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The Mangled End Of Markets: An Unambiguous Signal Of Malfunction If Not Distress
Submitted by Jeffrey Snider via Alhambra Investment Partners,
While the stock market had one of its best months in years, it was, like the jobs report, uncorroborated by almost everything else. The junk bond bubble, in particular, stands in sharp and stark refutation of whatever stocks might be incorporating, especially if that might be based upon assumptions of Yellen’s re-found backbone. Do or do not, corporate junk remains unimpressed and therefore depressed against the same background drowning as has been in place going back to June 2014.
At yesterday’s close, the S&P/LSTA Leveraged Loan 100 index had fallen back to only a few fractions above its early October multi-year lows. That price action was matched by other high yield, high risk bond views.
Retail junk debt prices have been somewhat more responsive which isn’t surprising given the mood in general stocks (or at least the narrowing segment of stock markets and indices that are rising). Though more so than institutional, even retail junk prices have begun to turn around again of late.
Undoubtedly, part of that is due to what can only be termed and categorized as atrocious liquidity conditions. The mortgage REIT ETF REM suggested a quarter-end liquidity bottleneck at the end of September before rising as HYG (the two are well-correlated). However, in recent days REM has sunk almost to that late September nadir, suggesting, firmly, that “dollar” funding and perceptions are continue to be far more problematic than the unspecifiable euphoria elsewhere.
The recent turn toward “hawkish” opinions about FOMC predilection has sparked some noteworthy returns in “dollar” proxy currencies, especially the franc. The Swiss currency had been trading in bouts of appreciation which tied closely to upwelling in fear and safe haven demand. Around October 21, however, the franc suddenly fell under a sustained bout of depreciation that has brought it to parity with the dollar. That is almost the same disastrous level that forced the SNB to noisily and dangerously abandon the euro peg back on January 15.
Whether that relates to the changing views of monetary policy isn’t fully clear, but it would be a reasonable assumption especially as this return is matched by other currencies such as the Indian rupee.
Of course, behind all this is the “dollar” which continues to press devilishly in the same perturbed direction. I examined this morning the commodity and even eurodollar futures view of that, but the most concerning parcel has to be interest rate swaps. As noted on several prior occasions, swap spreads have been sinking fast and to unprecedented levels. Though mainstream commentary will provide plausible-sounding excuses, mostly about corporate or even UST issuance, that is only because these places will not even consider that Janet Yellen has it all wrong; thus, they only search for possibilities that allow that narrative to remain undisturbed even though that narrative itself can never account for negative spreads.
Again, the swiftness of the erosion is remarkable and down the entire swap curve. Even the 2-year spread unthinkably has flirted with zero:
The fact and observation of a negative swap spread is simple dealer balance sheet capacity; for a swap rate to fall below its correspondent maturity UST can only be related to a significant reduction in offered money dealing capacity. As I wrote just a few weeks ago:
A negative swap spread…assaults conventional financial sense. To most, a negative spread is nonsense and leads to so much consternation about how to interpret the situation when it has arisen. Unfortunately in 2015, especially after July 6, it has been near-universal across far too many maturities.
While on the surface it would suggest that the “market” in swap derivatives is pricing more risk of UST’s than swap counterparties, the only real inference about such compression is the nonsense itself. In other words, the nonsense nature of negative swap spreads is precisely the point – for them to be negative in the first place, let alone highly so (like the 30s again), is a pretty unambiguous signal of malfunction if not full distress. It is only great imbalance that can change the information content of a market price into meaninglessness; therefore we can interpret that case as some great reduction in balance sheet capacity since it is dealer capacity that determines the nature of the spreads.
This is not a revelation to anyone paying even slight attention to what has been taking place in global, eurodollar banking of late. The banks themselves have all but declared that they want out, with the events of this last “dollar” run convincing them to do so at all possible haste. If banks are withdrawing capacity and swap spreads have turned not just nonsense but insanity, then we can only conclude taking banks at their word.
Investment Grade Bonds:
And Junk Bonds:
That brings us back to dear Janet. What is most notable on the charts above showing all the swap spread maturities is the inflection surrounding the September FOMC, not the October meeting. In other words, spreads turned quickly downward where the Fed chickened out and thus confirmed the dead recovery (and the end of “transitory”). That they continued to be negative even after supposedly the FOMC revisited their nerve more than suggests what I explained this morning – that the background recovery and “dollar” baseline has been set and that any changes in monetary policy are secondary if not further remote. Thus, all Yellen et al can do is make a bad (and growing far worse) situation that much worse. I believe that is why they intermittently seem to gain resolve only to lose it closer to their own call for action.
This view is all the more pressing given that the likely specifics of the balance sheet capacity withdrawal emanating from those very banks that followed Yellen toward her recovery idea in the first place – Deutsche Bank and Credit Suisse, perhaps even Goldman Sachs. That means that this descent into economic and financial darkness is being driven by the same firms that were once completely, utterly and fully onboard the recovery and its most optimistic case. Their “betrayal” then simply completes and confirms the recovery’s mangled and explicit end. As I wrote back in late September, ignore swap spreads at your own peril; a sentiment increasingly applied beyond the “dollar” into the real economy as one follows the other here and across the globe.
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Can someone explain the significance of negative swap spreads? I'm not quite grocking the message here (except that it's bad news).
Yes, I'm lost too. Are banks positioning for interest rates rising or falling? What part of the yield curve will move?
Probably wrong (and been that way before) but my guess is that negative rates on all these assets means that there is a high likelihood of swift and titanic demand for redemption occurring all at once at some point in the near future. Interest rates will go even negativer and trigger a sudden "fuck this noise" run for the exits.
Such a glut of withdrawl would overwhelm the fractional system, which is set up for a more sedate and balanced pace of incoming and outgoing. By getting out of the business, they are making sure that angry investors will be hammering on someone else's door when redemptions are halted or delayed.
That dealers would want out of a business built around the idea of being paid to hold onto someone's money signifies a great deal about the hidden risks.
Little Miss Muppet put her funds in their tuffet, which seemed like the only play.
Along came a spider, which sat down beside her, and her money went screaming away.
double post
I'm no expert, and I invite correction and amplification from any ZH-ers who actually play in this sandbox, but think about simple swaps. Say you're a bank and you own a long-term fixed-rate bond, and you want to hedge the risk of rising interest rates, probably to avoid a mismatch between your short-term liabilities and your long-term assets. You can swap the revenue stream from your bond for the revenue stream from some other, variable rate bond of the same maturity . Tadahh, you're hedged.
But how much should you pay for this insurance? Clearly, one consideration is how long you need the protection. Since one leg of the swap is almost always a US Treasury bond, whose default risk is assumed to be zero, your cost will reflect the perceived riskiness of the other leg over time. LIBOR traditonally was the impartial yardstick used to calculate the risk premium. You would swap your UST cash flow for LIBOR plus/minus some agreed-upon number of basis points. The difference in what you pay and what you get is the spread.
Now, what would it mean if the spread went negative? It would mean that investors considered USTs more risky than the other leg of the trade. This does not compute. It's like dividing by zero or squaring the circle. Our current system simply doesn't allow for this possibility, or as Snider says,it's "a pretty unambiguous signal of malfunction if not full distress.
Jamie Dimon told you months ago this was coming, but of course the QE drunk masses can't even see straight anymore, much less think with any clarity.
http://www.marketwatch.com/story/jp-morgans-dimon-warns-next-crisis-will...
I have limited knowledge, but I looked it up and this is what I came up with. The swap spread is based on the difference between the the interest an entity agrees to pay on a debt and the amount that the entity can actually afford to pay on the debt. So, when retailers are doing really well they take on debt at higher interest rates than they could actually qualify for, so they take on a loan or issue bonds at 5% interest/yeild, but they could actually qualify for loans at 3% = a spread of 2%. The difference is underwritten and traded by banks. So, the banks take these differences from all retail loans and bundle it up into a theoretical swap of sorts as a way to make money off of the good credit of biz, when these swaps go neg it says that biz is not going so well and retailers can no longer afford to obtain loans with such low rates = economic contraction. That is how direct debt swaps work.
Then there are swaps between say ust bonds and junk bonds, this comes from the differences in yeilds which is pricing in risks in one asset or the other. Generally Tbonds will have a better credit rating than junk bonds and so they have lower yeilds than junk bonds which makes for a positive swap rate. As the swap rate narrows, the economy is supposed to be getting better or growing because there is less overall risk for default. There are a handfull of reasons for these swap rates to go negative and why that would be a bad thing. The first is supply and demand, if banks are no longer trust worthy and everyone gets rid of their junk bonds you are going to have negative rates, in other cases a negative swap rate means that there is speculation that the US govt is bankrupt. For further understanding google it if you are so inclined, but basically that is it.
All the negative rates are basically saying that most biz and govt is too risky to invest in as per speculators, so like speculators see the US govt defualting sometime in the next 30 years for the last 6 or 7 years and thats y the swap has been neg for most all this time. The two year UTS swap is still trading above zero because speculators do not see them defaulting on their debt/bonds in that amount of time. In addition, supply and demand helps to drive the price one way or another, exacerbating potential speculations. So, it's a big warning sign because the best and brightest bankers or the smart money, whatever you want to call them are getting out of these swaps because they see the US and biz in the US as declaring insolvency sooner or later.
My guess would be that the FED and the UST just brush all this off as speculation and completely ignore it, otherwise they would do something about it. But, it is a sign that the economy is going down the shitter :)
Hope that helps, I certainly learned something new today!
those last two charts are the most telling: the banks are leaving the playing field and quickly. Remember that the FED is controlled by the banks so the FED knows what is going on (at least those that pull the strings). Once the banks have left the playing field then the debt bubble can explode. I'm sure that the banks will have taken the opposite position at that time so they can exploit it.
Banks == blood sucking leaches
I'm sure that the banks will have taken the opposite position at that time so they can exploit it".
Exactly, my good Doctor. It's the dynamic of all markets since antiquity. We--that means each and every type of player--are all in it to win it, are we not?
Voted you up.
repeated myself. fixed.
At best, markets occasionally coincide tangentially with macroeconomics. Was true in 1929. 'Tis true today.
PS. Trade well and prosper!
Translation: while the passengers on the Titanic have been partying the past few months, the crew has been robbing their cabins and gathering all means of escape.
They're now on the deck lowering themselves over to make their escape while the drunken fools on board are swinging from the chandeliers.
Well, thank god the banks (i.e Primary dealers) have gotten out in time. To go from 18 Trillion to zero is stunning to say the least. The real question in my mind is what did they buy? It apparently wasn't currency hedges so who is putting up 18 Trillion in collateral on what appears to be a guaranteed losing proposition? The only entity I know of that has that kind of firepower is China.
chart's wrong - it says billions but it should say millions. no one holds trillions - the junk bond market itself is less than a trillion in total, if i recall correctly. dealer inventories were $18 billion at some point earlier this year.
No, I don't think it is only billions. Big banks hold much, much more bond capital than 18 Billion. That is the primary component of their Tier 1 capital ratios and for say, the Royal Bank of Canada alone, their Tier 1 capital is 150 Billion.
It is billions.
http://thenewsdoctors.com/?p=535722
Good article.
The grandma who cried wolf... too many times. That will become an article headline someday... when humans wake up, and gold/silver rocket past the moon in USD.
Based on the story and current events, apparently a "boy" can only cry wolf three or four times before nobody believes him... but a grandma like Yellen, well, that's an entirely different matter!
How many times has the top wolf at the federal reserve threatened to raise rates? A dozen? Two dozens? Three dozen? More?
It truly is amazing how long and how many times these transparent lies work to keep the worthless fiat dollar higher than other worthless fiat currencies.
Equally amazing is how many liars and imbeciles point to hyper-manipulated gold and silver prices and echo the exact same lie, namely "the dollar is wonderful, and gold/silver is an archaic worthless archaic and barbaric pet rock".
Obviously the endless lies about "raise rates" and manipulating gold/silver downward are done for the same reason... to keep the fiat, fake, fraud, fiction, fantasy, fractional-reserve debt-note currency scam going just a bit longer, and a bit further down the road... and finally, over the cliff.
Humans are so clueless... so easily fooled and manipulated.
Regulatory Capital charges for inventory bonds or swaps, especially longer dated, are stupidly high. Until this changes expect significantly reduced liquidity. Market making needs to be profitable.
The above said, large negative swap spreads can indicate a dearth of good collateral, as reflected in the repo market and can be a signal of fear.