ASIA - Credit Contraction Problems

Slower Asian Growth + Weaker Funding Conditions = ? 08-24-13 Morgan Stanley via ZH

The challenge to the world's credit cycle comes from both ends. An increasingly sluggish growth outlook creates downward pressures on earnings and internal cash generation. The slowdown is fairly widespread. In addition, the cost of funding is on the rise.

Credit, as an asset class, tends to perform best just coming out of a downturn when a growth recovery, coupled with balance sheet discipline, drives significant improvements in credit profiles. It can still do well in the middle parts of a cycle provided growth is stable and funding conditions benign, although carry is a more important return driver and idiosyncratic risks pick up as balance sheet trends become more mixed.

However, the downside skews begin to emerge in the later stages of a cycle when leverage has already increased and the cycle turns more adverse, and that is happening in Asia right now. 

This is critical in our current benign default environment... because the combination of highly leveraged firms, slowing GDP and rising real rates was exactly what created the spike in defaults in 2007-2009 (that only the largest monetary policy bailout in history was capable of kicking down the road).

Periods where the gap between real GDP and real rates is narrow or negative represent particularly challenging funding conditions for corporates: either cash generation is poor or funding costs high, or both. As a result, these are often the periods where default rates tend to rise.

The rise in cost of funding is broad-based and has many drivers making it difficult to reverse even if UST yields stabilise. The rise in the cost of funding is ‘real’ – higher rates are no longer balanced by high inflation – and the rise now means that the gap between real GDP growth and real rates is the narrowest since the downturns in 2008/09 and before that 2001/02.

Source: Morgan Stanley

ASIA CREDIT - India Rupee Collapse Showing Signs of Exhaustion

Key Technical Levels - 10-Year, Copper, Yen And Rupee BofAML's MacNeill Curry via ZH

USD/INR shows signs of exhaustion

USDINR is showing signs of stalling. The Daily Candlestick against weekly and daily channel resistance and bearish momentum all point to a near term turn. WATCH US Treasuries. A break of key resistance (2.802%/125-09) would likely be the catalyst for a move constructive near term outlook for the Indian Rupee.

STATISM - It’s The Government, Stupid

Detroitification - It’s The Government, Stupid 08-26-13 Monty Pelerin's World blog,via ZH

Facts are stubborn things.

No matter how hard the Washington crowd tries to sell an economic recovery, inconvenient and contrary facts keep rearing up to shatter their mythmaking. Few people any longer believe the claims of declining unemployment or low inflation at least based on purchases they make.

The fable of a housing recovery is now crumbling:  New Home Sales Plunge 13.4% in July, June Revised Lower; Blame Rising Mortgage Rates; Starts 896,000 – Sales 394,000. Two weeks ago, the same author (Mish) provided this article: Mortgage Applications Decline 13th Time in 15 Weeks; Are Mortgage Rates Cheap? What’s Next For Housing?

Rising interest rates are blamed for the housing reversal.  As the late Gilda Radner would have said: “it’s always something.”

The recession, declared over in June 2009, never ended. Over four years later there has been no meaningful sign of a recovery. In spite of unprecedented government and Federal Reserve stimuli, the economy has barely budged  These actions have only masked the true condition of our economy and will make us poorer in the future.

Some wonder how bad the recession/depression might have been had government not acted. Others worry that we will find out when the Fed tapers.

What is Going On?

Newspapers and the economic cacophony emitted by pundits and political hacks only confuse the average person as to what is really happening.

Rising interest rates, the reason given for weakening housing, provide a convenient and plausible excuse. But explaining complex economic issues rarely can be answered by citing a single variable. Such an answer is simplistic and begs the more fundamental question of why interest rates are rising now. Addressing this issue does not lend itself to snappy sound bites. Furthermore, it leads into complex relationships that few are able or willing to follow.

An unwillingness to explore these more complex issues is just fine from the political standpoint. They lead to a  host of inconvenient and embarrassing issues regarding Washington’s mismanagement of the economy. The also enable economists to leap into the weeds of their particular jargon, theory, empirics and political leanings regarding the economy.

Let’s keep this discussion simple, which can be done by assuming away some of the noise and complexities like economists are wont to do. Let’s assume away economics and economists for the moment. Let’s pretend that neither exists and try to take a common-sense approach to the economic problems of the country.

As an economist, I think it worthwhile so that others, untrained in this so-called discipline, may better understand the simplicity of what ails the country. The pejorative “simplistic” is one hurled usually by people trying to protect their turf by using smokescreens.

Economics for Dummies

The reason why the economy is not recovering and will not recover can be explained in five simple points:

1. Wealth and standard of living increases can only be achieved by producing more, not less.
2. Capital increases are required to produce more. Wage gains are directly tied to productivity gains and more capital enables productivity to rise. US workers earn more because they are more productive as a result of having more capital (tools and equipment) to work with.
3. The private sector uses and expands capital. Firms cannot achieve this result, go out of business. The remaining capital is taken over by better stewards. Successful firms grow, creating value, jobs, incomes, wealth and more capital.
4. Government destroys capital. It confiscates it from the private sector and uses it for consumption, effectively reducing the supply. Jobs, income and growth that otherwise would have developed do not. The rare exception is if government “invests” in capital projects like roads, infrastructure or meaningful education. If properly chosen, this government spending can assist in the production of capital.
5. The proportion of assets and capital confiscated has increased greatly over the last century. At some point, the capital and wealth left behind in the private sector is inadequate to reproduce itself. That is when economic growth turns negative and standards of living decline. Long before that point growth rates diminish.

It is this simple process which has crippled the US economy. Pointing to rising interest rates, declining innovations or a host of other variables as the cause of the problem is to miss the root cause of the problem.

Now What?

The golden goose has grown old and tired. It no longer has enough capital to achieve the performance of the past. The country is poorer than it should be as a result. Washington’s policies, interventions and disincentives are making it poorer still. These policies help Washington and its cronies. They lower the standard of living of the rest of the country.

Wealth (capital) enables economies to grow. It is the primary requisite for a rising standard of living. It provides the means to work less and have more. Workers are made more productive and achieve higher earnings. The well-known socialist economist Joan Robinson begrudgingly admitted to that fact at the height of Keynesianism and the intellectual attraction to socialism when she said the following of capitalism (my emboldening):

The system is cruel, unjust, turbulent, but it does deliver the goods, and, damn it all, it’s the goods that you want. Joan Robinson

A Simple Choice

Politicians do not want to discuss the economic problem in simple terms. They are the biggest beneficiaries of the welfare state which feeds their egos, desire for power and as a means to buy votes to retain office.

The golden goose upon which the horde of political parasites  feeds is not immune. It grows ever weaker and unproductive as a result of the predations. A decision must be made between two options: the Welfare State or the Prosperous State. There is no third way. The choice is to continue down this road to serfdom or to make a U-turn back toward prosperity.

Advanced stages of the welfare state will lead to its eventual demise. History is replete with governments that extended themselves beyond what their populations were willing or able to support. That is the point the US has reached. The so-called economic crisis did not begin in 2009 or even 2001. These were symptoms of the disorder and maladjustments that had been introduced into the economy years before.

We can continue down the current road and never see a return to economic vitality that was experienced only a few decades ago. Poverty, jobless and continued declines in the standard of living will increase. Ultimately the economy will collapse under its own weight or civil unrest will bring it down.

Or we can repeal much of the nonsense that has contributed to this problem and return  to the vitality, growth and rising incomes that characterized most of our history. That requires a massive reduction in government’s role in the economy and its spending.

These are the only choices that affect our destination. All other considerations are mere distractions and excuses. It is just that simple!

These comments are as relevant for the welfare states in Europe as they are the US.

What Happens Next

The choice above will likely not be addressed until an economic tragedy renders our economy dysfunctional.

Before that occurs, a collapse of financial asset prices (stocks and bonds) is a probable next event. The timing of such a collapse is not reasonably predictable, but current asset price levels reflect Fed-created smoke and mirrors liquidity. This reinflated bubble will collapse just as the now deflating housing bubble has. What is certain is that something as irrelevant as rising interest rates will be blamed.

Without rollbacks in confiscations of wealth, harmful policies and the removal of perverse incentives, this country must continue to decline.

Why There Can Be No Recovery — Simple Supply and Demand

Individuals are adjusting their behavior to the new normal — a declining real standard of living. That means driving cars longer, downsizing homes, dining out less often, buying new clothes less frequently, etc. etc. These adjustments are all demand side. They are rational in a world where the standard of living is falling short of expectations. There is no short-term fix for this problem.

The supply side of the economy is not as easily rationalized. Commitments in the form of fixed investments and long-term debt are in place. As the country becomes poorer and demand shifts downward, the supply side is not easily downsized. Workers can be laid off as a partial adjustment, but many of the costs are fixed and not downwardly adjustable. The number of retail stores, dry cleaners, car dealers,  restaurants, malls and virtually everything else was built for a higher expected standard of living than is forthcoming. This supply must shrink to the level of demand. That process inevitably involves layoffs, closures and bankruptcies.

Many of the marginal businesses that held on through the first wave (2009) will not make it through the next one. The great Recession that policy analysts claimed was cured has yet to come. It will, it is unavoidable.

Detroitification

For lack of a better term, the process the entire country is headed for is “Detroitification.” The term represents a declining if not dying economy. Higher interest rates, “slow growth,” lack of innovation, worldwide slowdown or many other variables will be used to rationalize what is coming. The tragedy results from one cause and one only — the idiocy of our federal government and its greed.

At this stage, the damage is done and cannot be undone quickly enough to avoid this crisis. Even if there were time, there is no way that politicians would willingly address the problem.

CANARIES - Signs of a 1987 Correction Abound

1987 Redux 08-23-13 Jim Quinn of The Burning Platform blog via ZH

1. Consumers are carrying more debt than they did in 2007. (Consumer credit - ignoring mortgages - is up to $2.8 trillion.. In 2007, at the height of the “credit bubble,” it was just $2.5 trillion.)
2. Corporations are carrying more debt than they did in 2007. ( U.S. businesses owe $12.9 trillion - compared with $11 trillion in 2007.)
3. The Federal government is carrying 60% more debt than it did in 2007.
4. Cities and States are carrying more debt than they did in 2007.
5. Interest rates have jumped by 80% in the last three months.
6. The economy is clearly in recession, as retailer after retailer reports horrific results.
7. Stocks are as overvalued as they were in 1929, 2000, and 2007.
8. China is experiencing a real estate collapse.
9. Japan is experiencing a cultural/economic/societal collapse.
10. The Middle East is awash in blood.
11. The European Union is held together by lies, delusion and false promises.

What could possibly go wrong? 

Are investors high?

Stock market investors continue to ignore one of the biggest, fastest jumps in long-term interest rates on record.

Yes, the Dow slipped below 15,000 this week, but it remains near its long-term peak — despite the harrowing plunge in the bond market in the past couple of months, which has sent rates surging. Indeed, I suspect one reason the stock market has risen is that some naive investors have calculated that they can be safe by “rotating” out of bonds and into stocks.

• At the start of May, the U.S. government could borrow money for 10 years at 1.6% interest. Today, barely four months later, it has to pay 2.88%.
• At the start of May, someone buying a new home with a $200,000 mortgage was locking in monthly interest costs of $566. Today, thanks to the surge in mortgage rates, someone making the exact same purchase will have to pay $766 a month in interest.
• A company with a BAA credit rating has seen its bond rates spike from 3% to 4% over the same period, and a riskier company with a BA rating jumped from 3.9% to 5.2%.

It’s easy to be fooled by the low absolute level of interest rates into thinking these are small moves. Rates are “only” up by 1% or 1.5%, after all. But actually these are huge moves, because they come from a low base. Mortgage costs are up about a third in a short period, from 3.4% to more than 4.4%. Uncle Sam’s cost of 10-year money has rocketed by 80%.

Traders continue to focus on the minutiae of Federal Reserve minutes and the timing of the Fed’s likely moves in the bond market. Ordinary investors should focus on the bigger picture. The Fed has announced that the era of quantitative easing, and aggressive manipulation of long-term interest rates, is coming to an end. We are due to move, sooner or later, back to an era of “normal” interest rates. Typically, that would mean 10-year Treasury rates about two percentage points above expected inflation, meaning today’s 2.88% yield would become more like 4.5%.

If 10-year Treasury rates hit 4.5%, mortgage rates will probably near 6% - meaning that a $200,000 home loan will cost $1,000 a month in interest, instead of $566. An investment-grade BAA borrower will have to pay about 5% on its bonds, instead of the 3.1% paid in early May.

At the very least, you had better understand the risks - of stocks, and not simply of bonds.

Rising interest rates will hit everything from car loans and credit card borrowers to closed-end investment funds, many of which have artificially goosed their yields with leverage. They borrow money at short-term rates and invest it at long-term rates. That has looked good for the past few years. It won’t look so good if the process reverses.

This surge in borrowing costs comes in an economy more in debt than any in history. It’s not just Federal debt and mortgages, either. Consumer credit - ignoring mortgages - is up to $2.8 trillion, according to the Federal Reserve. In 2007, at the height of the “credit bubble,” it was just $2.5 trillion. U.S. businesses owe $12.9 trillion - compared with $11 trillion in 2007.

The future is unknown, of course, and I am acutely conscious of Peter Lynch’s famous dictum, that an individual investor will probably lose more money fearing a stock market crash (over time) than he or she will likely lose in a market crash. Nonetheless, we do know that borrowing costs have surged, and if history is any guide, they have quite a bit further to rise. And we know how indebted the system has become.

People forget that the infamous 1987 stock market crash followed a surge in bond rates. In the months leading up to the October crash, the interest rate on 10-year Treasurys jumped about 45%, compared with the 80% hike we’ve just seen.

I asked my bond market guru over lunch what the risks were that the latest surge in interest rates could precipitate an ’87-style crash. “Quite significant,” he said.

DOLLAR-YEN CROSS - Consolidation May Be Completing

Key Technical Levels - 10-Year, Copper, Yen And Rupee BofAML's MacNeill Curry via ZH

BofA's MacNeill Curry warns that "several major FX, commodity, and bond markets are flashing warning signals of a change of trend." Specifically, he notes that JPY is set to resume its devaluation path (USDJPY bullish) with a 106.00 target; US 10Y Treasury bonds are "at risk" of a bullish turn on a break back below a yield of 2.802%. This would suggest the charts are beginning to price in a "Taper-on" story (as USD repatriation flows cease and allow the JPY to weaken and bonds rally back on 'moar printing') and perhaps that is what fits with his view that the Indian Rupee melt-down is showing signs of stalling.

Via BofAML's MacNeill Curry,

USDJPY Set To Resume Its Bull Trend

For the past 3 months, USDJPY has been confined to a well defined contracting range. Now that range is just about complete and NEAR TERM WEAKNESS MUST BE BOUGHT. Upside targets are seen to 106.00/105.80, potentially 109.80.

BOND SCARE - Near Term Overhead Resistance Near

Key Technical Levels - 10-Year, Copper, Yen And Rupee BofAML's MacNeill Curry via ZH

US 10yr Note futures at risk of a bullish turn

We have been and remain US Treasuries bears, targeting 3.045%/123-02 in 10s. However, evidence for a bullish turn in trend is RAPIDLY INCREASING. Specifically, the persistent Bullish Momentum Divergences and Friday Bullish Reversal Candles across much of the curve all warn of an earlier than anticipated turn in trend. For now we remain bearish, but a break of 2. 802%/125-09 in 10s would force us to change our view.

VOLATILITY - "Taper Talk" Gives Way to a "Taper Tantrum"

What's Driving Treasury Yields? 08-24-13 UBS via ZH

The 10Y Treasury yield has jumped nearly 130bp from its low point in early May. Given the tight ranges and low volatility of yields during the most of QE era, this kind of move in just over 3 months seemed stunning to some investors. Consequently, the question that has come up often recently is: what has been driving Treasury yields?

As UBS' Boris Rjavinski notes, several years ago a rate strategist would give you a straightforward and predictable answer:

1. Inflationary Expectations,
2. Economic growth projections, and
3. Current and future monetary policy.

The “monetary policy” part of the answer would likely simple deal with the path of the key short-term policy rate. Terms such as “quantitative easing”, “communication policy”, “thresholds and triggers” were foreign to bond investors during the era of pre-credit crisis innocence.

But now, as Rjavinksi notes,

1. Central banks and
2. Politics in the driver seat.

Volatility will remain elevated as we await key messages from the Fed in September, and U.S. political calendar will start to heat up as we approach the “drop-dead” dates to fund the government and extent the dent ceiling.

Via UBS,

Central banks and politics in the driver seat

The relative importance of these key Treasury yield drivers has flipped upside-down in the past couple of years, as central banks have assumed the key role. Through a host of unconventional monetary policy tools, such as

• zero interest rate regime,
• multiple rounds of QE purchases,
• new communication policy, and
• unprecedented transparency regarding future policy actions

... central banks have effectively crowded out the effects of economy and inflation. Having brought its short-rate benchmark to zero, the Fed has boldly moved out on the curve directly targeting longer maturity yields.

Politicians and policymakers have closely followed the Fed as the next important Treasury market driver. Fights over

• government borrowing limit,
• budget deficit, taxation policy,
• as well as pre-election sentiment swings and
• major political developments in the eurozone

have affected government bond yields in a major way.

With central banks and political risk driving the bus, traditional factors have been pushed down to the bottom of our short list. Figure 1 below provides a good illustration of these developments, as it shows evolution of 10y Treasury yield relative to some of the key developments in the recent years.

Prior to mid-2008 the 10y yield and the UBS US Growth Surprise Index have tracked quite closely, generally trending in the same direction and matching each other’s turning points. However, it had drastically changed starting in late 2008. The first big divergence occurred when the QE1 asset purchase program was announced by the Fed. While the Growth Surprise index continued to drop for a while, Treasury yields had turned higher on expectations of higher future growth and inflation, thanks to the huge amount of monetary stimulus. The politics had also played a role, as the Obama administration rolled out a very large fiscal stimulus package.

Figure 1 shows that as the effects of the QE1 and the fiscal stimulus started to fade in 2010, the two lines began to converge again. 10y yield and the Growth Surprise index even managed to march upward together in the early stages of the QE2 in late 2010. However, the firepower of Fed’s balance sheet through ongoing QE2 bond purchases forced yields lower in the spring of 2011, even as the Growth Surprise index kept going up for a while. Rising stress in the eurozone related to Greece further strengthened bid for Treasuries.

U.S. politics had stepped into the spotlight during the sovereign debt ceiling extension mess in July-August 2011 (Figure 1). As U.S. lurched to possible default, 10y yield plunged 100bp in virtually one swoop. The escalating eurozone crisis added downward pressure on yields. Finally, the Operation Twist announcement by the Fed forced Treasury yields to the cycle lows. Curiously, while the one-two punch of politics and monetary accommodation kept yields at historically low levels throughout H2 2011, the Growth Surprise index had turned decidedly upward, as one can see in Figure 1. However, that mattered little for some time; the central bankers and politicians were in the driver’s seat.

“Taper Tantrum” – same rule in reverse

Figure 1 shows that the same rule can be applied in reverse to the recent massive selloff in Treasuries. The U.S. Growth Surprise index has been clearly trending down throughout summer 2013. At the same time, Treasury yields were taking its cue from the Fed’s “taper talk” in its march upward. Clearly, investors decided that the timing, size, and composition of the taper were the key to where yields should be, while treating mixed economic data as the second order effect.

Bond fund redemptions have added upward pressure on yields

Recent rush of redemptions from fixed income mutual funds and ETFs may also have played a key role in the big jump in yields. As yields went lower during the QE era, many investors dutifully followed Fed’s lead into fixed income products. These inflows have been spread out over the period of 2-3 years and therefore allowed the markets some time to digest them, although they clearly contributed to rise in Treasury process and narrowing corporate bond spreads. The record amount of recent redemptions from bond funds and ETFs coming in a short time span may have added fuel to the fire of the Treasury selloff, especially given lower liquidity in the summer months.

To illustrate that point, we estimated historical flows into and out of the three large popular fixed income ETFs: a core bond, an agency mortgage, and an EM bond funds. We then plot estimated flows against the 10y yield in Figure 2. One can clearly see that, as the period of relatively balanced flows throughout 2012-early 2013 gives way to the flood of redemptions starting in May, the Treasury yields begin to move sharply higher. A risk of large redemptions is something we have discussed in our publications earlier this year1. Figure 2 does seem to indicate that bond fund flows may need to become more balanced first for the Treasury yields to be able to settle in a range again.

Recent move is not outsized in historical context

While Chairman Bernanke and other FOMC members have been adamant that “tapering does not mean tightening”, the market seems to interpret it that way, at least thus far. Therefore, it is logical to compare the recent upward move in 10y yield to the similar moves during previous monetary tightening cycles. In 1994, the 10y went up about 180bp in the first 3 months after the initial hike in February. The reaction after the first hike in June 1999 was much more muted, but the 10y yield had already jumped about 80bp prior to the hike. The tightening cycle that started in June 2004 may be the most appropriate comparison, since rates were rising from historically low levels. There was an almost 120bp jump in 10y yield in about 3 months prior to the first policy rate increase (which was followed by about 80bp rally over the next 3 months). While the current volatility may seem excessive, it is not outsized in historical context.

Volatility is here to stay for some time

Given that central banks, politics, and the outsized fund flows continue to be the key drivers behind Treasury yield gyrations, everyone’s model will likely be challenged to come up with accurate directional calls. We believe the best course of action for Treasury investors in the current environment is to stay close to the benchmarks and keep risk low. Several large U.S. fixed income investors we met recently seemed to agree with us that right now is not the best time to take directional view on rates. However, we feel confident that volatility will remain elevated as we await key messages from the Fed in September, and U.S. political calendar will start to heat up as we approach the “drop-dead” dates to fund the government and extent the dent ceiling.

If we get more clarity from the Fed on the size, timing and composition of QE taper, and if key political issues get addressed later this fall, we may actually see economy and inflationary expectations start to return to their traditional role as the drivers of Treasury yields.

DR. COOPER - Getting Ready to Top and Head Lower

Key Technical Levels - 10-Year, Copper, Yen And Rupee BofAML's MacNeill Curry via ZH

Judging by copper that the money will be flowing from China anytime soon...

A top is approaching in Copper

Copper is fast approaching levels from which we would expect a top and resumption of the bear trend. Into 7474/7534 we look for a top and turn lower for 6602/6635 and below .

Which makes sense since we remain confident that recent copper strength is as much about the cash-for-copper financing deals (which will likely be suppressed) as it is any fundamental-based demand for the much-vaunted economist-metal.