Debt – A Trader's Perspective

Turning Japanese

Photo by Nicki Eliza Schinow on Unsplash

The Fed’s response to COVID will zombify corporate America for a generation

Written June 21, 2020

In “The L-Shaped Recovery“, we predicted that a combination of demand destruction, job market uncertainty, rising debt, and a shift in consumer behavior would hinder the economy from achieving a rapid recovery from the COVID pandemic.

Since that writing, the Fed has taken the unprecedented step of intervening directly in support of the credit markets, producing a spectacular V-shaped rebound in the financial markets. But as we all know, the market is not the economy.

The economic template that the current public health crisis is most often compared to is the Great Depression of the 1930s, but a more instructive precedent for what the future holds might be that of Japan, which is still trying to shake off the effects of the financial market bubble that popped in 1989.

To put the excesses of 1980s Japan in context, it was said that the 280 acres of land within the walls of the Imperial Palace in central Tokyo was worth more than the entire state of California. At the time, this became the benchmark against which all other insane real estate and lending valuations were linked. When it inevitably crashed, Japan, Inc. tried borrowing their way out of trouble. More than 30 years later, and after racking up an eye-watering debt-to-GDP ratio of 279%, they’re still trying to find a way out.

In Japan, bankruptcy is not seen as a financial tool deployed to clear the decks of bad debt but rather as a cultural stain, one of humiliation and loss of face. So corporate Japan, and the country itself, stumbles onward like a zombie, burdened by mountains of legacy debt, unable to reap the benefits of innovation that leaner balance sheets would enable. This interminable trap is so ubiquitous that it even has its own name: Japanification.

Unfortunately, the Fed is headed down a similar path. Not only by backstopping the credit markets but by actively pushing prices higher, the Fed has allowed almost every corporation access to cheap money. It may be necessary, but just like the never-ending policy of quantitative easing destroyed the price discovery function in the equity markets, the unintended consequence of credit intervention is doing the same to the bond market. Normally where good corporate governance is rewarded and bad decisions are punished, everybody now gets a trophy.

In my day job as an editor for a financial news service, I spend a large portion of my time reading press releases from companies tapping into an almost unlimited supply of liquidity in the credit markets, with most of it going to refinance revolving bank debt incurred during the pandemic. Borrowing is literally exploding.

While this widespread refi effort is tactically beneficial in the near term to bridge the gap in cash flow created by the virus lockdown, the long term risk is that it will allow bad capacity to remain on the books, keeping unproductive companies alive and leaving little room for innovation and for fresh entities to thrive.

Corporate America was already running record levels of debt and leverage before the pandemic hit. Half of the investment-grade bond market is precariously rated BBB, just one notch above junk. Wide-scale bankruptcies and credit downgrades are indeed a systemic threat in a weakened economy, and it is forcing the Fed’s hand to prevent the entire system from snowballing downhill and out of control. But, like Japan, the unintended consequence of today’s policies will be a debt burden that will take years, if not decades, to climb out from under.

In a note to clients last week, Bridgewater Associates’ Ray Dalio warned of a “lost decade” for the equity markets as profit margins get squeezed by debt servicing costs. See here https://bloom.bg/3hMBVtC.

We tend to agree and would use this recent rebound in financial markets to reduce risk exposure while sticking with core long positions in the US dollar, short-term treasuries, and gold.

Debt explosion (courtesy Federal reserve bank of St. Louis)

Sharp rise in unproductive debt (courtesy Deutsche Bank)

Going Negative

Debt deflation starts the U.S. on a path to negative interest rates

Written May 10, 2020

Last week, for the first time in the country’s history, the financial markets began discounting the possibility of negative interest rate policy.

On Thursday, the December Fed Funds futures contract settled above par (100.00), implying that traders have moved beyond talking in the abstract about negative interest rates and started betting with real money that the Federal Reserve will be forced by events into crossing a line they’ve long insisted they would not step over.

Japan, Europe, Switzerland, Sweden, and Denmark currently have negative interest rates, policy legacies left over from fighting the last recession in 2008. The theory was that people would be so repulsed by having to pay a bank to hold their money that they would gladly spend it instead, stimulating the economy in the process. It hasn’t exactly worked out that way.

Rather than driving consumer demand, negative interest rates have resulted in a minefield of unintended consequences. Besides the lack of confidence it conveys to the public on behalf of impotent policymakers, it has clogged the banking system and perverted the lending process.

Count us among those who previously thought there was little chance that the Fed would follow the rate policies of its Japanese and European counterparts. But as we recently wrote in “The L-Shaped Recovery“, the pandemic has exposed and accelerated the threat of debt deflation that could end up triggering waves of bankruptcies.

The deflationary scenario was brought into stark relief after we recently came across a chart overlaying the Economic Cycle Research Institute’s Weekly Leading Index (WLI) with the US consumer price index (see below). As the name suggests, the WLI anticipates economic activity 2 to 3 quarters in the future. If the correlation with the CPI holds, it means prices could begin dropping later this summer.

Just as the value of debt falls in real terms in an inflationary environment, it rises in deflationary times. The problem is compounded by declining cash flows as a result of weak economic activity, making it harder to service that debt and potentially creating a serious problem for highly leveraged economies like ours.

The other moving part in the relationship between debt and deflation is the U.S. dollar. If the Fed’s policy rate is anchored at zero and market yields can’t keep pace with falling prices for goods and services, real yields (the nominal yield minus the rate of inflation) will rise, driving the dollar higher and depressing the price of imports domestically and commodities globally. As we said in “The Biggest Trade in the World“, “the risk to the broader economy is that a stronger dollar triggers a doom loop of debt deflation, where slower global growth causes the dollar to rise and a stronger dollar, in turn, depresses prices and causes growth to slow.”

As has been the case with every rate cut in this cycle, the market will lead the way for the Fed’s next move. And given the risk that rising real yields could pose to the prospects for a recovery, investors are concluding that the Fed may have no choice but to take rates negative.

Besides being long-time proponents of the U.S. dollar and front-end treasuries as core investment themes, we recently recommended adding a position in physical gold. Gold may be subject to bouts of selling if the dollar continues to rise, as many traders still reflexively see the two as inversely correlated. But because there doesn’t seem to be any limit on central bank money printing, gold will shine as the ultimate store of value in a world of increasingly negative interest rates.

Economic Cycle Research Institute Weekly Leading Index vs US Consumer Price Index. Chart courtesy of Real Vision.

December 2020 Fed funds Futures, trading above 100 for the first time ever and implying negative policy rates in the U.S.

The Biggest Trade in the World

The largest position in the history of the financial markets is about to get squeezed.

Written April 27th, 2020

Successful traders are always asking themselves two questions in the course of analyzing markets: 1) given a set of known inputs, are markets behaving as expected? and 2) if not, why not?

Since the COVID-19 pandemic crashed the world’s financial markets last month, central banks have responded with extraordinary measures to stabilize markets and prop up their respective economies.

For its part, the Fed has undertaken policies on a scale unprecedented in the history of finance, radically expanding their balance sheet and going so far as lending directly to municipalities and buying junk bond ETFs in the open market. Essentially printing money, but on steroids.

The equity markets have responded favorably, much as one would expect given the deluge of liquidity. It’s a reflexive response conditioned by a decade of the Fed propping up asset prices every time the markets stumbled. Will it last? Nobody knows.

However, the part of this scenario that is not going according to plan is potentially the most consequential for the financial markets. The US dollar needs to weaken. Big time. For a global economy staring at a tsunami of deflation, it is the most critical element to achieving a durable reflation of commodities and equity prices and restoring confidence in many regions of the world, especially the emerging markets.

This is not lost on central bank officials. In fact, if you were asked to come up with a policy to destroy your own currency, moves by the Fed and the Treasury over the past month to explode the federal deficit would be it.

The speculative trading community initially took the cue. According to CFTC data, the specs began shorting the dollar in the middle of March as rates went to zero and the money printing presses began working overtime.

But since then, not only hasn’t the dollar gone down, it is higher instead.

The latest study by the Bank for International Settlements estimates the world’s short position in the dollar at about $13 trillion, much of it based on dollar debt held by offshore banks and corporations, representing the largest aggregate position in the financial markets by far.

Currency swap facilities instituted and expanded by the Federal Reserve with the intention of ensuring these entities access to dollar funding helped settle the markets late last month, but the currency’s appreciation since then is a sure sign that it won’t be enough. For many of these foreign corporations, swap lines are of little value if their respective central banks don’t have sufficient reserves to swap or US Treasury securities to pledge as collateral.

Also, printing trillions won’t do much good if there is no turnover, or velocity, of that money due to the collapse in business activity. It just ends up in the vaults of institutions that don’t need it, crowding out the weaker borrowers.

Against all expectations, the steady grind higher in the dollar in recent weeks is a red flag that this massive short trade is about to get squeezed.

The implications will be felt everywhere. The risk to the broader economy is that a stronger dollar triggers a doom loop of debt deflation, where slower global growth causes the dollar to rise and a stronger dollar, in turn, depresses prices and causes growth to slow.

As we’ve been recommending for more than a year, stick with long positions in the dollar and front-end treasuries. In our last piece “The L-Shaped Recovery“, we suggested adding physical gold and taking advantage of near-term strength in equities to reduce exposure. If the dollar starts to accelerate, things could get ugly. Quickly. And despite the Fed’s insistence on not taking interest rates negative, it’s not impossible that this will end up being their next move.

Jaws 2

Diverging paths of the economy and the market continues to be a study in contradictions

In the weeks since our last comment the major central banks, led by the Fed, have ridden in hard to try and extend the life of what is already the oldest economic expansion in history. A confluence of declining corporate earnings forecasts, weakening industrial and retail activity, and persistent funding shortfalls in dollar-based securities markets has forced the Fed to administer CPR on the financial system. Despite the outwardly calm appearance, the Fed is very nervous, literally throwing money at both the economy and the markets in an effort to prevent a downturn in global growth from metastasizing into another financial crisis. Massive levels of debt and leverage encouraged by profligate central bank policies over the past decade now mean that the normal cycles of the economy…and the inevitable periods of weakness…cannot be allowed to play out naturally without risking a complete meltdown in the financial markets. (See BBBe Careful).

In October alone the Fed restarted their balance sheet expansion, ramped the daily overnight repo financing allocation and cut rates for the third time in four months. It’s a veritable fire hose of liquidity that pumps between $60 and $100 billion per month into the marketplace. It’s also a dead giveaway that everything is not fine. Former Dallas Fed advisor Danielle DiMartino-Booth aptly described the state of play as the Fed trying to “suppress the unknown, that at its best is credit volatility and at its worst systemic risk.”

So far the deluge of liquidity, at least initially, seems to be having the desired effect. Like every other time in the last eleven years that the Fed has fired up another round of quantitative easing, regardless of prevailing economic trends, record highs in the S&P were all but certain to follow. This time is no different. And almost as if the third consecutive quarterly decline in year-on-year corporate earnings don’t matter. The title of our recent piece ‘Liquidity Trumps Fundamentals‘ speaks for itself.

Don’t be fooled by Jay Powell’s attempt at downplaying the need for future rate cuts and reassuring investors that the expansion still has legs. See https://on.wsj.com/2pTHtfE Having to hit the panic button after nearly a decade of policy stimulus is definitely not a position in which anyone on the board of governors thought they would find themselves. It’s becoming abundantly clear that without a major reset in asset prices and a restructuring of the role of the central banks in the markets, rates will never be normalized. The Fed is headed into a policy cul-de-sac from which there is no exit. Like an addict, they’ve hooked the markets on easy money. Make no mistake, the minute stocks stumble, rate cuts will be back on the table. As much as they’d like everyone to believe it, this is no simple mid-cycle policy adjustment. It’s a one way street toward zero interest rates. If there’s a lesson from the past year, it’s that the economy remains vulnerable and that the bull market in equities and credit is not self-sustaining without the Fed’s foot firmly on the gas.

Presumably, corporate CEOs get this. These are the guys making decisions on hiring and capital investment. The latest survey of CEO confidence is shockingly bad and contrasts starkly with optimism among consumers (see charts below). Visually, the surveys are very similar to the chart that became popular several months ago comparing opposing trends in equities and bond yields. Coined with the name “Jaws” it illustrated two major financial benchmarks projecting distinctly different economic outcomes. (See “Jaws” Could Take a Bite Out of Markets). Which indicator is ultimately proven right (bonds or stocks) remains an open question. The two charts below from The Conference Board on confidence reveals a similar contradiction. History shows two things: 1) CEO confidence leads consumer confidence and 2) a sharp deterioration in CEO confidence has immediately preceded each of the last five recessions (the gray shaded areas). But as with the original Jaws chart, which side is ultimately right and how these normally correlated, but currently divergent, trends snap back into line is yet unknown.

Our preference is to bet on the side of history. The heavy dose of hopium from coordinated central bank intervention driving stocks and bond yields higher in the past few weeks will fade in time. It’s another sugar high. We have been long the front end U.S. rate complex for all of 2019 and still see this sector as the most effective play on slowing global growth. The Fed has a trigger finger with respect to cutting rates. Be patient, but the widespread position flush underway in the bond market this week is an excellent opportunity to reload those long positions between now and year-end.

Jaws 2. CEO and Consumer Confidence telling different stories. Shaded areas are recessions. Courtesy Quill Intelligence

Or, expressed another way:

Record discrepancy between corporate and consumer confidence. Shaded areas are recessions. Courtesy Deutsche Bank Global Research

Dec 2021 Eurodollar future. Approaching support.

Enjoy the Party but Dance Near the Door

Reason to be skeptical of the latest central bank reflation trade

The title of this piece refers to an old cautionary Wall Street cliche that describes a trader’s dilemma where the price action says one thing but his gut warns him that something is not quite right, and to not get too complacent. This is an apt description of the current state of play over the past few days. Markets are reacting optimistically to a potential trade deal with China and the prospect of supportive policy intervention by the major central banks, most of which involves creating more debt. Besides possible rate cuts by the Fed, BOJ, and ECB, China unleashed another huge credit impulse, see https://bit.ly/2kAGnTz, South Korea has enacted a massive fiscal spending program, see https://on.ft.com/2ZBihGx and the Germans are exploring ways to circumvent current limits on debt issuance, see https://reut.rs/2kDcsKl. That’s a lot of stimuli. No wonder the markets like it.

However, this collective panic among the policy crowd in the face of slowing economic growth doesn’t offer any new ideas other than to throw more money at a situation that previous waves of cash have failed to fix. Most investors now realize that after a decade of extreme monetary policies, excessive debt is becoming the problem, not the answer. It’s the reason why large parts of the world are trapped in a deflationary malaise. Not only will piling on more debt not work, but it will also make the eventual reckoning even more painful.

Since early this year we have focused on several trends: slowing global growth, falling rates, and a stronger dollar. A continuation of these generally-bearish themes, along with the pressure that it exerts on the vulnerable corporate credit and emerging market sectors, is still our base scenario.

Nevertheless stocks, yields, credit, and commodities have all caught a bid in recent days. The dollar is offered. With good reason, investors still strongly believe that the central banks can affect outcomes and that a safety net is firmly in place under the markets. One of our favorite risk sentiment canaries, the Canadian dollar, impressively held support at USDCAD 1.3400 (see chart below.) This is a sign that a broader recovery in the marketplace in the near-term is not only possible but likely.

Longer-term, the prospect of a global economy that is weakened by over-indebtedness and unable to maintain sustainable growth without the repeated intervention of central banks is a frightening prospect, and remains our primary concern. The big danger in our future will come at that point when investors lose faith in central bankers’ ability to keep the markets propped up. We’re not there yet but that re-set in valuations will be the trade of a lifetime…and not in a good way. Will it be next month, or next year, or five years from now? Nobody knows. So in the meantime enjoy this latest bull party but remember to dance near the door.

The Fed’s response to COVID will zombify corporate America for a generation

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Debt deflation starts the U.S. on a path to negative interest rates

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The largest position in the history of the financial markets is about to get squeezed.

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Diverging paths of the economy and the market continues to be a study in contradictions

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Reason to be skeptical of the latest central bank reflation trade

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