Sober Look

The fundamentals behind strong HY fund flows

2012-01-27T18:34:00.000-05:00

Following up on the post about HY fund flows, the amount of new cash hitting the system has not only been unusually high, but also consistent on a daily basis. As the chart below shows, we only saw one day of net outflows.

Source: EPFR

Here is the year-to-date cumulative net inflow ($7.4 bn YTD.)

Source: EPFR

It is clear that zero rates is one reason for these inflows, but what about fundamentals of the HY market? Are they really that attractive? Three items driving fundamentals are worth mentioning:

1. Defaults continue to stay near record lows and spreads seem interesting on a relative basis.

Source: JPMorgan

2. Leverage on in HY corporations in the US remains stable.

Source: JPMorgan

3. US corporations' liquidity, even at leveraged companies, has been rising steadily in the last few months (hat tip Royal Arse)

Source: JPMorgan

But even with these strong fundamentals, the speed of inflows we are seeing is unlikely to be sustained for long. The trend is somewhat troubling because a good portion of these flows is coming from retail investors. Some of the more leveraged names, particularly in the CCC range are still quite vulnerable to global economic shocks. Given the recent rally (the US JPM HY Index is up 2.8% YTD), the overall sector could sell off sharply with a sudden surprise out of Europe.

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The Fed extended start of tightening by 3 months, not 18

2012-01-27T13:51:00.000-05:00

It looks like some in the media are now using the appropriate language with respect to the Fed's latest action. Reuters, who tends to be fairly accurate in their reporting, described the extended low rate environment as being "probable" instead of "certain".

Reuters: The statement by the Fed, which announced on Wednesday it would probably keep interest rates near zero until at least late 2014 - some 18 months later than the Fed had suggested last year.

Given that we are working with probabilities instead of certainties, how did this event change the the timing of expected rate hikes? After all the general perception (as per Reuters quote above) is that the rate hike has been extended by 18 months.

The best markets to provide visibility into the Fed's future policy are the Chicago Board of Trade Fed Funds Futures contracts. The chart below compares the implied Fed Funds rates prior to the Fed's announcement as well as now.

Fed Funds rate implied by the Chicago Board of Trade Fed Funds Futures (Bloomberg)

The curve has definitely shifted further out, but not by 18 months as is generally believed. The shift is actually only about three months. The current curve is implying the first rate hike to be in the early part of 2014. So for those who are planning on zero rates throughout 2014 and into 2015, pay attention to the market - it may tell you otherwise.

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Restoring confidence in the Eurozone's sovereign credit markets

2012-01-27T11:07:00.000-05:00

Portuguese bonds continue to sell off as the market focuses on Portugal becoming the next Greece. Portuguese spreads have completely decoupled from the rest of the Eurozone periphery.

Portugal vs. Italy 5y spread to Germany

But Portugal is not trading down in a vacuum - the valuation of the nation's bonds is tied to the outcome of the Greek restructuring process. The markets are not only reacting to Portugal's insolvency but also to the market structure uncertainty. The sovereign credit markets in Europe are broken and two key events must take place to restore confidence.

1. The ISDA Committee must do the right thing and trigger the Greek CDS (call this a "credit event"). Even without the Collective Action Clause on Greek bonds, this is a default and should be treated as such. The impact on the market may actually be positive because it will mend (at least in part) the broken sovereign CDS market. This has implications for Portugal as investors will once again view sovereign CDS as potent protection against default (similarly to stock put option holders having the ability to exercise their puts). At least in some cases, holders of Portuguese bonds may choose not to dump their holdings because of the availability of a reliable CDS market (which now trades at 39 points upfront). Just as important is the fact that banks who are lenders to Portuguese corporations will have a reasonably liquid hedge for their assets. Since there is little CDS traded on Portuguese corporate bonds, a reliable sovereign market could be a good proxy.

2. The ECB must take the same haircut on Greek bond holdings as the private bond investors. It's bad enough that the market views sovereign bond holders as being subordinated to the IMF, the EFSF, and in the future to the ESM. Now also being subordinated to the ECB makes the sovereign bond market look completely rigged. A BNP Paribas research note put it quite eloquently:

BNP Paribas: The ECB has no legal right to be treated as apreferential creditor. Others who bought Greekdebt at the time, or who held onto debt theyalready held, should have been appraised of theECB’s preferential treatment. The ECB’sstanding should have been made clear in law.Not to have done so in advance is not onlyunfair, but it also distorted the markets. If theECB knew in advance that it would be treatedmore favourably than the private sector sellers itbought its bonds from, then it acted unfairly andabused an asymmetric information advantage;

Yes, Germany and others in the Eurozone will be upset because the ECB's loss in Greek debt will wipe out more than a year's worth of earnings and may require an injection of public funds. But the ECB must take a loss in order to assure investors that private holdings are pari passu with the ECB's positions. Otherwise investors will be constantly worried about the amount of ECB's holdings to determine the size of the ECB's "senior tranche" vs. their "junior tranche". The same bonds having two seniority levels depending on who holds them is not a viable market. Not only will this further impair existing Portuguese bonds, but will make it impossible for Portugal and Greece to return to the markets even after they restructure.

The Eurozone must take other steps as well to restore confidence in the sovereign credit markets, but these two actions are critical not just for Portugal but for the rest of the euro area periphery.

SoberLook.com

The chase for yield is on

2012-01-26T17:56:00.002-05:00

The US high yield (HY) market is starting to look somewhat frothy. We've had over $7 billion of fund inflows this month with $2.5 billion this week alone. Of the $2.5bn, roughly $1.5bn went into HY mutual funds and $1bn into HY ETFs. That compares to about half a billion into mortgage-backed bond funds and $700mm into muni funds (according to EPFR Global). With the Fed on hold for a while, investors are chasing yield.

For HYG (HY ETF) for example, the growth in the number of shares has been unprecedented, and the ETF again now trades at a 2% premium.

HYG Shares Outstanding (Bloomberg)

One can also see rising risk appetite in the HY primary market as well. Some new issues that hit the market are quite risky. For example Realogy, a company that nobody would look at a month ago, comfortably sold new bonds.

LCD News: Realogy's return to market was met with strong demand, with both tranches of secured notes pricing tight to talk, and the paper is volatile this morning in post-break trading. The 9% intermediate-lien notes due 2020, for instance, are pegged at 100/100.25 in the Street, against a break around 101 and trades earlier this morning at 100.375, according to sources. Pricing was at par.

Realogy's 7.625% notes due 2020 also priced at par, and this morning's markets are generally at 100.5/101, sources said. Meanwhile, the previously outstanding 11.5% exchange notes due 2017 are trading at 95.75 this morning, versus 95 yesterday but 90 before the new issue hit the market, trade data show.

The company is highly leveraged and is extremely vulnerable to economic shocks. (For those interested in learning more about Realogy's "distressed" past, read this excellent post).

Spreads are still above last summer's lows and the fundamentals are strong, but we could easily see a pullback in this market.

SoberLook.com

Cap-and-Trade is dead, even in California

2012-01-26T14:28:00.001-05:00

With the collapse of the CCX carbon credit trading, the only viable market based program for carbon emissions reduction has been developed at a state level in California. In conjunction with Cap and Trade, California implemented a law called California’s Low Carbon Fuel Standard (LCFS). Recently however Judge Lawrence O’Neill issued an injunction to stop LCFS from proceeding as planned.

The sticking point seems to be the discriminatory nature of the program against power generated outside the state that is viewed as hampering interstate commerce. This is why such programs are difficult to implement at the state level vs. nationally.

Judge O’Neill: "California is attempting to stop leakage of GHG emissions by treating electricity generated outside of the state differently than electricity generated inside its border. This discriminates against interstate commerce.”

Legal experts now believe that this injunction will also derail California's Cap and Trade program.

Marten Law: With respect to electricity, the cap-and-trade program imposes requirements on emissions of fossil fuel-based generation in California, requiring an allowance to be submitted for each ton of regulated GHG emissions in California. In order to avoid leakage of emissions to other states, California has imposed an allowance requirement on imported electricity representing the emissions of GHGs imputed to such electricity.

California Air Resources Board who sponsored these initiatives will appeal the LCFS injunction, but for now the whole program has been put on hold.

SoberLook.com

With Hollande in the lead, France may be making a shift to the left

2012-01-26T12:00:00.000-05:00

With a dimming employment picture in France, chances of a potential regime change in that nation have increased substantially. Sarkozy, should he decide to run again, will be opposed (among other candidates) by the Socialist candidate, François Hollande, who was chosen by his party in the October primaries.

Based on Intrade probabilities, Hollande now has an over 65% chance of winning the presidential election this spring (although trading volumes have been quite low.)

Probability of Hollande winning the 2012 presidency

The opinion polls on the most likely scenario of Hollande vs. Sarkozy (in the second round of voting) paint a similar picture.

Source: BNP Paribas

WSJ: The poll, carried out by CSA Jan. 23-24, showed that 31% of potential voters would chose Hollande if elections were held now, while 25% of them would pick Sarkozy, CSA said. Hollande gained two percentage points, while Sarkozy lost one point since the last comparable poll held by CSA Jan. 9-10.

Other candidates such as a centrist Francois Bayrou could change the political landscape (it's not a two-party system like the US.) Also the far-right candidate Marine Le Pen, who would push for France's exit from the Eurozone, has gained some ground. But for now it looks like Hollande is ahead. This is a significant development for the financial markets in France and may have implications for the Erozone as a whole.

Bloomberg: “We must make an effort for more fairness and to rein in the financial industry,” Hollande said today as he detailed his campaign platform in Paris. “We will separate the speculative sector from the credit sector.”

Hollande will clearly push for new French laws that would be similar to Vicker's recommendations in the UK. Other financial regulation such as prohibiting stock options could be considered as well .

Reuters: "In the battle ahead, my main adversary has no name, no face and no party. He will never run as a candidate. He will never be elected, but he rules inspire of all that. My adversary is the world of finance," Hollande said to a standing ovation in a packed conference hall on the northern outskirts of Paris.

Hollande would be the first Socialist president since Francois Mitterrand. Mitterrand too was not very fond of financial services:

Reuters: Mitterrand, who ruled France for 14 years, won power in 1981 a decade after he became Socialist Party leader with a similar tirade against what he then called the "power of finance, finance that corrupts, finances that buys, flattens and ruins, finance that rots through to the very conscience of man."

This election is particularly important given the pressure on Eurozone banks, the new Eurozone treaty and subsequent implementation of the ESM. Such change of leadership in France may even shift the balance of power in the Eurozone and potentially challenge the current state of Franco-German relations. In particular Hollande may pressure the Germans to have the ECB embark on quantitative easing involving direct purchases of sovereign bonds. This in what Hollande calls tackling "speculation efficiently". Because to a true Socialist any negative market reaction is just another form of speculation.

Bloomberg: “I know how much you hold dear the rules on the independence” of the ECB, Hollande told delegates at the German socialists’ annual convention. “But equally I want it to take more notice of the situation in the world of the real economy.” The ECB must use its powers “fully” to combat the crisis, “expanding its role as a credit source to tackle speculation efficiently,”

SoberLook.com

The squeeze on dollar funding in the Eurozone continues

2012-01-26T09:19:00.000-05:00

The latest data on US money market funds is continuing to show reduction in holdings of Eurozone banks' commercial paper (CP). Again, money funds do not sell their CP, they just let it mature without rolling into new paper from the same banks. Instead money market funds are buying Australian, Canadian, Japanese, and some UK bank paper (in addition to their holdings of US CP).

Non US holdings by US money market funds (Source: Fitch)

These Eurozone banks in turn are replacing their dollar funding with dollar loans from the ECB via the Fed's liquidity swap.

Fed Liquidity Swap

The impact of this transition will be a substantial reduction of dollar assets and even whole dollar businesses at European institutions. US corporations, real estate firms, US energy projects (where some European banks used to be active), etc. should not expect to see substantial new lending from Eurozone banks going forward. Dollar lending business will now be dominated by US banks who have easy access to dollar funding.

SoberLook.com

Deteriorating employment situation in France

2012-01-25T18:38:00.000-05:00

The headline number for French unemployment rate has been fairly steady in the past couple of years - between 9.5 and 10% (Bloomberg). The unemployment rate numbers however don't show the number of job seekers in France, which has been on the rise and recently reached the highest level ever. This index tends to be more of a leading indicator for the overall employment conditions in the country.

Number of job seekers in France (broad category). Source: Barclays Capital

Just as a background, category A represents the unemployed (registered with job centers), B represents part-time workers (under 78 hours per month), and C are people working over 78 hours a month.

The latest numbers show a significant jump in job seekers, currently at 17% above the long-term average.

ShareNet: UNEDIC said it expected the number of people out of work to rise by 214,500 by the end of 2012, taking the headline unemployment figure to 3.07 million from 2.86 million at end-2011, which was the highest level since April 1999.

This employment picture in France is a clear sign of deteriorating economic conditions in the Eurozone as a whole. It is particularly alarming to see this not just in the periphery but also at the core.

SoberLook.com

Fed's low rate statement is not a pledge

2012-01-25T15:32:00.002-05:00

There is no shortage these days of mainstream media misinterpreting current financial and economic events. The Fed's action today in fact created just such a misunderstanding.

Forbes: Wednesday’s Fed pledge to keep rates low for even longer helped perk up a stagnant market. About forty minutes after the statement and just over an hour to the Bernanke presser, the Dow Jones industrial average was up 36 ...

In fact there is no "pledge" from the Fed, and Bernanke made that point quite clear in his news conference. This is what was actually in the Fed's statement:

Fed Statement: ...the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

The FOMC survey indicates that the Committee members on average think that rates will stay low in 2014 because of slow economic growth. But the members are somewhat divided on that view as the scatter plot below shows. This is the Fed's forecast, which provides guidance for rates going forward and not any sort of commitment or a "pledge".

Target Federal Funds Rate at Year-End- FOMC survey (source: the Fed)

Here are the averages of the FOMC projections based on the scatter plot above.

Source: Capital Economics

There is no indication from this forecast that the Fed is absolutely committed to keep the target rate at 0-25bp through 2014.

SoberLook.com

Der Spiegel hypes hedge funds' role in Greek restructuring - and gets the Hype Award

2012-01-25T13:05:00.000-05:00

Mainstream media has been hyping up the hedge funds' role in the Greek restructuring process. The evil speculators are at it again, "holding out" on the voluntary exchange for new bonds. The argument goes that hedge funds bought bonds at a deep discounts and also bought the CDS protection. If there is a disorderly default or an involuntary restructuring, these funds would lose money on their bonds but more than make up for it on the CDS. Der Spiegel argues that these speculators are getting "free money" in this transaction.

Der Spiegel (Stefan Kaiser): Things look different for the hedge funds if an agreement breaks down. In this case, the threat of insolvency exists. The chance that the bondholders would get their money back would dramatically decrease. The bonds would have less value than before, and would no longer be worth €30 million, but say just €10 million. And the CDS guarantees would be due. The hedge funds would, depending on the arrangement of the CDS, receive up to 100 percent of the bonds' nominal value, or €100 million. Under this scenario, the hedge fund that invested €60 million would get €110 in return - a profit of almost 100 percent.

But let's check Der Spiegel's math. Evil Capital Hedge Fund buys a Greek bond at €30 (per Der Spiegel's comment) and a CDS protection that would cost them say €70. According to Der Spiegel the bond ends up worth €10 after the Greek default. The CDS will pay out par less the recovery amount or €100 - €10 = €90. So the trade makes them €20 on the CDS (from €70 to €90) and the bond loses them €20. Evil Capital is net flat on the trade, not up " almost 100 percent".

Some may argue that the shorter maturity CDS is cheaper than €70, closer to €60. But shorter term bonds are actually more expensive, closer to €40 (the 3/12 maturity bond is around €38). So the same math applies and Evil Capital still barely breaks even on the trade. Amazing. No free lunch here - the market is a bit more efficient than Der Spiegel gives it credit for. And Evil Capital may not be that smart after all.

Nevertheless hedge funds are still derailing the negotiations according Der Spiegel and the Greek Government won't stand for it.

Der Spiegel (Stefan Kaiser): The Greek government, though, has threatened not to tolerate such freeloaders. If an agreement is reached with 80 percent of the bond holders, they want to force the remaining 20 percent to take part in the haircut. In that case, the existing bonds would later be so-called "Collective Action Clauses." The hedge funds could still cash in because in this case the debt repayment would not be voluntary, and it would be considered a payment default, making the CDS also come due, and the gamblers would profit.

But wait a minute here. What other bond holders may be holding out? The answer is that the other big holdout may in fact turn out be the ECB. With the support of the German government, the ECB does not want to participate in the voluntary exchange.

Bloomberg: While the ECB faces pressure to join private-sector investors in accepting losses on Greek debt, the central bank sees any participation as risking damaging confidence in the institution, two people familiar with the Governing Council’s stance said. The debt was acquired for monetary policy purposes and the ECB is firmly opposed to any restructuring, they said on condition of anonymity because the matter is confidential.

Therefore not only there is no free lunch in the Greek CDS-bond trade, but the holdouts may actually be dominated by the ECB, not hedge funds. For their focus on sensationalism rather than unbiased journalism, Der Spiegel and Stefan Kaiser get the Sober Look Hype Award. Congratulations.

And by the way, this Der Spiegel story opens with the following photo. Read the caption.

NYSE business "strained" by the Greece negotiations? And we wonder why the public is confused about financial markets.

SoberLook.com

The story of two risk indices

2012-01-25T10:49:00.000-05:00

The latest reading from the Credit Suisse Risk Appetite Index shows that we are now out of the "panic mode". In fact the index is back to the pre-crisis (of 2011) levels.

CS Risk Appetite Index (Source: Credit Suisse)

One way to check the validity of being back to July-2011 levels of risk appetite is to compare the CS index to another indicator. Let's take a look at the Fisher-Gartman Risk Index, developed to allow investors to participate in the "risk on" trade.

Fisher-Gartman Risk Index (Source: Dow Jones)

This index has not recovered nearly as much as the CS one. According to Fisher-Gartman we are at the highs of the Nov-2011 levels. How can one explain such a difference in risk indicators?

We know that the CS index is calculated from bond and equity prices including emerging markets. On the other hand the Fisher-Gartman index has a substantial commodity and currency exposure.

Fisher-Gartman Risk Index Components (source: Dow Jones) - click on chart to expand

This next chart compares the CRB Commodity Index with the S&P500. Equities have outperformed commodities by over 10% since the beginning of last year.

CRB Commodity Index vs the S&P500 (Bloomberg)

Similarly one could compare a basket of currencies as represented by the Deutsche Bank US Dollar Short Futures Index with the equity index. The equity outperformance vs. currencies isn't as pronounced as it is for commodities, but it is still close to 5% over the same period.

Deutsche Bank US Dollar Short Futures Index vs. S&P500 (Bloomberg)

We now have the explanation for the CS Risk Appetite Index pulling significantly ahead of the Fisher-Gartman Risk Index. The difference is driven by the underperformance of currencies and in particular commodities that are not present in the CS index. The question of whether we have pulled out of the "crisis mode" therefore depends on which markets one believes better represent the global risk appetite.

SoberLook.com

The "robo-signing" settlement's impact on the mortgage market

2012-01-24T16:24:00.000-05:00

Tonight is the State of the Union Address and rumors are circulating that Obama will announce the robo-signing settlement with the big banks. The number thrown around is about $25 billion. The idea is to use these funds to help troubled homeowners avoid default via refinancing and/or principal forgiveness.

To see what this means in the context of the overall mortgage market, let's perform an oversimplified calculation. Let's take someone who is currently paying 5.5% on her 30-year mortgage. Refinancing at current rates and paying 2 points as well as full fees would mean that within 3 years of refinancing the borrower will recover the fees and start saving. That basically implies that anyone with a mortgage rate materially above 5.5% should be refinancing if they can. Again for simplicity, let's take the full universe of FNMA 30-yr Fixed securities and look at the mortgage characteristics of the underlying pools of loans. The chart below shows the amount of loans outstanding vs. the average mortgage coupon (WAC) in the pools.

Again this is oversimplified, but the borrowers in the red portion of the chart (higher than our 5.5% example above) should be all refinancing as quickly as possible. The question is, are they refinancing? The next chart shows the prepayment (refinancing) speed (PSA) over the past month vs. the average coupon.

The chart demonstrates that these homeowners are indeed refinancing but at a lower speed than the onses with a smaller coupon. One would think the trend should be reversed - the higher the coupon the quicker people would want to refinance. But that's not the case. In fact fewer high coupon borrowers are able to refinance because those who could, already did. The remaining homeowners are either really slow or just can't refinance because they have "negative equity" (mortgage principal higher than the value of their homes.).

Much of the refinancing is coming from the lower coupon borrowers, those with newer mortgages (since such low mortgage rates are a recent phenomena.) The folks on the red part of the chart represent over half a trillion dollars in mortgages. And it doesn't mean that everyone with a 5.5% coupon can refinance either. This exercise just represents the FNMA conforming 30-year mortgages, which is only a part of the overall mortgage universe.

This simplistic calculation tells us just how ineffective the $25bn settlement would be. In fact only about 100,000 borrowers who could be helped with these funds because only some of the funds would go to the homeowners. However there are some 11 million borrowers with negative equity and need help.

So why bother, given this is such a drop in the bucket? The answer is there may be a couple of potentially positive outcomes, though both are low probability events at this stage.

1. This settlement and the subsequent support for those few homeowners will give the government some idea of how effective partial principal forgiveness and lower rates are in reducing default rates and cutting overall losses for lenders/investors. Currently this subject is debated. These statistics may pave the way for a much bigger government sponsored refinancing package (although it is not at all clear whether the taxpayer should be supporting such action).

2. The deal may accelerate the foreclosure process that has been put on hold by banks because of the "robo-signing" legal proceedings. Timely foreclosures are key to stabilizing the housing market because they move assets from weaker holders to stronger ones. A couple of million homes in foreclosure could come to the market quicker, reducing the overhang. This may delay the market recovery in terms of prices, but the recovery would be healthier when it does take place.

Many uncertainties in this deal still remain, such as numerous states deciding not to participate in the settlement. States may want to pursue their own litigation that could tie the banks up in court for a long time. And that would delay foreclosures and make banks even less willing to provide new loans.

Either way, don't forget to tune in at 9 pm EST tonight and listen for the words "robo-signing".

SoberLook.com

Portugal in markets' crosshairs

2012-01-24T09:04:00.001-05:00

Portugal remains vulnerable, with the bond market looking increasingly pressured this week.

WSJ: The cost of insuring Portugal's debt against default was at record highs Tuesday and its bond yields remained at elevated levels amid concerns that a possible second bailout for the country in 2013 would include a Greek-model haircut for private-sector bondholders.

Worries have mounted among experts that Portugal won't be able to return to markets for funding next year, forcing it to request a second bailout package

Even though the WSJ keeps discussing Portugal sovereign CDS, the real focus should be on the bonds, since in the wake of Greece sovereign CDS market is becoming dysfunctional. Portuguese 5-year bond spread to Germany is near the highs.

Portugal 5-year spread to Germany (Bloomberg)

It is important to track the 5-year more than the 10-year point because in a stressed credits the bigger yield/spread moves tend to happen in the shorter end of the curve. Portugal's yield curve is inverted - a typical behavior for distressed bonds. Note that the move in the "belly" of the curve has been more pronounced than the 10-year move.

Portugal inverted yield curve now and on 1/13/12 (Bloomberg)

Once Greece is "sorted out", Portugal will come into market's focus even more. The notion that they can return to markets for funding in 2013 seems increasingly unlikely. Therefore a high probability of a Greek-style mess for Portugal will be pressuring European markets going forward.

SoberLook.com

Tired of hearing about the ECB Deposit Facility? Here is some good news.

2012-01-23T23:37:00.001-05:00

A chart from Barclays Capital just may limit media coverage of the ECB Deposit Facility. The badly needed chart (below) shows Barcap's projections for what's called the "liquidity surplus" in the euro-system.

Euro-system Liquidity Surplus (source: Barcap)

The "liquidity surplus" represents the Deposit Facility balances plus banks' excess reserves. Excess reserves are the banks' current accounts (reserve accounts) at the ECB less the required reserves. That amount fluctuates as banks "front load" their accounts to make sure the period average exceeds the required reserve amount.

Source: ECB

The excess reserves could be either positive or negative depending on where one is in the cycle. Therefore according to Barcap's chart, the Deposit Facility should be quite stable going forward except for the excess reserve cyclicality. Since the liquidity surplus is driven by the amount borrowed from the ECB (not banks hoarding cash), Barcap's forecast must assume that the net lending to banks by the ECB has stabilized. With the 3-year LTRO significantly extending the average maturity, banks are not expected to repay their loans for a while. This will keep the net Deposit Facility balances reasonably stable, declining slightly over time.

And that is good news for those who don't want to hear about this facility any more. Since the facility is not expected to change for a while, it should result in the mainstream media staying away from covering the topic. It's just not going to be sensational enough going forward.

SoberLook.com

EIA's latest energy projections for the US

2012-01-23T17:31:00.000-05:00

The EIA today released their abridged version of the 2012 Annual Energy Outlook. Here are three key highlights.

1. Net US consumption of "liquid fossil fuels" in the US is expected to stay almost unchanged through 2035. The domestic supply however is expected to grow, reducing the gap currently filled by imports from 49% in 2010 to 36% in 2035.

Source: EIA

This is not significantly different from their earlier forecasts.

2. The picture for natural gas however gets interesting. This post in early December pointed out the risks to the downside of Natural gas. As the weather stayed warm, that is in fact what happened. Today we finally saw a reversal (an 8% pop) to what has been a relentless decline in price. EIA's forecast shows continuing growth in natural gas production in the US driven by shale gas.

Source: EIA

The outcome of this growth in gas production has to involve significant US exports. As the chart below shows (hat tip Greg Merrill), liquifying natural gas and exporting it will allow companies to capture a massive spread differential.

EIA: The United States is projected to become a net exporter of liquefied natural gas (LNG) in 2016, a net pipeline exporter in 2025, and an overall net exporter of natural gas in 2021. The outlook reflects increased use of LNG in markets outside of North America, strong domestic natural gas production, reduced pipeline imports and increased pipeline exports, and relatively low natural gas prices in the United States compared to other global markets.

3. One surprising projection in the report is the continuing reliance on coal for power, given the vast amounts of cheap natural gas. Natural gas usage to generate power is expected to increase by only 3%. The chart below shows projected sources of electricity generation in the US, with coal usage dropping from 45% to 39%. The US should be able to have a bigger reduction, given the nasty effects of coal generated smog.

Source: EIA

Growth in renewables is expected to increase from 10% to 16%, still likely driven more by tax incentives rather than economics.

Enjoy!
2012 EIA projections

SoberLook.com

Two data points on US housing

2012-01-23T14:58:00.002-05:00

Two recent data points add support to our thesis of the US housing market bottoming this year. The first one is from the National Association of Home Builders (NAHB). NAHB publishes an index that represents builder perception of the market conditions. Here is how they determine the index,

Derived from a monthly survey that NAHB has been conducting for more than 20 years, the NAHB/Wells Fargo Housing Market Index gauges builder perceptions of current single-family home sales and sales expectations for the next six months as 'good,' 'fair' or 'poor.' The survey also asks builders to rate traffic of prospective buyers as 'high to very high,' 'average' or 'low to very low.' Scores from each component are then used to calculate a seasonally adjusted index where any number over 50 indicates that more builders view conditions as good than poor.

The recent moves in the index certainly have not reversed the loss of the "happy days" for builders since 2006, but it has been rising.

NAHB Index (Bloomberg)

This is what NAHB had to say when the latest number was released last week:

NAHB: “Builders are seeing greater interest among potential buyers as employment and consumer confidence slowly improve in a growing number of markets, and this has helped to move the confidence gauge up from near-historic lows in the first half of 2011,” noted NAHB Chief Economist David Crowe. “That said, caution remains the word of the day as many builders continue to voice concerns about potential clients being unable to qualify for an affordable mortgage, appraisals coming through below construction cost, and the continuing flow of foreclosed properties hitting the market.”

There is no question that lack of financing and a large distressed inventory continue to weigh on the market. Builders are in fact still quite cautions, but they don't see the situation as dire as they did just a few months back. And low levels of new construction will cap the housing inventory growth, helping markets recover.

The second data point is the convergence of the median cost of rent (monthly payments) with the median mortgage payments (monthly principal and interest).

Source: Capital Economics

We are now at the levels where for some people it may make sense to purchase a house, possibly as an investment in a rental property. Even at distressed prices, these transactions transfer assets from weaker holders to stronger ones, providing longer term support to the market.

SoberLook.com

Interpreting the divergence of HY spreads and VIX

2012-01-23T12:48:00.001-05:00

The following chart shows the average high yield bond spread (as measured by the JPMorgan HY index) vs. VIX. The divergence seems to indicate that credit is cheap (wide) relative to implied vols.

HY Index spread (STW) vs. VIX

But if the HY market really caught up to VIX, what would these bonds look like? The answer is that with the 5-year treasuries yielding 0.92%, HY bonds would have an absolute yield of about 6.3% (540bp +92bp). Even in this low rate environment investors may have a tough time buying non-investment grade bonds at 6.3% yield. In fact 6.7% has been the floor on absolute yield in the HY market historically, no matter what the spread was. The yield touched this "floor" level in the low rates environment / boom period of 2005 and again in the first half of 2011 during the euphoria of QE2.

Absolute yield (YTW) for the JPM HY Index (Bloomberg)

Therefore as spreads continue to tighten, investors will start looking more at absolute yields on HY bonds, potentially putting a floor on these yield levels. And until treasury yields rise substantially, we may be finding a floor on HY spreads as well.

As far as VIX is concerned, the recent drop definitely looks overdone relative to other risk indicators. This suggests that if the deviation between HY spreads and VIX begins to recede, the next leg of the convergence will be more from rising VIX levels than significant tightening in spreads.

SoberLook.com

Google Insights for Search and the contagion effect

2012-01-22T23:31:00.000-05:00

Google Insights for Search allows one to track the frequency of searches for a particular word or phrase in the Google search engine. This gives one an indication of public's interest in a specific subject matter over time. Results for the phrase "euro crisis" are shown below. Note that the peak of search volume was in early December.

Google Insights for Search interest in phrase "euro crisis" - relative index

If one looks at the Italian 5-year yields for example as a comparison, the shapes are similar but the yields on Italian debt peaked a little earlier.

Italy 5-year yield

A natural assumption would be that the general public using Google reacts to global events on a delayed basis. But let's take a closer look at who is actually doing the searching. Insights for Search produces the following distribution of users.

Google Insights for Search relative interest in phrase "euro crisis" by country

Of the top five countries Ireland, Netherlands, and the UK searching for the phrase "euro crisis" makes sense - particularly given this is an English phrase (the Dutch are quite proficient in English). But Singapore and India concerned with the Eurozone crisis more than the US for example? What exactly was going on in those countries in December to make them want to learn more about the situation in Europe? The simplest way to assess this is to look at the two nations' stock markets.

SGF - Singapore CEF

SENSEX - India

It turns out these countries' stock markets dropped to their lows in December, coinciding with the higher frequency of searches for "euro crisis". The market correction also took place in other Asian nations but they would be less likely than India and Singapore to search for an English phrase. That means the public in these countries was viewing this sell-off as a contagion effect driven by the Eurozone crisis.

The US on the other hand was number nine on the list because the US stock market was not as impacted by the same events - a lower contagion effect. Here are some possible conclusions that can be drawn from this exercise:

Google Insights for Search can be a useful indicator to track global public's interest in financial events.
It allows one to drill down to see exactly who is doing the searching in order to understand why there is interest in a specific phrase.
The most intriguing possibility is that this tool - particularly the rankings by country - may be used to track levels of contagion, as the public links events in their region (the stock market sell-off in Asia) to another global event (the crisis in Europe.)

SoberLook.com

The latest actions in the Eurozone's "war"

2012-01-22T15:56:00.001-05:00

The Eurozone bureaucrats and the ECB are trying to use an economic equivalent of the Powell Doctrine in fighting the crisis. Finally they are starting to realize the need for employing all available resources that are politically viable in the current environment. Here are some of the latest monetary and fiscal actions:

The ECB lowered bank reserve requirements from 2% to 1%. That’s a release of EUR 100bn into the banking system, which we should see showing up in the ECB Deposit Facility.

Draghi is gearing up for LTRO-II. The demand is expected to be high, though the amount is still capped by the availability of eligible collateral. The ECB will have to make exceptions for some banks on the types of collateral the central bank can accept. Many banks will simply shift some of what they currently have on the overnight basis with the ECB into the new LTRO.

The combination of the ESM and the EFSF will be set at EUR 500bn capacity for now. Some member states such as Slovakia are uneasy about taking it higher at this stage. However the Board of Governors of the ESM will have the ability to increase it if needed as part of the new Eurozone treaty. Depending on how the crisis progresses however, the EUR 500bn may not be enough. There has been some talk of the IMF increasing its lending capabilities to supplement the ESM. For now that’s off the table because the US, who has a veto power at the IMF, will not agree to an additional Eurozone exposure. And of course the issue of subordination will be on bond investors' minds as the ESM structure is finalized.

The latest draft of the Eurozone treaty will call for funds from member states in five annual installments of EUR 80mm in order to capitalize the ESM. As soon as the ESM gets to 90% of the target size, it will be made operational.
Only the member states that have started modifying their constitutions to comply with the new treaty will be eligible for any ESM support. The treaty effectively holds a gun to the heads of the periphery states, forcing them to begin the push toward balanced budgets. Countries who have not complied with the treaty budget modification requirements will not only be shut out of the ESM, but will also be brought before the European Court of Justice. The latest draft of the Eurozone treaty will make this process almost automatic. Repeat violators will have to pay a substantial penalty directly to the ESM. The idea is to diminish any ability of the periphery politicians to derail unpopular austerity measures.

The Eurozone treaty will become law once 12 out of 17 member states ratify it, ushering in a massive deleveraging process of the periphery states. It is gearing up to be an extended process with some potential casualties, made particularly treacherous by the onset of a Eurozone-wide recession.

SoberLook.com

Gingrich victory gives Obama an edge

2012-01-22T10:22:00.001-05:00

Newt Gingrich's victory in South Carolina GOP presidential primary demonstrated once again that the Republican party is uneasy with Mitt Romney. This trend has pushed Romney's nomination chances down sharply.

Mitt Romney chances of GOP nomination

But with all the noise around the Gingrich victory that CNN calls "a new ballgame", another trend is emerging. Obama's chances of getting reelected have jumped on the news.

Barack Obama's chances of reelection

The market is sensing the divisions within GOP and the difficulties Gingrich would face taking on Obama. After all whether or not one agrees with all the baggage Gingrich brings to the table, the media and campaign managers will have a field day with this nonsense. All of which is clearly giving Democrats an edge.

SoberLook.com

Treasury yields likely to rise in 2012

2012-01-21T20:02:00.000-05:00

This week we finally saw a sell-off in longer term treasuries after a relentless rally. With a great deal of new supply hitting the market, US treasuries will be under further pressure going forward. Here are six reasons that make higher yields more likely in 2012:

1. In 2010 the onset of QE2 pushed treasury yields lower (within a month of the Jackson Hole announcement the 5yr yield was lower by 16bp). As discussed earlier however, the probability of a quantitative easing redux has declined markedly.

2. Operation Twist which has been providing support to longer term treasuries is expected to end this summer.

3. Many managers who were short or under-invested in treasuries (such as PIMCO) have capitulated, as treasuries continued a powerful rally in 2011. Investors have been trying to short US treasuries for some time with the view that QE programs will ultimately debase the dollar and accelerate inflation. These projections did not materialize and the capitulation trade caused treasuries to rally further. The chart below shows shares outstanding of the ProShares Treasuries 20+ Year UltraShort ETF (ticker: TBT). It allows investors to easily short longer dated treasuries on a leveraged basis. The capitulation trade is clearly visible in the decline of the number of shares outstanding.

TBT shares outstanding (Bloomberg)

The Long Bond became known in some trading circles as the "widow maker" because of the losses numerous traders endured trying to short it. Many have since said "no more!" Now with fewer shorts in the market, there will be less support for treasury prices going forward.

4. Treasury yields have decoupled from "risk assets" such as equities. This is unlikely to be sustainable going forward.

5. Between the Fed's Liquidity Swap and the numerous actions by the ECB, the funding pressures in the eurozone have receded materially. Yet treasuries have not adjusted accordingly. The chart below compares 10-year treasury yield with the 3-month EUR/USD basis swap rate.

10-year treasury yield vs. EUR/USD 3m basis swap spread (Bloomberg)

6. Even though foreign private investors continue their love affair with treasuries, it seems that foreign central banks may be losing their appetite for US government debt. Treasuries holdings at the Fed by foreign central banks are showing declines.

Foreign banks' holdings of US treasuries at the Fed (Bloomberg)

There is no shortage of new supply, as the US Treasury is expected to hit the market with net new issuance of about $81bn/month excluding what the Fed is expected to purchase (see Businessweek - forecast by Credit Suisse). Clearly an unexpected shock in Europe could trigger a new rally in this market, but absent such an extreme event, longer term treasury yields should rise in 2012.

SoberLook.com

The Volcker Rule would not have prevented bank failures

2012-01-21T12:27:00.000-05:00

Further confirmation of risks to liquidity posed by the Volcker Rule came a couple of days ago in the Congressional testimony by the Securities Industry and Financial Markets Association (SIFMA).

The impact of the regulations will have broad implications. The ability ofcorporate issuers to raise capital in the U.S. by selling their debt securities is dependenton the availability of secondary market liquidity, which is largely provided by bankingentities through their market making activities. We are convinced that the proposalwill significantly reduce the liquidity of the secondary market for debt securities and islikely to have a profound and unintended adverse effect on our capital markets. TheU.S. economy will be forced to bear both short-term and long-term costs associatedwith the reduction in market liquidity that will result from an overly restrictiveinterpretation of the Volcker Rule.

It is still unclear what the regulators are trying to accomplish with the Volcker Rule. The only two large US bank holding companies* that failed in 2008 were Citibank and Wachovia. In structuring CDOs these firms sold the lower rated CDO tranches (that had "attractive" yields) to investors. But in order to create these tranches, the banks had to also create massive amounts of "AAA" (providing "leverage" for the lower tranches to boost the yield). Since the "AAA" tranches had low yields, it was difficult to place them, so the banks retained many of these bonds. But rather than putting them on their balance sheet, they employed off balance sheet CP conduits and used the asset backed commercial paper (ABCP) markets to fund these positions. This was known as the "regulatory capital arbitrage" - a concept US politicians still fail to grasp. The failure of the ABCP market in 2007 forced these banks to take the "AAA" tranches onto their balance sheets which ultimately led to their failure. But all of these activities were meant to facilitate the CDO business and had nothing to do with "proprietary trading". Therefore the Volcker Rule in its current form would not have prevented bank holding company failures.

SIFMA Testimony on Volcker Rule

* Note that WAMU failed because it was overextended on its mortgage loan portfolio (unrelated to prop trading), Lehman and Bear were not banks and failed because they could not roll their repo financing, and AIG was effectively an unregulated insurance firm, not a bank.

SoberLook.com

Forecasting China's GDP growth - and getting it wrong every time

2012-01-20T17:49:00.001-05:00

The chart from Credit Suisse shows just how consistently economists have been underestimating China's GDP growth in their forecasts. A significant slowdown has been in the forecast almost every year.

Source: CS - click on the chart to zoom

This is not surprising given that China's double digit growth is simply not sustainable.

Yuhan Zhang: Over-reliance on investment and exports makes China’s economy very unbalanced, vulnerable, and unsustainable. Prolonged investment on a massive scale creates significant overcapacity in a range of sectors such as steel and solar heating, which diminishes productivity improvements. Additionally, huge investment including the 4 trillion renminbi stimulus plan leads to increasing debt. Much of the medium- and long-term bank lending for infrastructure flows to local quasi-government agencies. At the end of 2009, local debt incurred by China’s investment reached to 6 trillion renminbi and now stands at 10.7 trillion or even more...

However each year economists tend to miss the impact of central planning that isn't present in other economies. Assuming it has inflation under control, the government can quickly turn on tremendous amounts of stimulus not available to other nations. Clearly as Zhang points out (above) this type of growth is unhealthy and even dangerous. But in order for the Communist Party to stay in power, it has to deliver strong growth and will stop at nothing to accomplish that goal.

SoberLook.com

More myths around Greek CDS trigger risk

2012-01-20T12:17:00.001-05:00

Significant misperceptions around Greek CDS triggers continue to persist.

WSJ: Since CDS function like insurance for debt, sellers of the protection pay buyers when a qualifying credit event, such as a default, occurs.

Again, CDS is not like insurance because it's an actively traded mark-to-market instrument.

WSJ: Hanging in the balance is the reputation of CDS as an instrument for hedgers and speculators--a $32.4 trillion market as of June last year; the value that may be assigned to sovereign debt, and $2.9 trillion of sovereign CDS, if the protection isn't seen as reliable in eliciting payouts; as well as the impact a messy Greek default could have on the global banking system.

It is true that the legitimacy of sovereign CDS settlement has been called into question because of the ability of governments to influence the "event of default" and conflicts of interest around the ISDA Committee. However the impact on the "global banking system" of Greek CDS triggering is minimal because banks who wrote protection have already marked these positions to market (as required by the US GAAP and IFRS).

By not triggering CDS, some have argued, the evil "speculators" who bought protection to bet against Greece will be punished because they will not get paid. And that supposedly would discourage others from "betting" against periphery sovereigns going forward. This is another misnomer because these so called speculators already made their money - they don't need to wait for the CDS settlement or maturity.

CDS holders who wanted to take profits simply sold their protection in the same way that an equity put holder can sell her put without exercising it and still make money when a stock drops. In fact some of the CDS holders have been taking profits causing Greek CDS to tighten some.

Greek 5-year CDS spread equivalent (Bloomberg)

Plus "betting" against a sovereign does not require a CDS. Shorting government bonds in the repo markets is even easier than using CDS because bonds are usually more liquid. A repo agreement is simpler to set up than an ISDA agreement. One can also achieve comparable or sometimes better leverage in the repo markets to what one would obtain using CDS. In fact that's exactly how MF Global leveraged their sovereign bond positions. So this whole concept that CDS somehow affords magical leverage capability unavailable elsewhere is a myth.

Another issue that continues to spook some people is the idea of counterparty risk.

WSJ: While the net volume of CDS outstanding is small at $3.2 billion, the gross amount--referring to the daisy chain of CDS bought and sold in the aggregate across financial market participants--tops $70 billion. If one of the those trading parties can't make good on its financial obligations, it could shake confidence in the system very quickly with potentially disastrous consequences.

Again, CDS is not like an insurance contract - in fact it trades more like futures. That means that counterparties are subject to variation margin which they post on a daily basis.

WSJ:... 93% of respondents to a recent International Swaps and Derivatives Association survey said their credit-derivatives trades were subject to collateral arrangements during 2010, which would cushion the blow.

During 2011 that proportion increased further with even some of the stronger banking institutions in Europe forced to post margin.

SoberLook.com

Divergence of gold price and sovereign CDS spreads

2012-01-19T19:02:00.000-05:00

Recent Sober Look post discussed the apparent "dislocation" between US equities and treasury yields. Here is another potential dislocation. The chart below shows gold price plotted against the 5-year SovX Western Europe (SovX WE) spread. SovX WE is an iTraxx CDS index comprised of 15 names from the Eurozone region plus Denmark, Norway, Sweden and the UK.

Gold price vs. SovX WE spread (Bloomberg)

As expected the widening in sovereign CDS rose in tandem with gold price which was driven by demand for "safe haven" assets. That relationship broke down when gold began to trade more like an industrial metal such as copper. Some of the dislocation in gold was driven by fears of a sharp economic slowdown across Asia, typically a big buyer of gold.

There are two events that could put this relationship between gold price and SovX WE back in line. One is a severe crisis in the eurozone, such as a disorderly exit of Greece from the euro. The other (and the two are not exclusive of each other) is an acceleration of monetary or fiscal stimulus in China and India. Both nations have shown willingness to use a variety of tools to avoid a slowdown (more on India later).

The non-zero probability of these events should provide some support for gold prices, at least in the near future.


Lending survey of credit conditions (source: Capital Economics)

Sober Look

The fundamentals behind strong HY fund flows

The Fed extended start of tightening by 3 months, not 18

Restoring confidence in the Eurozone's sovereign credit markets

The chase for yield is on

Cap-and-Trade is dead, even in California

With Hollande in the lead, France may be making a shift to the left

The squeeze on dollar funding in the Eurozone continues

Deteriorating employment situation in France

Fed's low rate statement is not a pledge

Der Spiegel hypes hedge funds' role in Greek restructuring - and gets the Hype Award

The story of two risk indices

The "robo-signing" settlement's impact on the mortgage market

Portugal in markets' crosshairs

Tired of hearing about the ECB Deposit Facility? Here is some good news.

EIA's latest energy projections for the US

Two data points on US housing

Interpreting the divergence of HY spreads and VIX

Google Insights for Search and the contagion effect

The latest actions in the Eurozone's "war"

Gingrich victory gives Obama an edge

Treasury yields likely to rise in 2012

The Volcker Rule would not have prevented bank failures

Forecasting China's GDP growth - and getting it wrong every time

More myths around Greek CDS trigger risk

Divergence of gold price and sovereign CDS spreads

Operation Twist update

Signs of China's monetary stimulus

Securitization of eurozone sovereign debt - European "safe bonds"

IG CDX swaption vol finally caught up with VIX

Why surveys are worthless as a forecasting tool

The divergence of treasury yields and equity prices

The Fed's profits

5 reasons QE3 is now off the table

New fund flows and limited supply provide support to the muni market

The Deposit Facility is an indicator of net borrowings from the ECB

Time to stop fearing the Greek CDS bogeyman

Shermer: decline in marriage likely cause of slow household formation

China sells to the US, EU, and buys from the rest of the world

The story of household formation weakness is about families

Mutual fund industry under pressure from ETFs

ESM, just like the IMF, will force bond holder subordination

Impact of sovereign downgrades on bank capital

Go ahead, bribe the SEC

Dissecting the HY bond issuance in the US

Five reasons 2012 will be the start of US housing recovery

Securities dealers' inventories at 2002 levels

What's driving Brent-WTI spread wider

Persistent resilience of the US equity market

Italian yield curve steepens as bill rate collapses

Okun's Law applied to the eurozone unemployment rate

Volkswagen does it again - with EUR weakness

EU corporates move cash from bank deposits to repo

ECB provides unsecured funding to banks to keep them from failing

Market Neutral Anti-Beta Index: an alternative portfolio hedging tool

Gold still trades in lockstep with copper

Equity futures are not "up on Alcoa"

Consumer credit increase will be used to pay tuition

3 observations about the AAA CLO market

Natural gas price hits new lows but many US residents are not benefitting

"Structurally impaired" sector job losses delay return to peak until 2015

The Chicago Climate Exchange and the "cap and trade" market in the US

The wonders of hedge fund accounting: incentive fees "reduce" volatility

Be careful when buying ETFs at premium to NAV

Declining HY durations in Europe tell a story

French spreads grinding wider

Maturing EU bank debt may hit a wall in 2012

Hungary: bad policies gone awry

Bank ratings migration is an attempt to fix old errors

Bill Gross' reversal on treasuries

China's housing market decline may be a positive sign

Ron Paul ahead in Iowa as Intrade is jammed

Eurozone citizens not benefitting from ECB's easing

Too early to get excited about China’s growth

HY bonds outperform leveraged loans

Eurozone M3 contraction

Gold lease rate turns positive

The S&P500 outperformed all major stock markets

Forecasting Italy's borrowing needs

TARGET2 and the collateral imbalance - diagram