Credit Markets

 

Non-Confirmations Still Persist

The S&P 500 has recently made a new high, in short the rebound from the mid October low has not failed at a lower high. Therefore, the clock has so to speak been reset. However, as our updated comparison chart between SPX and the major euro-land indexes shows, there is now a third divergence in place between them, and this one is even more glaring than the first two. Keep in mind that there such divergences have not always been meaningful in the past. However, when global markets are drifting apart, it is a sign that the global economy is no longer well-synchronized. Given that the Fed’s “QE inf.” is in relative pause mode (we hesitate to say it has ended), the situation is certainly worth keeping an eye on.

 

1-Euroland vs. SPXA third divergence between the SPX and the major continental European stock markets is now in place – click to enlarge.

 

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The Bad News First – Greece is Crashing Again

We only recently reported on the ludicrous idea of Greek prime minister Antonis Samaras to pretend that the Greek government is suddenly not bankrupt anymore (see: “Greece Tries to Escape Bail-Out” for details). Note that non-performing bank loans in Greece stand at an estimated €90 billion, so it should also be kept in mind that the banking system remains de facto insolvent as well – in spite of having been bailed out once already.

It is probably getting more so in recent days – Greek stocks and bonds have essentially crashed, with government bond yields back at levels that normally indicate severe crisis conditions (in other words, they are way above the level that would allow for what is generally considered “sustainable” refinancing of the government’s debt). The Greek stock market meanwhile is very close to getting cut in half once again:

 

AGTThe Athens General Index has been in free-fall lately – click to enlarge.

 

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A Test of Broken Trendlines from Below?

The divergence between US and European stock markets which we discussed in late August continues to persist. This happens in spite of the fact that major European markets have been somewhat stronger than US markets in recent weeks, no doubt due to further easing by the ECB – which was first anticipated, and then became reality. In fact, the measures announced by the ECB “exceeded expectations”.

Below is an updated version of the chart we showed previously. Germany’s DAX and France’s CAC-40 have rallied back to their previously broken trendlines and appear to be turning down from there. If they fail to exceed the recent interim peaks, their divergence with the SPX will so to speak have been “perfected”. Note though that we have seen similar short term divergences between these markets before (it happened e.g. in the summer of 2013), so it remains to be seen if they are meaningful this time.

Even though one cannot be certain yet whether it is an important signal, it is something we are keeping an eye on, especially as all these markets are far more stretched to the upside than they were previously. We have picked the DAX and CAC-40 on purpose, because they are the stock markets of the euro zone’s “core” countries. Moreover, the DAX has been Europe’s strongest market, the only one that has managed to reach new all time highs since the 2008 crisis. To be sure, the divergence is relatively small at this juncture, due to the recent strength in European stocks. Obviously though, no-one is going to ring a bell and shout “this time it means something”, even if it later turns out that it did. So it probably pays to be aware of these things in good time. If the divergences are going to be invalidated, it is in any case likely to happen soon, as it would require only very little by way of an additional advance.

Another reason why these divergences may actually be more meaningful this time around is that a very similar divergence between SPX and HYG (an ETF serving as a proxy for high yield debt) has recently formed.

 

1-european-DivergenceDAX, CAC-40 and SPX – the former are still diverging from the latter and may just have put in a lower high right at their previous trendline support – click to enlarge.

 

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Update on Global High Yield Debt Issuance Volumes

Here is a small addendum to our recent articles on the corporate debt bubble (“A Dangerous Boom in Unsound Corporate Debt”) and the associated derivatives-berg, which is intended to hedge both the credit and interest rate risk this credit boom has given rise to (“A Perilous Derivatives-Berg”).

We recently combed through John Hussman's weekly commentaries, one of which contained an up-to-date chart of global high yield debt issuance per quarter from Q1 2006 to Q2 2014. Both global issuance volume and the number of deals are depicted on the chart. As you can see, we have long left all previous records in the dust.

 

hi-yieldGlobal high yield debt issuance in USD billion per quarter, plus the number of offerings, via John Hussman.

 

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Derivatives and the Credit Bubble

In principle, there is absolutely nothing wrong with derivatives. They serve a valuable function, by transferring risk from those who don't want to be exposed to it to those who are willing to take risk on in their stead for a fee. However, since the adoption of the pure fiat money system, credit growth has literally gone “parabolic” all over the world. This growth in outstanding credit has been spurred on by interest rates that have been declining for more than three decades.

Larger and larger borrowings have become feasible as the cost of credit has fallen, and this has in turn spawned an unprecedented boom in financial engineering.

When critics mentioned in the past that this had created systemic dangers, their  objections were always waved away with two main arguments: firstly, the amount of net derivatives exposure is only a fraction of the outstanding gross amounts, as so many contracts are netted out (i.e., things are not as bad as they look). Secondly, the system had proven resilient whenever financial system stresses occurred. Perhaps not as resilient as it seemed, considering that these crises as a rule required heavy central bank interventions and/or bailouts in various shapes and forms. Would the system have been as resilient if those had not occurred? We have some doubts with regard to that.

 

total_derivativesSince the crisis, derivatives growth has stalled, but the notional amount has returned to its record highs as of the end of 2013 – click to enlarge.

 

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John Hussman's Latest Comments on the Bubble

In his newest weekly column, John Hussman talks about a feature of the current echo bubble era that we believe will turn out to be an extremely important one. Readers of this site know of course that we have frequently sung from the same hymn sheet, but it is a topic the significance of which cannot be stressed enough.  After briefly recapping the history of the housing bubble and the ensuing credit crisis, Hussman writes:

 

“Now, as we observed in periods like 1973-74, 1987, and 2000-2002, severe equity market losses do not necessarily produce credit crises in themselves. The holder of the security takes the loss, and that’s about it. There may be some economic effects from reduced spending and investment, but there is no need for systemic consequences. In contrast, the 2007-2009 episode turned into a profound credit crisis because the owners of the vulnerable securities – banks and Wall Street institutions – had highly leveraged exposure to them, so losing even a moderate percentage of their total assets was enough to wipe out their capital and make those institutions insolvent or nearly-so.

At present, the major risk to economic stability is not that the stock market is strenuously overvalued, but that so much low-quality debt has been issued, and so many of the assets that support that debt are based on either equities, or corporate profits that rely on record profit margins to be sustained permanently. In short, equity losses are just losses, even if prices fall in half. But credit strains can produce a chain of bankruptcies when the holders are each highly leveraged. That risk has not been removed from the economy by recent Fed policies. If anything, it is being amplified by the day as the volume of low quality credit issuance has again spun out of control.

 

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The Dear Departed

Not much action in the markets on Wednesday. So, let us return to the economy. That’s where the excitement is. According to leading economists – notably those paid by the US government to forecast the future – interest rates are going to stay low for a long time.

Perhaps we should pause and say an Ave Maria… or whatever you say when you put a market cycle into the grave. Maybe we should proclaim a day of mourning. Or at least raise a glass or two.

Yes, the feds have pronounced our old friend dead. Dead… dead… stiff dead… cold dead. Immobile. They denied responsibility for the death of the credit cycle, but admit that it was in their custody when it expired.

 

memento-moriHic iacet cyclus fenebris semimortuus

(Photo © Sekitar)

 

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Bond Yields Can Only Go Higher, Right?

There is a big warning sign out there that is widely ignored, so we thought we will briefly comment on it. Treasury note yields have trended lower since the beginning of the year – against widespread expectations that yields would surely rise (because of the “recovery”).

So what has happened to these expectations since then? This is actually truly astonishing. Below is are two charts showing where speculators stand – the hedger position in 10 year t-note futures and the Rydex bond bull ratio (which shows what percentage of all Rydex assets invested in bond funds is bullishly positioned).

In brief: speculators are fighting the trend in treasuries tooth and nail. This is a sign that the trend is likely to intensify. Why would it do so? One reason we can think of is that there will be a wobble in the current complacency about risk (which is becoming more absurd by the day – some of the data we recently posted with respect to positioning and sentiment have become even more extreme).

 

TNXThe 10-year t-note yield – click to enlarge.

 

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JGB Yields Nearing Record Lows

Not that anyone cares much in today's QE infested world, but Japan's economy continues to “temporarily” disappoint, in spite of his Arrowship's efforts. Apparently the real economy is being subjected to a rather stubborn soft patch, and there is at least one market that seems to believe it is going to continue. Unfortunately said market is the JGB market, which isn't exactly free of manipulation these days, so that the signals it is sending are not truly reliable. In fact, it continues to be one of the strangest major asset markets in the world – and it is only a touch away from hitting new all time highs (new all time lows in yields). In fact, on a weekly closing basis the 10-year JGB futures contract ended last week at a new all time high.

Trading volume has collapsed due to the BoJ entering the market as a massive buyer, and prices continue to drift higher. The real return of the 10 year JGB at the current official inflation rate is a deeply negative minus 3.16% per year – in other words, this market sports a completely unwarranted negative price premium, and obviously no risk premium whatsoever. This simply makes no sense.

 

JGB    10 year JGB (continuous contract) – ending last week at a new all time closing high – click to enlarge.

 

japan-inflation-cpiWhile the 10 year JGB yields just a little over 50 basis points, the annualized rate of change of Japan's CPI has accelerated further from 3.4% in April to 3.7% in March - click to enlarge.

 

At the very least it can be stated that the BoJ has managed to completely falsify interest rate signals across the yield curve, and is thereby obviously vitiating economic calculation in Japan.

 

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Excessive Optimism, but Money Supply Growth Rate Remains High

We recently remarked on the astonishing levels of optimism currently visible in the stock market. The present phase of excessive optimism has lasted for quite a long time already and has recently begun to once again approach the all time records seen in several indicators at the end of 2013. As we already mentioned on occasion of the last update, there is at least one 'good' reason for traders to be optimistic, and that is the fact that many charts of individual stocks and sectors look bullish (there have been a number of noteworthy break-outs lately, as one would expect).

However, the problem with good-looking charts is that they only look good until they don't anymore, so one has to keep an eye on market sentiment and the money supply. In summary the situation is that the market's underlying technical condition (apart from being overbought) still looks positive, sentiment is at absolute nosebleed levels and giving us a big warning sign, and money supply growth remains strong enough to continue to lend support to the market. The caveat to the latter remark is that y/y money supply growth has halved from its peak, and we cannot know with certainty where the 'bust threshold' will turn out to be this time.

First a chart from sentimentrader, the “smart/dumb money confidence spread” – which measures differences in market exposures of the two classes of traders. The definition essentially regards anti-cyclical market participants as 'smart' and pro-cyclical traders as 'dumb'. This doesn't mean that the former are always right – in fact, they very often aren't right for long stretches of time. However, they will as a rule be right at extremes.

 

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Commercial Banks Increase Lending to Business

Ever since the Fed's 'QE tapering' began, the annual growth rate of broad US money TMS-2 has actually not declined further (that may however change, as there have recently been two back-to-back monthly declines). The main reason for this is that commercial banks have 'taken the baton' from the Fed and have expanded their lending to corporations at an accelerating rate. Thus we find that commercial and industrial loans have recently expanded at a more than 11% pace year-on-year (not seasonally adjusted: we prefer to look at actual numbers instead of statistically smoothed ones. As Lee Adler often mentions, this is the best way to ascertain what is really going on). 

 

commercial and industrial loans-y-y growth

Commercial and industrial loans, year-on-year growth, not seasonally adjusted – click to enlarge.

 

In early May, we already wrote about the blistering business in CLOs (see: “Embracing Leverage Again”), describing how banks are eagerly helping investors not only with buying the corporate equivalent of sub-prime CDOs, but enabling them to do so at up to 1:10 leverage. We also commented on the enormous surge in leveraged loan issuance in March, and have frequently discussed how PIK bonds, 'frontier market' debt and other junk securities are gobbled up by yield-chasing investors as if they were the best thing since sliced bread. As of yet, there seems to be no let-up. Zerohedge has just discussed the topic as well, in the wake of a Bloomberg article that describes how banks are getting around the limitations imposed by the so-called 'Volcker rule' so as to continue CLO production to their hearts content. It is worth excerpting the first paragraph of the article:

 

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Youth Employment Plummets

Pity the class of ’14! News comes that students are defaulting on their loans at an annual rate of 11%. We’re surprised it isn’t higher. Fewer than half of Americans aged between 18 and 29 have jobs. Even among college grads, nearly half are jobless or underemployed. Hardly surprising, then, that as a share of national income, young people have less than ever.

Over the last 14 years, the number of Americans aged between 16 and 24 who have jobs has fallen by 18%. For most people, the unemployment rate is back to acceptable levels. But only because so many people are no longer included in the labor force participation numbers.

Retiring baby boomers account for some of the drop off. But there are also millions of young people who never seem to get a shot at gainful employment. Never getting on the ladder, they have no way to climb higher.

 

15-24-unemployment-vs.employment-annEmployment and unemployment rates for youth aged 15 – 24 compared. The unemployment rate, though still extremely high, has been declining – mainly because those who no longer bother looking for a job are no longer counted as unemployed. One may well ask: if they are not unemployed, what are they? - click to enlarge.

 

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Stocks and Bonds –  One of These Markets is Wrong

If one looks only at the SPX and the DJIA, one would have to conclude that stock market participants firmly believe in the recovery story that is peddled far and wide. After all, these indexes have only just retreated from new all time highs. However, something doesn't compute in terms of the 'market message'. Small caps and momentum stocks (mainly tech stocks in the widest sense) continue to leak, and they have been the leaders of the bull market.

That is not the only problem though. 10 year treasury note yields have just dropped below the short term support level we recently flagged as 'vulnerable',  and they have done so with gusto, by gapping right through it. Here is an updated chart:

 

TNX-TYX10 year yields break support – if there is one thing that could be construed as slightly encouraging for bond bears, it is the fact that 30 year bond yields are slightly diverging, but that may be simply because they have been leading the march lower thus far – click to enlarge.

 

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The Attention Span of Mayflies

The memory and attention span of financial market participants can be compared to that of mayflies. The mayfly is a member of the order ephemeroptera, from the Greek term for 'short-lived' (literally: 'lasting a day'). The English word 'ephemeral' comes from the same root. You get our drift.

Not long after yesterday's post about the growing signs of unbridled speculation in credit markets was published, we came across an article in the WSJ, entitled “Borrowing Cash to Buy Complex Assets Is In Vogue Again”. We're not particularly surprised to come across such an article, but this is definitely an interesting addendum to yesterday's missive.

The topic are collateralized loan obligations, or CLOs for short. As the WSJ informs us, CLOs were among the structured credit products that held up comparatively well in the 2008 crisis, with not too many defaults occurring in their component loans. What's contained in a CLO? CLOs are bonds typically backed by pools of low-rated corporate loans”, the WSJ informs us. Many CLOs are nevertheless sporting triple A ratings, either due to overcollateralization or due to being sliced into tranches of different seniority. Banks still hold quite a few of these securities, but they want, or rather have to, get rid of at least some of these holdings:

 

“Many banks own CLOs themselves, holding about $130 billion on their books. New regulations may mean some banks will be forced to sell some CLOs in the next few years.

Finding new buyers would help them offload the debt, while keeping prices relatively high. Some banks also are trying to ensure there will be demand for more CLOs they help create.

Banks "are resorting to creating economic incentives to get primarily hedge funds to step into this void," said Oliver Wriedt, senior managing director at CIFC Asset Management LLC, which manages CLOs.”

 

 

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Gold Breaks Character

After the payrolls report released on Friday turned out to be 'stronger than expected', the gold market initially duly sold off. The release of the jobs data has regularly provided short term pivot points for the gold market. This actually makes little sense, because they data will be revised several times. Even if they were painting a correct picture, they would represent a lagging indicator of the economy, which makes them largely useless for economic forecasting purposes. However, the market still regards the data as important due to the Fed's impossible 'dual mandate'. 

The superficially strong jobs report released on Friday must be taken with a grain of salt anyway: e.g. the household survey showed a loss of 75,000 jobs compared to the 288,000 gain in the establishment survey, while the participation rate continued to collapse. The latter is highly unusual in a 'recovery' (see Mish's regular write-up for details on the data).

Anyway, something odd happened after the initial Pavlovian sell-off: first gold regained the lost ground, then it embarked on a strong rally. The silver market mimicked this behavior, with a slight twist – it didn't dip below the previous day's low before reversing. Below are 20-minute charts of spot gold and July silver illustrating the action:

 

 

Gold, 20 minutes-annSpot gold, 20 minute candles: a knee-jerk sell-off after the release of strong payrolls data turns into a rally as the trading day progresses – click to enlarge.

 

 

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