Submitted by Tyler Durden on 07/01/2015 19:30 -0400

The Current Oil Price Slump Is Far From Over

The oil price collapse of 2014-2015 began one year ago this month (Figure 1).  The world crossed a boundary in which prices are not only lower now but will probably remain lower for some time. It represents a phase change like when water turns into ice: the composition is the same as before but the physical state and governing laws are different.*

Figure 1. Daily crude oil prices, June 2014-June 2015.  Source: EIA.
(Click image to enlarge)

For oil prices, the phase change was caused mostly by the growth of a new source of supply from unconventional, expensive oil. Expensive oil made sense only because of the longest period ever of high oil prices in real dollars from late 2010 until mid-2014.

The phase change occurred also because of a profoundly weakened global economy and lower demand growth for oil. This followed the 2008 Financial Collapse and the preceding decades of reliance on debt to create economic expansion in a world approaching the limits of growth.

If the cause of the Financial Collapse was too much debt, the solution taken by central banks was more debt. This may have saved the world from an even worse crisis in 2008-2009 but it did not result in growing demand for oil and other commodities necessary for an expanding economy.

Monetary policies following the 2008 Collapse produced the longest period of sustained low interest rates in recent history. As a result, capital flowed into the development and over-production of marginally profitable unconventional oil because of high coupon yields compared with other investments.

The devaluation of the U.S. dollar following the 2008 Financial Collapse corresponded to a weak currency exchange rate and an increase in oil prices.  The fall in oil prices in mid-2014 coincided with monetary policies that strengthened the dollar.

Prolonged high oil prices caused demand destruction. This also allowed the expansion of renewable energy that could compete only at high energy costs. Concerns about global climate change and its relationship to burning oil and other fossil energy threatened the future interests of conventional oil-exporting countries. OPEC hopes to regain market share from expensive unconventional oil and renewable energy, and to renew demand for oil through several years of low oil prices.

OPEC increased production in mid-2014, and decided not to cut production at its November 2014 meeting   By January 2015 oil prices fell below $50 per barrel.

Most observers expected a sharp reduction in U.S. tight oil production after rig counts fell with lower prices. Production fell in early 2015 but recovered as new capital poured into North American E&P companies. This and the partial recovery of oil prices into the mid-$60 per barrel range gave expensive oil another day to survive and fight.

If capital continues to flow to unconventional oil companies and OPEC’s resolve stays firm, oil prices could average near the present range for many years. Oil prices will probably fall in the second half of 2015 as the ongoing production surplus and weak demand overcome the sentiment-based belief that a price recovery is already underway.

Oil prices must inevitably rise as unconventional production peaks over the next decade and oil-exporting countries increasingly consume more of their own oil. Politically driven supply interruptions will inevitably punctuate the emerging new reality with periods of higher prices.

For now, however, we have crossed a boundary and notions of normal or business-as-usual should be put aside.

A New Supply Source and Over-Production 

The main cause of the price collapse of 2014-2015 was over-production of oil.  Most of the increase came from unconventional production in the United States and Canada–tight oil, oil sands and deep-water oil. From 2008 to 2015, U.S. and Canadian production increased 7.65 million barrels per day (mmpbd). During the same period, non-OPEC production less the U.S. and Canada decreased 2.85 mmbpd and OPEC production increased 1.79 mmbpd (Figure 2).

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Figure 2 . World liquids production since 2008 and the relative shares for the U.S. & Canada, OPEC and non-OPEC less the U.S. and Canada.
Source: EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

North American unconventional and OPEC conventional production increased almost 4 mmbpd in 2014 alone (Figure 3).

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Figure 3. U.S. + Canada & OPEC Liquids Production Since January 2014. Source: EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

Through 2013, unconventional production growth was matched by decreases in OPEC production mostly from supply interruptions due to political events (Figure 4). The result was that prices remained high despite increases in unconventional production.

         
Figure 4. U.S. + Canada & OPEC Liquids Production Growth, 2011-2015. Source: EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

OPEC responded to defend its market share in mid-2014 by increasing production. Prices started falling in late June 2014 from $115 per barrel (Brent) and reached a low in late January 2015 of $47 per barrel after OPEC decided not to cut production at its November 2014 meeting.

Unconventional production slowed and fell in early 2015. Then, prices increased beginning in February and Brent has averaged $63 per barrel since May 1 (WTI average $59 per barrel). Over-production continues as different parties struggle for market share, for cash flow to survive, or both.

If high oil prices created the conditions for unconventional oil to grow and challenge OPEC’s market share, then prolonged low oil prices must be part of OPEC’s solution.  By keeping prices below the marginal cost of unconventional production (about $75 per barrel), OPEC hopes that expensive oil production will decline along with the fortunes of the companies engaged in these plays.

Decreased Demand and Demand Destruction 

OPEC is as concerned about long-term demand as it is about market share. Oil is the only major source of revenue for many OPEC countries and low demand, potential competition from other fuel sources, and the effect of a perceived link between oil use and climate change are existential threats.

Demand growth for oil has been declining since the late 1960s (Figure 5).  OPEC hopes to stimulate demand through low oil prices back to the peak levels that existed before the price shocks of the 1970s and 1980s.

Figure 5. World Liquids Demand Growth.  Source: BP, EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

Demand destruction followed periods of high oil prices from 1979-1981 (Iran-Iraq War) and from 2007-2008 (demand growth from China).  2010-2014 was the longest period in history–33 months–of oil prices above $90 per barrel in real dollars (Figure 6). Since 2011, demand growth has fallen to only 0.5% per year so far in 2015 (Figure 5).

Figure 6. Crude oil prices more than $90 per barrel in 2015 dollars. Source: EIA, Federal Reserve Board and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

Prolonged low oil prices may restore growth to the global economy accomplishing what the central banks have failed to do since 2008. If successful, interest rates should rise and this may restrict the flow of capital to unconventional E&P companies. Most of the capital provided to these companies comes from high-yield (“junk”) corporate bond sales, preferred share offerings, and debt. In a zero-interest rate world (Figure 7), these provide yields that are are much higher than those found in more conventional investments like U.S. Treasury bonds or money market accounts. If interest rates increase with a stronger economy, capital may flow to more productive investments that offer yields that are more competitive with higher risk tight oil offerings.

Figure 7. Federal funds interest rates January 2000-June 2015 and Brent crude oil price.
Federal Reserve Board, EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

Over-Production Continues

The over-production that began the oil price collapse continues and has gotten worse. The global production surplus (production minus consumption) has gone on for 17 months and has grown from 1.25 mmbpd in May 2014, just before prices began to fall, to almost 3 mmbpd in May 2015 (Figure 8).

Figure 8. World liquids production surplus or deficit and Brent crude oil price. Source: EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

We may take some comfort that the rate of increase has slowed but it is difficult to explain the increase in prices over the last few months based on supply and demand.

The production supply surplus that is largely responsible for the current oil-price collapse is not a trivial event that will likely go away soon unless production is cut either by unconventional producers or OPEC. Earlier production surpluses in May 2005 and January 2012 were higher than today but were short-lived and related to specific non-systemic factors (Figure 9).

Figure 9.  World liquids relative production surplus or deficit and Brent price in 2015 dollars, 2003-2015. 
Source: EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

The present supply imbalance is structural and persistent. The only comparable episode in recent history was the production deficit immediately before the 2008 Financial Collapse that lasted 11 months. It was driven by growing Chinese and other Far East demand and by dwindling oil supplies following the peak of conventional production in 2005.

For now, OPEC appears committed to continued over-production to achieve its goals. Its production increased 1.4 million barrels of liquids per day during the last year (Figure 3) and some analysts suggest it might increase by an equal amount again in coming months.

Meanwhile, U.S. production has not fallen much so far. Production from the main tight oil plays fell about 77,000 bpd in January 2015, was basically flat in February and increased 51,000 bpd in March (Figure 10). This is partly because companies are high-grading well completions in the best parts of the plays. It is also because of the backlog of drilled but uncompleted wells that are being brought on production at a fraction of the incremental cost of drilling new wells.

Figure 10. Oil production from tight oil plays in the U.S. Source: Drilling Info and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

But the most significant factor is that capital flow to U.S. unconventional plays has increased. Figure 11 shows that almost $17 billion in equity offerings flowed to U.S. oil companies in the first quarter of 2015, more than in any other period since 2010. The percent of E&P equity rose to over 10% of overall issuance from an average of about 4-5% over the last decade. This can only be explained because there are no alternative investments with comparable yields and that investors believe that they are buying assets that are somehow viable at current oil prices.

Figure 11. Capital available to U.S. E&P companies in the first quarter of 2015. Source: Wall Street Journal.
(Click image to enlarge)

Tight oil companies have made the case that through increased efficiency and lower service costs that their economics are better at lower oil prices today than they were at $90 per barrel prices a few years ago. First quarter (Q1) financial results do not support this claim.

In fact, tight oil companies are losing more than twice as much money in Q1 2015 as they were in 2014. On average, companies that were spending $1.40 for every dollar they earned from operations last year are now spending $3.20 for every dollar earned (Figure 12).

Figure 12. First quarter (Q1) 2015 vs. full-year 2014 capital expenditures-to-cash flow from operations ratio.
Source: Google Finance and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

Follow The Money

The strength of the U.S. dollar provides a simple and generally reliable way to cut through the complex factors that govern oil prices. A negative correlation exists between the strength of the U.S. dollar and the price of oil (Figure 13). This correlation is particularly strong beginning in about 1997.

Figure 13.  U.S. Federal Reserve Board broad dollar index and CPI-adjusted Brent and WTI crude oil prices.
Source:  Federal Reserve Board, EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

The relationship is key to understanding the current oil-price collapse. Figure 14 shows the daily exchange rate of the U.S. Dollar and the Euro in relation to Brent and WTI crude oil prices.  The onset of price decline coincided with a stronger U.S. dollar beginning in June 2014 that may be related to the end of quantitative easing and to an improving U.S. economy.  The recent increase in oil prices in 2015 corresponds to weakening of the dollar that may reflect disappointingly weak first quarter 2015 U.S. GDP growth.

Figure 14. U.S. dollar/Euro exchange rate, Brent and WTI prices. Source: EIA, Oanada and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

The standard explanation for the relationship between the dollar and oil price is that global oil transactions are carried out in U.S. dollars. When the dollar is weak against other currencies, oil prices are higher and when the dollar is strong, oil prices are lower. In other words, a stronger U.S. economy and currency may reduce oil prices and vice versa. While the observation is accurate, the explanation is more complex.

Oil and other commodities are hedges against economic risk and uncertainty. Oil prices increase and decrease as risk perception rises and falls. High oil-supply risk or “fear premiums” generally manifest as short-lived, upward price spikes that are quickly integrated into forward price expectations. Following the initial shock of oil-supply risk, U.S. Treasury bond and related “flight-to-safety” investments tend to lower oil price trends as the U.S. dollar appreciates.

Supply and demand balance operates as a first-order cycle against which economic uncertainty and geopolitical risk fluctuate as second- and third-order cycles. When a  first-order supply imbalance coincides with second- or third-order economic or geopolitical factors, an upward or downward price-cycle may develop. Higher energy costs are a weight on the economy that may lower currency values.  Conversely, lower energy costs may lift the economy and currency values.

The U.S. is the world’s largest economy and the U.S.dollar is the world reserve currency. This makes the U.S. dollar a fairly reliable reflection and measure of all of these factors.

The 2014-2015 oil price collapse may be understood then as a supply surplus that occurred at a time of a strengthening U.S. economy (low economic uncertainty) and relatively low geopolitical risk (Figure 15).  The additive effect of these three cycles was a sharp decline in oil prices.

Figure 15. World liquids production or surplus, Brent price and U.S. dollar index.
Source: EIA, Federal Reserve Board and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

Are Low Oil Prices Long or Short Term?

Oil price collapses in 1981-1986 and 2008-2009 are the only analogues for the present price situation (Figure 16). So far, the current price collapse seems more similar to 1981-1986 than to 2008-2009.

Figure 16. The 1981-1986 and 2008-2009 oil price collapses in the context of OPEC and
non-OPEC oil  production, oil consumption and Brent crude oil price in 2014 U.S. dollars.
Source: BP, EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

1981-1986 was a long-term event. The price collapse itself lasted for 5 years but oil prices remained below $90 per barrel in real dollars until 2007, almost 27 years.

2008-2009 was a short-term event. Prices began falling in July 2008 and reached a low point in December 2008. Prices recovered and reached $90 per barrel in April 2010 and $100 per barrel in March 2011. Then entire cycle from $90 per barrel and back again lasted a little more than 2 years.

The oil price collapse of the 1980s was similar to the present price collapse because the primary cause was a new source of supply. Non-OPEC production exceeded OPEC production in 1978 as new supply from the North Sea (U.K. and Norway), western Siberia (Russia), the Campeche Sound (Mexico) and China came on line. Unlike the present, the new supply was inexpensive conventional oil.

Oil prices had increased in 1979-1981 to more than $90 per barrel in real dollars because of supply interruptions at the beginning of the Iran-Iraq war. This caused approximately 4.3 mmbpd of demand destruction. Lower demand and continued supply growth from non-OPEC countries caused a production surplus beginning in 1982.

Oil prices fell from $106 per barrel in 1980 to $31 per barrel in 1986. OPEC cut 10 mmbpd of production between 1980 and 1985 with no effect on falling oil prices. In 1986, OPEC decided to increase production to protect market share, abandoning its role as “swing producer.”

Although neither the volume of new supply or the amount of demand destruction during the current price collapse are as great as 1981-1986, they are more similar than to 2008-2009.

The 2008-2009 oil price collapse was part of an overall crash of the entire global economy. High oil prices in 2007 and 2008 were due to a large and persistent production supply deficit because of high demand from China and the Far East, and dwindling supplies following the peak of conventional oil production in 2005 (Figures 15 and 17). The surplus had nothing to do with new supply but was completely due to decreased demand from a collapsing global economy. The surplus only lasted for 6 months and never approached the level seen in 2014-2015 (an OPEC production cut  in early 2009 limited the length of the surplus and possibly its magnitude).

Figure 17. World liquids production surplus of deficit (12-month moving average) and Brent oil price. Source: EIA and Labyrinth Consulting Services, Inc.
(Click image to enlarge)

High oil prices preceding the 2014-2015 price collapse began because of supply interruptions resulting from the Arab Spring. Brent price reached a maximum of $129 per barrel in April 2011 at the height of the Libyan Civil War. These events corresponded with a period of U.S. currency devaluation following the 2008 Financial Collapse and an extraordinarily weak U.S. dollar (Figures 13 and 15). The additive effects of a supply deficit, economic uncertainty and geopolitical risk resulted in high oil prices.

Case histories neither predict the present or the future but offer guidelines. These two case histories simply suggest is that the present period of low oil prices is more similar to that of the 1980s and 1990s than to that of the 2008-2009 period. That similarity means that the current phenomenon is likely to be a relatively long-term event.

Conclusions

The availability of capital to fund unconventional production is the key to how long low oil prices will last going forward. If the flow of capital continues, then the production surplus and lower oil prices will also continue, assuming that OPEC is able to maintain higher production levels and that demand growth remains relatively low.

Eventually, price will win and unconventional production will fall. The market will rebalance and prices will rise. If oil prices stay low for long enough, demand will increase to support those higher prices. I doubt that prices will increase to levels before mid-2014 barring politically driven shock events. $90 per barrel appears to be the empirical threshold price above which demand destruction begins.

It is more difficult to predict how the second- and third-order effects of economic uncertainty and geopolitical risk may affect supply and demand fundamentals and, therefore, price.  These are the wild cards that could change the  outcome that I describe.

The most likely case is that oil prices will decrease in the second half of 2015 and that financial distress to all oil producers will increase. The hope and expectation that the worst is over will fade as the new reality of prolonged low oil prices is reluctantly accepted.

We have had a year of lower oil prices. Based on available data, I see no end in sight yet. The market must balance before things get better and prices improve. That can only happen if production falls and demand increases. That will take time.

We have crossed a boundary and things are different now.

GEO-POLITICAL EVENT RISK - Greece, Puerto Rico, China and France

Greece Will Default To IMF Tomorrow, Government Official Says

Earlier today, as the exchange between Greece and its creditors got increasingly belligerent, Estonian Prime Minister Taavi said that "Greece’s debt would still remain outstanding and creditors would expect this money back." So did this latest antagonism change the Greek mind? According to a flash headline by the WSJ released moments ago, not all. In fact, Greece just made it official that it would default to the IMF in just over 24 hours: "Greece won't pay IMF tranche due Tuesday, government official says"

Puerto Rico Announces Bond Payment "Moratorium"

Having concluded last night that Puerto Rico debt is "unpayable," and that his government could not continue to borrow money to address budget deficits while asking its residents, already struggling with high rates of poverty and crime, to shoulder most of the burden through tax increases and pension cuts, Padilla confirmed tonight that: PUERTO RICO TO SEEK "NEGOTIATED MORATORIUM", 'YEARS' OF POSTPONEMENT IN DEBT PAYMENTS. Likening his state's situation to that of Detroit and New York City (though not Greece), Padilla concluded, the economic situation is "extremely difficult," which is odd because just a few years ago when they issued that bond - everything was awesome?

Strap In! China Is Crashing Again

In the last 2 days, PBOC has thrown everything at the ponzi-fest they call a rational market. An RRR cut, a Benchmark rate cut, a rev repo rate cut, a CNY50 Bn rev repo injection, a stamp duty cut, IPO halts (cut supply), and last but not least permission to speculate with a reassurance that shares on a solid foundation. The outcome of all this policy-panic - CHINEXT (China's Nasdaq) is down another 6% today (down 25% in 3 days) and aside from CSI-300 futures, all other major Chinese indices are in free-fall. Add to that the fact that industrial metals are collapsing with steel rebar limit down and it appears Central Bank Omnipotence is under threat.

French Economy In "Dire Straits", "Worse Than Anyone Can Imagine", Leaked NSA Cable Reveals

Moscovici who served as French finance minister until 2014 and then became European commissioner for Economic and Financial Affairs, Taxation and Customs, used some very colorful language, i.e., the French economic situation was "worse than anyone [could] imagine and drastic measures [would] have to be taken in the next two years”. 

1. On Monday, the Dow fell by 350 points. That was the biggest one day decline that we have seen in two years.
2. In Europe, stocks got absolutely smashed. Germany’s DAX index dropped 3.6 percent, and France’s CAC 40 was down 3.7 percent.
3. After Greece, Italy is considered to be the most financially troubled nation in the eurozone, and on Monday Italian stocks were down more than 5 percent.
4. Greek stocks were down an astounding 18 percent on Monday.
5. As the week began, we witnessed the largest one day increase in European bond spreads that we have seen in seven years.
6. Chinese stocks have already met the official definition of being in a “bear market” – the Shanghai Composite is already down more than 20 percent from the high earlier this year.
7. Overall, this Chinese stock market crash is the worst that we have witnessed in 19 years.
8. On Monday, Standard & Poor’s slashed Greece’s credit rating once again and publicly stated that it believes that Greece now has a 50% chance of leaving the euro.
9. On Tuesday, Greece is scheduled to make a 1.6 billion euro loan repayment. One Greek official has already stated that this is not going to happen.
10. Greek banks have been totally shut down, and a daily cash withdrawal limit of 60 euros has been established. Nobody knows when this limit will be lifted.
11. Yields on 10 year Greek government bonds have shot past 15%. 
12. U.S. investors are far more exposed to Greece than most people realize.
13. The Governor of Puerto Rico has announced that the debts that the small island has accumulated are “not payable“.
14. Overall, the government of Puerto Rico owes approximately 72 billion dollars to the rest of the world. Without debt restructuring, it is inevitable that Puerto Rico will default. 
15. Ukraine has just announced that it may “suspend debt payments” if their creditors do not agree to take a 40% “haircut”.
16. This week the Bank for International Settlements has just come out with a new report that says that central banks around the world are “defenseless” to stop the next major global financial crisis.

LINK HERE to the article

Alasdair Macleod sees the criticality of the Greek crisis as being central to the solvency of the European Central Bank (ECB) itself & therefore confidence in the euro currency .. "The ECB's balance sheet, which is heavily dependent on Eurozone bond prices not collapsing, is itself extremely vulnerable to the knock-on effects from Greece. As the situation at the ECB becomes clear to financial markets, the euro's legitimacy as a currency may be questioned, given it is no more than an artificial construct in circulation for only thirteen years. In conclusion, the upsetting of the Greek applecart risks destabilizing the euro itself, and a sub-par rate to the U.S. dollar beckons."

LINK HERE to the essay

Bloomberg reports that European investors are increasing their purchases of gold as Greece's crisis intensifies .. "Investors are searching for a safe haven after Greece imposed capital controls, closed banks and stopped selling gold coins to the public until at least July 6."

LINK HERE to the article

Early China Strength Fades Fast As Margin Debt Plunges Most In 3 Years

Wed, 01 Jul 2015 05:16:47 GMT

Chinese QE Calls Officially Begin: Bond Swap "Sucks Liquidity", "Contributes To Stock Slump", Broker Claims

Posted:Wed, 01 Jul 2015 00:40:00 GMT

How China Lost an Entire Spain in 17 Days

Posted:Tue, 30 Jun 2015 22:58:45 GMT

FUNDAMENTALS -The Truth "Slipped Out" Under Cover of Political Turmoil

Goldman Just Crushed The "Strong Fundamentals" Lie; Cuts EPS, GDP, Revenue And Profit Forecasts

To summarize: the first revenue drop for the S&P in 5 years, a major downward revision in EPS now expecting just 1% increase in 2015 EPS, a 25% cut to GDP forecasts, a machete taken to corporate profits and 10 Yields, and not to mention double digit sales declines for some of the most prominent tech companies in the world. And that, in a nutshell, is the "strong fundamentals" that everyone's been talking about.

SEE BELOW FOR EXPANDED ARTICLE DETAIL

Gross Says Hold Cash, Prepare For "Nightmare Panic Selling"

That an ETF can satisfy redemption with underlying bonds or shares, only raises the nightmare possibility of a disillusioned and uninformed public throwing in the towel once again after they receive thousands of individual odd lot pieces under such circumstances.

Goldman Just Crushed The "Strong Fundamentals" Lie; Cuts EPS, GDP, Revenue And Profit Forecasts

Posted:Wed, 01 Jul 2015 02:15:06 GMT

FINANCIAL REPRESSION

Is Financial Repression Here to Stay?

LINK HERE to the Article

BCA Research Chief Economist Martin Barnes:

"Financial Repression is Here to Stay"

LINK HERE to the Article & Link to Report

The Era of Financial Repression:

Norway's Sovereign Wealth Fund says

Monetary Policy is a Risk to Watch

LINK HERE to the Article

"Financial repression is not a conspiracy theory, it is rather a collective set of macroprudential policies focused on controlling and reducing excessive government debt through 4 pillars - negative interest rates, inflation, ring-fencing regulations and obfuscation - to effectively transfer purchasing power from private savings." - The Financial Repression Authority

SUB-PRIME ECONOMY -Auto Loans

Just as Used Car prices start to roll over again... (for the first time since the financial crisis, 4-year price changes - average term then - are now negative)

Worse yet, the most popular compact car prices are down 5.2% YoY and mid-size down 1.9% YoY.

As Goldman notes,

We attribute March’s sequential decline to rising supply coming to market from growing off-lease volumes.

However, if there is further deterioration from here – either from a rapid used supply increase or waning retail demand – we could see pricing pressure spill over into new vehicles through a rise in incentives.

LTV 137% - In Unprecedented Development, Lenders Now Take Record Losses On Every Used Car Loan

This wasn't supposed to happen...

Domestic Auto Sales Tumble, Miss For 6th Of Last 7 Months (Don't Tell Phil LeBeau)

Judging by the smiling Phil LeBeau who earlier opined of an 8.9% plunge in For F-Series sales that "I don't know if I'd Call that a slowdown," you would think the US Auto industry was killing it. Apart from the fact that all but the most luxurious brands missed expectations, we sum up the month of June's results by nothing the credit-spewed spike in May is now over and domestic car sales are continuing to trend lower. This is the biggest MoM drop since Sept 2014. As Ward's notes, they have now missed expectations for 6 of th elast 7 months...

Auto Loans In "Untested" Territory Blackstone Warns As Subprime ABS Sales Accelerate

Earlier this month, we gave readers a snapshot of the US auto market on the way to explaining why it was that car sales hit a 10-year high in May. To recap: 

• Average loan term for new cars is now 67 months — a record.
• Average loan term for used cars is now 62 months — a record.
• Loans with terms from 74 to 84 months made up 30%  of all new vehicle financing — a record.
• Loans with terms from 74 to 84 months made up 16% of all used vehicle financing — a record.
• The average amount financed for a new vehicle was $28,711 — a record.
• The average payment for new vehicles was $488 — a record.
• The percentage of all new vehicles financed accounted for by leases was 31.46% — a record.

We went on to note that despite the worrying statistics shown above, optimists (like Experian) will likely point to the fact that the average FICO score for borrowers financing new cars fell only slighty from 714 to 713 Y/Y while the same Y/Y scores for those financing used vehicles actually rose from 641 in Q1 2014 to 643 in Q1 2015. While that's all well and good, there's every indication that those figures are likely to deteriorate significantly going forward. Why? Because Wall Street's securitization machine is involved. in the consumer ABS space (which encompasses paper backed by student loans, credit cards, equipment, auto loans, and other, more esoteric types of consumer credit), auto loan-backed issuance accounts for half of the market and a quarter of auto ABS is backed by loans to subprime borrowers. Put simply, those subprime borrowers are getting subprimey-er. 

In other words, the same dynamic that prevailed in the US housing market prior to the collapse is at play in the auto loan market. Lenders are competing for borrowers as lucrative securitization fees beckon, and this competition is directly responsible for loose underwriting standards. Bloomberg has more on the interplay between auto ABS issuance and “stretched” auto loan terms:

Demand for automobile debt in the U.S. is enabling lenders to make longer loans to people with spotty credit, stoking concern that car shoppers are being lulled into debt loads they won’t be able to sustain.

Of the subprime vehicle loans bundled into securities, 73 percent now exceed five years, up from 64 percent during the first three months of 2014, according to data from Citigroup Inc. 

Loans as long as seven years are increasingly being put into more bonds as auto-finance companies and Wall Street banks sell the securities at the fastest pace since 2007.

The longer loans make it easier for consumers to afford rising new and used car prices by spreading out and lowering payments. While the securities are attracting plenty of buyers with high loss buffers and AAA ratings, some investors are beginning to question the wisdom of lending at terms that have never before extended beyond five years.

“Everyone has used the argument that borrowers pay car loans because they have to get to work,” said Anup Agarwal, a money manager who oversees $65 billion at Western Asset Management Co. and hasn’t bought a subprime auto bond in a year and a half. “But borrowers only pay loans if the car is working. We have not seen this cycle come through yet.”

A debt offering recently marketed by American Credit Acceptance LLC demonstrates some of the risks. About one-third of the 14,628 loans in the deal are tied to borrowers with credit ratings under 500 according to the Fair Issac Corp. grading system known as FICO -- or with no score at all, according to a prospectus obtained by Bloomberg. The company is charging interest rates of between 27 and 28 percent for almost one-third of the borrowers, and more than half of its loans exceed five years.

While cars are lasting longer than in the past, regulators are concerned that the value of the vehicles will fall faster than borrowers can pay off the debt.

“Because cars depreciate quickly, a borrower is typically upside down or underwater toward the end of a long loan term,” Date said. “If times are tough you might have to sell your car, but you’re still going to owe more than you can get through the sale.”

The riskiest auto bonds offer compensation of up to four times the coupon of comparably dated Treasuries, Bloomberg data show.

History is also on the side of investors. Since 2004, S&P has upgraded 371 classes of subprime auto deals and downgraded none, data from the company show.

Even with the built-in protections, some market participants are starting to caution that buyers may be letting down their guard for the sake of higher yields.

Auto securities sold in 2014 have registered the highest loss rate of any period since 2008, according to data from JPMorgan Chase & Co.

Some finance companies are avoiding the longer terms. Exeter Finance Corp., a Blackstone Group-backed subprime lending firm based in Irving, Texas, isn’t offering them because the risk is too high, said the firm’s treasurer, Andrew Kang.

“At this time we have no intention of going longer than 72 months,” he said. “The risk is that you extend a loan that a borrower cannot afford over its term schedule. Inching out to 75 and 84 months, I don’t think that has been tested yet.”

Here's a visual overview of the auto loan-backed ABS market (note the resurrgence of subprime as a percentage of total issuance post-2009 and the rising net loss rates):

*  *  *

The takeaway here is simple: under pressure to keep the US auto sales miracle alive and feed Wall Street's securitization machine (which is itself driven by demand from yield-starved investors) along the way, lenders are lowering their underwriting standards and extending loans to underqualified borrowers.

Particularly alarming is the fact that even as average loan terms hit record highs, average monthly payments are not only not falling, but are in fact also sitting at all-time highs.

This cannot and will not end well. 

Submitted by Tyler Durden on 02/21/2015 20:14 -0400

Subprime Car Loan Bubble 2.0 Full Frontal

FLOWS - Liquidity, Credit & Debt

Submitted by Tyler Durden on 06/05/2015 13:35 -0400

It's Not The Economy, Stupid, It's The Flow

By now it should be clear, without the flow of Federal Reserve funny money, the wedge between the reality of collapsing macro- and micro-fundamentals and ever-expanding valuation hope-based stock prices is bound to close... and that is why the following 2 charts must be scary for Janet (and every asset-gathering commission-taking talking head out there).

The Wedge: (the Fed-engineered gap between reality and unicorns)

And the flow: (the rate of change of The Fed balance sheet - as opposed to the level or 'stock' of The Fed balance sheet - is what matters after all, via NJC)

So once again we'll ask, as we have ever since 2014: is the Fed simply rising rates just so it badly crashes the economy and has the cover to launch QE4, the same way Russian sanctions crippled Germany's economy and led to the ECB's very first episode of bond monetization?

Bond Trading Revenues Are Plunging On Wall Street, And Why It Is Going To Get Worse

Submitted by Tyler Durden on 06/04/2015 21:58 -0400

The Real Reason Why There Is No Bond Market Liquidity Left

Back in the summer of 2013, we first commented on what we called "Phantom Markets" - displayed quotes and prices, in not only equities, FX and commodities but increasingly in government bonds, without any underlying liquidity. The problem, which we first addressed in 2012, had gotten so bad, even the all important Treasury Borrowing Advisory Committee to the US Treasury had just sounded an alarm on the topic.

Since then we have sat back and watched as our prediction was borne out, as bond market liquidity slowly devolved then sharply and dramatically collapsed recently to a level that is so unprecedented, not even we though possible, leading first to the October 15 bond flash crash and countless "VaR shock" events ever since.

And while we urge those few carbon-based life forms who still trade for a living to catch up on our numerous posts on market "liquidity" and lack thereof, here is a quick and dirty primer on just why there is virtually no bond market left, courtesy of the man who, weeks ahead of the Lehman collapse when nobody had any idea what is going on, laid out precisely what happens in 2008 and onward in his seminal note "Are the Brokers Broken?", Citigroup's Matt King.

Here is the gist of his recent note on the liquidity paradox which is a must read for everyone who trades anything and certainly bonds, while for the TL/DR crowd here is the 5 word summary: blame central bankers and HFTs.

* * *

The more liquidity central banks add, the less there is in markets

• Water, water, everywhere — On many metrics, liquidity across markets seems abundant. Bid-offers are tight, if not always  back to pre-crisis levels. Notional traded volumes in credit and rates have reached all-time highs. The rise of e-trading is helping to match buyers and sellers of securities more efficiently than ever before.
• Nor any drop to drink — And yet almost every institutional investor, in almost every market, seems worried about liquidity. Even if it’s here today, they fear it will be gone tomorrow. They say that e-trading contributes much volume, but little depth for those who need to trade in size. The growing frequency of “flash crashes” and “air pockets” – often without obvious cause – adds weight to their fears.
• Yes, street regulation has played a role — The most frequently cited explanation is that increased regulation has driven up the cost of balance sheet and reduced the street’s appetite for risk, and hence ability to act as a warehouser between  buyers and sellers.
• But so too have the central banks — And yet this fails to explain why even markets like FX and equities, which do not consume dealers’ balance sheets, have been subject to problems. We argue that in addition to regulations, central banks’ distortion of markets has reduced the heterogeneity of the investor base, forcing them to be the “same way round” over the past four years to a greater extent than ever previously. This creates markets which trend strongly, but are then prone to sudden corrections. It also leaves investors more focused on central banks than ever before – and is liable to make it impossible for the central banks to make a smooth exit.

How Bad Is Liquidity Reall?

From the BIS to BlackRock, and Jamie Dimon to Jose Vinals, everyone seems to be talking about market liquidity. Chiefly they seem to be fretting about a lack of it. Primary markets might be wide open, thanks in large part to the largesse of central banks, but the very same investors who are buying today seem deeply concerned about their ability to get out tomorrow.

Liquidity as a concept is notoriously difficult to pin down. It has a reputation for being very much in evidence when not required, and then disappearing without trace the moment you need it. For strategists – and regulators – this represents a challenge: conventional metrics like bid-offer and traded volume can go only so far towards capturing what investors mean by liquidity. And yet because investors’ concept of liquidity tends very much to be focused on tail events, by definition, data to help monitor it are scarce.

This paper tries to assess the evidence across markets, and evaluate what is driving it.

Some observers have argued that even if liquidity is disappearing from some markets, it is being maintained – or even concentrated – in others. We argue in contrast that the risk of illiquidity is spreading from markets where it is a traditionally a problem, like credit, to traditionally more liquid ones like rates, equities, and FX. There is a bifurcation – but it is between decent liquidity much of the time and then sudden vacuums when it is really required, not across markets.

We likewise take issue with the widespread notion that the problem is solely due to regulators having raised the cost of dealer balance sheet, and could be ameliorated if only there were greater investment in e-trading or a rise in non-dealer-to-non dealer activity. To be sure, we see the growth in regulation – leverage ratio and net stable funding ratio (NSFR) in particular – as one of the main reasons why rates markets are now starting to be afflicted, and indeed we expect further declines in repo volumes to add to such pressures. But illiquidity is a growing concern even in markets like equities and FX, which use barely any balance sheet at all, and where e-trading is the already the norm rather than the exception.

Instead, we argue that in addition to bank regulations, there is a broad-based problem insofar as the investor base across markets has developed a greater tendency to crowd into the same trades, to be the same way round at the same time. This “herding” effect leads to markets which trend strongly, often with low day-to-day volatility, but are prone to air pockets, and ultimately to abrupt corrections. Etrading if anything reinforces this tendency, by creating the illusion of lliquidity which
evaporates under stress.

Such herding implies a reduction in the heterogeneity of the investor base. One potential cause is the way steadily more investor types having become subject to procyclical accounting and capital requirements in recent years, most obviously for insurance companies and pension funds.

But the tendency towards illiquidity pockets even in markets where insurance and pension money is not dominant suggests a deeper cause. We think the most likely candidate is central banks’ increasing hold over markets. Over the past four years, it is expectations of central bank liquidity, not economic or corporate fundamentals, which have become the main driver of everything from €/$ to credit spreads to BTP yields.

While central banks have always been significant market participants, their role has obviously grown since 2008. Most obviously, their global asset purchases have drastically reduced the net supply of securities available to be bought by investors. At the same time, we have seen a breakdown in a number of fundamental relationships which had previously correlated well with markets – and their replacement with metrics directly linked to central bank QE. Because the herding is not directly backed by leverage, it is unlikely to be reduced by macroprudential regulation.

To date, the air pockets and flash crashes represent little more than a curiosity, having mostly been resolved very quickly, and having had little or no obvious feedthrough to longer-term market dynamics, never mind to the real economy.

But we think ignoring them would be a mistake. Each has occurred against a largely benign economic backdrop, with little by way of a fundamental driver. And yet with each one, investors’ nervousness about the risk of illiquidity is likely to have been reinforced. When the time comes that investors do see a fundamental reason all to sell – most obviously because they start to doubt the extent of central banks’ support – their desire to be first through the exit is liable to be even greater.

There when it’s not needed

First, let us consider the evidence that all the fuss about liquidity is much ado about nothing. In many markets, under normal conditions, it is now possible to trade on more platforms, with more counterparties, and with tighter bid-offer, than ever before. While some market developments may perhaps point to the potential for problems, day-to-day liquidity remains remarkably good.

Plenty of notional volume, with tight bid-offer

The most obvious data point in this respect is that notional traded volumes in many markets are at or close to all-time highs.

US credit, for example, saw nearly $27 trillion in secondary trading last year; HY volumes have doubled since the crisis (Figure 1). In government bonds, the increase was typically pre-crisis, but volumes have typically remained flat even in the face of a growing proportion of bonds being absorbed by the central banks (Figure 2). German Bunds are a notable  exception. Notional volumes in equities have fallen from precrisis peaks, but remain close to them in the US and Japan (Figure 3).

Likewise, data on bid-offer across markets mostly paints a healthy picture. The BIS shows that bid-offer in govies has largely fallen back towards pre-crisis levels. Equity bid-offer is likewise close to pre-crisis lows, and seems to suggest that even quite large portfolios could be transacted at tight spread levels – provided volumes were split quite broadly across a large number of stocks (Figure 4). Bid-offer in credit remains wide to pre-crisis levels, as far as we can tell4, but is the tightest it has been since then (Figure 5). For small investors not correlated with the broader herd, these gains in notional volume and tight bid-offers will represent a very real ability to transact.

Turnover in decline

Admittedly, the positive message in these notional data is considerably mitigated when the growth in many markets – and in many investors’ portfolios, especially in rates and credit – is taken into consideration. Once transaction volumes are adjusted to show the difficulty an investor is likely to have moving a given percentage of the market, a very different picture emerges – and one which is much more consistent across markets.

In credit, rates, and equities alike, turnover relative to market outstandings has fallen considerably. Corporate turnover has almost halved since the crisis (Figure 6). The decline in government bond turnover has been more protracted, but is just as drastic, especially in US Treasuries (Figure 7). Equity turnover is more obviously influenced by the rise and fall in outstandings with market movements, but has also suffered a post-crisis decline (Figure 8).

For most investors, turnover is probably a more useful metric than straight traded volume. Monthly mutual fund inflows and outflows have generally grown as fund sizes have increased; for high-yield bond funds, net outflows seem to have been growing even in percentage terms, never mind in notional ones (Figure 9). Given that their share of the market has also been growing, the capacity to move a given percentage of the market is a much better guide than the ability to move a  given notional volume. The same tendency is not quite as pronounced in other long-term fund types, but seems also to be true for money market funds (Figure 10).

And yet despite declining turnover, the fact remains that outflows to date have not led to obvious liquidity problems.

ETFs, futures and indices – can they be more liquid than their underlying?

If the mutual funds’ role in contributing to market liquidity risks has been exaggerated, then we think ETFs have been more maligned still. They may well be responsible for some of the reason “day-to-day” liquidity has held up so well, but we struggle to see that they can be blamed for any increase in its tendency to disappear under stress.

The rise in ETFs has certainly been striking; in equities, in particular, net ETF sales have outstripped regular mutual fund sales in recent years (Figure 16), though in fixed income their rise has been slower. More striking still is that ETF trading now constitutes just under 30% of all US equity dollar volume. The rise of ETFs is probably one reason why, also in Europe, a growing proportion of daily volume is shifting away from intraday trades and towards end-of-day auctions (Figure 17).

There may well be a positive feedback loop in which other large trades are increasingly executed at end-of-day auctions, precisely because investors know that liquidity is becoming concentrated there, and to avoid being seen for reporting purposes to have dealt away from the daily closing price.

But what is striking in Figure 17 is that non-auction equity volumes have also been rising in recent years. Rather than ETFs subtracting from cash traded volume, they seem to have added to it. The same might be said for the rise of traded volume  in dark pools.

In this respect, we see ETFs as very much akin to the CDS indices in credit, or futures in equities and rates. It is not that there is a fixed quantity of trading to be done, and that the arrival of a new instrument necessarily removes trades which would have been done elsewhere. If anything, we see the opposite phenomenon. Liquidity begets liquidity: when investors have new instruments with which to express views and refine their positions, it tends to encourage still more trading.

In addition, in contrast with open-ended mutual funds, ETFs – like closed-end investment trusts – offer the possibility for prices to diverge from net asset values. This affords an additional cushion, especially during periods of market stress. The fact that ETF volumes have a tendency to increase relative to cash volumes during periods of stress – even though they then are likely to be trading at a discount – suggests that this cushion works well, and may even act to boost liquidity during stressed conditions. We have much sympathy for the way one ETF provider put it: “Everyone complains when they see our prices deviating from the underlying. But what they fail to realize is that at least people can and do actually trade at those prices: in troubled times, the prices shown on broker screens for underlying instruments are often a fiction.”

So while we would agree with the statement that “no investment vehicle should promise greater liquidity than is afforded by its underlying assets”5, we think there is something for an exception for vehicles which are themselves tradable, and can trade with a basis relative to their underlyings. ETFs, CDS indices and futures can and do provide much more liquidity than their underlyings. This, though, is not so much because they “promise” more liquidity, as that they facilitate additional activity, much of which is crossed at the index level, and only a fraction of which is transmitted through to the underlying. While investors are periodically surprised and frustrated by these vehicles’ failure to perfectly track movements in their underlyings, this failure is in some ways the secret of their liquidity. Rather than stealing liquidity from the underlyings, we think their growth has added to it.

Missing when required

But if neither ETFs nor mutual funds can be held responsible for perceptions of reduced liquidity across markets, what can? The finger is most often pointed at the street. Many buysiders feel that dealers’ willingness to act as a liquidity provider even during good times has waned; might such reduced willingness also help explain an increased tendency of liquidity to evaporate altogether? We think this is much closer to the truth – but even so, we doubt it is the full story.

Are the brokers broken?

Such arguments have been voiced most persuasively in Jamie Dimon’s recent letter to JPM shareholders. He cited three factors: higher cost of balance sheet, explicit constraints for US banks as a result of the Volcker Rule, and in extremis the fact that the rescues of the likes of Bear Stearns, WaMu and Countrywide/Merrill have led not to gratitude but to heavy fines for JPMorgan and Bank of America, in at least one case following the abnegation of ex ante assurances otherwise.

The effects of the latter two factors are hard to observe, and would probably become visible only in a proper crisis. Even then, they might in principle be offset by “Rainy Day” funds. These are pools of money being set up by asset managers precisely so as to take advantage of liquidity-related distortions. But it seems doubtful that these will ever reach the scale required to take 2008-style rescues, at least without large amounts of leverage.

The effects of reduced dealer balance sheet, however, are visible already, and are contributing directly to the perception of illiquidity in fixed income. Unlike equities or FX, fixed income trading is fragmented across an extremely large number of outstanding securities. Only rarely can a willing buyer and seller of the same security be found at the same instant. As such, liquidity, particularly for larger trades, relies heavily on dealers’ ability to act as a warehouse, temporarily hedging a long position in one security with a short position in another. This requires both the availability of balance sheet, and the ability to borrow securities freely through repo. Both of these are now under threat from regulation.

Why e-trading is no panacea

E-trading works extremely well as an efficient means of uniting buyers and sellers of a given security – provided those buyers and sellers exist in the first place.

That is, a buyer can probably find a seller faster now than they could a few years ago, when they had to rely solely on email and phone calls. In indices, in equities and in on-the-run govies, where many investors are ready and willing to trade the same security on either side of the market multiple times in an hour, this can bring about significant improvements (Figure 24).

But in much of fixed income (and especially credit), liquidity is intrinsically fragmented. End investors’ willingness to buy and sell a large notional volume of a given security is simply not there in the first place (Figure 25). Even if investors could be persuaded to concentrate their positions in a given issuer on a smaller number of outstanding “benchmark” securities, as BlackRock has called for, issuers could never be persuaded to do so, since it would add to their refinancing risks. Issuers like the diversification that a multitude of outstanding securities brings.

As such, it is no use efficiently putting together buyers and sellers when those buyers and sellers do not exist in the first place. This is why many traders report that – even when they have on occasions been able to offer ‘choice’ markets with zero bid-offer for a while, these have not necessarily resulted in any trading. End user liquidity remains fundamentally dependent on a counterparty’s willingness to act as a warehouse: to buy the security the seller wants to sell, to offer the security the buyer wants to buy, find a hedge of some sort and then move to unwind the position later. This is also why so many bond market participants – buyside and sellside – are opposed to efforts to copy-paste equity-inspired regulations into a fixed income framework in the interest of increased transparency.

Nor is it obvious that there is an easy alternative to the existing broker-dealer model when it comes to warehouses. Bid-offers are tight enough that the market-making model relies upon leverage in order to generate a reasonable return on equity. Even if, say, asset managers or hedge funds are prepared to act as warehouses, for them to make money on the operation they will want to operate with leverage. But – as the clearing houses are now starting to find out, and banks discovered some time ago – such leverage represents precisely the sort of systemic risk that regulators are now keen to limit.

As such, e-trading to date has done a great deal to boost what the IMF calls “flow”, or day-to-day liquidity, for small-sized trades. But when it comes to larger transactions, they can seldom be cleared (Figure 26).

‘Phantom liquidity’ – is the problem getting worse?

There is an argument that the liquidity provided by e-trading seems to be more fleeting than that stemming from voice trades and personal relationships. When markets become volatile, e-trading operators tend to pull the plug – or, at best, reduce the size they are willing to trade. A recent IMF analysis concluded that it was precisely such a reduction in the depth of order books which seems to have led to the ‘flash rally’ in US Treasuries on October 15th 2014. A high dependence on electronic trading also seems to have contributed to the flash crash in equities on May 6th 2010.

It is this phenomenon that is known as “phantom liquidity”, or the “liquidity illusion” – a tendency to evaporate when really needed. It does seem possible that e-trading may have added to such a tendency, by improving the appearance of liquidity under normal conditions, and then withdrawing it in periods of stress. This could help explain why some of the most obvious instances of recent illiquidity have occurred in markets which already have high proportions of trades conducted electronically.

And yet beyond the anecdotal, quantitative data demonstrating an increased tendency towards “phantom liquidity” is extremely hard to pin down. After all, it makes predictions not about day-to-day circumstances but about tail events, which by definition are few and far between.

The best evidence is probably some increase in bifurcation in day-to-day trading conditions, visible in daily volatility levels across markets. Rather than there being a steady stream of moderately volatile days (and liquidity conditions), volatility seems to be becoming more clustered than it used to be: there are many days with tight ranges and good liquidity, and then occasional days of extreme intraday volatility and reportedly poor liquidity – even though (as in the flash crash and flash rally) volumes on such days can actually remain quite high.

Often, the volatility is thought to occur intraday, and therefore may not be captured by the net daily changes implicit in volatility metrics. Looking at intraday high-low ranges in markets paints a slightly clearer picture – but not decisively so. It does in general seem to us that intraday ranges have become more bifurcated since around 2005, most obviously with a period of low volatility prior to the financial crisis being followed by the extremely high ranges during the crisis itself, but also with post-crisis daily trading ranges being more bifurcated than prior to 2005.

Low day-to-day volatility, punctuated by occasional sharp corrections, are exactly what we might anticipate if markets were becoming less liquid. In credit, for example, they are one of the features which distinguishes the cash market relative to the continual bouncing around of the CDS indices. And we have argued previously that markets seem to be becoming more subject to positive feedback loops, which see them trending steadily upward only to fall back suddenly and often unexpectedly.

And yet the limited number of observations, and the variations across markets, make it hard to make confident statistical statements about any change in the shape of distributions. We are left with the unsatisfying conclusion that evaporating liquidity is as much a feeling voiced by many market participants as to what might happen under stress, illustrated by a few idiosyncratic examples, as it is a statistically demonstrable phenomenon.

The evidence of increased herding

A recipe for a perfectly liquid market would be one with a small number of homogeneous securities being traded by a much larger number of heterogeneous participants. This would do a great deal to improve the likelihood of a buyer and seller both wanting to transact in the same security at the same time, and hence being able to agree upon an appropriate price. Indeed, it has even been suggested that we might quantify markets’ potential for liquidity along such lines, taking the number of distinct market participants and dividing by the number of securities traded.15 This is one reason why liquidity in indices and futures is often so good, as they concentrate a large amount of activity in a small place.

One potential explanation for growing illiquidity is that markets have been evolving in an exactly opposite direction. Not only has the number of securities traded been growing (in credit in particular), but the heterogeneity of market participants seems to have been reducing as well. Here too, the regulations are partly to blame, with more and more investors being forced both to mark to market and to hold capital or cover pension deficits on the basis of such mark to market calculations. In addition, though, it feels to us as though market participants are increasingly looking at the same factors when they make their investment decisions.

For the last few years, valuations in more and more markets seem to have stopped following traditional relationships and instead followed global QE. Likewise in meetings with investors, we have been struck by how little time anyone spends discussing fundamentals these days, and how much revolves around central banks. Record-high proportions of investors think fixed income is expensive and think equities are expensive.  A growing number of property market participants seem to think real estate is expensive. And yet almost all have had to remain long, as each of these markets has rallied. Could it be that central bank liquidity has forced investors to be the same way round more so than previously, and that this is  making markets prone to sudden corrections.

While it is hard to demonstrate conclusively, a growing weight of evidence would seem to point in such a direction. CFTC data on net speculative positioning in futures and options markets has become more extreme in recent years, and abrupt falls in net positioning have often coincided with sharp market movements. Net shorts in Treasuries reached record levels immediately prior to the flash rally, for example (Figure 29); net longs in commodities contracts preceded the sharp fall in commodities indices in the second half of last year, and record net euro shorts (Figure 30) and dollar longs are being squeezed at the moment. However, it could be argued that growth in notional contracts outstanding is a normal part of financial market deepening; normalizing by the net open interest would (at least in some cases) suggest recent positioning is not too far out of line with history.

But other data also point to an increase in investor crowding. Our own credit survey shows that investors’ positions in credit since the crisis have not only been longer on average than ever previously, but also less mean reverting, and exhibiting less dispersion and less mean reversion (Figure 31). Fully 83% of those surveyed were long credit in December last year – a sizeable imbalance for any market. Similarly, the BAML global investor survey shows that investors have been long in equities for a longer period than would historically have been normal.

Research specifically designed to detect investor herding has reached the same conclusion. An IMF analysis of the correlation between individual securities transactions by US mutual funds, using the vast CRSP database, shows a clear pickup in herding with the crisis, and then another one in late 2011. The herding seems to have occurred consistently across markets, but was more intense in credit and especially EM than in equities. It also occurred both among retail and among institutional investors. The IMF were unable to test for herding in government bonds and FX because of the much more limited number of securities.

What we find striking about the herding numbers is the way they correlate with the metrics we use to track the scale of central bank interventions: rolling global asset purchases by DM central banks, and global net issuance of securities once central bank purchases (and, in this case, also LTROs) have been subtracted out. Over the past four years, we have had to use these metrics to help explain market movements when traditional fundamental relationships have broken down.

Investors likewise agree on the dominance of central banks: in a survey of global credit derivatives investors we conducted in January this year, fully two thirds thought “central bank actions” would be the main driver of spreads this year, well ahead of “credit fundamentals”, “global growth trends” or “geopolitical risks”. Even if the central banks are only having to intervene because the systemic risks they are confronting have become bigger, the effect remains the same.

This, then, would seem to be the final piece of the puzzle as to what is making markets prone to pockets of illiquidity. Central bank distortions have forced investors into positions they would not have held otherwise, and forced them to be the ‘same way round’ to a much greater extent than previously. The post-crisis increase in correlations, which has been visible both within credit and equities and across asset classes (Figure 35), stems directly from the fact that investors now increasingly find themselves focused on the same thing: central bank liquidity. Every so often, when they start to doubt their convictions, they find that the clearing price for risk as they try to reverse positions is nowhere near where they’d expected.

This explains why the air pockets have not just been in markets where the street acts as a warehouser of risk. It explains why they have occurred not only in the form of sell-offs which could have caused multiple market participants to suffer from procyclical capital squeezes. It also explains why the catalysts have often, while often trivially small, have nevertheless been macro in nature, since they have boosted expectations of a change in central banks’ support for markets.

Unfortunately, it leads to a rather ominous conclusion. The bouts of illiquidity will continue until central banks stop distorting markets. If anything, they seem likely to intensify: unless fundamentals move so as to justify current valuations, when central banks move towards the exit, investors will too.

Rather than dismissing recent episodes as relatively harmless, then, we are supposed to worry how much larger a move could occur in response to a more obvious stimulus. While financial sector leverage has fallen, debt across the nonfinancial   sectors of almost every economy remains close to record highs, meaning that the potential for negative wealth effects in the real economy is very much there.

In principle, markets could gap to a point where they went from being absurdly expensive to being absurdly cheap, and then – as investors stepped in again – gap tighter, perhaps even without very much trading. But the existence of the feedback loop to the real economy means that the fundamentals tend also to be affected by extreme market moves: “cheap” may be a moving target. This in turn could force central banks to step back in again.

To sum up, we are left with a paradox. Markets are liquid when they work both ways. Market participants, though, find themselves increasingly needing to move the same way. This is not only because of procyclical regulation; it is also because central banks have become a far larger driver of markets than was true in the past. The more liquidity the central banks add, the more they disrupt the natural heterogeneity of the market. On the way in, it has mostly proved possible to accommodate this, as investors have moved gradually, and their purchases have been offset by new issuance. The way out may not prove so easy; indeed, we are not sure there is any way out at all.

* * *

To which all we can add is: Good luck with the "exit"