Nov 26 weekly wrap. What if the market gets a toothache?

In the news this week was an item about the famous man-eating lions on display at the Chicago Field Museum.  The story begins in 1898, when two male African lions killed 35 people in the Tsavo region of Kenya, dragging them out of their tents in the dead of night.  After months of attacks, they were shot by Col John Patterson of the British Army and ultimately ended up stuffed in Chicago.

One lion was apparently out-eating the other by 2 to 1. This week, scientists are x-raying the skulls to determine if the cats are mislabeled in the display.  But that’s not the issue I want to focus on.  Earlier research tackled the issue of why these lions, with an ordinary diet of wildebeest and antelope, would target humans.  The answer is that one of the lions had a severe tooth abscess that led to the preference of easier prey with softer flesh.  In other words, an unhealthy situation caused a shift in the normal ecosystem that led to slaughter on ‘soft’ prey (as pictured below).

Now I want to shift again to a topic that I mentioned last week, from Russell Clark of Horseman Capital.  He cited the IMF’s Global Financial Stability Report, and noted 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.” An unhealthy ecosystem which has given rise to soft prey?

While the IMF report says that the global recovery is improving, the paper is jammed with warnings about possible dislocations.  On page 25: Credit and market risks are increasingly being mispriced.  ‘Low yields, compressed spreads, abundant financing, and the relatively high cost of equity capital have encouraged a buildup of financial balance sheet leverage as corporations have bought back their equity and raised debt levels. This means that the share of lower-rated companies in major US, European and global bond indices has increased.”

A couple of weeks ago, there were large junk bond outflows, which seems, like every market ‘correction’ in the US, to have had a run for a good 30 seconds; HYG has recovered around half the pullback, and SPX has launched to a new high.

When thinking about ‘high yield’, it’s inevitable to think of the father of junk bonds, Michael Milken.  Perhaps surprisingly, one of his themes was, “Risk in capital structure should vary inversely with business risk and volatility.”  Milken’s ascendancy, which took Drexel to powerhouse status, was in the late 1970’s to 1980’s.  Between 1976 and 1982 the DJIA bounced between 600 and 1000, finally breaking through once and for all in late ‘82.  Amazingly, this breakout occurred when the ten year yield had peaked just under 16%.  Milken was unlocking value in balance sheets and spurring leveraged buyouts in a period of incredibly high rates and high inflation.

Here are a couple of Milken quotes:

The optimal capital structure evolves constantly, and successful corporate leaders must constantly consider six factors — the company and its management, industry dynamics, the state of capital markets, the economy, government regulation and social trends. When these six factors indicate rising business risk, even a dollar of debt may be too much for some companies. [I guess there’s NO risk now]

The new law [from 2009] is also helpful for companies that made the mistake of buying back their stock with new debt or cash in the years before the market’s recent fall. These purchases peaked at more than $700 billion in 2007 near the market top — and in many cases, the value of the repurchased stock has dropped by more than half and has led to ratings downgrades. Particularly hard hit were some of the world’s largest companies (i.e., General Electric, AIG, Merrill Lynch); financial institutions (Hartford Financial, Lincoln National, Washington Mutual); retailers (Macy’s, Home Depot); media companies (CBS, Gannett); and industrial manufacturers (Eastman Kodak, Motorola, Xerox). [This from 2009, link below]

How starkly different is today’s environment.  Stocks are at all-time highs.  Volatility is at all-time lows.  Corporate spreads are at historic tights.  Debt levels have increased appreciably on a global basis.  Most importantly, China has become a major player.  Nowhere have the warnings been more severe and consistent than in China; nowhere have the debt ratios grown rapidly to such unsustainable levels.  From a Reuters piece this week:  “…analysis shows the debt pile at Chinese firms has been climbing, with levels at the end of September growing at the fastest pace in four years.” “By some estimates, China’s overall debt is now as much as three times the size of its economy.”

There’s a pretty long section in the IMF paper on China, but the bit that stood out for me was this.  Debt to GDP ratios in the US and China in 2016 were similar, at 259% for the US and 254% for China, However, the ten year change for the US was 225 to 259 and the change for China was 142 to 254. And where was the largest gain?  China’s non-financial corporates, from 105 to 165% (while the US went from 65 to 72%).

While financial conditions haven’t really tightened in the US, in China they have, and it might be starting to bite.  3 month Shibor is up about 140 bps from the start of the year, but unlike the US, the ten year government yield has also risen; it’s up about 90 bps on the year.  This week there was a pretty good pullback in Shanghai Comp, shown below with SPX.  From the chart, it’s obvious that declines in SHCOMP don’t necessarily impact the US.  However, if China does experience a “Minsky moment” as the PBOC’s Governor Zhou warned last month, then there will surely be global spillover.

Consider this snippet from the IMF report: “Marginal demand has been especially pronounced among Asian investors, with flows from insurance and pension funds from Japan and Taiwan accounting for almost two-thirds of all foreign institutional flows into US investment-grade credit over the past 3 years.”  Just remember, when the going gets tough, you sell what you CAN, which suggests US corporate spreads could widen significantly.

The topics above are longer tern in nature, and may not have much discernible impact on US rates for some time.  However, flatness in the US curve (which has been correlated with a decline in USD), suggests the market suspects global growth may encounter turbulence.


Dudley speaks on Monday evening (and Tuesday morning and Wednesday morning).  Yellen is in front of the Joint Economic Committee on Wednesday speaking about the outlook.   Note that the Employment Report is not THIS Friday, but one week later on Dec 8.


Market notes and trade thoughts

Week to week changes show continuing themes.  Flatter curve (2y up 1.9 bps and 30yr down 3.1).  New highs in stocks.  Strong jump in EUR (Dollar index declining again).  VIX in the gutter.  The standout is crude oil which rose over $2/bbl on the week to close at the highest level of the year, CLF 58.95.

I saw a note from Merrill that I am basically reproducing here with a bit more data.  One year ago, on Nov 27, 2016 there were 89 dte for March treasury options.  Today there are 89 days left for March’18 treasuries.  One year ago: TYH7 124-18+ and 124.5^ 2’59.  Today, (Fri settle) TYH8 124-23 and 124.5^ 1’50 (From 6.0 vol to 3.6).  USH7 151-14, 152^ 7’28. Now: USH8 153-04 and 153^ 4’32.  In dollars, EDH20 9778.5s, 3EH0 9775^ 46.5 with 103 dte.  Now, EDH21 9768.5, 3EH 9775^ 28.5 with 110 dte.  In 2016 of course, it was right after the election and there was volatility associated with that event.  Still, taking it back another year to 2015, TYH6 was 126-11+ and the 126.5^ was 2’25.  3EH9 was 9790 and the 9787.5^ was 40.0. At that time emerging markets were under pressure as were energy markets.

By the way, in 2016, EDH17 was 9894.5 and the 9900^ was 10.5 with 106 dte.  Now EDH18 is 9828 and the 9825^ is 10.5 with 113 dte.



11/17/2017 11/24/2017 chg
UST 2Y 172.5 174.4 1.9
UST 5Y 206.0 206.4 0.4
UST 10Y 235.2 233.8 -1.4
UST 30Y 279.1 276.0 -3.1
GERM 2Y -71.3 -69.6 1.7
GERM 10Y 36.1 36.5 0.4
JPN 30Y 81.4 83.2 1.8
EURO$ H8/H9 33.5 35.0 1.5
EURO$ H9/H0 15.5 14.0 -1.5
EUR 117.93 119.32 1.39
CRUDE (1st cont) 56.71 58.95 2.24
SPX 2578.85 2602.42 23.57
VIX 11.43 9.67 -1.76

Posted on November 26, 2017 at 8:09 am by alexmanzara · Permalink
In: Eurodollar Options

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