All posts by NY Times Bestselling author Lawrence McDonald

Larry McDonald; founder of THE BEAR TRAPS REPORT investment letter, is a political policy risk consultant to hedge funds, family offices, asset managers and high net worth investors. As former Managing Director, Head US Macro Strategy at Societe Generale, he's a frequent guest contributor on Bloomberg TV, CNBC, Fox Business, and the BBC. Larry is a NY Times bestselling author, his book "Colossal Failure of Common Sense" is now translated into 12 languages. He ran a $500 million proprietary trading book at Lehman Brothers, made over $75 million betting against the subprime mortgage crisis and was consistently one of the most profitable traders in the firm. His "Bear Traps" letter is one of the most highly regarded on Wall St. He's participated in 3 major financial crisis documentaries: Sony Pictures, Academy Award winning documentary the "Inside Job," BBC‘s "The Love of Money" and CBC‘s "House of Cards." He's delivered over 72 keynote speeches in 17 different countries, at Banks, Investment Firms, Conferences, Law Firms, Insurance Companies and Universities.

Mortgage Market Meltdown 2.0, Implications are Far and Wide

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“Our indicators tell us, we’re very close to a Lehman-like drawdown,” argues Larry McDonald, a former strategist at Société Générale who now runs The Bear Traps report.

Financial Times, February 20, 2020

Destructive Unintended Consequences 

The Federal Reserve’s response to the Coronavirus crisis is having a significant impact on the mortgage industry. Some industry players believe capital losses within the sector could be on par with the 2008 financial crisis. The epicenter of risk is focused on capital requirements (mortgage lenders need to function) and covenants allowing them to do business. Lets us take a look…

One Loud Backfire
From March 2nd to March 19th, the brain-trusts at the Federal Reserve took the Fed Funds target rate from 1.75% to 0.25%. During the financial crisis, they made a similar move but it was over a 3-month period, NOT 17 days. The unintended consequences of Fed policy are more than significant, the yield on the 30-year mortgage soared. Unintended Consequences:  housing, over 20% of US GDP is at risk as MOST of the entire US mortgage ecosystem is currently dysfunctional.

Three Year Break-Even

Mortgage servicers typically pay 1% of the mortgage loan amount for the privilege of typically earning 0.30% of the loan amount and the responsibility for forwarding the mortgage payments to the loan originator or secondary investor, taking care of insurance, taxes, and records. Thus the break-even for the servicer is a little more than three years.

Black Swan Drawdowns
Countless ETFs in the mortgage sector have crushed investors, large and small alike. Since non-bank financial companies now service most mortgages but don’t have access to the funding window at the Fed like banks do, aren’t these companies in for a massive liquidity shock once people start defaulting on mortgages?

Wipe Out

With the recent overnight collapse in interest rates, these mortgage loans will pre-pay rapidly. Thus the loans the servicers paid for vanish and the servicers see a loss from a wipe-out of their performing loan portfolio. Normally changes in interest rates are gradual enough such that pre-pays are gradually replaced with new mortgages. Not this time!  On the other hand, unemployed mortgagers will default. When that happens, servicers still have to pay the interest to the secondary owner of the mortgage. And most servicers are levered to boot. In sum, the good loans go away, and the bad loans that remain leave no way to pay interest to secondary owners or their lenders. Most banks don’t own the mortgages. They package them up and sell them to ETFs that are bought by retired people. They sell them to pensions and insurance cos. Banks get paid to originate, not to carry them. A holiday would have minimal if any impact on Wall St., but CRUSH servicers.

“The Federal Reserve and its master (Too Big To Fail
Banks) are trying to thin [knock-out] the nonbank servicer
herd through margin calls. As usual Fed economists are too
theoretical to understand markets. Killing one, in crisis
leads to broad failures.” 

Josh Rosner, New York Times Bestselling Author – Reckless Endangerment 

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Be Careful

In recent weeks, there is a meaningful amount of well-intentioned discussion about the suspension of payments (mortgage, car, student loans, etc); keep in mind contract rule of law, protection of private property (creditors) is constitutionally protected – a large reason investors flock to the USA.

Forbearance

Furthermore, the government has granted forbearance of mortgage payments. It is not clear that this is constitutional. Back in the depression, the Frazier-Lemke Act forbade banks from foreclosing on farms. The Supreme Court ruled that law unconstitutional.  The good news is that a Mortgage Services Facility has been created to bridge mortgage servicers through this difficult period. The bad news is that it’s too little, too late.

Many mortgages were already in pre-payment and replacement just as the homeowners became unemployed. The new facility doesn’t contemplate that challenge. Defaults are not deemed collateral and the servicers are left holding the bag.   Additionally, service fees have dropped from 1% to half that. While this means new portfolios may be bought less expensively, the servicers themselves are less creditworthy thus increasing their cost of capital. This loan conduit for the mortgage industry is a shadow of its former self.

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Finally, lenders and servicers alike have hedged their portfolio risk against default by shorting mortgage-backed securities or their derivatives. But the Fed is buying MBS in its new QE program! Thus their portfolios have deteriorated while their hedges have run-up in their faces. The situation is so bad we believe the Fed* is about to reduce the pace of its former announce MBS buying program.  The net result of the above is that the Fed’s actions restrain lending, the exact opposite of what the Fed intended. Whether or not the road to hell is paved with good intentions is a matter for debate. But the road to hell is certainly paved with the corpses of mortgage servicers.

*Note:

“The Fed bought $21B today and reduced the plan for the week from $40 to $30B, no more short settlement either. There should be a liquidity facility for the originators especially since the regulators caused this problem. They can’t allow the basis to blow back out though.”

Barry Knapp

“NY Fed task force to help servicers being formed and trying to figure out how to support servicers who will have to province timely interest and principal payments to investors from those who cannot pay their mortgages (forbearance).”

“The ramp-up in MBS TBA prices has led to unprecedented levels of margin calls on mortgage originators who use the TBA market to hedge their loan production and eliminate any interest rate risk. The situation became acute Monday leasing the Fed to announce a reduction in their daily MBS purchase: the pace of its MBS buying program. Housing, over 20% of US GDP is at risk as MOST of the entire US mortgage ecosystem is currently dysfunctional.  TBA prices did end the day lower than Friday’s close after being up 1/2 point in the late morning. Independent mbs issuers are over 500 firms, the entire industry with 2 more days of ramped up MBS would have been insolvent. “

Larry McDonald

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A Wounded Federal Reserve, a Lehman Era Tool Box sits on the Shelf

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“Our indicators tell us, we’re very close to a Lehman-like drawdown,” argues Larry McDonald, a former strategist at Société Générale who now runs The Bear Traps report.

Financial Times, February 20, 2020

In September and October of 2008, the Federal Reserve showed the beast inside the market their body armor.  With a newly minted – creative toolbox, they stood tall and stared down a large group of short-sellers in what was the most prolific “bear raid” since 1929.

In a strong bull market a larger and larger group of participants “buy the dip” taking stocks to places oftentimes they shouldn’t go.  In a ferocious bear, short-sellers pound overnight futures in an effort to shake the confidence of investors. As stops (stop losses) are triggered – a larger and larger collection of long term investors get placed on the sidelines, confidence is lost and some investors won’t return to stocks for years to come.

LQD Investment Grade Bond ETF

Some would say,  global central bank’s multi-trillion-dollar asset purchases in recent years sowed the seeds of this financial crisis. In early 2020, nearly every asset class was dramatically mispriced relative to encroaching risks. Now losses are in the trillions and we’re handing over more power to the enablers? Unfortunately yes, they hold all the cards.

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Leveraged Loans and the New Shadow Banks

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Breaking: *N.Y. FED’S 42-DAY REPO OP. OVERSUBSCRIBED; $42.55B OF BIDS – Bloomberg, December 2, 2019

$42B?!

Q: Who’s the Fed financing here? Leveraged loans??? Global hedge funds???

A: Fed financing lev loans: Why wouldn’t they? Easier to soak the ground now than be trying to put out the fire later (credit fund).

Looking Down the Road Ahead

Our 21 Lehman Systemic Risk Indicator Index (LSRII) was developed in 2007. It focuses on tracking the contagion effect and provides good and bad signals in terms of effectiveness with one important finding. Like a reliable caddie in golf, the longer you’re together – the better he / she is. There was a group of revolutionaries who tried to stop the madness at the ill-fated bank, but one by one they were silenced. We explore the legendary lessons below, enjoy.

The Crow’s Nest
We know elephants leave footprints. Looking over the calm seas across markets, from the crow’s nest if a hedge fund manager David Tepper sees something meaningful risk wise, the first thing he does is takes 0.25% of this year’s p/l and deploys it at the cheapest, relative value protection. If David Einhorn joins him, Seth Klarman’s head trader as well, that’s fairly detectable. Of course, we have no idea what hedge funds are leaving the footprints, just using those three veteran investors as an example.

Our Global Bloomberg Client Chat

In daily interaction with over 300 institutional investors globally, our live Bloomberg client chat helps to provide clues throughout the year. From time to time we’ll hear about a large “print” either in HY CDX, S&P Futures, Forex vol futures, Eurodollar futures, etc. We’re attempting to measure the accumulation of hedges. More size, the more encroaching risk.

At Lehman, our team attempted to hedge the $6B ish of leveraged loans the bank got stuck with, so the origin of the idea comes from that painful experience.

Over the years, we have altered the index weightings relative to parts of the world where risk is most concentrated. In 2011, CDS on Eurozone banks (exposure to Greece debt) were an outstanding leading risk indicator for US equities, much the way US banks were in 2007-8.

Today, the index has been much more Asia focused. Italian bank CDS is still a decent Salvini political risk indicator as well. Above all it’s important to note, we’re starting to shift the focus – back on the US.

US high yield, leveraged loans, and CLOs are near $3.2T, add the $2.6T of BBBs, you get nearly $6T of risk assets. In the QT (quantitative tightening) world, the Fed cluelessly over-cooked the goose. They pulled too many dollars out of the system and tightened FCIs (financial conditions) far faster than they were aware of at the time (Q4 2018). The beast inside the market literally broke the Fed over its knee like kindling being thrown into the fireplace. It was a beautiful capitulation.

We MUST keep in mind – during the 2000-2002 credit cycle flame out, over 45% of the investment-grade universe oozed into “high yield” bond territory. Today that’s the equivalent of $1.2T of “fallen angels” (vs. $195B in 2000-2002)  – a flood of junk near unimaginable proportions. It’s no surprise the Fed caved in such embarrassing fashion, they had a large gun pointing at their legacy (head).

Today, they’ve deployed the QE fire hose (term repo + $60B/m tbills) but when the mark-to-market of say $150B (20 or so idiosyncratic events) of HY, CLOs, loans and junk IGs falls quickly, the ability of banks / hedge funds to hold these assets is highly unknown, untested. It doesn’t matter if $5.5T of the risk pool is just fine, come near year-end everyone has to put some cards on the table.

U.S. Credit Risk Rising

In our view, leveraged loan funds and ETFs are the new shadow banks, outstanding debt in this dark corner of Wall St. has surged to nearly  $1.5 trillion in the US. While Collateralized Loan Obligations are the largest buyers (about 50%), leveraged loan mutual funds and ETFs are the second-largest buyers comprising around 30% of the demand. Over the years we’ve learned, there’s a waterfall effect across credit markets. Stress in one pocket often leads to two and three fairly quickly.  Credit spread contagion MUST be meticulously monitored, especially with an accommodative Federal Reserve. After 3 rate cuts and a $400B balance sheet reversal from contraction to expansion – why are we seeing stress on the rise? Let’s explore.

A Federal Reserve, Juicing Leverage on Leverage on Leverage
As you can see above, debt to EBITDA multiples at issuance > 5x have surged dramatically. It’s clear to us, the longer the Federal Reserve doesn’t allow the business cycle to function – clearing out the bad actors – leverage on leverage continues to pile up. Look at 2019 relative to 2007, it’s screaming moral hazard at Mr. Powell. Debt multiples < 4x make-up just 10% of loan sale volumes vs. close to 30% in 2007.

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The Liquidity Mismatch

Our friend Rod Dubitsky points out, leveraged loan funds offer the promise of daily liquidity, yet the underlying asset is fairly illiquid and the time to sell could be lengthy. Leveraged loans could take up to 21 days to settle, while the funds are required to meet redemption requests within 7 days, but in practice are expected to provide liquidity in one or two days. Innovation in financial products and ETFs has incentivized the unsustainable in our view. How can ETFs and mutual funds offer realistic liquidity on financial instruments inherently illiquid?

Cash Flow Coverage Fleeting in US Loan Market

It’s a clear liquidity mismatch in our view, one that takes us back to the mid-2000s.

A Lehman Visionary

It was a morning in June 2005, one we’ll never forget. Michael Gelband, a Lehman Brothers managing director and the firm’s head of global fixed income, gave a presentation to our team of traders about the dark side of the real estate market. The meeting began just after 6:45 a.m. Each attendee was handed a dossier of about 30 pages.

In our 2009 global bestseller –  A Colossal Failure of Common Sense (now published in 12 different languages), there’s an epic scene where Gelband described the stunning proliferation of “no-doc” mortgages and other toxic loans, sold by commission-driven salesmen and then purchased by Lehman and other Wall Street banks.

Steve Jobs once said of Einstein, “talent hits a target no one else can hit, genius hits a target no one else can see”. A true visionary, Mike could see the train wreck a mile away.

“He cited the shadow banks, the vast complex network of mortgage brokers that were not really banks at all but managed somehow to insert themselves into the lending process, making an enormous number of mortgages possible while having to borrow the money themselves to do so. He cited outfits such as Countrywide, New Century, HBOS, and NovaStar, among others, and he accused them of creating well over $1 trillion in economic activity that was comprehensively false money and would never be converted into genuine economic power.”

Gelband predicted that the house of cards could soon collapse — perhaps in 2007 or 2008 — producing serious consequences for the U.S. economy.  After the meeting, Gelband didn’t stop pressing the issue. He used his position on Lehman’s executive committee to try to persuade the firm to pull back from its massive bets on the real estate market.  But warnings from Gelband and others with similar concerns were largely ignored by senior management at Lehman Brothers.

We MUST NOT ignore the current signals coming from the leveraged loan market – they are screaming loud and clear.

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Are funds set up to meet a severe liquidity challenge in a distressed environment? We agree with Rod, “no way Jose”. While there have been redemption spikes (a surge in the number of people wanting their money back) even within the last year or so, they have been fairly brief, shallow and occurred during relatively robust economic times.

Fed’s Fire Hose
In recent years, the Fed has saved the day numerous times. First on ending rate hikes after promising to march on, then on quickly shifting to rate cuts, and finally a colossal capitulation on their beloved balance sheet reductions plans ($2.5T in reduction promises to recent $400B expansion of their balance sheet). There have been runs on leveraged loan funds, but each time the Fed put out the fire with a reversal toward far more accommodation. Even so, with all the Fed love, stresses are NOT going away!

Even after 3 Rate Cuts, a Downgrade Surge
We believe the market is underestimating this liquidity risk should the market face a true, prolonged downdraft. In 2019, defaults in the U.S. leveraged loan space are approaching $30B. In October and November, defaults are nearly $10B, that’s about 40% of last year’s total in JUST two months.

Fitch Problem Loans of Concern Index

November: $112B / 8% of the market
July: $71B / 5% of the market
January: $71B / 5% of the market

*Fitch Leveraged Loan data, defaults spike to the highest level in 2 years, forecast year-end 2020 retail and energy default rates at 8% and 13%, respectively. A five-year-old can tell you the rating agencies are the last to get the joke in any default cycle.  Looking back over the last 70 years, credit cycles are littered with embarrassing flashes of rating agencies playing catch up on defaults. Hence, if the Fitch “problem loan” basket is up to $112B, it’s safe to assume that the number is substantially higher in reality.

Cash vs. Low Quality “B” Holdings

To assess the risk for redemption fails, we looked at two key measures for the top 10 leveraged loan funds (about $60B in total). Specifically, pay attention to the percentage of holdings of Single-B rated and below assets and the percentage of cash held by the fund (cash being a proxy for the ability to meet a spike in redemptions).

Houdini Liquidity, now You See it Now You Don’t
As the chart above shows, most funds have over 60% invested in single-B and lower-rated assets, yet typically have cash positions at just 5% on average. One fund held only 0.32% in cash and yet had over 70% in single-B and below assets. In a prolonged sell-off, the 5% cash would likely prove grossly inadequate in the face of reduced overall market liquidity, lengthening settle times and a spike in redemptions. In a severe downturn, it’s likely that a significant percentage of the loans would be downgraded to CCC, rendering sale much more difficult and all the while prices likely would be collapsing.

Cash Shortfall, Implications

While some funds may supplement cash liquidity with access to a line of credit and/or holdings in more liquid bonds, it’s not clear either of these would be sufficient. Lines-of-credit may not be available when needed and even if they are drawn they may create a senior claim on the remaining assets thereby amplifying risk for those who remain in the funds.

Credit Leads Equities
The Blackstone GSO credit fund is loaded with lower quality (B rated) leveraged loans. It’s interesting with stocks ripping to new highs, B rated loans are under meaningful selling pressure as downgrades mount. If credit is weakening at this pace with a U.S. economy near full employment, what will happen when stresses mount?

Redemption Risk isn’t Theoretical

There is a history both during the financial crisis and more recently of funds having to freeze redemptions due to lack of asset liquidity (most recently the Neil Woodford managed funds in the UK). In fact, in 2015 the Third Avenue Focused leveraged loan fund collapsed amidst a flood of redemptions.

Finally, cascading redemption freezes would likely reverberate through the entire leveraged loan markets including CLOs which would face greater difficulty in trading distressed loans and a deterioration in recoveries.

Rod Dubitsky has over 30 years of experience in the financial services and global development sectors.  Founder of The People’s Economist (TPE).  The bulk of his career had been spent in financial services working for rating agencies, wall street dealers, banks and money managers developing a range of market-leading, award-winning research, and analytical platforms. Frequently quoted in the media including Time Magazine, Forbes, NY Times, WSJ, FT, and Bloomberg.  While working in finance, he was a top-ranked analyst for Credit Suisse in the consumer ABS finance sector and led the newly create advisory analytics division for PIMCO with responsibility for overseeing some of the largest post-financial crisis bailout consulting engagements.

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Dollar and Election 2020, the X-Factor

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US Dollar Carrying Outsized Macro Risk Factors

In our view, just 30 counties will determine the next President of the U.S., memories of 2016 indeed. If you look closely, the U.S. dollar’s labor market sensitivity in these key regions is the most compelling development of all. This unique data offers a “looking glass” into the 2020 election outcome. With our partners at ACG Analytics in Washington, we’re spending a lot of time focused on the most revealing inputs and locations across the United States. Four years ago we made some important discoveries for clients pointing to a Trump upset win. Today, we’re looking to add alpha down a path less traveled. Let’s explore.

What’s the True Price of a Strong Dollar?

Like a loud vacuum, a strong dollar sucks important U.S. manufacturing jobs overseas. Votes in all-important States with the most significant election-outcome influence are on the line. This is a major problem for the White House and it’s receiving substantial attention around the halls of the West Wing we’re told. The higher greenback raises the price tag of U.S. manufactured goods around the world. In response, President Trump desperately wants a softer USD, and he will do just about anything to get it.

Wrecking Ball Policy Divergence
In an attempt to support the Eurozone economy, since 2014 the European Central Bank has expanded its balance sheet by $2.7T and kept its deposit facility rate between -0.20% and -0.50%, suppressing the Euro currency. If there was a score for cheating on the global trade playing field, ECB chair Mario Draghi has a perfect “10”. Over the same time period, the Fed hiked interest rates 9x and reduced its balance sheet by $600B, per Bloomberg (since this clear policy error, the Fed has recently expanded its balance sheet by $200B and cut the Fed funds rate upper bound from 2.50% to 2.00%). This bizarre policy divergence between the Fed and ECB has empowered the global wrecking ball that has become the U.S. dollar. Trump’s bid to stay in the White House hangs in the balance.

U.S. Election Risk and the Dollar

As we look down the road ahead, this factor is forging significant macro-risk. A sharp blade hangs over markets. Day after day, asset managers are asking us more and more questions. “It’s like Argentina on roids. The candidates are just as far apart, but the possible wealth destruction in the United States with an incoming left-wing government – after Trump fueled bull-market is unimaginable”, our Larry McDonald told an audience at a conference in Latin-America last week. Enormous tails indeed. Unlike previous U.S. elections, the risk-dynamics for investors are LARGE given the colossal spread between market-friendly and un-friendly candidates in 2020. We must keep a trained eye on these developments. In our view, U.S. stocks could fall more than 40% if the probability of a – Warren, Sanders, Harris – election win starts to rise meaningfully. Watch the U.S. Dollar, here’s why.

President Trump pulled off a historic 2016 Electoral College upset with a 304 to 227 margin of victory. There are a total of 538 votes in the Electoral College and a candidate must win a simple majority (270) of those votes to win the election.

*Trump garnered 304 electoral votes and Clinton 227, as seven faithless electors, two pledged to Trump and five pledged to Clinton, voted for other persons. – Wiki

The Key States and Key Counties, Electoral Votes

20 PA Pennsylvania*
18 OH Ohio
16 MI Michigan*
10 WI Wisconsin*

*That’s 64 total electoral votes in these all-important States, Trump pulled off an inside straight, winning MI, WI, and PA by just 77,744 votes (per NYT, Wiki data).

Into 2020, the Greenback is Wearing Outsized Risk Factors 
In Q3, the U.S. Dollar’s surge to its October 1st peak of 99.67 (97.28 today) did some serious damage to manufacturing jobs in MI, WI, and PA (see the image below). This places TRUMP in a meaningful risk position, far more than U.S. equities are currently pricing-in. If you do the math, Trump CANNOT win these states in 2020 with a strong dollar. U.S. equities are at grave risk unless the White House / Fed can get the greenback down, and down fast.

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The 2019 Dollar Surge Higher Comes with a HIGH Price for TrumpSimilar to 2015-2016, this year as the dollar soared, U.S. export products to other countries became far more expensive and manufacturing jobs in Michigan, Wisconsin, and Pennsylvania plunged. 

Trump Tweets and the Dollar

In August, Trump tweeted yet another message of worry focused at Federal Reserve Chair Jerome Powell. That included yet another mention of how strong the dollar is, with Trump saying “highest Dollar in US History.” It was the latest entry in Trump’s crusade for a weaker dollar, which he says will give the US a leg up in the ongoing global trade war. He’s continuously lashed out at the Fed and Powell (see October 1, 2019, above) as the reasons for the greenback’s strength.

Important Lessons from 2016
After the 2015-2016 US Dollar surge, manufacturing jobs in the U.S. came under serious pressure. We believe this factor, among others, cost Hillary Clinton the election. Heading into 2020, there are few things Treasury Secretary Steven Mnuchin and of President Donald Trump want more than a weaker Dollar.  It’s probably not too much of a stretch to say that the Dollar’s 2014-2016 surge delivered Michigan, Wisconsin, and Pennsylvania to Trump on the back of undermined manufacturing and exports (see the above image, Dead Zone). The President clearly knows this and it’s part of the reason for his regular tweets and comments lamenting Powell’s interest rate 2018 rate hikes and the strong USD. Stay tuned.

US Labor Force Size, Millions of Americans Employed

October 2019: 164.5m
November 2016: 159.5m

*Seasonally adjusted, US Bureau of Labor Statistics data.

There’s is one very large bright spot for Trump coming out of the labor market. Roughly 5 million more Americans are employed today relative to November 2016.

“Are you better off today than you were four years ago?”

In the final week of the 1980 presidential campaign between Democratic President Jimmy Carter and Republican nominee Ronald Reagan, the two candidates held their only debate. Going into the Oct. 28 event, Carter had managed to turn a dismal summer into a close race for a second term. And then, during the debate, Reagan posed what has become one of the most important campaign questions of all time: “Are you better off today than you were four years ago?” Carter’s answer was a resounding “NO,” and in the final, crucial days of the campaign, his numbers tanked. On Election Day, Reagan won a huge popular vote and electoral victory. The “better off” question has been with us ever since. Its simple common sense makes it a great way to think about elections. And yet the answers are rarely simple.

 

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Madness of Crowds in Bonds

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June 2017

Since early 2017, the European Central Bank has purchased another $1T of assets, blowing their balance sheet up near $5T. Most of this capital has flown into government and corporate bonds with meaningful implication. Let us explore.

Each day that goes by, there are fewer and fewer bonds for investors to buy.  The ugly side effects of this experiment are now oozing through bond markets around planet earth.

It was an all you can eat buffet. Back in 2017 with the ECB distorting global bond prices, Argentina found loads of buyers for an ultra-long dated – 100 year – bond. Today, with this pile of debt approaching 36 cents on the dollar, investors have been left holding the bag to the tune of a $2B loss. That’s nothing, senior secured lenders to Argentina at the IMF are sitting on $56B of capital that has just been lit on fire, while U.S. taxpayers are on the hook for $20B of that loss.

If you sit back and think about the current dynamic playing out in the global bond markets, you see a circular beast eating nearly everything in its path. Central banks have been preventing the cleansing process of the business cycle from functioning by buying assets, near $15T between the Fed, ECB, and BOJ.  The good news is, trillions of dollars in new wealth has been created that needs a home, with the top 1% getting richer by the day.  On the other hand, with fewer choices to buy, bonds with negative yields have climbed from $5T in September to $17T today. Bottom line, investors are being “shoe-horned” into places they just shouldn’t be.

Years Argentina has been in Default

2013-15
2000-04
1980-92
1955-65
1950-51
1890-93
1826-58

Amazing, with this track record, investors bought $15B of bonds in 2016-2017. This week,  the Macri government in Argentina announced it will postpone paying $7B of short-term local debt for up to six months while pursuing a “voluntary reprofiling” of $50bn of longer-dated debt, the majority of which is owned by foreign investors. The government also said it plans to delay the repayment of loans already disbursed by the IMF. Argentine bonds plummeted to record lows on the news, with the once-popular “century bond” maturing in 2117 plunged near 36 cents on the dollar. The shorter-dated dollar debt coming due in 2021 fell below 50 cents on the dollar, pushing its yield to nearly 60%, per the FT.

A Tale of Two Countries
The double-edged sword of duration is on stage here.  Some investors like ultra-long maturities with low coupons because their prices rise dramatically when their yield falls. In the great race away from negative yields, over the last year, Austria’s long bond has doubled in value, while Silver is 32% higher, and gold up more than 29%.

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Have and Have Nots in U.S. Corporate Bonds
The junk of the junk, why has CCC-rated paper dramatically underperformed while capital is flying into BB credits in the U.S. In the middle of the ‘everything rally’ – one would expect beta-chasing to drive demand for the highest yield, worst rated high bonds. That’s NOT happening. To us, this is an important signal, we’re very close to the ugly credit saturation point. Even with colossal pressure from central banks to reach for yield, rising default risks are keeping investors away from CCCs. What does this mean for U.S. stocks?  Pick up our next report, just click on the link below.

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Semiconductors on the “Other Side of the Mountain”

Join our Larry McDonald on CNBC’s Trading Nation, Wednesday at 3:05pm ET

Pick up our latest report here:

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What is a reversal formation? It’s where you see distribution after a trend move.  The “Other Side of the Mountain”, or a 1999 style top, is a rare thing of beauty.  It’s the ultimate expression of “fear and greed”; a large group of people, completely oblivious to the reality coming upon them and the rapid transition from FOMO (fear of missing out) to GMO (get me out). There are many kinds of reversal formations, but a classic is the Island Formation. In the US  technology sector, 1999 and 2019 are looking more alike every day. Let us explore…

Land Ho!

Island Formations are rare and news driven. Typically, for an “Island Formation Top”, you would see gappy (short and intense) price action up to a peak, followed by gappy price action down. This is indicative of traders not having enough time to react to rapid news fire. They buy emotionally and then, with a negative change in the news, have to sell right away. This leaves a hard resistance level to overcome ⁠—  “the memory of pain”.  Ideally, one looks for other confirmatory technical indicators. The minimum target is merely the size of the formation itself, but they can be indicative of a permanent reversal of fortunes (for ill or good).

And, as per the above, if the formation happens without a change in the news, it is immediately suspect. Sometimes an island is nice and neat. Other times, however, it probes around a bit and looks a bit sloppy. The latter is what we’re seeing with the SMH Semiconductor ETF. However, individual members thereof had crisper, neater island formations.

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Here is the SMH chart (with detailed commentary below):

SMH Semiconductor ETF — Lookout Below
Part I: The possibility of an island: In April, the SMH Semiconductor ETF enjoyed a parabolic (and, by implication, unsustainable) rise dotted by a plethora of up gaps, indicating desperation to buy. The April 3rd gap was particularly impressive, as there had been a violent up-move day in late March which was immediately reversed in dramatic fashion in the next one and a half trading sessions. The April 3rd gap happened at the peak of that reversal.

Part II: The Prelude to an island:

There had been an uptrend line off the late December/January bottom that tracked nicely with the 50-day moving average. So all looked good until the second half of April. There was a big up day on April 16th, which was followed by a big gap up the next day. After a few days of trading with a peak that failed to hold the highs of the day, we saw a sharp move down on April 25th, then…

Part III: An island is formed:

The first down-gap occurred at the same level as the April 17th up-gap. In other words, an island was formed. The news was reversing quickly: enthusiasm for a deal with China turned into anxiety that one would fail to materialize.

Part IV: Aftermath of the Island top, a new downtrend:

After a tentative move up came to a halt in early May, SMH gapped down again but closed at recovery highs, albeit still down. However, what followed was a negative down-gap the next day and a failed rally attempt the one after…

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Part V: The uptrend breaks down completely:

At this point, true bear recognition that the end was nigh occurred when the uptrend line (in green on the SMH chart) broke. For two days, a noble effort ensued at the 50-day moving average (which latter was flattening out, not good). But all hope was lost the following day with a gap down to 105 and a close near the lows of the day. There followed a meek rally to the underbelly of the 50-day, which was quickly negated by crushing selling below the 100-day and a dramatic gap down. A valiant rally attempt filled the prior day’s gap only to be met with still more selling and a visually meek optimistic close on the 100-day. Then the next day, a gap down followed by yet another gap down the next day.

Clearly, traders were completely whipsawed by the shifting China tariff narrative.

Colossal Rotation is in the Works
A meaningful rotation is in the works here, near historic proportions in our view.  Slow growth consumer staples have outperformed growth stocks in the semiconductor sector by 2200bps (22%) over the last year.

Part VI: Short term base for a short term rally:

Several days of indecision followed this carnage, indicating that 1) ill-considered long positions had been liquidated and 2) a potential trading reversal was in the offing. Sure enough, in early June, we saw the first true solid up day in weeks with a substantial move back up above $100. A touch of indecision the next day preceded a brisk four-day pop that gapped over the 100-day moving average. However…

Part VII: Resumption of the downtrend:

The relief rally ended with a bearish reversal day at the 50-day moving average. This also coincided with the short term reversal top from late March and was roughly at the 50% retracement level of the previous precipitous decline. The next day, it broke the 100-day, though, on the day after, it tested its underbelly. On the third day, however, it gapped down again forming…

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Part VIII: A second mini-island formation:

As a result of today’s gap down, we have had four days of isolated trading at the gap level just below 105. (I excluded the mini-horizontal line in the chart as it clogged up the visual too much…).

In our view, the path of least resistance is down to the $90 area where it had shown support in the late October/mid-November period last year. Lookout below!

Island Formations don’t always work and you don’t always see them. Nonetheless, if the formation fits a violently shifting news flow, as this example clearly does, then the technical analysis and fundamentals agree and we have quickly reversing trade.

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Leading Indicators: Regional Banks, Corporate and Consumer Credit Risk

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1933 Industries

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In our 21 Lehman Systemic Risk Indicator basket, consumer credit is an important component.  In any late cycle economic slowdown, charge-offs at banks, or credit write-downs must be monitored closely.

With this in mind, Capital One COF is an important bellwether to keep an eye on – they have a heavy hand in the consumer credit space. From Q1 2006 to Q1 2008, COF equity was 55% lower, she was screaming, “Houston we have a problem.”

Today, there’s a far different picture (below).  Shares of Capital One surged nearly 5% Friday after the bank reported first-quarter results ahead of Wall Street expectations. The company reported first-quarter adjusted net income of $2.90, topping analysts’ expectations of $2.68 in the period. Adjusted revenue of $7.08 billion was also above Wall Street’s $7.01 billion expectations.  Revenue increased 1% year over year while non-interest expenses decreased 11% to $3.7 billion in the period.

They scored Q1 2019 net income of $1.42B or $2.86 EPS (earnings per share), compared with $1.33B or $2.62 EPS in Q1 of 2018. We have an eye on provisions for credit losses, which rose 3% sequentially, or 1% year-over-year, in Q1 to $1.6B, but charge-offs remained relatively flat.

The company’s management sees “degradation” in customer credit quality. Overall, COF’s 1Q U.S. card charge off rate was 5.05%. While industry charge off rates rose to 3.85%, the highest since 2Q12. There are clearly some red flags pointing toward problems approaching the credit-card industry.  A look at loans thirty days past due, a warning of future write-offs, surged at all seven of the largest U.S. card issuers.

There’s been a “degradation” in credit quality for some customers, per Richard Fairbank, Capital One’s  CEO. The company is the third-largest card issuer in the USA. Fairbank said some customers with negative credit events during the financial crisis are now seeing those problems disappear from their credit-bureau reports.

“In general, we have been contracting credit policy at the margin and tightening,” Discover CEO Roger Hochschild said on a conference call this week.  American Banker noted, some credit card companies are closing inactive accounts and slowing down the number and size of credit-line increases for both new and existing customers. Consumer credit is contracting, slowly shrinking, a tightening of financial conditions relative to recent years in our view.

Capital One, leaving Regional Banks Behind
Capital One COF was a standout this week, we noticed significant divergence to the upside relative to regional bank equities.  A short squeeze was in play in our view, short interest in COF shares rose to nearly 6m shares in Q1, up from 3m shares short in September 2018. Strong earnings results were the driver of the squeeze,  the company also put forth initiatives to boost margins as it lays out a path to become more efficient. It’s important to note, few stocks actually lost too much ground in Financials as the sector was firm this week but trust bank State Street STT was the worst performer. Organic growth at Trust Banks is facing a number of headwinds.

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Winner and Losers
The driving theme for the week across asset classes may have been the increasing emergence of relative value trades even as the S&P 500 Index climbed to a new all-time high. To be sure, being ‘long & strong’ has paid off for US stock investors again in April — the S&P 500 is up over 3.5% for the month. But April has also brought even greater returns from relative trades such as long Tech/short Healthcare or long the dollar vs. the euro over the past week.

Stocks Back on their Highs without Junk Bonds
Stocks are partying like it’s 1999, while junk bonds are showing signs of cracking. We’re looking down the barrel of a high pace of credit rating downgrades. Per S&P Ratings this year, the ratio of downgrades to upgrades is the worst since 2016’s energy price collapse, back then oil was $26 vs. $64 today. We’re seeing a sharp breakdown, a meaningful underperformance of poorer quality credits. Credit deterioration is picking up even with CCC high yield index up +10.1% YTD, Q4 loss was near -10%. If you look at the frequency of bonds in a -20% or more hole (substantial sell-off in price), in 2019 we’re at double the pace of 2017 in terms of blow-ups in the CCC corporate bond space.

Bonds: US CCCs in Q1

Loss of 10% or More: 8.2% of the Universe
Loss of 20% or More: 5.1% of the Universe

Citi data

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