20/8/20: All Markets are Now Monetized

 

While the economy burns, the stock markets are literally going bonkers. Here are the main implied volatility options:

Which are symmetric, in so far as they treat volatility as symmetrically-valued to the upside and downside. And here is another way of looking at the same concept via repricing speed, or the rate of change in actual P/E ratios of S&P500 over longer time horizons, in this case: 20 weeks running P/E ratios change:

Source of the chart is @longvieweconomics. What does the above show? We have S&P500 at an all-time high. S&P500's PE ratio (PER) is only slightly below the 2000 peak. And, we have the fastest rate of S&P over-valuation increase in history - full 85 percentage points trough to peak. Both, the fundamentals and the momentum of their deterioration are absolutely out of control. Of course, this is just the stocks. One must never mention the massive bubble blown up by the Fed in the bonds markets. 

The 20-weeks moving change in weekly yields for Aaa-rated bonds maxed out at historical high of -44.06% (remember, lower yields = higher prices) in the week of July 31st this year. Top three historically highest rates of change took place in the three weeks of July 24th-August 7 this year. Overall range of bonds repricing is in the range of 60 percentage points in the current cycle:

This is plain horrendous: there is nothing in the macro and micro fundamentals that can warrant these changes. Except for the expectation of continued monetary accommodation of the Wall Street into the infinitely long future. 

24/7/20: Bonds v Stocks: Of Yields, Investors and Large Predators

Corporates are reeling from the COVID19 pandemic impacts, yet stocks are severely overpriced by all possible corporate finance metrics. Until, that is, one looks at bonds.

Over the 3 months through June 2020, average 10 year U.S. Treasury yield has been 0.69 percent. Over the same period, average S&P500 dividend yield was 2.02 percent. The gap between the two is 1.33 percentage points, which (with exception of March-May average gap of 1.42 points) is the highest in history of the series (from 1962 on).

Given that today's Treasuries are carrying higher liquidity risk (declining demand outside the official / Fed demand channel) and higher roll-over risks (opportunity cost of buying Ts today compared to the future), the real (relative) bubble in financial markets todays is in fixed income. Of course, in absolute returns terms, long-term investment in either bonds or equities today is equivalent to a choice of being maimed by a T-Rex or being mangled by a grizzly. Take your pick.

8/7/20: On a Long-Enough Timeline, This Is Not Sustainable

Something will have to give, and on an increasingly more proximate timeline, although we have no idea when that timeline runs its course...

In basic terms, U.S. Bonds yields are only sustainable as long as:

1. There remains a market-wide faith that the U.S. Government will not deflate itself out of the fiscal mess it has managed to run, virtually un-interrupted, since at least 1980 on; 
2. There remains a regulatory coercion into the U.S. Government bonds being 'risk-free' capital 'instruments'; and
3. There remains vast appetite for the U.S. dollar as the store of value instrument for everyone - from migrants and legitimate business people in the politically questionable jurisdictions to drug dealers.

Which puts a serious question mark over how long can the U.S. Treasury afford to escalate weaponization of the dollar.

21/1/20: US Deficits, Growth and Money Markets Woes

My article for The Currency on the effects of the U.S. fiscal profligacy on global debt and money markets is out: https://www.thecurrency.news/articles/7371/the-us-deficit-has-topped-1-trillion-and-investors-should-be-worried.

Key takeaways:

"As the Trump administration continues along the path of deficits-financed economic expansion, the question that investors must start asking is at what point will debt supply start exceeding debt demand, even with the Fed continuing to throw more cash on the fiscal policies bonfire?"

"In the seven years prior to the crisis of 2008-2012, US economic growth outpaced US budget deficits by a cumulative of $1.56 trillion. This period of time covers two major wars and associated war time spending increases, as well as the beginnings of the property markets and banking crises in 2007.

"Over the last seven years since the end of the crisis, US economic growth lagged, on a cumulated basis, fiscal deficits by $928 billion, despite much smaller overseas military commitments and a substantially improved employment outlook.

"These comparatives are even more stark if we are to look at the last three years of the Obama Administration set against the first three years of the Trump Presidency. During the 2014-2016 period, under President Barack Obama, US deficits exceeded increases in the country’s GDP by a cumulative amount of $226 billion. Over the 2017-2019 period, under  Trump’s tenure in the White House, the same gap more than doubled to $525 billion.

"No matter how one spins the numbers, two things are now painfully clear for investors. One: irrespective of the stock market valuations metrics one chooses to consider, the most recent bull cycle in US equities has nothing to do with the US corporate sector being the main engine of the economic growth. Two: the official economic figures mask a dramatic shift in the US economy’s reliance on public sector deficits since the end of the crisis, and the corresponding decline in the importance of the private sector activity."

30/7/18: Annotated History of the U.S. Treasury Yield Curve

Courtesy of the forgotten source (apologies) a neat summary chart plotting the timeline of the 10 year U.S. Treasury yield:

For referencing purposes… 

6/7/2013: Feeding that Sovereign Cash Addiction?..

When the cure might be worse than the disease?

Two charts from BBVA Research:

Notice the size (as % of GDP) for the BoJ QE and notice the composition: BoJ now bought more JGBs as proportion of GDP than the Fed bought of Treasuries in Q1+Q2+Q3. But, as the chart below shows, that is still not making much of the difference (yet) in JGB holdings: banks and insurance companies remain captive to the state debt.

28/2/2013: Risk-free assets getting thin on the ground

Neat summary of the problem with the 'risk-free' asset class via ECR:

Excluding Germany and the US - both with Negative or Stable/Negative outlook, there isn't much of liquid AAA-rated bonds out there... And Canada and Australia are the only somewhat liquid issuers with Stable AAA ratings (for now). Which, of course, means we are in a zero-beta CAPM territory, implying indeterminate market equilibrium and strong propensity to shift market portfolio on foot of behavioural triggers... ouchy...

Economics 26/12/2009: Interest rates direction - US, Europe and China

One near-certainty that awaits us in 2010 is the return of the higher cost of borrowing. The growth killer pill o higher interest rates will pass into the system before countries like Ireland get to experience growth. And a double-dip, or an extremely prolonged slog at the bottom of a U will be looming for the US and Europe.

Here is how I know: the forces keeping pressures on the policymakers to keep rates low are declining, while the forces that will push rates higher are already in the making.

Two drivers helped to push US and global rates down since 2007. These are the US Fed’s financial crisis busting injections of liquidity and the Chinese desire to keep yuan pegged to the dollar on the way down. The former fuels the liquidity trap in the US, while the latter fuels the circular pump that converts dollar surpluses on trade and investment side into dollar-denominated paper recycling cash back to Uncle Sam.

US drivers

In effect, the Fed has created a massive and unsustainable demand for US Treasuries via:

• Direct purchase of US bonds (over the last two months this amounted to some 22% of the entire pool of newly minted US debt – some US$65 billion, driving the yield to near zero once again. The Fed bought some US$300bn worth of longer-term Treasuries at the end of October), and
• Indirect purchases of US debt via primary dealers and via its balance sheet operations (between January 2008 and December 2009 assets on Fed’s balance sheet grew some 142% to a whooping US$2,240 billion, or more than 16.7% of the entire US GDP).
  

Now, do the maths: over the last two years, the Fed bought into over US$300 billion in Treasuries purchased directly, some US$600 billion more went into indirect purchasing of Treasuries and the balance of roughly US$1,300 billion is sitting in the illiquid and largely non-performing assets such as US$901 billion worth of MBSs. The Fed has US$350 billion more of toxic stuff to buy before reaching its target by the end of Q1 2009. There after, unwinding of liquidity supports will be on order. And this process has already started with the Fed scaling back some 10 asset purchasing programmes.

Aptly, the hosting of the spending party is shifting from the Fed to FedG, or the Federal Government. Per Bloomberg, the amount the Fed and US agencies have lent, spent or guaranteed has fallen 15% to $8.2 trillion between September and mid December, “the lowest in a year”. The FedG spending on infrastructure, tax breaks and other fiscal measures accounts for 52% of the new total, up from 39% in March 2009. So far, the Government spent some US$4,200 billion – or 30% of the US economic output – in 2009. And last week, the US Congress approved a further increase in the Federal debt ceiling – raising it by US$290 billion to US$12,400 billion.

One problem is that this substitution of the Fed with the Federal Government is the sign of the end of the road nearing for massive money creation exercise in the US. While the Fed can print money as long as there is no significant inflation (in the US terms – anything below 4% per annum in the short term will probably be acceptable with current levels of unemployment), the Federales will have to tax their way out of the deficit hole one day. Inflation is a manageable thing, though for now: US consumer prices were up 1.8% yoy in November – well below the 2.6% annual average recorded over the 2000-2009 period.

But the fiscal hole is a formidable one – the US has managed to run 14 consecutive months of budget deficits since December 2007. The only positive on this front is that the Government still holds on to about 50% of the entire stimulus package allocated earlier in 2009 – some US$787 billion in unspent funding. Don’t bank on Democrats-controlled executive and legislature not burning through that in 2010.

Another problem is that reselling the toxic securities pilled up in Fed’s vaults back into the economy will risk draining liquidity out of the system. The Fed might think that’s ok in the short term, since the US banks are now less prone to tap into Fed’s window for liquidity: the Fed stated that since mid-August 2009 there has been no new borrowing at the Term Securities Lending Facility, while Primary Dealer Credit Facility had seen no clients since mid-May 2009. The Asset-Backed Commercial Paper Money Market has been inoperative since May 2009. These programmes, plus the Commercial Paper Funding Facility, the Primary Dealer Credit Facility and other are now set for a phase-out starting with February 2010. And the Fed is set to shorten maturity profile of its primary credit loans from 90 days to 28 days as of January 14, 2010. TALF (Term Asset-Backed Securities Loan Facility) will close on June 1, 2010. More? The Money market Investor Funding Facility (MMIFF) was discontinued on October 30.

China's conundrum

Obviously, the Fed could have swapped these fine ‘assets’ for Treasuries and sold the Treasuries on to the Chinese in a financial scheme that would have allowed it to retain dollar supply intact. Alas, things are much less promising for such a transaction today than they were a couple of years back.

Chart below (from here) shows just how dynamic China’s refusal to buy more into the US assets has been in recent months. And the next two charts confirm the same,
except the last one is an even scarier thing. It shows that even as the Chinese FX reserves were rising, their willingness to buy US Treasuries has been falling. Might it be the case that China has decided to recycle US dollars earned from the trade surpluses back into the global economy? Buying gold or even Euro?

Why not? The latter two operations offer Chinese a happy trip to a devaluation room – push supply of dollars globally up and the value of the dollar goes down. With it, the value of yuan, improving further Chinese exports competitiveness.

The side benefit to this for China is that their anti-dollar rhetoric backed by gold and euro buying also pushes the country reputation as a ‘counterweight to the US hegemony’. Naive Europeans keen on showing euro’s strengths are loving that not seeing that China has no love for the EU or for the euro, just an addiction to cheap yuan. Europeans are not even at the frontline as observers, obsessed with ‘strong euro = alternative reserve currency’ pipe dream.

This beggar-the-US position pays off for China in so many ways with such handsome returns that I am amazed no one so far has pointed out to the internal consistency of what the Chinese are doing through the concerted efforts of their monetary, exports and diplomatic/political pillars.

One spanner in the wheels is that the Chinese trade surplus vis-à-vis the US and Europe is now shrinking, and shrinking rapidly. According to China's General Administration of Customs, country exports in 10 months to November 1, 2009 dropped by 20.5% yoy and 14.8% vis-à-vis the US. Its terms of trade (the export price relative to imports) have fallen over 5%. China’s exports to the EU have fallen even faster – down 18.7% in value in the first 10 months of 2009, opening up a gap in its euro earnings relative to dollars.

This gap implies that any rebalancing of the FX reserves into euros away from the dollar will require direct purchases of euros and selling of dollar reserves. Now, China holds some US$2,270 billion worth of FX reserves – some 33% of this in US dollars, marking a 19% rise in the proportion of FX reserves allocated to dollars within the last 12 months. And China holds some US$791 billion worth of US Treasuries.

So this is another marker suggesting the reduction of China’s appetite for dollar-denominated assets going forward.

As US-China trade deficit shrinks from US$268 billion in 2008 to US$188.5 billion in 2009 China will have four powerful reasons not to buy much more of US Treasuries:

• Falling supply of dollars and even faster falling supply of euros;
• Falling appetite for Treasuries;
• Falling returns to both dollars and Treasuries, and
• Rising demand for gold and euro, both requiring sales of dollar-denominated assets and cash.
  

Summing it up

With record deficit in works for 2010, the supply of Treasuries is bound to go up – some US$1,300 billion will be pumped into the global markets next year alone, plus some US$2,000 maturing will have to be rolled over.

Meanwhile, the demand from the Fed is gone almost completely and the demand from China is dramatically cut back, if not turned negative. Last week, Morgan Stanley boys estimated that by June 2010, potential excess supply of newly minted Treasuries over demand will be US$598 billion or 33% of the new issuance for the year.

Prices are likely to collapse and yields to rise. The US has no other option, but to push yields even higher in order to rid itself of the surplus Treasuries. Overshooting of the rates will follow.

Now, considering the amount of paper already issued during the crisis, we are looking at a bond prices cycle of some 20-30 years (traditional cycle is 18-26 years). In other words, the era of low rates is now over. Firmly.

While back in the Euroland, elves and fairies are…

Oh, well, inhabiting the imaginary universe where the Grand Plan for world monetary domination requires strong euro (even if at the expense of dead exporters) boys in Frankfurt are happy with the dollar and sterling slide. To them, the game is about turning the euro into a worldwide reserve currency – the stuff held by everyone, from grey and black economy’s ‘entrepreneurs’ (why else would a monetary union with anemic income growth need a 1,000 euro note for?) to legitimate sovereigns. This requires stability of value and, as a side-effect, low inflation. It also requires systemic undermining of European exports competitiveness and, as a side effect, higher unemployment.

In the land of elves and fairies, even with a prospect of continued weaknesses in the financial system still looming over the euro area banks (which have so far failed to pass the 50% mark of expected writedowns), the ECB is already on the tightening path. Earlier this month the ECB raised long-term cost of borrowing under its 12-month lending programme and told the markets it will cease lending under this maturity at the end of Q1 2010.

These measures will have a double whammy effect on euro area interest rates – first, pushing the rates directly by forcing the banks back into the direct interbank lending markets, and second – by forcing the banks to rely on milking their borrowers through higher rates and fees and charges to raise funds to repair their balancesheets.

The global changes – particularly those discussed above – will aid the ECB intentions. As the US raises rates, the euro is bound to ease off relative to the US dollar, opening up some more room for interest rates rising in the euro area. As China switches into buying euro to displace its dollar holdings, and cuts purchases of the US Treasuries, euro will be pushed up in value against other currencies, leading to a deterioration in the EU trade balance. Higher rates will help here too, offsetting falling trade surplus with rising capital account position.

In other words, the ECB is an accidental co-traveler on the road to the higher interest rates. A New Brave World that awaits us in the near future is likely to be the one with high, very high cost of capital.

A tale of a missing bonds rally

US markets have seen some strong rally momentum in recent days. Here is a good piece on bond markets in the US.

"If there really are signs of financial recovery, nobody told the bond market. Treasury Secretary Timothy Geithner's plan to rescue the financial system sent the S&P 500 soaring 7% on Monday alone, bringing its gains from March 6 to an impressive 19% through Wednesday. But credit markets have hardly budged. Corporate debt is still priced for disaster... Until investors recover confidence in financial assets, credit spreads are unlikely to tighten significantly. And without a sustained improvement in the credit market -- the seat of the crisis -- it seems irrational to expect a durable move higher in equities."

Yes, pretty much on the money. Here's how the numbers work: in my post on personal income by states - California is overdue a democratic party payoff and it will come, so the municipals markets and TIPS are going to be a good bet for some time to come. But the stock market is running too hot on absolutely nothing new - US Treasury's latest plan is a net transfer to
shareholders, which, obviously, first reduces any possible haircuts for bondholders, thus giving a fundamentals support to bonds ahead of shares.

What does this mean? If shares rises in the last 20 days is justifiable by fundamentals, there
should be at least a noticeable rally in bonds (although not as strong as in stocks, since bonds have already priced in all seniority over equity, thus a boost to equity holders yields is not going to be translated into 1:1 gains on bond prices).

My estimate would be as follows: for a 19% rally in equities, were the new valuations to set a new 'floor', we we will see a 5-6% gain on equity yields (including cap gains) over the next 3 years.

This would imply a yield differential compression to comparable corporate bonds relative to underlying equity. Assuming average yield differential for equity relative to corporate bonds of 8-10% in favour of bonds prior to equities rally, our post rally differential is ca 7.5-9.5% range. So bond prices have an upside potential of ca 16%. This is just straight math.

Now, take a cautious assumption that a part of equity rally is due to a fall in the perceived risk of default on equities (the recovery rate priced in CDS stays put, but expected recovery rate rises). Say 1/2 of the rally is just that. Then, price upside on corporate bonds is in the regions of 8-11%, holding YTM fixed. Until we see at least such a movement, the equity markets are overshooting the floor. And they are doing so pretty dramatically.

Near Sovereign bonds - the next frontier II

Brad Sester on the same topic of the US Federal paper (here) gives pretty much the same analysis of the Treasury's supply and demand imbalance emerging at this time, with pretty much the same implications:

"My guess is that central bank demand for US Treasuries will fall both absolutely and as a share of the US borrowing need. That is no bad thing. It is a byproduct of a smaller US current account deficit and a smaller current account surplus in much of the emerging world."

And a bit more beef on the direction of US foreign holdings sales and foreign withdrawals from the US equities:

"To be clear, official demand for Treasuries surged in the fourth quarter even as reserve growth slowed – as central banks shunned Agencies and likely pulled big sums out of the hands of private fund managers and parked those funds at the Fed. But once that reallocation is finished, growth will be driven by the underlying growth in countries reserves. And that is slowing …"

At current valuations in the sovereign debt markets, you have to be mad to follow the crowd into buying low yield paper when the governments issuing it have extended near sovereign guarantees to higher yielding corporate debt and are about to do so for quasi-government / local government debt as well.

Near Sovereign bonds - the next frontier?

We all know 2008 wasn’t a good year for securities markets. Now that the data is trickling in, we can see just how badly things turned out. Foreign investors unloaded almost $90 billion of U.S. securities in Q3 2008 alone – the greatest quarterly sale by overseas shareholders since 1960. In return, US investors sold ca $85 billion worth of foreign equities and bonds, according to the US Bureau of Economic Analysis.

It is too early to tell how much of this $175bn liquidity went into Treasuries and how much into the US corporate debt. But, after a week of weakening fixed income ETFs discounts, it is now looking increasingly likely that the markets are running a bit too hot in the sovereign paper area. This means it is time to look for a new class of 'favorites' and long over-looked US state bonds and municipals might be coming back into play. Maybe on the back of some sort of a Federal Government guarantee.

The reason is two fold: (1) the sovereign debt markets for US and European paper are teetering at what appears to be the zenith of a mini-bubble; and (2) more recent institutional investors’ interest in corporate bonds might be leading to a renewed appetite for some risk.

On point (2) first: Sure the likes of PIMCO and Blackrock will be pushing corporate debt over sovereign, given these fixed income giants have been vacuuming large corporates’ bonds for over a month now (see PIMCO’s Bill Gross’ latest ‘rant’ on TIPS etc here). Nonetheless, there is logic to their strategies, especially the one that Gross is pushing for in his sales pitch - if the US Government is willing to underwrite companies like GM, their debt should be trading closer to the US debt than the current yeilds imply. Yild compression amongst the Washington-'backed' corporates, therefore, might be on the books.

But, there is also a serious concern out there that too much money has now flown into the US Treasuries – pushing the yields to their historical lows. And this brings us to point (1) above.

James Montier, from Société Générale, has found that since 1798 yields on US bonds have never been this low, except under war time price controls in the 1940s. Montier reminds those of us who are quick to forget history (i.e economists in general) that the end of these low yields era of the 1940s was a tearful one. “The Fed drove the 10-year bond down to 2.25pc, much as it is doing today with mortgage bonds”. Post-war inflation did the rest of the damage.

Overall, the historic average for 1798-2008 period is ca 4.5pc nominal yield or 2pc real return. Yields on 10-year US Treasuries have now fallen to 2.4pc, leading one famous bond investor – Jim Grant – to quip that we are now in a ‘return-free risk’ world. In effect, current markets are implying (at present yields) that a decade of deflation will ensue despite the global efforts to re-inflate economy. This is how bad things must get in order to justify current valuations relative to the historic path. The story is the same across the world, with yields at 1.3pc in Japan, 3.02pc in Germany, 3.13pc in Britain, 3.26pc in Chile, 3.47pc in France, and 5.56pc in Brazil.

Thus, globally, investors are betting that deflation will fully offset the effects of near-zero interest rates and over €2 trillion in fiscal stimuli.

A highly unlikely proposition. What is more likely is that the sovereign debt markets are now over-subscribed and the bubble is primed to burst. When this happens, two things will follow:

(1) new sovereign debt issues will become virtually impossible to place (read about the new issues auctions troubles brewing already in my forthcoming Business & Finance article – to be posted here over the weekend), and
(2) first wave of bubble exits will go chasing some new risk in the form of under-priced quasi sovereign debt, a.k.a munis and state notes (ETFs discounts on funds dealing in these are deep now, but if my thinking is right, this is about to change in late Q1-early Q2).

An additional problem with sovereign bonds is that they are also facing a latent glut of supply. China, Russia, Brazil and many other countries will need liquidity for their internal purposes. They are unlikely to continue clinging to their holdings of the US Treasuries. China alone has $1.9 trillion in foreign sovereign bonds and the country now faces a dilemma – issue own debt to pay for domestic stimulus or sell other countries’ debt. It is no brainer that some of the Chinese-held bonds will hit the market at some time in 2009. Sure, they will go about it tactfully, gradually, quietly. But equally one can be sure they will dump somewhere around $90-110bn worth of this stuff in the next 12-15 months - if only to offset currently accelerating capital outflows.

Looking at this from the global perspective, BRICs and Middle Easter oil producers have in effect financed European and American deficits through 2007. In 2008, their appetite for this ‘store of value’ paper has run a bit dry. In 2009, it will turn negative, just as the US and European deficits will balloon to $3.5 trillion.

The only possible response to this is: a helicopter drop of money. The Fed, unlike less experienced and less globally aware ECB, sniffed the trend few months back. Helicopter drop of money – a practice of monetizing sovereign debt by printing money and using it to hover domestic bonds – is a powerful inflationary monetary policy tool. If the Fed was not aware of an incoming opportunity to do so, it would have not ‘unloaded its policy gun’ by cutting rates down to zero. The fact that it did shows that the Fed is more than willing, nay – it is actually happy – to start the printing presses to liquefy the bond holdings.

And just how effective this can get? Look no further than the US mortgage rates, driven – within a span of two months down 150 bps to 4.5pc – by Feds aggressive purchasing of mortgage-linked bonds, some $600bn worth of these. This is dandy, but what happens when the Fed satisfied its hunger for paper and deflation risk abates – possibly toward Q4 2009. The air will burst out of the bond market as the Fed will start gradually clear some trillions of dollars worth of paper off its books.

It will be a bang, not a pop - yields up, prices down, and the current holders of Treasuries belly up. The process will not be complete until the Fed unloads, say $1-1.5 trillion of the bond holdings, implying that no sane person will be buying these in the middle of the lengthy sell cycle. Lengthy because selling such quantity of US paper amidst the world still languishing close to the recession bottom will require care in order to avoid running up the risk of reigniting deflation.

So the longer-term future might be bleak for the US sovereign debt. The near future is also uncomfortable.

The strategy of playing the Fed’s drive into the bonds market during the ‘drop’ phase of money creation is not on the cards for investors, as most likely large purchases will mirror large supply increases from the likes of China, implying limited upside potential early in the purchasing cycle as supply of bonds will always stay near Fed’s demand line.

When to elephants play, stay well out of their way.

All of this means smart money will move elsewhere in advance of the Fed buying cycle (prior to Q3 2009) and munis and state bonds will be just there, at the ‘Welcome’ gate for investors, with some fresh backing from the Feds and a pile of infrastructure projects to finance.