Houston (Fed), We Have A Problem (Problems) – Part 2/2

In the previous article, Houston (Fed), We Have A Problem (Problems) – Part 1/2, I addressed two risks (growing monetary policy divergence and emerging markets)  that will force the Fed to “land” (lower back) rates this year. I will address more risks here.

One huge risk that I will not address here, but will address in a future article is “lack of liquidity”. While I was doing research, I came across more information that I expected. I’m still getting more information and I believe it will be a great article. I will give a sneak peek of the article in the bottom of this article.

Junk Bonds, Credit Spreads, Energy, Manufacturing, Earnings Decline:

Earlier last month (December 10, 2015), Third Avenue’s Focused Credit Fund (FCF), a large mutual fund specializing in risky, high-yielding bonds, announced it would block investor redemptions, “no further subscriptions or redemptions will be accepted.” In mid-2014, they had $3.5 billion assets under management (AUM). As of December 31, 2015, they only had AUM of $660.67 million, as investors rushed to get their money back because of weakness in the junk bond market.

Now, investors’ money are being held hostage. “The remaining assets have been placed in a liquidating trust”, said David Barse, CEO of the firm, as the investor requests for redemptions and the “general reduction of liquidity in the fixed income markets” made it impossible for the fund to “create sufficient cash to pay anticipated redemptions without resorting to sales at prices that would unfairly disadvantage the remaining shareholders.”

The process is a pain in the ass, “Third Avenue anticipates that the full liquidation process may take up to a year or more.” Again, investors’ money are being held hostage.

This events highlights the danger of “over-investments” into risky areas, high levels of corporate debt, AND the lack of liquidity (will be addressed in a future article). With interest rates hovering around 0 (well, before the rate-hike in December), U.S. companies have rushed to issue debt.

Investors who poses a higher risk appétit can find junk bonds, yielding higher interest rates, to be “useful” for their style and capacity of investment. More rewards for more risks, right?

As the global economy continues to struggle, namely China and emerging markets, yield on junk bonds have been increasing since they are a higher chance of defaulting.

Rising interest rates adversely impact bond prices, pushing their yield of the bond higher (inverse relationship). While increase in rates does not largely affect junk bonds since they have a higher coupon (yield) and shorter maturities (shorter maturity means less price sensitivity to rates), current junk bond market combined the impacts of a stronger dollar and low commodity prices can be extremely adverse and dangerous.

High-yield debt yields, as represented by Bank of America Merrill Lynch U.S. High Yield Master II Effective Yield, have been increasing since mid of last year. It rose from 5.16% (June 23, 2014) to current 9.23%. That’s whopping 78.88% increase, representing the growing risks of junk bond market.

BofA Merrill Lynch U.S. High Yield Master II Effective Yield Source: retrieved from FRED, Federal Reserve Bank of St. Louis
BofA Merrill Lynch U.S. High Yield Master II Effective Yield
Source: retrieved from FRED, Federal Reserve Bank of St. Louis

 

According to Lipper, investors pulled out a total $13.88 billion from high-yield funds in 2015, with $6.29 billion in December alone. As redemptions increase, funds may suffer as high-yields are harder to trade due to its lack of liquidity (will talk more about the major risk of illiquidity in a future article) and funds may have to take an action like the Third Avenue did.

Credit spreads (difference in yield between two bonds of similar maturity but different credit quality) are widening, which possibly signals a wider economic trouble ahead. Widening credit spreads mark growing concerns about the ability of borrowers to service their debt. Not only borrowers will suffer, but also lenders since they lost money.

BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread, representing the credit spread of the high yield bond market as a whole, have been increasing the middle of 2014. It’s currently at 775 (7.75%) basis points (bps).

BofA Merrill Lynch US High Yield CCC or Below Option-Adjusted Spread is currently 1,804bps wide (18.04), a level of highly distressed territory. Credits are defined as distressed when they are trading more than 1,000bps (10%) wide.

BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread AND BofA Merrill Lynch US High Yield CCC or Below Option-Adjusted Spread Source: FRED Economic Data
BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread AND BofA Merrill Lynch US High Yield CCC or Below Option-Adjusted Spread
Source: FRED Economic Data

I believe it will continue to increase this year, reflecting the worsening of the credit conditions that would cause greater concern among investors and policymakers (Hi, Ms. Yellen. Time to reverse the policy?)

iShares iBoxx $ High Yield Corporate Bond ETF (NYSE: HYG), an index composed of U.S. dollar-denominated, high yield corporate bonds, is already down 1.39% year-to-date (YTD) and was down 10.58% in 2015, expressing the increasing uncertainty by the investors, as they pull back their money from high-yielding bonds/ETFs. The exposure of the index to CCC rated bonds, B rated bonds, and BB rated bonds, are 8.88%, 38.73%, and 50.25%, respectively. Stronger U.S. dollar and lower commodity prices are expected (and it will) to hurt the earnings of U.S. companies, increasing the chances of defaults, especially in energy.

iShares iBoxx $ High Yield Corporate Bond ETF (NYSE: HYG)
iShares iBoxx $ High Yield Corporate Bond ETF (NYSE: HYG)

The index’s energy exposure is 9.38%. Recently oil prices plunged to levels under $30. Energy companies borrowed a lot of debt during oil price boom, to increase production (so that they can gain more market share), are now being haunted by their own actions. A lot of energy companies are currently under an extreme pressure to make a dime, as oil prices plunge. According to law firm Haynes and Boone, 42 North American oil and gas producers filed for bankruptcy last year. Those 42 defaults account for approximately $17 billion in cumulative secured (over $9 billion) and unsecured debt (almost $8 billion).

2015 E&P Bankruptcy Filings Source: Law firm Haynes and Boone - Slide 5
2015 E&P Bankruptcy Filings
Source: Law firm Haynes and Boone – Slide 5

Out of those 42 bankruptcy filings, 18 of them come from Texas, a leading state in energy production. According to U.S. Energy Information Administration (EIA), Texas had a capacity of over 5.1 million barrels of crude oil per day and accounted for 29% of total U.S. refining capacity, as of January 2015, and accounted for about 29% of U.S. gas production in 2014.

In 2014, Texas gross domestic product (GDP) increased 5.2% year-over-year (Y/Y), the second greatest change in state GDP after North Dakota. Mining industry accounted for 1.25% increase to GDP, its largest contributor. Texas’s GDP accounted for 9.5% of U.S. total GDP in 2014.

The collapse of energy prices over the past several years are “fracking” down the Texas economy. The Dallas Federal Reserve’s general business activity index “collapsed” to -34.6 in January, the lowest reading since April 2009, when Texas was in recession. Same with company outlook index, it fell to -19.5 in January from -10.5 in December.

Texas Manufacturing Outlook Survey – General Business Conditions Source: Federal Reserve Bank of Dallas
Texas Manufacturing Outlook Survey – General Business Conditions
Source: Federal Reserve Bank of Dallas

The production index – a key measure of state manufacturing conditions – fell all the way from 12.7 in December to -10.2 in January. New orders index fell -9.2 in January from -7 in December.

Texas Manufacturing Outlook Survey – Business Indicators Source: Federal Reserve Bank of Dallas
Texas Manufacturing Outlook Survey – Business Indicators
Source: Federal Reserve Bank of Dallas

Employment Index, on the other hand, sharply dropped to -4.2 in January from 10.9 in December. Texas is a home to many energy giants, such as Schlumberger (NYSE: SLB), Halliburton (NYSE: HAL), Baker Hughes (NYSE: BHI), Exxon Mobil (NYSE:XOM), and ConocoPhillips (NYSE:COP). The companies slashed off tens of thousands of jobs over the past year and cut capex significantly, as the current stressed energy market heavily weighted on them.

In January 21, Schlumberger reported 38.7% decrease in fourth quarter revenue Y/Y, and net income declined substantially to a loss of $989 million, compared with profit of $317 million in the same period of 2014. Texas-based energy giant’s North American region 4th quarter revenue fell 54.79% to $1.9 billion from $4.3 billion in the same quarter of 2014. The company’s earnings announcement warned of a “deepening financial crisis in the E&P industry, and prompted customers to make further cuts to already significantly lower E&P investment levels. Customer budgets were also exhausted early in the quarter, leading to unscheduled and abrupt activity cancellations.” As a result of a weaker quarter and worsening conditions, they plan to lay off 10,000 workers, adding to already laid-off 34,000 workers, or 26% of its original workforce, since November 2014.

On Monday (January 25, 2016), Halliburton reported its fourth quarter earnings. Halliburton’s 4th quarter revenue fell 42% in Y/Y to $5.08 billion, including a 54.4% plunge to $2.1 billion in its North American region, which accounted for 42.4% of total revenue in 4Q.  On a GAAP basis, the Texas-based energy giant (and another one) reported a quarterly net loss of $28 million ($0.03 per share) compared with net income of $9.01 million ($1.06 per share) in the fourth quarter of 2014.

On Thursday (January 28, 2016), Baker Hughes reported a 48.85% decrease in fourth quarter revenue to $3.4 billion from $6.6 billion in the same period of 2014. On GAAP basis, the Texas-based energy giant (and another one) reported a quarterly net loss of $1 billion ($2.35 per share) compared with net income of $663 million ($1.52 per share) in the fourth quarter of 2014. Its North American region revenue fell 65.59% to $1.14 billion in the fourth quarter, compared with $3.30 billion in the fourth quarter of 2014.

Chevron Corp., (NYSE: CVX), California-based energy giant, posted its first loss since the third quarter of 2002 on Friday (January 29, 2016). It reported a fourth quarter loss of $588 million ($0.31 per share), compared with $3.5 billion ($1.85 per share) in the same period of 2014. During the same period, its revenue fell 36.5% to $29.25 billion from $46.09 billion.

Below is a graph by EIA, showing how the cost of debt service for U.S. oil producers has grown since 2012. In the second quarter of 2015, more than 80% of these producers’ cash flow went to service their outstanding debt, leaving very little cash to fund operations, to pay dividends, and to invest for the future. To adjust to those pains, the producers have significantly reduced capital expenditures.

Debt service uses a rising share of U.S. onshore oil producers’ operating cash flow Source: EIA
Debt service uses a rising share of U.S. onshore oil producers’ operating cash flow
Source: EIA

During the end of Q2 2015, oil prices were around $58. It’s currently at $38. Clearly, the situation has only gotten worse.

Both Exxon Mobil and ConocoPhillips will report its fourth quarter earnings next week.


I believe oil prices have hit bottom and it won’t break $27 this year.

Why do I say that?

I believe the market already priced in Iran’s entry into oil war. Recently, hedge fund bearish bets on oil were at all-time high (crowded trade). Crowed trade includes: a large numbers of participants who share similar beliefs and heavy short-term bag holders (speculators). I tend to take advantage of this types of situations.

Not only bearish bets on oil are at all-time high and not only I believe Iran is already priced in, but some OPEC countries, including Nigeria and Venezuela, already started calling for emergency meetings to try to cut production. I’m starting to believe that they can no longer handle the pain. While this is a political game – to gain and preserve more market share – it won’t last long enough to get oil breaking below $27. They can no longer bluff.

For many OPEC members, operating costs are around $30. With slowing global growth, they can’t afford to have even lower oil prices.

Conclusion: Oil has hit bottom and it won’t break below $27 this year. If you disagree with me, feel free to comment below.


Speaking of junk bonds, the energy sector makes up about a fifth of the high-yield bond index. Fitch Ratings forecast the US high yield energy sector default rate to hit 11% this year, “eclipsing the 9.7% rate seen in 1999.”

According to Fitch Ratings, at the beginning of December of last year, “$98 billion of the high yield universe was bid below 50 cents, while $257 billion was bid below 80 cents. The battered energy and metals/mining sectors comprise 78% of the total bid below 50 cents. In addition, 53% percent of energy, metals/mining companies rated ‘B-‘ or lower were bid below 50 at the start of December, compared to 16% at the end of 2014, reflecting the decline in crude oil prices.”

Not only energy companies will suffer, but also banks. The biggest U.S. banks – Morgan Stanley, Citigroup, Bank of America, Goldman Sachs, Wells Fargo, and JPMorgan Chase – have exposure to energy as part of their overall portfolios.

  • Morgan Stanley: Energy exposure assumed at 5% of total loans.
  • Citigroup: Energy exposure assumed at 3.3% of total loans.
  • Bank of America: Energy exposure assumed at 2.4% of total loans.
  • Goldman Sachs: Energy exposure assumed at 2.1% of total loans.
  • Wells Fargo: Energy exposure assumed at 1.9% of total loans.
  • JPMorgan Chase: Energy exposure assumed at 1.6% of total loans.

According to Fitch Ratings, exposure to energy sector were “cited as higher risk segments for the banks.”

The collapse in oil prices, strong U.S. dollar, and weakening global economy “crippled” manufacturers across the country. The Empire State manufacturing index fell to -19.4 in January from -6.2 in December, the lowest level since March 2009. The reading suggests manufacturing sector is slowing down and it raises questions about the outlook for the economy.

Manufacturing is very important to the U.S. economy. According to National Association of Manufacturers (NAM), there are 12.33 million manufacturing workers in the U.S., accounting for 9% of the nation’s workforce. Manufacturers recently contributed $2.18 trillion to the U.S. economy. “Taken alone, manufacturing in the United States would be the ninth-largest economy in the world.” according to NAM. For more facts and details, click here.

The manufacturing index have been below zero since July. Not only did the headline fell, but so did new orders index and shipments index. New orders fell 23.5 in January from -6.2 in December. Shipments fell -14.4 in January from 4.6 in December.

The Empire State Manufacturing Survey Source: Federal Reserve Bank of New York
The Empire State Manufacturing Survey
Source: Federal Reserve Bank of New York

Slump in new orders can shift the production into lower gear and possibly jeopardize jobs. The employment (number of employees) index continued to deteriorate for a fifth consecutive month. The weaknesses in the Empire State indexes suggests that the earnings of manufacturers are under pressure.

According to FactSet, the S&P 500 is expected to report a Y/Y decline in earnings of 5.7% for the fourth quarter. For Q4 2015, the blended earnings decline is -5.8%. A Y/Y decline in earnings for the fourth quarter will mark the first time S&P 500 has reported three consecutive quarters of Y/Y declines in earnings since Q1 2009 through Q3 2009.

For Q1 2016, 33 companies out of S&P 500, so far, have issued negative EPS guidance and 6 companies have issued positive EPS guidance.

Another drag on earnings can be the current inventories to sales ratio. Since early 2012, the ratio has been increasing.

Total Business: Inventories to Sales Ratio Source: Federal Reserve Bank of St. Louis
Total Business: Inventories to Sales Ratio
Source: Federal Reserve Bank of St. Louis

An increasing ratio is a negative sign because it shows companies may be having trouble keeping inventories down and/or sales have slowed. If they have too much of inventories, they may have to discount the products to clear their shelves, dragging on the earnings.

If you have any questions, feel free to contact me and/or leave comments below. Thank you.

Sneak peek of a future article that addresses one huge risk (lack of liquidity):

“With low liquidity in the bond market and increasing HFT transactions in it, the threat is real. Automated trades can trigger extreme price swings and the communication in these automated trades can quickly erode liquidity before you even know it, even though there is a very high volume. While liquidity in the U.S. bond market is high, it’s not high enough to battle the power of the technological progress.”

Houston (Fed), We Have A Problem (Problems) – Part 1/2

15 seconds and counting

12….11…10…9….IGNITION SEQUENCE START….6….5….4….3….2….1….0….ALL ENGINES RUNNING….LIFTOFF….WE HAVE A LIFTOFF!

The Fed finally raised rates after nearly a decade.  On December 16, the Fed decided to raise rates – for the first time since June 2006 – by 0.25%, or 25 basis points. It was widely expected by the markets and I only expected 10bps hike. Well, I was wrong on that.

The Federal Open Market Committee (FOMC) unanimously voted to set the new target range for the federal funds rate at 0.25% to 0.50%, up from 0% to 0.25%. In the statement, the policy makers judged the economy “has been expanding at a moderate pace.” Labor market had shown “further improvement.” Inflation, on the other hand, has continued to “run below Committee’s 2 percent longer-run objective” mainly due to low energy prices.

Remember when the Fed left rates unchanged in September? It was mainly due to low inflation. What’s the difference this time?

In September, the Fed clearly stated “…surveybased measures of longer-term inflation expectations have remained stable.”

Now, the Fed clearly states “…some survey-based measures of longer-term inflation expectations have edged down.”

So…umm…why did they raise rates this time?

Here is a statement comparison from October to December:

Fed Statment Comparation – Oct. to Dec. Source: WSJ
Fed Statement Comparison – Oct. to Dec.
Source: WSJ

On the pace of rate hikes looking forward, the FOMC says:

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

They clearly stated one of the things they look for, which is inflation expectations. But, they also did state that “inflation expectations have edged down.”

It seems to me that the Fed did not decide to raise rates. The markets forced them. Fed Funds Futures predicted about 80% chance of a rate-hike this month. If the Fed did not raise rates, they would have lost their credibility.

I believe the Fed will have to “land” (lower back) rates this year, for the following reasons:

  • Growing Monetary Policy Divergence

On December 3, European Central Bank (ECB) stepped up its stimulus efforts. The central bank decided to lower deposit rates by 0.10% to -0.30%. The purpose of lower deposit rates is to charge banks more to store excess reserves, which stimulates lending. In other words, free money for the people so they can spend more and save less.

ECB also decided to extend Quantitative Easing (QE) program. They will continue to buy 60 billion euros ($65 billion) worth of government bonds and other assets, but until March 2017, six months longer than previously planned, taking the total size to 1.5 trillion euros ($1.6 trillion), from the previous $1.2 trillion euros package size. During the press conference, ECB President Mario Draghi said the asset eligibility would be broadened to include regional and local debt and signaled QE program could be extended further if necessary.

ECB might be running out of ammunition. ECB extending its purchases to regional and local debt raises doubts about its program.

Not only ECB is going the opposite direction of the Fed. Three weeks ago, Bank of Japan (BoJ) announced a fresh round of new stimulus. The move was hardly significant, but it is still a new round of stimulus. The central bank decided to buy more exchange-traded fund (ETF), extend the maturity of bonds it owns to around 7-12 years from previously planned 7-10 years, and increase purchases of risky assets.

I previously stated in “Central Banks Smash: No Growth, No Inflation“,

The extensions of its QE are beginning to become routine or the “new normal”.

Japan's ETF Market - BoJ's holdings Source: Bloomberg
Japan’s ETF Market – BoJ’s holdings
Source: Bloomberg

The move by BoJ exposes the weakness of its past actions. It suggests the bank is also out of ammunition. Already owning 52% or more of the Japan’s ETF market and having a GDP-to-Debt ratio around 245%, it is only a matter of time before Japan’s market crashes. Cracks are already beginning to be shown. I expect the market crash anytime before the end of 2019.

So, what are the side-effects of these growing divergence?

For example, the impact of a US dollar appreciation resulting from a tightening in US monetary policy and the impact of a depreciation in other currencies resulting from easing in its monetary policies. Together, these price changes will shift global demand – away from goods and services produced here in the U.S. and toward those produced abroad. In others words, US goods and services become more expensive abroad, leading to substitution by goods and services in other countries. Thus, it will hurt the sales and profits of U.S. multinationals. To sum up everything that is said in this paragraph, higher U.S. rates relative to rates around the global harms U.S. competitiveness.

  • Emerging Markets

Emerging markets were trouble last year. It is about to get worse.

International Monetary Fund (IMF) decided to include China’s currency, renminbi (RMB) or Yuan, to its Special Drawing Rights (SDR) basket, a basket of reserve currencies. Effective October 1, 2016, the Chinese currency is determined to be “freely usable” and will be included as a fifth currency, along with the U.S. dollar, euro, Japanese yen, and pound sterling, in the SDR basket.

“Freely useable” – not so well defined, is it?

Chinese government or should I say People’s Bank Of China (PBOC), cannot keep its hands off the currency (yuan). It does not want to let market forces take control. They think they can do whatever they want. As time goes on, it is highly unlikely. As market forces take more and more control of its exchange-rate, it will be pushed down, due to weak economic fundamentals and weak outlook.

China, no need to put a wall to keep market forces out. Let the market forces determine the value of your currency. It is only a matter of time before they break down the wall.

In August, China changed the way they value their currency. PBOC, China’s central bank, said it will decide the yuan midpoint rate based on the previous day’s close. In daily trading, the yuan is allowed to move 2% above or below the midpoint rate, which is called the daily fixing. In the past, the central bank used to ignore the daily moves and do whatever they want. Their decision to make the midpoint more market-oriented is a step forward, but they still have a long way to go.

China saw a significant outflows last year. According to Institute of International Finance (IFF), an authoritative tracker of emerging market capital flows, China will post record capital outflows in 2015 of more than $500 billion. The world’s second largest economy is likely to see $150 billion in capital outflow in the fourth quarter of 2015, following the third quarter’s record $225 billion.

Ever since the devaluation in August, PBOC has intervened to prop yuan up. The cost of such intervention is getting expensive. The central bank must spend real money during the trading day to guide the yuan to the level the communists want. Where do they get the cash they need? FX reserves.

China’s foreign-exchange reserves, the world’s largest, declined from a peak of nearly $4 trillion in June 2014 to just below $3.5 trillion now, mainly due to PBOC’s selling of dollars to support yuan. In November, China’s FX (forex) reserves fell $87.2 billion to $3.44 trillion, the lowest since February 2013 and largest since a record monthly drop of $93.9 billion in August. It indicates a pick-up in capital outflows. This justifies increased expectations for yuan depreciation. Since the Fed raised rates last month, I would not be surprised if the capital flight flies higher, leading to a weaker yuan.

China Reserves Source: Capital Economics
China Reserves
Source: Capital Economics

Depreciation of its currency translates into more problems for “outsiders,” including emerging markets (EM). EMs, particularly commodities-linked countries got hit hard last year as China slowed down and commodity prices slumped. EMs will continue to do so this year, 2016.

The anticipation of tightening in the U.S. and straightening dollar put a lot of pressure on EM. EM have seen a lot of significant capital outflows because they carry a lot of dollar denominated debt. According to the October report from IFF, net capital flows to EM was negative last year for the first time in 27 years (1988). Investors are estimated to pull $540 billion from developing markets in 2015. Foreign inflows will fall to $548 billion, about half of 2014 level and lower than levels recorded during the financial crisis in 2008. Foreign investor inflows probably fell to about 2% of GDP in emerging markets last year, down from a record of about 8% in 2007.

Capital Flows to Emerging Markets, Annual Data Source: IFF
Capital Flows to Emerging Markets, Annual Data
Source: IFF, taken from Bloomberg

Also contributing to EM outflows are portfolio flows, “the signs are that outflows are coming from institutional investors as well as retail,” said Charles Collyns, IIF chief economist. Investors in equities and bonds are estimated to have withdrawn $40 billion in the third quarter, the worst quarterly figure since the fourth quarter of 2008.

A weaker yuan will make it harder for its main trading partners, emerging markets and Japan, to be competitive. This will lead to central banks of EM to further weaken their currencies. Japan will have no choice but to keep extending their QE program. And to Europe. And to the U.S.      DOMINO EFFECT

Why are EMs so important? According to RBS Economics, EMs have accounted for 50%-60 of global output and 70% of global economic growth each year since the 2008 crisis.

Emerging Markets Share of Global Economy Source: RBS Economics
Emerging Markets Share of Global Economy
Source: RBS Economics

Some EM investors, if not all, will flee as U.S. rates rise, compounding the economic pain there. Corporate debt in EM economies increased significantly over the past decade. According to IMF’s Global Financial Stability report, the corporate debt of non-financial firms across major EM economies increased from about $4 trillion in 2004 to well over $18 trillion in 2014.

Figure 3.1. Emerging Market Economies Evolving Capital
EM Corporate Debt and Market Cap. Source: IMF – Page 84

When you add China’s debt with EM, the total debt is higher than the market capitalization. The average EM corporate debt-to-GDP ratio has also grown by 26% the same period.

EM Corporate Debt (percent of GDP) - Page 84
EM Corporate Debt (percent of GDP) – Page 84

The speed in the build-up of debt is distressing. According to Standard & Poor’s, corporate defaults in EM last year have hit their highest level since 2009, and are up 40% year-over-year (Y/Y).

Corporate Defaults Source: WSJ
Corporate Defaults
Source: WSJ

According to IFF (article by WSJ), “companies and countries in EMs are due to repay almost $600 billion of debt maturing this year….of which $85 is dollar-denominated. Almost $300 billion of nonfinancial corporate debt will need to be refinanced this year.”

I would not be surprised if EM corporate debt meltdown triggers sovereign defaults. As yuan weakens, Japan will be forced to devalue their currency by introducing me QE which leaves EMs with no choice. EMs will be forced to devalue their currency. Devaluations in EM currencies will make it much harder (it already is) for EM corporate borrowers to service their debt denominated in foreign currencies, due to decline in their income streams. Deterioration of income leads to a capital flight, pushing down the value of the currency even more, which leads to much more capital flight.

Let IMF explain the situation in EM,

“Firms that have borrowed the most stand to endure the sharpest rise in their debt-service costs once interest rates begin to rise in some advanced economies. Furthermore, local currency depreciations associated with rising policy rates in the advanced economies would make it increasingly difficult for emerging market firms to service their foreign currency-denominated debts if they are not hedged adequately. At the same time, lower commodity prices reduce the natural hedge of firms involved in this business.”

According to its Global Financial Stability report, EM companies have an estimated $3 trillion in “overborrowing” loans in the last decade, reflecting a quadrupling of private sector debt between 2004  and 2014.

EM Corporate Bond Composition (Billions of U.S. dollars) - Page 86
EM Corporate Bond Composition
(Billions of U.S. dollars) – Page 86
Private Sector Debt to GDP (Percent - Page 11
Private Sector Debt to GDP
(Percent – Page 11

Rising US rates and a strengthening dollar will make things much worse for EMs. Jose Vinals, financial counsellor and director of the IMF’s Monetary and Capital Markets Department, said in his October article, “Higher leverage of the private sector and greater exposure to global financial conditions have left firms more susceptible to economic downturns, and emerging markets to capital outflows and deteriorating credit quality.”

I believe currency war will only hit “F5” this year and corporate defaults will increase, leading to the early stage of sovereigns’ defaults. I would not be surprised if some companies gets a loan denominated in euros just to pay off the debt denominated in U.S dollars. That’s likely to make things worse.

Those are some of the risks I see that will force the Fed to lower back the rates.  I will address more risks, including lack of liquidity, junk bonds, inventory, etc, in my next article. Thank you.

EXTRA: Market reactions,

EUR/USD:

EUR/USD - Hourly Chart
EUR/USD – Hourly Chart

USD/JPY:

USD/JPY - Hourly
USD/JPY – Hourly

10-Year Treasury Index:

10-Year Treasury Index (TNX on thinkorswim platform) - Hourly
10-Year Treasury Index ( “TNX” on thinkorswim platform) – Hourly

2-Year U.S. Treasury Note Futures:

2-Year U.S. Treasury Note Futures ( "/ZT" on thinkorswim platform) - Hourly
2-Year U.S. Treasury Note Futures ( “/ZT” on thinkorswim platform) – Hourly

Central Banks Smash: No Growth, No Inflation

European Central Bank:

On October 22 (Thursday), European Central Bank (ECB) left rates unchanged, with interests on the main refinancing operations, marginal lending, and deposit rate at 0.05%, 0.30% and -0.20, respectively. But the press conference gave an interesting hint. Mario Draghi, the President of ECB, was most dovish as he could be, “work and assess” (unlike “wait and see” before).

The central bank is preparing to adjust “size, composition and duration” of its Quantitative Easing (QE) program at its December meeting, “the degree of monetary policy accommodation will need to be re-examined at our December monetary policy meeting”, Draghi said during the press conference. They are already delivering a massive stimulus to the euro area, following decisions taken between June 2014 and March 2015, to cut rates and introduce QE program. In September 2014, ECB cut its interest rate, or deposit rate to -0.20%, a record low. Its 1.1 trillion euros QE program got under way in March with purchases of 60 billion euros a month until at least September 2016.

When ECB cut deposit rate to record low in September 2014, Mr. Draghi blocked the entry to additional cuts, “we are at the lower bound, where technical adjustment are not going to be possible any longer.” (September 2014 press conference). Since then, growth hasn’t improved much and other central banks, such as Sweden and Switzerland, cut their interest rates into much lower territory. Now, another deposit rate-cut is back, “Further lowering of the deposit facility rate was indeed discussed.” Mr. Draghi said during the press conference.

The outlook for growth and inflation remains weak. Mr. Draghi – famous for his “whatever it takes” line – expressed “downside risks” to both economic growth and inflation, mainly from China and emerging markets.

Given the extent to which the central bank provided substantial amount of stimulus, the growth in the euro area has been disappointing. The euro area fell into deflation territory in September after a few months of low inflation. In September, annual inflation fell to 0.1% from 0.1% and 0.2% in August and July, respectively. Its biggest threat to the inflation is energy, which fell 8.9% in September, down from 7.2% and 5.6% in August and July, respectively.

Inflation Rate - Annual Percentage Change Source: Eurostat
Inflation Rate – Annual Percentage Change
Source: Eurostat

Europe’s economy will slow down due to export demand decreasing from China and emerging countries, where a quarter of all euro-zone exports gets shipped to.

As the ECB left the door open for more QE, Euro took a dive. Euro took a deeper dive when Mr. Draghi mentioned that deposit rate-cut was discussed. Deposit rate cut will also weaken the euro if implemented. After the press conference, the exchange rate is already pricing in a rate-cut. Mentions of deposit rate-cut and extra QE sent European markets higher and government bond yields fell across the board. The Euro Stoxx 50 index climbed 2.6%, as probability of more easy money increased. Swiss 10-year yield fell to fresh record low of -0.3% after the ECB press conference. 2-year Italian and Spanish yields went negative for the first time. 2-year German yield hit a record low of -0.32.

Regarding the exchange rate (EUR/USD), I expect it to hit a parity level by mid-February 2016.

As I stated in the previous posts, I expect more quantitative easing by ECB (and Bank of Japan also). I’m expecting ECB to increase its QE program to 85 billion euros a month and extend it until March 2017. When ECB decides to increase and extend the scope of its QE, I also expect deposit rate-cut of 10 basis points.

ECB will be meeting on December 3 when its quarterly forecasts for inflation and economic growth will be released. The only conflict with this meeting is that U.S. Federal Reserve policy makers meets two weeks later. ECB might hold off until the decision of the Fed, but the possibility of that is low.

EUR/USD Reaction:

EUR-USD - ECB Press Conference - Nov 1 2015
EUR/USD – Hourly Chart

U.S. Federal Reserve:

On October 28 (Wednesday), the Federal Reserve left rates unchanged. The bank was hawkish overall. It signaled that rate-hike is still on the table at its December meeting and dropped previous warnings about the events abroad that poses risks to the U.S. economy.

It does not make sense to drop “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” (September statement) I’m sure the events abroad has its risks (spillover effect) to the U.S. economy and the Fed will keep an eye on them.

In its statement, it said the U.S. economy was expanding at a “moderate pace” as business capital investments and consumer spending rose at “solid rates”, but removed the following “…labor market continued to improve…” (September statement). The pace of job growth slowed, following weak jobs report in the past several months.

Let’s take a look at the comparison of the Fed statement from September to October, shall we?

Fed Statment Comparation - Sept. to Oct. Source: http://projects.wsj.com/fed-statement-tracker/
Fed Statment Comparation – Sept. to Oct.
Source: http://projects.wsj.com/fed-statement-tracker/

The Fed badly wants to raise rates this year, but conditions here and abroad does not support its mission. Next Federal Open Market Committee (FOMC) meeting takes place on December 15-16. By then, we will get important economic indicators including jobs report, Gross Domestic Product (GDP), retail spending and Consumer Price Index (CPI). If we don’t see any strong rebound, rate-hike is definitely off the table, including my prediction of 0.10% rate-hike for next month.

The report caused investors to increase the possibility of a rate increase in December. December rate-hike odds rose to almost 50% after the FOMC statement.

Greenback (US Dollar) Reaction:

U.S. Dollar ( "/DX" on thinkorswim platform) - Hourly Chart
U.S. Dollar ( “/DX” on thinkorswim platform) – Hourly Chart

 

Reserve Bank of New Zealand:

On October 28 (Wednesday), Reserve Bank of New Zealand (RBNZ) left rates unchanged at 2.75% after three consecutive rate-cuts since June. The central bank’s Governor Graeme Wheeler said that at present “it is appropriate to watch and wait.” “The prospects for slower growth in China and East Asia” remains a concern.

Housing market continues to pose financial stability risk. House price inflation is way higher. Median house prices are about nine times the average income. Short supply caused the house prices to increase significantly. “While residential building is accelerating, it will take some time to correct the supply shortfall.” RBNZ said in a statement. Auckland median home prices rose about 25.4% from September 2014 to September 2015, “House price inflation in Auckland remains strong, posing a financial stability risk.”

Further reduction in the Official Cash Rate (OCR) “seems likely” to ensure future CPI inflation settles near the middle of the target range (1 to 3%).

Although RBNZ left rates unchanged, Kiwi (NZD) fell because the central bank sent a dovish tone, “However, the exchange rate has been moving higher since September, which could, if sustained, dampen tradables sector activity and medium-term inflation. This would require a lower interest rate path than would otherwise be the case.” It’s a strong signal that RBNZ will cut rates to 2.5% if Kiwi continues to strengthening. I will be shorting Kiwi every time it strengthens.

“The sharp fall in dairy prices since early 2014 continues to weigh on domestic farm incomes…However, it is too early to say whether these recent improvements will be sustained.” RBNZ said in the statement. Low dairy prices caused RBNZ to cut rates. New Zealand exports of whole milk powder fell 58% in the first nine months of this year, compared with the same period in 2014. But, there’s a good news.

Recent Chinese announcement that it would abolish its one-child policy might just help increase dairy prices, as demand will increase. How? New Zealand is a major dairy exporter to China. Its milk powder and formula industry is likely to benefit from a baby boomlet in China.

NZD/USD Reactions:

NZD/USD - Hourly Chart
NZD/USD – Hourly Chart

 

Bank of Japan:

On October 30 (Friday), Bank of Japan (BoJ) maintained its monetary policy unchanged and downgraded its growth and inflation projections. BoJ left – by 8-1 majority vote – its QE program at current level of 80 trillion yen (about $660 billion) a year.

BoJ expects to hit its 2% inflation target in late 2016 or early 2017 vs. previous projection of mid-2016. Again and Again. This is the second time BoJ changed its target data. The last revision before this week was in April. It also lowered its growth projections for the current year by 0.5% to 1.2%.

They also lowered projections for Core-CPI, which excludes fresh food but includes energy. They lowered their forecasts for this fiscal year to 0.1%, down from a previous estimate of 0.7%. For the next fiscal year, they expect 1.4%, down from a previous estimate of 1.9%. Just like other central banks, BoJ acknowledged that falling energy prices were hitting them hard.

Low inflation, no economic growth, revisions, revisions, and revisions. Nothing is recovering in Japan.

Haruhiko Kuroda, the governor of BoJ, embarked on aggressive monetary easing in early 2013. So far he hasn’t had much success.

In the second quarter (April-June), Japan’s economy shrank at an annualized 1.2%. Housing spending declined 0.4% in September from 2.8% in August. Core-CPI declined for two straight months, falling 0.1% year-over-year both in September and August. Annual exports only rose 0.6% in September, slowest growth since August 2014, following 3.1% gain in August.

Exports are part of the calculation for Gross Domestic Product (GDP). Another decline in GDP would put Japan into recession, which could force BoJ to ease its monetary policy again. Another recession would be its fourth since the 2008 financial crisis and the second since Shinzo Abe (Abenomics), the Prime Minister of Japan, came to power in December 2012.

Its exports to China, Japan’s second-biggest market after the U.S., fell 3.5% in September. The third-quarter (July-September) GDP report will be released on November 16.

April 2014 sales tax (sales tax increased from 5% to 8%) increase only made things worse in Japan. It failed to boost inflation and weakened consumer sentiment.

In April 2013, BoJ expanded its QQE (or QE), buying financial assets worth 60-70 trillion yen a year, including Exchange Traded Funds (ETF).

QQE stands for Quantitative and Qualitative Easing. Qualitative easing targets certain assets to drive up their prices and drive down their yield, such as ETF. Quantitative Easing targets to drive down interest rates. Possibility of negative interest rates has been shot down by BoJ. But, why trust BoJ for their word? Actions speak louder than words.

In October 2014, BoJ increased the QQE to an annual purchases of 80 trillion yen. When is the next expansion? December?

Did you know that the BoJ owns 52% of Japan’s ETF market?

Japan's ETF Market - BoJ's holdings Source: Bloomberg
Japan’s ETF Market – BoJ’s holdings
Source: Bloomberg

For over a decade, BoJ’s aggressive monetary easing through asset purchases did not help Japan’s economy. Since 2001, the central bank operated 9 QEs and is currently operating its current 10th QE (or QQE). The extensions of its QE are beginning to become routine or the “new normal.”

Growth and prices are slowing in China, with no inflation in United Kingdom, Euro-zone, and the U.S. The chances that Japan will crawl out of deflation are very slim.

USD/JPY Reaction:

USD/JPY - Hourly Chart
USD/JPY – Hourly Chart

US Market Reactions (ECB and FOMC):

S&P 500 ("SPX") - Hourly Chart
S&P 500 (“SPX”) – Hourly Chart

 

Next week, both Reserve Bank of Australia (RBA) and Bank of England (BoE) will meet. Will be very interesting to watch.

Global Markets Crash + Asian Crisis Part 2

Global markets crash. Currency wars. What’s next? Good buying opportunity?

US markets: Markets plunged dramatically on Friday. The Dow Jones Industrial Average fell 530.94 points (3.12%), the worst one-day loss since November 2011 (on a % basis). The index is now down 10.2% (correction territory) below the May 19 closing and all-time high of 18,312, for the first time since 2011. For the week, the index is down 5.8%, the steepest decline since September 2011.

S&P 500 fell 64.84 points (3.19%), the worst one-day loss since November 2011 (on a % basis) and falling below 2,000 level for the first time since February. For the week, the index is also down 5.8%, the steepest decline since September 2011.

NASDAQ fell 171.45 (3.52%). For the week, the index is down 6.8%, the biggest weekly decline since August 2011.

European Markets: European stocks fell into correction territory on Friday. The Stoxx European 600 1.3% to 368.59. The index is down 11% from April 15 closing and all-time high of 414.06. For the week, the index is down 4.6%, the worst weekly performance since December. Other indexes fell into correction territory also. Germany’s DAX Index is down 18% from its highs. So far, 13 out of 18 western-European markets have lost 10% or more from their highs.

US oil prices fell just below $40 for the first time since February 2009, due to demand concerns and increasing supplies. US oil prices fell for their 8th consecutive week, the longest losing streak since 1986.

The CBOE Market Volatility Index (VIX) (also known as “Fear Index”) jumped 46.45% to $28.03 on Friday. For the week, the index rose 118.47% (from $12.83 to $28.03), largest % move ever in a week.


Three factors driving the free-fall of the global markets:

  • Growing concerns (or uncertainty) about China’s economy
  • US rate-hike uncertainty. Uncertainty is the market’s worst foe
  • Plunging oil prices

There are concerns about slowing growth in emerging economies, particularly China. Economic data from China showed manufacturing PMI in China fell to a 77-month low of 47.1 in August, down from July’s final reading of 47.8. A reading below 50 represent a contraction. About two weeks ago, China’s trade data showed that July exports declined by 8.3% year-over-year (Y/Y) due to a strong yuan and lower demand from its trading partners. Exports to the Japan, European Union, and United States fell 13%, 12.3%, and 1.3%, respectively. Exports are China’s strongest growth machine. The weakness in the fundamentals started (still is) putting pressures on policymakers. Then, a surprise move came.

On August 11 (days after the exports data), the People’s Bank of China (PBOC) made a surprising move to devalue its currency (so called “one-time” move), the renminbi (RMB) (or yuan), against the US dollar (greenback) by 1.9%, the biggest devaluation since 1994 and first devaluation since the yuan was de-pegged from the dollar in 2005. PBOC decided to lower daily reference rate – which sets the value of yuan against the greenback – to make yuan more market-oriented exchange rate.

Three reasons behind China’s move:

  • Weak fundamentals, including exports
  • Desire to be included in IMF SDR basket
  • Impending US rate-hike

China’s move increased concerns over the health of its economy (second largest economy in the world) and shocked the global markets which continues today. China’s devaluation signaled that the economy there must be worse than what everybody believes. Continuous slowdown as it shifts from an export-led economy to a consumer-led economy has led Chinese government (or PBOC) to help stimulate economic activity. Over the past year, they cut interest rates four times and cut RRR (Reserve Requirement Ratio) several times. The goal is to combat slowing growth by strengthening liquidity and boosting lending (so far, unsuccessful). The recent devaluation will make imports expensive and help boost exports (reminder: exports fell 8.3% Y/Y in July).

Another reason behind China’s recent move is its desire for the yuan to be included in the International Monetary Fund’s (IMF) Special Drawing Rights (SDR), a basket of reserve currencies, in which the US Dollar, Euro, Japanese Yen, and British Pound are part of. Earlier this week, IMF decided to extend its scheduled revision of SDR basket (revision takes place every five years) by nine months (to September 30, 2016), giving China more time to make yuan (or Renminbi ) “freely usable”, a key requirement join the SDR basket.

Last reason behind China’s recent move is impending rate-hike in the US, which would support the greenback and would have consequences for China. The recent devaluation ended the era of Yuan appreciation which began in 2005 (reminder: yuan was de-pegged from the dollar in 2005). Ever since “Strong Yuan” policy began in 2005, Yuan (CNY) appreciated 28% against the US Dollar (USD), 30% against the Euro (EUR), and 65% against the Japanese Yen (JPY)

Rise of Yuan against most of its trading partners’ currencies has made its trading partners exports attractive. US rate-hike would have made China’s export rivals even more attractive. Now that China devalued its currency in the wake of falling exports (reminder: exports fell 8.3% Y/Y in July), its trading partners would want to protect their exports share. Therefore, China has fired the first shot to start currency wars.

Consequences of China’s actions:

Countries like Australia, Thailand, New Zealand, Malaysia and Canada are likely to suffer from China’s devaluation. These countries are largest exporter to China. Don’t also forget that these countries can affect other countries. Basically, it is “Domino Effect” economically.

Earlier this week, Kazakhstan – whose top trading partners are China and Russia – switch to a free float (which means that the central bank stopped managing the exchange rate), causing its currency, the tenge (KZT), to fall 25%. The move comes due to three reasons; crude prices (Kazakhstan is central Asia’s biggest crude exporter) fell 55% in the past year, Russian has allowed its currency (ruble) to depreciate significantly as commodity prices plummeted, and due to the yuan devaluation. The motivation for the move is to preserve its export competitiveness.

Vietnam has also allowed its currency, the dong, to weaken further due to the recent devaluation by its biggest trading partner, China. Who will be next to devalue their currency in this crisis; Asian Crisis Part 2.

Commodities denominated in US dollars will become more expensive to buyers in China, the world’s largest consumer of raw materials. When China’s economy slows, demand for raw materials, such as copper, Iron-ore, etc decreases and the lower demand puts downward pressure on commodity prices.

China, second-largest oil consumer, is causing oil prices to drop non-stop, which will hurt oil exporters, such as Canada (possibly leading to another rate-cut).

Falling commodity prices mean one other thing; deflationary pressures.

Slow growth and lower commodity prices most likely will lead other central banks, especially large commodity exporters to maintain their easy monetary policies for longer. Countries with large current account deficits and/or corporations with large amount of debt denominated in US dollars could see their economic/financial conditions worsen, causing them to further increase/expand their easy monetary policy (rate-cuts, for example). Not only commodity exporters and emerging countries will suffer, but also US companies.

US companies with significant exposure to China will suffer from China’s devaluation. Such companies are Wynn Resorts, Micron Technology, Yum Brands, and Apple, accounting for China sales exposure of 70%, 55%, 52% and 30%, respectively.


When I noticed China economic getting worse earlier this year, I knew Apple depended on China a lot, so I said that Apple was overvalued as more competitors were emerging and China’s economy was about to get worse. Even though Apple’s earnings came out better than expected, I went ahead on twitter and responded to Carl Icahn’s comments on the Apple and the market. He expected (maybe still expects) Apple’s stock price to double, which I did not (and I still don’t). More competitors are starting to emerge and China’s economic conditions are getting worse (debt bubble coming).

Mr. Icahn believed the market was extremely overheated and expected market bubble. I have to agree with him. I preferred (still prefer) to use the term “correction”. At this time, I believe current market sell-off is temporary and the dust will be settled in a month (good-buying opportunity). I expect “market bubble” after the Fed raises interest rates to the range of 0.70% and 0.80% (early 2017?). That’s when market sell-off will be much worse than the current situation.

I’m calling Mr. Icahn to respond to my questions; how do you think China’s action will affect global economies (or markets)? Do you still think Apple could double in price?


Now, let’s get back to how else China can affect global economies (deflationary pressures). I expect Europe’s economy and Japan’s economy to slow down.

Europe’s economy will slow down due to export demand decreasing and the uncertainty created by Greece (Yes, they did get a bailout deal, but it’s not over). That’s why I believe European Central Bank (ECB) will either lower interest rates even further or they will increase current Quantitative Easing (QE) program, pushing Euro currency lower. Current falling prices in the European markets are a golden opportunity. Lower interest rates and/or increased QE program will send European equity prices higher>>>all-time highs will be made.

Japan, China’s largest trading partner, will also suffer due to export demand decreasing. The devaluation of yuan (or, Renminbi) will make Japanese exports less competitive. Japan’s economy is still suffering despite Abenomics (similar to QE). Recent data showed GDP (Gross Domestic Product) falling at annual pace of 1.6% in 2nd quarter, due to slowing exports and lack of consumer spending. Abenomics has failed. Additional monetary easing coming? If the economy does not get any better in the next several months, I expect additional monetary easing by the Bank of Japan (BoJ).

I don’t believe the Federal Reserve will stop its plan to hike the rates, but it will slow the pace of it. On Wednesday (August 19), Fed minutes of July meeting (leaked earlier) showed that Federal Open Market Committee (FOMC) members “…judged that the conditions for policy firming had not yet been achieved, but they noted that conditions were approaching that point.” They also said that “…the recent decreases in oil prices and the possibility of adverse spillovers from slower economic growth in China raised some concerns.” US dollar has been falling ever since the release of fed minutes, as expectations for September rate-hike decreased.

Now more troubles emerged, I wonder what the Fed will say or do. There are many US economic reports that will come until the Fed’s September meeting. The reports will decide the fate of rate-hike for September. At this time, I expect the Fed to hike the rates in September by 10 basis points (or 0.10%).

If the current China situation (or Asian Crisis Part 2) gets out of control, there will be no rate-hike for the rest of year even if there’s strong US economic reports.

All comments welcomed. Thank you.


Disclaimer: The posts are not a recommendation to buy or sell any stocks, currencies, etc mentioned. They are solely my personal opinions. Every investor/trader must do his/her own due diligence before making any investment/trading decision.