Aug 14. Smothered

There’s an interesting article on Bloomberg about US life insurance companies unintentionally holding increased amounts of distressed debt. These were once high quality energy bonds which went pear-shaped.  “Even if distressed holdings are largely accidental now, regulators are considering proposals that could ease the amount of capital life insurers can use to fund junk bonds, which makes it more profitable for the companies to increase their investment risk. …Under current rules, a bond with a rating four steps below junk needs to be funded with capital equal to at least 10% of the bond’s value before taxes.  The NAIC is considering a proposal to lower that to around 6%.”  Can, meet foot.  By the way, funding junk bonds with a smaller sliver of capital doesn’t make it ‘more profitable to increase investment risk’ which is especially apparent if the bonds default.

I had seen a previous piece which pointed out that High Yield ETFs were ironically edging up in credit quality, because some bonds dropped out of the indexes due to defaults. In a way, of course, it makes these products much less valuable in terms of their usefulness in understanding the bigger picture.  On the other hand, if standards are constantly relaxed and Central Banks continue to force investors out the risk curve, what is there to understand? The can keeps being kicked.

The link below has a similar theme, this one about agricultural credit conditions.  “Nearly 75% of surveyed bankers [in the Tenth District] reported farm income was less than a year ago… Respondents also noted that agricultural producers continued to reduce capital and household spending as profit margins generally remained weak.”

The chart below is the SPX divided by the Bloomberg Commodity Index BCOM.  It shows that stocks are in a parabolic bull market compared to commodities since the low of the financial crisis.  Obviously declines in crude oil and in grains are a big reason for this.  But is there more?  Is it that our need for physical goods has now become a miniscule part of GDP?  Is it that intellectual capital is the primary value in the economy?  Is it that income being generated by more valuable assets really isn’t going anywhere?   That central banks have simply forced down yields on financial assets by chasing more money into risk, thus smothering returns on all assets?  It may be a little hard to see the scale of this chart, but the current level near 26 is close to the high; nearly double the high seen in the 1999 dotcom boom, and up 5 times from the low in 2008.  Asset PRICES levitate, asset RETURNS languish.  By the way, my personal rule of thumb for extreme overvaluation is 3.5 to 4 doubles off the low within 10-12 years.  On this chart, 5 to 10 is 1, 10 to 20 is 2, 20 to 40 is 3.  So, for max craziness look for 60 to 80 by 2020.

spx_bcom Aug 2016

Let’s consider the ‘smothered’ thesis with respect to implied volatility.  The top chart is the 10 and 30 day historical vol of the SPX.  And the bottom panel is Ten Year treasury vol, both over the past ten years.  Both of these appear compressed, especially right now.  SPX 30-day vol is 7.3.






SPX hist vol
















And of course, the yield curve has been smothered as well.  In Eurodollars, reds (2nd year out) to greens (3rd), blues (4th) and golds (5th) are at new lows in terms of spreads.  Reds/golds settled the week at just 42.625 bps, a nine year low.  Remember, the last time it was this low was when funds were 5.25%.  The long bond yields 2.25%.  Prices jump, income falls.

As a friend remarked:  Vols are ridiculous,  “Nobody can afford to own options anymore or, said differently, sees no reason to given how skimpy the yield or potential return is on what they own.  But their risk is ever greater.”

When does it start to matter again?  When will risk be priced appropriately?

Bernanke’s latest post from the Brooking’s Institution is a case in point.  This guy must now get paid by the word.  I’ll summarize:  the Fed has been consistently wrong on the natural rate of unemployment, the neutral rate and the growth rate.  The Fed has moved down their estimates of above parameters based on empirical evidence.  And now that their thinking is becoming more aligned with actual outcomes (while still shoe-horning the data into the old models), it means that Fed moves are likely to be gradual.  Great post, but now I’ve ruined it for you.  Actually he could have stopped with the last sentence in the first paragraph,  “…Fed watchers should probably focus on incoming data and count a bit less on Fed policy makers for guidance.” [Of course, I too could have substantially shortened this post with: Fed crushes returns and vols, and simply ended there]

The problem is that Fed policy makers, or more to the point, global Central Banks, have altered the pricing of risk.  By changing the price of risk, they alter actual outcomes of economic data, perhaps in unintentional ways.  So, ‘focusing on incoming data’ becomes a less valid signpost.  It’s almost like the premise of the movie Back to the Future.  One fundamentally changes something in the past and ends up with flying DeLoreans.  Or, in the alternate ending, Marty McFly is permanently erased out of the picture.

Posted on August 15, 2016 at 5:06 am by alexmanzara · Permalink
In: Eurodollar Options

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