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May 16 2017

Commentary by Eoin Treacy

Email of the day on the yield curve spread and Plato:

I tried to find in the chart library the last chart you should on Friday's Video. That is the difference between the US 10 & 2 year. This Friday's long term outlook was different but I liked it; even got myself a copy of Plato to read

Eoin Treacy's view -

Thank you for a question which may be of interest to subscribers. The yield curve spread is the difference between the 10-year and 2-year Treasury yield. I created this video to discuss both how to create the chart and save it as a preset template for when you want to find it later. 



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May 05 2017

Commentary by Eoin Treacy

Kuroda Confident Can Raise Wages, Prices "Significantly"

This note by Chua Baizhen Bloomberg may be of interest to subscribers. Here it is in full:

“The mindset is still quite cautious about inflation expectations, but I’m quite sure that with continuous accommodative monetary policy, supported by fiscal policy, we’d be able to eventually raise wages and prices significantly,”

CNBC cites BOJ Governor Haruhiko Kuroda in interview.

* Projected growth rate of 1.5% “not great” but it’s well above medium-term potential growth rate

* Means output gap to shrink and become positive while labor market continues to tighten

* Wages, prices would eventually rise to achieve 2% inflation target around fiscal 2018

* Yield curve control “has been functioning quite well”

* 10-yr JGB target should, for the time being, be maintained around 0%

* Acknowledges that “headline inflation has been quite slow to adjust upward” in part because of weakness in oil prices

 

Eoin Treacy's view -

Since its bubble burst in the late 1980s Japan has been attempting to combat deflation and despite its best efforts failed. The big question is whether this was because they were not aggressive enough early on in forcing the banking sector to write down large bad loan books, or was it because their bust occurred in one of the greatest disinflationary periods in modern history and no matter what they did they could not have fomented inflation? I suspect the answer lies somewhere in between. 



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May 04 2017

Commentary by Eoin Treacy

Fed Sticks to Gradual Rate-Hike Approach Despite Slowdown

This article by Jeanna Smialek and Christopher Condon may be of interest to subscribers. Here is a section:

The widely expected decision contained no concrete commitment to the timing of the next rate increase. Even so, investors increased bets on a move in June after absorbing the Fed’s sanguine assessment of the outlook and its encouraging observations on inflation, following data showing first-quarter economic growth of 0.7 percent and monthly price declines in March.

“Nothing in the statement today, which was voted unanimously by the FOMC, leads me to believe that the Fed is even close to changing its mind on rates,” Roberto Perli, a partner at Cornerstone Macro LLC in Washington, wrote in a note to clients. “Base case is for a couple more rate hikes this year -- probably in June and September -- and for the beginning of balance sheet shrinkage in December.”

Eoin Treacy's view -

3-month Treasury bills are beginning to price in a rate hike in June but the rate is still only 86 basis points while the Fed Funds Target rate is 75 to 100 basis points. That highlights just how reluctant bonds traders have been to give credence to the Fed’s estimates of how often and by how much they are willing to raise interest rates. 



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May 03 2017

Commentary by Eoin Treacy

Fed May Finally Be Ready to Change Course

This article by Mohamed A. El-Erian for Bloomberg may be of interest to subscribers. Here is a section:

Nevertheless, this will be an interesting test of the view, which I and some others have espoused, that the Fed is in the process of shifting operating regimes -- from following markets to being more willing to lead them.

Last week’s disappointing reading of 0.7 percent gross domestic product growth for the first quarter, the lowest in three years, added to other data releases (such as retail sales, inflation and autos) suggesting that the U.S. economy -- and consumption in particular -- is going through a softer economic patch. In previous years, this would have provided the Fed with the excuse to soften its policy signals, assuring markets that monetary policies will remain ultra-stimulative and minimizing the risk of financial asset volatility. Indeed, these are the signals that the European Central Bank reiterated last week when its governing council met. And the ECB did so despite official recognition that, in the case of the euro zone, economic conditions have improved and forward downside risk is lower.

The Fed’s inclination to repeat past practices is countered by three considerations.

* An element of the recent data weakness is likely to be both temporary and reversible.

* The Trump administration has reiterated its intention to pursue a large tax cut that, if approved by Congress (a big if), would most likely lead to a considerably wider budget deficit, at least in the short-run until economic growth and budgetary receipts pick up (especially given the lack of large revenue measures).

* Though even harder to quantify, the Fed is not indifferent to the collateral damage and unintended consequences of prolonged reliance on unconventional monetary policies.

Eoin Treacy's view -

I believe the bond market is exhibiting what I term a “boy who cried wolf” mentality. After so many warnings and almost a decade where the Fed’s inflation target was wide of the mark on consecutive years there is no appetite for pricing in rate hikes until they are deemed to be imminent. I agree with El Erian, the flow of stimulative rescue funds has a conditioning effect on those benefitting from them. There is no credible belief that the Greenspan, Bernanke and now Yellen puts will be withdrawn.



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May 02 2017

Commentary by Eoin Treacy

Two Frances Collide in Battle to Shape Europe's Future

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

Tergnier may be Macron’s toughest sell.

The town, with a population of 13,000, used to vote Communist and then Socialist. It turned to the National Front as its sprawling rail freight station — once one of France’s biggest — shed hundreds of jobs. Steelworks, a sugar-manufacturing plant and other firms closed down or moved elsewhere leaving the jobless rate at 15 percent. The national average is 10 percent. Thirty-six percent of voters backed Le Pen last month, among her highest votes in the country.

“Globalization is bad for Tergnier,” said mayor Christian Crohem, 67, who heads a mainly leftist coalition. “We’ve brought more countries into the EU and we’ve allowed businesses to move around, so we’re up against workers from abroad who don’t play by the same rules, it’s unfair competition.”

He tells the story of a 70-year-old woman who came to see him recently because she didn’t have enough money to feed herself. Sitting in his office, she cried with shame as she asked him for a handout to buy food.

“That kind of thing really gets to you,” he says. “People here feel abandoned, and so do we, the officials they elect.”

 

Eoin Treacy's view -

In a country like France, which prides itself on its social infrastructure, this kind of story is all the more troubling. Fiscal austerity over much of the last decade has laid bare the hollowing out of rural and legacy manufacturing centres right across the developed world. We are talking about France right now because the election is on Sunday but this is a broad issue which has contributed to populism in a number of countries and there is little evidence of sincere efforts to curb it. 



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May 01 2017

Commentary by Eoin Treacy

The Global Investment Outlook

Thanks to a subscriber for this report from RBC GAM which may be of interest. Here is a section on bond yields:

The arguments for higher bond yields
The global economy is experiencing a cyclical recovery regardless of the political noise, and its performance should remain the key driver of fixed-income markets over the next 12 months. U.S. data releases have been strong and the employment picture continues to improve, leading many investors to prepare their portfolios for reflation. We believe that Trump’s loosening of financial regulations should re-ignite the animal spirits that went missing after the 2008 financial crisis, creating self-sustaining economic growth. Corporate America will likely invest and hire more, pushing up the cost of capital and inflation. 

Aiding this momentum will be an administration stocked with business-minded department heads and White House advisors. Trump has appointed Steve Mnuchin, a former Goldman Sachs executive, as Treasury secretary and billionaire investor Wilbur Ross to head the Commerce Department. Gary Cohn, the recently departed Goldman Sachs president, is Trump’s top economic counsellor. These appointments help to validate the optimism towards streamlining  regulations and promoting business investment. 

A tight labour market is another source of economic optimism and will foster inflationary pressures as higher wages embolden consumers to spend more. A higher-inflation, faster-growth environment would be a departure from the slow growth mindset that has prevailed since 2012. 

Assuming that the government spending materializes as advertised and stokes economic growth, we would expect yields to be pulled higher by competition for capital between Treasury bonds and businesses and individuals seeking loans. Here’s why: capital must be financed either from abroad and/or with domestic savings, and administration proposals aimed at reducing imports would increase the importance of domestic savings as a source of capital. Domestic private savers as a group tend to demand higher compensation for loans than foreign entities, potentially leading to higher rates as growth quickens. 

 

Eoin Treacy's view -

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

American Airlines offered pay rises of 5% and 8% for cabin crew and pilots last week. That’s well ahead of inflation and is further evidence of a tight labour market fuelling wage demands. 



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April 06 2017

Commentary by Eoin Treacy

The voter apathy that helped Donald Trump win is about to hit France

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

The paralysis has no quick fix. Last night (April 4), in an effort to lift spirits, France’s presidential debate organizers decided to trot out all 11 eligible candidates for the second televised debate, rather than just the top five. The barrage of small candidates on stage left each with “no room to develop an idea,” and voters no time “to exercise their judgment,” one critic (link in French) argued. “Does this really help the undecided to form an opinion?” another asked (link in French).
All the better for France’s far-right wing. Voter turnout in France (80% in 2012) has long upstaged that of neighboring Germany (71%), the UK (66%) and Switzerland (47%). But as that number drops in France’s multi-round system, the odds of a far-right win creep up.

That’s because fervent support for Le Pen in the first round will likely carry over to votes for her in the second. But candidates with more tepid support, including centrist Emmanuel Macron, conservative François Fillon, and socialist Benoît Hamon, may suffer if non-Le Pen voters abstain (paywall) in the second round. Right now, Le Pen and Macron are neck-and-neck in French polls for the first round.

The predicament was similar in 2002, when candidate Jacques Chirac’s famous slogan (link in French) “Vote for the Crook, not the Fascist” helped him secure a landslide victory against Le Pen’s father, Jean-Marie Le Pen, in the second round. This time, voters may have had their fill of crooks and fascists both.

 

Eoin Treacy's view -

Last night my 11-year old asked me what does ennui mean? My French classes from secondary school came roaring back with Mrs. O’Donoghue joking that ennui was roughly translated into boredom but the reaction of the class provided a much better definition than any she could come up with. Here is what Google comes up with “mid 18th century: French, from Latin mihi in odio est ‘it is hateful to me.’ and “a feeling of listlessness and dissatisfaction arising from a lack of occupation or excitement.” Ennui is a problem for entrenched politicians when they face a strident minority willing to vote. 



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April 03 2017

Commentary by Eoin Treacy

Email of the day on Japanese equity index composition

I wonder if you could please analyse why the historic charts of Japan's main equity market are so divergent? 

As you know, the Tokyo market reached its "bubble era" peak in Jan. 1990 at 38,564 but has since recovered to around 19,063. 

The Topix bank index peaked at the same time at 1,480 but is still languishing at a fraction of that level, 182.64 today. 

The Topix 2nd Section index on the other hand is now at an all-time high from its peak of 4,500 reached in 1990 to approaching 6,000. 

Normally the banks are the lead indicator but Japan's banks underwent immense restructuring so I can understand why they have languished but the discrepancy between these charts seems huge.

 

Eoin Treacy's view -

Thank you for this email which raises important points worth covering with regard to Japan’s primary stock market indices. 

The Topix is also known as the Tokyo Stock Price Index. It is a free-float adjusted market capitalization-weighted index and comprised of all 1997 shares in the 1st Section of the Tokyo Stock Exchange. 

Here is where some of the idiosyncrasies of the system begin. The 1st Section is supposed to comprise all of the large companies and the 2nd Section holds whatever is left. However, at least 80 of the 567 companies in the 2nd Section have larger market caps than the smallest company in the Topix which highlights the fact that the weightings are not actively managed.

 



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March 30 2017

Commentary by Eoin Treacy

Euro-Pound Hedging Costs Rise on Brexit Trigger, French Election

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

The premium on one-month options over the rate of actual market swings remains near a 10-week high set on Tuesday. It may increase further should Brexit-related negativity be less than feared in the near term, which would reduce realized volatility, and also as the implied rate should rise on capturing the second round of the French elections due May 7.

Realized volatility could find support as the euro-pound pair’s prospects look increasingly bearish on charts, with current market positioning significantly skewed toward sterling declines. Leveraged net short positions in the pound this month are at the highest level since November.

Not all investors have given up on the pound, with the British economy performing better than expected. BlackRock Inc., which reduced some of its exposure to sterling ahead of the triggering of Article 50, has said it is still marginally long as an expected slowdown of the U.K. hasn’t materialized.

With the latest reports suggesting that the European Central Bank isn’t anywhere close to reducing economic stimulus, a short-squeeze on the pound could materialize.

 

Eoin Treacy's view -

Now that Article 50 of the Nice Treaty has been triggered there are at least three big questions outstanding with regard to the Pound and the Euro. 

How willing is the Bank of England to run hot on inflation with the economy at full employment and economic growth continuing to surprise on the upside? 1-year notes yields pulled back today suggesting investors are less inclined to think an interest rate hike is anywhere on the horizon. 

 



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March 28 2017

Commentary by Eoin Treacy

Six Impossible Things Before Breakfast

Thanks to a subscriber for this report by James Montier for GMO which may be of interest. Here is a section:

It appears that asset markets are priced as if secular stagnation were a certainty. Certainty is a particularly dangerous assumption when it comes to investing. As Voltaire stated, “Doubt is not a pleasant condition, but certainty is absurd.”

In order to believe that asset market pricing makes sense, I think you need to hold any number of “impossible” (by which I mean at best improbable, and at worst truly impossible) things to be true. This is certainly a different sort of experience from the bubble manias that Ben mentioned in the opening quotation, which are parsimoniously captured by Jeremy’s definition of bubbles – “excellent fundamentals, irrationally extrapolated.” This isn’t a mania in that sense. We aren’t seeing the insane behaviour that we saw during episodes like the Japanese land and equity bubble of the late 1980s, or the TMT bubble of the late 90s, at least not at the micro level. However, investors shouldn’t forget that the S&P 500 currently stands at a Shiller P/E of just over 28x – the third highest in history (see Exhibit 17).

The only two times that level was surpassed occurred in 1929 and in the run-up to the TMT bubble. Strangely enough, we aren’t hearing many exhortations to buy equities because it is just like 1929 or 1999. Today’s “believers” are more “sophisticated” than the “simple-minded maniacs” who drove some of the other well-known bubbles of history. But it would be foolish to conflate sophistication with correctness. Current arguments as to why this time is different are cloaked in the economics of secular stagnation and standard finance work horses like the equity risk premium model. Whilst these may lend a veneer of respectability to those dangerous words, taking arguments at face value without considering the evidence seems to me, at least, to be a common link with previous bubbles.  

 

Eoin Treacy's view -

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

I find myself agreeing with a great deal of what James Montier is arguing. I believe that it does not make sense to take a secular trend which is obviously at a highly developed stage and extrapolate it into infinity. That is just not how markets work. Yet that is exactly what we see in the bond markets. 



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March 27 2017

Commentary by Eoin Treacy

Citigroup Canary in the Coal Mine

Thanks to a subscriber for this article by Christopher Whalen for theinstitutionalriskanalyst.com which may be of interest. Here is a section:

Citi’s equally large credit card book – in nominal terms the most profitable part of the business – has a gross spread of almost 1,100bp, but also reported over 300bp in defaults in 2016.  Still, with a 800bp net margin before SG&A, credit cards are Citi’s best business.  Indeed, Citi’s payment processing and credit card business are the crown jewels of the franchise.  If there were some way to sell the rest of the Citi operations, the payments processing and credit card business could be worth a multiple of Citi’s current equity market valuation. 

The trouble with Citi and many other US banks is that their business are dominated by consumer credit and real estate exposures, with little in the way of pure C&I loans.  When you look at most US banks, the vast majority of the exposures are related to real estate, directly or indirectly.  Thus when the Fed manipulates asset prices in a desperate effort to fuel economic growth, they create future credit problems for banks.  As our friend Alex Pollock of R Street Institute wrote in American Banker last year:

“[T]he biggest banking change during the last 60 years is… the dramatic shift to real estate finance and thus real estate risk, as the dominant factor in the balance sheet of the entire banking system. It is the evolution of the banking system from being principally business banks to being principally real estate banks.”

So whether a bank calls the exposure C&I or commercial real estate, at the end of the day most of the loans on the books of US banks have a large degree of correlation to the US real estate market.  And thanks to Janet Yellen and the folks at the FOMC, the US market is now poised for a substantial credit correction as inflated prices for commercial real estate and related C&I exposures come back into alignment with the underlying economics of the properties.  Net charge offs for the $1.9 trillion in C&I loans held by all US banks reached 0.5% at the end of 2016, the highest rate since 2012.

 

Eoin Treacy's view -

Commercial real estate has been directly influenced by the extraordinary monetary policies employed by the Fed and other central banks. I don’t think it is an exaggeration to conclude that rising rents have been a contributing factor in the migration of businesses online and the denuding of the high street and malls of active businesses. 



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March 24 2017

Commentary by Eoin Treacy

Email of the day on lengthy bond market top formations

We may not be done with the bull market in bonds, or at least a very extended period of ranging if this article has merit. It is publicly available so ok to post. Would appreciate your comments 

Eoin Treacy's view -

Thank you for this article which may be of interest to subscribers. I too think of the declining velocity of money as a headwind to inflationary pressures getting out of control. However this image of what they consider low interest rates, as below 4.5% is an average level over the last century rather than what might be considered low. 



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February 24 2017

Commentary by Eoin Treacy

Italexit is not a solution for Italy's problems

Thanks to a subscriber for this article by Lorenzo Codogno and Giampaolo Galli which may be of interest. Here is a section from the conclusion:

The euro is irrevocable. It was designed as Hotel California: “you can check out any time you like, but you can never leave!” However, we know that it would be wrong to take it for granted. Italexit could still happen as the unwilling and messy result of an unbearable deterioration in public finances and economic performance, combined with misguided political will and financial market turmoil. It would be a huge mistake. Much better, and less costly, would be to address the underlying problems, allowing Italy to survive and thrive within the euro by enhancing potential growth and economic resilience. 

It would be wrong to conclude that Italexit, or exit from the monetary union by any other Member State, is going to be an easy process that can be evaluated with a straight cost-benefit analysis and smoothly managed in an orderly way. While Roger Bootle, one of the advocates of the return to national currencies, came to somewhat different conclusions, he acknowledged that the exit merely being the reverse of the construction process does not make it easy: “it would be the equivalent of unscrambling an omelette”.

In the case of Italexit, redenomination and default would become very likely and would cause a number of side effects and negative spillovers into the economy. Exit without redenomination would lead the debt-to-GDP ratio to reach 190%, assuming 30% devaluation, making default even more likely. Hence, Italexit would not address the issues its proponents claim it would address, while producing significant financial instability. Just mentioning it as a viable solution as part of a political platform would imply risks of making it a self-fulfilling prophecy. The economic, social, and political consequences would be enormous and last for a number of years.

Eoin Treacy's view -

Links to the full reports are posted in the Subscriber's Area.

It has been my view for some time that the sustainability of the Eurozone is predicated on the assumption previously sovereign populations will accept any set of policies imposed by the European Commission. 

The Eurozone’s sovereign debt crisis arose because private sector loans made by banks in ‘creditor’ countries were at risk of being defaulted upon which would have caused a financial catastrophe for their home nations. The solution was to insist private sector debts be absorbed by the governments of the countries in which they were taken, with the result that sovereign debt-to-GDP ratios exploded. Massive fiscal austerity was imposed on the populations of peripheral countries which contributed to lower standards of living and deflation. 

 



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February 22 2017

Commentary by Eoin Treacy

Deviations From Covered Interest Rate Parity

I found this report by Wenxin Du, Alexander Tepper and Adrien Verdelhan for the National  Bureau of Economic Research to be fascinating and commend it to subscribers. Here is a section:

In this paper, we examine the persistent and systematic failures of the CIP condition in the post crisis period. After formally establishing CIP arbitrage opportunities based on repo rates and KfW bonds, we argue that these arbitrage opportunities can be rationalized by the interaction between costly financial intermediation and international imbalances in funding supply and investment demand across currencies. Consistent with this two-factor hypothesis, we report four empirical characteristics of the CIP deviations. First, CIP deviations increase at the quarter ends post crisis, especially for contracts that appear in banks’ balance sheets. Second, proxies for the banks’ balance sheet costs account for two-thirds of the CIP deviations. Third, CIP deviations co-move with other near-risk-free fixed income spreads. Fourth, CIP deviations are highly correlated with nominal interest rates in the cross section and time series.

Looking beyond our paper, we expect a large literature to investigate further the CIP deviations. The deviations occur in one of the largest and most liquid markets in the world after the crisis in the absence of financial distress, suggesting that other arbitrage opportunities exist elsewhere. While trading in exchange rate derivatives is a zero-sum game, the CIP deviations may have large welfare implications because of the implied deadweight cost borne by firms seeking to hedge their cash flows. Furthermore, the existence of CIP deviation introduces wedges between the interest rates in the cash and swap markets, which affects the external transmission of monetary policy. The welfare cost of the CIP deviation is behind the scope of this paper; it would necessitate a general equilibrium model. Yet, even without such model, the CIP condition is a clean laboratory to test the impact of financial frictions in a very general framework. In this spirit, we present the first international evidence on the causal impact of recent banking regulation on asset prices. We expect more research in this direction in the future.

 

Eoin Treacy's view -

A link to the full report is posted in the Subscriber's Area. When aberrations appear in what is by definition a zero-sum game it is certainly a topic worthy of further study. This is a subject likely to be of particular interest to large institutional traders where a move of 10s of basis points can be multiplied by weight of money and leverage. 



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February 09 2017

Commentary by Eoin Treacy

Markets on the cusp ...?

Thanks to a subscriber for this report by James W. Paulsen for Wells Fargo may be of interest to subscribers. Here is a section

Trends matter, for among other reasons, because they impact the impressions, expectations and actions of policy officials, investors, consumers and businesses. For this reason, we think investors should be aware of just how many financial market trends are on the cusp this year threatening to breach significant milestones.

Undoubtedly, not all of the trends we highlighted will actually break new ground this year and perhaps none will reach levels that draw much investor focus. However, in 2017, the following list of financial market trends are worth monitoring because they are “on the cusp”…

1. Evidence of inflation is broadening and inflation expectations embedded in the 10-year Treasury TIP bond is only about 0.5% below the highest level in at least 20 years.

2. Three major themes are on the cusp in the U.S. stock market. First, is the recent breach of a two-year old trading range in the S&P 500 Index to a new recovery high possibly suggesting a third leg in this bull market? Second, the relative total return performance of conservative investments is nearing its lowest level of the entire recovery. And finally, the relative performance of small cap stocks is within 10% of rising to a new all-time record high relative to large cap stocks.

3. Bond investors face several important trends on the cusp including the potential end of a 30-year bond bull, a flatter Treasury yield curve and investment grade yield spreads about to reach new narrows for the recovery.

4. The U.S. dollar is in a two-year old trading range which, with a break, will settle whether this is just a pause in an ongoing dollar bull market or the start of a fresh dollar bear market.

5. In the commodity markets, crude oil is on the cusp of breaking out of a two-year old trading range above $60 and industrial commodity prices are within 10% of rising to a new six-year high.

So far, this year has been dominated by political news and what it means for future economic and regulatory policies. Perhaps, however, in a year with so much on the cusp, investor mindsets will eventually become more impacted by financial market trends breaking outside old recovery trading ranges? 

 

Eoin Treacy's view -

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

I find the choice of words “on the cusp” to be very interesting because it represents a point of view which is outside. It suggests an investor is out of the market and potentially on the cusp of investing again. 

Perhaps that’s not overly surprising. The main stock market indices spent almost two years ranging and endured some scary pullbacks during that time. Bonds have sold off aggressively in the last few months which would have prompted at least some investors to raise cash. Commodities prices are rallying of off very depressed levels but with since they are already a year into an advance there are logical questions being asked by those on the side lines centring on whether they are already too late.

 



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February 03 2017

Commentary by Eoin Treacy

January 27 2017

Commentary by Eoin Treacy

France's Neighbors Sound Alarm Over Election 'Catastrophe' Risk

This article by Esteban Duarte  and Patrick Donahue for Bloomberg contains a useful calendar of political events for 2017 and may be of interest to subscribers. Here is a section:

Polls suggest that National Front leader Marine Le Pen will make it to France’s run-off vote on May 7, giving her a shot at claiming the presidency on anti-euro, EU-skeptic ticket. She shared a stage last weekend with Frauke Petry of Alternative for Germany and Geert Wilders, whose anti-Islam platform has helped propel his Freedom Party to within reach of winning the March 15 Dutch election.

Europe’s anti-establishment forces are drawing inspiration from Donald Trump’s surprise elevation to the U.S. presidency and unexpected victory of Brexit supporters in last year’s referendum. Another common strand is an anti-immigration stance that has flourished during the worst refugee crisis since World War II, with more than one million people fleeing war and oppression in Syria, Afghanistan and elsewhere having sought asylum in Germany alone.

Gabriel, who is poised to become German foreign minister in a cabinet reshuffle allied to the Sept. 24 election, pointed to France’s two-round ballot as the key moment that will shape Europe’s destiny. While no recent poll has shown Le Pen coming close to winning the second round, Brexit and Trump’s victory have made political analysts and investors reluctant to rule anything out.

“If Europe’s enemies, after Brexit last year, manage once again in France or in the Netherlands to be successful, then the threat to us is the collapse of the greatest civilization project of the 20th century, the European Union,” Gabriel said in a speech to lower-house lawmakers in Berlin on Thursday.

 

Eoin Treacy's view -

No one has much faith in polls anymore because people lie about their intentions and those that respond to polls are often not representative of the swing voters that shape results. Lurches to the right in the UK and USA represent dissatisfaction with the status quo. France’s generous social programs have helped nullify populist uprisings until now, but an unemployment rate stuck at 10.2% and youth unemployment of 24% are intransigent problems that the current political apparatus does not appear to have a solution for.



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January 26 2017

Commentary by Eoin Treacy

Italexit Risk Low, Debt Re-Profiling Better Option: Mediobanca

This note by By Francesca Cinelli summarises a report issued by Mediobanca earlier this week discussing the economic implications of Italy exiting the Euro. I’ve read the original report but we are precluded from posting it on the site.

Time costs money for Italy, due to collective action clauses (CACs) and thus, purely on financial grounds, it reduces Italexit risk and makes any voluntary debt re-profiling a better option to eventually sustain its borrowings, Mediobanca says in note.

Highlights no growth undermines debt sustainability; Sentix Index, which estimates the one-year probability of Italy leaving the monetary union based on the assessment of investors, signals stress

Says redenomination in any Eurozone country is a function of the freedom allowed on bonds issued under domestic law and the constraints of the recently introduced EU discipline on
CACs 

Quantifies cost of re-denomination, says four variables suggest EU280b loss, partly offset by EU191b gain from the Lex Monetae on bonds under domestic law

Compares CACs and non CACs pairs of Italian govies displaying similar features in order to test Mediobanca’s “time costs money” finding; that means as time goes by the
financial incentive for redenomination declines

Data suggest 30bps yield premium on 3.5yr non CACs bonds actually drops to 10bps on 12yrs

Says “Quanto” spread captures the “convertibility risk” implied in the premium between USD- and EUR-denominated CDSs

Data suggest that at end 2016 for the first time Italy’s “Quanto” exceeded Spain’s, confirming Italy crucial role for eurozone future given a 90% correlation the brokerage notes between Italexit probability and a euro break-up probability

Eoin Treacy's view -

I think most people would agree that if Italy quits the Euro the currency will be unable to function as a cohesive unit. Italy would use the opportunity of devaluation to flood the Eurozone with cheap goods which would encourage other countries to follow its lead. That’s not news and the EU is fully aware of the implications of a large country like Italy leaving the currency union. 



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January 25 2017

Commentary by Eoin Treacy

Fed Debate Over $4.5 Trillion Balance Sheet Looms in 2017

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

The dollar is a particular source of worry for U.S. policy makers, having appreciated 23 percent since mid-2014. The Fed expects to keep tightening while central banks in Japan and Europe hold steady or consider more accommodation. That could further strengthen the greenback and introduce a headwind for U.S. growth.

“Slowing down the economy a little bit at the long end of the market has some benefits if you think primarily that exchange rates are driven by short-term interest rates,” Rosengren said. “You might want some of the removal of accommodation to come at the long end, which would be done by the balance sheet.”

The Boston Fed released research on Jan. 19 that backs up this view of exchange rates and the yield curve. Former Fed economist Roberto Perli was more skeptical, pointing to global demand for longer-term U.S. Treasuries.

“If long U.S. rates were to increase significantly as a result of balance sheet shrinking, there would still be large inflows into U.S. assets, which would support the dollar,” said Perli, a partner at Washington consulting firm Cornerstone Macro LLC.

 

Eoin Treacy's view -

The Fed’s balance sheet at $4.46 trillion represents a potent source of supply for a bond market that shows increasing signs of topping out. As long as the balance sheet was increasing it was hard to argue with the rationale for pursuing the bullish momentum trade in Treasuries. However with interest rates now rising and the Fed no longer adding to its inventory of bonds a major source of fresh demand has been removed from the market.



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January 20 2017

Commentary by Eoin Treacy

The Tech Bubble Year 5+

This very well-illustrated presentation by Anand Sanwal from CBInsights for the benefit of attendees at the CanTech Conference in Toronto may be of interest to subscribers. 

Eoin Treacy's view -

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

The pace of technological innovation is graphically illustrated in this report. What becomes very clear is how start-ups view the all-in-one businesses of companies like Starwood, Proctor & Gamble and the car manufacturers and pharmaceutical companies as ripe for disruption. They could be right and there is certainly a great deal of venture capital money willing to make that bet. However we should not expect established companies to go down without a fight.



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January 19 2017

Commentary by Eoin Treacy

Bond Guru Who Called Last Bear Market 40 Years Ago Says Go Long

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

Money velocity isn’t a bullet-proof economic indicator. Financial innovation, and the rise of shadow banking, have made it hard to measure exactly how much money is floating around in the financial system. And some would say that "money" itself is going through an identity crisis these days.

Hunt isn’t the only one seeing the record-low pace as an ominous sign. The fact that money velocity declined rapidly during years of near-zero interest rates may signal aggressive monetary easing actually led to deflation instead of inflation, economists at the St. Louis Fed wrote back in 2014.

"In this regard, the unconventional monetary policy has reinforced the recession by stimulating the private sector’s money demand through pursuing an excessively low interest rate policy," economists Yi Wen and Maria A. Arias wrote.

"I know I’m the minority here,” Hunt said. “I’m just trying to see the world as I think it should be seen.”

 

Eoin Treacy's view -

I have long argued that the disintermediation associated with the internet and technological innovation is a major contributor in the decline in the velocity of money. The downtrend in the data from 1997 offers a graphic representation of the deflationary influence of technology. It also helps to explain why the surge in the quantity of money associated with quantitative easing has not resulted in high inflation. 



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January 18 2017

Commentary by Eoin Treacy

Behind China's Bond Selloff, a Risky Twist on the Repo Trade

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

As much as 12 trillion yuan ($1.73 trillion) in bonds—or 19% of the country’s $9 trillion bond market—could be subject to such repurchase agreements, according to an estimate by Shui Ruqing, president of bond clearing-house China Central Depository & Clearing Co., cited last month in China’s influential Caixin Magazine. Traders say the deals are so opaque that even estimates are hard to make.

Banks sometimes use the “dai chi” agreements to move risky assets temporarily off their books during earnings periods or audits, the people said. Brokers like Sealand typically use them to borrow quickly and flexibly—leveraging their investments many times over, they said.
Until last year, Chinese financial regulators had largely ignored the practice, beyond saying they opposed it during a bond-market crackdown in 2013. But the informal nature of dai chi also meant the trades could be difficult to enforce when conditions worsened.

“Because it’s not really an official business, agreements aren’t legally binding,” said the executive who had bought bonds from Sealand.

Sealand’s problems became apparent on Dec. 15, when the southern China-based company announced that two of its traders had forged dai chi agreements worth 16.5 billion yuan ($2.4 billion), a move that market participants interpreted as meaning the broker didn’t intend to honor the deals.

The amount was more than five times what Sealand had declared in its Sept. 30 financials as its financial assets under official repurchase agreements, and more than seven times its disclosed bond-holdings.

 

Eoin Treacy's view -

China has developed extraordinarily quickly from a closed backwater into a massive financially significant hub. While the pace of development has been blistering the evolution of regulatory standards of governance has been much more moderate. The single party system where cronyism, nepotism and the modern equivalent of simony combine to ensure just about anything is permissible, provided your social standing is within the correct circle, and only exacerbates the situation.  



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January 16 2017

Commentary by Eoin Treacy

Email of the day on the secular bull market in bonds

Enjoy watching the video presentations. Thought you may be interested in the following interview of Gary Shilling

Eoin Treacy's view -

Thank you for you kind words and this interesting interview which may be of interest to subscribers. 

Gary Shilling’s view that technological innovation is inherently deflationary is very much in tune with our view. The increasing commercial applications of biotechnology, automation, artificial intelligence, the internet and mobile technology are all likely to enhance productivity and could very well represent a deflationary influence. On the other hand, the increasing calls for free money (universal social payments) lower taxes, more spending and deregulation have the capacity to stoke inflation.

 



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January 12 2017

Commentary by Eoin Treacy

Latest memo from Howard Marks: Expert Opinion

Thanks to a subscriber for a link to this letter which may be of interest. Here is a section:

I’ll end this section by sharing my latest epiphany on the macro.  I realized recently that in my early decades in the investment business, change came so slowly that people tended to think of the environment as a fixed context in which cycles played out regularly and dependably.  But starting about twenty years ago – keyed primarily by the acceleration in technological innovation – things began to change so rapidly that the fixed-backdrop view may no longer be applicable.

Now forces like technological developments, disruption, demographic change, political instability and media trends give rise to an ever-changing environment, as well as to cycles that no longer necessarily resemble those of the past.  That makes the job of those who dare to predict the macro more challenging than ever.

Eoin Treacy's view -

The Velocity of M2 has been declining since 1997. A housing bubble, sovereign debt crisis and bubble, commodity bull market and crash and massive monetary largesse have done nothing to stall the decline.

This argument from the St. Louis Fed in 2014 blames the refusal of consumers to spend as the primary culprit and suggests ultra-low interest rates are at least partially to blame. Here is a section:

And why then would people suddenly decide to hoard money instead of spend it? A possible answer lies in the combination of two issues:

A glooming economy after the financial crisis

The dramatic decrease in interest rates that has forced investors to readjust their portfolios toward liquid money and away from interest-bearing assets such as government bonds

In this regard, the unconventional monetary policy has reinforced the recession by stimulating the private sector’s money demand through pursuing an excessively low interest rate policy (i.e., the zero-interest rate policy).



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January 06 2017

Commentary by Eoin Treacy

U.S. Payrolls Rise 156,000 as Wages Increase Most Since 2009

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

The employment report added to data ranging from housing to manufacturing and auto sales in suggesting that President-elect Donald Trump is inheriting a strong economy from the Obama administration. The labor market momentum is likely to be sustained amid rising business and consumer confidence.

Trump, who takes over from President Barack Obama on Jan. 20, has pledged to increase spending on the country's aging infrastructure, cut taxes and relax regulations. These measures are expected to boost growth this year.

But the proposed expansionary fiscal policy stance could increase the budget deficit. That, together with faster economic growth and a labor market that is expected to hit full employment this year could raise concerns about the Fed falling behind the curve on interest rate increases.

 

Eoin Treacy's view -

The US Hourly Earnings chart was updated today and it broke out. If people are demanding more money for the same work, it is hard to argue inflation is not picking up. Even though rents have increase, insurance premiums are higher and education has been outpacing wage growth for years these figures do not move the needle in how the Fed measures inflation the way wages do. 



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January 05 2017

Commentary by Eoin Treacy

Treasuries Soar Most Since Post-Brexit as Market Volatility Hits

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

Treasuries extended gains across the curve, driving down benchmark yields by the most since the days after the June Brexit vote, as traders across financial markets backed away from crowded bets.

The benchmark 10-year U.S. yield plunged about eight basis points to 2.36 percent at 12:15 p.m. in New York, touching the lowest level since Dec. 8, according to Bloomberg Bond Trader data. It’s on pace for the biggest decline since June 27. The 10-year break-even rate, a market measure of inflation expectations, fell from close to the highest level since 2014.

Across financial markets, trends snapped Thursday as investors weighed the risk of a lackluster payrolls report Friday and the prospect that trades based on Donald Trump’s impending presidency had gone too far. Data from the ADP Research Institute on Thursday indicated companies added fewer jobs in December than forecast. The figures come a day before the Labor Department releases its monthly payrolls report. 

“A bunch of the widely predicted trades for this year are all being broken at the same time, with oil going lower, investment-grade corporates widening out, TIPS break-evens tightening, and then rates rallying as a result,” said Mike Lorizio, a Boston-based senior trader at Manulife Asset Management, which oversees about $343 billion. “Some key levels being broken just inspired further buying.”  

 

Eoin Treacy's view -

The odds are in favour of the view that the 35-year bull market in bonds is over, however it would be a mistake to think that such a lengthy expansion will end overnight. Inflationary expectations might well be justified in the medium-term but they have run ahead of the market and Treasury yields in the region of 2.5% are competitive with many equities and therefore desirable by bond investors conditioned over generations to buy the dip. 



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January 04 2017

Commentary by Eoin Treacy

The Ugly Unethical Underside of Silicon Valley

This article by Erin Griffith for Fortune may be of interest to subscribers. Here is a section:

No industry is immune to fraud, and the hotter the business, the more hucksters flock to it. But Silicon Valley has always seen itself as the virtuous outlier, a place where altruistic nerds tolerate capitalism in order to make the world a better place. Suddenly the Valley looks as crooked and greedy as the rest of the business world. And the growing roster of scandal-tainted startups share a theme. Faking it, from marketing exaggerations to outright fraud, feels more prevalent than ever—so much so that it’s time to ask whether startup culture itself is becoming a problem.

Fraud is not new in tech, of course. Longtime investors remember when MiniScribe shipped actual bricks inside its hard-disk boxes in an inventory accounting scam in the 1980s. The ’90s and early aughts brought WorldCom, Enron, and the dot-bombs. But today more money is sloshing around ($73 billion in venture capital invested in U.S. startups in 2016, compared with $45 billion at the peak of the dotcom boom, according to PitchBook), there’s less transparency as companies stay private longer (174 private companies are each worth $1 billion or more), and there’s an endless supply of legal gray areas to exploit as technology invades every sector, from fintech and med-tech to auto-tech and ed-tech.

The drama has some investors predicting more disasters. “What if Theranos is the canary in the coal mine?” says Roger McNamee, a 40-year VC veteran and managing director at Elevation Partners. “Everyone is looking at Theranos as an outlier. We may discover it’s not an outlier at all.” That would be bad news, because without trust, the tech industry’s intertwined ecosystem of money, products, and people can’t function. Investors may find the full version of the old proverb is more accurate: “One bad apple spoils the whole barrel.”

 

Eoin Treacy's view -

Fraud isn’t generally identified immediately because it takes time for such contrivances to be discovered. The impetus for investigation doesn’t generally arise until someone goes looking for the money that was invested, when the expected return does not materialise. It took the credit crisis to reveal problems with Madoff’s Ponzi scheme, yet it had functioned unperturbed by regulators for years before that event. The above article does an excellent job of identifying the frauds which have occurred in Silicon Valley as well as the culture that promotes exaggeration.



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December 21 2016

Commentary by Eoin Treacy

Italy lawmakers approve 20 billion euro plan to prop up banks

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

If Monte dei Paschi's capital plan fails, Prime Minister Paolo Gentiloni's new government is likely to meet this week to issue an emergency decree to inject capital into it.

But that could prove to be politically explosive given that investors are required to bear losses under EU bailout rules.

Parliamentary approval for the 20 billion euro government plan was needed to allow the state to take on new debt. Italy's debt burden, at about 133 percent of annual output, is already the second highest in the euro zone after Greece.

The measure approved by parliament on Wednesday says the state can borrow money to provide "an adequate level of liquidity into the banking system" and can reinforce a lender's capital by "underwriting new shares".

The failure of Monte dei Paschi, the world's oldest bank, would threaten the savings of thousands of Italians and could undermine confidence in the country's wider banking sector, saddled with a third of the euro zone's total bad loans.

Before the vote, Economy Minister Pier Carlo Padoan vowed to shield retail bank investors from losses.

"The impact on savers, if a (government) intervention should take place, will be absolutely minimised or non-existent," Padoan told parliament.

Italy Senate also approves government request to lift debt to help banks
Monte dei Paschi said it expected its net liquidity position, now at 10.6 billion euros, to turn negative after four months.

 

Eoin Treacy's view -

A bailout of Italy’s banking sector highlights clearly that the EU has one set of rules for small countries but is willing to set them aside in the cause of realpolitik to ensure the sustainability of the currency regime. 

A rationalisation I have heard promulgated is that the bail-in imposed on the people of Cyprus was nothing more than a refusal to bailout Russian billionaires and that Italy represents an altogether different case. That of course ignores the very real pain and suffering of savers who had their assets confiscated simply because they were unlucky enough to live in Cyprus. 

 



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December 20 2016

Commentary by Eoin Treacy

The Emerging Markets Hat Trick: Time to Throw Your Hat In?

This article by Rob Arnott and Brandon Kunz for Research Affiliates may be of interest to subscribers. Here Is a section:

A common link between EM equities and EM local debt is the currency exposure. Based on our relative purchasing power parity (PPP) model, EM currencies tumbled from 25% above fair value in 2011 to 30% below fair value in January of this year. Even after this year’s rebound they remain about 19% cheap to the US dollar. If EM currencies’ relative valuations strengthen just halfway back to historical norms, such a move would translate into a near 1.0% tailwind to yearly returns over the next decade.

Although EM currencies, represented by the JPMorgan Emerging Local Markets Index Plus, have rebounded since January 2016, they continue to trade near the discounts associated with the 1997 “Asian Contagion” and 1998 Russian debt default. EM currencies can certainly get cheaper before they revert toward historical norms, but they might just as easily snap back quickly to fair value. Our relative PPP reversion expectations with high EM cash rates, a faster growing working-age population, and continued productivity growth as EM economies “borrow” technological advances from developed economies, all support our projected real return for EM currencies of 3.9% a year over the next decade.

 

Eoin Treacy's view -

The strength of the US Dollar represents a major shift in the status quo for many emerging markets, but most especially commodity exporters and comes at a time when budgets were already constrained by a multi-year bear market in commodity prices. US denominated debt has obvious risks for companies lacking substantial Dollar denominated income sources and that is likely to remain a headwind. The other side of the coin is that local currency debt is increasingly attractive for the same companies but the cost of that debt will likely rise. 



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December 15 2016

Commentary by Eoin Treacy

The worst of both worlds

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

Australia’ economy shrunk by 0.5% in 3Q16. Typically in such a situation a cut in official interest rates can ease the pain. While the RBA may choose to lower interest rates, its impact on customers’ borrowing costs may be limited. In fact mortgage rates could rise again soon.

Why? The RBA only controls the cost of borrowing overnight. The longer the term of the bond, the more the market sets its yield. As the marginal investor in the A$ bond market is from overseas what happens in the global market place drives our longer term bond yields.

Just as Australian home loan borrowers could do with some relief interest rates are edging up. The reason is Australian banks raise insufficient deposits to fund their loan book. The balance of funds comes from the bond market. Should the cost of borrowing for our “AA” rated banks rise further customers will likely get more hikes on their mortgage rates.

A concern Spectrum has is if the U.S continues to grow at near its current 3% run rate both U.S and Australian bond yields could rise further. Borrowing while rates were falling was easy 

Since the 1980’s Australian households have piled on the debt. Much of this has gone into residential real estate. The continuous fall in interest rates and rising property prices created a re-affirming inducement to borrow more. Today, Australian households have world beating debt levels. This makes parts of the sector hyper-sensitive to rate rises. Should the cost of borrowing rise notably from here wide-spread financial stress within Australian households looks set to follow.

 

Eoin Treacy's view -

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

Australian 10-year bond yields last traded above the trend mean in 2013 when rates were 2.5% or 100 basis points above today’s level. The yield is closing in on the 3% level more in sympathy with US Treasuries than any particular hike in Australian inflation expectations. 



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December 12 2016

Commentary by Eoin Treacy

China Warns Trump Against Using Taiwan for Leverage on Trade

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

China warned Donald Trump against using the One-China policy regarding Taiwan as a bargaining chip in trade talks, a swift response that indicates Beijing is losing patience with the U.S. president-elect as he breaks with decades of diplomatic protocol.

“Adherence to the One-China policy is the political bedrock for the development of the China-U.S. relationship,” Foreign Ministry spokesman Geng Shuang told reporters in Beijing at a regular briefing on Monday. “If it is compromised or disrupted, the sound and steady growth of the China-U.S. relationship as well as bilateral cooperation in major fields would be out of the question.”

Trump said in an interview broadcast on Sunday that his support for the policy --- which has underpinned U.S. behavior toward Taiwan since the 1970s -- will hinge on cutting a better deal on trade. He has repeated his accusations against China since election day, telling a crowd in Iowa last week that China would soon have to “play by the rules.”

Policy makers in Beijing initially had a more subdued response after Trump departed from diplomatic convention earlier this month and spoke by phone with Taiwan’s president. Now things are getting more serious: The official Xinhua News Agency warned that world peace hinges on close and friendly ties between the U.S. and China.

“For China, there is no balancing of trade and Taiwan,” said Wang Tao, head of China economic research at UBS AG in Hong Kong. “Taiwan is considered the utmost core interest of China, not for bargaining.”

 

Eoin Treacy's view -

China has been flexing its military muscle in the South China Sea for the last few years to the alarm of its neighbours but with very little push back from the rest of the world. Additionally it has been steadily increasing what it is spending on arms, with the total soaring from $123 billion in 2010 to an expected $233 in 2020. 



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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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