Leveraged Loans – History Rhyming?

Leveraged Loans – History Rhyming?

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Macro Letter – No 123 – 29-11-2019

Leveraged Loans – History Rhyming?

  • Despite three Federal Reserve rate cuts, leveraged loan credit quality is rapidly declining
  • Covenant-lite issues now account for more than 80% of US$ issues
  • CLO managers, among others, may need to sell, but few buyers are evident

For those of you who have not read Michael Lewis’s, The Big Short, the great financial crisis of 2008/2009 was caused by too much debt. The sector which precipitated the great unravelling was the US mortgage market and the particular instrument of mass destruction was the collateralised debt obligation, a security that turned out to be far from secure.

Today, more than a decade on from the crisis, interest rates are close to historic lows throughout much of the developed world. The problem of too much debt has been solved with even more debt. The nature of the debt has changed, so too has the make-up of debtors and creditors, but the very low level of interest rates, when compared to 2008, means that small changes in interest rates have a greater impact the price of credit.

Here is a hypothetical example, to explain the changed relationship between interest rates and credit. Back in 2008 a corporate borrower might have raised capital by issuing debt paying 6%, today the same institution can borrow at 3%. This means they can double the amount of capital raised by debt financing without any change in their annual interest bill. Put another way, apart from the repayment of the principal, which can usually be rolled over, the cost of debt financing has halved over the course of the decade. Firms can raise capital by issuing equity or debt, but, as interest rates decline, debt has become cheaper than equity finance.

In the example above, however, assuming the corporation chooses to double its borrowings, it becomes twice as sensitive to changes in interest rates. A rise from 3% to 4% increases its interest payments by one third, whereas, previously, a rise from 6% to 7% amounted to an increase of just one sixth.

So much for the borrower, but what about the lender? Bonds and other interest bearing securities are generally purchased by investors who need to secure a stable, long-term, stream of fixed income. As interest rates fall they are faced with a dilemma, either accept a lower return or embrace greater risk of default to achieve the same income. At the heart of the financial crisis was the illusion of the free lunch. By securitising a diversified portfolio of high-risk debt, the individual default risk was supposed to be ameliorated. The supposition was that non-correlated investments would remain non-correlated. There is a saying in financial markets, ‘during a crisis, correlations all rise to one.’ In other words, diversification seldom works when you really need it because during a crisis every investor wants the same thing, namely liquidity. Even if the default risk remains unchanged, the market liquidity risk contrives to wipe the investor out.

An alternative to a fixed-income security, which may be especially attractive in a rising interest rate environment (remember the Fed was tightening for a while prior to 2019), is a floating-rate investment. In theory, as short-term interest rates rise the investor can reinvest at more attractive rates. If the yield curve is essentially flat, floating rate investments will produce similar income streams to longer maturity investments, but they will be less sensitive to systemic market risk because they have shorter duration. In theory, credit risk should be easier to manage.

What’s new?

More than ten years into the recovery, we are witnessing one of the longest equity bull-markets in history, but it has been driven almost entirely by falling interest rates. The bond market has also been in a bull-trend, one which commenced in the early 1980’s. For investors, who cannot stomach the uncertainty of the equity market, the fixed income market is a viable alternative, however, as government bond yields have collapsed, income-yielding investments have been increasingly hard to find. With fixed income losing its lustre, credit products have sought to fill the void. Floating-rate leveraged loans, often repackaged as a collateralised loan obligation (CLO), are proving a popular alternative source of income.

The typical CLO is a floating-rate tradable security backed by a pool of, usually, first-lien loans. Often these are the debt of corporations with poor credit ratings, such as the finance used by private equity firms to facilitate leveraged buyouts. On their own, many of these loans rank on the margins of investment grade but, by bundling them together with better rated paper, CLO managers transform base metal into gold. The CLO manager does not stop there, going on to dole out tranches, with different credit risks, to investors with differing risk appetites. There are two general types of tranche; debt tranches, which pay interest and carry a credit rating from an independent agency, and equity tranches, which give the purchaser ownership in the event of the sale of the underlying loans. CLOs are hard to value, they are actively managed meaning their risk profile is in a constant state of flux.

CLOs are not new instruments and studies have shown that they are subject to lower defaults than corporate bonds. This is unsurprising since the portfolios are diversified across many businesses, whilst corporate bonds are the debt of a single issuer. CLO issuers argue that corporations are audited unlike the liar loans of the sub-prime mortgage debacle and that banks have passed ‘first loss’ risk on to third parties. I am not convinced this will save them from a general collapse in confidence. Auditors can be deceived and the owners of the ‘first loss’ exposure will need to hedge. CLOs may be diversified across multiple industry sectors but the market price of the underlying loans will remain highly dependent on that most transitory of factors, liquidity.

Where are we now?

Enough of the theory, in practice many CLOs are turning toxic. According to an October article in the American Banker –  A $40 billion pile of leveraged loans is battered by big lossesthe loans of more than 50 companies have seen their prices decline by more than 10%. The slowing economy appears to be the culprit, credit rating agencies are, as always, reactive rather than proactive, so the risk that many CLOs may soon cease to be investment grade is prompting further selling, despite the absence of actual credit downgrades. The table below shows magnitude of the problem as at the beginning of last month: –

Leveraged Loans

Source: Bloomberg

It is generally agreed that the notional outstanding issuance of US$ leveraged loans is around $1.2trln, of which some $660bln (55%) are held in CLOs, however, a recent estimate from the Bank of England – How large is the leveraged loan market? suggests that the figure is closer to $1.8trln. The authors go on to state: –

We estimate that there is more than US$2.2 trillion in leveraged loans outstanding worldwide. This is larger than the most commonly cited estimate and comparable to US subprime before the crisis.

As global interest rates have declined the leveraged loan market has more than doubled in size since its post crisis low of $497bln in 2010. Being mostly floating-rate structures, enthusiasm for US$ loans accelerated further in the wake of Federal Reserve (Fed) tightening of short-term rates. This excess demand has undermined quality, it is estimated that around 80% of US$ and 90% of Euro issues are covenant-lite – in other words they have little detailed financial information, often relying on the EBITDA adjustments calculated by the executives of the corporations issuing the loans. Those loans  not held by CLOs sit on the balance sheet of banks, insurance companies and pension funds together with mutual funds and ETFs. Several more recent issues, failing to find a home, sit on the balance sheets of the underwriting banks.

Here is a chart showing the evolution of the leveraged loan market over the last decade: –

CLOs

Source: BIS

Whilst the troubled loans in the first table above amount to less than 4% of the total outstanding issuance, there appears to be a sea-change in sentiment as rating agencies begin to downgrade some issues to CCC – a notch below investment grade. This grade deflation is important because most CLO’s are not permitted to hold more than 7.5% of CCC rated loans in their portfolios. Some estimates suggest that 29% of leveraged loans are rated just one notch above CCC. Moody’s officially admits that 40% of junk-debt issuers rate B3 and lower. S&P announced that the number of issuers rated B- or lower, referred to as ‘weakest links’, rose from 243 in August to 263 in September, the highest figure recorded since 2009 when they peaked at 300. S&P go on to note that in the largest industry sector, consumer products, downgrades continue to outpace upgrades.

As the right-hand of the two charts above reveals, the debt multiple to earnings of corporate loans is at an all-time high. Not only has the number of issuer downgrades risen but the number of issuers has also increased dramatically. At the end of 2010 there were 658 corporate issuers, by October 2019 the number of issuers had swelled 56% to 1025.

The credit spread between BB and the Leveraged Loan Index has been widening throughout the year despite three rate reductions from the Fed: –

Lev Loans spreads

Source: Morgan Stanley, FTSE

Q4 2018 saw a sharp decline in prices as the effect of previous Fed tightening finally took its toll. Then the Fed changed tack, higher grade credit recovered but the Leveraged Loan Index never followed suit.

Despite a small inflow into leveraged loan ETFs in September, the natural buyers of sub-investment grade paper have been unnaturally absent of late. Leveraged loan mutual funds have seen steady investment outflows for almost a year.

The inexperience of the new issuers is matched by the inexperience of the investor base. According to data from Prequin, between 2013 and 2017 a total of 322 funds made direct lending investments of which 71 had never entered the market before, during the previous five year only 85 funds had made investments of which just 19 were novices.

Inexperienced investors often move as one and this is evident in the recent absence of liquidity. The lack of willing buyers also highlights another weakness of the leveraged loan market, a lack of transparency. Many of the loans are issued by private companies, information about their financial health is therefore only available to existing holders of their equity or debt. Few existing holders are inclined to add to their exposure in the current environment. New purchasers are proving reticence to fly blind, as a result liquidity is evaporating further just at the moment it is most needed.

If the credit ratings of leveraged loans deteriorate further, contagion may spill over into the high-yield bond market. Whilst the outstanding issuance of high-yield bonds has been relatively stable, the ownership, traditionally insurers and pension funds, has been swelled by mutual fund investors and holders of ETFs. These latter investors prize liquidity more highly than longer-term institutions: the overall high-yield investor base has become less stable.

Inevitably, commentators are beginning to draw parallels with mortgage and CDO crisis. The table below, from the Bank of England report, compares leveraged loans today with sub-prime mortgages in 2006: –

how-large-is-the-leveraged-loan-market-chart-a

Source: Bank of England

The comparisons are disquieting, the issuers and underlying assets of the leveraged loan market may be more diversified than the mortgages of 2006, but, with interest rates substantially lower today, the sensitivity of the entire market, to a widening of credit spreads, is considerably greater.

The systemic risks posed by a meltdown in the CLO market is not lost on the BIS, page 11 of the latest BIS Quarterly Review – Structured finance then and now: a comparison of CDOs and CLOs observes: –

…the deteriorating credit quality of CLOs’ underlying assets; the opacity of indirect exposures; the high concentration of banks’ direct holdings; and the uncertain resilience of senior tranches, which depend crucially on the correlation of losses among underlying loans.

These are all factors to watch closely. The authors’ remain sanguine, however, pointing out that CLOs are generally less complex than CDOs, containing little credit default swap or resecuritisation exposure. They also note that CLOs are less frequently used as collateral in repurchase agreements rendering them less likely to be funded by short-term capital. This last aspect is a double-edge sword, if a security has a liquid repo market it can easily be borrowed and lent. A liquid repo market allows additional leverage but it also permits short-sellers to provide essential liquidity during a buyers strike, in the absence of short-sellers there may be no one to provide liquidity at all.

In terms of counterparties, the table below shows which institutions have the largest exposure to leveraged loans: –

BOE CLO heat map

Source: Bank of England

Bank exposure is preeminent but the flow from CLOs will strain bank balance sheets, especially given the lack of repo market liquidity.

Conclusions and Investment Opportunities

The CLO and leveraged loan market has the capacity to destabilise the broader financial markets. Rate cuts from the Fed have been insufficient to support prices and economic headwinds look set to test the underlying businesses in the next couple of years. A further slashing of rates and balance sheet expansion by the Fed may be sufficient to stave off a 2008 redux but the warning signs are flashing amber. Total financial market leverage is well below the levels that preceded the financial crisis of 2008, but as Mark Twain is purported to have said, ‘History doesn’t repeat but it rhymes.’

Until the US election in November 2020 is past, equity markets should remain supported. Government bond yields are unlikely to rise and, should signs of economic weakness materialise, may plumb new lows. Credit spread widening, however, even as government bond yields decline, is a pattern which will become more prevalent as the cash-flow implications of floating-rate borrowing instil some much needed sobriety into the market for leveraged loans. With interest rates close to historic lows credit markets are, once again, the weakest link.

Fragility – what the US money-market squeeze means for the future

Fragility – what the US money-market squeeze means for the future

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Macro Letter – No 122 – 18-10-2019

Fragility – what the US money-market squeeze means for the future

  • Last month’s squeeze in overnight domestic US$ funding rattled markets
  • The Fed responded rapidly but the problem has been growing for some time
  • Market fragility stems from problems in the transmission mechanism

At the end of October the Federal Reserve are expected to announce the details of their latest balance sheet expansion, this will follow the FOMC meeting. Fed watchers estimate the central bank will buy between $250bln and $330bln of Treasury bills in their effort to provide sufficient reserves to keep the benchmark Effective Federal Funds Rate (EFFR) within its target range. The allocation of liquidity is unlikely to be even, but the Fed has indicated that it will purchase $60bln/month and that they will continue until at least Q2 2020. They are making an unequivocal statement. Let us not forget that it is the traditional function of a central bank, to lend freely against good collateral. The fact that estimates do not exceed $330bln is due to perception that the Fed will not wish the markets to regard these money-market operations as tantamount to QE.

The markets are feverish with speculation, some commentators calling it a further round of QE, despite official statements to the contrary. The money-markets have been unsettled ever since the cash-crunch which occurred in mid-September. For once I concur with the Fed, that this is the management of liquidity via market operations, it is entirely different from the structural effect of longer-term asset purchases. George Selgin of the Cato Institute has coined the acronym SOAP – Supplementary Organic Asset Purchases – nonetheless, this additional liquidity has the effect of expanding the Fed balance sheet and expanding the monetary base. Perception will be all.

Spikes in overnight lending rates are not unusual, especially around tax payment dates, what is unsettling is the challenge the Fed has encountered trying to keep the EFFR within the Fed Funds target range for several days after the initial squeeze. The implementation of SOAP (or whatever they choose to call it) undoubtedly amounts to a further easing of conditions. The Fed may manage expectations by slowly the pace of easing in official rates, after all, what is the point in lowering official rates only to have your good intentions high-jacked by the money-market?

The chart below shows the Fed Fund Effective Rate over the last year (you will note the spike during September): –

Fed Effective Rate - 1yr

Source: Federal Reserve Bank of New York

At the same time the Secured Overnight Funding Rate (SOFR) spiked more wildly: –

SOFR YTD

Source: Federal Reserve Bank of New York

It is important to note that, while the EFFR squeezed higher, SOFR actually spiked more than the chart above indicates, rising from 2.19% to 9% on September 17th. The following day the Fed increased its holdings of Repos from $20bln to $53bln, it also officially cut the Fed Funds target rate by 25bp to 1.75%. On Wednesday 18th the Fed Repo balance rose again to $75bln, by Monday 23rd those balances had reached $105bln.

There are numerous theories about the stubbornness of money-market rates to moderate. Daniel Lacalle writing for Mises – The Repo Crisis Shows the Damage Done by Central Bank Policies – observes: –

What the Repo Market Crisis shows us is that liquidity is substantially lower than what the Federal Reserve believes, that fear of contagion and rising risk are evident in the weakest link of the financial repression machine (the overnight market) and, more importantly, that liquidity providers probably have significantly more leverage than many expected.

In summary, the ongoing — and likely to return — burst in the repo market is telling us that risk and debt accumulation are much higher than estimated. Central banks believed they could create a Tsunami of liquidity and manage the waves. However, like those children’s toys where you press one block and another one rises, the repo market is showing us a symptom of debt saturation and massive risk accumulation.

…what financial institutions and investors have hoarded in recent years, high-risk, low-return assets, is more dangerous than many of us believed.

A different opinion about the root of the Repo problem is provided by Alasdair Macleod, also writing for Mises – The Ghosts of Failed Banks Have Returned: –

The reason for its failure has little to do with, as some commentators have suggested, a general liquidity shortage. That argument is challenged by the increase in the Fed’s reverse repos from $230bn in October 2018 to $325bn on 18 September, which would not have been implemented if there was a general shortage of liquidity. Rather, it appears to be a systemic problem; another Northern Rock, but far larger. Today we call such an event a black swan.

The author goes on to suggest that a large non-US bank may be the cause of the issue. Inevitably Deutsche Bank’s name is mentioned.

I believe the issue stems from a number of different factors. Firstly, the Fed is far more central to the banking system today, especially since they elected to pay interest on bank deposits. Secondly, the banks have been wary of lending to corporates, or to one another, they are therefore more beholden to the Fed. Finally, the void created by the banks refusing, or being unable, to lend to the real economy has been filled by private capital, provided by hedge funds, money market funds and synthetic ETFs – these latter instruments have balances in excess of $4trln.

These new sources of funding cannot access the SOFR market directly, they must intermediate with the 24 broker-dealers with whom the Fed transact open market operations. Any hint of a bank being in difficulty will see these shadow-bankers move assets from that institution rapidly, causing the institution concerned (if it can) to make a dash for the Repo market and the succour of the Fed.

Macleod suggests other factors which might have contributed to the SOFR squeeze, including: –

…Chinese groups are shedding $40bn in global assets… domestic funding requirements faced by Saudi Arabia in the wake of the attack on her oil refining facilities, almost certainly being covered by the sale of dollar balances in New York.

…with $307.9bn withdrawn in the year to July, foreign withdrawals appear to be a more widespread problem than exposed by current events.

Enough of speculation, the official explanation is contained in this article from the Chicago Fed – Understanding recent fluctuations in short-term interest rates: –

Two developments in mid-September put stress on overnight funding markets. First, quarterly tax payments for corporations and some individuals were due on September 16. Over a period of a few days, these taxpayers took more than $100 billion out of bank and money market mutual fund accounts and sent the money to the U.S. Treasury. Second, the Treasury increased its long-term debt by $54 billion by paying off maturing securities and issuing a larger quantity of new ones. (A reduction in short-term Treasury bills outstanding partly offset the increase in long-term debt.) Buyers of the new debt paid for it by withdrawing money from bank and money market accounts. Combined with the tax payments, the debt issuance reduced the amount of cash in the financial system.

At the same time as liquidity was diminishing, the Treasury debt issuance caused financial institutions to need more liquidity. A substantial share of newly issued Treasury debt is typically purchased by securities dealers, who then gradually sell the bonds to their customers. Dealers finance their bond inventories by using the bonds as collateral for overnight loans in the repo market. The major lenders of cash in that market include banks and money market funds—the very institutions that had less cash on hand as a result of taxpayers’ and bond buyers’ payments to the Treasury.

With more borrowers chasing a reduced supply of funding in the repo market, repo interest rates began to rise on September 16 and then soared on the morning of September 17, reaching as high as 9% in some transactions—on a day when the FOMC was targeting a range of 2% to 2.25% for the fed funds rate.

Pressures in the repo market then spilled over to other markets, such as fed funds, as lenders in those markets now had the option to chase the high returns available in the repo market. In addition, when banks experience large outflows as a result of tax payments or Treasury issuance, they may seek to make up the money by borrowing overnight in the fed funds and other markets, putting additional pressure on rates there. The fed funds rate reached 2.25%, the top of the FOMC’s target range, on September 16 and 2.30% on September 17.

Here, is a chart showing the change in SOFR and EFFR over the last five years (you will notice that on none of these charts does the transaction struck at 9% ever appear – perhaps they do not want to frighten the horses): –

SOFR and EFFR

Source: Chicago Federal Reserve Bank

In their discussion of how the Fed responded (on September 17th) to the squeeze the authors point out: –

…the (Fed) Desk offered $75 billion in repos, primary dealers bid for only $53 billion. On the margin, this meant that primary dealers were forgoing the opportunity to borrow at the operation’s minimum bid rate of 2.1% and lend money into repo markets that were still trading at much higher rates. This outcome suggests that there could be some limits to primary dealers’ willingness to redistribute funding to the broader market.

They suggest that this may be a function of the level of leverage already in the banking system. By September 19th the Fed were compelled to lower the interest rate on excess reserves – IOER. Finally the relationship between EFFR and SOFR returned to its normal range.

According to the authors the Fed have learnt from their hysteresis that adjustments to the IOER are also critical to control of money-markets, repo operations may not be sufficient in isolation. The chart below shows the spread between SOFR and IOER: –

IOER - SOFR

Source: Chicago Federal Reserve Bank

This is how the Fed describes the evolution of the relationship (the emphasis is mine): –

When the repo rate is below the interest rate on reserves, as it generally was from 2015 through March 2018, the supply of liquidity is so great that Treasury securities are very easy to finance and have a lower effective overnight yield than reserves. From March 2018 through March 2019, repo rates were generally very close to the interest rate on reserves. Then, beginning in the second quarter of 2019, repo rates ticked above the interest rate on reserves. Around the same time, money market rates started to exhibit slightly more upward pressure near tax payment deadlines. Most recently, just before the volatility in mid-September, the spread between SOFR and IOER on September 13 was the highest yet on the business day before a tax date in the period since the FOMC began normalizing monetary policy in late 2015.

This confirms my suspicion that since the financial crisis the Fed (and central banks in general) have become far more central to the smooth functioning of the financial markets. Actions such as QE are clear, the function of the lender of last resort is less so. Professor Perry Mehrling’s – The New Lombard Street (published in 2010 the wake of the financial crisis) discusses the changed role of the Fed in detail, it is well worth re-reading.

Conclusions

I normally end my newsletters with an investment proposal. This time my advice is of a different nature. During the financial crisis central banks saved the global financial system, but, as last month’s’ SOFR Squeeze makes clear, the patient is still on life support. The solution to too much debt has been the reduction of interest rates, but, because lower rates make debt financing easier, this has led to an even greater system-wide burden of debt. In the process the role of the central bank has become far more pivotal. They have reaped what they sowed, the financial markets still function, but they remain inherently fragile. If the Fed analysis of the reasons for the price spike are correct, a relatively small imbalance may, on another occasion, derail the entire market.

The advice? Batten down the hatches, maintain excess liquidity and prepare for the next stress-test of the overnight lending market.

Uncertainty and the countdown to the US presidential elections

Uncertainty and the countdown to the US presidential elections

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Macro Letter – No 120 – 13-09-2019

Uncertainty and the countdown to the US presidential elections

  • JP Morgan analyse the impact of 14,000 presidential Tweets
  • Gold breaks out to the upside despite US$ strength
  • China backs down slightly over Hong Kong
  • Trump berates Fed Chair and China

These are just a few of the news stories which drove financial markets during the summer: –

VOX – The Volfefe Index, Wall Street’s new way to measure the effects of Trump tweets, explained

DailyFX – Gold Prices Continue to Exhibit Strength Despite the US Dollar Breakout

BBC – Carrie Lam: Hong Kong extradition bill withdrawal backed by China

FT – Trump lashes out at China and US Federal Reserve — as it happened.

For financial markets it is a time of heightened uncertainty. The first two articles are provide a commentary on the way markets are evolving. The impact of social media is rising, with Trump in the vanguard. Geopolitical uncertainty and the prospect of fiscal debasement are, meanwhile, upsetting the normally inverse relationship between the price of gold and the US$.

The next two items are more market specific. The stand-off between the Chinese administration and the people of the semi-autonomous enclave of Hong Kong, prompts concern about the political stability of China, meanwhile the US Commander in Chief persists in undermining the credibility of the notionally independent Federal Reserve and seems unable to resist antagonising the Chinese administration as he raises the stakes in the Sino-US trade war. Financial markets have been understandably unsettled.

Ironically, despite the developments high-lighted above, during August, US bonds witnessed sharp reversals lower, suggesting that geopolitical tensions might have moderated. Since the beginning of September prices have rebounded, perhaps there were simply more sellers than buyers last month. In Europe, by contrast, German bunds reached new all-time highs, only to suffer sharp reversal in the past week. Equity markets responded to the political uncertainty in a more consistent manner, plunging and then recovering during the past month. As the chart below illustrates, there has been increasing debate about the challenge of increased volatility since the end of July: –

VIX Index Daily

Source: Investing.com

Yet, as always, it is not the volatility or even risk which presents a challenge to financial market operators, it is uncertainty. Volatility is a measure derived from the mean and variance of a price. It is a cornerstone of the measurement of financial risk: the key point is that it is measurable. Risk is something we can measure, uncertainty is that which we cannot. This is not a new observation, it was first made in 1921 by Frank Knight – Risk, Uncertainty and Profit.

Returning to the current state of the financial markets, we are witnessing a gradual erosion of belief in the omnipotence of central banks. See Macro Letter’s 48, 79 and 94 for some of my previous views. What has changed? As Keynes might have put it, ‘The facts.’ Central Banks, most notably the Bank of Japan, Swiss National Bank and European Central Bank, have been using zero or negative interest rate policy, in conjunction with balance sheet expansion, in a valiant attempt to stimulate aggregate demand. The experiment has been moderately successful, but the economy, rather like a chronic drug addict, requires an ever increasing fix to reach the same high.

In Macro Letter – No 114 – 10-05-2019 – Debasing the Baseless – Modern Monetary Theory – I discussed the latest scientific justification for debasement. My conclusion: –

The radical ideas contained in MMT are unlikely to be adopted in full, but the idea that fiscal expansion is non-inflationary provides succour to profligate politicians of all stripes. Come the next hint of recession, central banks will embark on even more pronounced quantitative and qualitative easing, safe in the knowledge that, should they fail to reignite their economies, government mandated fiscal expansion will come to their aid. Long-term bond yields will head towards the zero-bound – some are there already. Debt to GDP ratios will no longer trouble finance ministers. If stocks decline, central banks will acquire them: and, in the process, the means of production. This will be justified as the provision of permanent capital. Bonds will rise, stocks will rise, real estate will rise. There will be no inflation, except in the price of assets.

As this recent article from the Federal Reserve Bank of San Francisco – Negative Interest Rates and Inflation Expectations in Japan – indicates, even central bankers are beginning to doubt the efficacy of zero or negative interest rates, albeit, these comments emanate from the FRBSF research department rather than the president’s office. If the official narrative, about the efficacy of zero/negative interest rate policy, is beginning to change, state sponsored fiscal stimulus will have to increase dramatically to fill the vacuum. The methadone of zero rates and almost infinite credit will be difficult to quickly replace, I anticipate widespread financial market dislocation on the road to fiscal nirvana.

In the short run, we are entering a period of transition. Trump may continue to berate the chairman of the Federal Reserve and China, but his room for manoeuvre is limited. He needs Mr Market on his side to win the next election. For Europe and Japan the options are even more constrained. Come the next crisis, I anticipate widespread central bank buying of stocks (in addition to government and corporate bonds) in order to provide liquidity and insure economic stability. The rest of the task will fall to the governments. Non-inflationary fiscal profligacy will be de rigueur – I can see the politicians smiling all the way to the hustings, safe in the knowledge that deflationary forces have awarded them a free-lunch. Someone, someday, will have to pay, of course, but they will be long since retired from public office.

Conclusions and Investment Opportunities

During the next year, markets will continue to gyrate erratically, driven by the politics of European budgets, Brexit and the Sino-US trade war. These issues will be eclipsed by the twittering of Donald Trump as he seeks to win a second term in office. Looked at cynically, one might argue that Trump’s foreign policy has been deliberately engineered to slow the US economy and hold back the stock market. During the next 14 months, a new nuclear weapons agreement could be forged with Iran, relations with North Korea improved and a trade deal negotiated with China. Whether this geopolitical largesse is truly in the President’s gift remains unclear, but for a maker of deals such as Mr Trump, the prospect must be tantalising.

For the US$, the countdown to the US election remains positive, for stocks, likewise. For the bond market, the next year may be broadly neutral, but given the signs of faltering growth across the globe, it seems unlikely that yields will rise significantly. Economies will see growth slow, leading to an accelerated pace of debt issuance. Bouts of volatility, similar to August or Q4 2018, will become more commonplace. I remain bullish for asset markets, nonetheless.

AIER -U.S. Dollar Supremacy Could Quickly Fade

AIER -U.S. Dollar Supremacy Could Quickly Fade

American Institute for Economic Research

U.S. Dollar Supremacy Could Quickly Fade

As you may have seen elsewhere I have recently been invited to contribute to AIER. This article was first published in June.

https://www.aier.org/article/us-dollar-supremacy-could-quickly-fade

dollarfade

AIER also operate the Bastiat Society, a global network of business professionals committed to advancing free trade, individual freedom, and responsible governance. To find a chapter near you please click on the link below: –

https://www.aier.org/bastiatsociety/chapters

 

 

Low yield, no yield, negative yield – Buy now but don’t forget to sell

Low yield, no yield, negative yield – Buy now but don’t forget to sell

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Macro Letter – No 118 – 12-06-2019

Low yield, no yield, negative yield – Buy now but don’t forget to sell

  • The amount of negative yielding fixed securities has hit a new record
  • The Federal Reserve and the ECB are expected to resume easing of interest rates
  • Secondary market liquidity for many fixed income securities is dying
  • Outstanding debt is setting all-time highs

To many onlookers, since the great financial crisis, the world of fixed income securities has become an alien landscape. Yields on government bonds have fallen steadily across all developed markets. As the chart below reveals, there is now a record US$13trln+ of negative yielding fixed income paper, most of it issued by the governments’ of Switzerland, Japan and the Eurozone: –

Bloomberg - Negative Yield - 21st June 2019

Source: Bloomberg  

The percentage of Eurozone government bonds with negative yields is now well above 50% (Eur4.3trln) and more than 35% trades with yields which are more negative than the ECB deposit rate (-0,40%). If one adds in investment grade corporates the total amount of negative yielding bonds rises to Eur5.3trln. Earlier this month, German 10yr Bund yields dipped below the deposit rate for the first time, amid expectations that the ECB will cut rates by another 10 basis points, perhaps as early as September.

The idea that one should make a long-term investment in an asset which will, cumulatively, return less at the end of the investment period, seems nonsensical, except in a deflationary environment. With most central banks committed to an inflation target of around 2%, the Chinese proverb, ‘we live in interesting times,’ springs to mind, yet, negative yielding government bonds are now ‘normal times’ whilst, to the normal fixed income investor, they are anything but interesting. As Keynes famously observed, ‘Markets can remain irrational longer than I can remain solvent.’ Do not fight this trend, yields will probably turn more negative, especially if the ECB cuts rates and a global recession arrives regardless.

Today, government and investment grade corporate debt has been joined by a baker’s dozen of short-dated high yield Euro names. This article from IFR – ‘High-yield’ bonds turn negative – explains: –

About 2% of the euro high-yield universe is now negative yielding, according to Bank of America Merrill Lynch.

That percentage would rise to 10% if average yields fall by a further 35bp, said Barnaby Martin, European credit strategist at the bank.

He said the first signs of negative yielding high-yield bonds emerged about two weeks ago in the wake of Mario Draghi’s speech in Sintra where the ECB president hinted at a further dose of bond buying via the central bank’s corporate sector purchase programme. There are now more than 10 high-yield bonds in negative territory…

The move to negative yields for European high-yield credits is unprecedented; it didn’t even happen in 2016 when the ECB began its bond buying programme.

During Q4, 2018, credit spreads widened (and stock markets declined) amid expectations of further Federal Reserve tightening and an end to ECB QE. Now, stoked by fears of a global recession, rate expectation have reversed. The Fed are likely to ease, perhaps as early as this month. The ECB, under their new broom, Christine Lagarde, is expected to embrace further QE. The corporate sector purchase program (CSPP) which commenced in June 2016, already holds Eur177.8bln of corporate bonds, but increased corporate purchases seem likely; it is estimated that the ECB holds between 25% and 30% of the outstanding Eurozone government bond in issue, near to its self-imposed ceiling of 33%. Whilst the amount in issues is less, the central bank has more flexibility with Supranational and Euro denominated non-EZ Sovereigns (50%) and greater still with corporates (70%). In this benign interest rate environment, a continued compression of credit spreads is to be expected.

Yield compression has been evident in Eurozone government bonds for decades, but now a change in relationship is starting become evident. Even if the ECB does not increase the range of corporate bonds it purchases, its influence, like the rising tide, will float all ships. Bund yields are likely to remain most negative and the government obligations of Greece, the least, but, somewhere between these two poles, corporate bonds will begin to assume the mantle of the ‘nearly risk-free.’ With many Euro denominated high-yield issues trading below the yield offered for comparable maturity Italian BTPs, certain high-yield corporate credit is a de facto alternative to poorer quality government paper.

The chart below is a snap-shot of the 3m to 3yr Eurozone yield curve. The solid blue line shows the yield of AAA rated bonds, the dotted line, an average of all bonds: –

Eurozone AAA bond Yields vs All Bonds - ECB

Source: ECB

It is interesting to note that the yield on AAA bonds, with a maturity of less than two years, steadily becomes less negative, whilst the aggregated yield of all bonds continues to decline.

The broader high-yield market still offers positive yield but the Eurozone is likely to be the domicile of choice for new issuers, since Euro high-yield now trades at increasingly lower yields than the more liquid US market, the liquidity tail is wagging the dog: –

US vs EZ HY - Bloomberg

Source: Bloomberg, Barclays

The yield compression within the Eurozone has been more dramatic but it has been mirrored by the US where the spread between BBB and BB narrowed to a 12 year low of 60 basis points this month.

Wither away the dealers?

Forgotten, amid the inexorable bond rally, is dealer liquidity, yet it is essential, especially when investors rush for the exit simultaneously. For corporate bond market-makers and brokers the impact of QE has been painful. If the ECB is a buyer of a bond (and they pre-announce their intentions) then the market is guaranteed to rise. Liquidity is stifled in a game of devil take the hindmost. Alas, non-eligible issues, which the ECB does not deign to buy, find few natural buyers, so few institutions can justify purchases when credit default risk remains under-priced and in many cases the yield to maturity is negative.

An additional deterrent is the cost of holding an inventory of fixed income securities. Capital requirements for other than AAA government paper have increased since 2009. More damaging still is the negative carry across a wide range of instruments. In this environment, liquidity is bound to be impaired. The danger is that the underlying integrity of fixed income markets has been permanently impaired, without effective price intermediation there is limited price discovery: and without price discovery there is a real danger that there will be no firm, ‘dealable’ prices when they are needed most.

In this article from Bloomberg – A Lehman Survivor Is Prepping for the Next Credit Downturn – the interviewee, Pilar Gomez-Bravo of MFS Investment Management, discusses the problem of default risk in terms of terms of opacity (the emphasis is mine): –

Over a third of private high-yield companies in Europe, for example, restrict access to financial data in some way, according to Bloomberg analysis earlier this year. Buyers should receive extra compensation for firms that curb access to earnings with password-protected sites, according to Gomez-Bravo.

Borrowers still have the upper hand in the U.S. and Europe. Thank cheap-money policies and low defaults. Speculation the European Central Bank is preparing for another round of quantitative easing is spurring the rally — and masking fragile balance sheets.

Borrowers still have the upper hand indeed, earlier this month Italy issued a Eur3bln tranche of its 2.8% coupon 50yr BTP; there were Eur17bln of bids from around 200 institutions (bid/cover 5.66, yield 2.877%). German institutions bought 35% of the issue, UK investors 22%. The high bid/cover ratio is not that surprising, only 1% of Euro denominated investment grade paper yields more than 2%.

I am not alone in worrying about the integrity of the bond markets in the event of another crisis, last September ESMA –  Liquidity in EU fixed income markets – Risk indicators and EU evidence concluded: –

Episodes of short-term volatility and liquidity stress across several markets over the past few years have increased concerns about the worsening of secondary market liquidity, in particular in the fixed income segment…

…our findings show that market liquidity has been relatively ample in the sovereign segment, potentially also due to the effects of supportive economic policies over more recent years. This is different from our findings in the corporate bond market, where in recent years we did not find systematic and significant drop in market liquidity but we observed episodes of decreasing market liquidity when market conditions deteriorated…

We find that in the sovereign bond segment, bonds that have a benchmark status and are characterised by larger outstanding amounts tend to be more liquid while market volatility is negatively related to market liquidity. Outstanding amounts are the main bond-level drivers in the corporate bond segment…

With reference to corporate bond markets, the sensitivity of bond liquidity to bond-specific and market factors is larger when financial markets are under stress. In particular, bonds characterised by more volatile market liquidity are found to be more vulnerable in periods of market stress. This empirical result is consistent with the market liquidity indicators developed for corporate bonds pointing at episodes of decreasing market liquidity when wider market conditions deteriorate.

ESMA steer clear of discussing negative yields and their impact on the profitability of market-making, but the BIS annual economic report, published last month, has no such qualms (the emphasis is mine): –

Household debt has reached new historical peaks in a number of economies that were not at the heart of the GFC, and house price growth has in many cases stalled. For a group of advanced small open economies, average household debt amounted to 101% of GDP in late 2018, over 20 percentage points above the pre-crisis level… Moreover, household debt service ratios, capturing households’ principal and interest payments in relation to income, remained above historical averages despite very low interest rates…

…corporate leverage remained close to historical highs in many regions. In the United States in particular, the ratio of debt to earnings in listed firms was above the previous peak in the early 2000s. Leverage in emerging Asia was still higher, albeit below the level immediately preceding the 1990s crisis. Lending to leveraged firms – i.e. those borrowing in either high-yield bond or leveraged loan markets – has become sizeable. In 2018, leveraged loan issuance amounted to more than half of global publicly disclosed loan issuance loans excluding credit lines.

… following a long-term decline in credit quality since 2000, the share of issuers with the lowest investment grade rating (including financial firms) has risen from around 14% to 45% in Europe and from 29% to 36% in the United States. Given widespread investment grade mandates, a further drop in ratings during an economic slowdown could lead investors to shed large amounts of bonds quickly. As mutual funds and other institutional investors have increased their holdings of lower-rated debt, mark-to-market losses could result in fire sales and reduce credit availability. The share of bonds with the lowest investment grade rating in investment grade corporate bond mutual fund portfolios has risen, from 22% in Europe and 25% in the United States in 2010 to around 45% in each region.

How financial conditions might respond depends also on how exposed banks are to collateralised loan obligations (CLOs). Banks originate more than half of leveraged loans and hold a significant share of the least risky tranches of CLOs. Of these holdings, US, Japanese and European banks account for around 60%, 30% and 10%, respectively…

…the concentration of exposures in a small number of banks may result in pockets of vulnerability. CLO-related losses could reveal that the search-for-yield environment has led to an underpricing and mismanagement of risks…

In the euro area, the deterioration of the growth outlook was more evident, and so was its adverse impact on an already fragile banking sector. Price-to-book ratios fell further from already depressed levels, reflecting increasing concerns about banks’ health…

Unfortunately, bank profitability has been lacklustre. In fact, as measured, for instance, by return-on-assets, average profitability across banks in a number of advanced economies is substantially lower than in the early 2000s. Within this group, US banks have performed considerably better than those in the euro area, the United Kingdom and Japan…

…persistently low interest rates and low growth reduce profits. Compressed term premia depress banks’ interest rate margins from maturity transformation. Low growth curtails new loans and increases the share of non-performing ones. Therefore, should growth decline and interest rates continue to remain low following the pause in monetary policy normalisation, banks’ profitability could come under further pressure.

Conclusion and investment opportunities

Back in 2006, when commodity investing, as part of a diversified portfolio, was taking the pension fund market by storm, I gave a series of speeches in which I beseeched fund managers to consider carefully before investing in commodities, an asset class which had for more than 150 years exhibited a negative expected real return.

An astonishingly large percentage of fixed income securities are exhibiting similar properties today. My advice, then for commodities and today, for fixed income securities, is this, ‘By all means buy, but remember, this is a trading asset, its long-term expected return is negative; in other words, please, don’t forget to sell.’

Trade Wars, the prospects for freer trade and the impact on asset prices

Trade Wars, the prospects for freer trade and the impact on asset prices

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Macro Letter – No 115 – 24-05-2019

Trade Wars, the prospects for freer trade and the impact on asset prices

  • Will the Sino-US trade war breed contagion?
  • Will the dispute trigger a global recession?
  • Has the era of freer trade ended?
  • Will asset prices suffer?

As Sino-US trade talks ended, not only, without a deal, but with another sharp increase in tariffs, it is worth looking at what has happened and why. During 2018 the US reversed 38 years of tariff reduction with a radical abruptness, imposing tariffs on 50% of Chinese imports, China retaliated in kind, imposing tariffs on 70% of US imports. The Peterson Institute – The 2018 US-China Trade Conflict after 40 Years of Special Protection – published before the recent tariff increases, reviews the situation in detail. The author, Chad Brown, begins by looking at the tariff reductions since the late 1980’s. For the US, these tariffs had fallen from 5% to 3%, whilst for China they declined from 40% to 8% by 2017. Over the same period China’s share of US imports rose from near to zero in 1978 to 20% by 2014. By contrast, Chinese imports from the US rose steadily, reaching 10% in 2001 – which coincided with their ascension to the World Trade Organisation (WTO) – however, since then, imports from the US have declined, dipping to 8.5% by 2017. In bilateral terms Chinese imports from the US are about a quarter of her exports to the land of the free.

At first sight, it might seem as if the trade tensions between China and the US are new, but relations have been deteriorating since the bursting of the US Tech bubble in 2001, if not before. Looking at the chart below, which measures antidumping and countervailing tariffs, it appears as if the Chinese did not begin to retaliate until 2006: –

US China countervaling tariffs 1980 to 2018

Source: Peterson Institute

Analysing anti-dumping and countervailing tariffs in isolation, however, gives a misleading impression of the US response to China. Peterson research attempts to assess the entire scope of the Sino-US trade dispute, by incorporating all forms of US special protection against China over the entire period. The next chart shows the true scale of US tariff reduction on Chinese imports; seen in this light, the extent of the recent policy shift is even more dramatic: –

US special prtections against China

Source: Peterson Institute

Using this combined metric, US special protection peaked at 39% in 1986, after which these barriers declined rapidly reaching a nadir at 4.3% in 2005. On the eve of the trade war in 2017 barriers had risen to 8.1%. Prior to the May 10th tariff increase, that figure had jumped to 50%. An updated version of the Peterson chart of shown below: –

Sino-US Tariff update since May 1oth 2019

Source: Peterson Institute

The additional tariffs imposed this month will raise the average US tariff on Chinese goods to 18.3%. If Trump follows through with his threat to impose a 25% tariff on most of the rest of US imports from China, the average US tariff toward China would increase to 27.8%.

Sino-US Tariffs 2017 - 2019

Source: Peterson Institute

What is the likely impact of these actions on trade and prices? For the US, import prices will increase, but given that US inflation has tended to be below the Fed target, this is manageable; corporates and consumers will pay the cost of tariffs, the tax receipts will help to finance the cost of recent US tax cuts. In China, whilst the impact is still negative, as this recent article from CFR – China Never Stopped Managing its Trade makes clear, the majority of imports are made by state owned enterprises or by companies which have a government permit to import such goods, added to which Chinese inflation has also been reasonably subdued, despite impressive continued economic expansion: –

When the state controls the firms that are doing the importing, a few phone calls can have a big impact. That’s why China can shut down trade in canola with Canada without formally introducing any tariffs.

That’s why China can scale back its purchases of Australian coal without filing a “dumping” or “national security” tariffs case.

And that’s why—when the trade war with the United States started—U.S. exports in a number of goods simply went to zero (normally, a 25 percent tariff would reduce imports by more like 50 percent or something…]

For US companies the four largest exports to China are aircraft, automobiles, soybeans and oil and gas. Of these, only automobiles are sold directly to the private sector. Here are three charts which explain why, for the US (at least in the near-term) there may be less to lose in this global game of chicken: –

Auto Exports to China

Source: US Census Bureau, Haver Analytics

Soybean Exports to China

Source: US Census Bureau, Haver Analytics

Ooil and Gas Exports to China

Source: US Census Bureau, Haver Analytics

The decline in US imports has been driven by a combination of substitution for imports from other sources and a rising domestic capability to manufacture intermediate goods. Faced with a dwindling market for their exports, the US might be forgiven for wishing to retire from the fray whilst it still has the advantage of being the ‘consumer of last resort’.

To date, US government receipts from tariff increases have amounted to an estimated $2bln. A study by the World Bank and the International Finance Corporation, however, estimates the true cost the US economy has been nearer to $6.4bln or 0.03% of GDP. The chart below shows the already substantial divergence between prices for tariff versus non-tariff goods: –

tariffs-inflation

Source: Financial Sense, US Department of Labor, Commerce department, Goldman Sachs

The impact on China is more difficult to measure since Chinese statistics are difficult interpret, however, only 18% of Chinese exports are to the US – that equates to $446bln out of a total of $2.48trln in 2018, added to which, exports represent only 20% of Chinese GDP – all US imports amount to 3.6% of Chinese GDP.

The scale of the dispute (bilateral rather than multilateral) should not detract from its international significance. One institution which seen its credibility undermined by the imposition of US tariffs is the World Trade Organisation (WTO) – Chatham House – The Path Forward on WTO Reform provides an excellent primer to this knotty issue. Another concern, for economists, is that history is repeating itself. They fear Trump’s policies are a redux of the infamous Smoot-Hawley tariffs, imposed during the great depression. Peterson – Does Trump Want a Trade War? from March 2018 and Trump’s 2019 Protection Could Push China Back to Smoot-Hawley Tariff Levels published this month are instructive on this topic. These tariffs were implemented on 17th June 1930 and applied to hundreds of products. To put today’s dispute in perspective, the 1930’s tariff increase was only from 38% to 45% – a mere 18% increase – this month tariffs have increased from 10% to 25%: a 150% increase. Those who note that 25% is still well below 1930’s levels should not be complaisant, China remains a WTO member, were it not, US average tariffs would now be 38%. Back in 2016 President Trump talked of raising tariffs on Chinese imports to 45%, a number cunningly lifted from the Smoot-Hawley playbook.

One of the counter-intuitive effects of the 1930’s tariff increase was price deflation, in part due to many tariffs being imposed on a per unit cost basis. Today, per unit tariffs apply to only around 8% of goods, added to which, due to monetary engineering, by central banks, and the issuance of fiat currency by governments, the threat of real deflation is less likely.

Another risk is that the Sino-US spat engulfs other countries. The EU (especially Germany) has already suffered the ire of the US President. Recent trade deals between the EU and both Canada and Japan, have been heralded as a triumph for free-trade, however, they are an echo of the trading blocs which formed during the 1930’s. To judge by Trump’s recent tweets, for the moment, China has been singled out, on 13th May the President said: –

“Also, the Tariffs can be completely avoided if you buy from a non-Tariffed Country, or you buy the product inside the USA (the best idea). That’s Zero Tariffs. Many Tariffed companies will be leaving China for Vietnam and other such countries in Asia. That’s why China wants to make a deal so badly!”

Even if the trade dispute remains a Sino-US affair, there are other unseen costs to consider, on productivity and investment, Bruegal – Implications of the escalating China-US trade dispute takes up the discussion (emphasis mine): –

The direct aggregate effect of the tariffs on the welfare of the US and Chinese, while negative, is likely to be very small… because they represent a transfer from consumers, importers and partner exporters to the government… sooner or later, the American consumer will bear much of the cost of the tariff though higher prices, but also that tariff revenue will return to American residents in some form. The negative aggregate welfare effect of tariffs thus arises because, at the margin, they displace more efficient producers by less efficient ones… because, at the margin, tariffs artificially reduce the consumption or use of imports in favour of domestic goods or goods imported from third parties…

The distributional effect of tariffs is likely to be very uneven and severely negative on some people and sectors… while the Treasury will see increased revenue, and some producers who compete with imports will gain, small companies that depend on imported parts from China are likely to be very badly affected by tariffs…

Larger importers will also be adversely affected… US farmers who depend on Chinese markets have already been badly hurt by Chinese retaliation…

The biggest adverse effects of tariffs on aggregate economic activity is through investment. Lower investment is the natural result of the tariffs’ big distributional effects… and the uncertainty they engender. This effect on ‘animal spirits’ is difficult to model and impossible to quantify with precision… The extraordinary sensitivity of stock markets to trade news and their volatility is just one manifestation of this effect. The widening growth gap between the global manufacturing and services sectors evident in recent quarters is another, as is the slowdown in investment in many countries.

Bruegal go on to discuss the risk to the international trading system and the damage to the credibility of the WTO. Finally they suggest that the trade dispute is a kind of proxy-war between the two super-powers: this is much more than just a trade dispute.

Putting the Sino-US dispute in an historical context, a number of commentators have drawn comparisons between China today and Japan in the 1980’s. I believe the situation is quite different, as will be the outcome. Again, I defer to Bruegal – Will China’s trade war with the US end like that of Japan in the 1980s?  The author’s argue that Japan chose to challenge the US when it was close to its economic peak and its productivity was stagnating. China, by contrast, has a younger population, rapidly improving productivity and, most importantly, remains a significant way below its economic peak: –

…Because China is at an earlier stage of economic development, it is expected to challenge the US hegemony for an extended period of time. Therefore, the US-China trade war could last longer than the one with Japan. With China’s growth prospects still relatively solid –  it will soon overtake the US economy in size and it does not depend on the US militarily – China will likely challenge US pressure in the ongoing negotiations for a settlement to the trade war. This also means that any deal will only be temporary, as the US will not be able to contain China as easily as it contained Japan.

If you are looking for a more global explanation of the current dispute between the US and China, then this article from CFR – The Global Trading System: What Went Wrong and How to Fix It is instructive: –

As economist Richard Baldwin lays out in his book The Great Convergence, the Industrial Revolution of the 19th century had launched Europe, the US, Japan and Canada on a trajectory that would see their wealth surge ahead of the rest of the world. In 1820, for example, incomes in the US were about three times those of China; by 1914 Americans would be 10 times as wealthy as Chinese. Manufacturing clustered in the technologically advanced countries, while advances in containerized shipping and the lowering of tariffs through trade negotiations made it possible for these countries to specialize and trade in the classic Ricardian fashion.

The information technology revolution of the 1990s turned that story upside down. With the advent of cheap, virtually instant global communications via the Internet, it became possible – and then imperative for competitive success – for multinational companies to take their best technologies and relocate production in lower-wage countries. Manufacturing output rose in middle-income countries like China, India, Thailand, Poland and others, while falling sharply in the US, Japan, France, the UK and even Germany…

The global great convergence, however, coincided with a great divergence within the wealthy countries (and many developing countries as well). The new technologies and the disappearance of trade barriers upended the balance between labor and capital in the advanced industrialized countries, and contributed to soaring economic inequality…

In the US in 1979, an American with a college degree or higher earned about 50% more than one who had only a high school education or less. By 2018, American workers with a four-year college degree earned almost twice as much as those with just a high-school education, and were unemployed half as often, while those with a professional degree earned nearly three times as much.

The author goes on to liken today’s tension between the US and China with the situation which existed between the UK and US at the beginning of the 20th century: –

The world today again faces the same governance gap – a US that no longer has the economic muscle nor the political will to organize the global system, and a rising China that is reluctant to play a greater role.

CFR ask what the prospects maybe for renewed globalization? They identify three key elements which need to be addressed in order for de-globalisation to be reversed: a trade war truce (once both sides wake up to the extent of the empasse they have engineered), a filling the Leadership Vacuum (caused by both sides turning their backs on the WTO – they need to reengage and lead the world towards a solution) and, especially for the US, meeting the challenges at home (Trump cannot rely on a trade war in the long-run to solve the problem of inequality within the US).

Conclusions and investment opportunities

What is the likely impact on financial markets? To answer this question one needs to know whether the current trade war will escalate or dissipate: and if it escalates, will it be short and sharp or protracted and pernicious?

Alisdair Macleod of Gold Money – Post-tariff considerations identifies the following factors: –

The effect of the new tariff increases on trade volumes

The effect on US consumer prices

The effect on US production costs of tariffs on imported Chinese components

The consequences of retaliatory action on US exports to China

The recessionary impact of all the above on GDP

The consequences for the US budget deficit, allowing for likely tariff income to the US Treasury

Leading, in MacLeod’s opinion, to: –

Reassessment of business plans in the light of market information

A tendency for bank credit to contract as banks anticipate heightened lending risk

Liquidation of financial assets held by banks as collateral

Foreign liquidation of USD assets and deposits

The government’s borrowing requirement increasing unexpectedly

Bond yields rising to discount increasing price inflation

Banks facing increasing difficulties and the re-emergence of systemic risk

The author suggests that, all other things equal, tariffs should lead to price increases, but, with the US consumer already heavily burdened with debt, consumption demand will suffer.

I am less bearish than MacLeod because, if the Sino-US trade war threatens to puncture the decade long equity bull-market, we will see a combination of qualitative and quantitative easing from the largest central banks and aggressive fiscal stimulus from the governments of G20 and beyond. I wrote about this scenario (though without reference to the trade war) earlier this month in Macro Letter – No 114 – 10-05-2019 – Debasing the Baseless – Modern Monetary Theory. My, perhaps overly simple, prediction for assets in the longer-term is: bonds up, stocks up and real estate up.

In an alternative scenario, we might encounter asset price deflation and consumer price inflation occurring simultaneously. Worse still, this destructive combination of forces might coinciding with a global recession. The severity of any recession – and the inevitable correction to financial markets that such an economic downturn would precipitate – will depend entirely on the time it takes for US and Chinese trade negotiators to realise the danger and reach a compromise. I believe they will do so relatively quickly.

Attempting to predict what President Trump might do next is fraught with danger, but, due to the inherent weakness of the democratic process, I expect the US administration to concede. The US President has an election to win in November 2020; the President of China has been elected for life.

Central bank balance sheet reductions – will anyone follow the Fed?

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Macro Letter – No 110 – 15-02-2019

Central bank balance sheet reductions – will anyone follow the Fed?

  • The next wave of QE will be different, credit spreads will be controlled
  • The Federal Reserve may continue to tighten but few other CB’s can follow
  • ECB balance sheet reduction might occur if a crisis does not arrive first
  • Interest rates are likely to remain structurally lower than before 2008

The Federal Reserve’s response to the great financial recession of 2008/2009 was swift by comparison with that of the ECB; the BoJ was reticent, too, due to its already extended balance sheet. Now that the other developed economy central banks have fallen into line, the question which dominates markets is, will other central banks have room to reverse QE?

Last month saw the publication of a working paper from the BIS – Risk endogeneity at the lender/investor-of-last-resort – in which the authors investigate the effect of ECB liquidity provision, during the Euro crisis of 2010/2012. They also speculate about the challenge balance sheet reduction poses to systemic risk. Here is an extract from the non-technical summary (the emphasis is mine): –

The Eurosystem’s actions as a large-scale lender- and investor-of-last-resort during the euro area sovereign debt crisis had a first-order impact on the size, composition, and, ultimately, the credit riskiness of its balance sheet. At the time, its policies raised concerns about the central bank taking excessive risks. Particular concern emerged about the materialization of credit risk and its effect on the central bank’s reputation, credibility, independence, and ultimately its ability to steer inflation towards its target of close to but below 2% over the medium term.

Against this background, we ask: Can central bank liquidity provision or asset purchases during a liquidity crisis reduce risk in net terms? This could happen if risk taking in one part of the balance sheet (e.g., more asset purchases) de-risks other balance sheet positions (e.g., the collateralized lending portfolio) by a commensurate or even larger amount. How economically important can such risk spillovers be across policy operations? Were the Eurosystem’s financial buffers at all times sufficiently high to match its portfolio tail risks? Finally, did past operations differ in terms of impact per unit of risk?…

We focus on three main findings. First, we find that (Lender of last resort) LOLR- and (Investor of last resort) IOLR-implied credit risks are usually negatively related in our sample. Taking risk in one part of the central bank’s balance sheet (e.g., the announcement of asset purchases within the Securities Market Programme – SMP) tended to de-risk other positions (e.g., collateralized lending from previous longer-term refinancing operations LTROs). Vice versa, the allotment of two large-scale (very long-term refinancing operations) VLTRO credit operations each decreased the one-year-ahead expected shortfall of the SMP asset portfolio. This negative relationship implies that central bank risks can be nonlinear in exposures. In bad times, increasing size increases risk less than proportionally. Conversely, reducing balance sheet size may not reduce total risk by as much as one would expect by linear scaling. Arguably, the documented risk spillovers call for a measured approach towards reducing balance sheet size after a financial crisis.

Second, some unconventional policy operations did not add risk to the Eurosystem’s balance sheet in net terms. For example, we find that the initial OMT announcement de-risked the Eurosystem’s balance sheet by e41.4 bn in 99% expected shortfall (ES). As another example, we estimate that the allotment of the first VLTRO increased the overall 99% ES, but only marginally so, by e0.8 bn. Total expected loss decreased, by e1.4 bn. We conclude that, in extreme situations, a central bank can de-risk its balance sheet by doing more, in line with Bagehot’s well-known assertion that occasionally “only the brave plan is the safe plan.” Such risk reductions are not guaranteed, however, and counterexamples exist when risk reductions did not occur.

Third, our risk estimates allow us to study past unconventional monetary policies in terms of their ex-post ‘risk efficiency’. Risk efficiency is the notion that a certain amount of expected policy impact should be achieved with a minimum level of additional balance sheet risk. We find that the ECB’s Outright Monetary Transactions – OMT program was particularly risk efficient ex-post since its announcement shifted long-term inflation expectations from deflationary tendencies toward the ECB’s target of close to but below two percent, decreased sovereign benchmark bond yields for stressed euro area countries, while lowering the risk inherent in the central bank’s balance sheet. The first allotment of VLTRO funds appears to have been somewhat more risk-efficient than the second allotment. The SMP, despite its benefits documented elsewhere, does not appear to have been a particularly risk-efficient policy measure.

This BIS research is an important assessment of the effectiveness of ECB QE. Among other things, the authors find that the ‘shock and awe’ effectiveness of the first ‘quantitative treatment’ soon diminished. Liquidity is the methadone of the market, for QE to work in future, a larger and more targeted dose of monetary alchemy will be required.

The paper provides several interesting findings, for example, the Federal Reserve ‘taper-tantrum’ of 2013 and the Swiss National Bank decision to unpeg the Swiss Franc in 2015, did not appear to influence markets inside the Eurozone, once ECB president, Mario Draghi, had made its intensions plain. Nonetheless, the BIS conclude that (emphasis, once again, is mine): –

…collateralized credit operations imply substantially less credit risks (by at least one order of magnitude in our crisis sample) than outright sovereign bond holdings per e1 bn of liquidity owing to a double recourse in the collateralized lending case. Implementing monetary policy via credit operations rather than asset holdings, whenever possible, therefore appears preferable from a risk efficiency perspective. Second, expanding the set of eligible assets during a liquidity crisis could help mitigate the procyclicality inherent in some central bank’s risk protection frameworks.

In other words, rather than exacerbate the widening of credit spreads by purchasing sovereign debt, it is preferable for central banks to lean against the ‘flight to quality’ tendency of market participants during times of stress.

The authors go on to look at recent literature on the stress-testing of central bank balance sheets, mainly focussing on analysis of the US Federal Reserve. Then they review ‘market-risk’ methods as a solution to the ‘credit-risk’ problem, employing non-Gaussian methods – a prescient approach after the unforeseen events of 2008.

Bagehot thou shouldst be living at this hour (with apologies to Wordsworth)

The BIS authors refer on several occasions to Bagehot. I wonder what he would make of the current state of central banking? Please indulge me in this aside.

Walter Bagehot (1826 to 1877) was appointed by Richard Cobden as the first editor of the Economist. He is also the author of perhaps the best known book on the function of the 19th century money markets, Lombard Street (published in 1873). He is famed for inventing the dictum that a central bank should ‘lend freely, at a penalty rate, against good collateral.’ In fact he never actually uttered these words, they have been implied. Even the concept of a ‘lender of last resort’, to which he refers, was not coined by him, it was first described by Henry Thornton in his 1802 treatise – An Enquiry into the Nature and Effects of the Paper Credit of Great Britain.

To understand what Bagehot was really saying in Lombard Street, this essay by Peter Conti-Brown – Misreading Walter Bagehot: What Lombard Street Really Means for Central Banking – provides an elegant insight: –

Lombard Street was not his effort to argue what the Bank of England should do during liquidity crises, as almost all people assume; it was an argument about what the Bank of England should openly acknowledge that it had already done.

Bagehot was a classical liberal, an advocate of the gold standard; I doubt he would approve of the nature of central banks today. He would, I believe, have thrown his lot in with the likes of George Selgin and other proponents of Free Banking.

Conclusion and Investment Opportunities

Given the weakness of European economies it seems unlikely that the ECB will be able to follow the lead of the Federal Reserve and raise interest rates in any meaningful way. The unwinding of, at least a portion of, QE might be easier, since many of these refinancing operations will naturally mature. For arguments both for and against CB balance sheet reduction this paper by Charles Goodhart – A Central Bank’s optimal balance sheet size? is well worth reviewing. A picture, however, is worth a thousand words, although I think the expected balance sheet reduction may be overly optimistic: –

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Source: IMF, Haver Analytics, Fulcrum Asset Management

Come the next crisis, I expect the ECB to broaden the range of eligible securities and instruments that it is prepared to purchase. The ‘Draghi Put’ will gain greater credence as it encompasses a wider array of credits. The ‘Flight to Quality’ effect, driven by swathes of investors forsaking equities and corporate bonds, in favour of ‘risk-free’ government securities, will be shorter-lived and less extreme. The ‘Convergence Trade’ between the yields of European government bonds will regain pre-eminence; I can conceive the 10yr BTP/Bund spread testing zero.

None of this race to zero will happen in a straight line, but it is important not to lose sight of the combined power of qualitative and quantitative easing. The eventual ‘socialisation’ of common stock is already taking place in Japan. Make no mistake, it is already being contemplated by a central bank near you, right now.

A world of debt – where are the risks?

A world of debt – where are the risks?

In the Long Run - small colour logo

Macro Letter – No 108 – 18-01-2019

A world of debt – where are the risks?

  • Private debt has been the main source of rising debt to GDP ratios since 2008
  • Advanced economies have led the trend
  • Emerging market debt increases have been dominated by China
  • Credit spreads are a key indicator to watch in 2019

Since the financial crisis of 2008/2009 global debt has increased to reach a new all-time high. This trend has been documented before in articles such as the 2014 paper from the International Center for Monetary and Banking Studies – Deleveraging? What deleveraging? The IMF have also been built a global picture of the combined impact of private and public debt. In a recent publication – New Data on Global Debt – IMF – the authors make some interesting observations: –

Global debt has reached an all-time high of $184 trillion in nominal terms, the equivalent of 225 percent of GDP in 2017. On average, the world’s debt now exceeds $86,000 in per capita terms, which is more than 2½ times the average income per-capita.

The most indebted economies in the world are also the richer ones. You can explore this more in the interactive chart below. The top three borrowers in the world—the United States, China, and Japan—account for more than half of global debt, exceeding their share of global output.

The private sector’s debt has tripled since 1950. This makes it the driving force behind global debt. Another change since the global financial crisis has been the rise in private debt in emerging markets, led by China, overtaking advanced economies. At the other end of the spectrum, private debt has remained very low in low-income developing countries.

Global public debt, on the other hand, has experienced a reversal of sorts. After a steady decline up to the mid-1970s, public debt has gone up since, with advanced economies at the helm and, of late, followed by emerging and low-income developing countries.

The recent picture suggests that the old world order, dominated by advanced economies, may be changing. For investors, this is an important consideration. Total debt in 2017 had exceeded the previous all-time high by more than 11%, however, the global debt to GDP ratio fell by 1.5% between 2016 and 2017, led by developed nations.

Setting aside the absolute level of interest rates, which have finally begun to rise from multi-year lows, it makes sense for rapidly aging, developed economies, to begin reducing their absolute level of debt, unfortunately, given that unfunded pension liabilities and the escalating cost of government healthcare provision are not included in the data, the IMF are only be portraying a partial picture of the state of developed economy obligations.

For emerging markets, the trauma of the 1998 Asian Crisis has finally waned. In the decade since the great financial recession of 2008 emerging economies, led by China, have increased their borrowing. This is clearly indicated in the chart below: –

eng-december-26-global-debt-1

Source: IMF

The decline in the global debt to GDP ratio in 2017 is probably related to the change in Federal Reserve policy; the largest proportion of global debt is still raised in US$. Rather like the front-loaded US growth which transpired due the threat of tariff increases on US imports, I suspect, debt issuance spiked in expectation of a reversal of quantitative easing and an end to ultra-low US interest rates.

The IMF goes on to show the breakdown of debt by country, separating them into three groups; advanced economies, emerging markets and low income countries. The outlier is China, an emerging market with a debt to GDP ratio comparable to that of an advanced economy. The table below may be difficult to read (an interactive one is available on the IMF website): –

imf chart of debt by country december 2018

Source: IMF

At 81%, China’s private debt is much greater than its public debt, meanwhile its debt to GDP ratio is 254% – comparable with the US (256%). Fortunately, the majority of Chinese private debt is denominated in local currency. Advanced economies have higher debt to GDP ratios but their government debt ratios are relatively modest, excepting Japan. The Economist – Economists reconsider how much governments can borrow – provides food for thought on this subject.

Excluding China, emerging markets and low income countries have relatively similar levels of debt relative to GDP. In general, the preponderance of government debt in lower ratio countries reflects the lack of access to capital markets for private sector borrowers.

Conclusions and Investment Opportunities

Setting aside China, which, given its control on capital flows and foreign exchange reserves is hard to predict, the greatest risk to world financial markets appears to be from the private debt of advanced economies.

Following the financial crisis of 2008, corporate credit spreads narrowed, but not by as much as one might have anticipated, as interest rates tended towards the zero bound. The inexorable quest for yield appears to have been matched by equally enthusiastic issuance. The yield-quest also prompted the launch of a plethora of private debt investment products, offering enticing returns in exchange for illiquidity. An even more sinister trend has been the return of many of the products which exacerbated the financial crisis of 2008 – renamed, repackaged and repurposed. These investments lack liquidity and many are leveraged in order to achieve acceptable rates of return.

The chart below shows the 10yr maturity Corporate Baa spread versus US Treasuries since March 2007: –

baa 10yr spread 2007 to 2019

Source: Federal Reserve Bank of St Louis

The Baa spread has widened since its low of 1.58% in January 2018, but, at 2.46%, it is still only halfway between the low of 2018 and the high of February 2016 (3.6%).

The High Yield Bond spread experienced a more dramatic reaction into the close of 2018, but, since the beginning of January, appears to have regained its composure. The chart shows the period since September 2015: –

high yield spread 10yr 2016 to 2019

Source: Federal Reserve Bank of St Louis

Nonetheless, this looks more like a technical break-out. The spread may narrow to retest the break of 4% seen on November 15th, but the move looks impulsive. A return to the 3.25% – 3.75% range will be needed to quell market fears of an imminent full-blown credit-crunch.

If the next crisis does emanate from the private debt markets, governments will still be in a position to intervene; the last decade has taught us to accept negative government bond yields as a normal circumstance. Demographic trends have even led long dated interest rate swaps to trade even lower than risk-free assets.

A decade after the financial crisis, markets are fragile and, with an ever increasing percentage of capital market transactions dictated by non-bank liquidity providers, liquidity is ever more transitory. Credit spreads have often been the leading indicator of recessions, they may not provide the whole picture this time, but we should watch them closely during 2019.