"It slightly worries me that when people find a problem, they rush to judgment of what to do."
- Janet Yellen
Looking at the growing convolutions of various bond markets, following a similar pattern seen during the previous "Taper Tantrum" of 2013, we decided to use another term for the ongoing situation for our title analogy. A ruck is a situation where a group of people are fighting or struggling, such as bond investors and CTAs alike as of late. But, in our much enjoyed game of rugby, it is a situation where a group of players struggle for possession of the ball, leading to a loose scrum. A ruck typically evolves from a tackle situation and can develop into an effective method of retaining or contesting possession. A ruck can commit defenders, therefore creating an opportunity to create space. On formation of the ruck, offside lines are created. Admittedly, for those in the know when it comes to rugby matters, a ruck is the most complex and subtle phase in rugby. It necessitates individual talent, vivacity, and precision.
While we remained bullish for the first semester of 2017, we have voiced on numerous occasions our concerns for the second part of 2017. Given the most recent "Bond ruck", thanks to central banks recent hawkish pattern, we think one should approach a more defensive stance for the second part of the year. In the ongoing tussle between investors and central bankers, one would be wise to commit defenders, as you can expect volatility to creep up in the coming months. As a piece of advice for the second part of the year, in a bond ruck you need strong posture to minimize injuries, because the ruck is a tough place to be. You have been warned.
In this week's conversation, we would like to look at signs that we are about to enter a regime change in volatility, coming from the bond market and which could easily spill over to equities in the coming months, thanks to a potential risk for a convexity event.
- Macro and Credit - On the road to a convexity event?
- Final chart - Unemployment and volatility may be too low for the Fed
Macro and Credit - On the road to a convexity event?
Back in August 2013, in our conversation "Osmotic pressure" relating to the "Taper Tantrum" effect on Emerging Markets, we reminded ourselves the wise words from one of our very astute credit friends (a former head of European credit research at a house we know very well) on the subject of convexity in June 2013 in our conversation "Singin' in the Rain":
"Convexity is a bigger issue in all the pensions + fixed income funds. That's one reason mortgages have been whacked. the Fed will basically have to do a ECB - stop buying USTs and start buying RMBS. But pensions (or Fannie / Freddie) do not hedge MBS with USTs - they do it with LIBOR."
At the time, we argued:
"The Fed is likely to step in and actually increase QE to try and hold rates down, because mortgage rates have spiked substantially over the last month from a low of around 3.5% to around 4.3%, we have to agree with our friend that a "new dance" routine from the Fed might be coming."
- Macronomics, June 2013
But convexity is a bigger issue in all the pensions + fixed-income funds. That's one reason mortgages have been whacked during the Taper Tantrum and all. In 2013, our very astute credit friend told us the Fed would basically have to do an ECB - stop buying USTs and start buying RMBS at some point, and guess what, they did precisely that.
Why so? Pensions (or Fannie / Freddie) do not hedge MBS with USTs - they do it with LIBOR. So, if the cost of LIBOR goes up, then these are the whales you want to watch. Not the commercial banks.
It looks like our very astute credit friend was prescient in 2013. In a roughly two-year span that ended in 2014, the Fed increased its MBS holdings by about $1 trillion, which it has maintained by reinvesting its maturing debt, according to Bloomberg, from February 2017 entitled "Everyone Is Suddenly Worried About This U.S. Mortgage-Bond Whale":
"In the past year alone, the Fed bought $387 billion of mortgage bonds just to maintain its holdings. Getting out of the bond-buying business as the economy strengthens could help lift 30-year mortgage rates past 6 percent within three years, according to Moody's Analytics Inc.
Unwinding QE "will be a massive and long-lasting hit" for the mortgage market, said Michael Cloherty, the head of U.S. interest-rate strategy at RBC Capital Markets. He expects the Fed to start paring its investments in the fourth quarter and ultimately dispose of all its MBS holdings."
- Source: Bloomberg
And, of course, the new dance routine was buying RMBS in size... In that sense, the Fed executed perfectly its bond ruck in recent years to avoid a "convexity event."
As a reminder from our conversation "Cloud Nine" from July 2013, year of the "Taper Tantrum":
"If we look at GM and FORD which went into chapter 11 due to the massive burden built due to UAW's size of "unfunded liabilities", they are still suffering from some of the largest pension obligations among US corporations. Both said this week they see a significant improvement in their pension plans liabilities because of rising interest rates used to calculate the future cost of payments. When interest rates rise, the cost of these "promissory notes" fall, which alleviates therefore these pension shortfalls. So, over the long term (we know Keynes said in the long run we are all dead...), it will enable these companies to "reallocate" more spending on their core business and less on retirees. Charles Plosser, the head of Philadelphia Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2."
- Source: Macronomics, July 2013
What matters for these guys is the velocity in the rise in interest rates. So, if the Fed is facing a raft of sellers and the economy is not as strong as it seems, it might need to revisit QE at some point. But we are not there yet, dear friends.
All in all, we think today the Fed is in a bind with the planned reduction of its balance sheet and hiking rates at the same time, hence our Bond ruck title analogy.
From Bloomberg article above:
"Mortgage rates have started to rise as the Fed moves to increase short-term borrowing costs. Rates for 30-year home loans surged to an almost three-year high of 4.32 percent in December. While rates have edged lower since, they've jumped more than three-quarters of a percentage point in just four months.
The surge in mortgage rates is already putting a dent in housing demand. Sales of previously owned homes declined more than forecast in December, even as full-year figures were the strongest in a decade, according to data from the National Association of Realtors."
- Source: Bloomberg
And guess what Marc Faber, Dr. Doom, said in 2013?
"Yields will go down first, and if they go up further, it will kill the economy including the housing market".
- Marc Faber
As we have argued in our March 2012 conversation, "Modicum of relief":
"In relation to systemic risk, credit risk conditions can significantly and persistently be decoupled from macro-financial fundamentals as indicated by Bernd Schwaab, Siem Jan Koopman, and André Lucas in their December 2011 paper "Systemic risk diagnostics: coincident indicators and early warning signals":
"We demonstrate that a decoupling of credit risk conditions from macro financial fundamentals has preceded financial and macroeconomic distress in the past with non-negligible lead time (about four quarters)."
In their paper, they also added:
"Latent residual effects are highest when aggregate default conditions (the 'default cycle') diverge significantly from what is implied by aggregate macroeconomic conditions (the 'business cycle'), e.g. due to unobserved shifts in credit supply. Historically, frailty effects have been pronounced during bad times, such as the savings and loan crisis in the U.S. leading up to the 1991 recession, or exceptionally good times, such as the years 2005-07 leading up to the recent financial crisis. In the latter years, default conditions are much too benign compared to observed macro and financial data. In either case, a macro-prudential policy maker should be aware of a possible decoupling of systematic default risk conditions from their macro-financial fundamentals."
- Source: Bernd Schwaab, Siem Jan Koopman, and André Lucas
What we are seeing right now, we think, is a similar decoupling mentioned in their very interesting paper, where they also added:
"Changes in the ease of credit access surely affect credit risk conditions: it is hard to default if one is drowning in credit. As a result, systematic default risk ('the default cycle') can decouple from what is implied by macro-financial conditions ('the business cycle')."
- Source: Bernd Schwaab, Siem Jan Koopman, and André Lucas
As we have mentioned in our previous conversations, we are very closely monitoring the change in credit from the Fed Senior Loan Officer Opinion Survey published on a quarterly basis (SLOOs), as well at the weakening tone as of late in consumer credit.
In our book, the variation of global private credit growth matters and matters a lot, hence our growing concerns relating to the divergence between the credit cycle and the business cycle. A slowdown in nonrevolving consumer credit in the US is a worrying sign, we think.
On the specific matter of divergence between the two cycles we read with interest J.P. Morgan's note from the 30th of June, entitled "Credit growth slows, reinforcing already tame cycle":
- "Global private credit growth has slowed further...
- ... driven by EM and US businesses
- In DM, credit has shifted from growth drag to neutral
- In EM ex. China, deleveraging an ongoing headwind
The growth of global private nonfinancial credit has slowed in recent quarters, dropping to an estimated 5.5%oya pace as of 1Q17. Credit growth has been subdued throughout this economic expansion and the recent moderation reinforces this point (Figure 1).
In part, credit growth is lower than in past cycles because inflation is lower. More important, the mid-cycle surge typical of recent economic expansions has been missing this time around.
The bifurcated nature of the credit cycle also continues to stand out. The DM and the EM are totally out of sync. DM credit is recovering slowly following a long phase of deleveraging that dragged on economic growth from 2010 through 2014 (Figure 2).
Even so, DM credit growth remains sluggish and only is equal to nominal GDP growth. EM credit growth has decelerated to about 8%oya overall and just 5.8%oya excluding China, down from peak rates near 20%oya in 2011. Indeed, the EM private sector is now deleveraging: 15 of the 23 countries meet this criterion in our sample, which is limited to the countries in our global economic forecast.
Both supply and demand factors have influenced credit growth. Surveys of senior loan officers show that banks tightened credit standards during and after the Great Recession. In the DM, banks subsequently removed a portion of this restraint although it seems likely that credit supply remains tighter than a decade ago. In the EM, banks have tightened standards in recent years, the opposite of the DM (Figure 3).
With respect to demand, the evidence suggests that DM households have radically altered their use of credit. Personal saving rates are elevated across the DM, wealth effects are largely absent, and credit growth remains weak following a long period of deleveraging (Figure 4; for more details see "In a break with the past, DM households are saving more," GDW, June 2, 2017).
In the EM ex. China, corporates are deleveraging following a huge increase in debt.
Our economic forecast envisions little change in credit dynamics. In the DM, we look for personal saving rates to remain near current levels despite rising confidence and household wealth. This shift in household behavior is manifested in low credit growth. In turn, the moderate growth of household demand is restraining business borrowing and spending. This backdrop helps to explain the relatively trend-like and stable GDP growth during this expansion. Although the credit cycle has turned more neutral for DM economic growth, this marks a sharp contrast with past expansions when rapid credit growth fueled GDP growth, notably in the household sector.
In the EM, we look for the credit cycle to remain a headwind to economic growth in coming quarters. Deleveraging appears likely to persist as higher rates of private saving reinforce lingering credit restraint.
DM: Credit shifts from headwind to neutral
The buildup of DM private-sector debt during the 2000s expansion was concentrated in the household sector though corporates joined in during 2006 and 2007 (Figure 5).
Double-digit growth rates in household credit were common across the DM except for Japan, where credit contracted in most years (Figure 6).
Not surprisingly, the deleveraging phase (defined as a decline in credit/GDP ratio) that followed in 2010-14 also was focused in the household sector. As noted above, DM deleveraging was accompanied by a break in personal saving behavior, specifically, the virtual absence of the "wealth effect" that helped power the economy in past cycles.
In recent years, DM household credit growth has firmed slowly though only to match the growth of nominal income. DM personal saving rates remain high even after a dramatic improvement in balance sheet positions. The ratio of household net worth to disposable personal income has increased to a record high while debt/income ratios have declined substantially.
US households were central to these trends. US household debt rose steadily during the 2000s, largely driven by mortgages used to finance home purchases and consumption. In the years after the housing bust, mortgage balances fell steadily as households paid down some debts and lenders wrote off others. In the last couple of years, the ratio of household debt to GDP has stabilized. Mortgage balances as a share of GDP have continued to drift down, but have been offset by rising consumer and student loans. On net, the ratio of household debt to GDP now stands near where it was in 2002.
US business leverage is high
Although DM businesses got less over-indebted than households during the last cycle, the recovery in business credit during the current economic expansion has been moderate nonetheless (Figure 5). Against his backdrop, the somewhat more robust growth in US business credit has stood out (Figure 7).
On balance, the US has experienced a stronger capex recovery than the other majors, although it fell behind the Euro area and Japan in the past two years.
US corporates have issued bonds heavily during this expansion, often using the proceeds to buy back equity. This behavior has left US corporates highly levered by historical standards on a variety of leverage metrics shown in Table 1 (for more details on the different metrics see "Monitoring US nonfinancial leverage," GDW, August 17, 2016).
The ratio of nonfinancial business debt to GDP is just shy of its all-time high reached in 2008 and now exceeds the peaks reached in advance of the 1990 and 2001 recessions (Figure 8).
Low interest rates mean that interest coverage ratios still look healthy and lengthened debt maturities will likely cushion the impact of Federal Reserve rate hikes relative to past cycles. We also take some reassurance that US corporate profits recently have returned to growth. Nonetheless, the US corporate sector appears vulnerable to potential economic shocks.
A gradual slowdown in US corporate borrowing would likely be a positive sign for the durability of the expansion, as it could increase the likelihood of the economy achieving a soft landing at a lower rate of growth in the coming years. This is what appears to be happening (Figure 9).
Total business credit growth reached a high of about 7%oya in 2015 and early 2016 but has since moderated to just above 5%oya as of 1Q17. To be sure, the growth of C&I loans, which comprise less than 20% of the total, have slowed much more sharply. However, the downshift in this high-beta category has been mitigated by resilient growth in bond financing (which accounts for about half the total) and mortgage credit. For this reason, we have not been overly concerned by the slowdown in C&I loan growth. The most pressing issue would be if some combination of tight credit or corporate attempts to deleverage produced a renewed capex contraction. However, the opposite appears to be happening. US capex growth has picked up along with corporate profits and confidence even as debt growth has slowed. The drop-off in C&I loan growth may be tied to the recent stall in business inventory growth.
That said, we continue to monitor US credit metrics and the Fed's quarterly survey of senior loan officers carefully. High US business leverage and the decline in profit margins are among a number of indicators that look increasingly "late cycle," and indeed we recognize substantial risk of the next recession beginning within a few years."
- Source: JP Morgan
The problem, of course, is to paraphrase again Bastiat - in the case of this growing divergence between the two cycles - is that there is always what you see and what you don't see.
Moving back to the issue of convexity, some would argue that in a rising rates environment you would be better off with buying short-duration High Yield bonds with callable features as well as RMBS, thanks to negative convexity features. But for the second item, there is a catch - given the non-linearity of RMBS, you would need to significantly "delta hedge" as described in a March 2014 article from Liberty Street Economics paper, entitled "Convexity Event Risks in a Rising Interest Rate Environment":
"When interest rates increase, the price of an MBS tends to fall at an increasing rate and much faster than a comparable Treasury security due to duration extension, a feature known as the negative convexity of MBS. Managing the interest rate risk exposure of MBS relative to Treasury securities requires dynamic hedging to maintain a desired exposure of the position to movements in yields, as the duration of the MBS changes with changes in the yield curve. This practice is known as duration hedging. The amount and required frequency of hedging depends on the degree of convexity of the MBS, the volatility of rates, and investors' objectives and risk tolerances.
Duration hedging of MBS can be done with interest rate swaps or Treasury bonds and notes. When rates decline, hedgers will seek to increase the duration of their positions. This can be achieved by buying Treasury notes or bonds, or by receiving fixed payments in an interest rate swap. Conversely, MBS holders will find the duration of their MBS extending when rates increase, which they may choose to offset by selling Treasury notes or bonds, or by paying fixed in swaps. If sufficiently strong, this hedging activity can itself cause interest rates to rise further, and further increase duration for MBS holders, inducing another round of selling of Treasuries.
A Convexity Event Averted
A sudden initial rise in medium- to long-term rates can therefore trigger a self-reinforcing sell-off in Treasury yields and related fixed income markets, fueled by MBS hedging - a phenomenon known as a convexity event. During a convexity event, MBS hedgers collectively attempt to decrease duration risk by selling Treasury securities or paying fixed in swaps. The two most important factors that determine the likelihood of a convexity event are the size of the MBS portfolio held by duration hedgers and the convexity of that portfolio. The large-scale purchases of MBS initiated by the Federal Reserve in November 2008 as part of the post-crisis LSAPs have had a profound impact on both these determinants.
MBS investors, broadly speaking, fall into two categories: those holding MBS on an unhedged or infrequently hedged basis and those that actively hedge the interest rate risk exposure. Unhedged or infrequently hedged investors include the Federal Reserve, foreign sovereign wealth funds, banks, and mutual funds benchmarked against an MBS index. MBS holders who actively hedge include real estate investment trusts (REITs), mortgage servicers, and the government-sponsored enterprises (GSEs)."
- Source: Liberty Street Economics
You probably understand more, therefore, our Bond ruck title analogy, given that a "convexity event" was avoided thanks to the massive Fed purchases of RMBS following the 2013 "Taper Tantrum". Admittedly, for those in the know when it comes to convexity matters, a "Bond ruck" will be the most complex and subtle phase in bond markets for the Fed. It necessitates individual talent, vivacity, and precision in their balance sheet reduction. Therefore, you need strong posture in fixed-income markets to minimize injuries because the "Bond ruck" is a tough place to be, and this is, we think, where we are heading.
Right now, we think complacency in credit markets, particularly in Investment Grade - which has received massive fund inflows - is staggering. US HG (high grade) fund inflows YTD has also been very strong, which has already reached 91% of the full-year record inflows in 2016, according to J.P. Morgan.
One might even wonder if credit can widen. On that specific case we agree with DataGrapple's blog post from 7th July, entitled "Credit Cannot Widen, Can It?":
"It was another fairly weak and lacklustre session. Credit indices were pushed wider in the morning as investors were still digesting the sale-off in rates yesterday which took 10-year rates at their highest in 18 months in Europe. But it never felt that the market was about to melt, and no one rushed to add hedges to the downside. Quite the opposite happened actually. Most people looked at it as an opportunity to "buy the dip". It was obvious in the option market. Hardly anyone was buying payers - which give you the right to purchase protection - and enquiries received by dealers came from investors asking to buy receivers - which give you the right to sell protection - across August, September and October expiry, with the 52.5 and 55bps strikes very popular for iTraxx Main. Market participants feel very relaxed about any downside at the moment, and they are more worried about a sudden rip tighter in risk premia."
- Source: DataGrapple
Indeed, market participants seem very relaxed about any downside and a bit too much for comfort, we think. We would rather be on the other side of the trade "gamma" wise, rather than picking nickels in front of a steamroller should we continue to see a rise in government bond yields. Given the convergence between US treasuries and the German Bund, the interest rate buffer is close to zero these days, so your margin of error is very slim confidence,wise. Remember what we said last week:
"We therefore think that rather than being focusing your volatility attention towards the VIX index, you should switch your attention towards the MOVE index we discussed in our previous conversation:
"Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...)."
- Macronomics, January 2014
As noted above for leveraged and carry players, namely the "Beta" crowd, interest rate volatility matters, particularly the "Risk-parity crowd". From a positioning perspective in an environment impacted by dwindling liquidity and rising "convexity" risk from both a duration and credit quality perspective, we believe in a defensive position in H2 on US investment Grade, meaning lower duration exposure in credit as well as higher credit quality given the disappearance of interest rate buffers in the credit space, thanks to central banks "meddling" and "overmedication".
- SourceL Macronomics, July 2017
All in all, volatility might be the new target for the Fed, given its growing discomfort with loose financial conditions and low unemployment as per our final chart below.
Final chart - Unemployment and volatility may be too low for the Fed
As we move towards a "Bond ruck" with a Fed aiming at hiking further rates in conjunction with reducing its bloated balance sheet, there is indeed a heightened risk of a "convexity event" down the road, we think. The next play by the Fed, in similar fashion to the rugby play, is no doubt a very technical move that demands tremendous skills on its part. You can therefore expect a return of volatility, particularly in the interest rate space (hence the importance of tracking the MOVE index), which would no doubt weight heavily on risky assets. Our final chart comes from Bank of America Merrill Lynch Securitization Weekly Overview note from 7th July, entitled "Targeting higher volatility (effectively) as policy objective". It displays the unemployment rate versus volatility, as it might be too low for the Fed:
"In "Is Yellen a Hawk?" BofAML Chief Economist Ethan Harris argues that the Fed simply is concerned with an unemployment rate that is too far below NAIRU; if left unchecked, as in the case of the 1960s, excess inflation could be seen down the road. The risk for the Fed is that if it waits too long, and has to tighten aggressively when inflation does show up, it could increase the unemployment rate by enough to cause recession.
From our perspective, whatever the Fed's focus may be, we think the hawkish shift is likely to bring with it higher volatility. In other words, effectively, higher volatility is now a policy objective for the Fed.
The comparison of the Merrill Lynch Option Volatility Estimate (MOVE) index to the unemployment rate in Chart 3 gives some perspective on this view.
Arguably, depending on the viewpoint, both are now too low or at risk of moving even lower. The goal is to avoid even a mild repeat of the 2007-2008 experience, when volatility first rose sharply and then unemployment followed. Rather, by preemptively moving them modestly higher or perhaps just preventing further declines, the pain of massive spikes down the road can be avoided."
- Source: Bank of America Merrill Lynch
If indeed in this ongoing "Bond ruck" volatility is now a policy objective for the Fed, in the coming difficult balance sheet exercise, the leverage community should take note, particularly the CTA crowd and risk-parity community which have been burn recently on the violent gyrations seen. As we pointed out in a "Bond ruck", you need strong posture to minimize injuries, so you better polish your rugby skills, we think.
"Ballroom dancing is a contact sport. Rugby is a collision sport."
- Bulls coach Heyneke Meyer