Tag: Repurchase agreement

Chinese “Ghost Collateral” Scam Leads To Market “Shockwaves”, Huge Loss For Giant Commodity Trader

Back in 2014, a scandal erupted when media reports confirmed what many had previously speculated about China’s banking system: namely that much of China’s staggering loan issuance had been built (literally) upon air and that trillions in loan collateral had been “rehypothecated” between two, three or many more debtors – or never even existed – forcing banks to accept that they would never recover much if any of the pledged collateral – in most cases various commodities – if the economy were to suffer a hard-landing resulting in mass defaults. The most famous example involved collateral fraud at China’s 3rd largest port, Qingdao, where numerous borrowers were found to have “pledged” the same collateral of steel and copper to obtain funding from various banks.

For those unfamiliar there is an extensive selection of stories covering the topic, which peaked three years ago, and then quietly faded away as China did everything in its power to deflect attention from what some have said is the biggest threat facing its economy: a giant hole . Below we link to some of our more comprehensive articles on the topic:

To be sure, the story briefly resurfaced in May when we reported that “Some Chinese Banks Suspend “Interbank Business” As Regulator Demands That Collateral “Actually Exists”, although it then quickly fizzled again, for two reasons: i) China watchers assumed that Beijing no longer had a “collateral problem” which had been somehow fixed after all the noise rehypothecation stories from in 2014, and ii) China now seemingly has even bigger problems on its hands, such as finding the right balance between maintaining the latest housing bubble, keeping capital outflows in check and its currency stable at a time when China’s debt (well over 300% of GDP) was downgraded by Moody’s (and later S&P) for the first time in 28 years, while its gargantuan shadow debt powder keg is one big red headline away from a $9 trillion shadow bank run.

And while the latter is certainly accurate, the former couldn’t possibly be further from the truth.

That was revealed by a terrific June expose when Reuters reporters went to China to determine the current status of China’s long-standing collateral problem. What they found was that “ghost collateral” continues to haunt countless loans across China’s debt-laden banking system, which is a problem because as we explained in 2014, and as Reuters noted “lax lending practices and overvalued collateral spurred the U.S. financial crisis in 2008. Now, banks in China face risks of their own as fraudulent borrowers and corrupt bankers burden the financial system with loans lacking genuine collateral.

Fast forward to today, when China’s “ghost collateral” problem has re-emerged with a bang, and this time there is a quantifiable price tag. As Bloomberg reports, the giant agricultural commodities merchant ED&F Man Holdings Ltd., best known for trading sugar and coffee, has taken a major hit of about $80 million “after falling victim to a scam in the metals market.”

The scam, for those who have been following our reports on China’s ghost collateral, will be familiar: ED&F Man’s loss is linked to fraudulent metal-financing that was uncovered at a warehousing firm owned by Glencore Plc earlier this year, said Bloomberg’s sources.  Back in 2013, we published an extensive discussion on the nature of China’s commodity-financing deals, many of which were designed as quasi-legal ponzi scheme, meant to boost liquidity and funding by rehypothecating the underlying collateral on numerous occasions; at the time copper was the preferred underlying asset, however with time this spread to virtually all commodities.

This tale of “missing” collateral comes at a bad time for ED&F Man, which was already nursing a smaller losses at its sugar unit.

The metals issue comes as ED&F Man had a tough year at its sugar business, with the 230-year-old commodities trader last month saying it would cut costs and headcount at the unit amid surplus supplies and low prices. The London-based firm this week said Chief Executive Officer Phil Howell is leaving after three years in the role and more than two decades at the company.

While the impact on the company’s final earnings won’t be clear until ED&F Man releases its annual financial statements, it will be sizable: last year the company reported pretax profit, adjusted for acquisitions, of $100.9 million, which means that China’s fake collateral has cost nearly one full year of net income for one of the world’s best respected independent traders.

Here’s what happened: Glencore’s Access World – one of the world’s biggest provider of LME warehousing and logistics services –  warned customers in January that it found forged warehouse receipts circulating in the market. The announcement, Bloomberg writes “sent shock waves through the commodities-trading industry, reawakening concerns about fraud after a metal-financing scam was uncovered at the Chinese port of Qingdao in 2014.

Meanwhile, ED&F Man Capital Markets acted as a broker between Australia & New Zealand Banking Group and two Hong Kong-based trading companies in a sale-and-repurchase financing deal. The trade was backed by storage receipts for about $300 million of nickel stored in Access World warehouses in Asia, according to court documents filed by the bank in the U.S in June. However, when ANZ looked to sell the nickel, it discovered that all but one of the 84 storage receipts were likely to have been forged, leaving it with “substantial losses,” the bank said in court filings, which were part of a request for information it could use in lawsuits in other jurisdictions.

There is still some hope that ED&F Man can recover some losses…

Some of ED&F Man’s nickel-related losses could still be recovered when court proceedings are concluded, the people said. The company last month said its brokerage business in general continues to perform well.
Suedzucker AG, Europe’s largest sugar producer, has a 35 percent stake in ED&F Man.

… however, the odds are slim to none. In fact, what is surprising is that it has taken over three years for the first serious hit from China’s “ghost collateral” to emerge. Or perhaps not: in a time of generally rising prices, few if any traders actually bother to check if their pledged collateral ever exists. The problem emerges when prices decline, which courtesy of China’s bubble machine, has so far not been an issue. However, there are those random occasions when spot checks reveal shocking surprises, as Reuters reminded of over the summer:

The banker at the other end of the phone line was furious, recalled Shanghai lawyer Wang Chaoyu. A pile of steel pledged as collateral for a loan of almost $3 million from his bank, China CITIC, had vanished from a warehouse on the outskirts of the city. Just several months earlier, in mid-2013, Wang and the banker had visited the warehouse and verified that the steel was there. “The first time I went, I saw the steel,” recalled Wang, an attorney at Beijing DHH Law Firm, which represents the Shanghai branch of CITIC.

 

“Afterwards, the banker got in contact with me and said, ‘The pledged assets are no longer there.’”

Now, it was ED&F Man’s turn to make the same shocking discovery. However, with trillions in dollars “guaranteed” by Chinese “ghost collateral” based on various third party estimates, at least the giant commodity trader can find solace in the fact that it will not be the last to learn that “it’s gone… it’s all gone.”

http://WarMachines.com

A Technical History Of Market Melt-Ups

Authored by Vincent Delaurd via INTL-FCStone,

Melt-Up, FOMO, and Other Climaxes – A Technical History of Good Times

Bottom Line:

  • Many strategists are calling for a year-end melt-up: I believe it already happened
  • There have been 76 melt-ups since 1900: the current one is already the second longest on record
  • Stocks have achieved a Sharpe ratio of 4.5 this past year – better than 99.7% of the times since 1900
  • There is little sidelines cash and leverage levels are high • A re-allocation from bonds into equities could push the market higher
  • I’d rather bet on higher rates than on a continuation of this over-extended bull run

Warren Buffett famously joked that “bull markets are like sex. It feels best just before it ends”. Based on my sometimes-unlucky experience of sex and bull markets, I would add another commonality: the climax is sometimes reached before every participant realized that the party had even started.

Market pundits have pumped the notion of a year-end melt-up with quasi sexual frenzy lately. This report will make the sobering case that the melt-up already happened. Defining a melt-up as the combination of new all time-highs and 20% + year-over-year gains, I documented 76 such explosions since 1900. The median melt-up lasted 45 days. The longest and greatest of these jubilations lasted a glorious 320 days. The current climax has lasted 311 days, and counting.   This remarkably resilient market Nirvana also featured a 1-year Sharpe ratio of 4.5, enough to break the heart, mind, and soul of the most seasoned hedge fund manager.  

Racy jokes aside, I do not want to join the bears which have broken their claws on the back of this soaring bull. Melt-ups alone do not portend future losses: the S&P 500 index has gained an average 6.8% in the year following the 76 prior meltups. Also, bond investors have poured about $10 trillion into bond funds since 2009, and almost nothing into equity funds.  Even a small re-allocation could propel the stock market into an unprecedented jubilee. 

But I’d much rather play the melt-up game by betting on rising rates, rather than a continuation of this overextended and overvalued equity bull market.

A melt-up is a subjective affair.

What If the Melt-Up Already Happened?

"Melt-up" seems like one of the most overused expression in market commentary these days. Yet, very few analysts bother to define what they mean by the term. The first step to analyze a phenomenon is to define it properly, so here is my suggested definition of a melt-up:

  • A 20 % year-over-year gain – or about double the normal market gain
  • New all-time highs: melt-ups are born out of optimistic sentiment getting more extreme. Bounces from corrections, no matter how large, do not qualify.

Hence, the start of a melt-event is met when these two conditions (a new ATH on year-over-year gains of 20% or more) are met. It lasts for as long as the market remains above its 6-month moving average. I measured the gain as the maximum price appreciation between the start and the end of the event. Using this definition, there have been 77 melt-ups since 1900. The S&P 500 index spent a total of 16 years in meltup mode, or about 14% of its time. This reflects the extraordinary performance of U.S. stocks, which have returned an annualized total return of 8.1% this past century.

What Could Make the Melt-up Last Longer?

Historical precedents clearly suggest that the melt-up is already behind us. But as the French say, “comparaison n’est pas raison”, and maybe it is different this time. In the short-term, only three factors can push a bull market higher:

1. More money coming into the market

 

2. Investors taking in more leverage

 

3. Investors rotating money from other asset classes

Let’s start with #1, sidelines cash. As bulls never tire of repeating, this is “the most hated bull market ever”. It may be so, but there are a lot of fully-invested bears out there. A decade of financial repression has turned cash into trash. Money market funds assets account for just 17% of the assets of long-term funds, a historical low. Similarly, the cash balance of equity mutual funds is at an all-time low 3.3%. Hence, there is not much sidelines cash left to push stocks higher.

How about leverage? Perma-bears love to point that margin debt has risen to a record $550 billion, up from $381 billion at the July 2007 peak. I believe that this statistic is misleading: asset prices are also much higher today, which would allow for higher absolute levels of leverage. Scaling margin debt by market capitalization adjusts for this bias. Margin debt accounts for 2.2% of U.S. stocks’ market cap, slightly above the long-term average.

Then again, margin debt may not be the best measure of leverage these days. Day-traders may use margin debt in their eTrade accounts, but the big boys have better ways to lever up. According a recent and excellent presentation of Fasanara Capital, U.S. corporate debt sored to $5.8 trillion in 2016, almost doubling in five years. Nearly 70% of the new debt issued in Europe and U.S. is “cov-lite” as investors are happy to pile into any instrument that offers a positive yield. Caveat emptor, as the Romans used to say.

The only prospect for significant inflows into the equity market would come from the bond market. According to the Fed’s latest Flow of Funds Report, bond mutual funds took in almost $10 trillion since January 2009, while equity funds have taken less than $1.1 trillion. Hence, it is theoretically possible that an accelerating economy, coupled with a more hawkish Fed and a progressive tightening of global central banks’ liquidity faucets, could convince investors to rotate from bonds into equities. 

It is hard to estimate the impact of such a rotation on stocks’ valuations. Over the short-term, more money flowing into the stock market would be bullish. However, equities would eventually be impacted by higher rates – low interest rates and “TINA” have been the main justification for sky-high multiples. I doubt that the S&P 500 index would trade for 22 times earnings if bond yields normalized.

Hence, it is probably safer to play the “great rotation” by betting on higher rates than hoping for an extension of this stretched bull market. As I argued in “the Other, Bigger, ETF Bubble”, bonds are still much more overpriced than equities. At these valuations, I’d much rather be a bond bear than a stock market bull. 

http://WarMachines.com

This Will Be The Biggest Buyer Of Stocks In 2018

In July, many were surprised to learn (even though we have shown this many times prior), that according to Credit Suisse analysts there has been just one buyer of stocks since the financial crisis: the corporate sector, also known as “stock buybacks.”

Well, don’t change the channel, because according to Goldman’s just released forecast of fund flows in 2018, it will be more of the same as the single biggest buyer of stocks next year will be the same one as before:corporationg buying back stock, some $590 billion of it to be precise, and more than all other sources of stock purchasing in the coming year combined. In fact, without buybacks, instead of net equity demand of $400 billion in 2018, there would be nearly $200 billion of outflows, something not seen since the financial crisis.

Here’s the summary from David Kostin: “Corporate buybacks and ETF inflows will drive US equity demand in 2018. We forecast corporate equity demand will rise by 3% to $590 billion next year. Increased authorizations and high cash balances should more than offset headwinds to buybacks from high valuations.”

In addition to buybacks, Goldman is confident that the passive investing euphoria will continue, and expects expect investor purchases of ETFs to hit a record high of $400 billion in 2018. Investor preference for passive vs. active funds should continue to drive demand for ETFs

Meanwhile, Goldman predicts that active investors will continue to liquidate holdings, and mutual funds will remain net sellers of equities in 2018 while foreign investors will reduce net buying.

We forecast mutual funds will sell $125 billion of equities in 2018, in line with net equity demand during the past two years. We expect stable US GDP growth and a flat US dollar will support $100 billion of foreign investor demand for US equities next year.

Visually:

Some more details on next year’s near record corporate buybacks:

CORPORATIONS: We forecast corporations will purchase $570 billion (-9%) of US equities in 2017 and $590 billion (+3%) in 2018 primarily through share buybacks (net of issuance). During 1H 2017 there was a considerable slowdown in repurchase activity given elevated policy uncertainty. Net buybacks are on pace to fall by 21% vs. 2016. Consequently, we lower our 2017 corporate demand forecast to $570 billion from $640 billion, implying a decline of 9% vs. 2016. However, our estimate still assumes an acceleration in net buybacks in 2H vs. 1H given a 60% expected increase in Financials buybacks due to CCAR results and buyback seasonality (2H usually comprises around 60% of annual buybacks). Net buybacks should rise by 3% in 2018 given an increase in repurchase authorizations including and excluding Financials, high cash balances, and solid earnings growth. However, extended valuation should limit substantial buyback growth. Rising interest rates and the underperformance of stocks focused on buybacks could pose additional headwinds to total corporate equity purchases.

So why the modest slowdown in buybacksin 2017? According to Goldman, “corporate equity demand plummeted in 1H 2017 in the face of fiscal and monetary policy uncertainty.”

The pace of buyback executions in 2017 vs. 2016 has declined more sharply across all US companies (-21%) than the S&P 500 (-7%) because ex-SPX US equity demand has fallen by more than 60%. Policy uncertainty has also hurt other uses of cash. Annualized S&P 500 capital expenditures (-7%), R&D (-8%), and cash M&A (-13%) are all lower this year compared with 2016.

That is expected to change, and it’s not only contingent on the fate of Trump’s tax reform especially as it regards repatriation: an increase in buyback announcements and high cash balances is expected to drive repurchases next year. S&P 500 repurchase authorizations have increased by 18% YTD compared with the same time in 2016. Financials authorizations are 25% higher than the prior peak in 2015. Even excluding Financials, authorizations have risen by 4% so far this year. S&P 500 cash balances as a share of assets are near record highs (12%), indicating significant potential to deploy cash. The boost from the CCAR test results to Financials buybacks should also continue to support elevated buyback activity next year while positive earnings growth should benefit M&A. We expect share issuance will remain at the 5-year average of $125 billion through year-end 2018.

Even so, there is one major reason why corporations will limits their buybacks – their stocks have never been more overvalued.

We expect the rise in corporate demand will only be modest in 2018. Total corporate repurchases next year should remain below 2016 levels. The equity market is at record highs and valuations are stretched, which will discourage firms from sharply boosting share repurchases. In addition, rising interest rates suggest that companies may refrain from issuing large amounts of additional debt to fund buybacks, especially when leverage for the median stock is at a record high. If policy uncertainty persists, management teams may continue to curb cash spending as they did during 1H 2017. Lastly, investors have rewarded firms investing for growth over those  returning cash to shareholders. Our sector-neutral basket of 50 stocks that have spent the most on capex and R&D (GSTHCAPX) has returned 25% YTD vs. 16% for the S&P 500. In contrast, a similar basket of stocks with the  highest trailing 4-quarter buyback yields (GSTHREPO) has lagged the S&P 500 by 470 bp this year (12% vs. 16%).

Still, should Trump tax reform pass, it is a key upside risk to Goldman’s forecast: “In the event tax reform passes, we expect corporate demand could rise by an incremental $75 billion relative to our baseline estimate of $590 billion to reach $665 billion in 2018, implying 17% growth vs. 2017.

* * *

Ok, buybacks will once again determine the fate of the market in 2018; what about other sources of stock buying, and selling? Here is the full breakdown:

  • ETFs: We estimate investor flows into ETFs will rise to a record of $400 billion in 2018, a 33% jump from our 2017 estimate of $300 billion. The vast majority of ETFs are owned by retail investors. ETF assets as a share of the total corporate equity market (public and private) have doubled since 2009 and now stand at a record high (6% of total). The magnitude of passive fund influence is greater when looking only at public equities. ETF AUM, including index objective funds, is equal to 14% of S&P 500 market cap and 9% of the total US public equity market. US equity ETFs have witnessed inflows during each of the past seven years and inflows of $132 billion YTD. Investor preference for passive over active and strong household balance sheets should support strong ETF inflows next year.
  • MUTUAL FUNDS: We expect mutual funds will be net sellers of equities in 2017 ($100 billion) and 2018 ($125 billion). Mutual funds have sold equities for seven consecutive quarters since the end of 2015. Equity mutual fund outflows ($98 billion YTD), coupled with a declining liquid asset ratio, have been key drivers of negative equity demand among active funds during the past two years. We reduce our 2017 estimate of mutual fund equity demand to -$100 billion from -$50 billion given greater-than-expected net selling during the first half of the year. The combination of passive fund popularity and weak active fund returns will continue to hurt mutual fund equity demand in 2018.
  • FOREIGN INVESTORS: We expect foreign investors will remain net buyers of US equities but reduce purchases from $150 billion in 2017 to $100 billion in 2018. Foreign investors were net sellers of US equities during the past two years. However, a weak US dollar during 1H 2017 helped reverse the trend of net selling. We raise our 2017 estimate of foreign investor equity demand to $150 billion from $25 billion. Demand should remain positive in 2018 given stable US GDP growth of around 2%. However, a flat trajectory for the USD suggests lower purchases in 2018 compared with this year. We expect US investor purchases of foreign equities will equal $300 billion in 2017 and $250 billion in 2018 given solid global economic growth.
  • PENSION FUNDS: Pension funds will sell $300 billion and $250 billion of equities in 2017 and 2018, respectively. We lower our 2017 estimate of pension fund equity demand to -$300 billion from -$175 billion given elevated net selling (-$273 billion annualized) in 1H 2017. We expect pension funds will continue to sell equities in 2018 as the 10-year US Treasury yield rises by 100 bp to 3.3%. Net selling of equities by pension funds has averaged $200 billion annually since 2012.

Finally, what if rising rates blow up the corporate buyback machine, and make it prohibitively expensive to sell debt and buy stock with the proceeds, leading to the loss of the marginal buyer? Well, just to cover itself for that contingency, Goldman left the following footnote:

BEAR MARKETS: Investors continue to worry about the timing of the next bear market. Although we think an imminent correction is unlikely, we analyzed flows around bear markets during the past 70 years. In general, corporations, foreign investors, and mutual funds reduce equity demand during a downturn while pension funds increase net buying. Households have been net sellers 100% of the time.

Yes thank you, what we’d like to know is if households will also be “100%” net sellers in 2018…

http://WarMachines.com

Goldman: This Will Be The Biggest Buyer Of Stocks In 2018

In July, many were surprised to learn (even though we have shown this many times prior), that according to Credit Suisse analysts there has been just one buyer of stocks since the financial crisis: the corporate sector, also known as “stock buybacks.”

Well, don’t change the channel, because according to Goldman’s just released forecast of fund flows in 2018, it will be more of the same as the single biggest buyer of stocks next year will be the same one as before:corporationg buying back stock, some $590 billion of it to be precise, and more than all other sources of stock purchasing in the coming year combined. In fact, without buybacks, instead of net equity demand of $400 billion in 2018, there would be nearly $200 billion of outflows, something not seen since the financial crisis.

Here’s the summary from David Kostin: “Corporate buybacks and ETF inflows will drive US equity demand in 2018. We forecast corporate equity demand will rise by 3% to $590 billion next year. Increased authorizations and high cash balances should more than offset headwinds to buybacks from high valuations.”

In addition to buybacks, Goldman is confident that the passive investing euphoria will continue, and expects expect investor purchases of ETFs to hit a record high of $400 billion in 2018. Investor preference for passive vs. active funds should continue to drive demand for ETFs

Meanwhile, Goldman predicts that active investors will continue to liquidate holdings, and mutual funds will remain net sellers of equities in 2018 while foreign investors will reduce net buying.

We forecast mutual funds will sell $125 billion of equities in 2018, in line with net equity demand during the past two years. We expect stable US GDP growth and a flat US dollar will support $100 billion of foreign investor demand for US equities next year.

Visually:

Some more details on next year’s near record corporate buybacks:

CORPORATIONS: We forecast corporations will purchase $570 billion (-9%) of US equities in 2017 and $590 billion (+3%) in 2018 primarily through share buybacks (net of issuance). During 1H 2017 there was a considerable slowdown in repurchase activity given elevated policy uncertainty. Net buybacks are on pace to fall by 21% vs. 2016. Consequently, we lower our 2017 corporate demand forecast to $570 billion from $640 billion, implying a decline of 9% vs. 2016. However, our estimate still assumes an acceleration in net buybacks in 2H vs. 1H given a 60% expected increase in Financials buybacks due to CCAR results and buyback seasonality (2H usually comprises around 60% of annual buybacks). Net buybacks should rise by 3% in 2018 given an increase in repurchase authorizations including and excluding Financials, high cash balances, and solid earnings growth. However, extended valuation should limit substantial buyback growth. Rising interest rates and the underperformance of stocks focused on buybacks could pose additional headwinds to total corporate equity purchases.

So why the modest slowdown in buybacksin 2017? According to Goldman, “corporate equity demand plummeted in 1H 2017 in the face of fiscal and monetary policy uncertainty.”

The pace of buyback executions in 2017 vs. 2016 has declined more sharply across all US companies (-21%) than the S&P 500 (-7%) because ex-SPX US equity demand has fallen by more than 60%. Policy uncertainty has also hurt other uses of cash. Annualized S&P 500 capital expenditures (-7%), R&D (-8%), and cash M&A (-13%) are all lower this year compared with 2016.

That is expected to change, and it’s not only contingent on the fate of Trump’s tax reform especially as it regards repatriation: an increase in buyback announcements and high cash balances is expected to drive repurchases next year. S&P 500 repurchase authorizations have increased by 18% YTD compared with the same time in 2016. Financials authorizations are 25% higher than the prior peak in 2015. Even excluding Financials, authorizations have risen by 4% so far this year. S&P 500 cash balances as a share of assets are near record highs (12%), indicating significant potential to deploy cash. The boost from the CCAR test results to Financials buybacks should also continue to support elevated buyback activity next year while positive earnings growth should benefit M&A. We expect share issuance will remain at the 5-year average of $125 billion through year-end 2018.

Even so, there is one major reason why corporations will limits their buybacks – their stocks have never been more overvalued.

We expect the rise in corporate demand will only be modest in 2018. Total corporate repurchases next year should remain below 2016 levels. The equity market is at record highs and valuations are stretched, which will discourage firms from sharply boosting share repurchases. In addition, rising interest rates suggest that companies may refrain from issuing large amounts of additional debt to fund buybacks, especially when leverage for the median stock is at a record high. If policy uncertainty persists, management teams may continue to curb cash spending as they did during 1H 2017. Lastly, investors have rewarded firms investing for growth over those  returning cash to shareholders. Our sector-neutral basket of 50 stocks that have spent the most on capex and R&D (GSTHCAPX) has returned 25% YTD vs. 16% for the S&P 500. In contrast, a similar basket of stocks with the  highest trailing 4-quarter buyback yields (GSTHREPO) has lagged the S&P 500 by 470 bp this year (12% vs. 16%).

Still, should Trump tax reform pass, it is a key upside risk to Goldman’s forecast: “In the event tax reform passes, we expect corporate demand could rise by an incremental $75 billion relative to our baseline estimate of $590 billion to reach $665 billion in 2018, implying 17% growth vs. 2017.

* * *

Ok, buybacks will once again determine the fate of the market in 2018; what about other sources of stock buying, and selling? Here is the full breakdown:

  • ETFs: We estimate investor flows into ETFs will rise to a record of $400 billion in 2018, a 33% jump from our 2017 estimate of $300 billion. The vast majority of ETFs are owned by retail investors. ETF assets as a share of the total corporate equity market (public and private) have doubled since 2009 and now stand at a record high (6% of total). The magnitude of passive fund influence is greater when looking only at public equities. ETF AUM, including index objective funds, is equal to 14% of S&P 500 market cap and 9% of the total US public equity market. US equity ETFs have witnessed inflows during each of the past seven years and inflows of $132 billion YTD. Investor preference for passive over active and strong household balance sheets should support strong ETF inflows next year.
  • MUTUAL FUNDS: We expect mutual funds will be net sellers of equities in 2017 ($100 billion) and 2018 ($125 billion). Mutual funds have sold equities for seven consecutive quarters since the end of 2015. Equity mutual fund outflows ($98 billion YTD), coupled with a declining liquid asset ratio, have been key drivers of negative equity demand among active funds during the past two years. We reduce our 2017 estimate of mutual fund equity demand to -$100 billion from -$50 billion given greater-than-expected net selling during the first half of the year. The combination of passive fund popularity and weak active fund returns will continue to hurt mutual fund equity demand in 2018.
  • FOREIGN INVESTORS: We expect foreign investors will remain net buyers of US equities but reduce purchases from $150 billion in 2017 to $100 billion in 2018. Foreign investors were net sellers of US equities during the past two years. However, a weak US dollar during 1H 2017 helped reverse the trend of net selling. We raise our 2017 estimate of foreign investor equity demand to $150 billion from $25 billion. Demand should remain positive in 2018 given stable US GDP growth of around 2%. However, a flat trajectory for the USD suggests lower purchases in 2018 compared with this year. We expect US investor purchases of foreign equities will equal $300 billion in 2017 and $250 billion in 2018 given solid global economic growth.
  • PENSION FUNDS: Pension funds will sell $300 billion and $250 billion of equities in 2017 and 2018, respectively. We lower our 2017 estimate of pension fund equity demand to -$300 billion from -$175 billion given elevated net selling (-$273 billion annualized) in 1H 2017. We expect pension funds will continue to sell equities in 2018 as the 10-year US Treasury yield rises by 100 bp to 3.3%. Net selling of equities by pension funds has averaged $200 billion annually since 2012.

Finally, what if rising rates blow up the corporate buyback machine, and make it prohibitively expensive to sell debt and buy stock with the proceeds, leading to the loss of the marginal buyer? Well, just to cover itself for that contingency, Goldman left the following footnote:

BEAR MARKETS: Investors continue to worry about the timing of the next bear market. Although we think an imminent correction is unlikely, we analyzed flows around bear markets during the past 70 years. In general, corporations, foreign investors, and mutual funds reduce equity demand during a downturn while pension funds increase net buying. Households have been net sellers 100% of the time.

Yes thank you, what we’d like to know is if households will also be “100%” net sellers in 2018…

http://WarMachines.com

Active Bond Traders Have Never Been More Short Treasurys: Is A Squeeze Imminent?

Yesterday, when discussing Crispin Odey’s letter to clients and what appears to be his “Hail Mary” trade, we pointed out that according to his latest client letter, the billionaire hedge fund manager has effectively bet everything on a plunge in bond prices, with a whopping 135% net short in gilts and JGBs.

We noted that, in light of recent shifts mostly among the CTA and hedge fund crowd, he is hardly alone in his mega bearish outlook on bonds.

Sure enough, according to the latest JPMorgan survey (for the week through Oct. 2) the bank’s clients as a whole have dramatically soured on Treasuries, with 44% holding a short position relative to their benchmark, the most since 2006, or before the financial crisis, and up from 30 percent in the prior period. Among those who actively place bets, such as speculative accounts, a record 70% were short, while an unprecedented (and impossible) 0% responded that they were long: in other words, everyone is on the same side of the boat.

As Bloomberg commented on the dramatic move, “the shift shows how a confluence of factors is weighing on the minds of bond traders as the fourth quarter begins. The Federal Reserve will start unwinding its balance sheet this month, and Chair Janet Yellen has signaled that stubbornly low inflation won’t deter policy makers from tightening. Meanwhile, in the betting markets, former Fed Governor Kevin Warsh, seen by some traders as having a more hawkish tilt, has the highest odds to succeed Yellen.”

In the eyes of William O’Donnell at Citigroup Inc., the selling pressure may have only just begun.

 

“The crowd of longs between seven years and 30 years in U.S. rates is both heavy and also now slightly underwater,” with yields near or above their 2017 averages, O’Donnell, a strategist, wrote in a report Tuesday. “It leaves us thinking that any additional positioning stress via higher rates may one day turn a trickle of selling into a torrent of secondary market supply under the right conditions.”

Of course, with everyone “on the same side of the boat”, a far likelier outcome is a massive squeeze as even the smallest deflationary event spark a scramble for the exits. One example, from the other side, can be seen in the week through Dec. 12, when 39% of clients were short, which at the time was the most since 2015. On Dec. 15, the benchmark 10-year yield reached 2.64%, the highest in more than two years. It hasn’t returned to that level. Subsequent record positions in early 2017 per CFTC Committment of Trader readings led to even bigger slides in Treasury yields, in turn leading to a near record long exposure just week later, only to lead to a move higher in yields.

Indeed as Bloomberg concedes, “at the moment, Treasuries don’t look like the screaming “sell” they did when 10-year yields approached 2% last month. Now at 2.34 percent, the yield is approaching the most oversold level in months, based on relative strength index analysis.

That leaves traders eyeing 2.42% , a high from May and also a key retracement level based on Fibonacci analysis.

 

“Short-term oversold conditions suggest that this support band should hold, at least initially,” O’Donnell said. But there’s “still more upside for yields and USD, which should keep bears’ hopes alive for a re-test of 2.60% before the end of the year.”

With few active traders left who can add to the short pile up, look for yields to glide lower once again as the next Tsy short squeeze materializes in the coming weeks.

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Weekend Reading: Yellen Takes Away The Punchbowl

Authored by Lance Roberts via RealInvestmentAdvice.com,

September 20th, 2017 will likely be a day that goes down in market history.

It will either be remembered as one of the greatest achievements in the history of monetary policy experiments, or the beginning of the next bear market or worse.

Given the Fed’s inability to spark either inflation or economic growth, as witnessed by their dismal forecasting record shown below, I would lean towards the latter.

The media is very interesting. Despite the fact there is clear evidence that unbridled Central Bank interventions supported the market on the way up, there is now a consensus that believes the “unwinding” will have “no effect” on the market.

This would seem to be naive given that, as shown below, the biggest injections of liquidity from the Fed have come near market bottoms. Without the proverbial “punch bowl,” where does the “support” come from to stem declines?

I tend to agree with BofA who recently warned” the paint may be drying but the wall is about to crumble.”

This point can be summarized simply as follows: there is $1 trillion in excess TSY supply coming down the line, and either yields will have to jump for the net issuance to be absorbed, or equities will have to plunge 30% for the incremental demand to appear.”

“An unwind of the Fed’s balance sheet also increases UST supply to the public. Ultimately, the Treasury needs to borrow from the public to pay back principal to the Fed resulting in an increase in marketable issuance. We estimate the Treasury’s borrowing needs will increase roughly by $1tn over the next five years due to the Fed roll offs. However, not all increases in UST supply are made equal. This will be the first time UST supply is projected to increase when EM reserve growth likely remains benign.

 

Our analysis suggests this would necessitate a significant rise in yields or a notable correction in equity markets to trigger the two largest remaining sources (pensions or mutual funds) to step up to meet the demand shortfall. Again, this is a slower moving trigger that tightens financial conditions either by necessitating higher yields or lower equities.”

Of course, as I have discussed previously, a surge in interest rates would lead to a massive recession in the economy. Therefore, while it is possible you could experience a short-term pop in rates, the end result will be a substantial decline in equities as money flees to the safety of bonds driving rates toward zero.

“From many perspectives, the real risk of the heavy equity exposure in portfolios is outweighed by the potential for further reward. The realization of ‘risk,’ when it occurs, will lead to a rapid unwinding of the markets pushing volatility higher and bond yields lower. This is why I continue to acquire bonds on rallies in the markets, which suppresses bond prices, to increase portfolio income and hedge against a future market dislocation.”

My best guess is the Fed has made a critical error. But just as a “turnover” early in the first-quarter of the game may not seem to be an issue, it can very well wind up being the single defining moment when the game was already lost. 

In the meantime, here is what I am reading this weekend.


Politics/Fed/Economy


Markets


Research / Interesting Reads


“If you are playing the rigged game of investing, the house always wins.” ? Robert Rolih

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Ugly, Tailing 10Y Auction: Lowest Indirects Since 2016

If yesterday’s 3Y auction was ugly, today’s $20 billion 9-year-11 month reopening was just as abysmal.

With a high yield of 2.18%, this was not only a whopping 1.1bp tail to the 2.169% When Issued, it was the 6th consecutive “tail” in a row, with just 2 10Y auction stopping through so far in 2017 (January and March). That said, the yield was also the lowest since November, which may explain some of the weak bidside interest.

The internals were ugly, with a Bid to Cover of 2.28, fractionally above August’s 2.23, but well below the 6 month average. Just like yesterday, foreign bidders balked, and the Indirect award was a paltry 55.3%, down from 57.9% last month, and below the 63.4% average. This was the lowest Indirect award since November 2016. With Directs once again in line, at 6.0%, just below the 6.8% last month, it was the Dealers who had to step up and they do, taking 38.7% of the final allottment, the highest since November, and well above the 29.3 6 month average.

Finally, what likely prevented today’s auction from printing notably better, is that the recent record specials in repo, which last week hit a sub-fails rate of -3.75%, was completely gone as of this morning, and the 10Y traded at 0.00% in repo at 8am on Tuesday. And with no shorts to squeeze, the result was as expected.

 

 

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Ugly, Tailing 3Y Auction: Bid to Cover Tumbles, Lowest Indirects Since 2016

Whether due to the broader risk-on move, or as a result of a surge in inflation fears in the aftermath of Hurricanes Irmas and Harvey, today’s auction of $24 billion in 3Y paper was arguably the ugliest yet in 2017.

Printing at a high yield of 1.4330%, while this was the lowest yield since February, it was also a 0.6 bps tail to the 1.427% When Issued. The internals were even uglier, with the Bid to Cover tumbling from 3.13 to 2.70, and below the 6 month average of 2.85. Just as notable was the plunge in the Indirect award, which slumped from 64.1% in August to just 46.2% in August, the lowest since December 2016. And while Directs were largely unchanged from last month, at 10.4%, above the 8.7% 6M average, the Dealer award soared from 25.8% to 43.4%, nearly eclipsing the Inidrect take down, well above the 6 month average of 35.6%, and the highest since December 2016.

Overall, an unexpectedly ugly auction in light of last week’s plunge in bond yields, although perhaps not all that surprising in light of the broad elimination, if only for the time being, of both geopolitical and climate-linked risk. And now, we look forward to the upcoming 10Y auction which may be just as ugly, if not worse should today’s risk on euphoria persist, despite 10Y paper still trading quite special in repo as of this morning.

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“We’ve Never Seen Anything Like This”: Repo Market Snaps As 10Y Suffers “Epic Fail”

It’s been a while since we saw any major dislocations in the Treasury repo market, i.e., collateral shortages as a result of surging TSY shorts, for the simple reason that after the first quarter when everyone was certain that Trump reflation trade would kick in but didn’t, the record number of built up spec net shorts got trampled by the rising price, rapidly shifting over to record longs.

However, the peace and quiet quiet in the repo market was shattered this week, when almost overnight the 10Y went from “normal” in repo, at a rate of 0.50% on Friday, to a special -2.00% on Monday, and then a Super Special, if not record, “fails rate” of -3.50% this morning.

Commenting on this dramatic move in 10Y repo rates, Stone McCarthy’s Alan Chernoff, in a note titled “Epic Fail”, writes that “the 10-year note has been below the fails rate and shows no signs of moving! It opened at -350 basis points, and though pressure has eased off of it slightly, it is STILL below the fails rate at -300 basis points.”

As a reminder, the fails rate is the 300 basis points below the lower end of the target fed funds rate, putting it at -200 basis points currently. And, if an issue falls below the fails rate, it becomes cheaper to just pay the fails charge of 200 basis points rather than deliver than issue, which is what is happening. In dollar terms, the agency repo fails nominal was at $131BN on  Sept. 6 vs $153.6 BN on Sept. 5, above the 5-DMA $90.7b, according to DTCC data.

To be sure, some firms that want to maintain good client relationships will likely want to deliver the trade at such a low rate, although it appears that not many are rushing to do so.

As Bloomberg writes, confirming what we have said repeatedly in the past 3 years when we commented on these sudden repo market dislocations, the “specialness is due to lack of supply as shorts roll from triple-issued old 10Y into single issue current 10Y.”

No matter the reason, Chernoff observes that he has never seen a move quite like this and that “this is one of the lowest rates that we’ve ever seen the 10-year note repo trade at, and definitely the furthest below the fails rate.”

One final observations: while even term 10-year repos are below the fails charge at -215 basis points, the 3-year note is only modestly tight at 65 basis points, while and most other issues are trading near GC.

Some final parting words: keep a close eye on the 10Y – a positioning move of this magnitude does not take place in a vacuum, and either “someone knows something” or another busload of specs is about to be crushed once more.

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Is A US Default Imminent: Liquidation Panic Grips T-Bills Market

While the politicians and the mainstream media are playing down any concerns about the US debt ceiling, Treasury Bill market participants are seeing chaos as the yield curve has snapped across the Sept-Oct divide with panic-buying in bills that mature ahead of the September-end (Q3-end liquidity needs), and dumping of October bills.

 

As Treasury Cash declines…

 

The T-Bill curve is steepening drastically… to its steepest yet…

As the debt-ceiling anxiety indicator is exploding…

With the short-end bid and anything maturing just after September is getting crushed…

As a reminder – USA Sovereign risk has spiked to double that of Germany's recently – the highest since Lehman…

As we noted previously, one potential catalyst for the spike in odds of an adverse outcome is that earlier today, the chairman of the conservative House Freedom Caucus said aid for victims of Hurricane Harvey should not be part of a vehicle to raise the debt ceiling.

Quoted by The Hill, Rep. Mark Meadows (R-N.C.), a Trump ally who leads the conservative caucus, said disaster aid should pass on its own, apart from separate measures the government must pick up in September to raise the nation's borrowing limit and fund the government.

“The Harvey relief would pass on its own, and to use that as a vehicle to get people to vote for a debt ceiling is not appropriate,” he said an interview with The Washington Post, signaling agreement with Trump on the approach. It would “send the wrong message” to add $15 to $20 billion of spending while increasing the debt ceiling, Meadows added.

Ironically, it was precisely the Harvey disaster that prompted Goldman yesterday to lower its odds of a debt ceiling crisis from 50% to 33%, on the assumption that it would make conseratives more agreeable to a compromise, when in fact precisely the opposite appears to have happened, and the new dynamic is now playing out in the market where the odds of a government shutdown have never been greater.

So what does it mean for the US if the T-Bill market is correct and a debt ceiling deal is not reached in time over the next 30 or so days? For an unpleasant perspective on what may happen next, here is Deutsche Bank's preview of what a debt ceiling crisis would look like:

Guide to a Debt Ceiling Crisis

 

If Congress doesn’t act in time and the above fallbacks are deemed untenable, the Treasuries with affected principal or coupon payments would likely be handled in two ways, according to scenarios considered by SIFMA. The first option would extend maturity and coupon payments, where payment decisions are explicitly announced by Treasury one day at a time, and both coupon and principal payments are ultimately made in full once the debt limit is raised. These securities would be able to be transferred normally, and a market for them would develop. While the security is not “defaulted” as its maturity date has been extended in systems, the extension would likely constitute a change in terms that triggers CDS.

 

The other outcome would a failure pay , where Treasury does not set a date for future payment, and there is no pre-announcement (or it comes last minute). A failure to pay would mean the affected securities drop off the Fed system and cannot be transferred normally. A market would eventually develop, but once there is a failure to pay and the securities are not extended in systems, they cannot be “unmatured” and maturity extended.

 

Regardless of whether it is a payment extension or a failure to pay, the longer Treasury remains in default, the worse the situation for financial markets. Market reactions and market functioning might be comparatively stable at first, but the concern is of widespread panic and systemic market disruptions.

 

As for immediate ramifications, noted that CDS would likely triggered either default scenario , as sovereign CDS is triggered by either a failure to pay, repudiation/moratorium, or a restructuring. A failure to pay occurs when a sovereign doesn’t pay principal or interest when due, with a 3 day grace period applying to that due date in the case of the US. In our view, a CDS trigger would apply to all debt obligations backed by the full faith and credit of the US government (including GNMA, FHA securities, etc.). A CDS event is unlikely to have much direct market impact, however, as net CDS exposure is a modest $1bn as of the end of July, down from about $4bn in 2013 and its peak near $6bn in 2011. As long there is no one particular bank that is overly short protection, we do not expect any knock-on CDS event. 5y CDS is currently suggesting no real concern, sitting at the bottom end of its 19-24bp ytd range. While the supply of deliverable securities is more than adequate to satisfy the outstanding contracts, demand deliverable bonds may cause distortions . The 2.25% Aug 2046 bonds are currently the cheapest-to-deliver into the CDS, and would likely trade upward in price towards recovery value.

 

Among Treasury market investors, money market funds are a key group possible propagation risk . Even after money fund reform, government funds continue to be quoted at a stable $1 NAV, leaving them vulnerable to perceptions around “breaking the buck,” and therefore large scale investor redemptions in an extreme scenario. Treasuries accounted for $678bn of money funds $2.7tn AUM as of the end of July, while Treasury repo makes up another $595bn (with about $150bn of that made up by RRP’s with the Fed). Money funds’ Treasury holdings tend to be concentrated in securities maturing in the first month – more than 40% of their Treasuries held at the end of July matured in August. This suggests that the bias will be for money funds to accumulate more securities maturing around the debt ceiling, though they may be cautious around specific issues. However, it’s worth noting that they then owned over $40bn combined in the October 5 bills, October 12 bills, and October 15 coupon maturities – more than 20% of the amount  outstanding. Of the $1.3tn of Treasuries (bills and coupons) that mature between October and mid-January, money funds own about 19% – potentially an important factor in the event that a default drags out. Also note that maturing notes and bill holdings are concentrated in a relatively few fund families.

 

Potential outflows from money funds has implications repo market . Possible forced selling of Treasuries, money funds would likely cut back on their provision of financing to banks through repo. While reforms have reduced banks’ reliance on short term funding and put them in a place to better withstand a significant reduction in availability of things like repo funding, a sharp contraction in overall repo financing would likely have ramifications for market functioning and liquidity.

 

In terms of market plumbing, given the reliance Treasuries managing credit risk derivatives , a default event could spread quickly to derivatives market via a sudden drop in the valuation of UST collateral. This loss in value would trigger calls for additional collateral, and given the widespread use of UST’s, it is possible that a number of market participants fail to post sufficient collateral; this would constitute a default in a centrally cleared trade. The requirement that the surviving counterparty replace the risk of that trade could subsequently result in a major revaluation of all related trades, triggering new collateral calls, and potentially create a vicious cycle.

 

 

How might the Fed might react to a major disruption?

 

The question is complicated by a possible reinvestment decision in the September meeting, but extracting that for the time being, there is nothing immediately apparent in the Federal Reserve Act that would preclude the Fed from purchasing defaulted Treasury securities. This would likely not be a proactive step, as the Fed would not want to be seen “bailing out” the Treasury, but given the extremity of a default situation, the Fed would be governed by its financial stability mandate.

 

The Fed could intervene by removing defaulted securities from the market and sell or repo non-defaulted issues to provide the market with good collateral. Additional emergency facilities similar to those seen in 2008 are another option wherein the Fed could support money funds by accepting their assets and providing liquidity. To the extent that liquidity concerns became extreme the Fed could obviously move to add further monetary accommodation especially if it perceived knock on effects to the growth and inflation outlook.

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Breadth, Bonds, Bills, & Bear Funds Signal Trouble Ahead For Stocks

The 'resilience' of stock markets is proclaimed as self-reflectingly positive, as they surge higher, enthusiastically embracing debt ceiling anxiety, nuclear armageddon, and biblical floods. However, below the surface all is very much not rosy

As Bloomberg reports, this is a warning for stock traders entranced by a market that remains resilient to surprises. Even though the S&P 500 is less than 1 percent away from a record set this month, the best move is to wait out more selling, according to Strategas Research Partners.

Breadth has deteriorated as the benchmark gauge has been mostly listless. Only about 48 percent of stocks in the S&P 500 are currently trading above their 50-day moving averages, near the fewest of the year and down from 74 percent last month, data compiled by Bloomberg show.

And longer-term trends are just as bad with only 65% of S&P members above their 200-day average…

“Tepid momentum is often consistent with below average returns in the short-run,” Strategas analysts led by Chris Verrone wrote in a research note Tuesday.

*  *  *

Bonds are not buying the bounce in stocks at all.

Treasury yields are at 2017 lows (despite strong GDP and strong ADP?) signaling a total lack of belief in the global growth vision being sold to the world's equity investors.

*  *  *

Treasury Bills are signaling massive concerns over debt ceiling discussions.

The pre-debt-ceiling bills are massively bid…

 

Sending debt ceiling anxiety premiums to record highs.,..

As S&P analysts warn, if this hits, it will be catastrophic.

*  *  *

And finally, Bear Fund Assets have collapsed to record lows…

The squeeze ammunition is running very low for the next leg higher in stocks.

*  *  *

Bloomberg concludes, that caution is the buzzword at Raymond James & Associates, which is advising clients to be patient and pick their entry points carefully amid thinner markets and gold prices that look poised to break through a “longer-term downtrend,” according to Andrew Adams, a strategist at the firm.

We continue to exercise patience in the near term, as most of the indicators we follow are still weak-to-neutral and not really flashing that ‘attractive opening’ that we look for,” St. Petersburg, Florida-based Adams wrote in a note Tuesday morning.

With the dollar sitting near the lowest level in 2.5 years and the outlook for government funding murky, some traders say it may be the time to take the chips off the table.

“Perhaps take a percentage of your portfolio and put it in cash,” said Stephen Carl, principal and head equity trader at Williams Capital Group LP in New York. “You don’t go broke taking profits.”

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About That Debt Ceiling Crisis…

With just one month left until the “X Date”, better known as the first day on which Treasury has exhausted its borrowing authority and no longer has sufficient funds to pay all of its bills in full and on time, and also known as the date the US is technically in default on its debt obligations and would be forced to prioritize debt payments according to that infamous 2011 Fed transcript

… traders were hoping if not for resolution, then at least a modest dose of optimism in the days ahead: after all with Houston reeling, the last thing the US needs is a full government shutdown in addition to the emergency crisis in Texas.

Alas, that’s precisely the opposite of what is taking place in the market, where the September/October Bill Spread has again blown out to record levels…

… making the October T-Bill “hump” the worst it has been yet.

One potential catalyst for the spike in odds of an adverse outcome is that earlier today, the chairman of the conservative House Freedom Caucus said aid for victims of Hurricane Harvey should not be part of a vehicle to raise the debt ceiling.

Quoted by The Hill, Rep. Mark Meadows (R-N.C.), a Trump ally who leads the conservative caucus, said disaster aid should pass on its own, apart from separate measures the government must pick up in September to raise the nation’s borrowing limit and fund the government.

“The Harvey relief would pass on its own, and to use that as a vehicle to get people to vote for a debt ceiling is not appropriate,” he said an interview with The Washington Post, signaling agreement with Trump on the approach. It would “send the wrong message” to add $15 to $20 billion of spending while increasing the debt ceiling, Meadows added.

Ironically, it was precisely the Harvey disaster that prompted Goldman yesterday to lower its odds of a debt ceiling crisis from 50% to 33%, on the assumption that it would make conseratives more agreeable to a compromise, when in fact precisely the opposite appears to have happened, and the new dynamic is now playing out in the market where the odds of a government shutdown have never been greater.

So what does it mean for the US if the T-Bill market is correct and a debt ceiling deal is not reached in time over the next 30 or so days? For an unpleasant perspective on what may happen next, here is Deutsche Bank’s preview of what a debt ceiling crisis would look like:

Guide to a Debt Ceiling Crisis

 

If Congress doesn’t act in time and the above fallbacks are deemed untenable, the Treasuries with affected principal or coupon payments would likely be handled in two ways, according to scenarios considered by SIFMA. The first option would extend maturity and coupon payments, where payment decisions are explicitly announced by Treasury one day at a time, and both coupon and principal payments are ultimately made in full once the debt limit is raised. These securities would be able to be transferred normally, and a market for them would develop. While the security is not “defaulted” as its maturity date has been extended in systems, the extension would likely constitute a change in terms that triggers CDS.

 

The other outcome would a failure pay , where Treasury does not set a date for future payment, and there is no pre-announcement (or it comes last minute). A failure to pay would mean the affected securities drop off the Fed system and cannot be transferred normally. A market would eventually develop, but once there is a failure to pay and the securities are not extended in systems, they cannot be “unmatured” and maturity extended.

 

Regardless of whether it is a payment extension or a failure to pay, the longer Treasury remains in default, the worse the situation for financial markets. Market reactions and market functioning might be comparatively stable at first, but the concern is of widespread panic and systemic market disruptions.

 

As for immediate ramifications, noted that CDS would likely triggered either default scenario , as sovereign CDS is triggered by either a failure to pay, repudiation/moratorium, or a restructuring. A failure to pay occurs when a sovereign doesn’t pay principal or interest when due, with a 3 day grace period applying to that due date in the case of the US. In our view, a CDS trigger would apply to all debt obligations backed by the full faith and credit of the US government (including GNMA, FHA securities, etc.). A CDS event is unlikely to have much direct market impact, however, as net CDS exposure is a modest $1bn as of the end of July, down from about $4bn in 2013 and its peak near $6bn in 2011. As long there is no one particular bank that is overly short protection, we do not expect any knock-on CDS event. 5y CDS is currently suggesting no real concern, sitting at the bottom end of its 19-24bp ytd range. While the supply of deliverable securities is more than adequate to satisfy the outstanding contracts, demand deliverable bonds may cause distortions . The 2.25% Aug 2046 bonds are currently the cheapest-to-deliver into the CDS, and would likely trade upward in price towards recovery value.

 

Among Treasury market investors, money market funds are a key group possible propagation risk . Even after money fund reform, government funds continue to be quoted at a stable $1 NAV, leaving them vulnerable to perceptions around “breaking the buck,” and therefore large scale investor redemptions in an extreme scenario. Treasuries accounted for $678bn of money funds $2.7tn AUM as of the end of July, while Treasury repo makes up another $595bn (with about $150bn of that made up by RRP’s with the Fed). Money funds’ Treasury holdings tend to be concentrated in securities maturing in the first month – more than 40% of their Treasuries held at the end of July matured in August. This suggests that the bias will be for money funds to accumulate more securities maturing around the debt ceiling, though they may be cautious around specific issues. However, it’s worth noting that they then owned over $40bn combined in the October 5 bills, October 12 bills, and October 15 coupon maturities – more than 20% of the amount  outstanding. Of the $1.3tn of Treasuries (bills and coupons) that mature between October and mid-January, money funds own about 19% – potentially an important factor in the event that a default drags out. Also note that maturing notes and bill holdings are concentrated in a relatively few fund families.

 

Potential outflows from money funds has implications repo market . Possible forced selling of Treasuries, money funds would likely cut back on their provision of financing to banks through repo. While reforms have reduced banks’ reliance on short term funding and put them in a place to better withstand a significant reduction in availability of things like repo funding, a sharp contraction in overall repo financing would likely have ramifications for market functioning and liquidity.

 

In terms of market plumbing, given the reliance Treasuries managing credit risk derivatives , a default event could spread quickly to derivatives market via a sudden drop in the valuation of UST collateral. This loss in value would trigger calls for additional collateral, and given the widespread use of UST’s, it is possible that a number of market participants fail to post sufficient collateral; this would constitute a default in a centrally cleared trade. The requirement that the surviving counterparty replace the risk of that trade could subsequently result in a major revaluation of all related trades, triggering new collateral calls, and potentially create a vicious cycle.

 

 

How might the Fed might react to a major disruption?

 

The question is complicated by a possible reinvestment decision in the September meeting, but extracting that for the time being, there is nothing immediately apparent in the Federal Reserve Act that would preclude the Fed from purchasing defaulted Treasury securities. This would likely not be a proactive step, as the Fed would not want to be seen “bailing out” the Treasury, but given the extremity of a default situation, the Fed would be governed by its financial stability mandate.

 

The Fed could intervene by removing defaulted securities from the market and sell or repo non-defaulted issues to provide the market with good collateral. Additional emergency facilities similar to those seen in 2008 are another option wherein the Fed could support money funds by accepting their assets and providing liquidity. To the extent that liquidity concerns became extreme the Fed could obviously move to add further monetary accommodation especially if it perceived knock on effects to the growth and inflation outlook.

http://WarMachines.com

US Stock Buybacks In Biggest Slide Since The Financial Crisis

In light of today’s euphoric market reaction, which has seen the VIX plunge by over 3 vols, or 20% lower, to just over 12 and sent both the Nasdaq and S&P higher by 1% on relief that there were no mushroom clouds of the weekend, the jury is out whether last week’s sharp risk off, short-vol mauling will persist or be just another BTFD opportunity. But while last week’s tension may already be forgotten, some disturbing trends persist. As SocGen’s Andrew Lapthorne writes, while the S&P trades near all time highs, the smaller cap Russell 2000 dropped a much sharper 2.7%, leaving this index up just 1.3% for the year and down 5% over the last couple of weeks on what we discussed last week was a growing concern for the US economy and companies who do not have exposure to international revenue.

Furthermore, High Yield Credit also fell sharply. Along with the Russell 2000, HYG has also unwound most of this year’s positive performance in a matter of weeks. As Lapthorne writes, “in our view, high yield credit and the Russell 2000 are all the same trade with different wrappers. Their continued success is highly dependent on asset volatility remaining as subdued and debt markets as generous as they have been, both of which we think is highly unlikely.”

But the most interesting observation made by the SocGen strategist in his overnight report is that the sudden aversion to balance sheet risk is not restricted to US small caps or HYG, “indeed within the S&P 500 ex financials such a strategy remains the most profitable of our US investment styles this year.”

“What might be contributing to this performance trend”, Lapthorne asks rhetorically? Here is the most likely explanation: “share buybacks have slumped by over 20% YoY.” Ominously, this is the sharpest drop in corporate buybacks since the financial crisis effectively shut down bond markets in 2008, as a result of the market no longer rewarding companies that lever up just to repurchase their own stock. 

SocGen’s conclusion: “Perhaps over-leveraged US companies have finally reached a limit on being able to borrow simply to support their own shares.” If so, this is a big problem because as Credit Suisse showed recently, corporate buybacks have been the only source of equity injection since the crisis.

If this phase is now officially over, it is unclear what – if any – new source of capital inflows, central banks notwithstanding, will replace corporations as the main buyers of US equities going forward.

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