FLOWS - Liqudity, Credit and Debt

Investors Ditch Cash Market For Futures As Treasury Liquidity Evaporates 06-15-15 ZH

Over the past several months we’ve spent quite a bit of time discussing liquidity (or, more appropriately, a lack thereof) in the market for US Treasurys, German Bunds, and JGBs.

Liquidity in government bond markets has become a hot-button issue in the wake of last October’s Treasury flash crash wherein the world’s deepest, most liquid market was suddenly exposed as having become nothing more than a playground for the Fed and HFTs. Six months later, the market was again forced to bear witness when German Bunds, the safe haven asset par excellence, began to trade like a penny stock as the reincarnation of 2013’s JGB VaR shock sent 10-year Bund yields on a wild ride from just 5 bps to nearly 80 bps in the space of just three weeks (the rout resumed last week, with yields rising above 1% on Wednesday). 

The great Bund battering provided an opportune time for analysts to revisit the idea of illiquid government bond markets, and invariably, the focus turned to Treasurys and Bunds. Here’s what JP Morgan had to say recently about market depth for US Treasurys:

Market depth for USTs is proxied by the 5-day average of tightest three bids and asks each day, shown in Figure 7 in $mn for 10y US Treasuries. Similar to US IG corporate bonds, there was an earlier collapse in market depth during 2007 already as the US subprime crisis erupted. But different to US IG corporate bonds, there has been a deterioration in UST market depth in the most recent years, since 2013. We argued before that the deterioration in UST market depth since 2013 reflects the contraction of US repo markets caused by regulations as well as UST collateral shortage induced by the Federal Reserve’s QE3 program coupled with a declining US government deficit. A retrenchment in repo markets is unwelcome news for the liquidity of the underlying securities. Most repos, around 80%-90%, are against government-related collateral and it is the repo market which makes government securities relatively more liquid by allowing fast and efficient financing and short covering. It is not accidental that trading volumes in bond markets are so closely related to the outstanding amount of repos. See previous Flows & Liquidity “Leverage ratios to hit repo markets”, July 19th 2013 which shows that US outstanding repo amounts and overall bond trading volumes have been drifting lower in recent years with no signs of a return to pre Lehman levels. And similar to USTs, Bund and JGB market depth has been also suffering as a result of government collateral shortage inflicted by the ECB’s and BoJ’s QE programs and shrinkage in their respective repo markets. 

Now, UBS is out with a fresh take on UST market liquidity. Investors, UBS says, are increasingly turning to futures as liquidity in the cash market dries up. Here’s more:

Bond market liquidity has become such an overriding concern for investors that mentioning "liquidity" in the title could simply be a plot to entice readers.  

Markets for high-quality government bonds can get out of balance due to rising one-sided demand to transfer risk. Consequently, market-makers' have a limited ability to serve as "shock observers." At this point, we need to consider the true meaning of liquidity. Is liquidity the ability to execute fairly small trade at tight bid-ask spreads, or being able to get a price – any price – for a truly large transaction? In our opinion, the latter form of "liquidity" is the important one.

At the same time that one investor has difficulty doing a very large trade at a tolerable level, a multitude of smaller trades could be executed at or near mid-market. Furthermore, algorithm-driven trades also likely would happen close to mid, even while the market is gapping, since algos would simply not execute if bid-offer were too wide. In this case, publicly reported bid-offers in Treasuries may move very little, yet liquidity has fallen in the most meaningful sense.

Futures provide clues

We turn to futures to help us discern liquidity trends. First, consider US Treasuries. A relative shift in turnover volume from cash bonds to futures could arguably serve to confirm worsening liquidity in cash Treasuries. Futures mechanics help mitigate both the balance sheet constraints and the potential challenges of flow trading restrictions, since participants need to fund only a small portion of notional and they always effectively transact with the exchange.

Figure 12 plots turnover volumes of the entire futures and cash Treasury markets, and their ratio (dark line, right axis). It reveals an unambiguous trend: turnover in futures has been catching up to cash Treasuries. To be clear, we compare total market volumes by simple par amount. 

For the past three months, daily average futures volume stands at nearly 70% of cash Treasuries, based on the notional amounts transacted. That is up from about 50% in 2011. The big leap in the turnover ratio occurred in 2014, and appears to have been sustained this year. 

Figure 13 and Figure 15 shows a stark shift in the way market participants access liquidity in short and intermediate Treasuries. The futures/cash turnover ratio surged in 2014 from the low 20s to 40% for short maturities and from low 40s to 60% for intermediates.

Migrating to futures from cash bonds may introduce a new set of challenges to investors. First, running large structural futures exposure in place of cash bonds does increase counterparty risk. Instead of having direct custody of full faith and credit government bonds, investors face a clearinghouse when they hold futures. True, major clearinghouses have excellent track records in getting past various crises. Still, regulators and policymakers have expressed concerns about potential systemic risk of central clearing counterparties. 

Note that this is still more evidence of the market-wide shift out of cash and into derivatives in order to avoid illiquidity. This is the same dynamic that's causing fund managers to use ETFs to avoid tapping illiquid corporate credit markets (see here and here) and serves to reinforce what we said back in February when we highlighted a Citi client survey which showed that increasingly, sophisticated investors are turning to derivatives not for hedging, but to express directional views on markets:

Fair warning: the more often derivatives are used as a way of avoiding the underlying cash markets, the more illiquid those cash markets become, meaning the 'solution' to illiquidity effectively makes the problem orders of magnitude worse. 

GLOBAL RISK -What Happened The Last Time The Fed's Balance Sheet Hit 25% Of GDP

What Happened The Last Time The Fed's Balance Sheet Hit 25% Of GDP 06-16-15 ZH

Ever since the Fed launched its unprecedented, unsterilized debt monetization rampage known as quantitative easing, coupled with seven years zero interest rates, there has been much confusion about how the Fed will achieve two gargantuan tasks: i) hike rates, and ii) reduce the amount of holdings on its balance sheet. The quandary, according to conventional wisdom, is magnified because something like this "has never been done before."

Conventional wisdom is wrong: something like this has been done before; the reason why nobody wants to talk about it is because it ended in epic disaster.

The chart below shows the Fed's balance sheet expressed as a % of GDP: it has grown from its long-term "normal" 5% to just over 25%.

Never before has this happened, right? Wrong.

As the following chart below shows, the Fed's response to the first (not to be confused with the current) great depression was, drumroll, identical.

Whereas the Fed's balance sheet expressed as a % of GDP was humming along nicely largely at just over 5% in the period ever since the Fed was created in 1913, things got promptly out of control when the Great Depression hit in 1929. At that point the Fed's balance sheet grew from 5% to just shy of 25% at its peak. Maybe there is a reason why some call the current period the second great depression...

More to the point, last night we showed that the first Great Depression period is comparable to the current time period not only in being a mirror image of the Fed's balance sheet, but also of interest rates, which by necessity had to be virtually zero in a time when the Fed was monetizing assets to stimulate aggregate demand. And so they were... until 1937, when the Fed hiked rates.

As we showed yesterday, what happened next was that a little over a year after the Fed hiked rates for the first time, the Dow Jones tumbled, plunged by 50% in March 1938 (the S&P500 in its current form would not appear for another 20 years).

But that was the topic of last night's post. What we want to emphasize here is what happened after. Because as the market crashed and the economy collapsed yet again in the last such acute episode of the Great Depression, something far more historic than a simple market collapse took place.

In other words, from the first rate hike by a Fed whose balance sheet as a % of GDP was nearly identical to the current one, to the start of World War II: less than three years.

We truly hope this time its different, although judging by today's dramatic return of the nuclear arms race and the countless war zones across the middle east and Africa, slowly all the increasingly militarized geopolitical events are falling into place.

GLOBAL RISK -The Biggest Risk To Global Equities

According To Bank of America, This Is "The Biggest Risk To Global Equities" 06-16-15 BOAML via ZH

On Monday evening we brought you “Bank Of America Begins 66-Day Countdown Until The 'Ghost Of 1937'" Returns,” in which we discussed why, if history is any guide, a rate hike cycle will be a disaster for equities. As a refresher, here’s the narrative:

Put simply, central bank's provision of liquidity for financial markets has been unprecedented. The extent of Wall Street addiction to liquidity is about to be revealed and the potential for unintended consequences is clearly high.

Which is not to say that attempts to "renormalize" rates are unheard of: previously both Israel and the RBNZ tried it and failed, with markets promptly forcing them to reverse tightening.

More notably, it was the ECB itself which in April of 2011 tried to halt Chinese inflation exports in their tracks, and pulled off one rate hike... before the wheels came off and Europe promptly entered a double dip recession.

But no episode is more notable than what happened in the US in 1937, smack in the middle of the Great Depression. This is the only time in US history which is analogous to what the Fed will attempt to do later this year, and not only because short rates collapsed to zero between 1929-36 but because the Fed’s balance sheet jumped from 5% to 20% of GDP to offset the Great Depression. Just like now. And then, briefly, the economy started to improve superficially, just like now, and as a result the Fed tightened in a series of three steps between Aug’36 & May’37, doubling reserve requirements from $3bn to $6bn, causing 3-month rates to jump from 0.1% in Dec’36 to 0.7% in April’37. As Bank of America notes, this didn’t end well: "The Fed exit strategy completely failed as the money supply immediately contracted; Fed tightening in H1’37 was followed in H2’37 by a severe recession and a 49% collapse in the Dow Jones."

So, now that Janet Yellen has the green light for liftoff courtesy of the BEA, Steve Liesman, and her friends at the San Francisco Fed, who have conspired to pass off an epic perversion of statistical analysis as a legitimate attempt to do away with what they would like the public to believe is a statistical aberration called “residual seasonality”, we can now look nervously towards mid-2016 when, after rates have been hiked by a total of 50bps or so, the elusive correction will finally come, only instead of a “healthy” 10% move to the downside, it may well be a gut wrenching, QE4-inducing firesale. 

But if the Fed does use a post-hike recessionary tailspin as an excuse to implement yet another round of bond buying (which should please the Boston Fed who, you'll recall, thinks QE should be moved from the "unconventional" policy toolbox into the bin labeled "use as necessary to micromanage business cycle"), expect the diminishing returns which everyone has now become accustomed to associating with QE to be readily apparent. Here's BofAML on why "another round of QE [is] the biggest risk to global equities":

While most are focused on the risks around a withdrawal of liquidity, we believe the biggest hit to confidence could be the opposite: if another round of US QE is necessary to prop up the economy. While the market could have a knee-jerk rally on an indication of forthcoming stimulus, we think this would likely be short-lived and could end in the red. QE fatigue is already evident: each subsequent round of QE has seen diminishing risk rallies. Another round of QE would imply that $4.5tn was not enough. And it would also likely have a very negative read-through for QE programs currently underway in Europe and Japan.

In other words, the Fed is cornered.

Normalizing policy rates could well risk destabilizing financial markets and the economy, both of which are addicted to central bank liquidity and haven't seen a rate hike in nearly a decade. But because the Fed needs to at least be able to say it tried to pull off an exit, the FOMC will gingerly tighten until it sees evidence that the wheels are coming off.

At that point, the addict will fall off the wagon as the Fed delivers a fresh dose of monetary heroin. The addict, having developed a tolerance, will not respond as planned, necessitating still more QE as the Fed chases the dragon while the BoJ and ECB watch in horror as the future of PSPP and Abenomics suddenly becomes crystal clear.

As for what happens next, we'll reiterate our warning from Monday: "If the S&P is cut in half the Fed will launch not just QE4, but 5, 6 and so on, resulting in every other central bank doing the same as global currency war goes nuclear, and the race to the final currency collapse enters its final lap.

GLOBAL RISK - China Selling US TReasury Holdings - But Who Is Buying?

China Dumps Record $120 Billion In US Treasurys In Two Month Via Belgium 06-15-15 ZH

Those who have been following the saga of "Belgium's" US Treasury holdings learned last month that the "mysterious buyer" behind Belgium's Euroclear was, as some speculated, China all along. Nowhere was this more evident than when showing an overlay of China and Belgium's combined TSY holdings versus China's forex reserves.

This is what we concluded last month:

• "Belgium" is, or rather, was a front for China: either SAFE, CIC, or the PBOC itself.
• That Belgium's holdings, after soaring as high as $381 billion a year ago, have since tumbled back to only $2532 billon as China has dumped the bulk of its Euroclear custody holdings, and that once this number is back to its historical level of around $170-$180 billion, "Belgium" will again be just Belgium.
• China's foreign reserves tumbled and this was offset by a the biggest quarterly drop in Chinese pro-forma treasury holdings, which dropped by a record $72 billion in the month of March, and a record $113 billion for the quarter.

It wasn't precisely clear just why China, which had historically used UK-based offshore banks to transact in US paper in addition to the mainland, would pick Belgium or why it chose to hide its transactions in such a crude way, however the recent accelerated capital outflow from China manifesting in a plunge in Chinese forex reserves, coupled with a record monthly liquidation in total Chinese holdings, exposed just where China was trading.

And while we have yet to get an update from Beijing of its April forex reserves, we know that China's Treasury liquidation has continued. Enter: Belgium, only this time it is not a "mystery" buyer behind the small central European country, but a seller.

As the chart below shows, after a record $92.5 billion drop in March, "Belgium" sold another $24 billion in April, bringing the total liquidation to a whopping $116.4 billion for the months of March and April.

This means that after adding mainland China's token increase of $2 billion in April after a $37 billion increase the month before, net of Belgium's liquidation China has sold a record $77 billion in Treasurys in the most recent two months.

And while we eagerly await the monthly update of Chinese official forex reserves, we can estimate that the drop will be another $50-60 billion in the month of April.

The good news, for those tracking the story of China's unprecedented capital outflows, is that after "Belgium's" record March dump, in April Chinese Treasury sales slowed to the slowest pace in the past three months.

In other words, China may finally be getting its capital outflow problem under control, which, incidentally is bad news for the Chinese stock market because if true, it means the PBOC can now step back from micro-managing the stock market bubble and its "beneficial" current account inflows to offset the declining capital account.

But what is perhaps most curious is that even with China liquidating such a massive amount of US paper into a very illiquid market, the yield on the 10Y did not blow out far more in the months of March or April. And the last question: who did China sell all this paper to?

CHINA - Mocks G7 As "Gathering Of Debtors"

China Mocks G7 As "Gathering Of Debtors", Warns "Confrontation Will Be A Disaster For Europe" 06-15-15 ZH

Vladimir Putin didn’t get an invite to the Angela Merkel-hosted G7 Summit in Bavaria last week, which means the Russian President not only missed out on two days at the scenic Castle Elmau, but also on lederhosen shopping with US President Barack Obama who, judging from eyewitness accounts and a variety of amusing photo ops, channeled his inner Clark Griswold upon touching down in the Bavarian town of Krun. The G7 isn’t pleased with Russia’s ‘behavior’ in Eastern Europe and so, Moscow has been expelled from the cool kids club until such a time as the Kremlin agrees to uphold Western democratic values. 

But the G7 is an equal opportunity exclusionist which means it’s not just former superpowers that aren’t welcome, but rising superpowers as well, which means you won’t be seeing Xi Jinping at the table either.

But “Big Uncle Xi” (as he is affectionately known in China) likely isn’t losing any sleep because in the eyes of Beijing,

the G7 — much like the IMF and the ADB — is a relic of a global economic and political order that is well on its way to obsolescence if it isn’t there already.

The Global Times (which, it should be noted, is owned by the ruling Communist Party’s official newspaper, the People’s Daily) has more on why the G7 is largely irrelevant in the modern world.

Via The Global Times:

The G7 summit concluded in Germany last week. Chinese scholars and media barely showed any interest to this outdated informal institution, except for a Declaration on Maritime Security issued by G7 foreign ministers. The declaration expressed their concerns on "unilateral actions" in the South China Sea, with China as the obvious target.

Judging from the agenda and outcomes of this year's G7 summit, it has run counter to the global trend of peace, development and cooperation and become mere of a geopolitical tool.

Since the very beginning of the establishment of the G7, it has been a rich-man's club that consists of Western major powers and aims to maintain the collective hegemony of the US-led West. It used to focus on the world's economic issues, and then extended to political and security affairs. After the Cold War, Russia was included in this grouping, which almost became the core of global governance and looked as though it might replace the UN Security Council. 

However, the other G7 members never treated Russia as an equal partner. Russia was only entitled to discuss politics and security but not financial and economic issues.

As the world entered the 21st century, new economies started to emerge and the world's political and economic center has gradually shifted to the Asia-Pacific. The 2008 global financial crisis forced G7 members into a stalemate, and these nations started to realize that they could only get rid of the crisis with the help of emerging economies. Therefore, the US proposed defining the G20 as the main platform to discuss international economic problems. Within the G20, although the G7, as a sub group, intends to dominate the agenda-setting, the G7 cannot play its role without cooperation from new economies whose voices can be heard more nowadays.

Yet countries such as the US and Japan can hardly accept the rising international status of emerging economies and are reluctant to give up their hegemony. When the financial crisis eased slightly, Western media vigorously propagated the "revival" of the G7. But the economic performance of G7 members meant the summit was a gathering of debtors.

To some extent, the role of the G7 in global economic governance is negative. The IMF and the World Bank are under the control of G7 members. This is one of the reasons for the low implementation capacity of the G20.

In the field of politics and security, Western powers relentlessly promoted the role of the G7. But the G7 has proved to be unable to maintain regional stability, and has led to chaos in the Middle East instead. After the Ukrainian crisis, the West excluded Russia from the original G8, making the current G7 grouping on the way to becoming a Cold War relic.

Russia and China are main targets of the discussion at this G7 summit. They decided to continue to impose pressure on Russia amid the ongoing Ukrainian crisis. As for China, they focused on issues around the Asian Infrastructure Investment Bank and the East and South China Sea. But it is worth noting that European members have shown a different stance from the US and Japan on both matters.

Whether the G7 will become a geopolitical tool or a Cold War relic largely depends on European countries. Unlike the US, Europe shares a closer geopolitical and economic links with Russia. If the G7 becomes a platform for the confrontation between the West and Russia, it will undoubtedly be a disaster for Europe. Seeking a peaceful solution to the Ukrainian crisis with Russia fits European interests. As for the East and South China Sea disputes thousands of kilometers away from the European continent, these countries needn't necessarily get involved.

During the G7 summit, Japanese Prime Minister Shinzo Abe tried to pull European countries to Japan's anti-China bandwagon. China should continue to stay wary of the Japanese government.

Obviously this is to be taken with a grain of salt considering it comes directly from the politburo, but nevertheless, there are some important observations here that deserve attention.

For instance,

• China equates the G7 with the IMF and the World Bank, two institutions which Beijing is well on its way to challenging via the AIIB and The Silk Road Fund.
• In public, China has been careful to adopt a conciliatory stance towards existing multilateral lenders. This partly reflects the fact that China isn’t eager to ruffle any feathers among the Western countries who took a rather palpable political risk by throwing their support behind the AIIB in the face of fierce opposition from Washington.
• Beyond that though, adopting an overly critical stance towards institutions whose goals are ostensibly similar to those of the AIIB risks sending the wrong message to countries who depend on supranational institutions for aid.
• That said, equating the IMF, The World Bank, and the ADB with the G7 before subsequently calling the latter a “Cold War relic” is a kind of backdoor way of suggesting that the G7-dominated multilateral institutions are, by virtue of their leadership, hurtling towards irrelevancy.

Further, the assertion that “the economic performance of G7 members [means] the summit [is] a gathering of debtors” is on the one hand hypocritical (China, after all, is sitting on $28 trillion in debt) but on the other hand speaks to the fact that, even as China’s economic growth slows as Beijing marks a difficult transition from an investment-led economy to a consumption driven model, economic growth in the West has simply stalled out altogether and as for Japan, well, Tokyo has been grappling with a deflationary nightmare for decades, something Abenomics has so far failed to correct. In other words, China’s economic miracle may be “landing hard” so to speak, but there’s certainly an argument to be made that even in its crippled state, the Chinese economic machine is still capable of outperforming the West.

Finally, and perhaps most importantly, China suggests Washington’s dominance has led the G7 to pursue myopic foreign policies that have conspired to stoke sectarian chaos in the Middle East (it’s now almost impossible for the US to keep track of where it supports Shiite militias and where it backs Sunni militants) and create the conditions for a second Cold War in Eastern Europe. The deliberate exclusion of Russia, Beijing says, risks transforming the G7 into what is effectively the political arm of NATO, which undercuts the institution's ability the foster peace and cooperation. 

Again, some of this is propaganda served hot and fresh straight from the Communist Party kitchen. That said, the underlying geopolitical analysis is spot-on even if it's presented with a hyperbolic veneer. 

The G7, like the IMF and the World Bank, is quickly falling victim to the arrogance of its most powerful members. If an overriding sense of Western exceptionalism is allowed to create the same type of complacency and rigidity that has paralyzed the IMF, it may not be long before the world's emerging powers supplant entrenched political bodies much as they have moved to supersede ineffectual economic institutions.

Cashless Society Needed for Negative Rates

FINANCIAL REPRESSION

SPECIAL GUEST: JAYANT BHANDARI is constantly traveling the world looking for investment opportunities, particularly in the natural resource sector. He advises institutional investors about his finds. Earlier, he worked for six years with US Global Investors (San Antonio, Texas), a boutique natural resource investment firm, and for one year with Casey Research. Before emigrating from India, he started and ran Indian subsidiary operations of two European companies. He still travels multiple times a year to India. He is an MBA from Manchester Business School (UK) and B. Engineering from SGSITS (India). He has written on political, economic and cultural issues for the Liberty magazine, the Mises Institute (USA), Mises Institute (Canada), Casey Research, International Man, Mining Journal, Zero Hedge, Lew Rockwell, the Dollar Vigilante, Fraser Institute, Le Québécois Libre, Mauldin Economics, Northern Miner, Mining Markets etc. He is a contributing editor of the Liberty magazine. He runs a yearly seminar in Vancouver titled Capitalism & Morality.

GLOBAL MINING ANALYST

JAYANT BHANDARI

"ITS AN OVER SUPPLY PROBLEM!"

FINANCIAL REPRESSION

"There are two parts of the world in my opinion. One is the western developed civilization and the other is the non-western civilization. The western civilization was primarily based on reason and respect for the individual. This has considerably deteriorated over the last few decades. Increasingly the coming of the police state in particularly the USA. In the West-European part of the western civilization the regulatory controls have become particularly horrendous as well. The welfare system of these economies is deteriorating these societies now. Culturally the western civilizations are increasingly on a slippery slope."

"The non Western civilizations have adopted the consumerism and wealth creating mechanism of the western civilizations, but I am not sure they have really adopted these things properly! Democracy has not done well in these countries. As a result consumerism is making these countries very unstable. The only countries I feel relatively positive about right now are China and some of the smaller countries like Singapore, Hong Kong, Mauritius - these countries are doing very well."

HARD ASSETS & NATURAL RESOURCES

The problem is with the investors who have over-funded mining. They shouldn't have ramped up mining as much as has been done!

'The places to invest are places like Canada, Scandinavia, Australia and parts of South America. You need consistency in the political climate. You want the stability for people to invest billions of dollars in these countries."

"I don't think global demand has fallen. If you look at Iron Ore the world is using three times more Iron Ore. The world requires three times more Iron Ore than it used to 10-15 years ago. What is changed is that we have started to supply more commodities than the world demand is there for it. The problem is with the investors who have overfunded mining. They shouldn't have ramped up mining as much as has been done!

PERVASIVE GLOBAL OVER-REGULATION

"Global western economies are stagnating and this is a direct result of over regulating business in those countries."

"Businesses are suffocating in the west now. There is pretty much zero growth. You need to understand the off balance sheet liabilities these businesses have, and continue to increase. They have benefited from technological evolution and the low hanging fruit over the last twenty years." This has now changed.

The US$ shows that though the US is deteriorating according to Jayant Bhandari "it is deteriorating slower than the rest of the world!"

"Economic repression is a fact of the day everywhere in the world"

Where growth is happening it is because of increasing consumerism and this is not good for the future because growth should be happening as a result of the increase in supply of products - which would mean we should be saving more - which would mean we should be producing more than we are consuming!"

INCREASINGLY BULLISH ABOUT GOLD

"I have never been too bullish about gold but increasingly I am very bullish about gold. The reason is a lot of people misunderstand why Indians buy gold. The reason Indians and Chinese buy so much gold is that for example in India the yield on investment is negative. It pays them to invest in something that gives them positive real yield. In my view India is going to increase its consumption of gold and the Chinese will keep doing it."

"Once the US$ becomes too over-valued people will begin putting their money in precious metals!"

.... and much more in the video interview. Listen to the whole interview.

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