Category: asset classes

Is Mario Draghi pulling away the punch bowl?

“Draghi hints ECB may start winding down QE,” read the MarketWatch headline this morning:

European Central Bank President Mario Draghi hinted on Tuesday that the ECB might start winding down its large monetary stimulus as the eurozone economy picks up speed, even as he warned against an abrupt end to years of easy money.

The comments, at the ECB’s annual economic-policy conference in Portugal, come as investors watch closely for a sign that the world’s second most powerful central bank is preparing to withdraw controversial policies such as its EUR60 billion ($67.52 billion) a month bond-buying program.

Mr. Draghi said the ECB’s stimulus policies are working and will be gradually withdrawn as the economy accelerates. However, he warned that “any adjustments to our stance have to be made gradually, and only when the improving dynamics that justify them appear sufficiently secure.”

With the Fed now talking about contracting its balance sheet and the BOJ and ECB doing the heavy lifting, this seems like a big deal, yet equity markets have barely noticed.  The Euro Stoxx index was -0.13% while S&P 500 futures are currently -0.07%.  3-month VIX futures (Oct contract) stand at just 14.25. The eurozone sovereign debt markets are a different matter:

Germany 10-year = -0.56% (0.32% yield-to-maturity)

France 10-year = -0.59% (0.69% ytm)

Italy 10-year = -0.80% (1.98% ytm)

“Today Draghi moved his first step towards indicating that ECB monetary policy will become less [stimulative] in 2018,” said Marco Valli, an economist with UniCredit in Milan.

Mr. Valli said the ECB might reduce its monthly bond purchases to EUR40 billion in the first half of next year, followed by a further reduction to EUR20 billion per month in the second half of the year. That would be a slower pace of stimulus reduction than many analysts had been expecting.

Keep in mind, the ECB and Bank of Japan have been doing the heavy lifting as year-over-year growth in total assets shows:

Fed = 0%

ECB = +36.7%

BOJ = +20.0%

The bond markets are starting to pay attention (though still wildly delusional). Perhaps the equity markets should as well.

Global asset deflation: nowhere to run, nowhere to hide

Over the past several months global stocks, bonds and currency markets have hit a wall.  Just 6-8 months earlier the central banks of Europe, Japan and the US were signaling endless monetary accommodation which initially emboldened global speculators and their reach-for-yield mantra.  Now we look around for evidence or confirmation that the four year stimulus experiment is DOA.

First, emerging market stocks, bonds and currencies have all dropped somewhere between 7% and 12% the last few months as the carry trade (borrowing in low cost currencies in order to buy higher returning risk assets, thus capturing the spread) comes off the boil.  Second, political commentary out of China confirms our earlier thoughts that a credit bubble for the ages has begun to burst.  Since the central banking talking heads opened their mouths last month, Shibor rates (Chinese overnight unsecured lending rate amongst 16 largest banks)  have spiked to levels not seen since 2004:


Here is the latest on the Chinese banking system from Bloomberg:

Policy makers could be taking advantage of tight funding to “punish” some small banks, which previously used low interbank rates to finance purchases of higher-yielding bonds, Bank of America Merrill economists led by Lu Ting wrote in a report. Tight interbank liquidity could last until early July, according to the report.

‘Warning Shot’

“The PBOC [People’s Bank of China] clearly has an agenda here,” said Patrick Perret-Green, a former head of Citigroup Inc.’s Asian rates and foreign exchange who works at Mint Partners in London. “To fire a massive warning shot across the banks’ bows and to see who is swimming naked. Moreover, it fits in well with the new disciplinarian approach” adopted by the government, he said.

Chinese regulators are forcing trust funds and wealth managers to shift assets into publicly traded securities as they seek to curb lending that doesn’t involve local banks, so-called shadow banking, according to Fitch Ratings.

The tightening is “emblematic of some of the shadow banking issues coming to the fore as well as some of the tight liquidity associated with wealth management product issuance, and the crackdown on some shadow channels,” Charlene Chu, Fitch’s head of China financial institutions, said in a June 18 interview. She earlier estimated China’s total credit, including off-balance-sheet loans, swelled to 198 percent of gross domestic product in 2012 from 125 percent four years earlier, exceeding increases in the ratio before banking crises in Japan and South Korea. In Japan, the measure surged 45 percentage points from 1985 to 1990, and in South Korea, it gained 47 percentage points from 1994 to 1998, Fitch said in July 2011. [Emphasis mine.  Japan and South Korea experienced bubble economies during these periods which both burst.]

Look at the massive growth in nonbank (shadow) lending in China post 2008 credit crisis while keeping in mind most of this was indirectly backed by the largest banks under the “wealth management” label:

Chinese shadow banking

Maybe this is why China made the news last week when a proposed 15.5 billion renminbi bond offering failed (for the first time in nearly 2 years), receiving only 9.5 billion renminbi.

Over in Russia and Korea we see even more instability permeating the credit landscape.

Romania’s Finance Ministry rejected all bids at a seven-year bond sale yesterday because of market volatility, while South Korea raised less than 10 percent of the amount planned in an auction of inflation-linked bonds. Russia scrapped a sale of 15-year ruble-denominated bonds June 19, the second time it canceled an auction this month, and Colombia pared an offering of 20-year peso debt by 40 percent. A cash shortage led to failures last week of China Ministry of Finance debt sales.

More than $6.9 billion left funds investing in developing-nation debt in the four weeks to June 19, the most since 2011, according to Morgan Stanley, citing EPFR Global data. The exodus is reversing the $3.9 trillion of cash that flowed into emerging markets the past four years as China’s annual economic growth averaged 9.2 percent and spurred demand for Brazilian iron ore, Russian oil and gas and Chilean copper.

Romania rejected all 688 million lei ($200 million) of bids at a bond sale yesterday because of “unacceptable price offers,” according to an e-mailed statement from the central bank. It was the first failure since August.

South Korea sold just 9 percent of the 600 billion won ($524 million) it targeted from 10-year inflation-linked bonds this week. Colombia’s government pared an auction on June 19 of 20-year inflation-linked peso bonds by 40 percent, to 150 billion pesos ($77 million).

Russia canceled planned sales of 10 billion rubles ($311 million) of notes this week, citing a lack of demand within an acceptable yield range of 7.70 percent to 7.75 percent. Yields on ruble bonds due in 2028 jumped 30 basis points, or 0.30 percentage point, yesterday to 8.1 percent, the highest level since the debt was sold in January.

After endless monetary interventions the prior 3-4 years governments around the world temporarily created the illusion that interest rates would stay below nominal GDP growth targets.  The sleight of hand only lasted this long because so many of the “professional money managers” never questioned the actions of central bankers (a.k.a. asset inflationistas) .  As currencies, bonds and stock markets decline in unison around the world, one might pose the question “Have central bankers lost control of their monetary experiment?”  Or better yet, why would so many “investors” believe that a group of central banks with combined reserves of $11.5 trillion could levitate with over $240 trillion in global assets?   Which then begs the question,  where does one hide?

Beware ultrashort-bond funds

The reach-for-yield bubble continues to scale record heights of insanity.  The latest milestone: the recent popularity of ultrashort-bond funds.  These typically invest in high-quality bonds with maturities, on average, of less than a year.  According to a June 3 Barron’s article, “When It Comes to Cash, Less Is More“:

For the trailing one year through April 30, the nearly 50 ultrashort funds tracked by Morningstar have taken in $10 billion in new assets.  “That’s pretty big considering that there’s $52 billion in the entire category,” notes Morningstar analyst Timothy Strauts.

While this is a drop in the bucket compared to the $895 billion in retail money market funds, the vigor in which fund companies are marketing this product should raise red flags:

In the past year alone, roughly a half dozen new ultrashort-bond funds have made their debut – the BlackRock Short Obligations fund, Sterling Capital Ultra Short, and T. Rowe Price Ultra Short-Term Bond among them.  In May, Legg Mason’s subsidiary filed SEC documents for the Western Asset Ultra Short Obligations Fund.

According to Morningstar, ultrashort-bond funds have an average 30-day yield of 0.59%, but is this worth the extra risk?  During the financial crisis, many of these funds posted losses.  In fact the largest at the time, Schwab YieldPlus, lost 35% of its value in 2008.

“Our feeling on ultrashort bonds right now is ‘What’s the point,” says Jeremy Welther, a principal at Brinton Eaton, a financial advisory based in Madison, NJ.  “Any time you get back less than what you put in, it’s not cash.”

Besides gold, cash appears to be the most unloved asset class on the planet.

Worst investments of the next 5 years?

With so many qualified candidates, the challenge is to narrow down to our ten least-favorites, but here goes:

10.  VelocityShares Daily Inverse VIX ST ETN (XIV)  – Volatility measures such as the VIX are at their lowest levels since the top of the 2007 credit bubble.  This ETN is short.

9.  PIMCO California Municipal Income Fund II (PCK) – The bonds in this closed-end fund yield a tempting 6.8% for a reason: California is a fiscal mess.  Even worse, yield-chasers bid the fund’s shares to a 20% premium over net asset value.

8.  iShares iBoxx $ Invest Grade Corp Bond ETF (LQD) – With an average yield of 3.79% and weighted average maturity of 11.8 years, this ETF offers what Jim Grant derides as “return free risk.”  Worse, one-third of the portfolio is invested in bonds of financials: mostly mega-banks and investment banks.  LQD has attracted nearly $8 billion in inflows the past 2 years.

7.  iShares Dow Jones US Real Estate ETF (IYR) – Powered by investors reaching for yield, this ETF boasts a total return of 25.9% per year over the past 4 years.  Unfortunately, valuations are stretched: current yield is just 3.2% and REITs typically trade at 20 x FFO (funds from operations), at the high end of their range.  Worse, access to cheap capital has translated into acquisition binges at some of the portfolio companies.

6.  30-year U.S. Treasury bonds – When entitlements are included, the U.S. government’s debt/GDP is estimated at over 600%, in all likelihood the highest in the world.  For this elevated risk, bondholders are locking in all of 3.18% interest for 30 years.  A default is coming within the next 5 years, either openly by default or insidiously via the printing press.

5.  PIMCO High Income Fund (PHK) – The current yield is 11.5%, but a good chunk of this is being paid out of principal as high yield bonds yield close to 5%.  The portfolio is loaded with financial and mortgage-related paper.  For this, closed-end investors are paying a 45% premium to NAV.

4.  iShares FTSE China 25 Index Fund (FXI) – Call us skeptical of the Chinese miracle with its central planning, cronyism, loose lending, artificial booms in housing, infrastructure and commodities, empty cities, rampant waste, and conspicuous consumption.  This popular ETF has a 57% weighting in financials, mostly large domestic banks.

3.  PIMCO Global Stocksplus & Income Fund (PGP) – This closed-end fund boasts a seductive 10.7% current yield and 30.8% compounded annual return over the past 4 years.  Investors may or may not realize returns have been turbo-charged with 50% leverage coming from S&P 500 stock index futures.  Either way, they don’t seem to care, bidding up the shares to a 58% premium over NAV.

2.  Global “Too Big to Fail” bank/investment bank stocks – Fractional reserve banking + moral hazard of TBTF = toxic combination.  The 2008 meltdown claimed its share of these political capitalists always teetering on insolvency (Bear Stearns, Lehman, Citigroup, et. al.).  What sins have the survivors committed during this epic stimulus/sovereign debt/reach-for-yield bubble?  We’re about to find out.

1.  10-year Japanese government bonds – Japan has the second highest debt in the world behind the U.S. with an economy one-third the size.  Debt/GDP is the highest in the world at over 220%, well ahead of #2 Greece and #3 Zimbabwe.  Thanks to the kindness of domestic savers (burned by the bursting stock bubble of the late 1980s), the 10-year yields just 0.83%.  In an effort to stimulate its economy, the Bank of Japan is hell bent on creating 2% inflation.  (We’re guessing they’ll succeed.)  So far, selling by bondholders planning for their golden years has been orderly.  As the government strains to meet higher interest payments, these patriotic creditors could turn tail and run.

Let the race to the bottom begin!

Yield-chasers line up to buy Bolivian bonds

Under the You-Can’t-Make-This-Up category of sovereign debt insanity, the May 17th Grant’s Interest Rate Observer files this report:

Many these days are picking the poison of foreign places – Bolivia, for instance.  Last fall, the scenic, private-property expropriating, contract-abrogating and formerly hyper-inflating South American nation issued its first international sovereign debt since 1920.  And the Bolivian 4 7/8s of 2022 this year have rallied by 57 basis points, “the most among sovereign bonds with BB-minus ratings tracked by Bloomberg.” [according to Grant’s analyst Evan Lorenz]

The Great Bond Bull Market began in September, 1981 (over 31 years ago) with U.S. T-bond yields over 15%.  Yields on the 10-year now stand just a shade below 2%.

Precisely 2 years ago, Jim Grant was quoted in an Associated Press interview:

I think it’s useful to imagine how things might look ten years hence.  What will one’s children, heirs or successors think about a purchase  today of ten-year Treasurys at 3.25 percent? They’ll look back and say,  “What were they thinking?”  The (federal deficit) was running at 10  percent of GDP, the Fed had pressed its interest rates to zero, it had  tripled the size of its balance sheet, and they bought bonds?  Treasurys  are hugely uninteresting, as is similar government debt the world over.

Today the Bolivian government can borrow for 9 years at 4 1/2%.  Have bond investors completely lost their minds?

Japanese government bonds take biggest 2-day hit in 5 years

As Tyler Durden of Zero Hedge reported, 10-year JGBs took their worst 2-day plunge since the financial meltdown of Q4, 2008:

The last 2 days have seen JGB prices plunge at the fastest rate since the post-Lehman debacles in Sept/Oct 2008 smashing back to 13 month highs.  5Y yields are surging even more – trading above 34bps now (up from 9.9bps on March 5th). These are simply astronomical moves in the context of JGB history and strongly suggest Abe & Kuroda are anything but in control of the quadrillion Yen domestic bond market as they jawbone inflation expectations into the psychology of the people.

Meanwhile, the Japanese yen has fallen off a cliff as the Bank of Japan (BoJ) opens the monetary floodgates:

Jeff Berwick, editor of The Dollar Vigilante Blog weighs in on the bond vigilantes calling the BoJ’s bluff:

Traders should take note of Japanese Government Bond prices.  On April 4th the Bank of Japan made the announcement that they intended to DOUBLE the money supply and buy government bonds roughly equaling $80B a month.  Does this number sound familiar?  It should since the US Federal Reserve’s own quantitative easing program is roughly $85 B a month.  An important data point to remember here is that the Japanese economy is only 1/3 the size of the US economy, but its own quantitative easing program equals that of the US.   To say Japan is “doubling down” on the same failed policy approach it has taken for the last 20 years would be a bit of a misnomer.  This is Japan’s “all in” move as I try to keep the gambling metaphor rolling.  A gamble is exactly what this is, a very big gamble with no precedent in economic history.

What are the consequences of rapidly increasing government spending, monetizing $80B a month in debt, and flooding the market with yen?  It is hard to miss the headlines as the Yen on the futures exchange is now trading at below 100 yen to the USD for the first time in four years.

Berwick offers an explanation as to why bondholders are beginning to act more rationally:

Why are bonds trading lower?  Think about this from a prudent lender’s point of view and you will have your answer.  If I give you yen, and you give me a security (bond) that says you will give me back my yen with interest in 10 years, then why would I sit with that security and let you pay me back with a devalued currency?  Well, in Japan bondholders appear to be speaking with their market participation.  Bond holders are doing exactly what they should be doing.  Bond holders should be liquidating bonds and converting money out of yen into non-yen denominated securities and investments (note all the M&A activity from Japanese companies in the last seven months as the smart money runs and not walks out of Japan and the yen).

How can the savers in Japan be sitting idly by and watching the purchasing power of their savings being destroyed?  We are on the first chapter of a very ugly time in Japan where policy makers decisions will strain the very social fabric of the country.  We will have a front row seat to the failings of the Keynesian economic philosophy.  It will not be pretty for Japan. And it could very well be the first major event in The End Of The Monetary System As We Know It.

Last Friday, in his Daily Rap, Bill Fleckenstein mentioned the possibility of a Japanese canary in the sovereign debt coal mine:

Japan was the epicenter of fireworks that spread around the world, as last night their equity market rallied 3% even as their debt market had a bit of a nasty spill. However, it must be kept in perspective that the change was rather small and rates have only backed up to where they were in February. So it is not exactly huge trouble, but it could be the start of a shift. At the moment, the bond and currency markets are declining in Japan. Should that continue and should the bond market worsen materially, it would be an early sign of what an eventual funding crisis would look like.

Of course, as long as Japan’s central bank is buying such huge amounts of paper it can thwart that for a time, but it could be the first sign of a bond market anywhere revolting against the printing press. As I say, it is very early days and I don’t want to make too much of it, but a trickle can eventually become a flood, and a trickle has to start somewhere.

Over three weeks ago, in our Q1 letter to investors, we mentioned the possibility of a “Wizard of Oz moment” as the BoJ accelerated its monetary experiment:

Two weeks ago, the Bank of Japan announced a doubling of its asset purchase program.  In Pavlovian response, speculators bid up Japanese government bonds strongly, with the 10-year yielding just under 0.40%.  The following day those gains completely evaporated.  Had the BoJ lost control and the market called its bluff?

For now Goldilocks prevails, but for how long?  Fleckenstein considers the glaring (and widening) disconnects:

So we continue to be in the most perverse sweet spot in the history of the money-printing era that began over 20 years ago. Between the BOJ and the Fed, we are printing about $1.8 trillion a year, along with massive deficit spending, and those policies are regarded as a panacea for equities and just fine for bonds, but horrible for assets that protect one against inflation. Of course, that makes no sense, but when you are in a warped environment (and this is the most warped ever), crazy things not only happen, they lead to even crazier outcomes until the madness finally stops, after which all hell breaks loose.

So much for the notion that central bankers are in control.  Did the global reach-for-yield bubble just go “pop”?

Gold fund exodus at record levels

As reported by Bloomberg, investors withdrew $1.27 billion from gold and precious-metals funds in the week ended May 8, according to Cameron Brandt, the director of research for Cambridge, Massachusetts-based EPFR Global, which tracks money flows. This year’s outflows of $20.8 billion are the largest withdrawals since the firm began tracking the data in 2000.

Housing recovery?

Over the past year, more and more of the housing pundits, circa 2006, have resurfaced on Bloomberg and CNBC.  Many claim the bottom in housing is in as the US recovery continues due to low interest rates and a healing consumer.  Like any story, the devil is in the details so let’s parse the facts and make our own diagnosis.

Beginning in 2009 the new administration, assisted by the new wards of the state Fannie Mae and Freddie Mac (thank you Hank Paulson), began a series of mortgage moratoriums -aka “mortgage modifications.”  Essentially, the government would entertain a variety of mortgage defaults/delinquency cases with the intention of keeping bodies in their homes.  Can’t let the home ownership (or should I say “lease”) program go to waste now.  Since then we note the following facts provided by housing analyst Mark Hanson:

Mods are greater in number by 50% than legacy Sub prime loans in 2006. And they are worse in structure.

– There have been 9.953 MILLION loans “tampered with” through trials, mods and workouts based on OTS data through Q4 2012.  

– Bank “proprietary” Alt-A, high-risk mods outnumber HAMP (Home affordable modification program) mods by over 200%.   Banks have had a field day re-leveraging millions of bad loans into structures that would make Angelo Mozillo blush.  

– Mods are why banks brought back $10s of billions in loan loss reserves as revenue. And why they will have to add back reserves.  

– Mods are where all that housing “supply” went.

– Mods are why foreclosures are at pre-crisis lows.

– Mods turn people into underwater, over-levered renters of their own house.

– Mods prevent the deleveraging process needed for housing to achieve a “durable” recovery with “escape velocity”. 

– Mods compete fiercely with all those new-era buy and rent “investors” (Blackrock, Och-Ziff, Tom Barrack) whose top demand theme when raising opportunity capital a couple of years ago was all of the “millions of homeowners displaced through foreclosure who will need a place to rent until they can buy again”. 

If you look at mods structurally — sky-high DTI, LTV, CLTV and low credit score — they make legacy Subprime loans look sane.  People say “banks aren’t lending”. I say ‘go look at their loan mods volume’.  Loan mods are nothing more than low rate, exotic refi’s for people who can’t do a traditional refi. But they are so exotic they make Pay Option ARMs look structurally sound.  

To put this in context there were only about 4 million legacy Sub-prime loans in existence in 2007 when the wheels came off the sector spurred by the ‘Sub-prime Implosion”.

– Four million Sub-prime loans ignited the mortgage meltdown. So, six million or more ‘worse-than-Sub-prime’ loans hanging over housings’, banks’, and MBS investors’ heads probably isn’t a great thing. 

-HAMP mod redefaults are surging…but banks and servicers have been making much more risky “proprietary” mods than HAMP in much larger volume.   Thus, expect redefaults across ALL loan mods to increase significantly over the next year.  Obviously, this means more distressed supply and for many banks this could mean higher loan loss reserves, etc.  See picture below:

My Comment: So one should ask the question “How long can the government continue to hide inventory from the public”?  Or as importantly, since the public bailed out the banks shouldn’t they be entitled to purchase homes at reasonable price levels, not the artificially inflated kind?

Glencore International, world’s largest commodity trader, considering $7B IPO

IPOs like this occur frequently, but not always, near the top of an industry’s underlying price ranges. From CNBC:

Glencore International, the world’s largest commodities trader, is signaling to bankers that it expects to issue at least $7 billion in stock as part of an initial public offering to launch as early as April, says someone familiar with the matter.

The Swiss trading firm, which is also heavily engaged in the physical production and marketing of oil, gas, wheat, corn, aluminum, nickel, and other raw materials, met with bank analysts in London as part of a two-day presentation earlier this week, according to several people who were briefed on the meetings.


The company carries a heavy net debt load of $14.8 billion, up from $10.2 billion last year.

Indebtedness and the strong need for cash in its capital-intensive trading business may be spurring Glencore’s desire for an IPO, say bankers and traders knowledgeable about the company. Glencore debt trades at junk levels, and its bonds were battered during the financial crisis, amid doubts about the company’s future creditworthiness.

Commodity bubble reaches July, 2008 levels

These were the vital signs at the top of the commodity bubble on July 4, 2008 when crude oil traded at $145/bbl:

  • Reuters/Jeffries CRB Index = 472.36
  • average Bullish Consensus = 68.9% (18 commodities)
  • soybeans = 89%
  • crude oil = 80%
  • heating oil = 84%
  • natural gas = 85%
  • cocoa = 86%


  • Reuters/Jeffries CRB Index = 341.27
  • average Bullish Consensus = 70.0%
  • corn = 82%
  • coffee = 94%
  • cotton = 96%
  • copper = 80%
  • silver = 84%

The 2008 bubble was fueled by the energy complex (crude -39%, heating oil -34%, nat gas -71% since).  It’s 2011 cousin is inspired by the endless-demand-from-China fantasy with the wildest speculation in soft commodities like cotton, coffee and sugar, and industrial metals like copper, palladium and platinum.

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