Thursday, July 30, 2020

Evening Note: At Best...

I've noticed a developing trend in my end-of-day perusing of credit market internals; it's that most things credit appear to be truly on the mend.

To give you a visual, below is a color-coded handful of the things we track. While this clearly isn't screaming green, rest assured that it's a far tamer look than we were getting just a few weeks ago.



    • LEVERAGED LOAN PRICE INDEX: Ytd: -5.3%, retraced >62% of BM decline…

    • PSP (Private Equity ETF): Ytd: -15.80%, retraced >62% of BM decline.

    • HYG: Ytd: -308 bps, retraced >76% of BM decline…

    • MUNI/TREASURY SPREAD: 122% of 10-yr treas, 61% wider vs equity mkt peak

    • HY SPREAD (1-day behind): 489 bps, 36% wider vs equity mkt peak

    • Ba SPREAD: 342 bps, 60% wider vs equity mkt peak

    • BB-BBB SPREAD: 168 bps, 95% wider vs equity mkt peak

    • CDS Inv Grade Index 70.37


So what gives? I mean, just last evening I illustrated how corporate debt stress -- in terms of debt service relative to key corporate income metrics -- is rising in a manner never seen in the history of all past recessions. Not to mention Q2 GDP declining at an all-time record quarterly pace, and the 1.4 million in first-time unemployment claims filed last week. How on Earth could credit markets be so sanguine right here?

Well, if you listened to Fed Chair J. Powell talk up US monetary policy yesterday, you'd understand completely. Essentially, while he was as straightforward as a fed chair could be in terms of the anything-but-rosy present state of affairs, his commitment to keeping markets afloat was firm, unwavering and unlimited in scope. 

The thing is, however, if the current episode is indeed to fall short of ending in what we'll call massive blood in the financial streets, we have to ultimately be concerned with what we end up with on the other side? For if the authors of The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis have it right, central banks at best are merely what they call "agents of carry", and, thus, can at best only succeed in keeping this massive corporate debt bubble inflated. Well, till they can't...      

emphasis mine...
The wealth that is made by the financial players (and businesses and individuals) who are implementing carry trades is not real wealth of the sort that derives from an economy’s greater ability to produce better goods and services that the general population needs and desires. On the contrary, it causes financial asset prices to become hopelessly distorted, unhinged from the real economy, and therefore ends up misdirecting scarce capital into potentially unproductive uses. Over time, the economy will perform progressively more poorly, with income and wealth more and more concentrated in a few hands.
Nevertheless, it is also important to realize that the carry regime, as it progresses, fundamentally weakens the true power of central banks (and by extension governments). This may seem counterintuitive, but as with regulatory capture, central banks are themselves “captured” by carry. During the intensely deflationary carry crashes (such as occurred in 2008), they appear to have no option other than to increase moral hazard further, via even greater intervention and bailouts. In one of the various seemingly contradictory aspects of the carry regime, central bankers seem to have enormous power—their extraordinary power to create high-powered money, set short-term interest rates, and strongly influence financial markets with everything they say—but ultimately they themselves have little latitude to act. Central banks become merely the agents of carry. Their seeming immense power is, in reality, mostly illusory.
If you're unfamiliar with the term "carry trade", it typically refers to the act of borrowing in a low-yielding currency and lending in a higher yielding currency, the differential (the profit) is called "the carry." The authors quoted above use the term to describe any scheme that involves "the use of borrowed funds or else utilize some set of contracts that creates a potential risk of loss greater than the amount of capital initially employed in the trade." Which, alas, describes the myriad of "trades" investors, pension funds, other institutions, etc., have resorted to either out of greed, or need, these years since the last bubble burst. These include everything from currency carry as described above, writing insurance, selling credit default swaps, buying high-yielding equities or junk debt on margin, mortgaging property investments, writing options, and buying leveraged ETFs, to companies borrowing to fund share buybacks, to a whole gamut of other complex financial strategies.

I.e., Suffice to say that the Fed has its back against a ginormous wall of risky debt-financed schemes that allow for very little volatility in financials markets; without, that is, major systemic consequences...

Stay tuned, and stay hedged...

Thanks for reading,

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