Global Real Estate – Has the tide begun to recede?

Global Real Estate – Has the tide begun to recede?

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Macro Letter – No 113 – 19-04-2019

Global Real Estate – Has the tide begun to recede?

  • Despite the fourth quarter shakeout in stocks, real estate values keep rising
  • Financial conditions remain key, especially in a low rate environment
  • Isolated instances of weakness have yet to breed contagion
  • The reversal of central bank tightening has averted a more widespread correction

I last wrote about the prospects for global real estate back in February 2018 in Macro Letter – No 90 – A warning knell from the housing market – inciting a riot? I concluded: –

The residential real estate market often reacts to a fall in the stock market with a lag. As commentators put it, ‘Main Street plays catch up with Wall Street.’ The Central Bank experiment with QE, however, makes housing more susceptible to, even, a small rise in interest rates. The price of Australian residential real estate is weakening but its commodity rich cousin, Canada, saw major cities price increases of 9.69% y/y in Q3 2017. The US market also remains buoyant, the S&P/Case-Shiller seasonally-adjusted national home price index rose by 3.83% over the same period: no sign of a Federal Reserve policy mistake so far.

As I said at the beginning of this article, all property investment is ‘local’, nonetheless, Australia, which has not suffered a recession for 26 years, might be a leading indicator. Contagion might seem unlikely, but it could incite a riot of risk-off sentiment to ripple around the globe.

More than a year later, central bank interest rates seem to have peaked (if indeed they increased at all) bond yields in most developed countries are falling again and, another round of QE is hotly anticipated, at the first hint of a global, or even regional, slowdown in growth.

In the midst of this sea-change from tightening to easing, an article from the IMF – Assessing the Risk of the Next Housing Bust – appeared earlier this month, in which the authors remind us that housing construction and related spending account for one sixth of US and European GDP. A boom and subsequent bust in house prices has been responsible for two thirds of recessions during the past few decades, nonetheless, they find that: –

…in most advanced economies in our sample, weighted by GDP, the odds of a big drop in inflation-adjusted house prices were lower at the end of 2017 than 10 years earlier but remained above the historical average. In emerging markets, by contrast, riskiness was higher in 2017 than on the eve of the global financial crisis. Nonetheless, downside risks to house prices remain elevated in more than 25 percent of these advanced economies and reached nearly 40 percent in emerging markets in our study.

The authors see a particular risk emanating from China’s Eastern provinces but overall they expect conditions to remain reasonably benign in the short-term. The January 2019 IMF – Global Housing Watch – presents the situation as at Q2 and Q3 2018: –

housepricesaroundtheworld IMF, BIS, ECB,Federal Reserve, Savills, Sinyl Real Estate

Source: IMF, BIS, Federal Reserve, ECB, Savills, Sinyl, National Data

Hong Kong continues to boom and Ireland to rebound.

They go on to analyse real credit growth: –

creditgrowth IMF, Haver Analytics

Source: IMF, Haver Analytics

Interestingly, for several European countries (including Ireland) credit conditions have been tightening, whilst Hong Kong’s price rises seem to be underpinned by credit growth.

Then the IMF compare house prices to average income: –

pricetoincome IMF, OECD

Source: IMF, OECD

Canada comes to the fore-front but Ireland is close second with New Zealand and Portugal not far behind.

Finally the authors assess House price/Rent ratios: –

pricetorent IMF, OECD

Source: IMF, OECD

Both Canada, Portugal and New Zealand are prominent as is Ireland.

This one year snap-shot disguises some lower term trends. The following chart from the September 2018 – UBS Global Real Estate Bubble Index puts the housing market into long-run perspective.

ubs-bubbles-index

Source: UBS

UBS go on to rank most expensive cities for residential real estate, pointing out that top end housing prices declined in half of the list:-

real-estate-bubbles list UBS

Source: UBS

Over the 12 months to September 2018 UBS note that house prices declined in Milan, Toronto, Zurich, New York, Geneva, London, Sydney and Stockholm. The chart below shows the one year change (light grey bar) and the five year change (dark grey line): –

housing-bubbles-growth-rates 1yr - 5yr change UBS

Source: UBS

Is a global correction coming or is property, as always, local? The answer? Local, but with several local markets still at risk.

The US market is generally robust. According to Peter Coy of Bloomberg – America Isn’t Building Enough New Housing – the effect of the housing collapse during the financial crisis still lingers, added to which zoning rules are exacerbating an already small pool of construction-ready lots. Non-credit factors are also corroborated by a recent Fannie Mae survey of housing lenders which found only 1% blaming tight credit, whilst 48% pointed to lack of supply.

North of the border, in Canada, the outlook has become less favourable, partly due to official intervention which began in 2017. Since 2012, house price increases in Toronto accelerated away from other cities, Vancouver followed with a late rush after 2015 and price increases only stalled in the last year.

In their February 2019 report Moody Analytics – 2019 Canada Housing Market Outlook: Slower, Steadier – identify the risks as follows: –

Interventions by the BoC, OSFI, and the British Columbia and Ontario governments were by no means a capricious attempt to deflate a house price bubble for the mere sake of deflation. Financial and macroeconomic aggregates point to the possibility that the mortgage credit needed to sustain house price appreciation may be unsustainable. Since 2002, the ratio of mortgage debt service payments to disposable income has gone from a historical low point of little more than 5% in 2003 to almost 6.6% by the end of last year…

The authors go on to highlight the danger of the overall debt burden, should interest rates rise, or should the Canadian economy slow, as it is expected to do next year. They expect the ratio of household interest payments to disposable income to rise and the percentage of mortgage arrears to follow a similar trajectory. In reality the rate of arrears is still forecast to reach only 0.3%, significantly below its historical average.

External factors could create the conditions for a protracted slump in Canadian real estate. Moody’s point to a Chinese real estate crash, a no-deal Brexit, renewed austerity in Europe and a continuation of the US/China trade dispute as potential catalysts. In this scenario 4% of mortgages would be in arrears. For the present, however, Canadian housing prices remain robust.

Switching to China, the CBRE – Greater China Real Estate Market Outlook 2019 – paints a mixed picture of commercial real estate in the year ahead: –

Office: U.S.–China trade conflict and the ensuing economic uncertainty are set to dent office demand in mainland China and Hong Kong. Leasing momentum in Taiwan will be less affected. Office rents will likely soften in oversupplied and trade and manufacturing-driven cities in 2019.

Retail: The amalgamation of online and offline will continue to drive the evolution of retail demand on the mainland. Retailers in Hong Kong and Taiwan will adopt a conservative approach towards expansion due to the diminishing wealth effect. Retail rents are projected to stay flat or grow slightly in most markets across Greater China.

Logistics: Tight land and warehouse supply will translate into steady logistics rental growth in the Greater Bay Area, Yangtze River Delta and Pan-Beijing area. Risks include potential weaker leasing demand stemming from the U.S.-China trade conflict and the gradual migration to self-built warehouses by major e-commerce companies.

The Chinese housing market, by contrast, has suffered from speculative over-supply. Estimates last year suggested that 22% of homes, amounting to around 50 million dwellings, are unoccupied. Government intervention has been evident for several years in an attempt to moderate price fluctuations. Earlier this month the National Development and Reform Commission (NDRC) said it aims to increase China’s urbanization rate by at least 1% with the aim of tackling the surfeit of supply. This is part of a longer-term goal to bring 100 million people into the cities over the five years to 2020. As of last year, 59.6% of China’s population lived in urban areas. According to World Bank data high middle income countries average 65% rising to 82% for high income countries. For China to reach the average high middle income average, another 70mln people need to move from rural to urban regions.

The new NDRC strategy will include the scrapping of restrictions on household registration permits for non-residents in cities of one to three million. For cities of three to five million, restrictions will be “comprehensively relaxed,” although the NDRC did not specify the particulars. Banks will be incentivised to provide credit and the agency also stated that it will support the establishing of real estate investment trusts (REITs) in order to promote a deepening of the residential rental market.

The NDRC action might seem unnecessary, average prices of new homes in the 70 largest Chinese cities rose 10.4% in February, up from 10.0% the previous month. This is the 46th straight monthly price increase and the strongest annual gain since May 2017. Critics point to cheap credit as the principal driver of this trend, they highlight the danger to domestic prices should the government decide to constrain credit growth. The key to maintaining prices is to open the market to foreign capital, this month’s NDRC policy announcement is a gradual step in that direction. It is estimated that at least $50bln of foreign capital will flow China over the next five years.

Despite the booming residential property market, the Chinese government has been tightening credit conditions and cracking down on illegal financial outflows. This has had impacted Australia in particular, investment fell more than 36% to $.8.2bln last year, down from $13bln in 2017. Mining investment fell 90%, while commercial real estate investment declined by 32%, to $3bln from $4.4bln the previous year. Investment in the US and Canada fell even more, declining by 83% and 47% respectively. Globally, however, Chinese investment has continued to grow, rising 4.2%.

Australian residential housing prices, especially in the major cities, have suffered from this downdraft. According to a report, released earlier this month by Core Logic – Falling Property Values Drags Household Wealth Lower – the decline in prices, the worst in more than two decades, is beginning to bite: –

According to the ABS (Australian Bureau of Statistics), total household assets were recorded at a value of $12.6 trillion at the end of 2018. Total household assets have fallen in value over both the September and December 2018 quarters taking household wealth -1.6% lower relative to June 2018. While the value of household assets have fallen by -1.6% over the past two quarters, liabilities have increased by 1.5% over the same period to reach $2.4 trillion. As a result of falling assets and rising liabilities, household net worth was recorded at $10.2 trillion, the lowest it has been since September 2017…

As at December 2018, household debt was 189.6% of disposable income, a record high and up from 188.7% the previous quarter. Housing debt was also a record high 140.2% of disposable income and had risen from 139.5% the previous quarter.

In 2018 the Australian Residential Property Price Index fell 5.1%, worst hit was Sydney, down 7.8% followed by Melbourne, off 6.4%, Darwin, down 3.5% and Perth, which has been in decline since 2015, which shed a further 2.5%. The ABS cited tightening credit conditions and reduced demand from investors and owner occupiers.

According to many commentators, Australian property has been ready to crash since the bursting of the tech bubble but, as this chart shows, prices are rich but not excessive: –

AMP Capital - Australian housing since 1926

Source: AMP Capital

Conclusions and Investment Opportunities

The entire second chapter of the IMF – Global Financial Stability Report – published on 10th April, focusses on housing: –

Large house price declines can adversely affect macroeconomic performance and financial stability, as seen during the global financial crisis of 2008 and other historical episodes. These macro-financial links arise from the many roles housing plays for households, small firms, and financial intermediaries, as a consumption good, long-term investment, store of wealth, and collateral for lending, among others. In this context, the rapid increase in house prices in many countries in recent years has raised some concerns about the possibility of a decline and its potential consequences…

Capital inflows seem to be associated with higher house prices in the short term and more downside risks to house prices in the medium term in advanced economies, which might justify capital flow management measures under some conditions. The aggregate analysis finds that a surge in capital inflows tends to increase downside risks to house prices in advanced economies, but the effects depend on the types of flows and may also be region- or city-specific. At the city level, case studies for Canada, China, and the United States find that flows of foreign direct investment are generally associated with lower future risks, whereas other capital inflows (largely corresponding to banking flows) or portfolio flows amplify downside risks to house prices in several cities or regions. Altogether, when nonresident buyers are a key risk for house prices, contributing to a systemic overvaluation that may subsequently result in higher downside risk, capital flow measures might help when other policy options are limited or timing is crucial. As in the case of macroprudential policies, these measures would not amount to targeting house prices but, instead, would be consistent with a risk management approach to policy. In any case, these conditions need to be assessed on a case-by-case basis, and any reduction in downside risks must be weighed against the direct and indirect benefits of free and unrestricted capital flows, including better smoothing of consumption, diversification of financial risks, and the development of the financial sector.

Aside from some corrections in certain cities (notably Vancouver, Toronto, Sydney and Melboune) prices continue to rise in most regions of the world, spurred on by historically low interest rates and generally benign credit conditions. As I said in last month’s Macro Letter – China in transition – From manufacturer to consumer – China will need to open its borders to foreign investment as its current account switches from surplus to deficit. Foreign capital will flow into Chinese property and, when domestic savings are permitted to exit the country, Chinese capital will support real estate elsewhere. The greatest macroeconomic risk to global housing markets stems from a tightening of financial conditions. Central banks appear determined to lean against the headwinds of a recession. In the long run they may fail but in the near-term the global housing market still looks unlikely to implode.

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A global slowdown in 2019 – is it already in the price?

A global slowdown in 2019 – is it already in the price?

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Macro Letter – No 106 – 07-12-2018

A global slowdown in 2019 – is it already in the price?

  • US stocks have given back all of their 2018 gains
  • Several developed and emerging stock markets are already in bear-market territory
  • US/China trade tensions have eased, a ‘No’ deal Brexit is priced in
  • An opportunity to re-balance global portfolios is nigh

The recent shakeout in US stocks has acted as a wake-up call for investors. However, a look beyond the US finds equity markets that are far less buoyant despite no significant tightening of monetary conditions. In fact a number of emerging markets, especially some which loosely peg themselves to the US$, have reacted more violently to Federal Reserve tightening than companies in the US. I discussed this previously in Macro Letter – No 96 – 04-05-2018 – Is the US exporting a recession?

In the wake of the financial crisis, European lacklustre growth saw interest rates lowered to a much greater degree than in the US. Shorter maturity German Bund yields have remained negative for a protracted period (7yr currently -0.05%) and Swiss Confederation bonds have plumbed negative yields never seen before (10yr currently -0.17%, but off their July 2016 lows of -0.65%). Japan, whose stock market peaked in 1989, remains in an interest rate wilderness (although a possible end to yield curve control may have injected some life into the market recently) . The BoJ balance-sheet is bloated, yet officials are still gorging on a diet of QQE policy. China, the second great engine of world GDP growth, continues to moderate its rate of expansion as it transitions away from primary industry and towards a more balanced, consumer-centric economic trajectory. From a peak of 14% in 2007 the rate has slowed to 6.5% and is forecast to decline further:-

china-gdp-growth-annual 1988 - 2018

Source: Trading Economics, China, National Bureau of Statistics

2019 has not been kind to emerging market stocks either. The MSCI Emerging Markets (MSCIEF) is down 27% from its January peak of 1279, but it has been in a technical bear market since 2008. The all-time high was recorded in November 2007 at 1345.

MSCI EM - 2004 - 2018

Source: MSCI, Investing.com

A star in this murky firmament is the Brazilian Bovespa Index made new all-time high of 89,820 this week.

brazil-stock-market 2013 to 2018

Source: Trading Economics

The German DAX Index, which made an all-time high of 13,597 in January, lurched through the 10,880 level yesterday. It is now officially in a bear-market making a low of 10,782. 10yr German Bund yields have also reacted to the threat to growth, falling from 58bp in early October to test 22bp yesterday; they are down from 81bp in February. The recent weakness in stocks and flight to quality in Bunds may have been reinforced by excessively expansionary Italian budget proposals and the continuing sorry saga of Brexit negotiations. A ‘No’ deal on Brexit will hit German exporters hard. Here is the DAX Index over the last year: –

germany-stock-market 1yr

Source: Trading Economics

I believe the recent decoupling in the correlation between the US and other stock markets is likely to reverse if the US stock market breaks lower. Ironically, China, President Trump’s nemesis, may manage to avoid the contagion. They have a command economy model and control the levers of state by government fiat and through currency reserve management. The RMB is still subject to stringent currency controls. The recent G20 meeting heralded a détente in the US/China trade war; ‘A deal to discuss a deal,’ as one of my fellow commentators put it on Monday.

If China manages to avoid the worst ravages of a developed market downturn, it will support its near neighbours. Vietnam should certainly benefit, especially since Chinese policy continues to favour re-balancing towards domestic consumption. Other countries such as Malaysia, should also weather the coming downturn. Twin-deficit countries such as India, which has high levels of exports to the EU, and Indonesia, which has higher levels of foreign currency debt, may fare less well.

Evidence of China’s capacity to consume is revealed in recent internet sales data (remember China has more than 748mln internet users versus the US with 245mln). The chart below shows the growth of web-sales on Singles Day (11th November) which is China’s equivalent of Cyber Monday in the US: –

China Singles day sales Alibaba

Source: Digital Commerce, Alibaba Group

China has some way to go before it can challenge the US for the title of ‘consumer of last resort’ but the official policy of re-balancing the Chinese economy towards domestic consumption appears to be working.

Here is a comparison with the other major internet sales days: –

Websales comparison

Source: Digital Commerce, Adobe Digital Insights, company reports, Internet Retailer

Conclusion and Investment Opportunity

Emerging market equities are traditionally more volatile than those of developed markets, hence the, arguably fallacious, argument for having a reduced weighting, however, those emerging market countries which are blessed with good demographics and higher structural rates of economic growth should perform more strongly in the long run.

A global slowdown may not be entirely priced into equity markets yet, but fear of US protectionist trade policies and a disappointing or protracted resolution to the Brexit question probably are. In financial markets the expression ‘buy the rumour sell that fact’ is often quoted. From a technical perspective, I remain patient, awaiting confirmation, but a re-balancing of stock exposure, from the US to a carefully selected group of emerging markets, is beginning to look increasingly attractive from a value perspective.

Is there any value in the government bond markets?

Is there any value in the government bond markets?

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Macro Letter – Supplemental – No 4 – 12-5-2017

Is there any value in the government bond markets?

  • Since 2008 US 10yr T-bond yields have fallen from more than 5% to less than 2%
  • German 10yr Bunds yields have fallen even further from 4.5% to less than zero
  • With Central Bank inflation targets of 2% many bond markets offer little or no real return
  • In developed markets the inverse yield gap between dividend and bond has disappeared

Since the end of the great financial recession, bond yields in developed countries have fallen to historic lows. The bull market in stocks which began in March 2009, has been driven, more than any other factor, by the fall in the yield of government bonds.

With the Federal Reserve now increasing interest rates, investors are faced with a dilemma. If they own bonds already, should they continue to remain invested? Inflation is reasonable subdued and commodity prices have weakened recently as economic growth expectations have moderated once more. If investors own stocks they need to be watching the progress of the bond market: bonds drove stocks up, it is likely they will drive them back down as well.

The table below looks at the relative valuation between stocks and bonds in the major equity markets. The table (second item below) is ranked by the final column, DY-BY – Dividend Yield – Bond Yield, sometimes referred to as the yield gap. During most of the last fifty years the yield gap has been inverse, in other words dividend yields have been lower than bond yields, the chart directly below shows the pattern for the S&P500 and US 10yr government bonds going back to 1900:-

Chart-2-the-reverse-yield-gap-in-a-longer-term-con

Source: Newton Investment Management

Bonds_versus_Equities

Source: StarCapital, Investing.com, Trading Economics

The CAPE – Cyclically Adjusted Price Earnings Ratio and Dividend Yield Data is from the end of March, bond yields were taken on Monday morning 8th May, so these are not direct comparisons. The first thing to notice is that an inverse yield gap tends to be associated with countries which have higher inflation. This is logical, an equity investment ought to offer the investor an inflation hedge, a fixed income investor, by contrast, is naturally hedged against deflation.

Looking at the table in more detail, Turkey tops the list, with an excess return, for owning bonds rather than stocks, of more than 7%, yet with inflation running at a higher rate than the bond yield, the case for investment (based simple on this data) is not compelling – Turkish bonds offer a negative real yield. Brazil offers a more interesting prospect. The real bond yield is close to 6% whilst the Bovespa real dividend yield is negative.

Some weeks ago in Low cost manufacturing in Asia – The Mighty Five – MITI VI looked more closely at India and Indonesia. For the international bond investor it is important to remember currency risk:-

Currency_changes_MITI_V (1)

Source: Trading Economics, World Bank

If past performance is any guide to future returns, and all investment advisors disclaim this, then you should factor in between 2% and 4% per annum for a decline in the value of the capital invested in Indian and Indonesian bonds over the long run. This is not to suggest that there is no value in Indian or Indonesian bonds, merely that an investor must first decide about the currency risk. A 7% yield over ten years may appear attractive but if the value of the asset falls by a third, as has been the case in India during the past decade, this may not necessarily suffice.

Looking at the first table again, the relationship between bond yields in the Eurozone has been distorted by the actions of the ECB, nonetheless the real dividend yield for Finnish stocks at 3.2% is noteworthy, whilst Finnish bonds are not. Greek 10yr bonds are testing their lowest levels since August 2014 this week (5.61%) which is a long way from their highs of 2012 when yields briefly breached 40% during the Eurozone crisis. Emmanuel Macron’s election as France’s new President certainly helped but the German’s continue to baulk at issuing Eurobonds to bail out their profligate neighbours.

Conclusion and Investment Opportunity

Returning to the investor’s dilemma. Stocks and bonds are both historically expensive. They have been driven higher by a combination of monetary and quantitative easing by Central Banks and subdued inflation. For long-term investors such as pension funds, which need to invest in fixed income securities to match liabilities, the task is Herculean, precious few developed markets offer a real yield at all and none offer sufficient yield to match those pension liabilities.

During the bull-market these long-term investors actively increased the duration of their portfolios whilst at the same time the coupons on new issues fell steadily: new issues have a longer duration as well. It would seem sensible to shorten portfolio duration until one remembers that the Federal Reserve are scheduled to increase short term interest rates again in June. Short rates, in this scenario will rise faster than long-term rates. Where can the fixed income portfolio manager seek shelter?

Emerging market bonds offer limited liquidity since their markets are much smaller than those of the US and Europe. They offer the investor higher returns, but expose them to heady cocktail of currency risk, credit risk and the kind of geopolitical risk that ultra-long dated developed country bonds do not.

A workable solution is to consider credit and geopolitical risk at the outset and then actively manage the currency risk, or sub-contract this to an overlay manager. Sell long duration, low yielding developed country bonds and buy a diversified basket of emerging market bonds offering acceptable real return and, given that in many emerging markets corporate bonds offer lower credit risk than their respective government bond market, buy a carefully considered selection of liquid corporate names too. Sadly, many pension fund managers will not be permitted to make this type of investment for fiduciary reasons.

In answer to the original question in my title? Yes, I do believe there is still value in the government bond markets, but, given the absence of liquidity in many of the less developed markets – which are the ones offering identifiable value – the portfolio manager must be prepared to actively hedge using liquid markets to avoid a forced liquidation – currency hedging is one aspect of the strategy but the judicious use of interest rate swaps and options is a further refinement managers should consider.

This strategy shortens the duration of the bond portfolio because, not only purchase bonds with a shorter maturity, but also ones with a higher coupon. Actively managing currency risk (or delegating this role to a specialist currency overlay operator) whilst not entirely mitigating foreign exchange exposures, substantially reduces them.

Emerging market equities may well offer the best long run return, but a portfolio of emerging market bonds, with positive rather than negative real-yields, is far more compelling than continuously extending duration among the obligations of the governments of the developed world.

US 30yr Swaps have yielded less than Treasuries since 2008 – does it matter?

US 30yr Swaps have yielded less than Treasuries since 2008 – does it matter?

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Macro Letter – No 74 – 07-04-2017

US 30yr Swaps have yielded less than Treasuries since 2008 – does it matter?

  • With 30yr Swap yields below T-bond yields arbitrage should be possible
  • Higher capital requirements have increased the cost of holding T-bonds
  • Central clearing has reduced counterparty risk for investors in swaps
  • Maintaining swap market liquidity will be a critical role for Central Banks in the next crisis

Global investors are drawn to US fixed income markets, among other reasons, because of the depth of liquidity. The long term investor, wishing to match assets against liabilities would traditionally purchase US Treasury bonds (T-bonds). This pattern of investment has not changed, but the yield on longer dated Treasuries has become structurally higher than the yield on interest rate swaps (IRS).

In a normally functioning market the lowest yield for a given maturity is usually the yield on government bonds – the so called risk free rate – however, regulatory and monetary policy changes have undermined this relationship.

Writing in March 2016 for Forbes, Darrell Duffie of Stanford University – Why Are Big Banks Offering Less Liquidity To Bond Markets?  described the part of the story which relates to the repo market:-

The new Supplementary Leverage Ratio (SLR) rule changes everything for the repo market. For the largest U.S. banks, the SLR, meant to backstop risk-adjusted capital requirements, now requires 6% capital for all assets, regardless of their risk. For a typical large dealer bank, the SLR is a binding constraint and therefore pushes up the bank’s required equity for a $100 million repo trade by as much as for any other new position of the same gross size, for example a risky real estate loan of $100 million. This means that the bank’s required profit on a repo trade must be in the vicinity of the profit on a risky real estate loan in order for the repo trade to be viable for shareholder value maximization. That profit hurdle has become almost prohibitive for repo intermediation, so banks are providing dramatically less liquidity to the repo market. As a result, the spread between repo rates paid by non-banks and by banks has roughly tripled. The three-month treasury-secured repo rates paid by non-bank dealers are now even higher than three-month unsecured borrowing rates paid by banks, a significant market distortion. Trade volume in the bank-to-non-bank dealer market for U.S. government securities repo is less than half of 2012 levels.

Other factors that are distorting the Bond/Swap relationship include tighter macro prudential regulation and reduced dealer balance sheet capacity. Another factor is the activities of companies issuing debt.

Companies exchange floating rates of interest for fixed rates. When a company sells fixed-rate debt, it can use a swap to offset the payment of a bond coupon and pay a lower floating rate. Heavy corporate issuance can depress the spread between swaps and bonds. This can be exacerbated when dealers are swamped by sales of T-bonds. A combination of heavy company issuance being swapped and higher dealer inventories of Treasury debt, might explain why swap spreads turn negative over shorter periods.

Back in 2015, when the 10yr spread turned sharply negative, Deutsche Bank estimated that the long term fair value for swaps was 3bp higher than the same maturity T-bond. But negative spreads have continued. A side effect has been to raise the cost of US government financing, but Federal Reserve buying has probably more than compensated for this.

The declining volume of transactions in the repo market is one factor, the declining liquidity in the T-bond market is another. The quantitative easing policies of the Federal Reserve have lowered yields but they have also lowered liquidity of benchmark issues.

The final factor to consider is the demand for leveraged investment. One solution to the problem of matching assets versus liabilities is to leverage one’s investment in order to generate the requisite yield. This does, however, dramatically increase the risk profile of one’s portfolio. The easiest market in which to leverage a fixed income investment remains the IRS market but, as a white paper published last May – PNC – Why are swap rates trading below US Treasury Rates? highlights, the cost of leverage in the swap market has, if anything, increased more than in the bond repo market:-

The regulatory requirement for central clearing of most interest rate swaps (except for swaps with commercial end users) has removed counterparty risk from such swap contracts. Regulatory hedging costs and balance sheet constraints have also come into effect over the past few years. These rules have significantly reduced the market-making activity of swap dealers and increased the cost of leverage for such dealers. This is evidenced in the repo rates versus the Overnight Interest Swap* (OIS) basis widening. This basis widening strips rate expectations (OIS) from the pure funding premium (repo) rates. Swaps and Treasuries are less connected than in the past. The spread between them is a reflection of the relative demand for securities, which need to be financed, versus derivatives, which do not.

*The LIBOR-OIS Spread: The difference between LIBOR and OIS is called the LIBOR-OIS Spread and is deemed to be the health taking into consideration risk and liquidity. (An Overnight Index Swap (OIS) is a swap where the floating payments are based on the overnight Federal Funds Rate.)

For a more nuanced explanation, the publication, last month by Urban J. Jermann of the Wharton School, of a paper entitled – Negative Swap Spreads and Limited Arbitrage – is most insightful. Here are his conclusions based on the results of his arbitrage model:-

Negative swap spreads are inconsistent with an arbitrage-free environment. In reality, arbitrage is not costless. I have presented a model where specialized dealers trade swaps and bonds of different maturities. Costs for holding bonds can put a price wedge between bonds and swaps. I show a limiting case with very high bond holding costs, expected swap spreads should be negative. In this case, no term premium is required to price swaps, and this results in a significantly lower fixed swap rate. As a function of the level of bond holding costs, the model can move between this benchmark and the arbitrage-free case. The quantitative analysis of the model shows that under plausible holding costs, expected swap spreads are consistent with the values observed since 2008. Demand effects would operate in the model but are not explicitly required for these results.

My model can capture relatively rich interest rate dynamics. Conditional on the short rate, the model predicts a negative link between the term spread and the swap spread. The paper has presented some empirical evidence consistent with this property.

The chart below, which covers the period from 1999 up to Q3 2015, shows the evolution before and after the Great Financial Crisis. It is worth noting that the absolute yield may be an influence on this relationship too: as yields have risen in the past year, 30yr swap spreads have become less negative, 5yr and 10yr spreads have reverted to positive territory:-

US Swap Spreads Zero Hedge Goldman Sachs

Source: ZeroHedge, Goldman Sachs

This table shows the current rates and spreads (6-4-2017):-

Bond_-_Swap_Spread_6-4-17

Source: Investing.com, The Financials.com

Conclusion and investment opportunity

The term “Risk-Free Rate” has always been suspect to my mind. As an investor, one seeks the highest return for the lowest risk. How different investors define risk varies of course, but, in public markets, illiquidity is usually high on the list of risks for which an investor would wish to be paid. If longer dated US T-bonds trade at a structurally higher yield than IRS’s, it is partly because they are perceived to lack their once vaunted liquidity. Dealers hold lower inventories of bonds, repo volumes have collapsed and central counterparty clearing of swaps has vastly reduced the counterparty risks of these, derivative, instruments. Added to this, as Jermann points out in his paper, frictional costs and uncertainty, about capital requirements and funding availability, make arbitrage between swaps and T-bonds far less clear cut.

When the German bond market collapsed during the unification crisis of the late 1980’s, it was Bund futures rather than Bunds which were preferred by traders. They offered liquidity and central counterparty clearing: and they did not require a repurchase agreement to set up the trade.

Today the IRS market increasingly determines the cost of finance, during the next crisis IRS yields may rise or fall by substantially more than the same maturity of US T-bond, but that is because they are the most liquid instruments and are only indirectly supported by the Central Bank.

At its heart, the Great Financial Crisis revolved around a drying up of liquidity in multiple financial markets simultaneously. Tightening of regulation and increases in capital requirements since the crisis has permanently reduced liquidity in many of these markets. Meanwhile, increasingly sophisticated technology has increased the speed at which liquidity provision can be withdrawn.

It behoves the Federal Reserve to become an active participant in the IRS market. Control of the swap market is likely to be the key to maintaining market stability, come the next crisis. IRS’s, replete with their leveraged investors, have assumed the mantle which was once the preserve of the US Treasury market.

In previous crises the “flight to quality” effect was substantial, in the next, with such a small free float of actively traded T-bonds, which are not already owned by the Federal Reserve, the effect is likely to be much greater. The latest FOMC Minutes suggest the Fed may turn its attention towards reducing the size of its balance sheet but the timing is still unclear and the first asset disposals are likely to be Mortgage Backed Securities rather than T-bonds.

Meanwhile, although interest rates have risen from historic lows they remain far below their long run average. Pension funds and other long term investors still require 7% or more in annualised returns in order to meet their liabilities. They are being forced to continuously increase their investment risk and many have chosen to use the swap market. The next crisis is likely to see an even more pronounced unravelling than in 2008/2009. The unravelling may not happen for some while but the stresses are likely to be focused on the IRS market.