Investment Themes - Fixed Income

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December 05 2016

Commentary by Eoin Treacy

Information Gaps and Shadow Banking

This article by Kathryn Judge from Columbia University School of Law may be of interest to subscribers. Here is a section:

This article argues that information gaps—pockets of information that are pertinent and knowable but not currently known—are a byproduct of shadow banking and a meaningful source of systemic risk. It lays the foundation for this claim by juxtaposing the regulatory regime governing the shadow banking system with the incentives of the market participants who populate that system. Like banks, shadow banks rely heavily on short-term debt claims designed to obviate the need for the holder to engage in any meaningful information gathering and analysis. The securities laws that prevail in the capital markets, however, both presume and depend on providers of capital playing the lead role performing these functions. In synthesizing insights from diverse bodies of literature and situating those understandings against the regulatory architecture, this article provides one of the first comprehensive accounts of how the information related incentives of equity and money claimants explain many core features of both securities and banking regulation.

The article’s main theoretical contribution is to provide a new explanation for the inherent fragility of institutional arrangements that rely on money claims. The literature on bank runs typically focuses on either coordination problems among depositors or information asymmetries between depositors and bank managers to explain bank runs. This article provides a third explanation, one which complements the established paradigms. It shows how information gaps increase the probability of panic by increasing the range of signals that can cast doubt on whether short-term debt that market participants had been treading like money remain sufficiently information insensitive to merit such treatment. It further examines how information gaps also impede the market and regulatory responses required to dampen the effects of a shock once panic takes hold. Evidence from the 2007-2009 financial crisis is consistent both with the article’s claims regarding the ways shadow banking creates information gaps and how those gaps contribute to fragility.

Eoin Treacy's view -

The shadow banking sector has benefitted inordinately from quantitative easing because the cost of leverage has been so low and access to the sea of liquidity issued by central banks has been limited to a relatively small number of market participants. That fact alone has contributed to the rise of populist movements, but the prospect of rising interest rates in response to proposed fiscal stimulus represents a challenge for the shadow banking sector. 



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December 01 2016

Commentary by Eoin Treacy

Jeremy Siegel Why Long-term Investors Should Own Stocks: Bonds are 'Dangerous'

Thanks to a subscriber for this common sense article which may be of interest. Here is a section:

Last year you expected “some increase” in the 10-year Treasury yield. On November 30 of last year it was at 2.21% and on Friday it closed at 2.34%, so your forecast was accurate. What is your forecast now for interest rates? Have we finally seen the end of the 35-year secular downtrend in rates? 

Rates took a huge jump after the Trump election. They are going to work their way higher. Again, there is a lot of uncertainty about what policies will be enacted, but I would not be surprised to see the ten year between 2.5% and 3% by the end of next year. That is a rate that should not be threatening for equities. If rates move well above 3% without a corresponding big increase in economic growth, it’s a problem. If there’s a big increase in economic growth, a move above 3% could still be all right. But if there is an inflation problem, the Fed will fight by increasing rates even more. That certainly would be a challenge to the equity market. 

President-elect Trump has criticized the Fed for being too dovish. Would he be wise to appoint a new chairperson or governors who are more hawkish? 

Janet Yellen’s term doesn’t end until January 2018. Vice Chair Stan Fischer’s term ends about six months after that. Trump has given no indication that he’ll ask either to step down now, although he has definitely said that he wants to replace Yellen when he becomes president. 

Yes, Trump has criticized the Fed for keeping interest rates down too much. After accusing the Fed of trying to help Clinton and Obama by keeping rates low, Trump might have to welcome low rates if he wants to implement the infrastructure program that he desires. In fact, I believe the Fed is going to move with the 10-year rate next year. If the 10-year Treasury continues to rise to 2.5%, 2.75% or 3% or more, you are going to see two or three Fed rate hikes. We are certainly going to see one in December. That’s a slam dunk. But there could be anywhere from two to three hikes next year depending on how high that 10-year rate goes. 

It’s one thing to finance infrastructure at a near-zero rate, which is where short-term rates are. But if short rates rise to 1.5% and the long rates approach 3%, it is going to be more of a challenge. Trump may not appoint someone who is very hawkish, such as John Taylor, and maybe we’ll find that Yellen’s dovishness will be welcome at a later date. 

I should mention that for quite a while there have been two openings on the Board of Governors of the Federal Reserve and the Board wants them filled. They want to be at full strength. There are only five governors now and there should be seven. Trump will have the opportunity to appoint two new governors very early in his term.

 

Eoin Treacy's view -

US 10-year Treasury yields surged again today and have now comfortably broken the progression of lower rally highs evident since the yield peak that accompanied the taper tantrum. This move is amicably being referred to as the Trump tantrum. There is some weight to the argument it will be temporary since many investors have been conditioned to buy-the-dip and the Presidential inauguration will not be until January 20th. 



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November 30 2016

Commentary by Eoin Treacy

After Brexit and Trump, It's Italy's Turn to Keep Traders Awake

This article by Chiara Albanese , Stefania Spezzati , and Charlotte Ryan for Bloomberg may be of interest to subscribers. Here is a section:

Renzi, 41, has staked his political future by suggesting he would resign if he were to lose, and the first projections of the result are due just before midnight Rome time.

“You have to ask how much the market will react to something they are expecting,” said Andy Soper, head of Group of 10 foreign-exchange options at Nomura in London. "The difference this time is that it might be less about the result and more about how the vote is won or lost. There are a lot of unknowns.”

 

Eoin Treacy's view -

If you look back at history you don’t often see old revolutionaries. The leaders might be mature adults but the people on the streets doing the fighting tend to be young, idealistic, ready for anything, and glorying in the freedom they have suddenly been allowed to grasp. 

A big part of the reason Europe has not had more social unrest is because it simply does not have a large population of young people. We’ve all seen the headlines talking about youth unemployment but the reality is that the 18-25 year old bracket is small relative to the massive aging populations in Spain and Italy.

 



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November 30 2016

Commentary by Eoin Treacy

Top Ten Market Themes For 2017: Higher growth, higher risk, slightly higher returns

Thanks to a subscriber for this report from Goldman Sachs which may be of interest. Here is a section:

8. Inflation: Moving higher across DM
‘Reflation’ is the theme du jour following Donald Trump’s unexpected emphasis on infrastructure spending in his acceptance speech on election night. Since then, market participants have been hard at work trying to figure out the policy agenda that Trump the president might pursue (distinct from the rhetoric of Trump the candidate). What seems clear to us, as argued above, is that economic issues, notably tax cuts, infrastructure spending and defense spending, are high on the agenda — a recipe for reflation.

There was a strong case for rising inflation in the US even before Trump’s victory. Our call for higher rates in long bonds this past year was premised more on a repricing of inflation risk and inflation risk premia than on a rise in real rates. And, globally, we expect rising energy prices to push up headline CPI across the major advanced economies in early 2017. After years of deleveraging and highly accommodative monetary policy, we expect inflation to gain momentum in 2017 just as many countries are shifting their policy focus to fiscal instruments. For example, we are forecasting large boosts to public spending in Japan, China, the US and Europe, which should fuel inflationary pressures in those economies. Moreover, having had to work so hard for so long to get inflation even to the current low levels, the major central banks in developed markets sound increasingly willing to let inflation run above 2% targets

Eoin Treacy's view -

A link to the full report is posted in the Subscriber's Area.

As recently as early this month a significant number of investors were betting the discount rate was never going to go up. That has definitely changed with the bond markets rapidly pricing in the potential for inflation to pick up as fiscal stimulus is expected to kick in. 



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November 16 2016

Commentary by Eoin Treacy

Go Figure

Thanks to a subscriber for Howard Marks’ latest memo to Oaktree clients focusing on the outcome of the US election. Here is a section: 

That brings us to the outlook for bonds. Just as the U.S. stock market has celebrated Trump’s election, the bond markets have been discouraged. Interest rates rose very rapidly last week following Trump’s election, bringing big losses to bond holders. The FT wrote the following, citing Henry Kaufman, the Solomon Brothers chief economist who correctly called the bond bear market in the 1970s:

“It’s a tectonic shift”…the end of a three-decade bond bull market, because of the likelihood of unfunded tax cuts, infrastructure spending and a radically reshaped Federal Reserve. “I would say the secular trend is going to be upwards now” he told the FT “Secular swings are hard to forecast, but the secular sweep downwards in interest rates is over, and we are about to have a gentle swing upwards”

I always feel it takes a degree of innate optimism to be a devotee of stocks (with their reliance on conjectural returns awarded by the market) as opposed to bonds (which bring contractual returns guaranteed by their issuers). Thus U.S. equity investors have exhibited an optimism regarding the Trump administration that virtually no one foresaw a week ago. 

Equity investors like inflation because it pumps up profits. Bond investors dislike it because it raises interest rates, reducing the value of the bonds they hold. But the two can’t go in opposite directions forever. At some distant point, higher interest rates can cause bonds to offer stiffer competition against highly appreciated stocks. 

Eoin Treacy's view -

A link to the full report is posted in the Subscriber's Area.

Generally speaking the stock and property markets are reasonably good hedges against inflation because both dividends and rents can increase over time and compensate the asset holder. Fixed rates bonds on the other hand do not have this advantage and are therefore one of the most interest rate sensitive sectors. 



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November 15 2016

Commentary by Eoin Treacy

Signs Are Flashing That Bond Rout Has Gone Too Far, Too Fast

This article by Yun Li for Bloomberg may be of interest to subscribers. Here is a section:

 

Expectations that Trump, along with a Republican-led Congress, would make good on pledges to spend $550 billion on infrastructure improvement to stoke economic growth sent inflation expectations to the highest since 2015. Yields on two-year notes, the coupon maturity most sensitive to monetary-policy expectations, rose to above 1 percent on Monday for the first time since January as traders added to bets the Federal Reserve will raise interest rates next month.

"The consensus has shifted for good reason," Matthew Hornbach, head of global interest-rate strategy at Morgan Stanley, said in an interview with Bloomberg Television. "There is some concern over the timing and the extent to which President-elect Trump will be able to follow through on some of his campaign promises specially with respect to infrastructure spending and the tax cuts."

 

Eoin Treacy's view -

This sell off in bonds has been both swift and aggressive with the net result that yields have surged to levels not seen in at least a year. For bond investors who have been conditioned by a 35-year bull market the natural response is to buy the dip. As with any bull market that has been a winning strategy for as long as anyone cares to remember and in order to conclusively signal this historic bull market is over it will have to stop being a profitable strategy. 



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November 11 2016

Commentary by Eoin Treacy

November 09 2016

Commentary by Eoin Treacy

Investment ramifications of a Trump Presidency

Eoin Treacy's view -

It was a bruising campaign but with control of all three branches of government the Republican Party now has a relatively unfettered path to introducing a broad range of policy options. The one obstacle of course is that the entrenched bureaucracy in Washington and the various unions are totally opposed to just about any change to the status quo. 

Corporate taxation and the tax code more generally could be up for debate. Securing a budget large enough to make a dent in the deferred maintenance of the USA’s infrastructure is perhaps the clearest ambition of a Trump Presidency. Protectionism is also high on the agenda and the responses of NATO and EU spokespeople to the news was a picture of unease at this new source of uncertainty. Immigration is also likely to be a major topic of conversation for this administration. 

 



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November 09 2016

Commentary by Eoin Treacy

The world has just become a more dangerous place

This article by Lara Marlowe for the Irish Times may be of interest to subscribers. Here is a section:

White Americans are traumatised to know they will become a minority within 50 years. The French extreme right believe there’s a conspiracy to replace the European population with Africans and north African Arabs. Like Trump supporters, they hark back to the “good old days” and want France to be “great again”.

Virtually all western democracies appear to be infected with the anger and disillusion that brought Trump to power. An opinion poll published by Le Monde on November 8th showed that close to three-quarters of the French electorate believe their elected officials are corrupt. They believe elections serve no purpose, and that political parties, trade unions and media block the country. Trump’s promise to “drain the swamp” has certain resonance.

During the campaign, Le Pen told the right-wing magazine Valeurs Actuelles: “What Americans like is that he’s a free man. If I were American, I’d choose Donald Trump.”

On Wednesday morning, she tweeted congratulations before final results were in.

 

Eoin Treacy's view -

This has been a year in which the “perceived wisdom” has been proved not to hold true. The UK voted to leave the EU, the Chicago Cubs won the World Series for the first time in more than a century, the Irish rugby team beat the All Blacks for the first time,(although it was only a friendly) and now a rank outsider has won the US Presidential Election. The question now is whether this trend of surprises and disruptions to the status quo will continue and most particularly in Europe?



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November 08 2016

Commentary by Eoin Treacy

Not With A Bang But A Whimper (and other stuff)

Thanks to a subscriber for this report by Ben Inker and Jeremy Grantham for GMO which may be of interest. Here is a section:

At GMO we have put particular weight for identifying investment bubbles on the statistical measure of a 2-sigma upside move above the long-term trend line, a measure of deviation that uses only long-term prices and volatility around the trend. (A 2-sigma deviation occurs every 44 years in a normally distributed world and every 35 years in our actual fat-tailed stock market world.) Today’s (November 7) price is only 8% away from the 2-sigma level that we calculate for the S&P 500 of 2300.

13. Upside moves of 2-sigma have historically done an excellent job of differentiating between mere bull markets and the real McCoy investment bubbles that are likely to decline a lot – all the way back to trend – often around 50% in equities. And to do so in a hurry, in one to three years.

14. So we have an apparent paradox. None of the usual economic or psychological conditions for an investment bubble are being met, yet the current price is almost on the statistical boundary of a bubble. Can this be reconciled? I believe so.

15. There is a new pressure that has been brought to bear on all asset prices over the last 35 years and especially the last 20 that has observably driven the general discount rate for assets down by 2 to 2.5 percentage points. Tables 1 and 2 compare the approximate yields today of major asset classes with the average returns they had from 1945 to 1995. You can see that available returns to investors are way down. (Let me add here that many of these numbers are provisional. We will try to steadily improve them over the next several months. Any helpful inputs are welcome.) But I do believe that readers will agree with the general proposition that potential investment returns have been lowered on a wide investment front over the last 20 years and that stocks are generally in line with all other assets.

Eoin Treacy's view -

A link to the full report is posted in the Subscriber's Area.

I agree that the topic of bubbles is central of what our job as analysts is. If we can succeed in identifying the latter stages of a bubble, we can avoid the worst effects of the subsequent bear market, so that we are in the privileged position of having ample liquid capital with which to participate when a new bull market evolves. The big question now is to what extent the major stock market indices exhibit bubble characteristics. 



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November 04 2016

Commentary by Eoin Treacy

Payrolls in U.S. Rise 161,000 in October as Wages Accelerate

This article by Michelle Jamrisko for Bloomberg may be of interest to subscribers. Here is a section:

Wage gains picked up, with average hourly earnings rising 0.4 percent from a month earlier to $25.92. The year-over-year increase was 2.8 percent, compared with 2.7 percent in the year ended in September.

Higher wages are starting to encourage more Americans to quit their jobs with the confidence they’ll find other work that pays more. The number of job leavers as a share of unemployed rose to 12.1 percent in October, the highest since February 2007.

The average work week for all workers held at 34.4 hours in October. Among service providers, education and health services led with an increase of 52,000 jobs, followed by professional and business services at 43,000. Retailers pared payrolls by 1,100 on declines at electronics and appliance stores and clothing shops.

Factories reduced payrolls by 9,000 after an 8,000 decline the month before, in line with a report earlier this week that showed manufacturing barely expanded in October while orders moderated. Employment at construction companies rose by 11,000. Governments added 19,000 workers.

 

Eoin Treacy's view -

Wage growth broke out on these figures. Considering it is almost the one measure of inflation that cannot be hedonically moderated it carries weight in the Fed’s decision on whether to raise rates. In fact all other factors being equal the pop in wage demands is likely the figure that pushes the Fed over the line into definitely raising rates in December. The only thing that could derail such a move would be market tumult following a surprising US election result not least if it is deadlocked. 



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November 02 2016

Commentary by Eoin Treacy

Musings from the Oil Patch November 1st 2016

Thanks to a subscriber for this edition of Allen Brooks' ever interesting report for PPHB which may be of interest. Here is a section:

It appears to us that everyone in the energy industry is fixated on whether the OPEC oil ministers meeting in Vienna, Austria on November 30th will produce an agreement to limit the group’s output, and how that production volume will be shared among the group’s 12 members. Also, it will be important to see who among the 12 OPEC members will be exempted from a monthly production quota and what those countries near-term output goals are. Lastly, we need to see some support from Russia for OPEC’s production cap to have much strength. While all these details are important to the outcome of the OPEC meeting and how the energy world reacts to whatever is agreed to, the lack of executive thinking about what happens to energy demand if the U.S. enters a recession could be the pothole everyone steps in. The duration and depth on any recession will determine how much oil demand might be lost due to weaker economic activity. We suggest you should pay attention to this hidden elephant in the OPEC meeting room. 

Eoin Treacy's view -

A link to the full report is posted in the Subscriber's Area.

While Allen Brooks is not predicting a recession more than a few analysts have floated the idea. It’s an important consideration that would of course have a significant impact on the energy markets but also on just about every other asset class. Perhaps it would be timely to review some of the leading indicators for recessions to see where we are in the cycle. 



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November 01 2016

Commentary by Eoin Treacy

Renzi Looks to Ends of Earth for Referendum Votes to Save Job

This article by Lorenzo Totaro, Chiara Albanese and Marco Bertacche for Bloomberg may be of interest to subscribers. Here is a section:

A little more than five weeks before the ballot on reforms that Prime Minister Matteo Renzi says are needed to streamline the government, Italy’s main pollsters signal that voters are almost equally split, with the naysayers slightly ahead. While the surveys don’t take into the views of overseas voters, history suggests they might break in favor of Renzi. In the 2013 general election his Democratic Party was their No. 1 pick.

The most likely scenario is a victory for “No” by a small margin, JPMorgan economist Marco Protopapa wrote in a note on Friday. London-based Protopapa added that faced with a defeat, Renzi would likely offer his resignation to the president of the Republic, who would reject it and invite the premier to verify that he has the support of a majority in the parliament.

 

Eoin Treacy's view -

Renzi has already rolled back on his commitment to leave office if the referendum does not pass and little wonder considering how close the polls are. An Italian subscriber sent through this article which highlights the fact a number of politicians are beginning to float the idea of delaying the plebiscite to allow for greater focus on managing the response to last weekend’s earthquakes. 



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October 27 2016

Commentary by Eoin Treacy

Swedish Krona Plunges as Riksbank Signals More Easing to Come

This article by Johan Carlstrom and Amanda Billner for Bloomberg may be of interest to subscribers. Here is a section:

Nordea’s chief analyst in Stockholm, Andreas Wallstrom, said he still expects more easing by the Riksbank, "including a rate cut” to minus 0.6 percent in December. “The government bond purchase program is forecast to be expanded by 30 billion kronor ($3.4 billion), equally distributed between government bonds and index-linked bonds,” Wallstrom said.

“The revised repo rate path delivers enough softness to keep the krona on the weak side,” said Knut Hallberg, an analyst at Swedbank AB in Stockholm. “It shows a bigger probability of a cut.”

Some analysts had predicted the Riksbank would announce more easing already on Thursday after inflation missed the bank’s forecasts by a wide margin last month. The annual inflation rate slowed to 1.2 percent in September after peaking at 1.6 percent at the start of the year.

The Riksbank also cut its inflation forecast for next year, from 1.8 percent to 1.4 percent, and for 2018, from 2.6 percent to 2.2 percent. It predicted that unemployment will average 6.7 percent next year, while economic growth will slow to 3.3 percent this year and 2 percent in 2017.

“I don’t really see the logic of making monetary policy more expansionary,” since the economy is doing well, Bergqvist said. Still, “it’s a good tactic that the Riksbank keeps the door open,” he said.

 

Eoin Treacy's view -

The video interview within the above article is quite illustrative of the complacency of central banks when married to a narrowly defined measure of inflation. Riksbank Governor Stefan Ingves quite clearly admits that a bubble is expanding in the Swedish property market and in the same breath says it is not within the remit of the central bank to do anything about it. In fact, like other central banks asset price inflation is viewed as a positive despite the fact household debt is at a record and the bubble is still inflating. 



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October 27 2016

Commentary by Eoin Treacy

Selling Sweeps Global Government Bonds; U.S. 10-Year Yield Above 1.8%

This article by Min Zeng for the Wall Street journal may be of interest to subscribers. Here is a section:

The combination of low global growth, subdued inflation and ultra loose monetary policy among major central banks has been sending bond yields to unprecedented levels. Yet over the past few weeks, the narrative has appeared to shift.

Concerns have been growing over less support for the bond market from central banks in Japan and Europe as their bond buying is reaching limits. Economists and analysts have started talking about a shift toward fiscal stimulus to combat low growth. Such fiscal action typically raises supply of government debt for funding and is seen as a negative for long-term government bonds.

Demand for haven bonds has also been diminishing as data lately have pointed to some positive signs on the global economic outlook. Meanwhile, inflation expectation is rising, driven by a rally in crude oil prices this month and comments from major central banks to tolerate inflation slightly above their desired targets to tackle still low inflation.

 

Eoin Treacy's view -

Central banks are expressing some reluctance to continue with the same tired strategies that have fostered perhaps the greatest asset price inflation across multiple asset classes in history while failing to stock the kind of inflation central banks measure. Concurrently inflationary pressures are mounting with healthcare and education leading but Chinese producer prices and wages are two important additional factors. 



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October 24 2016

Commentary by Eoin Treacy

Most Crowded Trade in Bonds Is a Powder Keg Ready to Blow

This article by Brian Chappatta and Anchalee Worrachate for Bloomberg may be of interest to subscribers. Here is a section:

“Rates are rising from a very, very low base, which means there’s lots of downside and very little upside” for bond prices, said Kathleen Gaffney, a Boston-based money manager at Eaton Vance Corp., which oversees $343 billion. She runs this year’s top-performing U.S. aggregate bond fund and has reduced duration and boosted cash. “If you don’t know how to time it, and I certainly don’t, you just want to get out of the way.”

The lengthiest maturities have dominated the decades-long bull market in bonds, precisely because of their higher duration. Investing in 30-year Treasuries since the turn of the century has produced a 7.8 percent annualized return, compared with 4.3 percent for the S&P 500 index. Yet that run has faltered: U.S. long bonds are on pace for their worst month since June 2015, losing 3.2 percent as yields have climbed about 0.2 percentage point.

 

Eoin Treacy's view -

I’ve written quite a bit about the sensitivity of bond prices to interest rates but this is the first article I’ve seen that specifically talks about the duration of the market and how that represents a risk for investors as interest rates begin to rise. What I have not yet seen is a discussion of convexity which is the influence interest rates have on the relationship between price and yield. Nevertheless it is inevitable that this will become a greater consideration as interest rates rise further. 



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October 14 2016

Commentary by Eoin Treacy

Your money market fund has changed

This article by Darla Mercado for CNBC may be of interest to subscribers. Here is a section:

All of that changed in September 2008, when Lehman Brothers filed for bankruptcy. The Reserve Primary Fund, a large money market fund, held Lehman bonds.

In turn, institutional investors pulled billions of dollars from the fund, knocking its share price from the supposedly steady $1 to 97 cents on Sept. 16, 2008. It had "broken the buck."

That crisis spurred new rules from the SEC, aimed at protecting smaller investors from large redemptions.

Two key reforms came about: One would require so-called prime institutional money market funds (generally used by large investors) to have a floating net asset value rather than a fixed $1 share price.

The other creates liquidity fees and "redemption gates," which are temporary halts on withdrawals to certain money market funds.

Eoin Treacy's view -

Highlighting the clear difference in risk between government and corporate commercial paper is at the root of these changes to the structure of money market funds. That is likely to be a net positive overall but it represents a change to the status quo and therefore an uncertainty.  



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October 13 2016

Commentary by Eoin Treacy

I have seen the future and his name is Kevin

Thanks to a subscriber for this note by Albert Edwards at SocGen which may be of interest to subscribers. Here is a section:

Summers’ relaxed view on the debt build-up, particularly visible in the corporate sector, is in sharp contrast with our own view that this looks set to wreck the US economy. Summers was particularly dismissive of comparing debt to income as the former is a stock and the latter a flow concept. He thought it entirely appropriate in a world of lower interest rates that debt had reached record levels relative to income? belying, for example, the concerns expressed by the IMF this week. Should we worry about the chart below or not?

The charts above and below have just been updated by my colleague Andrew Lapthorne (and using the S&P 1500 ex financials universe). Summers? point was we shouldn’t be too stressed about rising debt as 1) QE is driving up asset prices and higher debt does not look excessive relative to assets, and 2) rock-bottom interest rates mean the debt is easily serviceable. Now on the first point, Andrew shows that quoted company corporate debt has rocketed relative to assets to now exceed the madness last seen at the height of the 2000 TMT bubble. Indeed the problem with Summers? analysis in my view is that it is the higher debt that is being used to push up asset values (via share buybacks), just as it did during the housing bubble in 2005-7. And by pushing asset values well beyond fundamentals you build debt structures on false asset values, which only become apparent when the asset bubble bursts. And am I in any way reassured that the Fed sees no bubbles? No, I am not. These dudes will never identify an asset bubble? at least before the event!

Andrew notes that the way corporate bond pricing models work (e.g. Moody’s KMV and Merton’s “distance to default” models) it is not just a company’s ability to pay its coupon that affects its valuation. Investors are in effect always asking, can this company repay its principal TODAY, even though the repayment is not actually due for 30 years. If asset values collapse in the event of a recession, corporate bond spreads will explode irrespective of the fact that they can easily pay the interest. But hang on a second, let’s just look at interest cover for the quoted sector, for Andrew finds that despite record low interest rates, cover has declined to levels last seen in the depths of the last recession (see chart below)! In the next recession a sharp decline in both profits and the equity market will reveal this Vortex of Debility. US corporate spreads will then explode as the economy is overwhelmed by corporate defaults and bankruptcies. And with the Fed having been the midwife of yet another financial crisis, what price do you give me for it to lose its independence?

 

Eoin Treacy's view -

A link to the full report is posted in the Subscriber's Area.

A point I’ve made on a number of occasions is that the corporate finance courses taken by MBA students dictate that corporations attempt to access the cheapest cost of funding in order to reduce the weighted average cost of capital. It is advantageous, from a balance sheet perspective, to load up on debt when interest rates are low and to extend the maturity out as far as is practicable, then to use the proceeds to buy back shares, regardless of price, because that reduces funding costs overall. 



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October 11 2016

Commentary by Eoin Treacy

A $7 Trillion Moment of Truth in Markets is Just Three Days Away

This article by Tracy Alloway may be of interest to subscribers. Here is a section: 

Not since the financial crisis of 2008 has Libor, to which almost $7 trillion of debt including mortgages, student loans and corporate borrowings, is pegged — experienced such a surge. The three-month U.S. dollar Libor rate has jumped from 0.61 percent at the start of the year to 0.87 percent currently — a 42 percent rise — ahead of money market reform that's due to come into effect on Oct. 14.

The new rules require prime money market funds — an important source of short-term funding for banks and companies — to build up liquidity buffers, install redemption gates, and use 'floating' net asset values instead of a fixed $1-per-share price. While the changes are aimed at reinforcing a $2.7 trillion industry that exacerbated the financial crisis, they are also causing turmoil in money markets as big banks adjust to the new reality of a shrinking pool of available funding.

Some $1 trillion worth of assets have shifted from prime money market funds into government money market funds that invest in safer assets such as short-term U.S. debt, according to Bloomberg estimates. The exodus has driven up Libor rates as banks and other corporate entities compete to replace the lost funding.

Now, analysts are debating whether the looming Oct. 14 deadline will mark a turning point for the interbank borrowing rate, as money markets acclimatize to a new reality.

 

Eoin Treacy's view -

A great deal of capital is parked in money market funds overnight because they are considered relatively secure because the NAV is steady. The transition to two types of money market fund; one investing only in government securities with a static NAV and others in commercial paper with a highly variable NAV, represents a major change and will need time for bedding in so the potential for volatility is non-trivial.



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October 07 2016

Commentary by Eoin Treacy

Remarks at the 40th Annual Central Banking Seminar

This transcript of a speech by Ray Dalio of Bridgewater Capital to the New York Fed may be of interest to subscribers. Here is a section:

As a result of this confluence of conditions, we are now seeing most central bankers pushing interest rates down to make them extremely unattractive for savers and we are seeing them monetizing debt and buying riskier assets to make debt and other liabilities less burdensome and to stimulate their economies. Rarely do we investors get a market that we know is over-valued and that approaches such clearly defined limits as the bond market now. That is because there is a limit as to how negative bond yields can go. Their expected returns relative to their risks are especially bad. If interest rates rise just a little bit more than is discounted in the curve it will have a big negative effect on bonds and all asset prices, as they are all very sensitive to the discount rate used to calculate the present value of their future cash flows. That is because with interest rates having declined, the effective durations of all assets have lengthened, so they are more price-sensitive. For example, it would only take a 100 basis point rise in Treasury bond yields to trigger the worst price decline in bonds since the 1981 bond market crash. And since those interest rates are embedded in the pricing of all investment assets, that would send them all much lower.

At the same time, as bonds become a very bad deal and central banks try to push more money into the market and yields go even lower and price risks increase further, savers might decide to go elsewhere. At existing rates of central bank buying—which I believe will be required for the foreseeable future—central banks are going to start to hit the limits of their existing constraints. Those limits were put into place because they originally thought that they were prudent but they are going to have to go buy other things. Right now, a number of the riskier assets look attractive in relationship to bonds and cash, but not cheap in relationship to their risks. If this continues, holding non-financial storeholds of wealth like gold could become more attractive than holding long duration fiat currency flows with negative yields (which is what bonds are), especially if currency volatility picks up.

Concerning what policies will likely be required of central bankers given the reduced effectiveness of interest rate cuts and quantitative easing, and assuming that political limitations on fiscal policies and structural reforms remain stringent, it appears to me that there will have to be greater purchases of riskier assets and more direct placements of purchasing power in the hands of spenders, especially as the previously described squeeze intensifies.

 

Eoin Treacy's view -

The number of large bond investors calling for direct provision of liquidity to consumers is growing steadily as serious doubts about the sustainability of negative yields continue to be voiced. In central bank parlance that equates to helicopter money.



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October 06 2016

Commentary by Eoin Treacy

The Overlords of Finance

Thanks to a subscriber for this article by Danielle DiMartino Booth which may be of interest. Here is a section:

Well ain’t that a thing! Now we know why the dialogue shifted just after former chair Ben Bernanke made his way out the door in January 2014. The exit from unconventional monetary policy, you may recall, was originally set to begin with the tapering of purchases, being followed by allowing the balance sheet to run off and then prompt the first rise in interest rates – in that order.

A funny thing happened on the way to the exit, though. Bill Dudley is not only the president of the Federal Reserve Bank of New York but also the vice chairman of the Federal Open Market Committee and coveted holder of a permanent vote. Back on May 14, 2014, in a question and answer session with reporters following a speech, he literally stood the preexisting exit principles on their head.

“Delaying the end of reinvestment puts the emphasis where it needs to be — getting off the zero lower bound for interest rates,” explained New York Fed president Bill Dudley. “In my opinion, this is far more important than the consequences of the balance sheet being a little larger for a little longer.” Luckily for investors in any and every risky asset, his opinion holds a lot of sway. Dudley’s central banking peers in developed countries have followed his lead and peace on earth has held ever since.

As for those pesky financial stability concerns, we’ve been instructed to look the other way. Some have even gone so far as to suggest that the time has come to devise a new term to replace ‘bubble.’ No doubt, it’s an unseemly word given the nasty images it conjures. But what if the word ‘bubble’ is not substantial enough to capture what’s been created before our very eyes, across the full spectrum of asset classes?

 

Eoin Treacy's view -

This article offers an erudite exposition of the problems residing in the fixed income markets and the extent to which leverage now plays a role in just about all asset classes. The simultaneous asset price inflation of the stock, bond and property markets, particularly since 2011, is a testament to the fact that a potential problem is brewing.  

The Velocity of Money is on a steady downward trajectory, and in fact has been declining since 1997. That goes a long way towards explaining why monetary policy has been so easy and why central banks are reluctant to withdraw the additional liquidity from the market. The only reason a problem might arise is if the status quo changes. 

 



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September 30 2016

Commentary by Eoin Treacy

Ultra-Easy Money: Digging the Hole Deeper?

Thanks to a subscriber for this excellent summary of the rationale, effects and repercussions of loose monetary policy. Here is a section:

These are not just theoretical considerations. The BIS Annual Report of 2014 sounded the alarm when it noted that the level of debt in the AMEs (sum of corporate, household and governments) was then significantly higher than it had been in 2007. Moreover, it has since risen further, to over 260 percent of GDP. This increase has prompted the question “Deleveraging? What deleveraging?”18 This suggests that, by following polices that have actively discouraged deleveraging, we may instead have set ourselves up for an even more serious crisis in the future.

As for the history of economic thought, Keynes himself said in Chapter 13 of the General Theory (1936) that monetary stimulus was likely to be ineffective; “If, however, we are tempted to assert that money is the drink that stimulates the system to activity, we must remind ourselves that there may be several slips between the cup and the lip”. This conclusion marked a sharp change from the policy changes he had recommended in the Treatise on Money (1930). Hayek (1930, p21) went even further in suggesting that monetary easing would actually hold recovery back. “To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about”.

And 

The BIS Annual Report for 2016 also highlights a number of persistent market anomalies27. Not only do they indicate price distortions and potential misallocations but could also indicate underlying structural developments whose full implications for market liquidity are not yet obvious. Recall the plight of European banks in 2008 who had borrowed dollars from money market mutual funds in the US. When this source of funding dried up, the Federal Reserve was forced to reopen US dollar swap lines that it had closed only a few years earlier. All that can be said with certainty, is that we are in uncharted territory when it comes to market functioning.

And for the record, it should be noted that central bank policies might have had other downsides as well. First, with income distribution already a source of great concern (due mainly to changing technology and globalization) the recent stance of monetary policy has likely made it worse. The rich own most of the risky financial assets whose prices have increased the most. Conversely, the middle classes mainly hold the less risky interest-bearing assets whose yields are at record lows. While central banks seem increasingly aware of these effects29, what can be done about them is another issue

 

Eoin Treacy's view -

A link to the full report is posted in the Subscriber's Area.

I think we can all agree that the introduction of extraordinary monetary policy helped to avoid a much deeper economic contraction but has also led to distortions in how markets function and contributed to asset price inflation. There are substantial questions about what the eventual normalisation of policy might look like but equally important are considerations of what a further intensification of extraordinary policy might look like. 



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September 28 2016

Commentary by Eoin Treacy

France unlikely to achieve 2017 deficit target: fiscal watchdog

This article from Reuters may be of interest to subscribers. Here is a section:

"Based on the information at its disposal, (the HCFP) considers as uncertain that the nominal deficit will be brought to less than 3 percent of GDP in 2017," it said in a report issued as Hollande's government prepares to publish its 2017 budget on Wednesday.

Finance Minister Michel Sapin dismissed the watchdog's concerns, saying that it was skeptical every year and yet the deficit targets had been met.

"I therefore reaffirm the seriousness of the budget and the government's determination to bring the deficit to less than 3 percent in 2017," Sapin said in a statement.

Paris hopes to rebuild its fiscal credibility with its European partners by targeting a deficit of 2.7 percent of GDP for 2017, the lowest in a decade and under the EU's limit of 3 percent.

A serial offender of the EU's fiscal rules, France has delayed bringing its deficit below 3 percent several times under both Socialist and center-right governments in recent years.

EU Economic Affairs Commissioner Pierre Moscovici, who in effect polices government finances to ensure they are living up to their promises, said he expected France to get the deficit below the 3 percent threshold next year.

"I think it's possible," Moscovici, a former finance minister in Hollande's first government, said in an interview with L'Opinion newspaper.

France's fiscal watchdog said government forecasts for 1.5 percent GDP growth this year and next were optimistic, noting they were higher than what most private sector economists expected.
"The government's growth outlook, which is based on a number of favorable assumptions, does not display the caution necessary to best meet public finance targets and commitments," it said. 

 

Eoin Treacy's view -

More than any other country France exemplifies that within the EU there is one set of rules for large countries and quite another for smaller ones. If any smaller country had failed to adjust its fiscal deficits in the same way that France has it would have come under severe scrutiny from the EC, ECB and possibly even the IMF. Yet for France there has been no such talk despite the fact it has been a serial offender. 



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September 27 2016

Commentary by Eoin Treacy

Twilight of the Central Bankers

Thanks to a subscriber for this article by Tad Rivelle for TCW which may be of interest to subscribers. Here is a section:

It’s back to the future – again. Leverage has returned, most notably in the corporate sector where debt metrics have not just roundtripped but indeed are now in excess of the levels experienced before the Great Recession.

And while the Fed clings to the fiction that it is “data dependent,” its response function – cowering in the face of every market “tantrum” – reveals monetary policy to be what it really is: a put on financial prices. But can the Fed, Canute-like, hold back the future tides of de-leveraging? No, though we expect that they, like their comrades in arms at the ECB and BOJ, will keep trying. Indeed, negative rates can be best understood as merely the latest attempt to forestall the failures of policies past. But, is anyone helped by establishing negative “hurdle” rates to incentivize “investment?” If a commitment of capital requires a negative opportunity cost, then whatever activity that might be launched will assuredly be productivity destroying. Negative rates have all the economic “logic” of destroying the village so as to rebuild it. It is monetary madness and while it might hold back the flood for a time, it fairly well guarantees that when the flood comes, it will be worse than it would otherwise.

Face it: the central banking Emperors have no clothes. But, might the Fed come up with new artifices to prop up the towers of leverage they have built? They might, though it would be folly. Yet, underestimating folly is, I suppose, a folly of its own. The Fed could continue to use its printing press to falsify capital market signals, but to what end? When a central bank buys an asset with an electronically printed dollar, a “something for nothing” trade has taken place. Unless everything we understand about economics is plain wrong, the Fed cannot go on blithely adding printing press dollars to the system and expect no ill effects. Essentially, inflationist monetary policies cannot be the answer to the problems caused by inflationist monetary policy.

And this is precisely our point: when the supposed “solutions” to the Fed’s dilemma are merely new “problems,” you know you are approaching the cycle’s end. Our counsel remains as it has been: avoid those assets that will be broken in the coming de-leveraging while keeping a “steady as she goes” attitude towards the future purchase of those assets that will merely bend when the flood comes

 

Eoin Treacy's view -

Friends of ours are moving out of LA because they find the cost of living and the pace of life too hectic. Wishing to spend more time with their kids they are moving to Savannah Georgia. Thinking it would take time to sell their house they asked for a start time of January at their new employment. They were pleasantly surprised, to say the least, to find they received 3 offers within 24 hours of the house hitting the market. 

The Case Shiller 20 Index rallied 5% year on year but that does little to highlight just how hot the property market is in some of the USA’s major cities where prices for desirable locations are well above the 2007 peak. 

 



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September 26 2016

Commentary by Eoin Treacy

Email of the day on zero down mortgages

Today I heard on the BBC news that in the US the banks are giving mortgages with "0" down payments. Is this correct, and if so how serious do you think is the risk of a similiar financial crises as we had in 2008. 

As always thanks a lot for the wonderful service

 

Eoin Treacy's view -

Thank you for your kind words and this question. As you are no doubt aware NINJA loans (No Income, No Job, No Assets) were popular ahead of the credit crisis as lax lending standards made property available to people who had no chance of ever paying back the loans. 

100% mortgages do exist in the USA and are not a new feature. For example the USDA (Department of Agriculture) offers zero down mortgages for rural development and the Veterans’ Administration (VA) offers even more attractive terms to veterans. This article from themortagereports.com may also be of interest. 



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September 21 2016

Commentary by Eoin Treacy

Gold Seen Entering Long-Term Bull Cycle as Asset Bubbles Pop

This article by Ranjeetha Pakiam for Bloomberg may be of interest to subscribers. Here is a section:

Parrilla joins a slew of investors who are bullish on gold because of low borrowing costs and central-bank bond buying. Billionaire bond-fund manager Bill Gross has said there’s little choice but gold and real estate given current bond yields, while Paul Singer, David Einhorn and Stan Druckenmiller have all expressed reasons this year for owning the metal.

Some are not confident prices will rise. The probability of three rate hikes through end-2017 means there’s little room for rallies, according to Luc Luyet, a currencies strategist at Pictet Wealth Management. Cohen & Steers Capital Management, which oversees $61 billion, has pared its gold allocation, while investor Jim Rogers said after the Brexit vote in June that he’d rather seek a haven in the dollar than bullion.

While global bond yields are still very low, they’ve been rising. Yields have climbed to 1.21 percent from a record low 1.07 percent in July, according to the Bloomberg Barclays Global Aggregate Index in data going back to 1990. The odds of the Fed hiking in December have risen to 58 percent after the U.S. reported higher-than-expected inflation in August, from just below 50 percent on Thursday.

 

Eoin Treacy's view -

Despite the fact precious metal prices have been in a reaction and consolidation for the last few months, the biggest bulls are unabashed because they don’t see a solution to how central banks can support growth while simultaneously reducing the debt mountain without the assistance of inflation which could involve helicopter money. 



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September 20 2016

Commentary by Eoin Treacy

Banks Are Now Too Scared to Even Make Money

This article by James Mackintosh for the Wall Street Journal may be of interest to subscribers. Here is a section:

In both cases, those shifting money across borders want to avoid foreign exchange risk, so they hedge using basis swaps. These involve swapping yen or euros in exchange for dollars, which will be swapped back at the end of the contract at the forward rate, typically a year or more later. Meanwhile they pay each other interest at the Libor rate for their currency, plus (or minus) the basis, which moves with demand.

Without banks willing to take the other side of the trade, the basis has blown out to levels usually only seen when the financial system is in meltdown, as in 2008-9 after Lehman or in 2011-2 as the euro seemed to be failing.

Most investors care as much about basis swaps as they do about cash-settled butter futures, but the shifts in the basis have already had highly visible effects. U.S. companies now have little reason to issue bonds in euros, because the basis cost has risen so much it almost entirely offsets the benefit of issuing at a lower yield in Europe. Japanese investors have no reason to buy U.S. Treasurys, as the extra yield they earn would all be eaten up by the basis when they hedge.

In short, the world’s banks aren't doing what they should be doing to grease the flows of money between countries. They’re too regulated and too scared of the risks, slight as those are.

We should welcome the fact that banks now try to price such risks, rather than the precrisis practice of simply ignoring them, but perhaps they are going too far the other way.

 

Eoin Treacy's view -

The reorientation of the money markets funds sector due to take place on October 14th has been a contributing factor in the uptick in LIBOR rates seen over the last couple of months. As the above article highlights it is not the only factor. 

Cross Currency Basis Swaps represent one of the most expedient ways of hedging currency exposure to interest rates and therefore are a hedged carry trade. LIBOR rates breaking out may be considered one of the unintended consequences of negative interest rates. 

 



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September 16 2016

Commentary by Eoin Treacy

Essence of Decision

This article by Ben Hunt for Epsilon Theory may be of interest to subscribers. Here is a section:

It’s always really tough to predict one equilibrium over another as the outcome in a multi-equilibrium game, because the decision-making dynamic is solely driven by characteristics internal to the group, meaning that there is ZERO predictive value in our evaluations of external characteristics like Taylor Rule inputs in 2016 or US/Soviet nuclear arsenals in 1962. (I wrote about this at length in the context of games of Chicken, like Germany vs. Greece or the Fed vs. the PBOC, in the note “Inherent Vice”). But my sense — and it’s only a sense — is that the “Hike today and then delay” equilibrium is a more likely outcome of the September meeting than “No hike today and then no more delay”. Why? Because it’s the position both a hawk like Fischer and a dove like Bullard, both of whom are high-reputation members, would clearly prefer. If one of these guys stakes out this position early in the meeting, such that “Hike today and then delay” is the first mover in establishing a “gravitational pull” on other members, I think it sticks. Or at least that’s how I would play the game, if I were Fischer or Bullard.

Eoin Treacy's view -

This represents an interesting perspective on the bureaucratic and institutional psychology of the Fed. Considering how much political capital has been expended on pursuing extraordinary monetary policy the decision to hike rates is a major endeavour on all fronts. 



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September 14 2016

Commentary by Eoin Treacy

There's a $300 Billion Exodus From Money Markets Ahead

This article by Liz McCormick for Bloomberg may be of interest to subscribers. Here is a section:

The transformation of the money-fund industry, where investors turn to park cash, is a result of regulators’ efforts to make the financial system safer in the aftermath of the credit crisis. The key date is Oct. 14, when rules take effect mandating that institutional prime and tax-exempt funds end an over-30-year tradition of fixing shares at $1. Funds that hold only government debt will be able to maintain that level. Companies such as Federated Investors Inc. and Fidelity Investments, which have already reduced or altered prime offerings, are preparing in case investors yank more money as the new era approaches.

And

A major repercussion of the flight from prime funds is that there’s less money flowing into commercial paper and certificates of deposit, which banks depend on for funding. As a result, banks’ unsecured lending rates, such as the dollar London interbank offered rate, have soared. Three-month Libor was about 0.85 percent Wednesday, close to the highest since 2009.

Libor may stabilize after mid-October because prime funds may begin to increase purchases of bank IOUs, although the risk of a Federal Reserve interest-rate hike by year-end will keep it elevated, said Seth Roman, who helps oversee five funds with a combined $3.2 billion at Pioneer Investments in Boston.

“You could picture a scenario where Libor ticks down a bit,” Roman said. But “you have to keep in mind that the Fed is in play still.”

 

Eoin Treacy's view -

The transition from fixed NAVs to floating NAVs in the money market fund sector, where only government paper will be eligible to be supported at $1, is a major contributing factor in the surge that has taken place in LIBOR rates this year. With so much uncertainty about how the new system will function investors are understandably skittish about leaving money in the system ahead of the implementation. 



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September 13 2016

Commentary by Eoin Treacy

Libor's Reaching Point of Pain for Companies With Big Debt Loads

This article by Sally Bakewell for Bloomberg may be of interest to subscribers. Here is a section:  

Companies that took out floating-rate loans knew they would have to pay more to borrow once rates started rising, but they haven’t experienced real increases for years. Even when the Federal Reserve started hiking rates in December, many companies did not have to pay higher rates on their loans until Libor breached key levels, because of the way their floating rates are calculated. Rising interest payments would only add to pain for U.S. borrowers that are already suffering from falling profits and higher default rates. And Libor could rise further-- JPMorgan Chase & Co. strategists recently forecast it could reach 0.95 percentage point by the end of this month.

There will be some companies “for which it might become an issue," said Neha Khoda, a high-yield credit strategist at Bank of America Corp. With Libor having risen above key levels like 0.75 percentage point, many issuers have to think about how they will pay the extra interest, she said. Three-month Libor now stands at 0.86 percentage point, and has been rising as new money market fund rules curb investor demand for companies’ short-term debt. 

Interest rates on loans in the leveraged loan market are calculated by starting with a benchmark borrowing rate like three-month Libor and adding a margin known as a "spread." About $230 billion of the loans in the market have a minimum benchmark level, or "floor," equal to 0.75 percentage point, meaning that even if Libor has fallen below that level, the borrower must pay the minimum plus the spread. Most of the debt in the $900 billion leveraged loan market has Libor floors, which is often set around 1 percent.  

 

Eoin Treacy's view -

High yield issuers of floating rate notes are at an obvious disadvantage as the prospect of short-term rates rising is priced in. That represents an important consideration because floaters are one of the primary destinations for bond investors seeking to hedge their exposure to rising interest rates since they would avail of higher yields.



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September 08 2016

Commentary by Eoin Treacy

Draghi Dialing Down the Drama May Mark Wane of Monetary Activism

This article by Jeff Black for Bloomberg may be of interest to subscribers. Here is a section:

Take European Central Bank President Mario Draghi, who on Thursday talked up the effectiveness of his institution’s stimulus policies to date, but damped expectations that he’ll load up with fresh asset-buying soon. His only new announcement after again downgrading euro-area growth forecasts was that officials will look into how to ensure the current program overcomes a worsening scarcity of bonds.

Even with the scheduled end of the 1.7 trillion-euro ($1.9 trillion) plan just six months away, Draghi said policy makers meeting in Frankfurt haven’t yet discussed what they’ll do when that day comes. If a new laissez-faire tone is creeping in to replace years of hyperactivity, it may be a signal that the division of labor between central banks and governments in providing economic support is shifting.

“Draghi doesn’t sound like a central banker who’s in any hurry to ease further,” said Tim Graf, head of European macro strategy at State Street in London. His stance “fits in with the G-20 statements about using all actors to support growth, including the fiscal side. Taking ever-easier monetary policy for granted is becoming less valid.”

 

Eoin Treacy's view -

The ECB faces a number of obstacles to employing a US style quantitative easing program within its jurisdiction. Among these are the relative depths of the respective markets. The ECB has self-imposed rules about how much of any particular issue it can own and how much debt of any one country it can purchase. Additionally, the EU’s corporate bond and asset backed markets are not nearly as liquid as their US equivalents, which represent a challenge for the size of purchases the ECB needs to make to have an influence on the market.



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September 07 2016

Commentary by Eoin Treacy

Bond Traders Pare Fed Wagers as Goldman Reverses September Shift

This article by Rebecca Spalding for Bloomberg may be of interest to subscribers. Here is a section:

"With slightly softer data and less ‘time on the clock,’ a rate increase this year now looks a bit less certain," Jan Hatzius, chief economist at Goldman, wrote in a note to clients Tuesday. "While this is just one indicator, the surprise was meaningful, and there may have been some Fed officials feeling lukewarm on a September hike to begin with."

The central bank meets Sept. 20-21 after officials have stood pat on rates this year and twice pared projections for the path of increases. San Francisco Fed President John Williams on Tuesday said the U.S. economy is “in good shape and headed in the right direction” without indicating whether he was leaning one way or another regarding a rate increase.

 

Eoin Treacy's view -

With a wall of debt that needs to be either retired or refinanced coming due in the next few years the Fed is understandably cautious about raising rates without robust economic growth to swell government coffers. In fact since monetary easing has not quite achieved the growth rates envisioned by central bankers, the case for fiscal stimulus is growing, regardless of the potential for it to create a bigger problem later. 



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September 02 2016

Commentary by Eoin Treacy

The Credit Strategist

Thanks to a subscriber for receiving permission to post this edition of Michael Lewitt’s ever interesting report. Here is a section on junk bonds:

Junk bonds may be rallying but it has little to do with corporate credit quality, which keeps deteriorating. As of the end of August, 113 companies had defaulted on their debt in 2016, already matching the total number of defaults from 2015. The year-to-date default count was also 57% higher than a year earlier. In case anyone is paying attention (it appears they are not), the last time defaults were this high was in 2009 when 208 companies failed during the financial crisis. Standard & Poor’s is now projecting that the annual default rate will hit 5.6% by June 2017 with 99 junk-rated companies expected to default in the 12 months ending June 2017. That would significantly exceed the 79 U.S. companies that defaulted in the previous 12-month period ending June 2016, which resulted in a 4.3% default rate. While low oil prices are a major contributor to this ugliness, energy companies only accounted for 57% of the defaults in the 12 month period ending in June 2016. That means that there is plenty of distress to go around

Even more disturbing is the fact that defaults are rising rapidly while many leveraged companies continue to enjoy low borrowing costs courtesy of the Federal Reserve. If interest rates were remotely normalized, the default rate would already be well above 5% and heading to the high single digits. None of this appears to bother investors, who are chasing yield in the rare places they can find it, which is always in all the wrong places. As a result, the normal spread-widening that occurs when defaults spike is not occurring, which is a very unhealthy phenomenon because it signals high levels of risk-taking and complacency on the part of investors. 

The history of the modern junk bond market teaches that most returns are earned in compressed periods after the market suffers a sharp sell-off. The rest of the time, investors are pushing water uphill as they invest in securities that offer poor-to-mediocre risk-adjusted returns until the point when the bottom falls out and they suffer catastrophic losses. There is good reason why very few credit hedge funds or other large investors made any money in junk since mid-2014, when the market began a sharp sell-off that coincided with the slide in oil prices and the slowdown in China. This sell-off ended early this year when the market began to rally based on the realization that the Federal Reserve lacks the intellectual capacity to understand the consequences of its own policies or the moral courage to change them. But investors are chasing zombies because numerous companies are not generating enough cash flow to reduce their debts or repay them when they mature. Instead, they are just living on fumes and waiting for the day of reckoning when their debt matures and they can’t pay it back. More of them will hit the wall when their debt comes due and they can’t refinance it at a reasonable interest rate because they are financially infirm. Standard & Poor’s is telling us that more of these companies are heading to the boneyard. Investors should be selling rather than buying this risk.

Eoin Treacy's view -

A link to the full report is posted in the Subscriber's Area.

I don’t think there is any argument that central bank measures to inflate asset prices through, previously unimaginably, low interest rates and outright purchases of bonds have had a distorting effect on asset prices. In fact that was the whole purpose of the policies in the first place. After-all quantitative easing was conceived to avoid an even more calamitous crash and succeeded on many fronts.  The problem is that we are now more than seven years into an era of extraordinary monetary policy and the self-sustaining robust growth that could upend dire warnings of overvaluations has been slow to appear. In fact because much of the G7 is contending with weak growth the extent of the dislocation in valuing bonds has increased. 



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September 02 2016

Commentary by Eoin Treacy

Solid Hiring Without Wage Jump Tests Fed Hopes for Inflation

This article by Craig Torres for Bloomberg may be of interest to subscribers. Here is a section:

The August employment report released Friday will sharpen the debate. The figures showed a monthly net gain of 151,000 jobs, an unemployment rate holding at 4.9 percent and a slowdown in wage growth. There’s ammunition in the latest data for officials who want to delay a rate increase as they look for signs of continued tightening in the job market. A critical component in Fed officials’ forecast is a rise in wages that boosts demand and drives prices higher.

“Nobody understands the inflation process, including the Fed,” said Torsten Slok, chief international economist at Deutsche Bank AG in New York. “When we are near full employment, why has inflation been so incredibly well-behaved?”

After the report, traders trimmed their bets on a rate hike at the Sept. 20-21 FOMC meeting to a roughly 14 percent chance, according to federal funds futures contracts.

The mystery of weak wage growth is troubling, for the short run and the longer-term. If Yellen and the FOMC majority are wrong, inflation could remain stuck below their target, setting the economy up for lower rates of inflation in the next downturn.

 

Eoin Treacy's view -

Wages are one of the most important figures to watch to decipher what the direction of Fed policy is likely to be because it cannot simply be headoniced out of the data. For example unemployment is a factor both of how many people are unemployed but also how many are looking for jobs. Lower participation rates flatter unemployment. You can’t do that with wages and because wage demands rise when workers feel they need more money to meet their liabilities they act as a barometer for inflation. 



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August 30 2016

Commentary by Eoin Treacy

How the European Commission calculated 13bn tax bill

This article by Suzanne Lynch for the Irish Times may be of interest to subscribers. Here is a section:

Ms Vestager said on Tuesday that the commission had concluded that the splitting of Apple’s profits between the two parts of the AOE and ASI companies “did not have any factual or economic justification.”

In short, the commission has concluded that Ireland gave illegal state aid to Apple, in breach of EU law.

It will now fall to lawyers for the accused to contest this.

The refrain from Government circles has long been that the EU may not have liked the tax structures that were in place at the time when the Apple deal was struck but that does not mean that they were illegal.

It may be some years before a definitive answer on this question will be reached.

 

Eoin Treacy's view -

The European Commission has raised important issues for Ireland not least because without its sovereign ability to set taxation there is very little reason for such a large number of Silicon Valley’s best and brightest companies to choose the little island in the North Atlantic as their favoured destination for European headquarters. 



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August 30 2016

Commentary by Eoin Treacy

Ports, a Sign of Altered Supply Chains

This article from the Wall Street Journal may be of interest to subscribers. Here is a section:

“The running joke going around is that flat is the new growth,” said Jett McCandless, chief executive of transportation-technology startup project44.

Freight volumes are stagnating despite strong consumer spending, which rose for a fourth-straight month in July. The problem for traditional retailers: More of those dollars are being spent online, or on entertainment and services such as health care.

Many retailers are stuck with large amounts of unsold goods as a result, reducing their need to import more merchandise. Even after a year of attempting to slim down inventories, retailers’ ratio of inventories to sales, a measure of excess stocks, touched 1.5 in June, close to a seven-year high, according to the Census Bureau. In their most recent earnings reports, Target and Lowe’s reported inventories up more than 4% over the same period last year.

J.C. Penney is placing “slightly smaller orders…or holding back quite a bit” to reduce inventories, Mike Robbins, J.C. Penney’s executive vice president for supply chain, told investors in June. The company has reduced the size of some orders at the beginning of major shopping seasons by as much as 70%.

The focus on reducing inventories is proving to be a drag on growth because it signals that businesses are spending less, and might be pessimistic about future demand. Inventory drawdowns cut second-quarter growth by 1.26 percentage points, to just 1.1%.

Shipping lines are struggling to plan their routes as order volumes become more difficult to predict, said Niels Erich, spokesman for a group of 15 major shipping lines known as the Transpacific Stabilization Agreement. In the past, carriers could count on the peak summer months to make up for slower winter trade.

 

Eoin Treacy's view -

There is no doubt that the disintermediation which characterises online retail has a deflationary impact on how economic growth is measured because it inhibits the velocity of money. I do not view it as a coincidence that the Velocity of M2 has been contracting since 1997 when the internet began to have an impact on the retail sector. 



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August 25 2016

Commentary by Eoin Treacy

If Not Normal, Where Are We in the Cycle? Late

Thanks to a subscriber for this note from Wells Fargo which may be of interest. Here is a section:

Credit Standards: Move to Tighter Standards
Over the economic cycle, banks adjust their lending standards but, unfortunately, the dynamic adjustment of credit standards appears to impart a very pro-cyclical bias to the credit cycle. From the middle graph, we can see that the percentage of banks that tighten credit drops dramatically in the early phase of an economic recovery (1992-1994, 2002-2004, 2010-2011) and remains low for most of the economic expansion. Then the percentage of banks that tighten credit rises sharply just before a recession (1999-2000, 2007-2008). This credit cycle, while certainly rational from an individual bank’s point of view, becomes quite pro-cyclical when viewed in the aggregate. We have entered the tighter credit phase of this cycle.

For Whatever the Reason: A Flatter Yield Curve
Ever since the taper tantrum in 2013, there have been two distinct moves in the yield curve as illustrated in the bottom graph. The long-end of the yield curve has exhibited a bullish flattening trade with the decline in the 10-year/two-year spread. This reflects the yield pick-up for U.S. Treasury debt relative to what is available for investors in Europe and Japan, while also reflecting the incentive of a stronger dollar to attract foreign inflows. Meanwhile, the short end of the yield curve reflects the anticipation of a FOMC increase in rates or at least some form of tighter policy going forward.

Uncertainty in financial markets provides the motivation for two distinct
moves. First, investor uncertainty at the global level has prompted a safehaven move into U.S. Treasury debt. Meanwhile, uncertainty on the economic outlook limits the extent of Fed tightening of policy as well as the private market discounting of future fed funds moves.

 

Eoin Treacy's view -

A link to the full report is posted in the Subscriber's Area. 

With interest rates so low there is very little margin for error when trading in bonds and not least when so many are sporting negative yields. An increasing number of seasoned bond investors are expressing emotions ranging from caution to fear and frustration at the destabilising influence of central bank policy on the markets. They are in a difficult position because pre-empting an end to the 35-year bull market has resulted in underperformance while overstaying one’s welcome, when it eventually does peak, will result in ever larger underperformance. 



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August 25 2016

Commentary by Eoin Treacy

South Africa President Zuma Says He Can't Stop Gordhan Probe

This article by Mike Cohen and Sam Mkokeli for Bloomberg may be of interest to subscribers. Here is a section:

Gordhan, 67, was named finance minister in December after Zuma roiled markets by firing Nhlanhla Nene from the position and replacing him with a little-known lawmaker. His relationship with Zuma has been a fractious one, with the president denying his requests to fire the nation’s tax chief for insubordination and appoint a new board at the state-owned airline.

“President Jacob Zuma wishes to express his full support and confidence in the minister of finance and emphasizes the fact that the Minister has not been found guilty of any wrongdoing,” the Presidency said in a statement. “The negative effect of these matters on our economy, personal pressure on the individuals affected as well as the heads of institutions, however disturbing, cannot be cause for the president to intervene unconstitutionally.” 

The National Prosecuting Authority hasn’t received a docket from the police and there was no indication when they would receive one, Luvuyo Mfaki, a spokesman for the national prosecutor, said by phone. City Press reported that the docket would be handed to the NPA on Friday after the police questioned tax agency officials including Ivan Pillay, the former deputy commissioner, and Oupa Magashula, the ex-commissioner.

 

Eoin Treacy's view -

Standards of political governance have been declining steadily since the ANC assumed what is in effect single party rule. Institutions and laws which support the free market, such as the independence of the judiciary, minority shareholder and property righrs have all been under attack. Continued political turmoil and the volatility of Zuma’s administration are additionally not good for confidence. 



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August 24 2016

Commentary by Eoin Treacy

A Grim Outlook for the Economy, Stocks

Thanks to a subscriber for this interview of Stephanie Pomboy expressing a bearish view which appeared in Barron’s. Here is a section:

The presumption supporting equity prices is that all the bad news we’ve seen this year has been due to anomalies—the lagged effect of the strong dollar and weaker energy prices as well as Brexit. Everyone is looking for a significant second-half rebound for earnings and GDP—when the clouds will part and the sun will come out. I strongly believe that won’t happen, in large part because of inventories. Inventory accumulation has been explosive.

What’s caused this growth in inventories?
It isn’t because companies ramped up production. Companies aren’t using cheap capital to increase production and capital expenditures, but are lavishing money on shareholders instead. They bought the lie that consumer spending would turn up any moment, and produced at the same pace. Now they find themselves with a monster inventory overhang. Inventory-to-sales ratios across a variety of industries—manufacturing, machinery, autos, wholesale—are at the highest level since 2009. In prior inventory liquidation cycles, nominal GDP growth is cut in half during the liquidation phase. As for profits, we’re starting with five negative quarters and we haven’t even begun the inventory liquidation cycle. So the second half will be a real eye-opener.

In your view, today’s too-low rates will cause the next financial crisis. Describe it.
In the past rates that were too high were the trigger. Not this time. No. 1, we have basically bankrupted corporate and state and local pensions by having rates at these repressive levels. If you lay on top of that a decline in equity prices, there will be a scramble to plug holes in pensions. Obviously if a state or local government has to divert funds to plugging its pension, it won’t build more roads. The corporate sector has the luxury of kicking the can down the road, and because their spending has been on buybacks, not plants and equipment, the economy would suffer less. For S&P 1500 companies, the pension deficit is roughly $560 billion, but for state and local governments, it’s $1.2 trillion. According to the Center for Retirement Research, if you used a more conservative discount rate, the unfunded liability would go to $4 trillion.

No. 2, you’re pushing consumers to the brink as they try to save enough for retirement at zero rates. You’re already seeing a reluctant return to credit-card usage, a clear sign of distress—they are charging what they previously paid with cash. The credit-card delinquency rate is picking up.

 

Eoin Treacy's view -

The way people generally think about pensions is that you accumulate a pot of money over your lifetime, purchase an annuity with a yield greater than your living costs and a maturity that extends to the end of one’s life. Of course that is not realisable in practice so pension funds have to manage the duration of the overall portfolio so they can plan to meet future liabilities with some degree of accuracy. 

The problem is that in formulating their models they typically assume a 7% yield. That’s OK when nominal interest rates are somewhere close to that level but with rates close to zero, for nearly a decade, they have no choice but to rely on capital appreciation to make up for the absence of yield. The alternative is to take on a lot more risk to capture the yield they require. For example, and this is obviously not a recommendation, Rwanda’s senior unsecured US Dollar B+ 2023 bond currently yields 6.195%. 

 



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August 16 2016

Commentary by Eoin Treacy

Dudley Says September Hike Is Possible, Markets Too Complacent

This article by Matthew Boesler for Bloomberg may be of interest to subscribers. Here it is in full:

The Federal Reserve could potentially raise interest rates as soon as next month, New York Fed President William Dudley said, warning investors that they are underestimating the likelihood of increases in borrowing costs.

“We’re edging closer towards the point in time where it will be appropriate, I think, to raise interest rates further,”

Dudley, who serves as vice chairman of the rate-setting Federal Open Market Committee, said Tuesday on Fox Business Network.

Asked whether the FOMC could vote to raise the benchmark rate at its next meeting Sept. 20-21, Dudley said, “I think it’s possible.”

Investors only expect about one rate hike between now and the end of next year, according to federal funds futures contracts. Dudley said such estimates are too low and that “the market is complacent” about the need for rate hikes. With Treasury yields low, the bond market “looks a little bit stretched,” he said.

“We are looking for growth in the second half of the year that will be stronger than the first half,” Dudley said. That should be enough to support sturdy job gains and keep the Fed’s outlook intact, he added.

 

Eoin Treacy's view -

Dudley has been quite adamant that the Fed’s intention to raise rates cannot be dismissed. However, the performance of the Dollar and low bond yields suggest market participants are sceptical. 

12-month yields are trading at just under 54 basis points suggesting the bond market is in no hurry to price in imminent rates hikes. The rationale being that the Fed is unlikely to want to influence the outcome of the Presidential election not least because the event itself is a source of uncertainty that can have economic consequences. 

 



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August 15 2016

Commentary by Eoin Treacy

Email of the day on bonds versus equities

Having read John Authers FT.com column today, I confess to a bit of confusion. Listening to your outstanding audios over past weeks and months (for which, many, many thanks), I had formed the impression that when the bond markets turns, it would be good for equities on the basis that money has to go somewhere, and it would flow in a large part to equities. Authers seems to be saying the opposite - see his last 3 paras today:

"Look at the chart of the S&P and this looks like a peak, and a bad time to buy. Look at the chart of how stocks have performed relative to bonds, and it looks like stocks should be ready to shine. This illustrates the paradox that has also lasted for years that stocks look expensive by almost any sensible historical measure — except when compared to bonds, when they look cheap. 

But there is a nasty problem with this. If bonds finally go into reverse, rates will rise, the support for stocks will be removed and the risk is more that stocks will start to fall. The bond market rally is extraordinary, it has gone on for a long time, defeating predictions by many (myself included) that yields had become unsustainable. US Treasury yields have been falling steadily for more than three decades. 

If bonds can somehow continue this, then stocks will probably continue to prosper (although they may fail to outstrip bonds). If bonds go into reverse, it would be bad news for both stocks and bonds. And either way, the record in the S&P 500, which has created genuine wealth for those who hold it, is a sideshow besides what is happening in bond markets."


Can you comment please and perhaps remove my confusion?

Thanks as always

Eoin Treacy's view -

Thank you for this topical email and snippet from John Authers’ article. Here is a pdf of the full article. 
If you had asked me a couple of years ago, before just about every central bank in the world was engaged in quantitative easing, I would have said that a peak in the bond market would have helped act as fuel for an additional rally in equities. However I’m not so sure now. 

 



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August 09 2016

Commentary by Eoin Treacy

Email of the day- on financial repression

I just came across this article which was published a week ago by Bloomberg.   So, money market funds will become less safe for storing cash than they have been. One could see this as the US government wanting to attract billions into its own coffers by issuing 2 month bills that attract the money. Or maybe it's concern over the solvency of large money market funds if things go haywire during another crash. I wondered if you have any insights on this change.

Eoin Treacy's view -

Thank you for this article which highlights the continued trend of financial repression where governments, and not just the USA’s, are creating markets for their paper. They have little choice considering the quantity of debt that has been issued over the last decade and the outsized debt to GDP ratios we are presented with. The simple fact is investors are going to help out with the problem like it or not. I covered this issue in relation to another article focusing on the changes to money market fund holdings on August 2nd 



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August 08 2016

Commentary by Eoin Treacy

Bond Market's Big Illusion Revealed as U.S. Yields Turn Negative

This article from Bloomberg may be of interest to subscribers. Here is a section:

It’s been a “no-brainer since forever,” said Sekiai, a money manager at Tokyo-based DIAM Co., which oversees about $166 billion.

That truism is now a thing of the past. Last month, yields on U.S. 10-year notes turned negative for Japanese buyers who pay to eliminate currency fluctuations from their returns, something that hasn’t happened since the financial crisis. It’s even worse for euro-based investors, who are locking in sub-zero returns on Treasuries for the first time in history.

That quirk means the longstanding notion of the U.S. as a respite from negative yields in Japan and Europe is little more than an illusion. With everyone from Jeffrey Gundlach to Bill Gross warning of a bubble in bonds, it could ultimately upend the record foreign demand for Treasuries, which has underpinned their seemingly unstoppable gains in recent years.

“People like a simple narrative,” said Jeffrey Rosenberg, the chief investment strategist for fixed income at BlackRock Inc., which oversees $4.6 trillion. “But there isn’t a free lunch. You can’t simply talk about yield differentials without talking about currency differentials.”

 

Eoin Treacy's view -

With interest rates so low there is very little cushion left in a foreign investment dependent on harvesting low yields. Therefore it is unsurprising that Japanese and Euro denominated investors are losing money on investments in Treasuries. With Euro/Dollar volatility at 18-month lows, the low return for Euro investors on investing in Treasuries is truly a testament to how low rates are.



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August 02 2016

Commentary by Eoin Treacy

It's Called Financial Repression, and Governments Around the World Are Doing It

This article by James Mackintosh for the Wall Street Journal may be of interest to subscribers. Here is a section:

All money funds also will be given an option to restrict or impose a fee on withdrawals when a fund’s easy-to-sell assets are depleted. This makes explicit that in times of stress it might be impossible to access one’s money. This has prompted assets in prime funds to drop below $1 trillion for the first time this century.

So far, so sensible. But there is a wrinkle. Money funds that buy government paper are exempt from the new rules, on the basis that Treasury bills are always easy to sell and there is no risk of default. The rule makers seem to have forgotten the near default in 2010 and the downgrade of the U.S. debt rating, not to mention the accidental failure to pay some Treasury bills in April 1979 due to paperwork backlogs.

The effect of the exemption is that money has poured in to government funds as investors worry that they might not always be able to access cash in prime corporate funds.

Carmen Reinhart, a finance professor at Harvard University’s John F. Kennedy School of Government, says governments across the developed world are interfering more with private flows of cash as their financing needs soar. Directing money to the state at the same time as the central bank keeps interest rates below inflation to boost growth amounts to a subsidy of the government by savers, a hidden tax.

“The way we have revamped regulation has clearly favored government debt,” she said. “The regulation creates the captive audience, and the monetary easing creates the ‘tax.’ ”

Outside Iceland, Greece and Cyprus, the West remains far less financially repressed than in the 1950s or 1960s, when capital controls meant Britons couldn’t take more than £50 ($66) out of the country, while Americans were still forbidden from investing in gold.

 

Eoin Treacy's view -

Financial repression might not be as restrictive today as it was in the 1960s but there is no denying that it has become a more relevant factor for investors over the last decade. Tinkering with money market funds is a further iteration of government policy to ensure they have a market for the paper they are printing and this is as equally true for both short and long maturity paper. Europe in particular has been proactive in forcing insurance companies and banks into holding long-dated government paper as security against future perils. 



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July 20 2016

Commentary by Eoin Treacy

Brazil Real's Volatility Falls to One-Year Low on Temer Optimism

This article by Paula Sambo for Bloomberg may be of interest to subscribers. Here is a section: 

Volatility in Brazil’s real dropped to the lowest level in a year as the central bank acts to limit gains in the world’s best-performing currency amid speculation that a new government will pull the nation from its deepest recession in a century.

Three-month implied volatility on the real declined 0.05 percentage point to 16.78 percent, the lowest level since July 22, 2015, at 12:25 p.m. in Sao Paulo. The currency advanced 0.3 percent to 3.2393 per dollar.

Brazilian assets have led gains globally this year amid speculation that Acting President Michel Temer will trim a budget deficit, end credit-rating downgrades and restore confidence. Concern that the currency’s rally would hamper exports at a time when Latin America’s largest economy already faces its worst recession in a century has led the central bank to sell almost $50 billion of reverse swaps to stem gains. While the offerings are unlikely to change the direction of the real, they can mute volatility, Morgan Stanley strategists led by Gordian Kemen wrote in a report published last week.

“The domestic reform narrative in Brazil is an important qualifier for the currency and for the decrease in its volatility," said Mike Moran, the head of economic research for the Americas at Standard Chartered Plc in New York.

Eoin Treacy's view -

The Brazilian Real is the best performing currency this year; gaining over 30% year to date. The chronic mismanagement of the economy that prevailed under Dilma Rousseff’s administration is now in the past and the new government has the opportunity to introduce unpalatable reforms early in its tenure so that it might benefit from the results by the time the next election needs to be called. Whether that eventually translates into improving governance and a sustained reduction in corruption and graft is an altogether different question, but we can conclude that at least for now governance is improving from a low base.

 



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July 20 2016

Commentary by Eoin Treacy

Email of the day on the Dollar and Yen

I very much enjoyed last Friday's and yesterday's audio recordings. I think too that we are close to entering the final phase for this bull run notwithstanding a potential pull-back first. The expected further liquidity injections by the global central banks has intensified the hunt for yield. Emerging markets should do well as they offer both yield and the potential for large capital gains. Incidentally, if as David suggests, the $ index (developed markets) rises towards 100 again, will the EM currencies also weaken? Or as they have already fallen substantially in recent years, the dollar's rise against the developed market currencies will not impact EMs much? Your thoughts would be appreciated. I'm also interested in your views on $/Yen on a medium term basis.

 

Eoin Treacy's view -

Thank you for your kind words and I agree the strength of the Dollar is a major consideration in assessing the outlook for global markets.

It is worth considering that the Dollar Index is composed of Euro (57%), Yen (13.6%) and Pound (11.9%), none of which one is likely to consider a strong currency at present. 



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July 15 2016

Commentary by Eoin Treacy

Italy Slowly Moves Toward Comprehensive Bank Rescue

Thanks to a subscriber for this report from Kroll Bond Agency focusing on Europe. Here is a section:

One of the major sources of public anxiety is the fact that the EU nations have not followed established rules for dealing with troubled banks in a consistent and transparent fashion. EU officials also have refused to consistently “bail in” bond holders of EU banks by converting debt to equity, a partial solution to the solvency problem that apparently is politically unacceptable. The fact of a bail-in, however, while reducing debt service expenses, does not provide the financial institution with significant new cash. Because the EU lacks a federal fiscal agency with receivership powers similar to the Federal Deposit Insurance Corporation in the US, the community is essentially in the position of the US prior to 1933. Before the FDIC was created in that year, bank insolvencies were dealt with by receiverships overseen by the courts of the individual states. This arrangement made it problematic, for example, for the Federal Reserve System to lend to banks because the state courts would not give preference to the security interest of the central bank for discount window loans.

In the case of Italy, over the past decade the country’s banking system has moved from institutional funding sources to selling junior bonds to retail investors. As a result, the political system’s reaction to growing problems in the nation’s banks is one of growing alarm. Italian Prime Minister Renzi says he wants urgent bank reform but does not say how it should be accomplished. Significantly, the Bank of Italy has called for a ban on the sale of subordinated bank debt to private individuals. Such a ban would effectively cut off the remaining funding source for Italy’s banks.

Authorities ranging from Bank of England Governor Mark Carney to Deutsche Bank chief economist David Folkerts-Landau have called for a direct bailout of some $150 billion, but KBRA believes that this figure is inadequate and represents merely a down payment on a full solution to the crisis. Meanwhile, EU officials refuse to consider direct infusions of capital from the governments of the member states. Dutch Finance Minister Jeroen Dijsselbloem has stated that he is not "particularly" worried about Italian banks:

“The only thing that to me is very important is that we respect what we have agreed between us, because otherwise everything will be questioned in Europe… There have always been and will always be bankers that say ’we need more public money to recapitalize our banks.... and I will resist that very strongly because it is, again and again, hitting on the taxpayer… the problems with the banks need to be sorted out in the banks and by banks.”
Bail-In vs. Bail Out

Under EU rules requiring the “bail in” of debt holders in the event of bank , Italy faces the prospect of wiping out millions of retail investors. Estimates of the total amount of money that is potentially subject to a bail-in easily exceed €1 trillion, or twice the amount of bad loans admitted in official statistics. The pressures building on elected officials in the EU are intense and have caused Renzi to publicly attack ECB head Mario Draghi for not doing enough to help Italy’s banks. These striking developments have gone largely unnoticed by investors, media, and policy makers outside the EU.

For years now, the ECB has been pouring liquidity into the Italian banking system, in part because the banks are funding the debt issuance of the Italian government. As one well-placed EU analyst told KBRA last week, “the priority during the 2008 financial crisis was for the banks to fund the state, and for the private sector to fund the banks.” The liquidity provided by the ECB ran right back out the door, however, as retail and institutional investors frequently have been bailed out and the insolvent banks have been supported with government guarantees and inflows of fresh funds from new retail investors.

 

Eoin Treacy's view -

A link to the full report is posted in the Subcsriber's Area.

Considering the relative strengths of the UK economy it remains highly likely Brexit will represent a greater challenge for the Eurozone than it does for the UK. The decision to leave for an island nation with its own currency is orders of magnitude less troubling than the inability of highly indebted governments to directly recapitalise banks while operating within the limits of a central bank focused on big picture pan European questions rather than national priorities.  

In the early 2000s while at Bloomberg I was asked to give a talk to clients in Milan. While chatting with some of the delegates afterwards it came to light that the big sales push going on at the banks they worked for was to sell reverse convertibles to retail clients. 

For the issuer, a reverse convertible is attractive because it comes with an embedded put so the principal can be converted into equity. For the creditor they often get an attractive face yield but the embedded put option held by the issuer means the rating on the bond is meaningless as it can be converted to equity at any time. 

 



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July 13 2016

Commentary by Eoin Treacy

Jeffrey Gundlach on Stocks, Trump, and Gold

Thanks to a subscriber for this transcript of an interview from Barron’s. Here is a section:

How much lower could yields on Treasury bonds go? Could we see a 1% yield? 
We just passed the all-time low on the 10-year yield of 1.39%, which we saw in July 2012. It is no surprise the 10-year has been strong after Brexit. I’m not at all convinced that we are going to see much lower yields in the U.S. But even if we do, you’re talking about a de minimis profit. Even if the 10-year yield drops another percentage point, how much will you make? Less than 10%. There are better ways to speculate. 

Such as? 

Gold miners have a very high probability—if you bought them today and were disciplined—of making 10%. One of the things driving markets lower is a declining belief in—and enthusiasm for—central-planning authorities and the political establishment. In this environment, gold is a safe asset. There’s an 80% chance of making 10% in gold; the probability of a 10% gain on Treasuries is 20% at best. I’ve never seen a worse risk-reward setup. 

That doesn’t make for a very exciting portfolio. 

Our portfolios are high-quality bonds, gold, and some cash. People say, “What kind of portfolio is that?” I say it’s one that is outperforming everybody else’s. I mean, bonds are up more than 5%, gold is up substantially this year [28%], and gold miners have had over a 100% gain. This is a year when it hasn’t been that tough to earn 10% with a portfolio. Most people think this is a dead-money portfolio. They’ve got it wrong. The dead-money portfolio is the S&P 500.

Eoin Treacy's view -

With yields well below the dividend on the S&P 500 Treasuries are relying on momentum to boost returns. Like any market, when prices are accelerating higher, it will look like the strongest thing in the world until it turns. Then the repercussions of running a momentum strategy will become painfully obvious for those not also running a tight money control exit strategy such as trailing stops and diligent position sizing. Quite when that is likely to happen is another question entirely. 



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July 13 2016

Commentary by Eoin Treacy

Email of the day on what is helicopter money

What is helicopter money?

Eoin Treacy's view -

Thank you for this question which I’m sure will be of interest to the Collective. Last month a subscriber very kindly sent through a report from National Australia Bank laying out in detail what forms helicopter money might take. I posted it in Comment of the Day on June 10th and here is a link to the report. 



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July 08 2016

Commentary by Eoin Treacy

Insights

Thanks to a subscriber for this edition of Gary Shilling’s report which is well worth taking the time to read, not least for the details of how many populist movements are gaining traction globally. Here is a section on Treasuries: 

As for Treasurys, we believe that what we dubbed “the bond rally of a lifetime” 35 years ago in 1981 when 30-year Treasurys yielded 15.2% is still intact. This rally has been tremendous, as shown in Chart 33 (page 38), and we happily participated in it as forecasters, money managers and personal investors. Chart 33 uses 25-year zero-coupon bonds because of data availability but the returns on 30-year zeros were even greater.

Even still, $100 invested in that 25-year zero-coupon Treasury in October 1981 at the height in yield and low in price and rolled over each year to maintain its maturity or duration was worth $29,096 in May of this year, for a 17.9% annual gain. In contrast, $100 invested in the S&P 500 index at its low in July 1982 is now worth $4,608 with reinvested dividends. So the Treasurys have outperformed stocks by 6.3 times since the early 1980s. And as we’ve often said, most investors believe Treasurys are only suitable for little old ladies and orphans. 

Most investors only look at the yield on Treasurys and say it’s now far too low to be of interest. But we’ve never, never, never bought Treasurys for yield. We couldn’t care less what the yield is as long as it’s going down—so prices are rising. We’ve always bought Treasurys for the same reason most investors buy stocks: appreciation. 

We’ve discussed in detail in past Insights the many reasons that equity investors, investment bankers, Wall Street analysts and even institutional bond managers are negative on Treasurys and have been throughout this marvelous 35-year rally. The current disdain was expressed in the June 10 edition of The Wall Street Journal: “The frenzy of buying has sparked warnings about the potential of large losses if interest rates rise. The longer the maturity, the more sharply a bond’s price falls in response to a rise in rates. And with yields so low, buyers aren’t getting much income to compensate for that risk.” Since then, the 30-year Treasury yield has dropped from 2.48% to 2.15% as the price has risen by 6.5%.

Then, the July 1 Journal wrote: “Analysts have warned that piling into government debt, especially long-term securities at these slim yields, leaves bondholders vulnerable to the potential of large capital losses if yields march higher.” Since then, the price of the 30-year Treasury has climbed 3.1%.

But what if instead of rising, Treasury yields fall, as they have this year, returning 14.1% on the 30-year Long Bond compared to 3.9% for the S&P 500? And we believe there's more to go. Over a year ago, we forecast a 2.0% yield for the 30-year bond and 1.0% for the 10-year note. If yields fall to those levels in a year from the current 2.14% and 1.38%, respectively, the total return on the 30-year coupon bond will be 5.1% and 4.9% on the 10-year note. The returns on zero-coupon Treasurys with the same rate declines will be 4.2% and 3.8% (Chart 34).

Eoin Treacy's view -

A link to the full report is posted in the Subscriber's Area. 

A big question right now is whether the stock market is rallying because investors believe the liquidity on which asset price inflation has been predicated over the last six years is going to get another big infusion. The Fed is unlikely to raise rates while global growth is mixed at best because of the upward pressure that would put on the Dollar. 



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July 06 2016

Commentary by Eoin Treacy

U.S. Stocks Advance Amid Drug Maker Rally as Caution Subsides

This article by Anna-Louise Jackson and Bailey Lipschultz for Bloomberg may be of interest to subscribers. Here is a section: 

“There was a big flight to safety trade earlier and a lot of that has reversed,” said Michael Antonelli, an institutional equity sales trader and managing director at Robert W. Baird & Co. in Milwaukee. “You’re looking at a market that’s lacking direction right now. The primary driver for concern is what it always is -- a slow growth backdrop. We’re in a no-man’s land before the next Fed meeting and the kick-off of earnings next week.”

American equities shook off declines in global markets, which fell as knock-on effects of Britain’s vote start to materialize. Anxiety has increased over the potential for instability to spread after at least five asset managers froze withdrawals from U.K. real-estate funds following a flurry of redemptions, while data on Wednesday showed German factory orders were unchanged in May, disappointing forecasters who had called for an increase.

Before yesterday’s decline, the S&P 500 capped its strongest weekly rise since November, boosted by assurances that central banks are prepared to loosen monetary policy to limit the fallout from Brexit. The benchmark is trading at 16.6 times estimated earnings, a higher valuation than the MSCI All-Country World Index and above its own three-year average.

 

Eoin Treacy's view -

10-year Treasury yields steadied today in the region of 1.38% amid a deep overextension relative to the trend mean. Some consolidation in this area is looking likely but with absolute levels so low there has been a surge into assets with the prospect for a higher dividend yield or dividend growth.  



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June 21 2016

Commentary by Eoin Treacy

Japan Won't Intervene in FX Lightly, Finance Minister Aso Says

This article by Yoshiaki Nohara for Bloomberg may be of interest to subscribers. Here it is in full:

Finance Minister Taro Aso signaled that Japan’s government won’t intervene to stem the yen’s strength without due consideration, saying the markets have already somewhat taken into account the potential impact of a vote in favor of Brexit.

“Speaking of FX intervention, we won’t do it lightly,” Aso said at a press conference in Tokyo on Tuesday. “The G-7 and G-20 have agreed that abrupt moves are not desirable and we aim for stability. We will take action in line with that agreement.”

Aso’s comments came as the yen has surged more than 5 percent versus the dollar in June as global markets await the outcome of Britain’s June 23 referendum on European Union membership. The vote and its effect on the global economy has boosted the yen’s demand as a safe-haven currency.

The finance minister said the market has already taken into account Brexit to some degree, limiting upward pressure on the yen. Aso last week voiced strong concern about one-sided, abrupt and speculative moves in the foreign exchange market. The yen traded at 104.03 per dollar as of 12:49 p.m. in Tokyo.  

 

Eoin Treacy's view -

Negative interest rates inhibit the BoJ’s ability to weaken the currency since it is inherently deflationary and therefore reduces rather than increases the quantity of currency in circulation. The question therefore is at what point the strength of the Yen is likely to pressure officials to try something new? 



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June 16 2016

Commentary by Eoin Treacy

Negative bond yields

Eoin Treacy's view -

Bond traders have been enjoying a very profitable time with central banks doing just about everything to make sure they make money, provided of course they are long. On the other hand bond investors are not happy. With close to 50% of all outstanding sovereign bonds and quite a few highly rated corporates now yielding less than zero the ability of bond investors to cover their liabilities, namely pensions, is far from ensured. 

The problem is not today with prices surging higher and the price component of total return more than making up for the negative yield. The issue comes for those rolling out of maturing bonds, into negative yields with a view to holding to maturity. Valued on that basis one is sure to lose money even if price do not fall and yet that is not the primary issue to consider. 

 



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June 16 2016

Commentary by Eoin Treacy

Yen Surges to Strongest Since August 2014 as BOJ Holds Fire

This article by Anooja Debnath and Kevin Buckland for Bloomberg may be of interest to subscribers. Here is a section: 

“100 is a serious risk that’s growing by the day,” said Cliff Tan, the East Asian head of global markets research at Bank of Tokyo-Mitsubishi UFJ in Hong Kong. “Both domestic and foreign investors are giving up on the idea the government can do much to revive Japan.”

The yen’s jump comes after about a quarter of analysts surveyed by Bloomberg had predicted additional BOJ stimulus today. More than half forecast action at the July meeting.

“Further easing is still on the cards,” said Kohei Iwahara, director of economic research at Natixis in Tokyo. “The yen is already stronger than most companies feel comfortable with, and a dovish Fed could strengthen the yen further.”

Projections released by the Federal Open Market Committee Wednesday showed the number of officials who see just one rate increase in 2016 rose to six from one in the previous forecasting round in March. The U.K.’s June 23 referendum was also “one of the uncertainties that we discussed and that factored into” the decision, Fed Chair Janet Yellen said.

 

Eoin Treacy's view -

The Japanese remain committed to their negative interest rate policy, the net effect of which is to remove currency from the system rather than add it. To increase the bank’s purchases of bonds while they are at negative yields would ensure it makes a loss. It would appear the BoJ is not yet ready for outright helicopter money but that could change at any time as the impact of a stronger currency takes a toll on the economy.  



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June 15 2016

Commentary by Eoin Treacy

The Changing Investment Climate: Higher Correlation Risks as QE Benefits Fade

Thanks to a subscriber for this note from Morgan Stanley which may be of interest. Here is a section:

The long-term effects of these purchases have, over time, whittled down the fundamental component of an asset’s valuation, leaving what is left over, the risk premia, to become more prominent. The unintended consequences are higher volatility, increased correlations, and decreased value of risky assets. This, in turn, ends up reducing the value of risky assets—an attenuation of QE policy that produces the opposite effects of its original design. We refer to this change in the investment climate as QE policy attenuation, a new dynamic risk factor that investors need to account for in their allocations by adding strategies that reduce correlation risks in order to balance their portfolios.  

In addition to QE policy attenuation, additional structural risk factors have arisen from financial market regulation that has reduced liquidity and adversely impacted an economic transfer of risk. This promotes a rise in idiosyncratic uncertainties that increases volatility, or risk for fixed income asset returns, which creates anxiety for investors who expect bonds to be a more stable investment. We find that all these structural risk factors compound and manifest in the risk premia component of an asset’s valuation. Risk premia, once a small part of an asset’s overall valuation, thus now has a larger influence on asset price changes. This presents a challenge to investors as changes in risk premia are highly unpredictable, difficult to calculate and tend to have the characteristic of highly correlating asset prices.

 

Eoin Treacy's view -

With greater than $10 Trillion in debt now with a negative yield it is a bit of an understatement to say that extraordinary monetary policy has had a distorting effect on bonds markets. Nevertheless, as with any momentum move that exhibits acceleration the market will look like the strongest asset in the world until it turns. 



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June 14 2016

Commentary by Eoin Treacy

Email of the day on the outlook for stock markets

Hello Eoin, I am particularly enjoying listening to your audio recordings as markets are so interesting. I was a little confused by something you said in Friday's audio compared to the previous Friday. In the latest audio, you were saying that there was a lot a bullishness amongst analysts on Wall Street and that this was a contradictory indicator which is how I would interpret it after a strong move up in markets. But if I remember correctly, the previous week you sounded very bullish yourself and seemed to be suggesting that the US indices were more likely to break out to the upside. I was left with the distinct impression that you felt this was imminent. Have I read you correctly? Even before Europe's swoon over the past few days, the US markets were looking a bit tired.

Eoin Treacy's view -

Thank you for this email which may be of interest to the Collective. My comment on Friday was in relation to the fact that sentiment was extraordinarily bearish at the low in February while more recently there have been a number of high profile analysts predicting an imminent breakout. This suggests they were already positioned for such an outcome, so we can conclude there were less people with available cash to buy new highs. Scope for a pullback increased as a result and there was evidence at the end of last week that it was underway. 



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June 10 2016

Commentary by Eoin Treacy

A Guide to Helicopter Money

Thanks to a subscriber for this report from National Australia Bank. Here is a section:  

Unlike ‘QE’, Helicopter Money has an explicit fiscal element. Moreover, in a Helicopter Money operation the central bank commits to making any asset purchases permanent and to not paying interest on the resulting bank reserves. It differs from a normal fiscal stimulus as it is not financed by interest paying debt (a bond issued to the public) but by money creation by the central bank. 
Introducing Helicopter Money will potentially affect existing monetary policy goals and tools. For example, it might require a change to the inflation target and changes to the system of interest on reserves. It could also complicate how monetary policy will operate in circumstances when the central bank seeks to tighten monetary policy. 

The key channels through which it is expected to work are increased demand for goods & services (either by government or households) and by raising inflation expectations, thereby lowering real interest rates. Proponents also argue it gets around possible problems with normal fiscal stimulus – crowding out (though higher interest rates) and households increasing savings as they perceive a future higher tax burden. 

In theory Helicopter Money should result in some combination of inflation and real economic growth. Exactly what the mix will be is harder to determine, and it is even possible for inflation to be rising while real activity goes the other way. How individuals and business react to Helicopter Money, and how it changes their expectations of the future, will be an important determinant of its effectiveness. 

While a central bank money financing government spending is not new, there are good reasons why it is considered a ‘taboo’. There are many cases where too much money printing has led to hyperinflation, with disastrous consequences. 

What this points to is the need for credible institutions and the need for any Helicopter Money program to be consistent with the inflation goals of the central bank. An open question is whether credible arrangements could be put in place given political realities. 

Legal and political obstacles to Helicopter Money vary by country. Of the major advanced economy central banks, the European Central Bank is the one facing the greatest possible constraints, given legal prohibition of (direct) money financing of governments by the ECB, the lack of a central fiscal agency and the difficulty of getting agreement amongst member states. 

 

Eoin Treacy's view -

A link to the full report is posted in the Subscriber's Area. 

With an increasing quantity of the global bond market now yielding less than zero, the ECB accepting just about anything counterparties wish to lodge as collateral and negative deposit rates at a handful of central banks, speculation is understandably turning to what central banks might next try to achieve their inflation goals. Negative rates represent something of a Rubicon for bond investors so helicopter money, which was once inconceivable, is now openly being discussed as a possibility. 



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June 02 2016

Commentary by Eoin Treacy

A Cautionary Tale from the '80s for Today's Loan Participations

Thanks to a subscriber for this article by Christopher Whalen for the American Banker. Here is a section: 
 

 

Since 2013, the federal regulatory agencies have been warning banks and investors about the potential risks in leveraged lending. These warnings have been both timely and prescient, particularly in view of the ongoing credit debacle in the energy sector. In addition to the well-documented credit risk posed by leverage loans, we believe that the widespread practice of selling participations in leveraged loans represents a significant additional risk to financial institutions and other investors from this asset class.

While regulators have appropriately focused on the credit risk component of leveraged loans held by banks and nonbanks alike, the use of participations to distribute risk exposures to other banks and nonbank investors also raises significant prudential and systemic risk concerns. The weakness in oil prices, for example, has caused investors to cut exposure to companies in the energy sector. This shift in asset allocations caused by the decline in oil prices has negatively impacted prices for leveraged loans and high yield bonds. In some cases, holders of these securities are attempting to exit these exposures by securitizing the participations.

The investor exodus away from leveraged loans with exposure to the petroleum sector brings back memories of the 1970s oil bust, an economic shock that led to the failure of Penn Square Bank in 1982, the subsequent failure of Seafirst Bank later in that year, followed by Continental Illinois Bank in 1984. Before its failure, Penn Square technically continued to "own" — and service — loan interests held by other banks with participations. As receiver for the failed bank, the Federal Deposit Insurance Corp. deemed those investors to be nothing more than general creditors of the failed bank's estate. Those participating banks lost their entire investment.

 

Eoin Treacy's view -

Leveraged loans issuance overtook the 2007 peak a couple of years ago. That fact is bemusing to many people who remember claims that bankers would never again engage in such activity. Yet with interest rates so low and the demand for yield so high the rationale for issuing to less than optimal borrowers is hard to resist. 



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May 20 2016

Commentary by Eoin Treacy

The Endgame

Thanks to a subscriber for this transcript of a very bearish speech given by Stan Druckenmiller. Here is a section: 

Look at the slide behind me. The doves keep asking where is the evidence of mal-investment? As you can see, the growth in operating cash flow peaked 5 years ago and turned negative year over year recently even as net debt continues to grow at an incredibly high pace. Never in the post-World War II period has this happened. Until the cycle preceding the great recession, the peaks had been pretty much coincident. Even during that cycle, they only diverged for 2 years, and by the time EBITDA turned negative year over year, as it has today, growth in net debt had been declining for over 2 years. Again, the current 5-year divergence is unprecedented in financial history!

And if this wasn’t disturbing enough, take a look at the use of that debt in this cycle. While the debt in the 1990’s financed the construction of the internet, most of the debt today has been used for financial engineering, not productive investments. This is very clear in this slide. The purple in the graph represents buybacks and M/A vs. the green which represents capital expenditure. Notice how the green dominates in the 1990’s and is totally dominated by the purple in the current cycle. Think about this. Last year, buybacks and M&A were $2T. All R&D and office equipment spending was $1.8T. And the reckless behavior has grown in a non-linear fashion after 8 years of free money. In 2012, buybacks and M&A were $1.25T while all R&D and office equipment spending was $1.55T. As valuations rose since then, R&D and office equipment grew by only $250b, but financial engineering grew $750b, or 3x this! You can only live on your seed corn so long. Despite no increase in their interest costs while growing their net borrowing by $1.7T, the profit share of the corporate sector peaked in 2012. The corporate sector today is stuck in a vicious cycle of earnings management, questionable allocation of capital, low productivity, declining margins, and growing indebtedness. And we are paying 18X for the asset class

Eoin Treacy's view -

Links to both the transcript and slides associated with the above presentation are posted in the Subscriber's Area. 

The points discussed by Stanley Druckenmiller above echo those discussed in the Subscriber’s Audio and in Comment of the Day over the last number of weeks and months but this fleshes out some of our concerns with hard figures. .



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May 19 2016

Commentary by Eoin Treacy

Conviction themes for a fat and flat market; equities to N over 12m

Thanks to a subscriber for this report from Goldman Sachs. Here is a section: 

Markets have been calmer and cross-asset correlations with oil have fallen since our last GOAL on March 21. Declines in bond yields, owing to a continued dovish Fed, a weaker dollar and stronger commodity prices, have been the key cross-asset moves. This has lifted bond and credit returns, but equities have not benefited much. Global earnings growth revisions have been negative and equity valuations remain high, with the equity risk premium a less useful predictor of returns owing to uncertainty over trend growth and normalisation of bond yields (see GOAL – Global Strategy Paper No. 18: Valuation investigation: Varying signals for the ERP, May 3, 2016).

We stick with our ‘fat and flat’ view for equities. After the rebound from the trough on February 11, and with the S&P 500 at the upper end of its recent range, we downgrade equities to Neutral over a 12-month horizon, in line with our 3-month view. Until we see sustained signals of growth recovery, we do not feel comfortable taking equity risk, particularly as valuations are near peak levels. Our equity strategists have become more defensive, owing to heightened drawdown risk and growth scarcity (see US Weekly Kickstart, May 13, 2016 and Strategy Expresso, May 16, 2016). While we see some upside to equities in local currency (particularly Japan), we expect the dollar to strengthen (see FX Views, May 13, 2016), resulting in poor USD returns over the next 12 months (Exhibit 1).

We prefer to implement the divergence theme via FX rather than equities; equities are generally more volatile than FX and, while the equity/FX correlation for Europe and Japan remains negative, it has increased recently (Exhibit 2) (see GOAL: Lost in translation, October 2, 2015). For Europe, equity/FX correlations could become even less negative as political risks in Europe intensify. We also move to Neutral across equity regions on a 12-month basis (in line with our 3-month basis) alongside these effects.

 

Eoin Treacy's view -

A link to the full report is posted in the Subscriber's Area. 

Corporate Profits have come in below expectations in the first quarter which makes it harder to justify valuations at where they are right now. 

Companies are not spending as much on buybacks and what they are spending is buying less because prices have gone up so much already. Quite apart from that buybacks inflate earnings per share which has a knock-on effect that compresses P/E ratios. 

 



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May 13 2016

Commentary by Eoin Treacy

Yield Grab Pushes Treasuries Curve Near the Flattest Since 2007

This article by Alexandra Scaggs and Taylor Hall may be of interest to subscribers. Here is a section: 

The analysts expected a steeper curve after the Fed’s March meeting, when it lowered forecasts for 2016 rate increases, since the policy statement prompted traders to anticipate officials will let inflation quicken. That would erode the value of long-term debt most. Yet securities maturing in 10 years or longer have returned 5.9 percent since that meeting, while short-term notes have gained 1.3 percent, according to Bloomberg index data. That’s because long-term debt prices have been supported by investors searching for yield, the RBS strategists wrote.

“We’ve got a large wall of money from investors who need to hit a nominal yield target. As the market rallies, they need to reach farther out the curve to meet those targets,” Blake Gwinn, a U.S. rates strategist with RBS Securities, said in an interview. The market “hasn’t really behaved in the way we would have envisioned.”

 

Eoin Treacy's view -

Nobody knows what the net effect of the negative rate experiment, much of Europe and Japan are engaged in, is likely to be. The resilience of precious metals is probably one of the unintended consequences. The fact Australian 10-year yields are testing the historic lows and likely to contract further is another. 



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May 05 2016

Commentary by Eoin Treacy

Negative interest rates are the dumbest idea ever

This interview of Jeff Gundlach by Christoph Gisiger for Finanz und Wirtschaft may be of interest to subscribers. Here is a section:

Energy companies are playing an important role in the junk bond sector. What would oil at $ 38 mean for the credit markets?

Just like oil, the high yield market has enjoyed the easy rally. I think it’s basically over. I don’t see how you are supposed to be all fond off high yield bonds, since they are facing enormous fundamental problems. I thought people would learn their lesson but the issuance in the years 2013/14 was vastly worse than the issuance in 2006/07. Also, in the bank loan market covenant lite issuance rose to 40% in 2006/07. In this cycle it climbed to 75%. The leverage in the high yield bond market is enormous and you’re about to have a substantial increase in defaults. I wouldn’t be surprised if the cumulative default rate in the next five years were going to be the highest in the history of the high yield bond market.

What would be the consequences of that?
We are now in a culture of default. There is no stigma about defaulting anymore. During the housing crash, homeowners walked away from their mortgages. That was the beginning of a massive tolerance of default. Today, people talk about Puerto Rico defaulting like it’s nothing. But if Puerto Rico defaults why won’t some clever person in Illinois say: «Let’s default, too! » Constitutionally, Illinois is not allowed to default, but Puerto Rico wasn’t either. For Illinois it just seems impossible to pay their pension obligations. And then, what about Houston, what about Chicago, what about Connecticut? I am surprised that people have lost their focus on the enormity of the debt problem. Remember, in 2010 and 2011 there was such a laser focus on the debt ceiling in the US and we were worried about Greece. Nobody is worried anymore. People are distracted by this negative interest rate experiment. 

 

Eoin Treacy's view -

The first time I visited Boston was about four years ago and there was a sign from Prudential above the Charles which proclaimed “We have $1 trillion under management”. That’s an impressive number but what popped into my head was “What do they own?” The answer of course is that a great deal of that money is invested in bonds. In fact regulators insist conservative portfolios, aimed at the pensions market, have to own bonds in order to ensure some degree of security that future liabilities can be met. The fact bonds have been in a 35-year bull market has only bolstered the sector’s “risk free” credentials. 



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April 29 2016

Commentary by Eoin Treacy

Goldman Sachs Calls Bonds Expensive as Morgan Stanley Is Bullish

This article by Wes Goodman for Bloomberg may be of interest to subscribers. Here is a section: 

The firms, which are among the 23 primary dealers that trade with the Fed, are at odds as investors decipher the central bank’s views on the economy in its statement this week. Morgan Stanley called the comment “slightly dovish.” Goldman forecasts rate increases in June, September and December. U.S. consumer spending rose less than forecast in March, Commerce Department figures showed Friday, after data Thursday showed the economy growing at its slowest pace in two years.

Looking for Growth
Central bankers used their statement to indicate growing confidence in the world economy while suggesting they’re still looking for the signs of growth, inflation and global stability to justify a move.

 

Eoin Treacy's view -

This divergence between the opinions of Goldman Sachs and Morgan Stanley with regard to Treasuries has been an open bone of contention for months. There is a lot at stake not least since the bond market has been in a secular bull market for 35 years and has been supported in spectacular fashion by the extraordinary measures employed by central banks to avoid a depression. 



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April 28 2016

Commentary by Eoin Treacy

Japan Stocks Tumble After BOJ Holds Off on Adding to Stimulus

This article by Yuko Takeo, Toshiro Hasegawa and Yuji Nakamura for Bloomberg may be of interest to subscribers. Here is a section:

“We’ve had the knee-jerk reaction to no change as the majority expected some form of action,” said Cameron Duncan, Sydney-based co-head of income strategies at Shaw and Partners, which manages the equivalent of $7.6 billion. “In, hindsight, it’s probably consistent that they haven’t done anything because they eased three months ago.

There’s typically a lag in terms of response to that sort of easing. It’s the Bank of Japan and they’re pretty conservative and they are still waiting to see what the impact of that is.”

Goldman Sachs Group Inc. and HSBC Holdings Plc were among those expecting the central bank to add to ETF buying. Goldman Sachs estimated the BOJ would expand annual purchases to 7 trillion yen, while HSBC predicted an increase to 13 billion yen.

The central bank’s decision to forgo additional easing this time hasn’t deterred some from expecting more stimulus in the future. It’s inevitable that economic growth and inflation will take a downturn and given the outlook for a stronger yen, the BOJ will likely boost stimulus eventually, SMBC Nikko Securities Inc.’s chief market economist Yoshimasa Maruyama said.

Driven to Ease
“The situation the BOJ is in won’t change for the better because of its decision today,” Maruyama wrote in a note to clients. “It’ll be driven into easing further sooner or later.”

The Topix is down 13 percent this year, making it the worst performing developed market in 2016, after starting 2016 tumbling into a bear market on worries over oil prices and slowing global economic growth. The measure has climbed back 12 percent from a Feb. 12 low, bolstered by a recovery in oil prices and signs of stabilization in China’s economy.

 

Eoin Treacy's view -

“If you’re going to go, go big” was something the BoJ appeared to have understood when it adopted the QE program that sent the Yen down more than 50% and ignited a major run in Japanese stocks between late 2012 and early 2015. Since the middle of last year the commitment to doing everything necessary to ignite inflation has waned. The wait and see attitude adopted of late suggests a lukewarm commitment to reform and expansion. 



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April 27 2016

Commentary by Eoin Treacy

Email of the day on inflation expectations and rates

You've drawn attention to the 12 month T-bill rate a couple of times over the past week. Additionally, it is also very instructive to monitor inflation expectations to gauge what is discounted in terms of the future direction of interest rates. The five-year “breakeven” rate, a market measure of inflation expectations derived from comparing the yield of Treasury Inflation protected bonds (Tips) and conventional Treasuries, has climbed from a low of 0.95% in early February, to 1.56% now. It peaked at 2.4% in October 2012 after reaching an unprecedented minus 0.9% in 2008. 

Movements in Tips have tended to reflect investor expectations about future consumer price inflation, and these have been stoked by the recent rise in oil prices and a weaker dollar, which means higher import prices. In fact, the breakeven rate has been rising in tandem with oil prices since February. Interestingly, the “core” US inflation rate, which strips out the impact of volatile components such as energy and food, has also been rising. The current buying of Tips reflects a view that the cycle of dollar strength and commodity weakness has come to an end. 

Like you and David, I also think that commodities have bottomed. However, there are no signs of strong underlying demand and inflationary pressures from the real economy at the moment. Furthermore, Janet Yellen, the Fed chair, has cast doubts on the durability of the recent pick-up in core inflation and inflation expectations, arguing that the case for moving cautiously on interest rates was still strong. It is not surprising that she would say that given that the Fed has reduced the likely number of rate rises this year. 

My view is that the US breakeven rate will rise with commodity prices which will push conventional yields up and stock markets down but I don't believe that oil prices, for example, will get anywhere near the previous peak for the reasons discussed by this Service. Thus bond yields too will peak at a much lower level. The collapse in commodity prices in the last few years has distorted valuations in various markets and there will be a ripple effect across the other asset classes.

 

 

Eoin Treacy's view -

Thank you for this thoughtful email and for highlighting breakeven rates which I have not looked at in a while. I watch the 12-month yield because if gives us a good indication of how the bond market is pricing the risk of the Fed raising rates. 



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April 19 2016

Commentary by Eoin Treacy

Helicopters 101: your guide to monetary financing

Thanks to a subscriber for this report from Deutsche Bank explaining just how many tools are available to central bankers that go beyond conventional thinking. Here is a section:

It is the adoption of modern accounting standards for central banks that perhaps best summarizes the tension between a central bank’s actual abilities and the institutional limits placed by modern practice. Unlike any corporate, government or household, a central bank has no reason to be bound by its balance sheet or income statement. It can simply create money out of thin air (a liability) and buy an asset or give the liability (money) out for free. It can run perpetual losses (negative equity) because it can fund these by printing more money.
Taking this fundamental principle on board leaves us with the following menu of policy options, in ascending order of unorthodoxy. We accompany each option with a discussion on the implications for the CB balance sheet.
1. Quantitative easing combined with fiscal policy expansion: This is the least “unconventional” option and is already happening, albeit with a lack of explicit co-ordination. Central banks purchase interest-bearing government debt with a temporary increase in the monetary base.
This is accompanied by increased fiscal spending (or tax cuts), enacted by the Treasury in reaction to implicit central bank support for bond markets. The Treasury has more room to increase the deficit and the outstanding term of its maturing government bonds, because financing costs are made lower by central banks, but this support can be withdrawn at any time. In this case, the central bank’s assets and liabilities rise in parallel: the rise in central bank government bond holdings shows up as an increase in assets, while the increase in private-sector cash holdings shows up as a rise in central bank liabilities.
2. Cash transfers to governments: Same as option (2) except the government debt is non-redeemable, and hence the increase in the monetary base is permanent. Money can be credited directly to the Treasury account at the central bank, which would keep government debt/GDP ratios stable. The central bank can purchase 0% coupon perpetuities from the Treasury, which because they have no value, should amount to the same thing.3 The precise impact on the balance sheet here will depend on the nature of the transaction with the government. In the case where cash is swapped for a zero-coupon perpetuity, assets and liabilities would rise correspondingly, but the central bank would make a loss because it would not receive a coupon on government debt while eventually having to pay interest on bank reserve balances if interest rates rise.
3. Haircuts on existing CB-held debt: The central bank can unilaterally restructure and/or forgive its government debt holdings, improving government debt sustainability and allowing the Treasury room for future deficit spending. This can happen in a one-off fashion, or according to some graduated rule. For instance, the central bank could commit to write off 5% of government debt holdings until some target is achieved. The Greek OSI and PSI experience offers a precedent for distinguishing between privately and publicly held government bond holdings thus potentially avoiding CDS triggers. Note that central bank purchases of negative-yielding instruments are a form of notional haircuts as the government pays back to the central bank less than it issued. The resulting balance sheet change here is also straightforward: the central bank’s assets would be reduced by the corresponding size of the haircut, and this would be registered as a loss on the central bank’s liability ledger.

4. Cash transfers to households: The most radical option has central banks create and transfer money to individuals directly (through cheques, bank transfers or state pension contribution credits), cutting out the role of the Treasury entirely. In this case, the central bank’s liabilities would rise, as the public’s cash holdings against the central bank would show up as a rising liability. If no asset is purchased by the central bank, the rise in the liability would have to be offset by a corresponding loss on the balance sheet in the form of negative equity.

 

Eoin Treacy's view -

A link to the full report is posted in the Subscriber's Area.

Anyone who believes central banks have come close to the end of what can be achieved by monetary accommodation should read this report. When a central bank has the ability to create money out of the nothing there is absolutely no limit to what they can do in an effort to achieve their goals. The results might not be to everyone’s’ liking because items 2, 3 and 4 above would stoke additional asset price inflation but that does not mean they cannot be implemented. 



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April 07 2016

Commentary by Eoin Treacy

Jamie Dimon's Rate-Spike Nightmare

This article by Lisa Abramowicz and Rani Molla for Bloomberg may be of interest to subscribers. Here is a section: 

3) Investors are piling into medium and longer-term U.S. bonds with increasing conviction that borrowing costs will stay low forever. The biggest exchange-traded funds that focus on such notes have experienced a surge of new money this year, with the volume of short interest on the ETFs' shares falling. This has helped fuel a 4.9 percent surge in Treasuries maturing in seven to 10 years so far this year, according to Bank of America Merrill Lynch index data.
 
4) The demand hasn't only come from ETFs and mutual funds. Big institutions and hedge funds have also bought more U.S. government bonds, particularly those maturing in the next decade, as they seek safe spots to park cash in the face of global economic uncertainty. 

Eoin Treacy's view -

How the Fed measures inflation does not appear to bear a great deal of resemblance to what we experience in our day to day lives. The cost of services such as insurance, education and healthcare have all trended higher and housing prices have recovered in many major cities but inflation measures have not responded. When I look at what I spend on a monthly basis that doesn’t make sense but the other side of the balance sheet also needs to be addressed.

Wages have been static for a long time and that means people have had to pay more for services but have cut back elsewhere to make ends meet. That is probably closer to how the Fed views inflation than any other explanation but it means wages are vital in how they decide to act. 



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April 06 2016

Commentary by Eoin Treacy

Bridgewater Daily Observations

Thanks to a subscriber for this educative report which in the early portion discusses the success the UK had with deleveraging following WWII and how that may offer a template for the deleveraging the Fed is facing over the next decade. Here is a quote from Janet Yellen and the subsequent paragraph:

So I want to make clear that our inflation objective is two percent and we’re projecting a move back to two percent. And we are not trying to engineer an overshoot of inflation, not to compensate for past undershoots…with a continuing improvement in the labor market, I think we’ll see upward pressure on inflation. And in that context, the committee sees it appropriate to, if things unfold in that way, to have some further increases in the federal funds rate. – March 16 2016

Tightening to prevent inflation from reaching or surpassing 2% has the risk of hindering the continuation of the beautiful deleveraging. Containing inflation creates the risk of rising real yields in a low-rate environment and reduces the ability to work through the debt overhand. And if such moves were more significant than current pricing, the hit to asset prices would also create a risk of a renewed downturn that is difficult to manage. As the chart below shows, the current Fed forecast implies further tightening before the end of the year and continued tightening in the years following, at a rate faster than what is currently expected by the market. Were the fed to tighten in line with their median forecast, assets prices would fall as discount rates increased, and the wealth of holders would take a hit. As we’ve discussed in previous Observations, this would be particularly dangerous, as there is limited ability to ease if the resulting tightening pushes the economy into self-reinforcing contraction. 

Eoin Treacy's view -

A link to the full report is posted in the Subscriber's Area.

The Fed printed a lot of Dollars to soak up the issuance of Treasuries and mortgage bonds that resulted from the bailout from the credit crisis. Having ceased purchasing bonds quite what it is going to do with its holdings when they mature is still very much an open question. Since early 2015 the Fed has been rolling over its holdings as they mature, but last year had very few maturities.

Rolling over is likely to be a greater challenge in the years ahead because they need to manage the maturity of over $200 billion this year, a little less than that in 2017 but over $350 billion in 2018 and over $300 billion in 2019. That’s a big question because the funding cost for the interest on that debt is going to rise if the Fed is simultaneously raising interest rates. 



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March 21 2016

Commentary by Eoin Treacy

When Older People Do Better Than Those of Working Age

This article by Jason Douglas and Jon Sindreu for the Wall Street Journal may be of interest to subscribers. Here is a section:

The average person 65 and older in the U.S. earns 77% of the income of the average citizen, up from 69% in 2008, at the start of the recession. In the U.K. the figure is 89%, up from 78%. In Spain and France, seniors now earn about 103% and 102% of the average worker’s income, respectively, according to an analysis of data from the European Union’s official statistics agency. That’s up from 86% in Spain and 96% in France in 2008.

This divergence between generations is in part a reflection of demographic shifts that have been brewing for years, as populations grow older and the wealthy postwar baby boomers in particular reach their golden years.

But it is also widening as a consequence of forces bearing down on the earnings of the young, creating a growing imbalance that threatens to undermine the promise that market economies will deliver rising living standards for successive generations. Younger workers are grappling with flat or falling pay, decreased job security and less-affordable housing, sapping the spending power that helps fuel the economy. As the elderly population increases, younger workers also face a rising bill for the extra tax dollars needed to fulfill past governments’ promises to retirees.

 

Eoin Treacy's view -

We don’t have to look far for a reason behind the surge in populist rhetoric across Europe and the USA this year. Whether it is the rise of right wing politics in France and Germany, the Eurosceptic referendum in the UK or Donald Trump in the USA there is a general sense that the measures implemented by governments to avoid a calamity in the financial sector have resulted in drops in living standards for many people. 



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March 21 2016

Commentary by Eoin Treacy

Wall Street's Pile of Unwanted Treasuries Exposes Market Cracks

This article by Alexandra Scaggs and Liz McCormick for Bloomberg may be of interest to subscribers. Here is a section: 

There are signs that the dislocations have abated. The gap between prices of new and old securities has fallen closer to its average for the past year, and in the repo market, 10-year Treasuries are no longer what’s known as “on special.” Dealers that lend cash in exchange for the notes in these deals now receive interest, since the repo rate is positive.

Bond bulls can also take heart in how the stress on the system didn’t slow the rush into U.S. government debt this year. Treasuries maturing in greater than a year have earned 1.7 percent in 2016 as stocks slumped to start the year amid concern global economic growth was cooling, Bloomberg Treasury bond index data show. The Treasury 10-year note yield rose four basis points, or 0.04 percentage point, to 1.91 percent as of 1 p.m. New York time.

In a twist, the demand for U.S. debt that drove 10-year yields toward record lows in February may have contributed to the strains, Keeble said. Buyers of Treasuries who typically don’t lend out securities in the repo market may have bought benchmark 10-year securities as a haven, he said.
For George Goncalves, head of rates research at primary dealer Nomura Securities Inc. in New York, dealers already holding so much debt may have less capacity to absorb more rounds of selling in the future.

“If there is another round of bond selloff, the market will need real-money support to keep everything orderly,” he said in a March 17 research note.

 

Eoin Treacy's view -

Quantitative easing has had a massively distorting influence on the bond markets because the Fed is now the largest owner of whole issues which has an influence on the yield curve. Selling pressure from foreign governments and sovereign wealth funds left primary dealers with bloated inventories of Treasuries they had difficulty shifting but the question of what the Fed is going to do with its massive holdings of bonds when they mature remains an open question. 



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March 10 2016

Commentary by Eoin Treacy

Segregating the resilience of EM banks to trying global macro outlook

Thanks to a subscriber for this heavyweight 101-page report from Deutsche Bank focusing on emerging market debt. Here is a section:

The debt stock of the EMs has increased significantly since the global financial crisis. In contrast to advanced economies in which governments are the main borrowers, the main driver of EM indebtedness is the private corporates (while banks and households are leveraged up as well), and the bulk of the financing is FX denominated, making EMs susceptible to financial stress, economic downturns, and capital outflows. We believe a correction has to an extent occurred in the EMs since the taper shock, and our base scenario foresees a slight rebound in economic growth in CEEMEA and LatAm in 2016. Under our central scenario that the Fed will raise rates only gradually, we recommend that investors Buy BZWBK (Poland), Doha Bank (Qatar), Garanti (Turkey), Standard Bank (South Africa), Bradesco (Brazil), and Credicorp (Peru). 

There are two main risks to our base-line projections: 1) more aggressive rate hikes by the Fed than assumed under our base scenario, and hence, more adverse market adjustments to a tightening Fed; and 2) a sharper slowdown in China, which would have obvious knock-on effects on commodities, global trade, and EMs in general. The past few weeks have shown that those two risks are unlikely to materialize together in the near term, and we believe that the risk of a sharp increase in rates is now a very unlikely scenario. We believe, however, that if they materialize, they will weigh on banks via two main channels. The first is margins, as funding costs will climb higher at a much faster pace and may also force banks to put on the brakes in terms of lending. The second one is asset quality. We think EM corporates are likely to face two related but distinct risks associated with their recent rapidly rising leverage under a more bearish scenario: liquidity risk and FX losses.

In the first part of this report, we opt to examine the refinancing risk and the associated deleveraging risk for the banking sectors in CEEMEA and LatAm. We look at the maturity structure of the external debt, as well as the FX liquid assets, and demonstrate the extent of ‘refinancing risk’. We then examine the extent of deleveraging if rollover ratios fall to the levels we witnessed during the global crisis. The second part of the report aims to assess the potential asset quality risks arising from the recent increase in private corporate debt. Accordingly, we stress-test our earnings estimates to a potential increase in risk costs under the assumption that some of the FX corporate debt will default this year. While sustained financial market volatility, slower lending, and weaker growth should inevitably affect other business segments as well, our focus here is on banks’ corporate exposures, which in most cases have increased significantly since the global crisis. 

Under a bearish scenario in which top-line revenues are challenged and corporate loan qualities deteriorate, we see greater risks in Turkey (with Vakifbank and Yapi Kredi relatively more vulnerable), Russia (VTB), Brazil (Santander Brasil), and Chile (Banco de Chile). Conversely, CE3 (with BZWBK, OTP and Komercni relatively less exposed), South Africa (Standard Bank), Mexico (Banorte), and Peru (Credicorp) appear as relatively less exposed to a scenario in which banks have to reduce their lending due to unfavorable external borrowing conditions and the quality FX corporate loan books erodes.

 

Eoin Treacy's view -

A link to the full report is posted in the Subscriber's Area.

There are two sides to every argument. There is no doubt that the strength of the US Dollar over the last few years has been a major headache for companies that intended to pay back foreign loans in their own currencies. That is going to act as a headwind for their balance sheets for as long as it takes them to refinance. On the other hand they may be assisted by the boost to productivity and relative competitive advantage that comes from a sharply weaker currency. 



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March 09 2016

Commentary by Eoin Treacy

Fed rate hikes coming

Thanks to a subscriber for this report by Torsten Slok for Deutsche Bank which is packed with interesting charts. 

March 07 2016

Commentary by Eoin Treacy

Email of the day on Treasuries, Wall Street and Australia

I am a retired Debt Capital Markets banker. I think US Treasuries are still an attractive investment. Well at least US Treasuries pay a coupon and the USD is an attractive currency to many global investors. You are right these ridiculous low yields are not sustainable long term. However before reality reappears in global bond markets we need to see the end of the many excessively accommodative global monetary policies. You are rather bullish on equity markets. Looking at the S&P500 I think I can see why you hold that point of view. As you say the S&P 500 seems to be forming a base or consolidation. Regrettably the chart for the local ASX200 to my observation looks awful. Thank you for all your good work.

Eoin Treacy's view -

Thank you for these comments and I agree US Treasuries represent a safe haven for bond investors, when so many other sovereigns have negative yields. The big question we will likely get an answer to over the coming six months is how willing the Fed is to go-it-alone in raising rates.

With the rest of the world moving towards further monetary accommodation the upward pressure on the US Dollar from additional Fed hikes would represent a significant headwind. Meanwhile the US economy is 70% domestic consumer and wage growth has become a focus for those looking at signs for what the Fed will do next. Last week’s decline in wage demands suggest the Fed has time to monitor the situation. 



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March 04 2016

Commentary by Eoin Treacy

Don't panic about high-yield defaults

Thanks to a subscriber for this report from Deutsche Bank which may be of interest. Here is a section:

An alternate view is that US high yield, with or without the commodities sector, remains within the trading range we have seen since 2010. The European market is similar. In other words, high yield has been behaving much as it has throughout the post-financial crisis period which has witnessed several episodes of major market stress. These include Greece in 2010, the US rating downgrade in 2011, the eurozone crisis in 2011/12, and the China equity meltdown in August 2015. During these periods, high-yield spreads gapped out as investors feared a re-run of the 2008-09 experience when spreads and defaults soared. 

This time around, things are a bit different in that spreads have widened on account of macro concerns combined with genuinely higher defaults in the energy and materials sectors (Figure 2). Investors must distinguish these two issues. Sure, macro concerns do keep mounting – prominent on the radar recently are US growth slowdown, China devaluation fears, slumping commodity prices, health of emerging market economies, European banks, the shift to negative interest rates and Brexit. But the view on the broader highyield market should have very little to do with the commodity cycle or the longevity of the recovery. Rather, it should have everything to do with whether one believes policymakers will keep muddling through or if they are about to make an error that plunges the global economy into another 2008-09 crash. 

If one believes policymakers will not make a significant blunder then high-yield is probably not on the verge of a default debacle, even if macro risks are on the rise. Even in the event of a major crisis, it is likely defaults will not reach the levels of recent cycles. Looking closely at past credit cycles provides some useful lessons.

Since 1970 there have been four major default cycles and one minor one in the mid-1980s (Figure 3). Note that while the default rate has averaged about four per cent over these 45 years, it is not a mean-reverting relationship – default rates are either low or high. Some have warned that hitting four per cent is an ominous sign beyond which defaults will likely keep rising much higher. However, the four per cent default level was breached thrice in the 1980s and again in 2012 without significant further increases. There is nothing sacrosanct or cataclysmic about hitting four per cent; every cycle has to be evaluated on its merits.

The business and default cycles of the past 45 years have mostly shared two broad characteristics – the Treasury yield curve has flattened and inverted and there has been explosive growth in corporate debt other than bonds. In the past three cycles a third factor has been asset bubble conditions in one or more sectors which caused these cycles to be particularly vicious. None of these three conditions conclusively exists now. 

Eoin Treacy's view -

A link to the full report is posted in the Subscriber's Area. 

This is one of the most bullish reports on bonds I’ve seen in quite a while and thought subscribers would benefit from a fresh perspective. One argument I have also seen proposed which makes sense is that while low oil prices have been a harbinger of defaults in the energy sector, the rebound will remove some of the pressure so the pace of defaults might be lower that currently priced in. 

 



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February 26 2016

Commentary by Eoin Treacy

New JPMorgan Flash-Rally Theory Sends Message on Today's Market

This article by Alexandra Scaggs for Bloomberg may be of interest to subscribers. Here is a section:

Some big names back JPMorgan’s view that it’s often tougher to trade Treasury securities in the roughly $500 billion-a-day cash market than the derivatives that track them. The Federal Reserve Bank of New York touched on the topic in a recent blog post. Sam Priyadarshi, head of fixed-income derivatives trading at Valley Forge, Pennsylvania-based Vanguard Group Inc., the largest private holder of Treasuries, says the relative ease is encouraging his team to trade more in futures. His team trades Treasuries for some of the firm’s active portfolios.

The JPMorgan analysts looked at measures of trading activity and the depth of the markets’ liquidity to determine the source of the steep drop in yields in October 2014. They found that shortly before the decline, volume in 10-year Treasury notes spiked. In contrast, trading volume in 10-year futures contracts only peaked after the note’s yield had plummeted to its low for that day, they said. They also found that, in futures, average transaction costs were lower, and distribution of market depth across the order book was more stable.

 

Eoin Treacy's view -

Activity in the Treasury market is receiving a great deal of attention at present. The level yields are at right now suggests to some people a recession is imminent, but other economic factors are considerably more benign. That is contributing the sense of dissonance many people feel.

The fact that upwards of $8 trillion in Euro, Yen and Swiss Franc denominated debt is trading with a negative yield has a lot of people on edge. The end of the Federal Reserve’s quantitative easing program has also altered the status quo, while the spike in junk yields raises questions about who is exposed. However there are some additional considerations that are potentially more important for the medium-term outlook. 

 



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February 24 2016

Commentary by Eoin Treacy

Trends & Inflection Points

Thanks to a subscriber for this note by Mark Steele for BMO which may be of interest to subscribers. Here is a section: 

Gold does well when the banking system is at risk.

The banking system is at risk.

Yesterday, we highlighted the CDS curve on Deutsche Bank, which went inverted (Markit pricing) when WTI hit $26. We updated that chart as of 5:30am, only this time with gold overlaid on the DB curve – Figure 3.

 

Eoin Treacy's view -

A link to the full note is posted in the Subscriber's Area. 

The correlation between the underperformance of the financial sector and the surge in gold prices is not a coincidence. Gold has been in need of a bullish catalyst and it has attracted interest as government bonds yields moved into negative territory. 



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February 16 2016

Commentary by Eoin Treacy

Email of the day on the impact of financial regulation

You write: "The prospect of negative interest rates is particularly bad news.....because not only do they have to hold more capital but they have to pay the ECB for the privilege". This is not particularly clear. Please explain why banks have to hold more capital when rates go negative. Also, how the link with the ECB works. Thank you very much.

Eoin Treacy's view -

Thank you for the opportunity to clarify what is an important point. The regulatory overhaul that has been implemented across markets means banks need to hold more Tier 1 capital. Prior to the financial crisis they could have substituted some Tier 2 capital, (lower quality assets) to fulfil their core capital requirements. If they don’t have enough Tier 1 capital they need to get it somewhere and the easy route is to borrow bonds at the discount window in exchange for Tier 2 and lower quality assets. The result of negative interest rates is that they now have to pay for the privilege rather than picking up the carry on the spread on higher yielding assets. 



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February 11 2016

Commentary by Eoin Treacy

A Dangerous Shift

Thanks to a subscriber for this characteristically bearish report by Gerard Minack which may be of interest. Here is a section:

The second corrosive factor for markets is the downgrading of perceived central bank potency. There are several recent hints of this decline. Mario Draghi’s ‘whatever it takes’ comment in 2012 was, in my view, the single most important central bank action of the past 5 years. However, European bank stocks – a principal beneficiary of ‘whatever it takes’ – have now almost given up all their ‘whatever it takes’ gains, despite recent ‘whatever it takes with steroids’ comments from Mr. Draghi (Exhibit 5).

Likewise, the Bank of Japan’s bazooka now seems to be firing blanks. The yen strengthened and equities fell after the cash rate was cut below zero – the opposite of what was presumably expected.

Most importantly, perceptions of the Federal Reserve also appear to be changing. Markets have never priced the Fed’s dot-plot rate guidance. More tellingly, in my view, the market is now pricing a non-trivial chance that the Fed will have to completely reverse course. Current pricing of Euro-dollar futures and options now implies a reasonable chance of zero or negative rates ahead (Exhibit 6).

Medium-term inflation expectations are my crude measure of central bank credibility. Exhibit 7 shows the 5 year-5 year forward breakeven inflation rates for Europe and the US (an implicit forecast of inflation 6-10 years from now). These measures have been falling for 18 months. Markets are increasingly of the view that central banks will not be able to achieve their key policy aim: returning inflation to normal levels.

My medium-term view is that central banks will not be able to overcome the forces of disinflation. I didn’t expect markets to agree with that until the next recession. However, if that is what is happening now, then this will be a more difficult year than I had been expecting.

 

Eoin Treacy's view -

A link to the full report is posted in the Subscriber's Area.

The IMF paper I posted on Tuesday highlighting a mechanism for introducing negative interest rates by reducing the attractiveness of paper money should not be taken lightly. It is perhaps the most relevant example of the lengths to which central banks are willing to go to achieve their goals. Since Janet Yellen refused to rule out the potential for the USA to adopt a negative interest policy in future we can conclude the ECB and BoJ are not the only central banks considering the tool.  



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February 09 2016

Commentary by Eoin Treacy

Breaking Through the Zero Lower Bound

Thanks to a subscriber for this report by Ruchir Agarwal and Miles Kimball for the IMF which may be of interest to subscribers. Here is a section:

We show here how the combination of (a) using electronic money as the unit of account and (b) a time-varying paper currency deposit fee can be used to eliminate the option to circumvent the negative rates by withdrawing, storing and, later, redepositing paper currency. The key idea is that a negative interest rate can be accompanied by a time-varying deposit fee that ensures the value of paper money and the value of funds in electronic accounts will move in tandem. Such a deposit fee only needs to be imposed at the central bank’s cash window—the facility through which the central bank and commercial banks interact to bring cash in to and out of circulation—and not on households, firms, or banks. Levying the paper currency deposit fee on net deposits of paper currency allows the central bank to create an exchange rate at the cash window between electronic currency and paper currency, so that in a negative interest environment, the value of paper currency can be caused to depreciate over time relative to electronic money. The objective is a policy at minimum distance from the current monetary system consistent with eliminating the zero lower bound. In particular, such a policy requires no extra regulations or quantity constraints. Instead, its impact on the economy works entirely through the price system.

Eoin Treacy's view -

This is about the best, though unintentional, argument for owning gold and stocks with reliable dividend growth I’ve seen. One of the primary arguments used by fundamental analysts to disparage gold is that it does not pay a dividend and as a result cannot be valued. That’s does not seem to trouble them when it comes to suggesting that fiat currency should be intentionally debased and eroded by negative interest rates. With $7 Trillion in bonds currently in a negative yield environment, gold has a positive carry just by virtue of not paying anything. 



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February 08 2016

Commentary by Eoin Treacy

Credit Market Risk Surges to Four-Year High Amid Global Selloff

This article by Aleksandra Gjorgievska and Tom Beardsworth for Bloomberg may be of interest to subscribers. Here is a section:

Exchange-traded funds that hold U.S. junk bonds slid to their lowest levels in almost seven years. BlackRock’s iShares iBoxx High Yield Corporate Bond exchange-traded fund and SPDR Barclays High Yield Bond ETF both fell to the lowest levels since 2009.

Financials and energy were the two investment-grade sectors that added the most risk in the U.S., Markit CDX North American Indexes show. In high yield, energy, communications and health care fared the worst.

Chesapeake Energy Corp., the U.S. natural gas driller that’s been cutting jobs and investor payouts to conserve dwindling cash flows, lost more than half it stock market value Monday after a report that it hired a restructuring law firm.

The company’s bonds led losses among high-yield debt on Monday. Chesapeake’s notes due March 2016 tumbled to a record to 74.5 cents, from 95 cents last week, while its bonds maturing in 2017 fell to an all-time low at 34 cents.

“Broad oil weakness has now turned into distressed energy cases, which investors view as possibilities of higher risk of restructuring or debt exchanges," Ben Emons, a money manager at Leader Capital Corporation. “Nothing has been announced of that matter but markets move quicker ahead of such possibility happening."

 

Eoin Treacy's view -

Regardless of the answer, when someone asks whether a default is imminent one has to conclude that the situation is troubling. This is as true of Chesapeake today as it was of Greece, Portugal et al a few years ago. 

Chesapeake’s 2017 6.25% Senior UnSecured bullet bond now yields 150% suggesting very few people think it will make its last coupon payment due in July.   

 



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January 29 2016

Commentary by Eoin Treacy

Japan Adopts Negative-Rate Strategy to Aid Weakening Economy

This article by Toru Fujioka and Masahiro Hidaka for Bloomberg may be of interest to subscribers. Here is a section:

Bank of Japan Governor Haruhiko Kuroda sprung another surprise on investors Friday, adopting a negative interest-rate strategy to spur banks to lend in the face of a weakening economy.

The move to penalize a portion of banks’ reserves complements the BOJ’s record asset-purchase program, including 80 trillion yen ($666 billion) a year in government-bond purchases, which was kept unchanged at the board meeting. By a 5-4 vote, Kuroda led his colleagues to introduce a rate of minus 0.1 percent on certain excess holdings of cash.

Long a pioneer in adopting unorthodox policies to tackle deflation and revive economic growth, the BOJ is now taking a page out of European policy makers’ playbooks in the goal of stoking inflation. The yen tumbled after the announcement, which came after Kuroda just last week rejected the idea of negative rates.

“This clearly shows the BOJ wanted to weaken the yen and raise the price of import goods and boost inflation,” said Daisuke Karakama, an economist at Mizuho Bank in Tokyo. “We don’t know this negative rate policy will be good for the economy in the end,” he said, adding that success in Europe doesn’t guarantee the same for Japan.

 

Eoin Treacy's view -

JGB yields plunged on today’s news since a yield of 0.1% is still better than receiving negative 0.1% from deposit. In addition to continued BoJ purchases, in line with its quantitative easing program, this has sent yields to record lows with little prospect for significantly higher levels while the policy persists. 



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January 25 2016

Commentary by Eoin Treacy

Plumbing the depths...

Thanks to a subscriber for this report from ICBC Standard Bank which may be of interest. Here is a section:

We would be biased long gold into Chinese New Year but only up to around $1,140 We expect the current rally to fade after that the metal to post a new low for the current down-cycle in Q3, followed by a sluggish recovery into year end.

Silver remains a derivative of gold. Trading opportunities are tactical and technical, not fundamental. We recommend buying silver volatility when one-month implied dips below 23%. We would rather own puts than calls.

In the short-term we expect platinum to trade below $800 and potentially test the global financial crisis low of $744. The medium-term outlook is improving, however, and we think platinum’s long period of underperformance relative to both gold and palladium will begin to reverse during H2.

Relative to spot prices we are most bearish palladium. That’s counter to consensus and recent history. But the demand outlook has deteriorated, supply is inelastic, inventories are large, and investor conviction is shaky. Palladium is more likely to trade in the $300s than $600s this year

Eoin Treacy's view -

A link to the full report is posted in the Subscriber's Area.

This report is representative of a large number that have crossed our desks recently with the abiding message being that there are short-term risks but medium-term upside potential. In any other circumstances investors would pre-empt a medium-term bullish view by buying now and using further weakness as an opportunity to increase positions. One has to ask why this is not more evident within the commodity complex right now?

 



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January 21 2016

Commentary by Eoin Treacy

Even the ECB's Cash Can't Stop Investors Worrying About Portugal

This article by Joao Lima for Bloomberg may be of interest to subscribers. Here is a section:

Central to the concern over Portugal is whether the government is shifting tack as it prepares to temper the austerity measures that won favor with investors, if not voters.

Prime Minister Antonio Costa’s government, sworn in at the end of November, is due to deliver a draft of its 2016 budget to European authorities this week. Plans include reversing state salary cuts and bolstering family incomes, policies he needs to ensure the support from the Communists and Left Bloc to have a majority in parliament.

The government already increased the minimum wage and plans to reinstate four holidays and reduce the working week for state workers to 35 hours, abandoning some measures introduced during Portugal’s three-year international bailout program that ended in 2014. It also plans to regain control of airline TAP SGPS SA.

Portugal still attracted foreign investors to a sale of 4 billion euros ($4.4 billion) of 10-year government bonds via banks last week. Finance Minister Mario Centeno said maintaining confidence in the country is crucial and it would be reflected in the budget. Bond yields peaked at 18 percent during the debt crisis.

Costa, 54, says he can still keep the budget deficit within the European Union limit of 3 percent of gross domestic product through 2019 as the country tries to deal with its 223 billion- euro debt pile.

 

Eoin Treacy's view -

The ECB has been circumspect about adding new liquidity because the speed of the Euro’s decline was doing their job for them. However with the stability of the Euro, and particularly with sentiment doubting whether the Fed will be able to raise rates four times this year, the need for ECB to take responsibility for its own policy has increased again. 



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January 20 2016

Commentary by Eoin Treacy

Gold and Safe Haven Status

Eoin Treacy's view -

Gold prices are down about 43% in US Dollar terms since the 2011 peak but have been notably quiet over the last few months as volatility has picked up in just about every other asset class. Sometimes just doing nothing is enough to attract attention when the emotionality of the market spikes higher and this has certainly been the case for gold. 



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January 08 2016

Commentary by Eoin Treacy

Bill Gross Says Tough Time for Bonds If Fed Relies on Jobs

This article by Sabrina Willmer for Bloomberg may be of interest to subscribers. Here is a section: 

Bill Gross says bonds will have a tough period ahead if the Federal Reserve relies on job growth as a critical measure for raising interest rates.

After a Labor Department report today showed that payroll growth surged in December to 292,000, Gross said it appears that the Fed is on track to raise rates three or four times this year, based on statements from policy makers. 

"If the Fed continues to believe jobs are a critical element as opposed to aggregate demand and global growth, bonds have a sad period ahead of them," Gross, the lead manager of the $1.3 billion Janus Global Unconstrained Bond Fund, said in a Bloomberg Radio interview.

The Federal Reserve raised interest rates in December for the first time in almost a decade after a strong year of job growth. Payrolls increased by 2.65 million last year compared with 3.1 million in 2014 -- the best back-to-back years for hiring since 1998-99. The central bank is counting on job growth leading to increases in worker pay and inflation.

"The Fed does believe that jobs and the unemployment rate is critical to future inflation over the medium term," Gross said. "So the three or four Fed steps that Stan Fischer and Janet Yellen seem to confirm are probably on track, at least in their verbiage."

Gross said he doesn’t think it’s possible to raise interest rates by 100 basis points in today’s levered global economy, in which the dollar is rising and hurting companies in emerging markets. Bonds will be stable if the Fed only raises interest rates one or two times over next 12 months, said Gross.

 

Eoin Treacy's view -

The first question is whether the Fed will raise rates four times this year the second is do they intend to raise them four times in 2017 as well? 

The bond market is telling us investors do not believe the Fed will be able to raise rates at such an ambitious pace not least because of the influence that will have on the ability of foreign companies to fund repayments of Dollar loans they took out over the last decade of a weak greenback. This has an issue we have been discussing for nearly 18 months now and the low level of commodity prices represents an additional headwind to many debt issuers in emerging markets.  



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January 05 2016

Commentary by Eoin Treacy

How are traditional Safe Haven assets performing?

Eoin Treacy's view -

Following yesterday’s disappointing start to the year and against a background of heightened geopolitical tension, weakening performance in emerging markets and fears about a paucity of earnings growth I thought it would be an interesting time to look at the performance of what have traditionally been viewed as safe haven assets. 



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December 22 2015

Commentary by Eoin Treacy

What the Fed rate hike could mean to mortgage borrowers

This informative article by Kathy Orton at the Washington Post may be of interest to subscribers. Here is a section:

 

It is likely that uncertainty in the global economy will continue to put downward pressure on long-term rates. The Mortgage Bankers Association is predicting the interest rate for 30-year fixed-rate mortgage will be around 4.8 percent at the end of 2016, that's an increase of less than one percent.

"We have a fairly weak global economy right now," said Michael Fratantoni, MBA's chief economist. "You have many global investors parking their money in U.S. Treasury securities or other safe assets and that is keeping our longer term rates lower than they otherwise would be." 

Despite those concerns, Fratantoni is optimistic about next year's real estate market.

"At some point, you could get to a level of rates, 6 to 6 1/2 percent, that would really begin to crimp affordability and then that would be a real negative," he said. "But at this point, it's going to be just a very modest headwind. Most of the other fundamentals are suggesting a very strong housing market in the year ahead."

Waters agrees. Although he demurred when asked what he thought the interest rate on a 30-year fixed-rate mortgage would be at the end of the year, he didn't think it would be significantly higher.

"I tend to think from a 30-year fixed mortgage standpoint there's not going to be an extraordinary change," he said. "I don't think they'll go up or down more than a quarter percent, at least not initially. It's not going to five [percent] and it's not going to three [percent]. We're going to stay in a tight band."

 

Eoin Treacy's view -

30-year Treasury yields moved to a new low in January and spent the rest of the year moving higher in a rangey uptrend characterised by a progression of higher reaction lows. A sustained move below 2.8% would be required to question current scope for continued higher to lateral ranging. 



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December 22 2015

Commentary by Eoin Treacy

Soaring Debt Yields Suggest Oil M&A Could Happen in 2016

This article by Liam Denning for Bloomberg may be of interest to subscribers. Here is a section:

Mergers haven't taken off in the oil patch this year largely because potential targets have been banking on a rebound and potential buyers have been expecting further falls. The spike in yields for borrowers in the energy sector, along with the growing acceptance that oil and gas prices likely face another year on their back, should mean those opposing views finally converge in 2016, prompting some deals.

What's more, this chart suggests the advantage should lie with large, strategic buyers like the oil majors for two reasons.

First, one way potential targets have been shoring up balance sheets is to sell assets rather than the entire company.

But a thriving asset market requires buyers being able to raise capital at reasonable rates, be they other E&P companies or private equity firms looking to snap up bargains. Asset sales have slowed already this year, with just $29 billion worth in North America, compared with $107 billion in 2014, according to data compiled by Bloomberg.

Second, with the cost of capital rising and cash harder to come by, any deals struck will require at least the promise of synergies and will favor those buyers able to use their own stock as a credible acquisition currency. One reason Anadarko's approach to Apache met with such scorn was that it scattered rather than tightened the company's focus. The majors, diversified anyway, bring the benefit of bigger balance sheets, which both alleviate any credit pressures weighing on the target and provide a clearer path to developing a smaller E&P company's reserves. Paying with shares also means that selling shareholders get to participate to some degree in the eventual recovery in oil and gas prices.

 

Eoin Treacy's view -

Major oil companies have slashed exploration budgets with the result they have more capital to pick up promising assets as prices decline. Private Equity firms have amassed sizable war chests to invest in troubled energy companies but have so far been slow to make large purchases. Meanwhile sellers are hoping for a rebound so they can get a better price. With everyone appearing to bide their time a catalyst is required to encourage deal making. 



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December 21 2015

Commentary by Eoin Treacy

Spanish Yield Rises to 5-Week High on Instability After Election

This article by Anooja Debnath and Lucy Meakin for Bloomberg may be of interest to subscribers. Here is a section:

Spain’s government bonds fell, pushing the 10-year yield to the highest in five weeks, after an indecisive election left Prime Minister Mariano Rajoy with limited options to forge a governing majority, threatening a period of instability.

The yield difference between Spanish and similar-maturity Italian bonds widened to the most since mid-November amid muted declines in the rest of the euro-area’s peripheral debt markets.
While Rajoy’s People’s Party placed first in Sunday’s election, earning the right to try to form government, the results suggest the only party able to form a majority with him in the 350- member parliament would be the Socialists, the PP’s historic rivals.

Even in Spain the losses were limited, with the slide only the largest in a week, as investors focus on European Central Bank bond purchases, lower debt issuance and an improving economic outlook. Monday is the last day of ECB buying until Jan. 4.

“The election outcome failed to provide us a clear picture of who will take power,” said Anders Moller Lumholtz, chief analyst with Danske Bank A/S in Copenhagen. “It is likely to take time before we get clarity, and uncertainty is not a friend of the market. ECB QE buying could cushion some of the knee-jerk reaction, but as Monday is the last day before the QE goes on pause we probably shouldn’t expect much effect from that side. Beyond the political uncertainty, we are positive on Spain.”

 

Eoin Treacy's view -

Spain has been a beneficiary both of relatively stable government and ECB largesse which has allowed the economy recover following a major property market crash. However since Greece represents investors’ most recent experience of government upheaval within the Eurozone nerves are understandably frayed.  This is particularly true when such a large country is involved. 



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December 16 2015

Commentary by Eoin Treacy

Email of the day on the impact of currency market volatility on returns

In your piece today [Ed. Yesterday] on bonds the foreign exchange rate aspect was not mentioned. Several years ago many international investors were tempted by the relatively high yields on Australian bonds. Non-Australian investors have lost out on the fall in the value of the Australian dollar.

Eoin Treacy's view -

Thank you for highlighting this issue which has been a topic covered in the Friday audio commentaries for at least the last 18 months. While the Dollar was trending lower, investors in emerging markets and commodity producers had the luxury of capital and currency market appreciation as well as being able to pick up a competitive yield. 

With a resurgent Dollar the status quo has been shaken up and that is creating both risks and opportunities across a number of assets. Since foreign issuers of US Dollar debt represent significant weightings in bond indices, the strength of the Dollar is a potential headache for investors in bond ETFs. 

 



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December 15 2015

Commentary by Eoin Treacy

Email of the day on bond fund risk:

You have made the following argument on bond funds. 

"In addition a bond fund has to manage duration, even in a falling market, which means bonds often cannot be held to maturity. This means investors in bond funds risk underperforming the bond market in a rising interest rate environment." 

That does not seem correct. If the fund rolls bonds in such an environment, it will take a capital loss but receive higher interest on the remaining capital. I have seen research that suggests that these effects cancel each other out.

 

Eoin Treacy's view -

Thank you for raising this point which allows me to elaborate on yesterday’s piece focusing on bond risk. Yes, of course there is an argument that if prices go down, yield goes up and over the course of a reasonably lengthy maturity the investor will be compensated for the additional risk that has been taken on. However for this to be true in all cases would be to subscribe to the belief that one cannot lose money by investing in bonds. We have plenty of evidence that this is not the case so there must be additional factors affecting value. 



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December 15 2015

Commentary by Eoin Treacy

Summers: Most Plausible Bubbles No Longer Plausible

This short interview with Larry Summers may be of interest to subscribers. 

Eoin Treacy's view -

In this interview Mr Summers goes on to highlight that a lot of bad news has already been priced into markets that were mentioned in the media over the last few years as representing bubble risks. He cites commodities, emerging markets  and high yield debt as examples of markets that have already contracted substantially and therefore have already priced in the effects of a first rate hike. 



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December 14 2015

Commentary by Eoin Treacy

Junk-Bond Fund's Demise Mars Vulture Investor's Storied Career

Thanks to a subscriber for this article by Gregory Zuckerman and Daisy Maxey for the Wall Street Journal which may be of interest. Here is a section: 

Traders said part of the reason the Third Avenue fund ran into deep problems: It allowed daily withdrawals but stuck with investments that have become harder to trade and have been steadily losing value as investors fled energy and other kinds of riskier debt. It has been harder to find investors willing to buy debt the fund holds, including energy company Magnum Hunter Resources Corp. and troubled Spanish gambling company Codere SA, traders said.

As the Third Avenue fund’s holdings began to decline, rival traders at hedge funds shorted, or bet against, some of the mutual fund’s holdings, wagering that Third Avenue would experience investor withdrawals and be forced to sell some of its holdings, according to the company and one trader who made this move.

“It all starts with maybe trying to overreach,” Mr. Tjornehoj  said. “Maybe this is the strategy—focused credit—that should only be available to institutions or accredited investors.”

Now, investors are focused on whether other funds may run into similar investor withdrawals and problems as the year-end approaches. Many investors move to exit losing funds and investments late in the year to generate losses to reduce capital gains taxes, traders said.

 

Eoin Treacy's view -

When I started in Bloomberg in 2000 most of my clients on the Belgium and Luxembourg sales route were fixed income oriented so the first thing my manager had me do was read bond math manuals to get up to speed with what clients were looking at. I remember reading about convexity, how much of a move in price and yield duration can be expected from a move in interest rates, and it made sense to me since interest rates tended to move a lot. Little did anyone expect at the time that trading convexity would become a one-way bet, that would last for the better part of a decade.  



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December 11 2015

Commentary by Eoin Treacy

High Yield and Energy

Eoin Treacy's view -

When interest rates are low there is an incentive to issue debt over equity. The low interest rate environment also contributes to spreads tightening as yield hungry investors move further out the risk curve to capture the return they require. The unexpectedly long length of time that interest rates have been low has created a situation where business models were framed around the situation continuing and now that the Fed is set to change tack an adjustment is underway. 



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December 10 2015

Commentary by Eoin Treacy

Zuma Sparks Outrage in South Africa by Axing Finance Chief

This article by Michael Cohen  Amogelang Mbatha for Bloomberg may be of interest to subscribers. Here is a section:

“The government has crossed a line which it hasn’t crossed for the last 20 years,” Steven Friedman, director of the Center for the Study of Democracy, said by phone from Johannesburg. “This is really, effectively, the first finance minister to be fired since 1994. The accurate perception is that the reason he was fired is that he was doing his job, insisting on fiscal discipline.”

While Zuma announced in February that the government had taken a decision to build new nuclear plants, Nene insisted that South Africa had to be able to afford them. Nene also clashed with the chairwoman of South African Airways, Dudu Myeni, a former schoolteacher who also heads Zuma’s charitable foundation, after he refused the national carrier permission to restructure a plane-leasing deal.

“It is common knowledge that Nhlanhla Nene sought to rein in excessive government spending and was causing too much of a blockage for President Zuma in respect of the nuclear procurement deal and SAA,” Mmusi Maimane, the leader of the main opposition Democratic Alliance, said by e-mail. This is “yet another example of how President Zuma puts himself first and the country second.”

 

Eoin Treacy's view -

Some of the best vacations I’ve had have been to South Africa and with the Rand making historic lows against a host of currencies the Sardine Run in 2016 is sounding increasingly enticing. While the Rand’s decline certainly makes South Africa more attractive as a tourist destination, the slide in standards of governance mean the country will be less attractive for foreign companies seeking manufacturing and services venues.  



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December 08 2015

Commentary by Eoin Treacy

Oaktree's Marks Likens Distressed Conditions to Post-Lehman

This article by Devin Banerjee for Bloomberg may be of interest to subscribers. Here is a section:

“Post Lehman there was too much to do and now there is again,” Marks said Tuesday, referring to the financial crisis that followed the collapse of the investment bank in September 2008. “For the credit investor we have our first opportunities in several years. It’s been a long, long time."

After Lehman’s bankruptcy, Oaktree deployed billions of dollars in distressed debt, reaping a handy profit. Its Opportunities Fund VII, which did the bulk of the investing, has so far distributed $22 billion to clients on $13.5 billion of drawn capital, according to its recent third-quarter earnings statement.

Oaktree’s top executives, including Marks and co-Chairman Bruce Karsh, had bemoaned a dearth of distressed-investment opportunities since at least 2013, when the Standard & Poor’s 500 index was still in the middle of a four-year run-up. That changed in August, when investor concern that China’s economic growth was slowing quicker than expected sparked a selloff in stocks and high-yield bonds. Energy companies have been hit particularly hard as oil prices continue to slide.

“What you saw in the third quarter of this year could well be a harbinger of things to come in the next year or two,” Karsh said in October. “We’re in the later stages of this credit cycle. We saw the psychology beginning to really roll over and change and people starting to get fearful. We started to see a lot of cracks.”

 

Eoin Treacy's view -

Private equity firms have had little trouble raising capital for energy sector acquisitions not least because it represents one of the few sectors trading at depressed valuations. With a dearth of truly high yield opportunities, investors have little choice but to look at energy and this is exacerbated by the availability of liquidity in an ultra-low interest rate environment. 



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December 03 2015

Commentary by Eoin Treacy

Draghi Braves QE Hype With Boost That Leaves ECB Room to Do More

This article by Jeff Black and Maria Tadeo may be of interest to subscribers. Here is a section: 

The fresh stimulus coincides with a shift in global monetary policy, with the ECB adding stimulus as the U.S. Federal Reserve prepares to start its process of normalization. Even so, financial markets reacted with skepticism, sending the euro up as much as 2.6 percent and equities and government bonds down in a sign that Draghi’s measures fell short of expectations.

“The expectations were too high, and this was the minimum he could do,” said Marco Valli, chief euro-area economist at UniCredit SpA in Milan. “I think this was a mix of Draghi being held back by the conservatives, but also him wanting to keep some powder dry in case more is needed.”

 

Eoin Treacy's view -

The ECB’s balance sheet is currently in the region of €2.7 trillion. At €60 billion a month until March 2017 they will add an additional €960 billion which will take the total to well in excess of the previous peak in largesse; reached during its previous expansionary program. With the announcement that they will continue to reinvest maturing issues the prospect of the balance sheet contracting is almost zero. Meanwhile they leave the door open to additional easing should the need arise.   



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November 17 2015

Commentary by Eoin Treacy

Email of the day Chinese selling and negative sway spreads

Just a short comment regarding the negative swap spread story Eoin posted: I've heard rumours about the Chinese selling large volumes of US treasuries, more than what the market can absorb. This due to their own domestic policy challenges recently. The heavy selling has depressed bond prices/pushed up yields, to unnatural levels compared to swaps. Just a rumour (I'm in no position to confirm it) but sounds plausible to me. If you have further views on this, I would be very interested.

Eoin Treacy's view -

Thank you for this information and I have also read about Chinese liquidation of Treasuries. At least part of the reason for this is because they are no longer holding back the appreciation of the Yuan but rather selling Dollars to slow its decline. This has removed a potent source of demand for Treasuries. 



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November 16 2015

Commentary by Eoin Treacy

Debt Market Distortions Go Global as Nothing Makes Sense Anymore

This article by Daniel Kruger, Liz Capo McCormick and Anchalee Worrachate for Bloomberg may be of interest to subscribers. Here is a section: 

It’s hard to overstate how illogical it is when swap spreads are inverted. That’s because it suggests that governments are less creditworthy than the very financial institutions they bailed out during the credit crisis just seven years ago. And as the Fed prepares to end its near-zero rate policy, those distortions are coming to the fore.

The rate on 30-year swaps, which allow investors, companies and traders to exchange fixed interest rates for those that fluctuate with the market, and vice versa, has been lower than comparable yields on Treasuries for years now as pension funds and insurers increasingly hedged their long-term liabilities.

But in the past three months, spreads on shorter-dated contracts have also quickly turned negative. Now, five-year swap rates are about 0.05 percentage points lower than similar- maturity Treasuries, while those due in three years are also on the verge of flipping.

 

Eoin Treacy's view -

There are three important charts in the fixed income markets right now. The Swap spread is one of them because at increasingly wide negative levels important questions are being asked about how risk is being priced. 



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October 20 2015

Commentary by Eoin Treacy

Email of the day on the nominal price of the DAX

Can you access the DAXK on Bloomberg? It’s the DAX without dividends reinvested. Then we can compare apples with apples as it were!

Eoin Treacy's view -

Thank you for this suggestion. The DAX is a total return Index so its 2.92% yield helps to flatter total return over the medium-term and makes shorting the Index a rather expensive proposition relative to nominal indices. I’ve added the DAXK to the Chart Library and you will observe that it has a similar chart pattern but I agree it makes sense to compare nominal indices with nominal indices in one’s analysis. 



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