Recession Around The Corner? Evidence From Treasury Market And S&P 500 Earnings Sentiment

It has been the longest bull market in modern history, enabled by massive Central Bank intervention. But with trade wars raging, Brexit, Presidential impeachment over something, etc., there remains a significant risk of a recession over the next 12 months.

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If we look at the normalized change in the 10Y-3M curve minus normalized change in 10Y yields, we can see a heightened recession risk.

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Lower yields and steeper curves are not a good recipe.

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And then we have the decline in S&P 500 earnings estimates.

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Recession coming?

The Way Out for a Global Economy Hooked On Debt? Even More Debt (??)

Apparently, debt control is out of the question in this era of low interest rates. There is seemingly only one way out … and that it is MORE debt.

(Bloomberg) — Zombie companies in China. Crippling student bills in America. Sky-high mortgages in Australia. Another default scare in Argentina.

A decade of easy money has left the world with a record $250 trillion of government, corporate and household debt. That’s almost three times global economic output and equates to about $32,500 for every man, woman and child on earth.

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Much of that legacy stems from policy makers’ deliberate efforts to use borrowing to keep the global economy afloat in the wake of the financial crisis. Rock bottom interest rates in the years since has kept the burden manageable for most, allowing the debt mountain to keep growing.

Now, as policy makers grapple with the slowest growth since that era, a suite of options on how to revive their economies share a common denominator: yet more debt. From Green New Deals to Modern Monetary Theory, proponents of deficit spending argue central banks are exhausted and that massive fiscal spending is needed to yank companies and households out of their funk.

Fiscal hawks argue such proposals will merely sow the seeds for more trouble. But the needle seems to be shifting on how much debt an economy can safely carry.

Central bankers and policy makers from European Central Bank President Christine Lagarde to the International Monetary Fund have been urging governments to do more, arguing it’s a good time to borrow for projects that will reap economic dividends.

“Previous conventional wisdom about advanced economy speed limits regarding debt to GDP ratios may be changing,” said Mark Sobel, a former U.S. Treasury and International Monetary Fund official. “Given lower interest bills and markets’ pent-up demand for safe assets, major advanced economies may well be able to sustain higher debt loads.”

A constraint for policy makers, though, is the legacy of past spending as pockets of credit stress litter the globe.

At the sovereign level, Argentina’s newly elected government has promised to renegotiate a record $56 billion credit line with the IMF, stoking memories of the nation’s economic collapse and debt default in 2001. Turkey, South Africa and others have also had scares.

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As for corporate debt, American companies alone account for around 70% of this year’s total corporate defaults even amid a record economic expansion. And in China, companies defaulting in the onshore market are likely to hit a record next year, according to S&P Global Ratings.

So called zombie companies — firms that are unable to cover debt servicing costs from operating profits over an extended period and have muted growth prospects — have risen to around 6% of non-financial listed shares in advanced economies, a multi-decade high, according to the Bank for International Settlements. That hurts both healthier competitors and productivity.

As for households, Australia and South Korea rank among the most indebted.

The debt drag is hanging over the next generation of workers too. In the U.S., students now owe $1.5 trillion and are struggling to pay it off.

Even if debt is cheap, it can be tough to escape once the load gets too heavy. While solid economic growth is the easiest way out, that isn’t always forthcoming.

Well, despite the conventional economic wisdom that public debt growth is fine as long as GDP grows at the same rate, the USA has almost always experienced higher rates of debt growth than GDP growth (YoY).

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Modern Monetary Theory (MMT) makes as much sense as this 1960s/1970s photo. (Is that New York Times opinion columnist Paul Krugman??)

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Does Carter’s “Misery Index” (Inflation + Unemployment) Forecast Recession? (No, Near Lowest Level Since Mid-1950s)

Back during the “days of malaise” under President Jimmy Carter, some clever wags thought of the term “misery index” which is the unemployment rate + inflation rate.

Sure enough, the misery index hit its all-time high in May 1980 of 21.93%. But the fear index subsided rapidly following the end of the July 1981 to November 1982 recession.

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But the misery index today is only 5.37%, near the lowest since the mid-1950s. So, no hint of an impending recession.

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Currently, the misery index is near its lowest level since the mid-1950s. The US Unemployment rate is low and is inflation is pretty low resulting in a misery index of 5.37%.

So, no recession in sight according to this indicator.

 

Victory! US Home Sales Have Best 2 Months In 12 Years As Hourly Earnings Growth Exceeds Home Price Growth

Victory! A slew of positive housing news two days before Thanksgiving Day.

First, new home sales rose 733K in October, continuing the best two months in 12 years. Second, home price growth rose a bit to 2.10% YoY for the 20 largest metro areas while hourly earnings growth is above 2.10% at 3.49% YoY.

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(Bloomberg) — Buyers snapped up new U.S. homes over the past two months at the fastest pace in more than 12 years, adding to signs of sturdy housing demand amid lower prices and borrowing costs.

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Single-family house sales ran at a 733,000 annualized pace in October, topping all estimates in a Bloomberg survey, following an upwardly revised 738,000 in September, government data showed Tuesday. Those were the two strongest readings since July 2007. The median sales price decreased 3.5% from a year earlier to $316,700.

And median price of new home sales continue to decline.

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And on the Case-Shiller home price front, average hourly earnings growth in finally exceeding home price growth!

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Happy Thanksgiving! And I wish Fed Chair Jerome Powell and former Fed Chair Janet Yellen a joyous day.

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Lowriding? Fed Funds Effective Rate Near Lower Bound (Time For Another Rate Cut?)

Is The Fed Lowriding its Target Rate? Or is the economy Slippin’ into darkness?

Not too long ago, the Federal Reserve’s problem was that the effective funds rate — its key policy benchmark — climbed too close to the top of its target range, prompting officials to adjust interest on excess reserves closer to the lower end of the band starting in mid-2018.

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Now, the fed funds rate is too close to the bottom — and right in line with the current IOER rate of 1.55% — leading some to question whether policy makers will increase the latter in December. Even if it’s just 5 basis points, a small increase in interest rates after back-to-back-to-back cuts would undoubtedly raise some eyebrows on Wall Street.

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Of course, with the Atlanta Fed GDPNow Q4 GDP at 0.4%, it is apparent that the US economy is slowing.

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President Trump is likely singing to Fed Chair Powell “Why Can’t We Be Friends?” and lower rates.

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US Treasury Yield Curve Un-inverts (Can’t Turn The Fed Loose) Sag Gone In Treasuries, Not Swaps

Federal Reserve Chair Jerome Powell has said that the US economy is in a good place, and further rate cuts are not warranted. That is, Trump can’t turn The Fed loose.

Various US Treasury yield curves are un-inverting and are all positive.

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The Treasury actives curve is no longer sagging, but the Dollar Swaps curve continues to sag.

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But in terms of Treasury futures, the volatility for 2 year, 10 year and 30 year (Ultra) contracts   are progressively warping for 10 Delta Puts as maturity increases.

2-year:

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10-year:

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30-year (Ultra):

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Every investor needs The Fed to keep propping up asset bubbles!

Of course, the yield curve can revert to a negative state if … the China trade agreement becomes unglued, Democrats succeed in impeaching President Trump, etc.

 

World’s Most Elite Bond Club (Primary Dealers) Are Getting Their Mojo Back Thanks To The Fed And Congress

Listen to The Fed!  Particularly if you are a primary dealer.

(Bloomberg) — Regardless of what you think about the Federal Reserve’s decision to get back into the business of buying Treasuries, one thing is clear: It’s a good time to be a primary dealer.

While this elite-bond trading club may never fully regain its former glory, the prospect of the Fed once again purchasing hundreds of billions of dollars worth of U.S. government debt is set to be a boon for the select group of banks and dealers at the center of the $16.3 trillion Treasury market.

That’s because only primary dealers, which have to bid at U.S. debt auctions, get to sell Treasuries directly to the Fed. And as the U.S. borrows more and more to fund its ballooning deficit, having a captive buyer to offload all those Treasuries could hardly have come at a more opportune time. So while Fed officials are tripping over themselves to stress it’s not quantitative easing, for primary dealers, the fact they’re buying is what really counts.

“The Fed’s secondary market activity provides an additional direct liquidity outlet for primary dealers, which can certainly add to the already strong allure of this distinction,” said Paul Hamill, head of global fixed income, currencies and commodities distribution at Citadel Securities.

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For Citadel Securities, the Fed’s decision is a also timely one. The brokerage and market-making firm, part of billionaire Ken Griffin’s empire, has been laying the groundwork to ultimately make markets in all Treasury securities for over a year now — a prerequisite for becoming a primary dealer.

The ranks of primary dealers have slowly started to rebound after falling by more than half since peaking in the late 1980s. In May, Amherst Pierpont Securities became the 24th member and the first addition since 2016, when the Fed tweaked requirements to make it easier for smaller firms to apply.

Back in the day, banks champed at the bit to become primary dealers, which enabled them to gain insights and market intelligence by trading with the Fed. But the role’s benefits have diminished as bond trading has become more regulated, consolidated and transparent.

And in the post QE-era, dealers have been saddled with more and more Treasuries, which they often financed in short-term funding markets, as debt auctions increased along with the deficit. The situation proved to be a key factor in the repo-market turmoil last month.

In response, the Fed began buying $60 billion a month of T-bills and building up assets on its balance sheet for the first time since the end of QE. The purchases are intended to ease the funding pressure and help build bank reserves. It’s also pumping cash into the system with temporary repo operations. As the Fed’s counterparties, primary dealers can submit offers to sell for themselves and on behalf of their customers.

“The Fed is going to be coming in to buy a big chuck of them,” said Zachary Griffiths, an interest-rate strategist at Wells Fargo, a primary dealer. That, he said, will help alleviate concern that dealers will be inundated with supply. The U.S. deficit reached almost $1 trillion in fiscal 2019, its fourth straight increase, and economists see it widening further in coming years.

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Wall Street strategists and traders also say the Fed may ultimately need to move beyond just purchasing T-bills, and include notes and bonds as well, to maintain ample liquidity in the banking system. Estimates suggest the Fed may buy as much as $300 billion of Treasuries from the open market next year. (Separately, the Fed will also replace maturing securities that it holds by buying directly from the government, helping to finance the deficit.)

“This makes being a primary dealer more attractive because they now have a non-economic buyer to sell to, which offsets some of the risk they face by having to participate in Treasury auctions,” said Scott Buchta, head of fixed income strategy at Brean Capital.

“Whether that will be enough incentive to bring more in is not clear. Still, overall most people become primary dealers because it opens door.”

On the equity side, VIX is muted as the S&P 500 index strives for an all-time high (on China trade optimism and Fed rate cuts.

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WIRP (World Interest Rate Probability) is for a 90% probability of a Fed rate cut on October 30th.

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So, the primary dealers got their mojo workin’ thanks to Congress and The Fed.

As of May 6, 2019, according to the Federal Reserve Bank of New York the list includes:

Amherst Pierpont Securities LLC
Bank of Nova Scotia, New York Agency
BMO Capital Markets Corp.
BNP Paribas Securities Corp.
Barclays Capital Inc.
Cantor Fitzgerald & Co.
Citigroup Global Markets Inc.
Credit Suisse AG, New York Branch
Daiwa Capital Markets America Inc.
Deutsche Bank Securities Inc.
Goldman Sachs & Co. LLC
HSBC Securities (USA) Inc.
Jefferies LLC
J.P. Morgan Securities LLC
Merrill Lynch, Pierce, Fenner & Smith
Mizuho Securities USA LLC
Morgan Stanley & Co. LLC
NatWest Markets Securities Inc.
Nomura Securities International, Inc.
RBC Capital Markets, LLC
Societe Generale, New York Branch
TD Securities (USA) LLC
UBS Securities LLC

Fed Will Purchase $4.65 Billion 3-7 Year Treasury Coupons Next Week (These Rates Were Made For Dropping)

These rates were made for dropping.

(Bloomberg Intelligence) — The New York Federal Reserve will purchase T-bills twice next week. Besides bills, it will buy the 3-4.5 year and 4.5-7 year coupons using MBS runoff proceeds. In this note, we look at the bonds the Fed is unlikely to purchase, given its self-imposed buying criteria; for T-bills, the Fed avoids those with four weeks or less to maturity. 

The Fed has several criteria for adding bonds to its portfolio. The trading desk will limit System Open Market Account (SOMA) holdings to a maximum of 70% of the total outstanding amount of any security. It also won’t purchase securities trading special in the repo market for specific collateral, newly issued nominal-coupon securities and those that are cheapest to deliver into an active Treasury futures contract. Exclusions also include securities that mature in four weeks or less.

The exhibit shows bonds the Fed likely won’t purchase, based on these conditions.

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Here is a snapshot of the 3-7-year sector of Treasury coupons outstanding and their spread relative to a theoretical relative-value spline curve. The Fed will look to purchase securities that are cheap to its own relative-value model.

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The US Treasury curve slope (10Y-3M) has creeped into positive territory.

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And mortgage rates continue to rise again.

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Yes, these rates were made for droppin’. And that’s just what they’ll do.

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Natural Born (Volatility) Killers! ECB’s Draghi’s Low Volatility Legacy (Fed Also Kills Bond Volatility AND Term Premium)

The ECB under Draghi has been effective a depressing bond volatility and yields as he passes the torch to Christine Lagarde.

(Bloomberg) — Looking through the lens of rates market volatility, Mario Draghi has performed a masterclass in the art of keeping it very low. Incoming European Central Bank President Christine Lagarde will have a challenge to achieve the same effect as monetary policy nears its limits.

A successful central bank will aim to keep market volatility controlled by the predictability of its policy. Draghi has been in the business of keeping euro rates volatility suppressed, by communicating policy shifts effectively and deploying large-scale monetary easing.

Lagarde may find it harder to achieve a consensus on easing, inheriting a divided Governing Council. Policy makers disagree on whether more monetary stimulus is needed, and have voiced louder calls for fiscal policy to do more.

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Of course, The Federal Reserve is not too shabby about killing bond volatility.

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Treasury note term premium (the amount by which the yield-to-maturity of a long-term bond exceeds that of a short-term bond) has been reduced to negative territory.

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Yes, the ECB and Fed are natural born volatility killers.

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Bond Quants Are Growing in Negative-Rate World (Bridgewater’s Pure Alpha Fund Loses 2.3% In Nine Months)

Slicing and dicing risk is the name of the game in equities, but not so much in fixed-income … until now.

The surge in negative-yielding debt is making the bond market the next frontier for factor investing, according to a study by Invesco Ltd.

About 70% of institutional and 78% of wholesale investors see the concept of slicing and dicing securities by their characteristics as applicable to fixed income, the survey showed. That’s up from 62% and 57% respectively in 2018. The study polled 241 factor investors responsible for managing more than $25 trillion across the world.

Quant houses have been trying to convert investors to fixed-income factors with the pitch that just as in equities, there are proven systematic sources of long-term returns in bonds. The result of Invesco’s survey is another sign that their push is gathering steam amid concern that the bull market in credit is in jeopardy. More than $13 trillion of debt worldwide has a negative yield, according to data compiled by Bloomberg.

“We are in an environment where yields continue to be very low and the yield curve is very flat and investors are increasingly looking at ways to add value to the portfolio,” Mo Haghbin, chief operating officer at Invesco Investment Solutions, said by phone. “The results show a very high conviction that this is possible, and the allocations are starting to come through as well.”

The survey showed yield (or carry), liquidity and value were the fixed-income factors most commonly cited by investors.

Here are other findings from the survey:

  • Around a third of the respondents have boosted their allocations to factor strategies in fixed income. Still, nearly nine in 10 said the asset class is currently poorly covered by factor offerings.
  • Some 59% of respondents plan to boost their allocations to factor strategies over the next three years.
  • 66%-70% reported factor investing met or exceeded the performance of their traditional active or market-weighted allocations in the year through March 2019.
  • Value was included in 69% of respondents’ portfolios, a drop from 78% in 2018. It was the most common factor, along with momentum. Low volatility followed at 68%.
  • Liquidity and transparency are the main reasons for using exchange-traded products for exposure to factors, according to institutional investors. Meantime, price is a key driver for wholesale investors.

While a large majority of investors now incorporate environmental, social and governance (ESG) goals, they are divided over how these interact with factors. The most common view is that it’s a combination of styles, while about a quarter sees it as an independent factor and another quarter considers it a variation of quality.

Deutsche Bank, as an example of FI factor momentum investment.

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And here is an example of a Nomura FI momentum index.

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Negative interest rates are causing havoc for some hedge funds, like Bridgewater.

Bridgewater’s flagship fund has failed to recover the losses it suffered in August when government bond yields globally plummeted to multiyear lows.

The Pure Alpha fund at Ray Dalio’s $160bn hedge fund group lost 2.3 per cent in the nine months to September, after a particularly difficult August when the firm was wrongfooted by the decline in global interest rates.

Dialo wrong footed? Apparently his “Economic Machine” model failed to predict the onslaught of Central Banks and negative interest rates.

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