FLOWS - Liqudity, Credit and Debt

ETF Issuers Quietly Prepare For "Market Meltdown" With Billions In Emergency Liquidity 05-13-15 Zero Hedge

Between the dramatic sell-off in German Bunds that unfolded over the course of three weeks beginning on April 21 and the erratic trading that ensued on Tuesday following the weakest JGB auction since 2009, the chickens, as they say, have come home to roost in government bond markets where thanks the ECB, the Fed, and the BoJ’s efforts to monetize anything that isn’t tied down, the market has become hopelessly thin. 

As we’ve documented exhaustively — and as every pundit and Wall Street CEO is now suddenly screaming about — the secondary market for corporate credit faces a similar dearth of liquidity and at just the wrong time. Issuance is at record levels and money is pouring into IG and HY thanks to CB-induced herding (i.e. quest for yield) and record low borrowing costs (again courtesy of central planners), but thanks to the new regulatory regime which ostensibly aims to curtail systemic risk by cutting out prop trading, banks are no longer willing to warehouse corporate bonds (i.e. dealer inventories have collapsed), meaning that in a rout, investors will be selling into a thin market. The result will be a firesale.

So while policymakers are still willfully ignorant when it comes to honestly assessing the effect their actions are having on government bond markets, the entire financial universe seems to have recently become acutely aware of the potentially catastrophic conditions prevailing in corporate credit. These concerns have now officially moved beyond the realm of lip service and into the realm of disaster preparedness because as Reuters reports, some of the country’s largest ETF providers are arranging billion dollar credit lines that can be tapped to keep illiquidity from turning an ETF sell-off into a credit market meltdown:

The biggest providers of exchange-traded funds, which have been funneling billions of investor dollars into some little-traded corners of the bond market, are bolstering bank credit lines for cash to tap in the event of a market meltdown.

Vanguard Group, Guggenheim Investments and First Trust are among U.S. fund companies that have lined up new bank guarantees or expanded ones they already had, recent company filings show.

The measures come as the Federal Reserve and other U.S. regulators express concern about the ability of fund managers to withstand a wave of investor redemptions in the event of another financial crisis.

They have pointed particularly to fixed-income ETFs, which tend to track less liquid markets such as high yield corporate bonds or bank loans.

"You want to have measures in place in case there are high volumes of redemption so you can meet those redemptions without severely impacting the liquidity of the underlying securities," said Ryan Issakainen, exchange-traded fund strategist at First Trust…

Under the Wall Street reform act known as Dodd-Frank, banks have been shedding their bond inventories, resulting in less liquidity in fixed-income markets. Because there are fewer bonds available for trading, a huge selloff in the bond markets could worsen the effect of a liquidity mismatch in bond ETFs.

Vanguard, the second-largest U.S. ETF provider, lined up its first committed bank line of credit last year and now has a $2.89 billion facility backed by multiple banks and accessible to all of Vanguard's funds, covering some $3 trillion in assets, the Pennsylvania-based fund company told Reuters. The new setup is to "make sure that funds will be available in time of market stress when the banks themselves may have liquidity concerns," Vanguard said.

Essentially, ETF providers are worried that in a pinch (i.e. when ETF sellers outnumber ETF buyers), they will be forced to liquidate assets into structurally thin markets at fire sale prices in order to meet redemptions, triggering a collapse in the underlying securities (like HY bonds). In the pre-crisis days, this would have been mitigated by banks’ willingness to purchase what the ETF providers are looking to sell, but in the post-Dodd-Frank world this isn’t the case so the idea now is that bank credit lines will essentially allow the ETF providers to become their own dealers, meeting redemptions with borrowed cash while warehousing assets and praying waiting for a more opportune time to sell. 

In case it isn’t clear enough from the above that ZIRP is in large part responsible for this, consider the following:

"These funds offer daily or even intraday liquidity to investors while holding assets that are hard to sell immediately, thus making the funds vulnerable to liquidity risk," U.S. Federal Reserve Vice Chair Stanley Fischer said in a speech in March in Germany, pointing directly to ETFs and saying they have mushroomed in size while tracking indexes of "relatively illiquid" assets.

That is all exacerbated because investors have been pouring money into bond ETFs, while banks, under regulatory pressure to limit their own holdings, have been slashing their bond inventories.

Growth in fixed-income ETFs also means there are now more products tied to corners of the bond market previously untapped by ETFs. Assets in U.S.-listed fixed-income ETFs are up nearly six-fold since 2008, to $335.7 billion at the end of April, according to Thomson Reuters Lipper data.

And why, one might ask, are investors suddenly interested in exploring “corners” of the bond market where they had previously never dared to tread thus creating demand for ever more esoteric ETF products? Because when risk-free assets are at best yielding an inflation-adjusted zero and at worst have a negative carry, investors are forced into credits they would have never considered before just so they can squeeze out some semblance of yield without simply dumping everything into equities. 

Of course liquidity protection comes at a cost:

Banks facing their own reserve requirements against these lines are charging commitment fees that can range from 0.06 percent to 0.15 percent, according to company filings. If a line is actually drawn upon, there would be additional interest charged on any amount borrowed. In many cases, these costs are included in the ETF's annual expense ratio, and borne by the funds' investors.

BOND BUBBLE - $5T Worth of Government Debt Trading with Negative Yields

Over HALF of ALL Government bonds in the world yield less than 1%.

Over $5 trillion in government debt has negative yields:

The ECB is Attempting to Corner the Bond Market… Buckle Up 05-11-15 Graham Summers, Phoenix Capital

In 2012, during the depth of the EU banking crisis which nearly took the entire EU financial system down, Mario Draghi stated that he would do “whatever it takes” to hold the EU together.

Anyone paying attention knew that this was a bluff. True, the ECB and EU leaders had already defied if not broken every condition of the Maastricht Treaty and the Schengen Treaty (the legislation that formed the EU proper). However, even to the most cynical analyst, Mario Draghi’s claim was pushing the envelope a little too hard.

Implementing capital controls and border controls limit freedom, but from the perspective of monetary policy, they’re secondary items. The REAL power is that of the printing press.

This is how Draghi’s promise to save the EU was different from every other action: it addressed the structure of the EU in its most critical component, namely the control of the currency.

It took the EU two years to cobble together its reasoning for how something that went completely against the Maastricht Treaty would be permitted. As usual it was the Germans (the ultimate holders of the purse strings) who gave the “OK.”

Now given the green light, Draghi has embarked upon a €60 billion a month QE program. Somehow this is meant to:

1)   Reboot a €46 TRILLION banking system that is totally insolvent.

2)   Generate lower interest rates when most EU-member sovereign bonds are at multi-century lows.

3)   Bring the EU economy back to growth. 

The whole idea is absurd. But it does reveal one important thing: that we are much closer to the end of the Central Bank-fueled $100 trillion bond bubble than ever before.

BOND MARKET HAS TRIPLED IN SIZE IN 14 YEARS

The bond market has tripled in size in the last 14 years. This has been fueled by the issuance of debt at an astounding pace as Governments attempted to paper over the massive decline in living standards plaguing the West.

Today, the bond bubble is over $100 trillion in size. When you include derivatives based on interest rates (bonds) it’s over $555 trillion.

To put this into perspective, the CDS market which nearly took down the financial system in 2008 was a mere $50-$60 trillion in size. So the bond bubble is literally 10X this in size and scope.

The derivatives story is key here, because all of those $555 trillion in trades are backstopped by sovereign bonds (Japanese bonds, German Bunds, US Treasuries, etc.).  These are the very bonds that Central Banks have been BUYING over the last five years (thereby shrinking the amount available to the banks to backstop those trades).

Put another way, the amount of high quality collateral backstopping this mess has shrunken dramatically. On top of this, traders have been piling into sovereign bonds in anticipation of various QE programs, forcing yields to multi-decade if not multi-century lows.

Currently over HALF of ALL Government bonds in the world yield less than 1%. Over $5 trillion in government debt has negative yields:

This is not only unsustainable… it is a clear sign of a bubble. A bubble that when it bursts when involve over $555 trillion worth of trades imploding.

AN EARNIGS RECESSION - No Pricing Power Due to an Excess Debt Payments Drain

The Debt, ZIRP, and Valuation Comstock

As we write the US stock market, as measured by the S&P 500 and Nasdaq Composite Index, hovers at or near new highs.  We will take this as an opportunity to reiterate that this is a bubble that is the direct creation of the Federal Reserve.  We continue to refer to this phenomenon as the “Central Bank Bubble”.

EARNINGS RECESSION

Just under one year ago, analysts were estimating S&P 500 operating earnings to increase for the first quarter of 2015 by over 10%.  That number is now substantially lower and has gone negative for the entire index. 

• According to “FactSet Earnings Insight”, both Q1 and Q2 2015 earnings are now expected to be lower. 
• Through May 1, the blended result of companies that have reported and have yet to report  for Q1 2015 stood at -.4%. 
• Analysts are in fact expecting year over year declines through Q3 2015 but are then expecting a strong rebound in Q4 2015. 

We agree with the former and strongly disagree with the latter. But whether attributed to weather, the west coast port strike, or dollar strength, the fact remains that for whatever the reason, two declining quarters constitutes an “earnings recession”.   

We have had 13 “earnings recessions” since 1945, and all but three of those have led to an economic recession.  We continue to believe corporate earnings will not grow as a whole at a meaningfully different rate than US Gross Domestic Product (GDP), as corporate earnings are a proxy for economic growth.  

Growth in the economy, in turn, is heavily influenced by “Total Credit Market Debt”, which is the sum of government, corporate and household debt.

Only at the time of the great depression of the 1930’s has “Total Credit Market Debt” been greater than 200% of GDP in the United States (see attached chart from Ned Davis Research)). 

That is, of course, until the middle 1980’s when this metric again penetrated that barrier.  After that time it went on an inexorable march to a whopping 367% of GDP just prior to the bursting of the “Housing Bubble” and stood at just under 332% as of the end of 2014.  The level of debt continues to be a headwind to economic growth that will persist until the debt is paid down. 

FED BUBBLE - Flawed Policy

What has acted to somewhat mask this headwind is, what we believe, is the most reckless policy ever adopted by the Fed.  The Fed was wrong on the “Dot Com Bubble”; was wrong on the “Housing Bubble”; and we believe will be wrong in the creation of the current “Central Bank Bubble”.  This Fed is in a major experimentation mode which is very dangerous.  The policy of which we speak is, of course, Zero Interest Rate policy, or (ZIRP).  This policy has driven the Fed’s Balance Sheet from $800 billion in 2008 to $4.4 trillion currently.

It is because of ZIRP that stocks do not appear, to some, to be expensive.  After all, if the alternative is a 2% ten year treasury or 2.6% thirty year treasury, maybe a 2% dividend yield isn’t so bad; or so the thinking goes.  But as stated above, the growth in corporate profits in the long run is a proxy for the growth in the economy, or GDP.  And right now stocks, measured by market capitalization, are near the highest they have ever been relative to GDP.    Every major market bottom and top has been coincident with very low or very high ratios of “Stock Market Capitalization to GDP”(see attached chart from Ned Davis Research). 

It is likely the reason is that this metric has purported to be a favorite of Warren Buffet.    In fact, the only time this metric has been higher was just before the” Dot Com Bubble” burst.   It comes at a time when deflation is playing out all over the world.  The dollar is strengthening, which hinders multinational companies from exporting goods abroad.   In addition, it appears that companies do not have enough pricing power to increase margins.

LIQUIDITY TRAP

We at Comstock have been telling our viewers that we have been in a deflationary environment for years.  It seems the markets now are agreeing with us as there are currently few countries that are expecting any material inflation over the next ten years.  This is evident by the yields in ten year sovereign paper. 

The following are yields as of the date of this writing:

• United States 2.19%;
• United Kingdom 1.97%;
• Italy 1.81%;
• Spain 1.78%;
• France .82%;
• Japan .36%, and
• Germany .52%.

What all of these countries have in common, in addition to being democracies, is that their respective central banks are in a “Liquidity Trap” situation, where low and even negative interest rates do not encourage consumer spending but rather consumer savings. 

Businesses in turn do not have the confidence to invest in new plant and equipment.  This is particularly true in the United States, where the average age of private fixed assets is the oldest in the past fifty years. 

So, to our viewers we say, we have been early on this, as we were with the Dot Com and Housing Bubbles, but we are confident this will end the same way as those bubbles.

The US stock market is historically expensive and financial assets have been inflated by an experimental central bank policy. 

It is an error that is now being repeated by central banks in Europe, Japan and just recently, China.  These markets are being influenced in similar ways as ours, rather than fiscal and tax policies that would stimulate sustainable growth.  

We will hold our view that stocks are expensive until they become priced more reasonably relative to the growth prospects of the economy.

We have maintained consistently that high levels of debt are the main problem affecting growth and those debt levels will not be going away any time soon.

A SUPPORTING RESEARCH PAPER BY THE BIS

FINANCIAL REPRESSION - Cashless Society

GOVERNMENT'S LAUNCH "TRIAL BALLOONS" IN THE PUBLIC MEDIA

READ BELOW AND WEEP

THEMES - Corporatocracy - Crony Capitalism

CORPORATOCRACY - CRONY CAPITALSIM