The Contrarian Market And The Liquidity Glut Dissected
BofA's credit strategist Jeffrey Rosenberg has shared some interesting insights with his clients. In a letter from August 2, Rosenberg explains everything one needs to know why the stock market continues to rise in the face of increasing adversity and ever more negative news:
“I can’t think of a reason to be bullish...so I guess that is the reason to be bullish.” That quote from a client at our June 30th credit roundtable dinner in our view best summarized investor sentiment at the beginning of July. It also highlighted a key technical reason to have been bullish in July as negative investor sentiment reached a peak at the beginning of the month."
Couple that with the sudden buzz that QE X.X is imminent, and a surge in market liquidity, and once can see how the market is now completely disconnected from fund flows, as contrarian animal spirits, and a rising liquidity tide have once again become the dominant, and only, factors in market tactics, if not strategy. And speaking of liquidity, here is an analysis of the key source and uses of liquidity in the market currently.
In a surprisingly candid piece from August 3, Rosenberg is honest that the only cause of the recent ebulience is liquidity, and the sudden impression that the Fed is en route to recreating the liquidity parameters from early 2009. To wit:
“I want to say one word to you. Just one word.” Not “plastics” but “liquidity”. Our longer term positive outlook on credit relies significantly on the technical condition of excess liquidity in financial markets. While eventually economic and credit fundamentals will need to catch up to those technicals to justify a continuation of spread compression (and credit market overweights), for now our year end outlook maintains that positive liquidity trends will lead to compression in spreads recouping much if not all of the European sovereign crisis induced spread widening.
In other words ignore fundamentals, ignore technicals, ignore everything you know about asset allocation and selection, and put your financial well being in the hands of the same people (the Fed) who have time after time proven the be the biggest wealth destructors of the US middle class year after year (unless of course one is a member of the privileged kleptocracy, in which case there is nothing to worry about). With all due respect, we prefer cash.
Yet despite our skeptical stance, it is useful to see where Rosenberg sees the imminent influx of cash, and what assets classes, in his opinion, will benefit the most from unsymmetric flows:
Financial market liquidity stems from monetary policy’s dual track: quantitative easing increases high powered money affecting primarily financial market liquidity, while zero interest rates increases allocated liquidity. Zero interest rates punishes as risk aversion with negative real returns forcing investments out the risk spectrum in either maturity or risk or both. Combined with overall deleveraging in consumer assets and stable leverage in corporate assets, the resulting negative net supply across all risky asset classes – Securitized Products (ABS/MBS/CMBS) and Corporates - lends a powerful tailwind to risky asset spread compression.
Figure 1 above highlights historical as well as our estimates for estimated 2010 net supply of risky debt and Treasury debt. We add to these estimates of net supply our estimates of annual cash flow generated in each asset class through coupons. To the extent this cash flow is reinvested back into the asset class, it represents a key source of investment cash before new asset allocation. Hence the bottom line on the table highlights that after accounting for the cash flow needs just from reinvestment flows, all risky asset classes show negative net supply in 2010. Only Treasuries provide net new investable assets. The reduction in supply relative to increasing demand for credit products (highlighted in Figure 2 and Figure 3 below) illustrates the positive technical conditions supporting risky asset spread compression.
Intuitively, all this makes perfect sense, and is to be expected in an environment in which ongoing corporate deleveraging is mitigated only by increasing public sector issuance. Essentially what BofA is saying is that the government will do everything in its power (and investors should sense this and front run it), to make spread differentials between public and private sector funding negligible, in essence making private debt as cheap as public (broadly speaking), in its attempt to allow firms to deleverage freely at the taxpayers' expense. The impetus for this broad move would be the far shortened duration allocation for corporate issues, in which the only trade off to duration is credit risk. In other words, at the same yield, a perfectly rational investor would be likely tempted to invest in a short maturity A-rated corporate bond, rather than a long duration (30 Year) Treasury. While many may laugh at this assumption, it is already in process of happening. To wit:
With weak economic growth having replaced the European sovereign crisis as the biggest investor concern, US fixed income markets have returned to their pre-crisis dynamics where strong liquidity conditions, and the absence of yield in the front end of the curve, have investors reaching for yield. Most relevant for fixed income risk markets, growth concerns – short of a double–dip – translate into the Fed remaining on hold longer, thus prolonging the period of time where investors reach for yield out the credit quality curve. For Treasuries, the reduction in inflation expectations encourages investors to reach for yield out the maturity curve. Thus growth concerns lead to curve flattening for both quality and maturity curves.
This is becoming all too evident with the recent daily records in the 2 Year Treasury, and the persistently sub-3% 10 Year (the question of whether and how this is sustainable is the topic of another analysis). To justify the point of investors fleeing from the ultra-short dated part of the curve, Rosenberg shows this notable correlation between money market assets and the Fed Funds rate:
Yet it is questionable whether the rate of decline in money market assets is at this point continuing to correlate with ZIRP. As we have pointed out, despite a nearly $1 trillion drop in MMF assets since the implementation of ZIRP, lately we have seen several consecutive weeks of money market inflows (not to mention the 13 weeks of straight equity fund outflows). Is not even ZIRP at this point sufficient to push the zero % yielding money on the sidelines into higher yields. Yet even if we assume that an investor is willing to chase some, any yield, what should one do? Rosenberg provides the following thought experiment:
For example, currently a fixed income investor with a modest 4% yield bogey can choose to take on considerable duration risk in 30-year Treasuries. Alternatively, if the investor is only willing to move out to the belly of the curve, as our rates strategists discuss below, she can trade off some interest rate risk for credit risk by buying A-rated 10-year industrial corporate bonds to achieve this yield target. Other fixed income asset classes - including CMBS and non-agency RMBS - offer yields that can meet the 4% bogey without maxing out duration as well, while Agencies and Agency MBS offer less yield pick-up. As more investors reach for yield, credit spreads compress within each risk asset class meaning that investors need to reach further out the curve to get yield. Thus a consequence of abundant liquidity is that the belly of the Treasury curve flattens, credit outperforms Treasuries, BBB-rated industrial corporates (or higher rated financials) outperform A or higher-rated industrials, and non-Agency MBS and CMBS outperform Agency securities (see also the mortgage section below).
The chart below is likely most telling of the ongoing change in sentiment toward risk. While the 7-10 year "belly" of the curve is indeed starting to provide a broader selection of options for comparable yielding securities across public and private domains (with the exception of CMBS, where as we have noted the deterioration across asset collateral just hit an all time record in June), the follow through of this argument is the ongoing flattening of the 2s10s. Should this phenomenon persist, the deterioration across the "originate to hold" mortgage business model (and without securitization, that would be pretty much all the banks) is inevitable. Ironically, should Rosenberg be correct in his assumption of ongoing spread convergence in risk and presumably risk-free assets, the profit margins fro the Bank Holding Companies will continue to erode to the point where the Fed will be forced to provide another round of assistance to undercapitalized from an equity standpoint financial system.
Yet going back to the question of liquidity, nowhere is the sudden perception that liquidity will be ample more visible than in the return of negative new issue concessions after over three months of investor favorable primary concessions. In other words, investors are willing to pay more for a primary issue than an near-identical piece of paper trading in the secondary market as far too much cash is once again sloshing around and chasing any and every piece of paper.
And another last place where the record liquidity overabundance can be seen is the new issuance of McDonalds 10 year paper, which came at an all time lowest on record yield of 3.5% among 10 year corporates.
To highlight the current strong liquidity conditions we consider the $750mm two-tranche McDonald’s corporate bond deal issued Wednesday. Demand for this deal was so strong that we estimate the 10-year tranche priced at a 10 bps negative new issue concession – that is, 10 bps tighter than secondaries. Normally new issues price wide to secondaries to accommodate the increase in supply. However, starting December last year liquidity has been at times so abundant – and available bonds so few - that we have seen many cases where investors are willing to pay a premium for any availability of bonds that the secondary market may not offer. Underscoring that liquidity conditions have returned to pre-sovereign crisis levels, this week was the first where the average new issue concession across all deals in high grade corporate credit was negative (-4 bps) since the week of April 19th.
The bottom line is that even strategists have given up pretending to put a narrative to asset yields. The only thing that matters once again is whether liquidity will be ample today, tomorrow and in one year, and whether the Fed can attempt to successfully recreate an asset bubble, which however unlike before, is asset agnostic and touches on anything and everything. And since fundamental asset values continue deteriorating, the Fed will be caught in the classical Ponzi dilemma of how to push prices ever higher without causing a Madoff-like collapse to fair value (i.e. zero). If previous examples are any indication, the Fed can only reflate a bubble for several years before the lack of inherent cash flows collapses the hollow house of asset cards on its head. We are already well into year two of the latest and final such experiment. All those who believe they can time the peak: by all means, invest in the riskiest of assets. For all the others who have been burned periodically trying to time inflection points (and let's fact it - that's pretty much everyone), the only safe bet is investing in hard assets or a cash under the mattress position. Because at the end of the day this is no longer a question of deflation or inflation: it is certain that the Fed will fail at achieving its preferred outcome in that regard as well. The real question is how should one be positioned when the tens of trillions of excess liquidity are, on the margin, found to be supported by nothing more than hopium, fraudulent accounting and the promises of a persistently wrong Federal Reserve that this "time is different." Sorry, it never is.