In September, interbank credit markets flashed a quick and brief warning that something was up... and Janet folded. Three months later and following The Fed's oddly-timed rate-hike, interbank counterparty risk - as proxied by The TED-Spread - has spiked over 45% in 2 days, the most since Sept 2008 (Lehman).
Wall Street’s proclivity to create serial equity bubbles off the back of cheap credit has once again set up the middle class for disaster. The warning signs of this next correction have now clearly manifested, but are being skillfully obfuscated and trivialized by financial institutions. Nevertheless, here are ten salient warning signs that astute investors should heed as we roll into 2016.
From time to time, the data (from economic activity, inflationary pressure, risk appetite and asset valuations) points unambiguously in a single direction and experience tells us that such confluences are worth watching. We are today at such a point, and the worry is that each indicator is flashing red.
Last week we warned of the ominously rising risks evident under the surface in US financials. Following Yellen's decision to chicken-out yesterday, it appears interbank counterparty risk is even ominous-er. With bank stocks prices tumbling, catching down to credit market's concerns, the TED Spread - implicitly measuring interbank credit risk - jumped over 21% yesterday - to its highest in 3 years.
We have been anxiously reminding investors of the drip-drip-drip increases in market-perceived credit risk for US financials for much of 2015. Having risen to almost 90bps amid the chaos of 2 weeks ago (almost double the lowest levels post-Lehman hit in June of last year), it appears systemic counterparty risk is very much on the rise. What is more concerning however, as Alhambra's Jeffrey Snider notes, the TED spread has exploded higher (since China's devaluation) indicating, as convention has it, a marked increase in perceptions of interbank credit risk.
Most leading indicators are warning; more trouble could be ahead...
In another well-funded research study, the New York Fed has, via its Liberty Street Economics blog, unveiled its explanation for why volatility is low (obviously missing the Kevin Henry-Citadel dark-pool VIX-slamming machinations that are so evident on an almost daily basis). Their findings are a little awkward for The Fed... the current volatility environment appears substantially different from what happened prior to the financial crisis. However, the Fed's conclusion, as Helen Thomas notes, is worrisome - low interest rates tend to mute volatility (something we already knew) - but if that is the case (from their findings) then implicitly: If low volatility is caused by low rates which in turn cause low volatility, what happens when rates go up?
Just a month ago, Goldman Sachs' head progonsticator David Kostin went full bulltard, telling clients to buy high-beta, high-momentum stocks because (paraphrasing) "hedge funds suck" and will need to play catch-up. Today, his tune has changed. The "dash-for-trash" meme has outperformed dramatically in the last few years as Fed experimentation breathed life into the zombie-est weak-balance-sheet companies and traders rode that artificial wave. However,as Kostin notes, tightening financial conditions have the greatest impact on firms with high leverage and weak balance sheets; and thus, with the Fed more biased towards tightening than loosening (and the market discounting that), the "dash-for-trash" is over (as we noted in July).
Could this be the last straw?
It seems liquidity (or counterparty mistrust) is beginning to reach extreme levels in China as the nation's banking system is now quoting overnight repo transactions at 25%. The explosion in funding costs echoes the collapse in trust (and surge in TED spread) among US banks in the run-up to the Lehman bankruptcy. MSCI Asia-Pac stocks are down over 3% with China's Shanghai Composite -2.5% at seven-month lows.
- China’s 1-day Repo Rate Climbs to Highest Since at Least 2006
- MNI - CHINA OVERNIGHT REPO FIXING AT RECORD HIGH
Many have argued that sovereign CDS markets 'caused' the problems in Europe - as opposed to simply 'signaled' what was in fact being hidden by cash market manipulation. But as the IMF notes in a recent paper, there are times when the CDS market leads the cash bond market and other times when it lags. But as far as looking at risk in Europe and the US, based on a wonderful model that uses Markov-switching to predict what the probability of the world being in a low-risk or high-risk state, we are as 'low risk' as we have been since the crisis began. Each time that level of complacency was reached before, equity markets have rapidly sold off. What is perhaps most notable is the systemic compression of every risk indicator, first VIX (Kevin Henry and the fungible excess reserves of every prime dealer whale), then the liquid SovX index (via Greece CDS auction uncertainty and 'naked' short bans), then the Euro TED Spread (via LTRO), then individual Sovereign CDS (via Draghi's 'promise'). The result, the 'free-market' signal of risk is non-existent.
It is hard enough to determine what, when and how to invest even with solid data. We live in an unpredictable and chaotic world, and the last thing that investors need is misinformation and distortions. That is why the LIBOR manipulation scandal is so infuriating; as banks skewed the figures, they skewed entire marketplaces. The level of economic distortion is incalculable — as LIBOR is used to price hundreds of trillions of assets, the effects cascaded across the entire financial system and the wider world. An unquantifiable number of good trades were made bad, and vice verse. Yet in truth we should not expect anything else from a self-reported system like LIBOR. Without real checks and balances to make sure that the data is sturdy, data should be treated as completely unreliable.
Unsurprisingly, it is emerging that many more self-reported figures may have been skewed by self-reporting bullshittery.