The Minsky Moment Approaches
Today, the yield curve hit a record. At 380 basis points, which incidentally was the widest spread between the 2 Year and the 30 Year ever, it has never been easier for banks to make money on the short-long interest spread.
Indeed, there are some wacky things happening in bond land. Recently, just like in the days after Lehman imploded, short-maturity bills traded at negative yields. While that particular rush for short maturities was at the time explained by a desire for year end window dressing and cash parking, the continued exuberance in bills (see chart below) can no longer be explained that simply.
There are a variety of explanations as to this surge in steepness, as well as for a continued preference of the short end of the curve. Some of these include the desire of foreign buyers to minimize duration, and as we have been pointing out over the past several months by deconstructing TIC data, the bulk of foreign purchasing has been in the Bill sector. And while there is no shortage of Bill interest, the traditional 30-Year buyers have shunned the long-end, and instead are opting for corporates for a better duration-risk profile. This is further coupled with the global doctrine of moral hazard which has made corporate failure essentially a thing of the past. With Bernanke onboarding private risk to the public balance sheet, the next big blow up will undoubtedly be sovereigns themselves. This is, in fact, confirmed by a glance at the spread between the SovX and the ITRAXX MAIN ex-FINS: for the first time in history, it is riskier to be a sovereign that it is to be an IG credit (green line on chart below).
So with the sweet spot in governments being exclusively Bills, it is natural to see further steepening, as more and more investors avoid the long end due to increasing sovereign and perceived inflation risk.
Yet there is nothing inherently wrong with steep curves. The bogeyman in credit land has always been the flat (or, heaven forbid inverted) curve. As CreditSights characterizies the flat curve situation:
A flat yield curve usually occurs when the market is making a transition that emits different but simultaneous indications of what interest rates will do. In other words, there may be some signals that short-term interest rates will rise and other signals that long-term interest rates will fall. Investors are uncertain and the margin for error is high. Tails get fat. Black Swans fly. X-Factors propagate.
What are the benefits of steep curve? They are numerous for all investor classes: i) a steep curve allows a wide margin for error, which incentivizes yield seeking lower in the capital structure, primarily equities; ii) banks can borrow cheap and lend expensive, which is a green light to "print money", and iii) a knee-jerk trading response to a steep curve is to buy equities, which creates a self-referential feedback loop, whereby steepness leads S&P higher, which increases asset prices, and hikes inflation expectations, which leads to an even steeper curve. The relationship is mapped on the chart below:
Lastly, by pushing yields down, the Fed is naturally trying to encourage the "virtuous cycle" of encouraging consumption and corporate investment. When inflation expectations are high and rates are low, companies and individuals are encourage to borrow as they should anticipate this debtload will be inflated in the future. However, judging by the latest consumer credit report and exorbitant excess reserve levels, Bernanke's plan has failed, as only Goldman et al can borrow at the short end.
In the current environment, in which economic reality is disjointed with the market, the steep curve is a source of concern. As CreditSight notes:
A steep yield curve can be a good thing. It should help the economic recovery and debt and equity markets. One could even argue that the Fed has done its job. ZIRP-American-style has both helped repair banks balance sheets and forced investors to take on riskier assets. Steep yield curves are generally seen at the end of a recession, when the economy is about to kick into full-gear.
So why all the worry? Well here is the rub: the evidence for economic expansion or the elements that make up an upward sloping yield curve are just not there yet. While it is a lagging indicator, credit creation has been scant. A recent survey from the Federal Reserve showed that since peaking in July 2008, consumer credit is down more than 4.8 percent. Bank lending is also down more than 8 percent over the past 12 months. Without a recovery in credit, there can be no self-sustaining economic recovery.
Also, it is interesting that we are seeing inflationary expectations when there is a complete lack of wage or producer price pressure. Employment (also a lagging indicator) has been weak and consumption continues to decline (though given its historic rise over the past decade, this could be a good thing). None of this seems consistent with a steep yield curve.
One certain outcome of a steep curve is dollar debasement: one of the goal of the Fed all along. And as Zero Hedge has been noting for almost half a year, the current FX dynamics are such that the dollar has supplanted the Yen to become the funding currency of choice (much to the chagrin of the BOJ). Logically, the question arises: how big is the carry trade?
The carry trade notably reared its wild and wooly head during the late 90s, when Japan announced a Zero Interest Rate Policy (sound familiar). Traders sold short the yen and bought just about anything else they could find, because everything was higher yielding. Indeed, if you were a mortgage trader, chances are you funded trades in yen. If you traded emerging markets, you crossed in yen. Baseball cards? Sell yen. Before the last time the world blew up, way back in 2007, the yen carry trade was estimated to be about $1 trillion (but who knows for sure). When the credit crisis hit, this trade was unwound, quickly. The dollar was (is) still the world’s reserve and money flocked to safety. Dollars were needed. The carry trade was killed and people lost big.
How do we tell there is a dollar carry trade? First off, Chairman Bernanke seemed to give the carry trade his blessing during his recent speech at the NY Economic Club, firmly saying that interest rates will not be raised in the short term. This gives traders license to sell dollars, not fearing that the Fed will raise rates and they will be caught out short.
Second, correlation. Everything seems to be correlated to everything (and we know how well that ended in 2007).
As the dollar weakens, investors look to harder or higher-yielding assets to contain some of the depreciation effects, causing asset classes to rise in tandem. In a recent piece, we pointed out that the correlation between equities and debt had an R-squared of greater than 90 percent. Dollar-equities, same thing, but inverse. Indeed, this is the first time since 1938 that we have had zero interest rates, dollar depreciation and equity markets rising. High yield continues to receive record inflows, despite coupons and current yield falling far short of extraordinary. Gold is also at record highs.
Zero Hedge has previously discussed why due to a funding mismatch, the globalized economy was on the dollar shortfall hook for a number as large as $6.5 trillion, which in turn explained why the Fed has to rush to save all Central Banks by pumping hundreds of billions of FX liquidity lines.
And here comes the first estimate ever attempted at quantifying the Fed sponsored "Dollar Destructive" moral hazard: the
upper bound of the total loss in the case of a major liquidity event
occurring with the Fed's complicit bailout on the table would amount to
a staggering $6.5 trillion from a dollar duration funding mismatch
alone! This is an astounding, unfathomable and untenable number. Yet it is likely the same now as it was at the onset of the Lehman crisis...As the H.4.1 discloses weekly, the Fed's liquidity swaps are now back
to almost zero. This means that foreign Central Banks believe they have
the FX swap and dollar maturity situation under control. They thought
the same before Lehman blew up. And they were wrong. As the DXY
continues tumbling ever lower to fresh 2009 lows, the trade de jour is
once again the dollar funding one, although unlike before when the Yen
was the carry currency of choice, this time it is the dollar itself,
positioning banks for the double whammy of not just a dollar funding
shock, but one coupled with a potential massive and historic short
squeeze. If and when an exogenous event occurs, not even $6.5 trillion
in Fed swap lines will be sufficient to bail out the world economy.
We wrote this in October 2009, before Roubini et al became dollar carry trade experts. We would like to highlight that the last time around, the dollar funding risk did not include the incremental need to cover hundreds of billions if not trillions in dollar shorts. The next time there is a risk flaring scenario, the cost to fund the dollar mismatch will be even greater due to additional rush to cover shorts.
The Minsky Moment
Today we pointed out that the VIX is at multi-year lows: complacency once again reigns supreme. So if indeed the market is correct, and growth is back, the Fed presumably has the tools required to facilitate and unwind, whether it is rising rates or using reverse repos. A return to Fed normalcy, however is not in the cards, as Bullard's presentation earlier highlighted. In fact, look for more Q.E., and more ZIRP.
So what happens if the optimists are wrong. A CreditSights readers makes the following observations:
I think what you are suggesting is a reversal of the high beta compression trade; we haven’t really seen economic recovery, just return from the precipice, so the markets have probably gone too far too fast.
Of course the brutality of the unwind in the carry trade depends on what moves the Fed off its mark. If it is inflation concerns, fixed income asset prices are dead and probably equities too, just on the discount factor. If it is due to real signs of economic recovery, then the carry trade unwind is mitigated by dollars chasing the economic recovery story in credit and equities. Third possibility is that the Fed intervenes on concerns about dollar weakness, but I really don’t see that happening.
To which CreditSights responds:
To have a dampening effect on dollar depreciation, the Fed would have to raise interest rates early and dramatically. Drawing from Chairman Bernanke’s recent statements, high unemployment and worries about choking off the recovery too soon are of greater concern. Also, a weak dollar solves a lot of problems for the US—of course, it creates problems for the rest of the world. But, as long as the US’s creditors are willing to accept dollar denominated debt, currency devaluation has to dual effect of monetizing the US’s debt and helping rebalance the trade deficit. But what happens if the world is no longer willing to accept Uncle Sam’s IOU? Last I checked, the US had some pretty big deficits it needs to finance.
The last is precisely what keeps PIMCO's Bill Gross at night, and is one of the main reasons why we believe the Fed has no option but to continue with Quantitative Easing...No option but to perpetuate the status quo which will merely make the ultimate unwind truly unprecedented.
The confluence of all these risk factors implies that there are simply too many variables for the Fed to be able to sustain control over what is an inherenetly chaotic situation:
An overly steep yield curve, combined with run away dollar depreciation generally indicates that authorities have lost control. There is a legitimate and real risk that the long-end could become “unstable,” as supply/inflation fears kick in. While consumer leverage is declining, leverage in the financial world is on the rise. And, it does feel like we have been here before: 2002, 2007—the so-called Minsky Moment years.
We have come full circle, only this time it took a mere two years. As Justin Lahart so effectively summarized some years ago:
At its core, the Minsky view was straightforward: When times are good, investors take on risk; the longer times stay good, the more risk they take on, until they've taken on too much. Eventually, they reach a point where the cash generated by their assets no longer is sufficient to pay off the mountains of debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. "This is likely to lead to a collapse of asset values," Mr. Minsky wrote.
When investors are forced to sell even their less-speculative positions to make good on their loans, markets spiral lower and create a severe demand for cash. At that point, the Minsky moment has arrived.
The Minsky moment is, once again, knocking on the door.