High Yield

And so Wall Street has set its sights on the next junk bond fund casualty, a name which is well-known to most equity market participants: none other than Waddell and Reed (WDR), the fund which rose to infamy in the aftermath of the May 2010 Flash Crash, after it was initially blamed by the SEC as the culprit behind the Dow's 1000 point crash...

Taken together with the rather steep drop in US industrial production, the risks of a full-blown and perhaps severe recession have undoubtedly grown. Unlike what the FOMC is trying to project via the federal funds rate, a rate that isn’t being fully complemented, either, at this point, visible economic risk is not just rising it is exploding.

FIRPTA was implemented during a better era for Americans in response to international investors in the late 1980s and early 1990s buying U.S. farmland, as well as the more publicly visible buying of trophy U.S. property by the Japanese.  The US government has now expediently waived FIRPTA.

The problem with all of this is that it’s now becoming apparent to everyone. The amount of mal-investment along with just how intertwined all the subsequent carry trades and more is becoming frightfully obvious and can no longer be hidden from view. The real problem now facing the Fed. which I believe they themselves did not fully comprehend was the extent in which all of this was: so blatantly obvious. Again: to anyone who truly wanted to look. Without the Fed’s interventionism – there is (and was) no market. And now with the raising of rates; no one will be able to miss or avoid that fact any longer. No matter how hard they try.

The Senate and House passed the spending bill this week, which the President signed into law on the same day. Embedded in the law is a provision to lift the 40-year old crude export ban. The lifting of the crude export ban is a historic milestone, but seemingly less relevant for US E&Ps, Midstream and Oilfield Services as compared to a year and a half ago when WTI-Brent spreads were close to $9.00/bbl vs. the current spread of $0.80/bbl. Nevertheless, there is still a negative long-term impact on refiners should spreads re-widen.

The Fed pricked the financial bubblethis week as expected. Janet Yellen’s press conference couldn’t have been more perfect as it confirmed that the money printers have come to a stark dead end. The fact is, the global economy is deflating rapidly and the U.S. is sliding into recession. But our Fed chairman is clueless about what’s happening. She and her posse of money printers are going to get bushwhacked by reality in the year ahead.

"In a worst case scenario, the real economy effects of the oil sector and the earnings slowdown hit the frothy commercial real estate and REIT sector, which in turn begin the widening of the contagion begun by energy high yield. Combine this with the sudden stop to lower quality energy credits I believe is inevitable and you likely have stall speed – or even recession. And that’s where subprime auto ABS, student loan securitization and US munis come into the picture for the US domestic economy. Those markets get hit in recession."

This was not supposed to happen. Since The Fed raised rates the temporary (one day) stability in high-yield bonds has been obliterated. Across all sectors, HY bonds are being sold; the HY bond ETF is tumbling back to recent lows; and Energy spreads have surged to record highs. In a nutshell, it's not over yet!

Yellen and her cohort have no clue, however, that all of their massive money printing never really left the canyons of Wall Street, but instead inflated the mother of all financial bubbles. So they are fixing to blow-up the joint for the third time this century. That was plain as day when our Keynesian school marm insisted that the Third Avenue credit fund failure this past week was a one-off event - a lone rotten apple in the barrel. Now that is the ultimate in cluelessness.

As new investor liquidity evaporates and as billions are redeemed first from the junk bond universe, then investment grade and then loans, the debt crisis which was unleashed in anticipation of the Fed's rate hike, is about to get much worse, and lead to even more prominent hedge fund "gates" and liquidations.

Heading into the Fed's first "dovish" rate hike in nearly a decade, the consensus was two-fold: as a result of relentless telegraphing of the Fed's intentions, the hike is priced in, and it will be a "dovish" hike, with the Fed lowering its forecast for the number of hikes over the next year. Consensus was once again wrong on both accounts: first the rate hike was far more hawkish than most had expected (see previous post), and - judging by the surge in Asian, European stocks and US equity futures - the "market" simply is enamored with such hawkish hikes which will soon soak up trillions in liquidity from the financial system.

"The irony in this year’s batch of outrageous predictions is that some of them are “outrageous” merely because they run counter to overwhelming market consensus. In fact, many would not look particularly outrageous at all in more “normal” times – if there even is such a thing!"

According to ScGen, the Fed is widely expected to start tightening policy on Wednesday and adds that "after the BoJ and ECB, we see a risk that the market will be wrong-footed for a third time, and that extreme positions built ahead of tightening will be reversed.... In particular, we are short US small cap equities vs large via being short Russell 2000 vs S&P 500.... As the Fed tightens and the market enters into a lower-liquidity environment (and higher-volatility regime), we think the premium on small caps is no longer justified."

The day has come when the boxed-in Fed has no choice: with the vast majority of the market expecting a rate hike, Yellen has to deliver or suffer a crushing confidence blow like no other. And deliver she will, with expectations that said hike will be "as dovish as possible." For now however, the market is desperate to convince itself that just as more easing and more QE were bullish for the market, so rate hikes are just as bullish. Recall from late 2013: "tapering is not tightening," then the 2015 version of this refrain is "tightening is not tightening."