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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This time, Stocks are Swimming Naked without Bonds

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“We believe inflation is set to finally pick up in 2018. Much of the passive and quant-side (a $1.5T shift in asset management) has become heavily invested in the “risk parity” model which involves being long equities and bonds on a risk-adjusted basis. One of the fundamental problems with this strategy is you’re effectively really long disinflation.  Sure, it’s worked very well in the post great financial crisis period, but it’s a grossly crowded trade and has all the makings of a gruesome slaughterhouse.   In this case, the risk tail is a period where equities and bonds fall together, which is not that uncommon in a late cycle inflationary environment (see 1980s and 1990s). Other than out of the money puts in rates (bonds) a big way for this crowd to hedge inflation is to increase commodity exposure.  As long-time bulls, we’re now ‘pounding the table’ bond bears for 2018.”

Bear Traps Report, January 2, 2018

Think of the dentist in Cleveland, Ohio with $1M in stocks and $1M in bonds in a portfolio. For the first time in twenty years, he / she is looking at their brokerage statement and seeing NO wealth destruction OFFSET from bonds.  Let us explain.

Bonds Protect Stocks, No More
In the 70s and 80s this was very common – over 21 instances where stocks and bonds sold off together two weeks + (clearly inflation-driven). In the 90s only a few (3) instances,  From 2000-2018 there had been nearly zero 2-3 periods where stocks and bonds moved lower together – UNTIL NOW.  As you can see above.  In the 2010, 2011, 2014, 2015 and 2016 equity market drawdowns – bonds rallied in a substantial fashion.  In every “risk off” regime, it has been  stocks DOWN – bonds UP for as far as the eye can see.  This month, for the first time in nearly two decades, the negative correlation between stocks and bonds turned positive.  This is a MAJOR game changer for the wealth management industry.

Twenty Year Lows

Investors cut bond market allocation to a 20-year low amid fears of a ‘crash’ – The recent market correction and spike on bond yields scared professional investors, according to the February Bank of America Merrill Lynch Fund Managers Survey. Investors sliced bond allocations to their lowest level since 1998, with a net 69 percent underweight fixed income.  – CNBC

  • US Treasury Federal Budget, Yearly Tax Receipts vs. National Debt

2017: $1.787T vs. $20.244T*
2007: $1.163T vs. $9.002T

US Treasury Data

*US debt to surge by $1T every year until 2022 under Trump budget.

Early Innings

When you think about the $1.5T of capital that’s flown into passive bond ETFs and risk parity strategies, this crowd has a colossal disinflation bet on. In a regime change, a period where stocks and bonds move lower together, the flight of assets out of passive bond risk parity will be ferocious. Then add the credit quality deterioration globally (AAA rated corporates / sovereign credits off 30-40% in terms of the amount of high-quality paper last 10 years). Then look at debt to GDP in G20 countries, up from 70% (ten years ago) to near 100% (maybe 110%) today.  Next, look at the emerging market (EM) dollar-denominated debt issued 2007-2017, in the trillions.  There’s a new EM player at the table trying to sell/refinance a large debt load.   Next, look at the budget explosion out of Washington.  The 2018 US budget deficit has ballooned from $700B (year-ago forecasts) to nearly $1.2T. All this speaks to a regime change.  We believe we’re in the first or second inning, there’s a lot more to come.  Stay tuned.

The 2529 Bounce

Fierce bulls are never taken down by one sword, this one has some fight left.  So far we’ve seen two bounces (7.8% and 4.9%) off of 2529 in S&P 500 futures.

Largest US Equity Market Wealth Destruction

2008: -$10.5T
2015: -$4.5T
2011: -$3.7T
2018: -$3.2T**
2010: -$2.4T

*Last 10 years, Bloomberg US Market Capitalization data.
**Only instance in the last 18 years where bonds also lost value.  As the ten-year Treasury bond surged in yield (2.02% to 2.85%), bonds have lost nearly $2T in value since September.

2008 Equity Drawdown

In the 2008 equity drawdown, bonds rallied from 4.22% to 2.05%, providing nearly $4T of positive cushion to offset the equity wealth destruction.

2015 Equity Drawdown

In the 2015 equity drawdown, bonds rallied from 2.44% to 1.35%, providing nearly $2.1T of positive cushion to offset the equity wealth destruction.

2011 Equity Drawdown

In the 2011 equity drawdown, bonds rallied from 3.42% to 1.74%, providing nearly $2.5T of positive cushion to offset the equity wealth destruction.

2010 Equity Drawdown

In the 2010 equity drawdown, bonds rallied from 3.92% to 2.82%, providing nearly $2T of positive cushion to offset the equity wealth destruction.

2018 Equity Drawdown

In the 2018 equity drawdown, bond SOLD OFF from 2.05% to 2.85%, ADDING nearly $1.4T of ADDITIONAL wealth destruction.

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Short Volatility Armageddon

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It was 5:30 pm Monday evening, after the largest single-day percentage move in the history of VIX.  And then it finally happened.

Short Volatility ETFs, like Credit Suisse’s VelocityShares Daily Inverse VIX ST ETN (XIV), plunged like never before.  The XIV was down 81% after-hours, from where it closed (-15%) during Monday’s trading session. At $18.60 per share of the ETN, traded 87% cheaper than its recently-minted all-time highs of around $145.  It was a game changer after hours.

Breaking:  *VIX SURGES ABOVE 50 FOR FIRST TIME SINCE AUGUST 2015, February 6, 2018 at 7:15am.

What happened to the SVXY?

We believe XIV and SVXY covered nearly 200,000 VIX futures just after Monday’s close.  That’s 200 ish million vega.  This was a major contributor to the colossal VIX futures spike from 4-4:15pm and added to the S&P selloff pain.

Stepping in Front of a Freight Train to Pick Up a $20 Bill

A look at the weighted 1-month VIX futures basket tracked by these ETNs (XIV SVXY), shows that they’re weighted roughly to 34%-36% Feb VIX futures and 64% – 66% March VIX futures.  These contracts went from 15.20 (on Friday, February 2nd) to close at 29.81 on Monday, February 5th.  Hit by a train? That’s a nearly 97% single-day increase or a lot of PAIN for volatility sellers.

Net Asset Value

VelocityShares has officially reported the XIV NAV of $4.22 for February 5th (down 96% from the February 2nd’s value). As for ProShares Short VIX Short-Term Futures (SVXY), the situation is far more opaque, but most likely the NAV is around $3 to $6, down from January’s $140 high.

Introduction To The Problem. Late Last Year, we laid it all Out for Clients in our Bear Traps Report

In the present environment of low volatility and low yield, many investors have reached out to yield enhancing strategies by selling volatility. When yields are low, investors sell volatility to generate extra income. The supply of yield seeking risk premia strategies has grown by $1bl vega in recent months, equal to 30% of S&P options market.

RIP XIV

Over the last year, a strategy that sells 1-month VIX futures has yielded a total return of 200%. During that time the XIV soared, but ultimately she was not long for this world.  Trading at $5.70, down from $145.40 just a few days ago, sustainability is the topic of the day.  The popularity of this strategy is manifested in the doubling of VIX futures’ open interest in the past year. Some strategies that target volatility are embedded in many equity-linked insurance products and risk parity funds. Risk parity funds tend to hold bonds and equities (parity) and have an estimated half a trillion of assets.

Bad Incentives

A low volatility environment encourages more option selling (and more leverage) in a self-reinforcing feedback loop. Another popular short vol strategy has been the selling of (levered) VIX ETFs and buying of inverse VIX ETFs. The popularity is demonstrated by the 6-fold increase in VIX ETF outstanding.

Off the Recent Highs, Global Pain

Japan Nikkei 225: -12.6%
Russell 2000: -12.6%
S&P 500: -12.1%
Nasdaq: -10.9%
China Hang Seng: -8.6%
Eurostoxx 600: -8.4%
India Sensex: -8.1%
China Shanghai: -6.1%
Brazil Ibovespa; -4.9%

*including futures markets, Bloomberg terminal data.  The Cboe Volatility Index climbed as much as 35 percent early in New York, surpassing 50 for the first time since August 2015. It traded at 49.21 as of 7:52 a.m., a level that would mark its highest since the stock-market bottom of March 2009 if held through the close.

The vega in levered VIX ETFs is close to extremes, as well. Vega measures the change in the price of the underlying asset for every 1% change in underlying volatility. The combined vega in levered and inverse ETFs has reached $200M, so even a spike in volatility similar to August 2015, would force VIX ETFs to buy an incredulous $37B exposure in short term VIX futures. Such a spike can even get more exacerbated in case liquidity dries up as the market realizes certain structures need to rush in and cover their shorts at whatever the cost.

This $200M vega creating $37B in demand for short term VIX was based on a 45% spike. Today VIX closed up 89.77%. The forced buying therefore could be much, much bigger.

The Ugly Resolution

When the gross Vega outstanding in inverse and leveraged VIX ETFs was approximately $200ml (for the AUG 2015 +45% VIX spike), if volatility increased, these inverse and levered volatility products become overexposed to short volatility and need to buy volatility via short-term VIX futures, to adjust their exposure. At the same time leveraged long VIX ETFs become underexposed and they too need to buy more short-term VIX futures to adjust exposure. Should the VIX futures go up by 50% in one day, these levered and inverse ETFs would need to buy 70,000 VIX futures to rebalance their portfolios. Many of these funds must rebalance by the end of the day.

The danger ahead is now twofold. In addition to the significant increase in exposure to short volatility strategies by all types of investors, the low absolute level of the VIX causes it to increase more in percentage terms with any move in the S&P.

Goldman on the Vol ETN Crash

Early Warning Signs

Back in August of 2015, when Chinese authorities unexpectedly devalued the Yuan, implied volatility surged almost 200% in a matter of days. But if such an event would happen these days, with $200ml Vega in VIX ETFs alone, the managers of these ETFs would -theoretically- need to buy $37bl in VIX futures. Open interest in the VIX future contract is not nearly enough to absorb such a burst in buying volume, especially if volume dries up as the market realizes certain structures need to rush in and cover their short at whatever the cost. ETF managers, as per their prospectus, can hedge via alternatives if the VIX futures market becomes inaccessible.

ETF managers and their investors are not the only ones being caught short volatility at the worst possible time. Hedge funds, in an effort to pick up extra yield by shorting vol, are now short $250ml vega as well, according to Morgan Stanley.

Options open interest is also significant from investor selling of options to generate extra income. As of the end of Q1, market makers had almost $700bl in long options positions. Since market makers are on the other side of an option selling strategy, it implies investors are short nearly 700bl in options, up from $500bl a year ago. While this is not the entire market and many of the options may offset a long position, it is a reflection of different facets of short vol exposure.

All these structures risk becoming unhinged if volatility spirals upward in an uncontrollable surge. The large concentration of assets in passive and quant funds, and their current dominance in liquidity, combined with the dramatic buildup of exposure to volatility ETFs, sets the stage for a systemic sell-off. When ETF managers have to rush in the market to buy volatility and at the same time quants and passive funds rush to the narrow door of liquidity to get out, the market could go into a free fall. The nature of the “unknown unknown” risk is that we don’t know it until it hits us in the face. So the timing of such an event is fluid, it could happen today but it could also never happen.

Short-Term VIX Buying; Front-Month Led Backwardation Across The CurveToday we saw backwardation across the VIX curve (above UX2-UX8) at levels on-par with Brexit, and much above election night. With all this forced buying happening — and left to happen– are we going to see even higher levels tomorrow?

 

A Case Study: August 2015 VIX Spike

Taken from August 14, 2017 The Bear Traps Report, “Regime Change”:

“A record number of VIX options traded on Thursday, as well as $11.5B of VIX ETPs, the second-biggest value ever. That led to the third-largest day for VIX futures rebalance, with nearly $55M vega bought on the close. There are two inverse ETPs that sell the front of the VIX futures curve – XIV (an ETN) and SVXY (an ETF). With VIX futures at higher levels, the risk of a blowup in ETPs because of large rebalance — and the potential for inverse VIX ETPs to be stopped out — is less likely. XIV could liquidate with a 80% move* or more in the underlying in one day, while SVXY could start getting margin calls with a 60%+ move. *According to the prospectus, for XIV (in possession of nearly 75k short contracts) would be forced to unwind if the NAV falls more than 80% intraday, with investors receiving the end of day value. Keep in mind, this is a publicly known trigger – therefore as market stress moved toward that figure would likely bring on buying (by the ETN provider and/or market participants) in anticipation of the unwind. As an ETN, XIV investors receive the theoretical value of the index based on its rules, not what the provider actually trades.”

 

UVXY Prospectus – Was Today An Act Of God?

From the Proshares UVXY prospectus: In the event position price or accountability rules or position limits are reached with respect to VIX futures contracts, the Sponsor, in its commercially reasonable judgment, may cause a Fund to obtain exposure to the Index through swaps referencing the Index or particular VIX futures contracts comprising the Index. The Fund may also invest in swaps if the market for a specific futures contract experiences emergencies (e.g., natural disaster, terrorist attack or an act of God) or disruptions (e.g., a trading halt or a flash crash) which, in the Sponsor’s commercially reasonable judgement, prevent, or otherwise make it impractical, for the Funds to obtain the appropriate amount of investment exposure to the affected VIX futures contracts. Each Fund will also hold cash or cash equivalents such as U.S. Treasury securities or other high credit quality, short-term fixed-income or similar securities (such as shares of money market funds and collateralized repurchase agreements) as collateral for Financial Instruments and pending investment in Financial Instruments. Each Fund may invest up to 100% of its assets in any of these types of cash or cash equivalent securities.

 

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Inflation Fears, Fragile Market

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The recent sell offs in the S&P 500 and U.S. Treasury markets have been tied to a narrative of increased inflation and rising interest rates.

The inflation concerns have been supported by a few surprise data-beats. Today’s ISM Non-Manufacturing Index beat the consensus of 56.2, printing a much-higher than expected 59.9. Last week, non-farm payrolls of 200k beat consensus of 160k. Also, the long-awaited increase in wages may be starting; average hourly earnings (YoY) was higher, 2.9% vs. 2.6% exp. Wednesday’s Chicago PMI came in modestly above consensus at 65.7 vs. 64.

 

ISM Prices and 10-Year: Soaring Inflation ExpectationsWhile ISM’s measure of prices paid increased to the highest level since May 2011 (keep in mind, U.S. 10 year bond yields were up near 3.50% in the Spring of 2011).  What’s driving all the bearish bond sentiment?  One major reason is found in the “growth to bold yield” disconnect.   For most of the last fifteen years, the U.S. 10 year bond yield was “tied to the hip” of manufacturing ISM prices paid.  In our view – as you can see above – the current level of ISM prices paid should be associated with U.S. Treasury bond yields 60-70bps (+0.60% to +0.70%) higher than current levels.  In recent years as inflation expectations plunged, the disconnect between ISM and 10s (Treasury bonds) widened.  Over the last month, as inflation expectations surged, these two long lost friends are spending far more time together. 

AHE Climbing; Breakout In 30 Year YieldIs increasing wage growth (finally) here? Above, Friday’s average hourly earnings beat expectations; showing 2.9% vs. the 2.6% expected. The 8:30am data release was a catalyst for the day’s bloody sell off in both bonds and stocks. The DJIA finished 666 points off; the U.S. bond selling rattled the global markets, prompting additional declines in nearly all major global indices since. Previously included in “Regime Change” . 

 

Inflation Isn’t A New Development

In addition to the data, there are supply and demand dynamics that should continue to put upward pressure on rates in 2018. The deficit is growing (at an increasing rate), and the Fed and ECB are both, for now, on course with their respective selling and decreased buying.

The mechanics of this paradigm shift in the bond market are not new, however. Most have been covered in past blog posts. The underlying symptoms have been untreated for quite some time, and the risk of an inflation-driven interest rate shock is still growing, according to some of the most powerful finance executives.

 

Finance Chiefs at Davos: “Can We Have a Soft Landing?”

One commonality in the commentary and speeches from this year’s World Economic Forum in Davos, Switzerland, was the globally-present susceptibility to an interest rate shock. Among the list of speakers to reference this apparent systemic risk was Axel Weber, of UBS, Benoît Cœuré, a member of the European Central Bank’s executive board, Ray Dalio, Bridgewater founder, and Min Zhu, the former deputy chief of the IMF and the People’s Bank of China.

 

Axel Weber

Mr. Weber, chairman of UBS and former leader of the Bundesbank, tips his hat to the central banks that have found themselves nearly 10 years into an unprecedented stimulus policy that they do not understand – an experiment with the potential to cause a sharp repricing among all asset classes globally.

According to Weber, the way monetary policy boosted the economy was through the wealth effect; by creating an environment of rising asset prices, in stocks, bonds, and real estate. This growth has been due to, and remains dependent on, low interest rates.

“At some point the inflection point will come,” he said. And when it does come, central banks will have significant challenges providing the same accommodative policy and pulling the same liquidity levers in the new political landscape.

 

Ray Dalio

Ray Dalio noted that the sensitivity to interest rate change is greater than before; “it is very high.” A surprise rise in back-end rates, even modestly, at this point in the aging cycle, could be the detriment to a market now reliant on high-duration bonds. It could abruptly end the party, and reprice all assets, generating trillions in losses.

He feels that post-QE and post-Tax Reform, the U.S. was already at capacity and near overheating, and now the weaker dollar adds “stimulus on stimulus.” When the global expansion begins to tire, the exhaustion of monetary and fiscal stimulus options leaves the system as we know it more fragile than before. If anything goes wrong, “It won’t be a pretty picture.”

VIX and 10sOn May 22, 2013, the Federal Reserve announced that it would begin tapering back their roughly $70 billion a month in bond and mortgage-backed securities program.  A series of positive economic developments in the spring of 2013 led Federal Reserve Chairman Ben Bernanke to testify to Congress on May 22, 2013, that the Fed would likely start slowing— tapering—the pace of its bond purchases later in the year, conditional upon continuing good economic news.   Similar to this week’s price action in markets, bond yields surged with equity market volatility as investors exited stocks and bonds together.  

In recent years as volatility surged, long bonds (U.S. Treasuries) rallied with lower yields. Today, we’re in the early innings of a secular change in this regard, bond yields are moving HIGHER with the VIX, wow.  We have a special report on bonds and our trading thesis for 2018, pick it up here.  Previously included in “Regime Change”

 

Stagflation, or Simultaneous Sell Offs in Stocks and Bonds

The market is coping with this newfound focus on inflation in its own way— by selling off equities and treasuries. To those who joined the markets in the 21st century, this may seem to be a glitch on the screen, if the S&P falls (an increasingly rare occurrence), USTs should catch a bid, sending yields lower. But a look back to the 1970s and 80s shows us that in times when inflation concerns were higher, stocks and bonds both used to sell off in tandem.

 

Number of Times With S&P Down and the U.S. 10Y Yield Up:

3 Weeks in A Row

2010-2018: 0

2000s: 3

1990s: 3

1980s: 19

1970s: 24

 

4 Weeks in A Row

1990-2018: 0

1980s: 4

1970s: 8

Source: Deutsche Bank

 

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Regime Change

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“We believe inflation is set to finally pick up in 2018. Much of the passive and quant-side (a $1.5T shift in asset management) has become heavily invested in the “risk parity” model which involves being long equities and bonds on a risk-adjusted basis. One of the fundamental problems with this strategy is you’re effectively really long disinflation.  Sure, it’s worked very well in the post great financial crisis period, but it’s a grossly crowded trade and has all the makings of a gruesome slaughterhouse.   In this case, the risk tail is a period where equities and bonds fall together, which is not that uncommon in a late cycle inflationary environment (see 1980s and 1990s). Other than out of the money puts in rates (bonds) a big way for this crowd to hedge inflation is to increase commodity exposure.  As long-time bulls, we’re now ‘pounding the table’ bond bears for 2018.”

Bear Traps Report, January 2, 2018

Inflow of into Passive MF and ETFs

January

2018: $105B
2017: $68B
2016: $18B
2015: $22B

Bloomberg data

Many of these investors don’t realize, passive investing in bond ETFs is a colossal disinflation bet.   As the tide turns, this mad mob will rush for the exits, commodities will become the big winners relative to bonds and equities.

Hot Wages

U.S. payrolls surged by 200k in January, ahead of Street expectations for 190k. Gains were largely in the private-sector hiring (+196k). The unemployment rate remained unchanged at 4.1%.

Wage growth caught all the attention in this report, and it didn’t disappoint. Average hourly earnings rose a relatively strong 0.3% in January and accelerated to 2.9% year-over-year. That marks the fastest pace of wage gains since 2009.

ISM Prices Paid are on Fire

This week we saw hot ISM prices paid (U.S. factories expanded more than forecast in January and near the fastest pace in more than 13 years). While ISM’s measure of prices paid increased to the highest level since May 2011 (keep in mind, U.S. 10 year bond yields were up near 3.50% in the Spring of 2011).  What’s driving all the bearish bond sentiment?  One major reason is found in the “growth to bold yield” disconnect.   For most of the last fifteen years, the U.S. 10 year bond yield was “tied to the hip” of manufacturing ISM prices paid.  In our view – as you can see above – the current level of ISM prices paid should be associated with U.S. Treasury bond yields 60-70bps (+0.60% to +0.70%) higher than current levels.  In recent years as inflation expectations plunged, the disconnect between ISM and 10s (Treasury bonds) widened.  Over the last month, as inflation expectations surged, these two long lost friends are spending far more time together. 

US Equity Long Futures Positioning

2018: $405B
2017: $280B
2016: $185B
2015: $280B
2014: $240B
2013: $220B
2012: $155B
2011: $160B
2010: $150B
2009: $130B
2008: $280B
2007: $210B
2006: $180B

CFTC, GS data

Heading into February, investors have never been this long equities.  We use CFTC (positioning, measuring the crowded trade) data as an important contrarian indicator.  Over the years, as positioning wanes (2006, 2009, 2016), these are the best times to over-weight stocks.  In the bond market, the sensitivity to a rate change (in prices and wages) is greater than ever before.  It is very high, in our view the U.S. is hitting capacity constraints and risks overheating. The Trump tax cuts and spending plans are further juicing the economy at the wrong moment.  At the same time, a weaker dollar adds even more stimulus (with over $60T of GDP outside the U.S. vs. $18T inside, a weak dollar injects emerging market economies with a steroid like high).  In Davos, Axel Weber (former Bundesbank head) said: “today we’re adding stimulus on stimulus, this is after the credit channel mechanism of monetary policy shut down when interest rates collapsed to zero during the post-Lehman slump.” Quantitative easing lifted the economy through a different mechanism, by boosting financial markets – a wealth effect from gains in equities, bonds, and property.  “People have been lulled into complacency, forgetting what will happen when normal conditions return,” Weber said.  We’re now switching back on the credit and interest rate channel. We do NOT believe central bankers can effectively manage the risk path they are on.

Bond Yields and Equity Market Volatility, now in a Regime Change

This week, with nearly a 4% drawdown, the S&P 500 just posted its biggest (weekly) loss in two years.  If you look carefully above, we’re clearly in the middle of an important regime change. In recent years as volatility surged, long bonds (U.S. Treasuries) rallied with lower yields. Today, we’re in the early innings of a secular change in this regard, bond yields are moving HIGHER with the VIX, wow.  We have a special report on bonds and our trading thesis for 2018, pick it up here.   

As the (Bond) Bears Dance in the Night

Short interest and bearish sentiment have reached rare levels in the bond market. In U.S. Treasuries, overall short positioning is back to all-time (high) extremes reached post the 2016 Presidential election. We must remember, after periods of highly unusual positioning – interest rates typically become range bound over the short to medium term. In other words, you have to let the shorts cover. This process will put a bid under the bond market over the near term in our view. Once the large short supply has been cleansed, we can get back to a firm, bearish view on rates. We’re sticking with our 3.50 to 4.00% (in U.S. 10 year Treasuries) range target for 2018.

Lessons Always Found in the Put-Call Ratio

Hindsight is always 20/20, but it’s so interesting to note that three of the LOWEST readings (last five years) in the put-call ratio occurred as the U.S. equity market reached its January 2018 perch.  Likewise, market bottoms are often found when put-call readings are up in the 1.00 to 1.20 neighborhood (we’re not there yet – even after Friday’s market plunge).  Investors often get all “beared up” at the lows and “bulled up” at the highs, there are a lot of lessons in here.  In January, mutual fund long positioning surged in tandem with the rebound in growth to a 6-year high, as some long lost investors came back to stocks.  A look over at aggregate shorts in cash equities and ETFs – led by reductions in Technology shorts – (in January) is telling.  This was the first time tech shorts moved below the elevated range they have been in since the financial crisis.  Similar to late 1999, this outcome is a sure sign that the shorts have been carted off the field in this vicious bull market run.  Right on cue, of course, January inflows into U.S. equities surged, and are on track for the largest monthly inflow on record (we’ll get the final data next week).

U.S. Treasuries and Corporate Bonds Held Overseas

Repatriation

2017: $650B
2007: $40B

*Post tax reform, as capital comes back to the United States, a very large bond buyer might NOT be there in the same way she’s been so over the last 10 years.  We believe this is starting to contribute to the latest rate shock.  The assumption was there was “cash” held overseas, ultimately it was actually “bonds.”  Data from company SEC filings, Bloomberg and CS. 

 

Last Time Bond Yields Surged with Equity Market Volatility?

On May 22, 2013, the Federal Reserve announced that it would begin tapering back their roughly $70 billion a month in bond and mortgage-backed securities program.  A series of positive economic developments in the spring of 2013 led Federal Reserve Chairman Ben Bernanke to testify to Congress on May 22, 2013, that the Fed would likely start slowing— tapering—the pace of its bond purchases later in the year, conditional on continuing good economic news.   Similar to this week’s price action in markets, bond yields surged with equity market volatility as investors exited stocks and bonds together.  

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Inside the Mind of the Fed

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

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“We believe inflation is set to finally pick up in 2018. Much of the passive and quant-side (a $1.5T shift in asset management) has become heavily invested in the “risk parity” model which involves being long equities and bonds on a risk-adjusted basis. One of the fundamental problems with this strategy is you’re effectively really long disinflation.  Sure, it’s worked very well in the post great financial crisis period, but it’s a grossly crowded trade and has all the makings of a gruesome slaughterhouse.   In this case, the risk tail is a period where equities and bonds fall together, which is not that uncommon in a late cycle inflationary environment (see 1980s and 1990s). Other than out of the money puts in rates (bonds) a big way for these guys to hedge inflation is to increase commodity exposure.  As long-time bulls, we’re now ‘pounding the table’ bond bears for 2018.”

Bear Traps Report, January 2, 2018

This week’s FOMC meeting marked Janet Yellen’s final meeting as Chairwoman of the Federal Reserve.

The Long Bond, on a Key Technical Level

The US 10 year has already broken the trend line above.  Fed policy, strong global growth and the new kid on the block, US fiscal policy have driven the latest round of selling.  Pick up our latest Bear Traps Report for our detailed investment thesis of 2018. 

No rate hike was expected at this week’s meeting, and none came, leaving the midpoint target level at 1.375%. The next 25bp increase – up to 1.50%-1.75% from 1.25%-1.5% – will come, in all likelihood, at the March meeting with Chairman-elect Jerome Powell at the helm.

Inflation Expectations

The big news of the day (see above) came when the Fed raised near-term inflation outlook to above two percent, driving the two-year bond yield even higher, while the long end (30s) rallied, thus more flattening.

The probability of rate hikes in 2019 has doubled since the last FOMC meeting:

The thing to keep your eye on, in our opinion, is the probability of four hikes in 2018, instead of the three (the recent consensus). The Street was hawkish today before the meeting. Much of the debate comes from the Fed’s word choice on near-term risks to the economic outlook. The Fed reiterates these risks as “roughly balanced,” a nod away from Goldman Sachs’ expectations that these risks would now be just “balanced”. Chair Yellen left today as dovish as she came, and the Street is looking at the Powell team as by definition, more hawkish (more likely to pull back accommodation). 

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The probability of four or more rate hikes in 2018:

Jan 24%

Dec 5%

Nov 3%

Bloomberg data

Data-dependent, gradual raising Yellen hands the baton today over to a similarly data-dependent Powell. However, if the data (recently firming prices and slightly higher, yet still sub-2%, PCE) is allowed to speak for itself, it was reasonable to expect a hawkish tone in today’s statement.

Today’s Chicago PMI printed 65.7, soundly beating the consensus estimate of 64, yet lower than the unsustainable prior-revised 67.8. Upcoming significant data releases include Jobless Claims and Nonfarm Payrolls, on Thursday and Friday respectively.

Yellen, while ill-advised to act based on market prices has a history of mentioning “rich asset valuations”, and must be keeping her eye on the technically-overbought S&P 500, which, even with this week’s move off the highs, is up 5% YTD, or an annualized rate of 83%. NY Fed President Dudley recently expressed concern about the possibility of an “overheating” economy that appears to be stretching its cycle after the passage of tax reform.

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GDP Impact on Bonds

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

Pick up our latest report here:

Don’t miss our next trade idea. Get on the Bear Traps Report Today, click here

“We believe inflation is set to finally pick up in 2018. Much of the passive and quant-side (a $1.5T shift in asset management) has become heavily invested in the “risk parity” model which involves being long equities and bonds on a risk-adjusted basis. One of the fundamental problems with this strategy is you’re effectively really long disinflation.  Sure, it’s worked very well in the post great financial crisis period, but it’s a grossly crowded trade and has all the makings of a gruesome slaughterhouse.   In this case, the risk tail is a period where equities and bonds fall together, which is not that uncommon in a late cycle inflationary environment (see 1980s and 1990s). Other than out of the money puts in rates (bonds) a big way for these guys to hedge inflation is to increase commodity exposure.  As long-time bulls, we’re now ‘pounding the table’ bond bears for 2018.”

Bear Traps Report, January 2, 2018

The 2.6 percent headline rate doesn’t do justice to fourth-quarter GDP where consumer spending rose a very strong 3.8 percent that reflects a 14.2 percent burst in durable spending.  Bloomberg noted Residential investment, which is another consumer-related component, rose at a very impressive 11.6 percent annualized rate. Turning to business spending, nonresidential fixed investment rose at a 6.8 percent rate which is the fourth straight mid-single digit result.

What does this mean for bonds?  We have an important note coming out, pick it up here.

Government purchases at a 3.0 percent rate, also added to GDP in the quarter.  What pulled down fourth-quarter GDP were net exports, at an annualized deficit of $652.6 billion, and inventories which rose at a slower rate than the third quarter. Looking at final sales to domestic buyers, which excludes inventories and exports, GDP comes in at a robust 4.3 percent.

Prices also showed some vigor in the quarter, with the index at 2.4 percent vs the third quarter’s 2.1 percent. This is a standout report led by the consumer that shows the economy accelerated into year-end 2017 with strong momentum going into 2018.

What are the key Takeaways?

There are both positive and negative views that can be extrapolated from today’s data.

  • The consumer savings rate fell to its lowest since November 2007, down from 3.3% to 2.6%. If it had stayed the same, Real PCE would have been 0.8% (annualized) instead of 3.8% and GDP would have been 0.6% instead of 2.6%.  Clearly, business and consumer confidence levels are nearly 2 standard deviations higher than the 1010-16 mean, thus spenders seem to be more confident dipping into savings with visions of better times ahead.
  •  The GDP came in lower than expectations, but net of hurricane-impacted inventories and exports, 4.3% is an objectively impressive number.

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Looking ahead into Q1, and Beyond

This adjusted 4.3% rate isn’t unprecedented growth, however, even in recent memory.  We saw 3% YoY in first half 2015. So, then, how sustainable is the growth? In the short term, a decreasing savings rate will boost demand. The near-term outlook is bond bearish, and it should be. Prices are rallying, savings are down, and over the next quarter or two we should see some legs on consumer demand; something that has been notably weak in recent memory. There is a reason to be optimistic into early 2018 from a consumer spending perspective, and perhaps even beyond, depending on the timeline for infrastructure spending.

Economic activity built on a foundation of lower savings, in the absence of wage growth, will eventually drag output lower.  Lower consumer savings is likely overstated; we regularly see upward revisions.

Cycle-low savings rates don’t stay low forever. Companies have shown a resilient hesitation toward raising wages. Americans are borrowing to finance their own spending and with any reasonable stall in consumer spending into 2018, our current annualized growth rate will be under significant pressure.

Pick up our latest report here:

Don’t miss our next trade idea. Get on the Bear Traps Report Today, click here

 

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