after an upwardly revised surplus of EUR19.6 billion in March, we expect the Euro to trade higher in the coming months, not lower. (The balance reflected a EUR16.9 billion surplus for goods and a EUR10 billion surplus for services).

Also, for the 12-month period that ended in April 2014, the cumulated surplus was 2.6% of the euro zone's gross domestic product, higher than the 1.9% in the 12 months ended April 2013, so regardless of the interest rate differential put forward, we have a hard time believing in a weaker euro for now, unless of course the European "Deus Deceptor" in chief Mario Draghi unleashes a €1 trillion QE but we do not see that happening anytime soon.

Our take on Japan:
Moving on to our take on Japan, given it has been seriously lagging in terms of equities performance since the beginning of the year being down -5.66%, the Nikkei has indeed rallied significantly in one month (+9.67%) while the Japanese yen have been lagging and holding in a tight range pattern around 102. What has been interesting as of late has been the disconnect between the Nikkei index and the JPY/USD as indicated in the below graph where we have been monitoring the USD/JPY exchange rate, the Nikkei index and the credit risk Itraxx Japan CDS spread (inverted) - source Bloomberg:
Credit spreads have led the significant rally seen in equities and the depreciation of the Japanese yen by the Bank of Japan has further supported the rally in both asset classes in 2013. A typical central bank's intervention, the "reflation trade" lifting risky assets, reducing perceived credit risk and suppressing volatility. As a result of aggressive quantitative easing, we think credit risk itself could even go lower due to the wealth effect on company assets and greater ease procuring large amounts of funds via debt financing. 

But, when it comes to Japan, there is hope, we think as displayed in the below growth showing somewhat an increase in bank lending - graph source Bloomberg:
The boost in the money supply has drastically reduced the yen effective exchange rate while bank lending has been gradually climbing.

What so far has been hindering the Japanese reflation story has been Mrs Watanabe's household savings even though the dollar-yen rate has been seriously impacted by the Bank of Japan's aggressive monetary stance as displayed in the below Bloomberg graph:

Of course the depreciation story has led as well Japanese CPI higher in conjunction with higher durable goods prices and furniture and utensils prices - graph source Bloomberg:

So all in all, we plan to re-enter the Nikkei play currency hedged in Euro again very shortly as we believe Japan is poised for a rebound. We plan to go long Nikkei but in Euros via a quanto ETF in that respect.

The story for  the remainder of 2014 in Europe is still France:
This is what we argued in January 2013 and this is still what we are arguing now. While French politicians are benefiting from low rates on French debt issuance courtesy of on-going Japanese support, but, on the economic data front France is increasingly showing signs of growing stress. 

France should be seen as the new barometer for Euro Risk. With Industrial Production at -2%, the French government is seriously in denial when it comes to growth assumptions: 1% in 2014 (down from 1.2%) and 2% in 2015 is way over optimistic we think. 

A sobering fact, services in the French economy represent around 80% of the GDP versus 76% for the rest of the European union. the latest read at 48.2 for Services PMI is indicating contraction (the lowest level reached in February 2009  was at 40.2).

French industrial production (white line), French GDP (orange line) and French Services PMI (blue line, data available since 2006 only) tell the story on its own, we think - source Bloomberg:
An industrial production at -3.3% equals zero growth.

If the Services PMI contracts, it doesn't bode well for France's unemployment levels. Services represent the number one employment sector in France (34% of total employment in 2010 according to INSEE).

Normally "entrepreneurial economy" can’t do that well as long when they are entrepreneurs in the picture but in the special case of France, given French civil servants have done their best to "kill" the entrepreneurs in France with great success, the economy will continue to linger.

A tight credit channel, high inventory levels vs. order books, depressed consumer sentiment and a forced fiscal tightening create a dangerous economic environment for an already weak economy.

On a final note we leave you with Bank of America Merrill Lynch's latest graph from the Thundering Word from the 19th of June displaying the infatuation with "yield" (it reminds us of our Dark Crystal reference from our March 2013 conversation "The Yield Skeksis"):

"Men still have to be governed by deception." - Georg C. Lichtenberg, German scientist

Stay tuned!

Tuesday, 17 June 2014

Credit - The Monkey's paw

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

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

Of course, all of this is part of the deflationary pressure we have been discussing and highlighting throughout our numerous posts. For illustration purposes we have used the shipping industry to support our deflationary stance and used what was happening with the Drewry Container Rates as an illustration of the tremendous deflationary forces at play. Container lines have made eight general rate increases and one peak season surcharge totaling $3,000 on Asia-U.S. routes since June 2013 and there have been four general increases this year - graph source Bloomberg:
Every single time, the increases have failed to hold because of excess capacity and a sluggish global economy. The benchmark Hong Kong-Los Angeles rate has fallen 7% this year through June 4 and is down 11% yoy. In our Bear Case scenario, slack capacity will continue undermining efforts to raise rates during 2014. Rates have been below $2000 in 16 of the past 17 weeks.

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

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

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

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

The "japonification" process and the growing risk posed by "positive correlations" is a subject we touched in our conversation "Misstra Know-it all" back in September 2013 and we referred to Martin Hutchinson's take on these correlations:
"Negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. 

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

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

In August 2013 in our conversation "Alive and Kicking" we argued the following:
For us, there is no "Great Rotation" there are only "Great Correlations" and we have to confide that we agree with Martin Hutchinson's recent take on "Forced Correlations":
"The lack of a major banking crash and major job losses from the LTCM debacle, and the Fed's insistence on goosing the stock bubble yet further by reducing interest rates when LTCM collapsed, produced the moral hazard from which we are now suffering, and in the long run the correlations from which the more leveraged and better connected are currently profiting. 

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

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

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

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

In this note Bank of America Merrill Lynch made the following interesting comments:
"Just to re-iterate our concern – the Fed’s rate hiking cycle tends to be associated with wider credit spreads (Figure 9). 
Three developments make us concerned that it may actually be much worse this time. 
1) The Fed’s zero interest rate policy has led to an unprecedented reach for yield for more than five years – when the Fed hikes rates the “un-reach” for yield is going to be unprecedented as well. 
2) Dealers have little ability to act as buffer in a sell-off this time, as balance sheets have collapsed due to new regulation (Figure 5 above ). And finally 
3) The mutual fund/ETF ownership share of the corporate bond market is much higher than we have seen in the past – and this is the “hot money” in the corporate bond market (Figure 6 above). However, in the short term we still view the initial increase in interest rates over the past two weeks as modestly bullish for credit spreads, as institutional investors come out and retail flows react to returns only with a lag." - source Bank of America Merrill Lynch

Higher interest rates so far in June have indeed highlighted rising interest rate risk for US high grade spreads and the lack of a significant buffer to counteract rising rates. Back in August 2013 in our conversation "Alive and Kicking" we argued the following when it comes to convexity and bonds:
Moving on to the subject of convexity and bonds, how does one goes in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":
"CDS benefits from positive convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays

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

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

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

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

What has been interesting indeed is the convergence we have seen between the Itraxx Financial Senior 5 year CDS index with the Itraxx Financial Subordinated 5 year CDS index - graph source Bloomberg:
This convergence can indeed be explained by the central banks support which has so far prevented further liability management exercises by providing more than enough liquidity to provide additional support in the on-going deleveraging process and capital raising exercise taking place in the European banking space.

Again, the use of the Monkey paw by central bankers has indeed clearly created mis-pricing and induced mis-allocation as indicated by the induced compression between financial senior risk and subordinated risk we think. For instance a recent example of the mis-perception and mis-pricing of risk in the subordinated space has been highlighted by the threat of the Austrian government towards subordinated creditors of Austrian distressed real estate bank Hypo Alper-Adria-Bank (HAA). The Austrian government in this specific case is trying to pass a law to impose haircuts on investors who thought were insured given the bonds have deficiency guarantee from the state of Carinthia in Austria. This is in effect putting into a new perspective regional government guarantees. The spillover effect of the HAA story had of course some impact on the Austrian financial sector and led S&P on the 10th of June to put the ratings of seven Austrian banks and four Austrian states under review for downgrade. As reported by CreditSights in their Euro Financial Movers report of the 15th of June:
"The government is also proposing to cancel loans of €800 mn provided by the bank's former owner Bayerische Landesbank (BayernLB), while a further €1.5 bn of loans from BayernLB will not be repaid or paid interest until June 2019 at the earliest. BayernLB has reacted angrily, not unexpectedly (see Bayerische Landesbank: HAA Bail-in Challenge), as this move could hit its capital ratios and potentially might require it to take further provisions or impairment charges." - source CreditSights

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

In relation to the widening expected, Barclays in their note from the 6th of June 2014 entitled "Implied valuations of '14 bank CDS definitions" expect a widening of 50 bps:
"We expect sub CDS to be up to 50bp wider, on average, with senior CDS 15bp tighter. Though September is a few months away, two trading implications that are relevant right now are to sell sub protection in names with positive CDS-cash basis and to own (or not be underweight) LT2 bonds in tier 2 banks." - source Barclays

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

On a final note as always, regardless of the final melt up in asset prices, credit prices will indeed be giving clues for a stock market correction as indicated by Bank of America Merrill Lynch in the below graph from their recent Thundering Word note from the 12th of June entitled "The Greatest Risk of All":
"We are a buyer of vol into fall when correction risks rise significantly: either Q3 growth is +3% confirming recovery and cause rates to rise or speculative excesses appear causing central banks to start "talking down" asset prices. Clues to stock market correction include rising gold prices and decline in credit prices (as in 1987 –Chart 1)." - source Bank of America Merrill Lynch

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

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

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

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

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

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

From Monkey's paw to Monkey business...

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

Stay tuned!

Saturday, 7 June 2014

Credit - Operation Mincemeat

"The greatest trick central bankers ever pulled was to convince the investing world that default risk didn't exist" - Macronomics.

Watching with interest government yields making new record lows (Spanish 10-year yields at 2.63%, the least since 1993, and Italian 10-year yields at 2.723%, an all-time low), with the Itraxx Crossover index, the CDS 5 year risk gauge for European High Yield falling 8 basis points to 229 basis, the lowest level since June 2007, we thought we had to adapt our quote above to reflect the "greatness" of our central bankers magic tricks and deceptive actions which is of course a reference to Usual Suspects' "Verbal Kint (when it comes to "Cantillon" effect and creating excessive risk taking mentality) and to great text from the French poet Charles Baudelaire: "My God! Lord, my God! Please make the devil keep his word!"

One may therefore wonder why our chosen title. Given this week saw the 70th anniversary of the D-Day landing in Normandy, we reminded ourselves of one of the greatest disinformation plans of World War II, namely Operation Mincemeat. It was a widespread deception plan intended to cover the invasion of Italy from North Africa. Operation Mincemeat helped convinced the German high command the allied would land in Greece and Sardinia in 1943 rather than the actual objective of Sicily. The glaring success of Operation Mincemeat, caused the Germans to disregard later genuine documents finds such as documents found 2 days after D-Day landings detailing future military targets and disregard similar documents found during Operation Market-Garden in the Netherlands in September 1944. 

In similar fashion the successful concerted action from our "Generous Gambler" aka Mario Draghi, with this week's new decisions from the ECB following his 2012 "whatever it takes" moment have had similar effects on keeping at bay the "feral bond hogs" and leading investors to completely disregard default risk.

Without the prior success of Operation Mincemeat, D-Day landings could not have been successful. In similar fashion the disappearance of "default risk" in Europe and the ensuring "Japonification" process of yields would not have been successful without the prior deceptive plan of the "OMT" ("believe me it will be enough" moment). On a side note for those who want to read great accounts of the D-Day landings in Normandy we recommend you read Max Hastings' masterpiece "Overlord" and "Decision in Normandy" by Carlo d'Este. For those of you who enjoy human's ability in practicing deception, like ourselves, we recommend the site "" dealing with its various forms.

But, moving back to this week's conversation, we would like this week to look at the on-going "Japonification" process and what it entails in terms of risk taking mentality and credit compression as well as the "deception" process at play when it comes to the new measures being set up by the ECB which are in fact once again supportive of the deleveraging and recapitalisation process of the European banking sector as a whole.

A good illustration of the "Japonification" process in the credit space can be seen in the below graph illustrating the degree of tightening of the Itraxx Crossover 5 year CDS index indicative of the risk gauge for European High Yield (based on 50 European entities) - graph source Bloomberg:
The spread is closing towards the lowest point encountered back in 2006 and 2007.

More worrinyingly, liquidity wise, as we have pointed out on numerous occasions on this blog, the degree of liquidity that can be provided by market makers is nothing comparable to what could be provided back then. Dealers simply do not have the inventories or the risk appetite to absorb a large sell-off should it occur in the market place. For instance, from a discussion with a large interdealer broker in the CDS space, it appears that only two banks are providing large enough liquidity in the High Yield CDS single name space in decent clip size (20-30 million of notional amount) whereas most of the time ticket size in the CDS single name space would be around 2-3 million per name in the CDS space. Markets have become indeed more defensive than in 2006-2007, particularly so when CDS dealers have a hard time recycling CDS bids being hit continuously with spread compression with no large loan books hedging taking place lifting protection in the process given the on-going deleveraging taking place in the European banking sector.

The latest move from the ECB has as well closed the gap between Investment Grade in Europe as seen in the credit index Itraxx Main Europe 5 year with its US counterpart CDX IG as illustrated recently by Bank of America Merrill Lynch's graph from their recent Credit Strategist note from the 6th of June entitled "Return to Order":
"Most measures - including the discussion of potential future ABS based QE - are clearly positive for credit as investors are crowded out of yield opportunities. Obviously most directly positive for European credit, but also indirectly for US credit as relative value improves. Hence US investment grade and high yield tightened 1.7bps and 0.26pts, while European IG tightened as much as 3.8bps (iTraxx). It should not be long before Main trades inside IG (Figure 9), especially as with the ECB out of the way US interest rates can better reflect the strength of the US economy." - source Bank of America Merrill Lynch

What of course the continuous tightening has done to Investment Grade Credit has been to increase the instability to sudden shock in rising rates, making the asset class increasingly more vulnerable than High Yield which from a convexity point of view is less sensitive to rates movements as indicated in the same report from Bank of America Merrill Lynch:
"The emerging June seasonal in rates
For the second consecutive year financial markets are working hard to establish a very bearish June seasonal for Treasuries, as 10-year interest rates two business days into the month have risen already 12bps. That represents the biggest 2-day increase in interest rates in more than six months (since 11/20/2013), but ranks only 15th since rates began to increase in May last year (Figure 21). 
However a representative IG ETF (long term) has declined 1.29% over the last two days – a move not seen since 7/5/2013, and the 6th biggest move since May last year. A benchmark HY ETF is down 0.76% over the same period, a move we have seen earlier this year, and only the 23rd biggest decline since May last year. Clearly this recent increase in rates is disproportionally adverse to IG returns compared with anything we have seen recently. The main reason is that, as credit spreads have rallied significantly, there is very little spread cushion available to offset the increase in interest rates. Clearly high yield has more capacity, and thus returns are faring better.
The past two days compare with the period 10/29/2013-12/31/2013, where the same representative IG ETF declined similarly (1.21% negative price return). However, that was on a 50bps move higher in 10-year interest rates (from 2.5% to 3.0%). One of the big differences is that back then credit spreads started at 144bps compared with just 112bps currently, and thus could play a bigger role in offsetting the rates move (Figure 22). 
We continue to expect some spread tightening initially as rates go back up, although this time much more modestly. This especially as retail flows – that tends to be driven primarily by past returns – are still driven in the short term by this year’s stellar performance through May. However, the experience the past two days shows just how fast returns erode this time when interest rate increase.
Thus eventually retail inflows end, which should more than offset the increase in institutional demand and lead to less favorable liquidity conditions and higher spread volatility." - source Bank of America Merrill Lynch

To illustrate further more interest sensitivity in conjunction with lack of liquidity, we discussed recently this very subject with our cross-asset friend and fellow blogger "Sormiou". For instance there are some new issues in investment grade in the primary market in the 300/400 million euro range size coming to the market. They are obviously smaller than the traditional 500 million benchmark size deals being generally placed and bought by mutual funds. They come with 10 year maturities with spread comprised between 70 and 90 bps. The problem is that on the secondary space these bonds are being priced by market makers with 10 bps bid/offer spread meaning that with a duration sensitivity of around 7/8 you lose 1 year of carry in the secondary space should you decide to part with your recently acquired bonds. So dear Investment Grade investors welcome to "Japonification" and "buy and hold" for the next 10 years...

The recent ECB decisions will of course reinforce the technical bid for credit even more and compressing even further already very tight spreads in the market place. In this environment, no doubt European High Yield will continue to perform as the "hunt for yield" will intensify in true "Cantillon Effects" fashion. We therefore expect financials to outperform significantly non-financials, and in particular Italian financials credit and equities to be as well the big beneficiaries from the latest generosity from our "Generous Gambler" aka Mario Draghi. Let's face it, when your central bank offers you 400 billion 4 year loans at 25 bps, it is hardly an offer you can refuse to play the "carry" game even further. While the ECB is hoping that banks will use to pass it on to corporate via increase lending, the deception in "Operation Mincemeat" is that it will be used rather as yet another source of cheap funding given the real constraint face by the European financial sector has more to do with capital issues rather than liquidity issues. 
What seems to be happening as well with the recent additional help of "Operation Mincemeat" by the ECB, is that investors are indeed pushed out even further out on the risk curve as confirmed by Morgan Stanley's Leveraged Finance Insights note from the 6th of June entitled "Here What You Own":
"We find that HY funds have gradually allocated away from high quality in recent history. In December 2012, the allocation to BBs stood at 36% (very much in line with the overall market, at 37%). The allocation to Bs was also close to the broader market, at 49%. Over the last five quarters, BBs have increased as a percentage of the overall market by 7%. However, BBs increased as a percentage of total mutual fund holdings by only 3.4% from 4Q12 to 4Q13 and remained flat from 4Q13 to 1Q14. Funds are now 5% underweight BBs compared to the overall market, showing that rising rates have likely surprised investors this year. To some extent though, we have seen moderation in risk-taking by funds quarter over quarter. For example, funds have moved from 1% overweight CCCs to 1% underweight, at the same time increasing their overw eight to Bs." - source Morgan Stanley

The latest round of central bank generosity will further trigger additional yield seeking investment and boost no doubt asset prices further up as illustrated by the performance of European High Yield versus Equities since 2009 as displayed by Bank of America Merrill Lynch in their latest Thundering Word report entitled "So it begins":
In true Japanese fashion, credit in a deflationary environment does indeed tend to outperform as we have previously discussed in our conversation from April 2012 entitled "Deleveraging - Bad for equities but good for credit assets":
"As volatility of credit is much lower than equities, investors could have taken a suitable amount of leverage on credit to convert this into high absolute returns"

We must confide we have indeed been playing this game and did in fact picked up some yield enticing junior  financial subordinated bonds in late 2011 at a cash price of around 94.5, yielding around 14% at the time, to see the yield drop below 4%  these days and the cash price of our position rising by nearly 50% thanks to the generosity of our great magicians. We also suffered minimal volatility in the process as illustrated in the below Bloomberg graph:

On a final note and to illustrate further our "deception" analogy from our chosen title as well as our gently twisted starting quote from above, Mario Draghi is truly a great magician when it comes to deception tricks as indicated by the below Bank of America Merrill Lynch graph from their latest Thundering Word note entitled "So it begins" given that Italy now appears more creditworthy than the US:
"From ZIRP to NIRP
ECB policy ease induced a phenomenal rally in European credit markets. 5-year Italian bonds yielded 700bps more than US 5-year bonds less than 3 years ago; now they trade 25bps below (Chart 2)."

- source Bank of America Merrill Lynch.

For us it seems we are indeed moving from ZIRP to NIRP, to ZILCH, when it comes to yield levels and no doubt the last leg of the rally has some more room to "overshoot" on the way up rest assured.

"Profit is sweet, even if it comes from deception." - Sophocles

Stay tuned!

Thursday, 5 June 2014

Chart of the day - Equity bear markets tend to coincide with high global core inflation

"Once is happenstance. Twice is coincidence. Three times is enemy action." - Ian Fleming

We came across this very interesting chart from Bank of America Merrill Lynch in their recent note from the 4th of June FX Quant Viewpoint "When carry met value":
"High global core inflation as a risk-off signal
Individual country inflation series are noisy, but the average across G10 economies has been stable in the 1-2% range, and has exhibited clear cyclicality. Bear markets for US equities have usually coincided with high global core inflation. We believe inflation based carry will remain attractive until inflation increases globally and we would expect currencies to mean revert when this occurs.

High inflation leads to mean reversion for currencies
Given the strong correlation between FX carry trades and equities in recent years, the observation that recent equity bear markets have coincided with high global inflation suggests that inflation can be used as a carry filter. More generally, we would expect currencies to mean revert during periods of risk-off, which may or may not be negative for carry strategies. Our analysis suggests that a strategy of mean reversion towards 5 year averages would have performed well during the last two periods of high inflation. Is there a fundamental link that makes this robust? 

Inflation matters when inflation is high
Central banks have historically been much more concerned with fighting inflation than deflation, so that high inflation is likely to result in greater attention being paid. Increased attention on fundamentals could drive currencies towards fair value. Behaviourally speaking, high inflation may tip the psychology of the market towards accepting the inevitability of some nominal currency depreciation. This shift in psychology might result in greater reluctance to buy expensive currencies.

Trades for a low inflation environment
The deflationary environment in Japan which began around 1999 coincided with an aging population. The number of people aged 60-64 exceeded the number aged 15-19 as of 2000 (Chart 8). 
There is a natural link between an aging population and low inflation, in that retired people frequently live on fixed incomes so may have constant spending over time. In recent years, central banks have aggressively reacted to deflationary pressure with quantitative easing. Arguably this has been somewhat successful (Chart 9), 
but while US inflation has been ticking higher consistent with our bullish USD view, globally inflation remains low."- source Bank of America Merrill Lynch

Interestingly, back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008:
- source

Of course we beg to differ slightly from Bank of America Merrill Lynch renewed bearish view on US Treasuries and rising yields as we are awaiting to see the impact of both Japan's behemoth GPIF re-allocation process in June on spreads as well as what China intends to do when it comes to weakening further its currency, which would in effect have a deflationary impact on the rest of the world

"If you would be a real seeker after truth, it is necessary that at least once in your life you doubt, as far as possible, all things." - Rene Descartes

Stay tuned!
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