Musing On The Great Credit Unwind

The how, why & when of what is happening right now according to my colleague at ...


PHASE 1:

Rising home values encourage a proliferation of sub-prime mortgages sales.

Sub-prime mortgages become the cornerstone of structured financial products (ABS).

Increasingly opaque ABS (CDO etc) facilitate a proliferation of this asset class.

Rapidly increasing sales of ABS allow liquidity conditions to improve even as credit quality deteriorates.

Liquidity manifests itself in abundant short term (wholesale) funding.

Short term funding is used to purchase higher yielding assets (either higher risk or longer maturity).

This “carry trading” pushes risk premiums even lower, promoting a “chase” for yield.

As yields compress further, more leverage is needed to garner the same results.

Carry trades now dominate global investing patterns.

The USD becomes the main casualty of the carry trade.

Emerging Markets and commodities become the main beneficiaries.

Higher commodity prices slow consumer spending in the West and increase inflation in the East.

Expected policy responses (notably by the Fed) drive the USD lower and commodity prices higher – creating a vicious circle.

The cycle is broken when the music stops playing for the ABS issuers (triggered by the collapse of the Bear Sterns CDO funds) – just as commodity prices have driven the US consumer into recession.

Lehman’s default removes all the other musical chairs, in one go.

The world de-levers.

THE LARGEST CARRY TRADES IN HISTORY ARE FORCED TO UNWIND.

The US dollar becomes the main beneficiary of unwinding carry trades.

Emerging Markets and commodities become the main casualties.

High correlations ensure that de-leveraging in one asset class is swiftly followed by de-leveraging in other risk assets.


PHASE 2:

This brings us to the policy response. The above perspective is essential in understanding what the Fed subsequently tried to achieve. The evaporation of trillions of dollars worth of carry trades meant the Fed was forced to use its balance sheet to fill the void.

The irony, of course, is that carry trading (selling low risk/low yield assets to buy higher risk/higher yielding assets), based on artificially available and cheap short term funding, was the cause of the credit crisis. However, the Fed had little option but to provide the exact same poison – I suppose much in the same way as one might give a heroin substitute to an addict suffering from too severe withdrawals.

In both cases, however, it is clearly not the long term solution – the side effects will eventually outweigh the benefits. And that is where we currently stand, with the inflection point passed somewhere during the course of QE2.

Once the initial liquidity black holes were filled, subsequent liquidity found its way into speculative carry trades (Emerging Market currencies and commodities) which hindered, rather than helped, global growth.

POLICY THEN CHANGED.

After 3 years of deliberately and explicitly recreating an even bigger beast of a carry trade, policy has changed.

THE FED IS NOW UNDWING THE BIGGEST CARRY TRADE IN HISTORY.


PHASE 3:

Again, the above is essential to understanding how markets are likely to evolve in the coming months. The Fed has DELIBERATELY broken the carry trades – a STRONG US DOLLAR POLICY IS NOW IN PLACE.

Full QE, let alone “twists” and “shouts”, has little more to offer. The only policy tool of any power left (and it has considerable power) is crushing the speculative element of the carry trades: INFLOWS to Emerging Markets, and COMMODITIES.

THE DAM HAS JUST BROKEN ON 3 YEARS WORTH OF CARRY TRADE BUILDING.

DO NOT EXPECT THE PROCESS TO COMPLETE IN A FEW WEEKS - LET ALONE DAYS.

DO EXPECT ENORMOUS COLLATERAL DAMAGE TO OTHER RISK ASSETS. THIS IS NOW THE “ACCEPTABLE” SIDE EFFECT OF POLICY.

Anyone long a Copper/ Short USD carry trade, for example, would have lost 30% over the past 3 weeks alone! Anyone more than 3x levered would clearly have been entirely cleaned out.

Given the ferocity of both the EM currency and commodity reversals, it’s hard to believe that more than a small fraction of those involved in these trades managed to unwind a meaningful amount of their positions. Again, anyone with any sort of leverage will now be in an impossible position – hoping for a massive bounce. If everyone’s hoping for a huge bounce, and the trades are exceptionally crowded, then I’d put the chances of those wishes being granted at zero. On the contrary, margin calls will soon start to bite, and de-leveraging of other risk assets will accelerate.

My biggest fear – given the role of the Chinese in commodity speculation – is that forced de-leveraging of commodities could lead to de-levering on the real estate side there, opening up a whole new front in the war against deflation.

In conclusion, one needs to see recent events from the proverbial “30,000 foot view”. This isn’t about the market discounting a US recession – or a drop in earnings (forget P/Es for the moment) – it is about changing policy and the resulting unwind of concentrated risk trades. This creates the wanted effect of lower commodity prices (good for the vast majority of the world), but it also creates the unwanted side-effect of higher volatility in risk assets, for a short period at least. The stakes are clearly being raised by the inertia amongst European leaders to their solvency issues, so I’m not in any hurry to change stance here. I remain negative on cyclical sectors and extremely negative on commodity related investments. Consumer Discretionary – particularly Restaurants – would be the only cyclical area I’d have decent exposure to – but that’s more as a hedge (as markets could easily bounce). On the defensive side I would favour the domestics over the internationals (i.e. Utilities and Telcos) – as the US dollar is likely only at the beginning of a major move higher. This is not meant as a trading call - markets don't tend to go in straight lines - but I would use any oversold bounces to continue to position defensively. Anecdotally, I still get the impression investors are confusing defensive with neutral, so I suspect we've got a way to go yet..


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Musings on Recessions

8/12/11

Re: Recessions

History would disagree with you on the necessity of a financial event to push us into recession.  Recessions follow quarters of below potential growth (now popularly called stall speeds) that are not self sustainable: growth falls to a level where job growth cannot be in excess of population growth which leads to rising unemployment, falling real estate values, and eventually falling business and consumer confidence.  You essentially fall into a disequilibrium state that has always resulted in a recession absent extraordinary monetary or fiscal action.  We are in such a state right now and certainly a bad financial or oil price event could accelerate a recession, but they are not necessary to have a recession.  Some would argue that we are Japan and we will just stay in stall speed for an extended period.  I have my doubts because stall speed has very different implications for a shrinking population than it does for a growing population.  A different argument is that temporary factors (e.g. Fukishima nuclear disaster and MENA unrest) make it look like stall speed but we are not actually in it.  I would argue that indicators like GDI (gross domestic income), CFNAI (Chicago Fed National Activity Index), and the employment to population ratio which declined to stall speed before the temporary factors argue otherwise.

Net Foreign Security Purchases (TIC)

Summarizes the flow of stocks, bonds, and money market funds to and from the United States (i.e. capital flow into US denomiated assets). The headline figure is the difference in value between American purchases of foreign securities and foreign purchases of American securities, expressed in millions of dollars. The Treasury International Capital or TIC statement is a major component of the American capital account and gives valuable insight into foreign demand for American investments and dollar.

A positive figure indicates that more capital is entering the US than leaving as sales of American securities to foreigners exceed American purchases of foreign securities. Positive figures suggest that American security markets are competitive with those of other countries.

Foreign security purchases are especially important in the case of a trade deficit, as a positive figure can offset the depreciating effect (on the USD) of a trade shortfall. A negative or declining TICS figure reflects a declining capital flow picture. Outflows are indicative of weaker demand for US assets which puts downward pressure on the value of the dollar.

TIC data breaks down investors into governments and private investors. Usually, a strong government holding of dollar denominated assets signals growing dollar optimism as it shows that governments are confident in the stability of the U.S. dollar. Most importantly seems to be the purchases of Asian central banks such as that of Japan and China. Waning demand by these two behemoth US Treasury holders could be bearish for the US dollar. As for absolute amount of foreign purchases, the market generally likes to see purchases be much stronger than the funding needs of that same month's trade deficit. If it is not, it signals that there is not enough dollars coming in to match dollar going out of the country. As a side note, purchases by Caribbean central banks are generally seen to be less consistent since most hedge funds are incorporated in the Caribbean. Hedge funds generally have a much shorter attention span than other investors.

Release Schedule: 9:00 AM (EST); monthly, in the second month following the reporting month

Revisions Schedule: Data are subject to revisions for 24 months following release

Source of Report: U.S. Treasury

Web Address: http://www.treasury.gov

Address of Release: http://www.treasury.gov/tic/ticsec2.html

Understanding The Yield Curve

What is it?

The graph you get when you plot the rates for 1-month T-Bills to 30-year T-Bonds.

When people think about interest rate changes, they generally are discussing a parallel change in interest rates, where rates change by the same amount across the yield curve.

When yield curve changes are discussed from a bearish or bullish standpoint...

Rising rates are considered bearish.

Falling rates are considered bullish.

Non-parallel shifts are generally discussed as yield curve twists.

The shape of the yield curve is simply the difference in yield between two maturities. The "rule of thumb" is to look at the 2-year to 10-year Treasury curve slope. If the 10-year rate less the 2-year rate is positive, the yield curve is normal, or positively sloped. If it were negative, it is called an inverted yield curve. If the difference is relatively small, it's considered flat.

Non-parallel shifts

Steepeners... when the difference between the long end & the short end increases

Bull steepener... short interest rates are falling faster than long rates

Bear steepener... long rates are rising faster than short rates.

Flatteners... when the difference between the long & short end decreases

Bull flattener... long interest rates are falling faster than short rates

Bear flattener... short rates rise faster than long rates