High Yield

In UBS' view, 1994 is critical for guiding investing today. The key point about 1994 was not that US bond yields rose during a global recovery. But that the leverage and positioning built up in previous years, on the assumption that yields would remain low, then got stressed. The central issue, they note, is that a long period of lacklustre growth, low rates and easy money induces individual investors, funds, non-financial corporates and banks to reach for yield. In many cases, they gear up to do it. And as Hyman Minsky warned; in this way, stability breeds leverage, and leverage breeds instability. It is much less likely that we see the US enter a ‘high plateau’ of growth as we saw from 1995-98, where the US saw a powerful productivity & credit fuelled boom while the emerging markets deflated. And it makes it more likely that the US stays on a lower trajectory, interspersed with periodic recessionary slowdowns in the years ahead. The point at which the market realises this would likely herald a significant risk-off event.

We’ll know more next week Wednesday when the Fed meeting concludes with a language parsing contest. In the meantime, stock market volatility is increasing as we’re experiencing alternating triple digit days now.

There is no way the pensions and benefits promised in an era of financialized abundance can be paid once the wheels of financialization fall off. During the past 30 years of financialized abundance, the benefits and pensions promised to public employees were increased substantially. Public unions are a powerful political force in many states, and in eras of rising tax revenues, it's an easy political decision to increase public employee benefits and pension payouts. The rising stock and bond markets generated huge profits for the public-employee pension funds, enabling them to grow without taxpayer contributions. Alas, the 8+% annual growth rate of the boom era is now structurally unrealistic. The New Normal is bond yields of 2% or 3% at best, and equities markets that are increasingly at risk of significant sell-offs. The endgame of promises made in an era of illusory, financialized abundance will be hurried along by a collapse in the equities and bond markets.

If there is one word to describe today's 3 Year $32 billion auction it would be atrocious. With the When Issued stopped at 0.577%, the closing high yield tailed notably at 0.581%, a dramatic spike from last month's 0.354% and the highest yield since July 2011, indicating substantial turbulence on the surface. Beneath the surface it was the same story, with the Bid To Cover plunging from 3.38 to just 2.95, the lowest since December 2010, driven by a crash in Direct Bidder take down to just 8.4% from 14.6% and a TTM average of 12.9%: this was the lowest Direct interest since August. The result was that Indirects were left with a sizable 33.1% of the auction well above the 26.3% TTM average, and Dealers had to absorb the remainder, or 58.4% of the auction. All in all, a very ugly auction although with investors still demanding only 0.5% to hold 3 year paper it would appear that any fears of an imminent hike in rates (regardless what the Fed does with the longer-end of the curve), is still far away.

The Fed’s zero lower bound policies have dislodged credit risk as the primary concern for investors, only to replace it with a major technical headache: interest rate risk. If rates remain too low for too long, financial stability suffers as investors reach for yield, companies lever up, and lending standards decline. The greatest of financial stability risks is probably the least discussed among those that matter at the Fed: the deterioration in trading volumes. As such, we suspect that the longer low rates persist, the worse the unwind of QE may be. And it may, in fact, already be too late. As events in the past two weeks have shown, credit markets also appear vulnerable to a rise in rates that occurs too quickly or in a chaotic fashion. Moreover, to the extent that issuers sense demand may be waning for bonds, there’s a distinct possibility the pace of supply increases precisely at the same time that demand decreases. Invariably, it’s this sort of dynamic that ends in tears.

This was one helluva week. Nevertheless current markets are still hooked on QE.

The schizophrenic good-is-good, "we dont need no stinking Taper" market action earlier seems to be hitting a small road-bump. Interestingly, homebuilders and high-yield credit was flashing some early-warning signals... with S&P 500 futures hovering back at VWAP, the noise from the rest of the risk-asset complex suggest there is some more downside for stocks here.

To get a sense of the momentous volatility in Japan, consider that the Nikkei225 is more or less in the same numeric ballpark as the Dow Jones, and that each and every day now it continues to have intraday swings of more than 500 points! Last night was no different following swing from 13100 on the high side to 12548 on the low, or nearly 600 points, with all this ridiculous vol culminating in a close that was just red however for a simple reason that the rumor of the Japanese Pension Fund reallocation taking place hit shortly before the close sending the USDJPY higher by 200 pips...  only for the news to emerge as an epic disappointment when it was revealed that the GPIF would raise its target allocation to domestic equities from 11% to... 12%. So much for the "Great Japanese Rotation."

Anyone expecting Abe to announce definitive, material growth reform instead of vague promises to slay a "deflation monster" last night was sorely disappointed. The country's PM, who may once again be reaching for the Immodium more and more frequently, said the government aims for 3% average growth over the next decade and 2% real growth, raising per capita income by JPY 1.5 million. The market laughed outright in the face of this IMF-type silly vagueness (as well as the amusing assumption that Abe will be still around in 7 years), which left untouched the most critical aspect of Abenomics: energy, and nuclear energy to be specific, and sent the USDJPY plummeting well below the 100 support line, printing 99.55 at last check. But more importantly, after surging briefly at the opening of the second half of trading to mask a feeble attempt at telegraphing the "all is well", it rolled over with a savage ferocity plunging 700 points from an intraday high of 13,711 to just above 13,000 at the lows: yet another 5% intraday swing in a market which is now flatly laughing at the BOJ's "price stability" mandate. Tonight's drop has extended the plunge from May 23 to 18.4% meaning just 1.6% lower and Japan officially enters a bear market.

Ongoing monetary stimulus is leading to heightened volatility, and the bull market which has been in place since 2009 is becoming overextended. The recent string of surprise downside moves in markets may be the canary in the coal mine for global investors. This is where we are today. The tide is rising for U.S. and Japanese markets and asset prices will ultimately move higher. The size and violence of each wave that advances or recedes will continue to increase due to the surge of liquidity from central banks. These tides of liquidity are strong, as are the currents underneath. We must guard ourselves from the risk of being pulled under.

On practically every day of the past four years, we have said that it was the Fed's own policies that are causing the ever-deeper systemic weakness in the US (and now global with all central banks going "all in") economy, which in turn forces the Fed to intervene even more aggressively in an attempt to counteract, in turn generating ever more economic weakness, leading to even more intervention, which is why every incremental episode of QE is larger and longer, and why the economic baseline is ever lower in the most perverse feedback loop of the New Normal. Now, it is once again Bill Gross to catch up to Zero Hedge and conclude just this in his latest monthly letter: "It’s been five years Mr. Chairman and the real economy has not once over a 12-month period of time grown faster than 2.5%. Perhaps, in addition to a fiscally confused Washington, it’s your policies that may be now part of the problem rather than the solution. Perhaps the beating heart is pumping anemic, even destructively leukemic blood through the system. Perhaps zero-bound interest rates and quantitative easing programs are becoming as much of the problem as the solution." Which is why there simply is no way out as long as Bernanke stays in.

With JPY losing 100 and the Nikkei futures trading down to a 19.25% loss from the highs (12815 the dreaded bear-market 20% drop level), a combination of a desperate Japanese 2015 plan for the pension fund to buy moar stocks, bad-is-good economic data, and front-running of the now-ubiquitous Tuesday rally provided the ammo for a rally in equities - recovering almost 50% of their post Friday drop losses. Risk-assets in general correlated extremely closely on the day and while volume was well above average, this was driven by the surge to the downside (not the upswing). Treasuries ended the day unchanged (amid a 12bps range on the day) ending near the low yields (moar QE). VIX snapped above 17.5% (its highest in 6 weeks) before fading back in the ramp to unchanged at 16.25%. Credit tracked stocks closely but was less exuberant in the late-day ramp. USD weakness (JPY and EUR strength) supported commodities, with gold and silver outperforming on the day (up 1.65% and 2.2% respectively).

Investors take note, the market has numeous red flags for stocks. If you're not prepared for a correction, now is the time to do so. 

Everything was going so well in the overnight session, following some mixed Japanese data (stronger than expected production, inline inflation, weaker household spending) which kept the USDJPY 101 tractor beam engaged, and the market stable, until just before 2 am Eastern, when Tokyo professor Takatoshi Ito, formerly a deputy at the finance ministry to the BOJ's Kuroda, said overvaluation of the yen versus the dollar has been corrected, which led to a very unpleasant moment of gravity for the currency pair which somehow drives risk around the world based on what several millions Japanese housewives do in unison. The result was a slide to just 30 pips away from the key 100 support level, below which all hell breaks loose, Abenomics starts being unwound, hedge funds - short the yen and long the Nikkei - have no choice but to unwind once profitable positions, the wealth effect craters, and streams are generally crossed.

Tuesday's weak 2 Year bond auction is now a distant memory, and following yesterday's strong 5 Year it was not surprising to see a very strong pick up in demand for the just concluded 7 Year auction. On the surface, the auction was very strong with the high yield printing at 1.496%, stopping through the 1.515% When Issued if still the highest since March 2012. The internals were also very strong, with the Bid to Cover closing at 2.70, in line with last month's 2.71, and above the TTM average of 2.68. More importantly, Direct demands soared with 20.68% of the takedown going to Direct bidders, the second highest ever in this series, and lower only to December's 23.11%. Indirects were no slouch either, with a final allotment of 40.84%, leaving just 38.48% for Dealers, the lowest take down for 2013. So with very strong primary market demand along the belly, it is safe to say all rumors of a blow up in the US bond market are greatly exaggerated. Remember: TSYs still continue to be the primary source of repoable collateral and for the time being at least, everyone still wants them.