Why the Libor Spike Matters to Stocks and Profit Margins

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Four Rate Hikes Mr. Powell?

“We agree with the market’s hawkish assessment of Powell’s comments this week. At this point, we see roughly even odds that the median dot will show 3 hikes (2.125%) or 4 hikes (2.375%) for 2018 in March, and we think the median dot for 2019 is likely to move up from 2.7% to 2.875%.”

The Goldman Victory Lap, Feb 28, 2018

Three Month Libor

2018: 2.00%
2017: 1.05%
2016: 0.62%
2015: 0.28%
2014: 0.21%

Bloomberg data

Refinancing???  As your eyes are trained on the surging numbers above, think about the impact on corporate credit and profit margins.  With the total amount junk-rated “floating rate” corporate loans up near $2.3T to $2.4T, and a smelly pile of ($1.2T) BB or less rated paper, “Houston, we have a problem.”

The Fed is Sitting at the Banquet of their Consequences

The surge in three-month libor matters because the entire ecosystem of U.S. short-term corporate finance is being repriced.  The Street is finally waking up to credit risk tied to rising rates.  In recent months we’ve warned, at the current pace of spending in Washington – a year from now we’re looking at quarterly Treasury auctions in the neighborhood of $23B – $26B for long bonds vs. $13-$15B now.  But above all, we must keep our eye on short-term, adjustable rate corporate finance.

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Without the Easy Money Gravy Train, Central Banks create Victims. Exit Strategy?  Oh Really???

“The first casualty from the shortage of $ Libor funding looks like it may well be $DB Deutsche Bank. Libor-OIS spreads are blowing out, as is Libor spread over Fed Funds. A state bailout awaits at some point…”

Raoul Pal

Powell’s Shot Across the Bow

Powell was hawkish on Tuesday. He may continue in that vein today, but he also has the opportunity to temper his comments. President Trump has used the stock market as a measure of his performance. While the Fed is clearly independent, Powell will not want to be pointed to as the reason for a bear market. PCE is reported before his comments today. PCE, as well as employment (w/avg hourly earnings) next Friday, and CPI the following week will be important inputs in formulating expectations for the Fed path. With markets fully pricing in 3 moves this year, we will need a fourth dot to justify the pricing.

Our Associate Arthur Bass, Wedbush

HYG Flash Crash
iShares iBoxx $ High Yield Corporate Bond ETF

It’s very clear, there’s substantial single name (specific companies / large drawdowns) pressure within the high yield index HY CDX, the same applies to the HYG.  Financial conditions are tightening at the fastest pace since 2015, those who are swimming naked (most highly levered) are being taken out to the woodshed.

Short-term, Adjustable rate Corporate Finance

In recent years, CFO’s across America stuffed themselves on an easy money gravy train of Federal Reserve (enabled) sponsored cash.  It was an “all you can eat” buffet and one by one they sat down for supper.

“Ultimately, many years from now, we’ll all be seated at the banquet of our consequences.”

Robert Louis Stevenson

Pumped Up Profits Margins Come with a Price

With pressure to keep profits high, many corporate heads of finance made one of the same mistakes Lehman made, the classic “maturity mismatch.”  Borrowing in the short term, at floating rates is the cheapest form of financing there is – it pumps up profit margins.  But when you borrow short-term and lend/spend long, there’s a price to pay if interest rates spike.  Quite frankly, the refinancing cycle is less attractive than a weekend at Guantanamo Bay.  If the FOMC stays on course, a very expensive and financially destructive consequence awaits many CFOs around the corner.

Floating Junk

Total Floating Rate Junk Loans: $2.3-$2.4T*
*BB or less rates Portion: $1.2T
*B or less portion: $500B

Bloomberg, Barclays data

Interest Coverage Ratio Evaporation

In recent years, many investors have talked up the interest coverage ratio across corporate balance sheets as a form of group therapy.  “Oh, it’s ok.  Even though leverage is at record levels, interest coverage (companies’ ability to meet interest payments) is very healthy.”  If you heard this once, you heard it one thousand times.  Now, think about the power of $2.3T of floating rate – speculative grade – paper at cheap financing terms 2010-17.  By borrowing short term at adjustable rates, U.S. CFOs juiced profit margins to record levels in 2016, but at what consequence?  What happens when short-term interest rates surge?  Memories of subprime adjustable-rate mortgages and their impact on U.S. consumption?

Three Month Libor

As the spike in three-month libor marches higher – with an impact on adjustable rates in mind – Mr. Powell may re-think those four rate  hikes (for 2018) by the time the March 21st Fed meeting arrives.  At the current pace, a large portion of U.S. junk-rated companies will have a very challenging refinancing mountain to climb.

Interest Coverage Decay

If you’re looking at total debt over EBITDA, lower quality U.S. corporate debt issuers’ are levered 4.4 to 4.6x.  Yes, that’s up at 2007 nosebleed levels, look out.  Relax, it’s nap time on the Yoga pad, “interest coverage is fine.”  In recent years, ridiculously low rates placed interest coverage rations at a healthy 4.3x.  But wait.  What happens to that smelly $1T pile of  BB in rated floating rate loans when libor spikes?  In our view, interest coverage plunges below 3x on lower quality paper.  If Powell’s FOMC goes through with (Street’s expectations) hikes 3-4x rate hikes this year, we’re looking at a substantial surge in the default cycle.  The Fed likes to pretend they have an exit strategy, but if you do the math, they’ve buried themselves in a “moral hazard” abyss.

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