Nov 19. Are Funding Costs About to Tighten?

There have been many interesting snippets of news this week, making it somewhat difficult to whittle them down to a specific topic and weave in a few anecdotes in support of a thesis.  For example, in the early part of the week, I thought I would run with a couple of stories that foreshadow a top in super-luxury spending.  To wit, a foreclosure at One57, a penthouse on Manhattan’s ‘billionaire’s row’, brought in $36m, 29% below the original sale price in 2014. “Even though it’s a foreclosure auction, “when you have multiple parties fighting for this unit, that’s a credible benchmark for value,” … “It places this type of transaction within the realm of what’s happening in the market.”   In another example, a flawless 163 carat diamond necklace sold for $34m at Christie’s.  “I am disappointed that the Art of De Grisogono didn’t sell for a more dazzling price,” … “This is a worrying sign for the top end of the diamond market.”

Even though the two examples above might indicate deterioration, along comes a mind-boggling sale of $450m for Leonardo Da Vinci’s Salvator Mundi.  Disaster averted.

Certainly the big tech stocks and the meteoric price of bitcoin (near $8000) are not signaling impending demise.  However, there was a temporary spasm of nerves related to outflows in junk bonds last week.  And there are a couple of other stories that suggest recalculation of risk in terms of financial diversification.  For example, Calpers is looking to increase its allocation of bonds relative to stocks.  Norway is selling oil equities from its sovereign wealth fund.  That would be like Warren Buffet selling Dairy Queen and Coke, the very foundations of US capitalism.

Underlying the entire edifice of financial architecture is faith in the idea that debts can always be easily rolled over, bolstered by the benevolent forward guidance of central banks.  There is little evidence of uneasiness associated with a changing of the guard at the Fed.  Overt warnings from the PBOC merit scant attention: “While reining in the total leverage ratio, we shall prioritize reducing the leverage of state-owned enterprises, focus on tackling ‘zombie firms’ and promote the debt-to-equity swap in a market-oriented and law-based manner,” the PBOC said in the report out Friday. [BBG]  Think about that for a second.  The Fed’s policies have encouraged firms to do just the opposite: increase debt to buy back shares.  China realizes that some debts may have to be restructured, and equity will be diluted as a result (in the same “law-based” manner that the Saudis relieved the burden of wealth from some prominent elites).  Loan growth has slowed substantially, and rates have increased, suggesting that China is tackling difficult adjustments right at the beginning of Xi’s new five-year term.

We often hear about financial conditions having eased in the US during the Fed’s ‘tightening’ campaign:  ten year yields have barely moved, stocks are higher, the dollar has weakened, corporate spreads are historically tight, volatility is low.

Horseman’s Capital Russell Clark has the following excerpt in his most recent missive:

What does the most recent issue of the Global Financial Stability Report have to say? It notes that BBB bonds now make up nearly 50% of the index of investment grade bonds, an all time high. BBB bonds are only one notch above high yield, and are at the greatest risk of becoming fallen angels, that is bonds that were investment grade when issued, but subsequently get downgraded to below investment grade, or what is known these days as high yield.

So let’s take a look at a concrete example of tightening conditions.  The chart below is the US 2yr note yield.  Just since the beginning of September it has surged over 40 bps, from 1.30% to this week’s yearly high of 1.725%.  From the Brexit low in summer of 2016, the yield has tripled.  On the week, the 2y went up just over 7 bps, while the 30-yr bond yield declined by 8.7.  The curve flattened to new ytd lows, not seen since 2007.

On a related note, China’s 10 year government yield has increased by 90 bps this year, starting 2017 at 3.06 and reaching 3.99 this week.

This is when rolling over shorter term debt begins to bite.  In 2007 and 2008 it was adjustable-rate mortgage resets that sparked problems.  In the current environment, both individuals and firms have an incentive to lock in long term funding at these levels.  Refi the 30 year mortgage…  But Mnuchin passed on the idea of issuing 100 year bonds, citing subdued interest from market participants.  Meanwhile, Canada this week sold 100-yr bonds and a Dutch energy firm had a 1000-yr hybrid issue with a coupon of 2.25%.

There was a post from the NY Fed’s Liberty Street Economics (The Low Volatility Puzzle: Are Investors Complacent?), which considered the idea that low volatility might actually be the normal state of affairs, and that ‘reversion to the mean’ of much higher vol levels might be a pipe dream.  Are gargantuan CB balance sheets ‘normal’ too?  I might have re-named this paper: The Low Vol Puzzle: Is the Fed Complicit?  In any case, while the paper’s conclusion is non-committal, there is one particular passage of note:

In contrast to mean reversion, the macro-finance literature has raised a more nuanced argument for why low volatility may lead to a buildup of risks to financial stability. In Brunnermeier and Sannikov (2014) and Adrian and Shin (2013) , decreased volatility during business cycle expansions may lead to lower value-at-risk constraints for investors as well as lower margin and collateral requirements. If investors respond by increasing leverage, small shocks to asset prices may suddenly make constraints bind, which can force investors to sell assets, raise volatility, and tighten constraints further. This feedback loop creates risk endogenously, meaning that low volatility in itself can be a catalyst for high future volatility.

The argument is so “nuanced” that it’s a blatant re-hash of Minsky’s decades old “stability breeds instability.”  Our question of the moment is this:  Does a ‘small shock to asset prices’ come as the result of an exogenous event?  Or does the ‘shock’ come in the initial form of a mild handshake buzzer where rising funding rates at the short end cause lenders to think twice about odds of payback, pushing BBB borrowers over the edge?



11/10/2017 11/17/2017 chg
UST 2Y 165.4 172.5 7.1
UST 5Y 205.1 206.0 0.9
UST 10Y 239.7 235.2 -4.5
UST 30Y 287.8 279.1 -8.7
GERM 2Y -74.6 -71.3 3.3
GERM 10Y 41.0 36.1 -4.9
JPN 30Y 80.3 81.4 1.1
EURO$ H8/H9 32.5 33.5 1.0
EURO$ H9/H0 17.5 15.5 -2.0
EUR 116.65 117.93 1.28
CRUDE (1st cont) 56.98 56.71 -0.27
SPX 2582.30 2578.85 -3.45
VIX 11.29 11.43 0.14

Posted on November 19, 2017 at 10:53 am by alexmanzara · Permalink
In: Eurodollar Options

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