July 24. Ignoring Credible Threats, the CBs Have Our Backs

A common theme this year, which seems to be growing, is that correlations have been breaking down in markets, making it extremely difficult to draw conclusions about underlying trends.  It’s a chore to even organize my own ideas about cause and effect.  I will start by going back to the 4th quarter of last year.  Oil had been selling off, the ten year treasury yield was around 2.25% (in November), one-year Eurodollar calendar spreads were between 55 and 65 bps.  The market was expecting a hike, and by early December the dollar index was at the very upper end of its range, over 100.  The Fed did indeed raise the FF target on Dec 16.  From there, oil accelerated its sell off.  High yield bonds plunged, as did emerging markets.  SPX fell over 10% from the beginning of December to the middle of January.  Central banks were nervous, and comforted the markets.

As of Friday SPX is at a new high.  The emerging market etf EEM is at a new high, as are high yield etfs HYG and JNK.  The High Yield Effective rate (BAML) went from 6% in mid-2015, to over 10% at the beginning of this year to 6.62% currently.  Euro$ one-year calendars are clustered between 15 and 18. An example of the yield plunge is below, the US Corporate BBB effective yield, which has plunged this year from 4.5% to under 3.4%.


The US ten year treasury yield also declined, from around 2.25 in November as mentioned above, to 1.57 on Friday.

Let’s keep that background in mind and introduce this note from Fitch:

Fitch Ratings-Chicago-18 July 2016: The U.S. Fitch Fundamentals Index dropped to -3 in 2Q16 from -2 the previous quarter as a pattern of weakening credit quality, mostly in the corporate finance space, took its toll, says Fitch Ratings. Six of the index’s 10 components remain in negative territory, three of those strongly so. The index is now at the lowest level since 3Q09.  “A key driver has been pressure in certain corners of the corporates area, leading to subdued growth expectations, higher defaults, and sharply lower recoveries, which at $0.20 on the dollar, are among the lowest that Fitch has seen”

The assessment by Fitch doesn’t really seem to square with the way stocks trade, so I checked corporate default rates:


Clearly accelerating, but from a fairly low level.  Regional Fed data, though having deteriorated slightly in some cases, doesn’t really support a case for waving red flags.  Chicago Financial Conditions Index, while rising (tighter) is still below zero, while Cleveland’s Financial Stress Index has been rising since Q1 of 2014.  However, KC and St Louis Financial Stress levels have been falling right along with corporate spreads.

In the beginning of the year, financial stress in the markets was apparent due to 1) plunging oil prices,;  which in turn caused 2) surging yields for junk bonds and 3) a stronger dollar which in turn hurt US exports, and sparked a USD funding crunch for emerging markets.  The Fed was thought to be on a tightening campaign.

Some of these conditions are returning:  Crude oil, (CLU6) ended at the low of the week at 44.19.  It’s nearly halfway back (down) from the low set in January of 32.85 to the high in June of 52.73.  The 50% retrace is 42.79; Friday’s low was 43.74.  The BBG Commodity Index likewise sold off, closing at its lowest level in two months.  The dollar index closed at its highest level in four months at 97.46, nearing the high end of the range from the past year (100.40 to 93.00).  GBP closed near the post-Brexit low, as did EUR.  China’s surprise devaluation of the yuan caused a rout in world equity markets last August; it’s now significantly weaker and though G20 officials jawbone about keeping the currency stable, USDCNY traded over 6.70 this week, a new high.  It was 6.40 AFTER the August adjustment.

In other words, some markets ARE starting to give warning hints, which are being ignored by SPX, EEM and HYG.  In short term interest rate markets, 3m LIBOR has pushed to a new high over 72 bps and swap spreads have blown out in response to money market reform regulations.  Odds for a Fed hike in December have edged higher.  On an anecdotal level, there’s this from Business Insider citing Edward Misrahi of RONIT:  “We see credit markets that are just surreal….The intermediation system has basically disappeared.  Regulation has made banks very unwilling to make markets.  …95% of bonds get bought by four people who put it away.  Those four are mostly mutual funds with daily liquidity, which means that if, for whatever reason, rates do go up, suddenly there are outflows from all these [funds], I don’t know what is going to happen.”  On this same topic of intermediation is Draghi: “…banks are important, especially for the Eurozone, which is basically a bank-based economy where the credit intermediation goes mostly through the bank lending channel…. That’s why we do care about bank equity prices for the transmission of our monetary policy.” (FT Alphaville).  From Reuters:  “Draghi hinted on Thursday at the possibility of setting up a public backstop to help Italian banks sell down some of their bad loans that have hampered their ability to lend.”  On Friday, the ECB is scheduled to release stress test results.  The banks’ stocks are barely holding together NOW; projecting scenarios of more extreme conditions can mean only one thing, nationalization.

This is already a bit long, but I want to display one other chart, which shows the percent of net worth to disposable personal income:

Net Worth vs Income



This chart is from Daniel Thornton (previously from the St Louis Fed) and Joe Carson.  Bloomberg link to story at bottom.

The problem, [Carson] said, is that “the financial cycle is way ahead of the economic cycle.” That’s a worry given that the past two downturns were driven by asset-price deflation.

“Nobody knows what’s going to happen,” Thornton said. “But there’s plenty of reason to think that’s a scary graph.”

The answer to the question as to why the financial cycle is way ahead of the economic cycle is pretty clear.  It’s the helicopter parenting of the central banks that want to soothe even the smallest aches of their charge, the financial markets, before any real pain is even felt.  As with children, it leads to bad behavior: funding share buybacks with debt, increasing leverage of all types, ignoring productive investment, flattening the curve, beating the VIX into submission, and whining.  By the way, the Democratic National Convention is this week.

Here’s one of the important planks:  “The Democratic Party is poised to adopt a policy platform at its convention next week that would prohibit bankers from serving on the boards of the Federal Reserve’s 12 regional headquarters and would aim to make the U.S. central bank more diverse.”  No bankers at banks.  No further comment.

Also this week (RTRS): “A total of 194 S&P 500 companies are expected report their quarterly earnings next week; that is much higher than normal for any one week, even during most reporting seasons.”  Big tech are GOOGL,  AMZN,  FB,  AAPL.  Bank of Japan also on Friday.

Posted on July 24, 2016 at 2:46 pm by alexmanzara · Permalink
In: Eurodollar Options

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