Credit Markets

 

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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An Unexpected Surge

There was an unexpected surge in initial unemployment claims, even as other economic data showed some improvement. Following on the heels of an extremely weak Q1 GDP report (flawed as GDP is as a measure of 'growth'), this continued the recent streak of 'mixed' and seemingly incongruous economic data points. Keep in mind that this Thursday's initial claims report was already outside the reporting period of the payrolls report that will be published on Friday.

As Lee Adler reports here, actual, unadjusted claims confirmed the surge in the seasonally adjusted number this time. Often the two data series fail to confirm each other, and as Adler frequently points out, the statistical 'smoothing' exercises usually only serve to obscure what is really happening. This week's number was quite bad, which is why it is worth mentioning. According to Adler:

 

“The actual weekly change of an increase of 18,000 compared with the 10 year average for this week of a decline of -12,200.In this week last year the week to week change was a drop of -24,700. In that respect as well, the current reading was bad.”

 

Calendar quirks (due to Good Friday) may have influenced the number, so one will need to watch for upcoming releases to see if a worsening trend is developing. What is already certain is that the unadjusted claims data have begun to diverge from the stock market.

 

Initial and continuing claims-close-up

Initial and continuing unemployment claims. These are the officially reported seasonally adjusted figures – click to enlarge.

 

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More Oddities

Along the lines of the recently discussed idea that central bank interventions have distorted numerous price signals, here is some additional evidence supporting this contention. The first chart shows the Eurostoxx Index compared to inflation expectations as reflected by yields on 5 year US and euro area inflation adjusted bonds. For a long time, stock prices and yields have moved in unison. This is no longer the case. They have increasingly decoupled since late 2012/early 2013. One cannot rule out that they will converge again at some point.

 

infladjbonds

Eurostoxx vs. 5 yr. US and euro area TIPs yields – click to enlarge.

 

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Dancing While the Music Plays: “You Will Have No Choice But to Buy”

In mid April, Reuters reported that there hadn't been any trades in 10 year JGBs for a day and a half – shortly after the BoJs holdings of JGBs topped 200 trillion yen for the first time. There once used to be a limit to 'QE' by the BoJ: it wasn't allowed to buy long term JGBs in excess of the amount of yen bank notes in circulation. This rule, which was introduced in 2001, was repealed 'temporarily' with the beginning of Kuroda's massive 'QE' operation, although it had already been broken almost a year earlier. Considering that Japan's bank notes in circulation amount to about 80 trillion yen, the limit has by now obviously been left completely in the dust. In fact, since 1999, the BoJ has gradually repealed all the 'JGB purchase rules' that were put in place in 1967.  Once it couldn't buy a government bond until one year after its issuance for instance, and only 20 issues of 10 and 20 year bonds were eligible. By now, all bonds are eligible, and the 'one year rule' no longer applies. By the end of 2013, the BoJ's long term JGB holdings amounted to 1.5 times bank notes in circulation:

 

JGB holdings vs. bank notes

BoJ's long term JGB holdings vs. bank notes in circulation – click to enlarge.

 

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A 100% Consensus

This doesn't happen very often.  Marketwatch reports that Jim Bianco points out in a recent market comment that the 67 economists taking part in a regular Bloomberg survey have a unanimous forecast regarding treasury bond yields: they will be higher 6 months from now. This is a truly striking result, and given the well-known propensity of mainstream economists to guess wrong (their forecasts largely consist of extrapolating the most recent short term trend), it may provide us with a few insights.

In fact, considering that there have been only a handful of instances since 2009 when a majority of the economists surveyed predicted a decline in yields, we can already state that their forecasts regarding treasuries are quite often (though obviously not always) wide off the mark. In fact, so far this year they are already wrong again – and so are fund managers, as they hold their lowest exposure to treasuries in seven years.

This is not the only thing there is complete unanimity about. Not a single economist taking part in a separate survey believes an economic downturn is possible.

 

“Economists are unwavering in their assessment of where yields are headed in the next half year.

Jim Bianco, of Bianco Research, points out in a market comment Tuesday that a survey of 67 economists this month shows every single one of them expects the 10-year Treasury yield to rise in the next six months.

The survey, which is done each month by Bloomberg, has been notably bearish for some time now, with nearly everyone expecting rising rates. In March, 97% expected rising rates. In February, 95% expected yields to climb. And in January, 97% held that expectation. Since the beginning of 2009, there have only been a handful of instances where less than 50% expected rates to rise.

Still, the fact that every single survey participant is bearish is striking. The last time the survey had that result was in May 2012, when benchmark yields were well below 2%.

“Literally there is maybe one economist in the United States straddling the bullish/bearish divide on interest rates. The rest are bearish,” Bianco writes.

He adds that a J.P. Morgan client survey shows that the percentage of money manager respondents who said they are underweight Treasurys is the second highest in seven years.

This is all the more surprising when we consider that investors went into 2014 thinking yields would rise significantly. Instead, the benchmark yield is lower than when the year started, as the market waded throw subpar economic data, geopolitical tensions, and uncertainty over the Federal Reserve. The 10-year note last traded at a yield of 2.72% on Tuesday, down from just over 3% on Dec. 31.

Then again, a separate poll of economists recently showed that exactly zero expect the economy to contract.

But when the entire market thinks one thing is about to happen, the opposite outcome is often in store, notes James Camp, managing director of fixed income at Eagle Asset Management. So don’t count out that result with Treasurys, he advises.

“It’s the most hated asset class,” says Camp, but Treasurys are some of the best performers year-to-date.”

 

(emphasis added)

Color us unsurprised regarding the fact that the 'most hated asset class' has turned out to be one of the better performing so far this year. Gold is probably hated even more, and for similar reasons. Everybody expects the weakest recovery of the entire post WW2 era to reach 'escape velocity' (whatever that is supposed to mean), even after adding almost $8 trillion to the federal debt and some $4.8 trillion to the broad true money supply since the 2008 crisis have led to such a dismal outcome (of course as card-carrying Austrians we believe this development is precisely what should have been expected).

 

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The 'Great Stretch'

Last week the Greek government celebrated its return to the bond market, selling 3 billion euros in five-year bonds at a yield of 4.95 percent. Reportedly there was great demand for the issue, which should be no surprise given the current propensity of investors to buy all sorts of junk debt as long as it yields more than just a smidgen.

Reuters report on the backdrop that made this successful auction possible:

 

“Call it the Great Stretch. Two years ago, Greece's debt crisis almost brought the euro zone crashing down. Now European partners are preparing to ease Athens' debt burden without writing off their loans but by stretching them out into the distant future, extending maturities from 30 to 50 years and further cutting some interest rates, EU officials say.

Greece made a successful, if artificially engineered, return to the long-term capital markets last week for the first time since its international bailout in 2010, and just two years after imposing heavy losses on its private creditors.

But with its economy shattered, the country is still a long way from being able to fund itself unassisted in the market. The International Monetary Fund says Greece is likely to need further financial help from the euro zone over the next two years.

One reason why the sale of 3 billion euros in five-year bonds at a yield of 4.95 percent went so smoothly, on the eve of a support visit by German Chancellor Angela Merkel, was that investors are widely anticipating official debt relief.

"That has been quite substantially priced in, and the market is also expecting Greece to be quickly upgraded by the credit rating agencies," said Alessandro Giansanti, senior rate strategist at ING bank in Amsterdam.

"In a second stage, the market is also expecting a reduction in principal on official debt, and no private sector involvement (write-down) in the coming years," he said.

Whether such expectations are fully realized will only become clear later this year, when negotiations start with the euro zone and the IMF on Greece's longer-term funding, and the end of its wrenching bailout program.

But EU leaders share an interest in helping conservative Prime Minister Antonis Samaras' shaky coalition cling to office rather than seeing leftist anti-bailout firebrand Alexis Tsipras sweep to power demanding a massive debt write-off.”

 

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