GLOBAL RISK - Bond Funds are Bracing for a Market Crash

$140 Billion Bond Fund Goes To Cash As It "Braces For Bond-Market Collapse" 06-22-15 ZH

Recently, it’s become readily apparent that some of the world’s top money managers are getting concerned about what might happen when a mass exodus from bond funds collides head on with a completely illiquid secondary market for corporate credit. 

Indeed, bond market illiquidity is the topic du jour and has almost become something of a cliche among pundits and mainstream financial media outlets years after we first raised the issue in these pages. But just because something has become fashionable to discuss doesn’t mean it’s not worth discussing and indeed, we’re at least pleased to see that the world is suddenly awake to the fact that a primary market supply bonanza catalyzed by rock-bottom borrowing costs and yield-starved investors could spell disaster when paired with shrinking dealer inventories. 

For illustrative purposes, here’s a look at turnover in corporate credit…

Chart: Barclays

...and a snapshot of shrinking dealer inventories and ballooning bond funds…

Chart: Citi

...and finally, here's UST market depth…

What all of these charts show is that whether you’re talking about corporate credit or “risk free” government debt, liquidity simply isn’t there and as was on full display last October, wild swings in illiquid markets will be exacerbated by the presence of parasitic HFTs. 

Meanwhile, Treasury market participants are shifting to futures and corporate bond fund managers are using ETFs to offset “diversifiable” outflows, phenomena which prove investors are actively avoiding credit markets by resorting to derivatives, a practice which only serves to make the underlying markets still more illiquid. 

Of course one way to mitigate risk is simply to move to cash (as we noted over the weekend, some managers are even moving to physical cash), a strategy TCW’s Jerry Cudzil is currently implementing in order to ensure he’s not one of the ones “looking silly” after the crash. Bloomberg has more: 

TCW Group Inc. is taking the possibility of a bond-market selloff seriously.

So seriously that the Los Angeles-based money manager, which oversees almost $140 billion of U.S. debt, has been accumulating more and more cash in its credit funds, with the proportion rising to the highest since the 2008 crisis.

“We never realize what the tipping point is until after it happens,” said Jerry Cudzil, TCW Group’s head of U.S. credit trading. “We’re as defensive as we’ve been since pre-crisis.”

TCW isn’t alone: Bond funds are holding about 8 percent of their assets as cash-like securities, the highest proportion since at least 1999, according to FTN Financial, citing Investment Company Institute data.

Cudzil’s reasoning is that the Federal Reserve is moving toward its first interest-rate increase since 2006, and the end of record monetary stimulus will rattle the herds of investors who poured cash into risky debt to try and get some yield.

Of course, U.S. central bankers are aiming to gently wean markets and companies off zero interest-rate policies. In their ideal scenario, borrowing costs would rise slowly and steadily, debt investors would calmly absorb losses and corporate America would easily adjust to debt that’s a little less cheap amid an improving economy.

That outcome seems less and less likely to Cudzil, as volatility in the bond market climbs.

“If you distort markets for long periods of time and then you remove those distortions, you’re subject to unanticipated volatility,” said Cudzil, who traded high-yield bonds at Morgan Stanley and Deutsche Bank AG before joining TCW in 2012. He declined to specify the exact amount of cash he’s holding in the funds he runs.

Price swings will also likely be magnified by investors’ inability to quickly trade bonds, he said. New regulations have made it less profitable for banks to grease the wheels of markets that are traded over the counter and, as a result, they’re devoting fewer traders and money to the operations.

To boot, record-low yields have prompted investors to pile into the same types of risky investors -- so it may be even more painful to get out with few potential buyers able to absorb mass selling.

“We think the market’s telling you to upgrade your portfolio,” Cudzil said. “Whether it happens tomorrow or in six months, do you want look silly before the market sells off or after?”

Well, preferably neither, but point taken and we would have to agree that if ever there were a time to take one's money and run — before the realities of a dealer-less corporate credit market and/or an HTF-infested, VaR shock-prone government bond market conspire to prove, once and for all, that in today's world, the idea that bonds are any safer than other asset classes is completely and utterly false — this is it.

HARD ASSETS - The Defintive Report on Gold Available

IN GOLD WE TRUST

Incrementum Li

DOWNLOAD FULL REPORT PDF

In Gold We Trust 2015 - Extended Version (e) by Financial Repression

Today, the 2015 edition of the gold report “In Gold We Trust” was launched. It is the 9th edition (read the 2013 and 2014 edition). With a global reach of some 1 million readers, it is probably the most read gold report worldwide. The In Gold We Trust 2015 is written by Ronald Stoeferle. He is the managing partner of a global fund at Incrementum AG in Liechtenstein, focused on the principles of the Austrian school of Economics.

2015 EDITION: "IN GOLD WE TRUST"

The gold price has stabilized in 2014, after its collapse in April and June of 2013. Investors' interest in the yellow metal is los. Hence, market sentiment vis-à-vis gold is standing at a multi-year low, maybe even a multi-decade low. History learns that extreme underperformance usually lasts for one year. If history is any guide, than there should be a recovery in the gold price in the foreseeable future. Even with the severe underperformance since 2013, gold is up approximately 9% per year since it started to trade freely in 1971. As seen on the next chart, depending on the currency in which it trades, the average yearly performance is excellent for investors with a long term horizon. In other words, gold does what is always has done throughout history: preserve value and purchasing power.

Preservation of wealth is the primary reason why one should hold gold nowadays. Monetary policies of central banks are extremely unusual. The U.S. Fed could be talking about “normalization,” but with 7 years at zero percent interest rates we are nowhere near “normal” conditions. The most extreme monetary conditions, today, are being seen in Japan. It is really no coincidence that the gold price in Yen is near its all time highs. The gold price in Yen is simply reacting on the extreme expansion of the monetary base by the Japanese central bank. As the next chart shows, the balance sheet of the Bank Of Japan (BOJ) is approximately 65% of the country's GDP. In other words, the assets that the BOJ is holding nears 2/3 of the total economic output of the country. When compared to other regions, it is clear that is a monstrous amount. It seems that Japan is near its endgame.

One of the “reasons” gold has gotten so little attention in the last two years is that investors have been focused on stock markets around the world. The U.S. stock market has seen a huge rally since October of 2012, European stocks catapulted higher when the European version of QE was announced earlier this year, Japan keeps on making multi-year highs in the wake of an ever expanding monetary policy. Meantime, however, stocks are not cheap anymore. On a historic basis, when expressed in a  price/earnings ratio according to the Shiller method, the stock market in the U.S. sits at relatively high levels (although no extremes). Although it is not given that the stock market is about to go south, there always is a possibility that the top is set in which case gold should see positive returns. As the next chart shows, during periods of the worst performance of the S&P 500, stocks and commodities have lost significant value while gold remained steady.

A correction in the stock market is certainly in the cards. Why? Because traditionally the gold/silver ratio is mostly negatively correlated with the S&P 500. In other words, as the gold/silver ratio goes down which means there is a disinflationary environment, stocks come down as well. Over the last 25 years, that correlation has held very well, but started to diverge strongly 3 years ago.

Gold is underperforming in a disinflationary environment. That has been one of the key observations in the last In Gold We Trust reports. There was enough evidence in the datapoints so far, but the most up-to-date chart says it all (see below). While the real rates were standing at -4% in 2011, they have gone up steadily since then, and are again in positive territory this year. The gold price has moved in the opposite direction in that same time period. The In Gold We Trust Report 2015 focuses, among many other things, on the correlation between the gold price and inflation expectations. Gold is an inflation sensitive asset. The U.S. 10-Year real yields provide an indication of inflation expectations. As readers can see, a strong divergence is in place since 2013, arguing for a strong revaluation of the gold price as inflation expectations are in an uptrend since then.

Suppose, however, that inflation expectations will change their trend … would that be bad for precious metals? The answer to that question is to be found in the last chart. During deflationary periods, like the ones starting in 1814 or 1864, the Great Depression of the 30ies or the financial crisis of 2008, gold did remarkably well. It is during those periods of “financial stress” that gold shows its real value, i.e. preserve wealth and provide protection against other assets.

The themes in this years 2015 "In Gold Trust Report" are the real value of gold as a financial asset and the end of gold's underperformance.

RISK - Post Q2 Quadruple Witch - Institutional Money Changing Direction

OUR BIG PICTURE

DRILLING DOWN

STUDY SEQUENCE:

1. THE ILLUSION
   • Don’t Fight The Market 06-21-15 Alhambra Investemtn Partners
   • All Their Eggs in Janet's Basket 06-22-15 John Hussman
2. THE EQUITY MARKET PROBLEM - One of Them
• "Debt Gone Wild" - Debt Funded Stock Buybacks Soar 06-22-15 Lance Roberts
• The Long Expansion 06-22-15 Ed Yardeni
3. THE BOND MARKET PROBLEM
• -$140 Billion Bond Fund Goes To Cash As It -Braces For Bond-Market Collapse 06-22-15 TCW Group / JP Morgan via ZH
4. NERVOUSNESS
• The "Smart Money" Just Sold The Most Stocks In History 06-23-15 BOAML via ZH
• Pop Goes The Bubble 06-23-15 Dmitry Orlov via ClubOrlov blog,

"DON'T FIGHT THE FED" MANTRA

• Real growth expectations are flat to falling.
• Inflation expectations are rising.
• Capital is flowing away from the US and back to international markets and economies.
• Credit markets are starting to get worried.

• Europe does not appear to have changed any economic policy sufficiently to affect their long term growth arc.
• Japan is improving but only slowly.
• Most people seem to think that China has a stock market bubble that will end badly.
• Australia, Canada and most of Latin America are dependent on China.

It seems best to trust what the market is saying. So, forget the Fed. Don’t fight the market.

Investors whose strategy is to follow the Fed – in the belief that stocks will advance as long as the Fed does not raise interest rates – are free to place all their eggs in Janet’s basket. On the other hand, for investors whose strategy is historically informed by factors that have reliably distinguished market advances from collapses over a century of history, our suggestion is to consider a stronger defense. Our greatest successes have been when our investment outlook was aligned with valuations and market internals, and our greatest disappointments have been when it was not. Both factors are unfavorable at present, and our outlook is aligned accordingly.

CHANGING INSTITUTIONAL FLOWS

FINANCIAL REPRESSION - Cashless Society Needed for Negative Rates

Cashless Society Needed for Negative Rates-Gordon Long

FLOWS - Liqudity, Credit and Debt

These Three Events Will Shatter "Liquidity Illusion", Trigger Crisis, OECD Says 06/25/15 OECD via ZH

The OECD has released its first Business and Finance Outlook which the organization describes as “an annual publication that presents unique data and analysis that looks at what might affect and change.. tomorrow’s world of business finance and investment.” 

Over some 250 pages, the first edition offers a sweeping look at the global financial landscape and outlines, in excruciating detail, many of the major themes we’ve built on in these pages including companies’ propensity to spend on buybacks and dividends at the expense of capex, the dangers of employing unrealistic pension fund investment return assumptions in a ZIRP world, and, of course, the liquidity paradox, wherein trillions in central bank cash injections mask underlying illiquidity — especially in bond markets. 

Here’s how Reuters summarizes the report:

Encouraged by years of central bank easing, investors are ploughing too much cash into unproductive and increasingly speculative investments while shunning businesses building economic growth, the OECD warned on Wednesday.

In its first Business and Finance Outlook, the Organisation for Economic Cooperation and Development highlighted a growing divergence between investors rushing into ever riskier assets while companies remain too risk-averse to make investments.

It urged regulators to keep a close eye on investors as they piled into leveraged hedge funds and private equity and poured cash into illiquid assets like high-yield corporate bonds.

Meanwhile, judging by stock market returns, investors were rewarding corporate managers focused on share-buybacks, dividends, mergers and acquisitions rather than those CEOS betting on long-term investment in research and development.

And here is the OECD’s take on the “liquidity illusion”:

There appears to be some illiquidity illusion in these trends. There has been a veritable “super-highway” of inflows into these “liquidity premium” products: corporate and emerging corporate credit, private equity and alternative assets. The “Super highway” into these products is not a dual carriageway — and when investors want to sell in a stressed environment they may find that there will be “accidents” in the reversal of flows.

High yield bonds have reduced liquidity due to declining covenant protection, making them harder to sell in a stressed event.

ETFs and alternative products that offer daily liquidity through trading in secondary markets when referencing illiquid underlying securities could be severely tested by redemptions in a sell off even where shares must be redeemed for in kind securities rather than cash.

Among the triggers the OECD says could spark a “liquidity crisis” are: 1) monetary policy normalization, the return of the EMU debt crisis, 2) a “falling oil price surprise” which could, in the organization’s words “undermine the oil-related and fracking business investment in the US,” 3) and geopolitical turmoil in the Middle East and Eastern Europe.

“Any of these events would likely trigger asset price volatility [and] attempts by institutional investors to redeem illiquid corporate bonds in crisis circumstances would amplify volatility.”

Once again we see that the proliferation of HY bond funds and other esoteric products (that have attracted unprecedented inflows in an environment where risk free assets yield at best an inflation adjusted zero and at worst have a negative carry) is cause for serious concern among very "serious" people who, years after the issue was first raised here, are now suddenly coming to the realization that when the market finally turns (due either to a poorly executed Fed liftoff or a geopolitical catastrophe), and previously diversifiableflows suddenly become a one-way rush to the exits, fund managers will be forced to sell the underlying assets, and in the absence of dealer liquidity (which has all but dried up in the post-crisis regulatory regime) a self-feeding firesale will ensue at which point central banks will either do as the IMF recently suggested and become market makers of last resort, or watch in horror from the sidelines as the bubble blown by allowing otherwise insolvent corporate issuers to stay afloat by tapping capital markets at artificially suppressed rates implodes in spectacular fashion.

Grab some popcorn.