High Yield

It was well-known that today's 10 Year auction would price somewhere north of 2.00%, for the first 2%+ print since April of 2012, it just wasn't known where. Sure enough, moments ago the US Treasury priced $24 billion in 10 Year paper at a high yield of 2.046% (38.76% allotted at high), the highest since last March when we had a 2.076% 10 Year auction (and a carbon copy environment in which every pundit was screaming about a great rotation out of bonds), only to see the April and especially May auction tumble in yield when Europe once again became unfixed. What was notable about today's auction is that it tailed the When Issued modestly, which was bid 2.039% at 1 pm, implying a 0.7 bps tail. Also notable: the Bid to Cover dropped to 2.68, below January's 2.83, and well below the 12 month TTM of 2.99. Dealers took down 47.7% of the auction, Directs as has recently been the case ended up with a sizable 24.2%, while Indirects took only 28% of the auction, higher than the December 24.2%, yet worse than all other auctions going back all the way to April 2009. For those confused - don't be - we have been here in 2012, and 2011, and 2010, when risk assets were surging, and when yields were sliding, only to see a modest subsequent pick up in inflation, mostly in China, but certainly Europe, at which point the global liquidity glut ceased and the economy (if not the centrally-planned market) resumed on its downward glideslope.

As we noted yesterday, the credit bubble is in full swing as high-yield covenant protections hit a new low in January. At the same time, new issue premia in high yield credit has remained extremely low (meaning demand is high) - even as leverage (measured in a number of ways) surges to post-financial-crisis highs. With low yields and technical demand so abundant, firms appear to be leveraging-up in favor of shareholders. But, as is always the case, there is a limit to just how much leverage can be piled on before credit spreads 'snap' and raise the cost of capital - hindering the equity price. Finally, for the 'cash on the balance sheet' advocates, US firms' Cash/Debt is its lowest (worst) since pre-crisis. Banks continue to delever, sovereigns relever, and non-financials taking their lead - this didn't end well last time... and this time, exuberance and positioning is very heavy.

Following yesterday's G-7 announcement which sent the USDJPY soaring, and its embarrassing "misinterpretation" clarification which undid the entire spike, by an anonymous source in the US who said the statement was in fact meant to state that the Yen was dropping too fast and was to discourage "currency wars", it was only a matter of time before another G-7 country stepped into the fray to provide a mis-misinterpretation of the original G-7 announcement. That someone was the BoE's outgoing head Mervyn King who at 5:30 am eastern delivered his inflation reporting which he said that "it’s very important to allow exchange rates to move," adding that "when countries take measures to use monetary stimulus to support growth in their economy, then there will be exchange rate consequences, and they should be allowed to flow through." Finally, King added that the BOE will look through CPI and relentless UK inflation to support the recovery, implicitly even if it means incurring more inflation.

Those who traded credit in the frothy days of 2007 will recall that virtually every piece of new paper, including LBO debt, would come to market with the skimpiest of creditor protections, i.e., "covenant lite" which to many was an indication that money was literally being thrown without any discrimination in the last epic chase for yield, just as many were preparing for the imminent market backlash. Which they got shortly thereafter. Judging by the amount of covenant lite loans issued in 2012 as a percentage of total and compiled by Brandywine Management, which just surpassed the credit bubble frenzy of 2007 at more than 30% of total issuance, the bubble in credit is now well and truly back - a job well done Federal Reserve, just 5 years after the last credit bubble.

One of the largest potential volatility events for the equity markets this year will be the Q1 US Debtapalooza.  There are three main issues that are to be debated with a crescendo coming in late February – the Long Term Budget Deal, the 2013 Budget Deal and the Debt Limit.  There will obviously be many consequential threats and theatrics associated with these events – including potential threats for government shutdowns and debt defaults – while the very real consequences could be additional US ratings downgrades.  It is important to remember that outside of the 2008 shock, the Debt Ceiling Debate and consequent US Debt Downgrade in Summer 2011 created the biggest volatility event of the past two decades. Volatility metrics show that the market is extremely complacent heading into these events.

We have been monitoring the shifts in the high-yield bond market for a few weeks, noting that bond ETF and credit derivative markets are showing some serious (divergent from stocks) signs of risk-off. Whether this was driven by call-constraints limiting upside potential, a fundamental realization of a shifting macro background, or ad hoc idiosyncratic risk elevation due to releveragings and potential public-to-private transactions is unclear. What is clear is that this week saw the largest HY ETF outflow on record. Furthermore, HYG's shares outstanding have plunged over 11% in the last 90 days as ETF units are for the first time destroyed QoQ not created. The rotation appears to be up-in-quality and up-in-capital structure as loan funds saw inflows - but with stocks and credit linked inexorably via the balance sheet, the divergence cannot last forever (and never has). Until very recently this has not spilled over into the cash bond market, but the last few days have seen selling pressure picking up into this illiquid market.

It was a busy session for Chinese "data" (more on the laughable validity of Chinese economic releases shortly), after China released January export and import data, which rose 25% and 28.8% from a year ago respectively. Futures were delighted by the data, until someone pointed out that January 2013 had some five more working days than 2012 due to the calendar shift of the Chinese new year, and that adjusted for this effect exports were a far more modest 12.5% while imports rose only 3.4%. Credit growth in January also rose to a record, with aggregate financing of 2.54 trillion, including new local-currency loans of 1.07 trillion, exceeding forecasts, as China dumped gobs of money into the economy, while somehow quite mystrriously inflation came right on top of the expected 2.0%. The Yen soared overnight following comments from Taro Aso who said that the Yen had depreciated too fast. Heading to Europe, the biggest news so far was the latest ECB LTRO repayment which saw some 21 banks repay €4.992 billion, less than the estimated €7.0 billion. Finally, trading today will be slower than usual as Nemo is finally found in the shape of some 12 inches of snow blanketing the Northeast.

Jeremy Grantham: "I like the analogy of the Fed beating a donkey (the 1% growing economy) for not being a horse (his 3% growing economy). I assume he keeps beating it until it either turns into a horse or drops dead from too much beating!"

The belly of the curve got whacked in today's $29 billion 7 Year auction, when the high yield of today's debt issuance came at some 1.416% (32.5% allotted at the high), outside the 1.408% When Issued, the first tail on a 7 Year of short maturity bond in a while, and a modest cause for concern, if not quite the "massive rotation out of bonds" we have been hearing about for months. The internals were hardly indicative of a major weakness, with a 2.60 Bid To Cover, below last month's 2.72, Directs taking down 19.75%, Indirects 38.21% and Dealers holding on to 42.04%: all in line with recent results as can be seen on the chart below. The yield, however, was well above December's 1.23%, and the highest since February 2012, when as today, things were supposedly getting much better and inflation was just around the corner, when it was really just the LTRO effect and some $1.3 trillion in liquidity courtesy of Europe.

Moments ago the Treasury closed its latest 5 Year bond auction in what was probably the most boring auction of 2013 to date, and perhaps of the last several months. The high yield was 0.889%, just inside of the 0.89 When Issued, with 32.39% allotted at the high, some 12 bps higher than December's 0.769 and the second month in a row of increasing yield. While hardly anything to write home about, this was the highest yield on 5 Year paper since march 2012. The Bid To Cover also rose, at 2.88, it was higher than last auction's 2.72, and right on top of the past 12 month average. The internals were boring too, with last month's record Direct take down of 30.4%, and correspondingly low Indirect 32.4% take down, inverting, with some 16.8% of the auction going to Directs, still the second highest ever, while Indirects ended up with 39.7%, and the remaining 43.5% handed to Dealers. In short- very uneventful, and just like yesterday, not even a trace that someone, anyone, may be losing their appetite for US paper.

There may be rotation out of bonds (there isn't), but don't tell the Direct bidders, who submitted a total $22 billion in bids for today's $35 billion Two Year auction, and well below last month's $18.2 billion, and were hit on just under half of this tendered amount, taking down a massive $10.4 billion, or precisely 29.99% of the entire auction. This was the second highest Direct takedown in history only less than October's 35.41%. What is curious is that Indirect buyers, traditionally strong buyers of the 2 Year point on the curve, and taking down on average 31% in the past year, were left with just 18% of the auction, slightly better than last month's record low 17.7%, and the second lowest as far as our time series goes. The balance of 52%, as always, was left to the Primary Dealers, who will promptly turn around and flip it back to the Fed at the first opportunity now that the Fed is monetizing across the curve and not just to the right of the belly. Other metrics of today's auction included a 3.77 Bid to Cover, roughly in line with the trailing 12 month average, and higher than December's 3.59, while the final high yield was not surprisingly, 0.288, just inside of the 0.289% When Issued at 1 PM trading. Overall hardly a flight from Treasurys, at least in the segment where the nominal return is absolutely laughable, and an indication that nobody believes for a second that ZIRP may be ending any time soon.

The S-Curve usefully charts the gradual development, explosive rise and eventual stagnation and collapse of complex systems. Remarkably, natural phenomena such as the spread of bacteriological diseases and financial dynamics both follow S-Curves. The S-Curve also helps us understand why the Expansionist Central State is doomed to inevitable implosion/collapse. The key dynamic in State spending is this: the allocation of public capital is intrinsically a political process, not a market or communal process. We are at the inflection point indicated on the chart below where the lines cross, just before the crisis: tax revenues are lagging spending in an enormous structural deficit. Tweaking tax policy or raising the debt ceiling will not change any of these dynamics. The Expansionist State is on the path to implosion (insolvency) and collapse, i.e. a political crisis. If we understand the core dynamics of the Expansionist Central State - the political allocation of scarce national income to favored constituencies and cartels - we understand why this process is inevitable.

Need just one chart to avoid anyone who says they have any idea where the S&P will close in three years... or two... or one? Here it is: the graphic below shows that when it comes to predicting the closing level of the S&P several years into the future, absolutely nobody, and certainly not the consensus outlook, has any clue. However, they sure make up for lack of accuracy and insight with hope, optimism, and relentless persistence and enthusiasm to be wrong again and again and again.

There have been some large moves in the foreign exchange market in recent days.  The euro posted its largest rally in four months last week.  The yen has fallen to its lowest level against the dollar since June 2010 and extended the declining streak to nine consecutive weeks, something not seen since 1989.  The Canadian and Australian dollar rose to multi-moth highs, as did the Mexican peso.  

In last week's technical note, we suggested the key question whether the sharp drop in the major foreign currencies following the avoidance of the full fiscal cliff in the US was trend reversal or overdue correction.  We favored the latter and looked for the underlying trends to continue.   They did.  

Now market participants face a different question.  Given the out-sized moves, have the trends become stretched?  The answer, we propose, is more nuanced than last week.  There is not one answer for all the major currencies we review here.

Another day, another epic European close trend reversal (or is it POMO that is driving that odd timing-based shift?). S&P 500 closes at 5-year highs. Today's ramp was brough to you by the algos that needed to enable high volume exits in AAPL and a Draghi-driven 200pip run in EUR against the USD (as the ECB head basically shut the door on rate cuts anytime soon). VIX slid lower (relatively outperforming stocks) but mid-dated VIX futures actually rose modestly today (to steepest in a year!); high yield credit ETFs tested new highs (but cash never followed) and even that collapsed again at the close; the USD dropped the most in 4 months (even as JPY weakened); and Silver surged (+2% on the week) along with gold (as oil slid in the afternoon). It appears that so far this year risk-assets in general had been less exuberant than stocks - but first Treasury yields, then VIX, and now FX markets (EURJPY today), and increasingly Gold (and Silver) are shifting to catch up to stocks. Today saw equities ramp from the end of POMO on to catch up to EUR-driven risk model perception, with AAPL trading like a penny stock (or HLF). The great recoupling of risk-assets from pre-holidays is almost complete...