March 19. Risks balanced, but large in both directions
American girl, she tell a lie/ She say ‘til then’, she mean goodbye.
–Chuck Berry, Havana Moon
https://www.youtube.com/watch?v=ipTvgnXtYtQ
One of the great things about Chuck Berry is that, in the early days, he insisted on being paid in cash for performances: “Due to being burned early on in his career, and occasional run-ins with the IRS, Chuck always gets paid in cash. A notable occasion in Australia 1975 saw Berry caught at Sydney Airport with $50,000 in an attaché case.”* Currency restrictions on travelers were instituted after this incident…and in general, have been accelerating ever since.
Now that’s the story of a guy who had a clear understanding of credit risk. Given the smothering influence of central banks, the concept of credit risk falls in and out of favor, and it seems currently that risks of all sorts are being priced at the low end of the spectrum. For example, the BAML BBB spread had ramped up to 290 bps in mid-2012 with the sovereign spread blowout in Europe, went back to the low of 143 bps two years later with the help of CBs, back up to 300 last February when the oil bust was shaking up the high-yield energy sector, and is now 155, having touched 150 earlier this month. **
In some quarters, the Chuck Berry quote above, ‘American girl, she tell a lie’, could refer to Janet Yellen. After guiding the market to last week’s hike with fairly hawkish forward rhetoric, the tone was softened on the actual move, leading to rapid unwinding of bearish fixed income bets in the US. On the table below I usually mark one-week changes, but this time I included the previous week. From March 3 to March 10, US yields jumped up in anticipation of the Fed meeting. But by Friday they had come right back down to two Fridays ago, especially on shorter maturities. For example, the two year yield went from 2.01 on March 3, to 210.3 on March 10, and right back to 201.8. Tens from 248 to 258 to 249.9. EDM8/EDM9 spread from 40.5 to 44.5 to 40.5. EDM7/EDM8 spread compressed even further, going from 57 to 58 and then down to 52.5. This is the peak one-yr Eurodollar spread, barely above ½% even though the Fed ‘dots’ still indicate three hikes per year. By the way, the Fed’s year-end FF projections remained at 1.4 for end of 2017, and 2.1 for end of 2018. As a comparison, Jan 2018 Fed Funds settled at 9869.5 or 1.305, 9.5 under the dot, and Jan 2019 settled 9822.5 or 1.775, 32.5 under. Two weeks ago EDZ7 settled 9838.5 and the 9837.5 straddle at 26.5; on Friday Z7 settled 9840.5 and the straddle was down to just 24.0.
The summary of the current environment is as follows: Markets had expected robust growth due to Trump’s victory, with associated fiscal stimulus and tax/regulatory relief. For example, the NFIB small business optimism index simply exploded after the election. Stocks, of course, reflected the same sentiments. The Fed won’t buy into the story until there’s proof, and given recent data the plot looks a bit suspect. With the Fed’s dovish hike, financial assets re-energized and the dollar declined, leading for example, to a new high in EEM, the Emerging Mkt etf. However, there are a myriad of overhanging risks, including widening sovereign spreads in Europe, the North Korean situation, etc. Against this is a general increase in inflation, and what appears to be global central bank acceptance that higher rates in the context of firmer inflation would make policy decisions a lot easier going forward.
I am leaning one way in the following notes simply to point out some pitfalls, which is not to say that the Fed will be idle; I think the Fed will continue to reduce stimulus due to renewed inflationary pressure (including financial asset prices) and a stated purpose of reaching ‘normalization’. Normalization means the Fed won’t always be there to catch the falling asset, or at least it might mean that. And without Tarullo pursuing macroprudential policies (this was his last meeting), perhaps the Fed will rely on more conventional tightening measures.
Stocks are likely overvalued. GDP data is getting revised down. Industrial production is soft. Auto loans are beginning to go sour, and since the industry is coming off near record sales, that may loop back to reduced industrial production. Trump policies aren’t being embraced by the deficit hawks in Congress. Retail sales aren’t as strong as expected. Global long end rates are edging higher and sovereign spreads in Europe are increasing.
First, GDP. In late Feb the Atlanta Fed GDP Now forecast was 2.5%. Now with two weeks left in the quarter, it’s just 0.9%. The NY Fed’s last Nowcasting report forecasts Q1 at 2.8%, and 2.5% for Q2. In late Feb, NY was forecasting 3.4% for Q1. As an article on ZeroHedge points out, the chasm between ATL and NY is huge. For me, it’s not the size of the discrepancy that’s important, it’s the direction. Both down from late Feb, by 1.6 point and 0.6 point. (An amusing note in the NY Fed’s FAQs is: “Why should we trust the model?” And the first sentence of the answer is: “Extensive back-testing of the model, research, and practical experience have shown that the platform is able to approximate best practices in macroeconomic forecasts.” That’s some good weed. WTF does it even mean? I think I might have been more comfortable with this: “The model’s results are highly correlated to actual readings of quarterly GDP data, +/- 0.2 within two weeks of the end of the quarter.” But that’s not what it says.
Second, here’s an IP chart lifted off ZeroHedge, with this note: “Industrial Production has never declined on a 24-month basis without the US economy being in recession.”
From Mauldin Research citing David Rosenberg: “…all these recent juicy ISM manufacturing releases have only managed to squeeze a string of 0.2% MoM gains in manufacturing output.”
Third, auto sales are beginning to turn. Seriously delinquent loans have bottomed and are turning higher. I’ve attached a footnote link from the NY Fed’s Household debt report, but more to the point is Business Insider citing Mizuho’s Steven Ricchiuto. Losses on subprime have jumped from 7.9% to 9.1% yoy in January. Recoveries are falling. From Ricchiuto: “Auto sales have exceeded all other consumer-related purchases and account for the bulk of the economy’s upside since the turn in 2009.”
Even with these factors, the household sector as a whole probably doesn’t represent a huge risk. However, the corporate sector might be a different story. While the growth in C&I loans from commercial banks has decelerated, going from growth of 12.3% in the beginning of 2015 to just 5.4% by the end of last year, corporate bond issuance has been on a record tear. A BBG article notes, “Investment-grade firms are on track to complete the busiest first quarter for debt sales since at least 1999. Firms from Apple Inc. to Morgan Stanley have pushed new issues to more than $360 billion so far in 2017, closing in on the previous record of $381 billion from 2009, according to data compiled by Bloomberg. That puts bond sales 14 percent ahead of last year’s record pace.” According to the Fed’s Z.1 report, Total business debt outstanding, including Corporate, was a record $13.47T at the end of 2016. The Bloomberg article ends with this quote: “I’m not sure we’re at a point where the market is compensating investors for all the risk.”
Credit spreads are tight, debt levels are high, and lofty equity prices that always seem to quickly rebound from turbulence have lulled investors into complacency.
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| http://kncifm.cbslocal.com/2017/03/19/top-5-facts-you-didnt-know-about-chuck-berry/
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| https://fred.stlouisfed.org/series/BAMLC0A4CBBB
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| https://www.newyorkfed.org/medialibrary/interactives/householdcredit/data/pdf/HHDC_2016Q4.pdf
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| http://www.businessinsider.com/mizuho-on-subprime-auto-lending-conditions-2017-3
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