Chinese Financial Conditions Loosening As Economy Slows

It does appear that the Chinese government is now loosening monetary conditions in the country in a bid to combat a slowing economy and heightened trade tensions with the United States. This comes as a deviation from Beijing's financial de-leveraging / de-risking campaign, which has been ongoing since late 2016.

The Chinese economy has been showing signs of fatigue as the first half of 2018 has come to a close.

Source: China National Bureau of Statistics

Investment in real-estate in China weakened for a third consecutive month to 9.7% growth in the year of 2018 through June. While this was above the 2017-through-June value of 8.5%, it marked a drop of 0.5 percentage points month-on-month, and the metric is now 0.7 percentage points lower from a peak of 10.4% growth in the first three months of the year, in annualized terms.

Source: China National Bureau of Statistics

In another concerning sign, the new orders portion of the China non-manufacturing purchasing managers' index (PMI) recorded its second consecutive fall in June to a value of 50.6. The 50.0 mark separates expanding activity (above 50) from contracting activity (below 50). In this instance, new orders are still expanding, but just barely as the metric floats above the threshold.

The drop-off in June appears to have been rather pronounced, with the new orders index falling 0.4 points to 50.6. It could be argued that Chinese companies and individuals became concerned with the escalating trade rhetoric from the United States in May and June, and therefore fewer new orders were submitted. The PMI data for July will be watched keenly for signs of continued falls in this new orders index, as early July marked the first implementation of U.S. tariffs on $34 billion of Chinese goods, with immediate Chinese retaliation of the same magnitude.

The Chinese economy has been heavily reliant on credit to maintain high growth rates since the global financial crisis, and this has left it with a substantial debt load.

Data from BIS

From the first quarter of 2015 to the first quarter of 2017, total private non-financial sector credit (all sectors) as a percentage of GDP jumped from roughly 190% of GDP to over 210% of GDP- quite an acceleration for the world's second-largest economy.

In late 2016, the Chinese government announced its intention to pursue a campaign of financial deleveraging and de-risking, an effort that authorities hoped would lower debt levels and close out opaque areas of financing, namely the shadow banking sector. As this campaign has plowed on, debt as a percent of GDP has fallen from a peak of 211.1% in the first quarter of 2017 to 189.8% in the first quarter of 2018.

That improvement, while still leaving the debt nearly double the annual output of the Chinese economy, is nothing to shake a stick at. This deleveraging campaign has put a dent in the credit-hungry habits of Chinese corporations and local governments (households maintain a debt-to-GDP ratio of less than 50%, per the BIS). This progress has come at the cost of economic growth, as the above data show. The side effect of a slowing economy was expected, as credit dried up and firms that truly relied on cheap credit to function began to struggle, but the slowing economy is now testing the resolve of the authorities. Beijing can either choose to continue tightening financial conditions and continue ahead with the deleveraging campaign, or the government may opt to pause the campaign and loosen monetary conditions to keep economic growth elevated, hoping that the stimulus does not destabilize the economy through asset price bubbles or other factors.

It now appears that Beijing has chosen to go with the latter option, as onshore financial conditions have undoubtedly eased during the first half of 2018. For evidence of this, we begin with interbank lending rates in China, benchmarked by the Shanghai Interbank Offered Rates or SHIBOR.

Source: Shibor.org

Traditionally, across global interbank lending markets, higher rates are a potential sign of stress, as banks may become less willing to lend to each other, thereby increasing the interest rates. Similarly, a flood of cheap credit may make banks rather lax about lending money, knowing their financial system is awash in liquidity (at least on the surface), and thus they reduce the interest rates at which they're willing to lend money.

The most-watched slice of the interbank rates is the overnight tenor, abbreviated above as O/N. This is the interest rate Chinese banks are charging each other to lend money simply for the overnight period. In the U.S., such overnight lending is primarily used for banks to maintain certain capital thresholds at the end of the day, for regulatory purposes. While I would assume the same can be said in China, I cannot say this for certain.

In any case, across tenors, interest rates have been falling. This trend has been most pronounced in the longer-term tenors, where rates are more stable. In particular, the interbank lending rates for periods exceeding 1 week (abbreviated as 1W above) really plunged around late-May or early-June, just eyeballing the graphs. I expect that these lower interbank interest rates surfacing around the time of escalating trade tensions with the United States is not a coincidence in the slightest, and instead is an effort by the Chinese government to cushion enterprises against any outsize effects from the U.S. tariffs.

Lending rates across all tenors, including overnight, have recently been falling yet again, with interest rates at the two-week period and beyond reaching >five month lows. This is another symptom of further monetary easing engineered by the Chinese government, which is now seeking to toe the line between supporting economic growth and deterring a resurgence of risk appetite as credit is re-introduced to the system. With trade tensions remaining elevated and the U.S. threatening tariffs on practically all of its imports from China, Beijing will likely continue keeping the deleveraging campaign in a holding pattern, instead preferring to support the economy via stimulus measures (both monetary and fiscal).

Source: AsianBondsOnline

Chinese local-currency sovereign bond yields have also recorded significant drops across the entire yield curve year-to-date, again a symptom of financial conditions easing instead of tightening. In an environment of tightening financial conditions, yields on bonds increase as credit in the financial system dries up, making money less readily available and thus placing a premium on attaining such money. This had been a feature of the Chinese financial system from late 2016 to early 2018, when the 10-year sovereign bond yield peaked at just over 4.00%, but since then yields on these bonds have fallen.

The yield curve can be used to determine the cause of these falling interest rates. Recall that interest rates in the longer-term end of the yield curve are primarily influenced by expectations for future economic growth, inflation and similar large-scale economic factors. In contrast, interest rates at the short-term end of the yield curve are more influenced by shorter-term economic and financial events; it is for this reason that the Italian 2-year sovereign bond yield exploded higher by a greater number of basis points than the 10-year yield did when political instability (a short-term factor, not a long-term factor like the business cycle) hit in May.

Year-to-date, the one-year Chinese local-currency sovereign bond yield has seen the steepest drop in basis points across the yield curve, falling 84 bps to stand at 2.98% as of the above image. In contrast, far tamer falls have been observed in the multi-year tenors, where the YTD basis points move has been confined to roughly 40.

Using the 'separation' of the yield curve explained in the second paragraph above, it is safe to determine that the significant fall in short-term yields relative to long-term yields stems from Chinese expectations and/or consequences of the government loosening financial conditions yet again to support the economy. It's the same situation as when short-term U.S. Treasury note yields rise in response to a Federal Reserve interest rate increase, but the 10-year and 30-year yields may barely budge; monetary policy primarily plays out in short-term interest rates.

Source: MarketWatch

Elsewhere in financial markets, the Chinese yuan (renminbi/Rmb) has rapidly depreciated against the U.S. dollar since mid-June, with the exchange rate jumping from Rmb 6.40 per US$ to Rmb 6.80. Much talk of the yuan has stemmed from U.S. President Donald Trump's accusation of currency manipulation by Beijing; whether or not that is the case is not to be decided in this post. Rather, the weakening of the yuan since April is another sign of easing financial conditions in China.

The gradual strengthening of the yuan throughout (at least) the second half of 2017 in the above image is not a fluke, but can be attributed to the tightening financial conditions observed in China throughout 2017 (for evidence, see the reduction of credit in the second half of 2017 from earlier in this post). In economic theory, the reduction of easily-available money in the Chinese financial system makes the remaining currency more valuable to hold, consequentially making that currency (the yuan) appreciate. This played out according to that script in 2017 as cheap credit dried up.

Now, as Beijing appears to relax financial conditions, the yuan has depreciated once again. It is necessary to consider that the depreciation in the yuan here may also be due to a variety of factors, such as trade tensions with the United States, a resurgent U.S. dollar amid U.S. economic outperformance relative to the world (especially the E.U.), overarching concerns about the slowing domestic economy, and even policy interest rate differentials with the U.S. No matter the amalgamation of factors that have contributed to the yuan's weakness in the second quarter of 2018, the easing of Chinese financial conditions has likely played a part.

Source: MarketWatch

Lastly, the renewed easing of Chinese financial conditions recently (as per the new leg down in most SHIBOR interest rates) has likely played a non-trivial role in the rebound of Chinese equities. The Shanghai Composite closed out June by entering a technical bear market, defined as a 20% drop from a recent peak. The above chart shows this sudden drop in mid-June, before the bleeding finally stopped in early July.

Since that nadir, the Shanghai Composite has drifted upwards, gaining as much as 200 index points as of this typing. Again, a number of factors may have contributed to this rebound, but this time it's a little less opaque than analysis of the yuan's moves. On one hand, Chinese stocks rebounded despite no material improvements in U.S. / China trade tensions. It is plausible to consider that the higher stock prices reflect optimism from investors that domestic companies will be able to take advantage of the depreciated yuan and see a boost in exports, but this assumption is destabilized when considering the still-murky final impacts of the still-unfolding U.S. / China trade tensions.

The rebound in the Shanghai Composite came despite the release of rather pessimistic Chinese economic data in mid-July; a brief dip was seen, but the index has more than erased those losses. For these reasons, I'm led to believe that Chinese stocks have benefitted in a non-trivial way from the government easing financial conditions within the last several weeks.

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As the Chinese government continues its balancing act of supporting the economy but discouraging irrational investment activities, further gradual easing of domestic financial conditions are expected. The U.S. Federal Reserve is expected to continue increasing interest rates this year and next - in addition to continuing its balance sheet normalization program -, while the European Central Bank will end its asset purchase program at the end of this year. Both actions will see global liquidity continue to dry up, tightening global financial conditions in general.

With Beijing showing its desire to support economic growth at the expense of delaying further progress in the financial deleveraging / de-risking campaign, further easing of domestic financial conditions looks probable. Chinese stocks and bonds look set to benefit further, absent an unexpected deviation from the path.

Andrew

Eight Months into Quantitative Tightening: Where Are We Now?

It has been eight months since the Federal Reserve began its balance sheet reduction program, affectionately adapted as "quantitative tightening (QT)" by Wall Street, the opposite of the "quantitative easing (QE)" program the Fed used to purchase securities after the 2007-2009 recession.

The pace of this balance sheet 'normalization' program was outlined in the Federal Open Market Committee's June 2017 policy meeting as an addendum, and was outlined as below:

For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.

For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month.

So, for Treasuries, the Federal Reserve began "rolling off" $6 billion worth of securities each month in 2017 Q4, and then $12 billion of securities each month in 2018 Q1, now at an estimated $18 billion per month in 2018 Q2. In July, that pace will again accelerate to $24 billion per month for the third quarter. For mortgage-backed securities (MBS) and agency debt, the initial pace in 2017 Q4 was $4 billion per month, then $8 billion per month in 2018 Q1, followed by $12 billion per month now in 2018 Q2. Similarly, this will increase again to $16 billion per month in 2018 Q3.

Adding it all up, the second quarter of 2018 is seeing the Federal Reserve "roll off" $30 billion in securities per month, for a cumulative $90 billion in securities released for Q2. When Q3 rolls around in July, the total number of securities coming off the Fed's balance sheet each month will ramp up to $40 billion, for a cumulative $120 billion balance sheet reduction in 2018 Q3.

This process is not an exact science, of course, so these numbers are more reference points than anything. But data from the Federal Reserve shows that this process is already well underway.

Source: St. Louis Federal Reserve FRED

The size of the Federal Reserve's balance sheet has shrunk from $4.46 trillion on October 4, 2017 to $4.32 trillion as of June 6, 2018, for a total reduction of $140 billion. By the math and FOMC guidelines above, through May 2018, roughly $150 billion in securities should have already been subtracted from the balance sheet. In the broad scheme of things, this discrepancy is pretty minor, and the key takeaway is that the Fed is proceeding with its balance sheet normalization program pretty much as advertised.

One of the main worries about quantitative tightening is that this increased rush of Treasury debt supply would ratchet up U.S. bond yields, thereby tightening domestic (and, for all intents and purposes, global) financial conditions as interest rates on mortgages and other consumer debts rise as well. Has this worry panned out?

Source: St. Louis Federal Reserve FRED

It is not debatable that U.S. Treasury yields have increased since September/October 2017. The 10-year Treasury note yield (the red line above) has risen from ~2.1% in September 2017 to as high as nearly 3.1% in May 2018. That's an increase of about 100 basis points in just under eight months- a non-trivial increase. However, it is wrong to fully attribute this increase in bond yields to the Fed's balance sheet reduction program, no matter how enticing the above chart makes that conclusion.

First, global growth was seen picking up to end 2017. Indeed, the phrase 'global synchronized growth', or something similar involving the word "synchronized", became quite popular as both advanced economies (AEs) and emerging market economies (EMEs) saw economic output kick into a higher gear. 

Prior to this, the United States was holding the honor of comparatively-strong economic growth; the eurozone continued to shake off scars from both the financial crisis and sovereign debt crisis into the middle of this decade, while China took a hard stumble near the halfway point of the decade. India's sudden demonetization injected uncertainty into the minds of foreign investors, and a less-than-stable banking system continues to stand in the way of more sustained and confident economic growth. 

However, 2017 saw the core of the eurozone - especially Germany - regain its economic mojo, with German real GDP growing at an annual rate of 2.9% in 2017 Q4, the highest mark since 2011 Q3. Worries over the Italian banking system were soothed as the largest trouble spots - Banca Monte dei Paschi di Siena and two regional banks - were cleanly dealt with. Elections in several major EU countries saw populist candidates lose out, much to the cheer of investors. Outside of the EU, China beat expectations with 6.9% annual GDP growth for 2017, African nations continued to see infrastructure investment as part of China's Belt and Road Initiative (BRI), and protectionist fears around the globe, aimed primarily at the U.S., were put off ... until this year, apparently.

The rebound in global economic growth provided a very convenient excuse for investors to diversify their portfolios and pursue investments in the eurozone, Africa, and other regions. The comparative decrease in the attractiveness of U.S. assets was likely a factor in sending U.S. interest rates higher.

Second, the new U.S. spending bill passed at the tail end of 2017 requires a significant uptick in the issuance of U.S. Treasury debt. This is an added supply burden to the increased supply already in place from the Federal Reserve's balance sheet runoff, and it's quite likely both the expectation and reality of increased Treasury debt supply due to the spending bill boosted U.S. bond yields.

Thus, while the Federal Reserve's "quantitative tightening" program is more than likely raising U.S. interest rates (and will likely continue to do so as the program's pace accelerates), there are other factors at play that have helped to keep interest rates elevated.

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So, where are we now? The Federal Reserve Bank of Chicago's Adjusted National Financial Conditions Index (ANFCI, a preferable acronym to that whole mouthful), a good way to see how easy or tight financial conditions are, has indeed increased since November 2017, but remains solidly in negative territory. In the ANFCI, negative values imply easier financial conditions.

Source: St. Louis Federal Reserve FRED

Warranting more attention than the ANFCI is the rise in mortgage rates, which have jumped from 3.90% to start December 2017 and peaked at 4.66% on May 24, 2018- a rise of 76 basis points in about six months, again a non-trivial movement. 

Source: St. Louis Federal Reserve FRED

I believe this rise in mortgage rates will eventually hurt housing, but I could (and probably will eventually) write a whole separate post about the reasons why and why not these higher rates could hurt housing this year. For this post, though, it's likely that the Federal Reserve's "quantitative tightening" program has helped increase mortgage rates, again combined with other factors.

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In general, these effects of higher U.S. bond yields are not yet significant, particularly when compared to yields of over 5% as recently as the eve of the financial crisis. It's plausible that there is some "sticker shock", particularly with respect to the higher mortgage rates, but aside from this the effects of the Federal Reserve's balance sheet runoff have not been debilitating, or even so much as notably inhibiting to the financial system. Indeed, "cov-lite" leveraged loans remain a hot commodity in global financial markets.

For now, "quantitative tightening" is more akin to a few gentle turns of the screwdriver than an electric drill. Perhaps in another eight months, the screws will have tightened even more... or perhaps too much more.

Andrew

Turkey's Cooking: A Case of Intentional Overheating

Turkey is seen as one of the weakest links in emerging markets, with the Turkish Lira (TRY) falling substantially against the U.S. dollar, an impressive feat in itself given how the U.S. dollar has weakened substantially year-to-date as well. This post will review the foundation of how Turkey appears to be at risk of over-heating, and how this seems to be intentional at the hand of President Recep Tayyip Erdogan.

Source: Federal Reserve Bank of St. Louis

The Turkish Lira has followed up on a weak performance in 2017 with new record highs against the dollar in 2018, hitting 4.195 lira per US$ at its peak on April 11 of this year. The currency's decline has since taken a breather, and as of this posting it sits at roughly 4.06 lira per dollar, still down nearly 7.3% on the dollar year-to-date.

The rapid depreciation of the lira stems from growing anxieties over the state of Turkey, particularly with the increasing likelihood that the country's economy is being deliberately set to overheat.

Source: Federal Reserve Bank of St. Louis

Shown above is the consumer price index for Turkey, percent change from a year ago. After hitting nearly 13% in November 2017, the annual rate of inflation has slowed to "only" 10.2% in March 2018. At face value, one might be inclined to believe that inflation may finally be contained, and that the depreciating lira may not have as strong an effect as it's been made out to be.
However, the lower inflation rate looks to be a consequence of the base effect.

Source: Federal Reserve Bank of St. Louis

Indexed to October 1955, Turkey's CPI showed an acceleration around this time in 2017, as highlighted in the image above. Note, however, that the CPI seemed to then decelerate substantially for May through September 2017. In other words, what the base effect gives, the base effect may very well take away. The lira's depreciation that really kicked off in October 2016 (see top image) is already feeding through into the CPI, given the leg up in the index seen beginning around January 2017.

Continued depreciation of the lira since then, combined with the base effect reversing in 2018 Q2 and Q3, should result in upside surprises to Turkish inflation figures in the coming months, potentially intensifying the lira's depreciation and maybe even disrupting capital inflows to the country, though that may be more a consequence of global monetary policy tightening throughout the year, if it does happen.

Source: Federal Reserve Bank of St. Louis

This inflation surge has been accompanied by a surging economy, as Turkey's gross domestic product spiked to nearly 7.5% in 2017, about double the growth rate seen in 2016 and the highest print since 2013. The combination of surging economic output and inflation is what's leading to the fears of an overheating economy, fears that will only intensify if 2018 Q2 - Q3 inflation figures do accelerate again and/or the lira continues to depreciate.

Interestingly enough, the overheating economy has been not only welcomed but instigated by the administration of Turkey's President Recep Tayyip Erdogan. Erdogan has announced snap elections for June 24, well ahead of the expected dates of late 2019. It's believed the elections may be to capitalize on the current strength of the economy, rather than waiting until 2019 when the overheating may take its toll and hurt Erdogan's chances at re-election. Whether Erdogan allows the economy to return to a more normal state after elections (assuming he does win) remains to be seen, although the announcement of a $30+ billion investment project to create jobs and further boost the economy makes that possibility seem rather remote.

The economy will likely be left to overheat, particularly given the lowered credibility and independence of the Turkish central bank. Although the central bank raised its late-liquidity lending window lending rate by 75 basis points this week, President Erdogan has repeatedly called for interest rates to be lowered, holding the view that lower interest rates will lower inflation. Current economic theory states that lower interest rates increase the availability of credit and money, increasing spending and boosting inflation. The interest rate increase this week is a sign that the central bank is at least attempting to retain some independence and credibility in preventing the economy from truly going off the rails, but so long as President Erdogan continues attacking the central bank for not cutting interest rates and the fiscal policy side remains extremely stimulative, the central bank's policy will likely have only minimal effects.

The country of Turkey looks to be enticing a textbook case of an overheating economy, with high inflation poised to jump higher in coming months, a currency continuing to depreciate, and economic output still growing strongly. The country's heavy reliance on capital inflows makes it a candidate for an economic crisis (whether FX-based or current-account based), although for now this remains only a possibility, not a certainty. What is certain, though, is Turkey is heading down an unsustainable economic path, and if concerted efforts aren't made to guide the economy back towards a more stable level, things could end quite badly, for the country and perhaps emerging markets in a broader sense.

Andrew

Economic Synopsis - March 2018

Note: All indexes and indicators shown here are experimental in nature and are not to be used for decision-making purposes. As the saying goes, 'beware of geeks bearing formulas'.

Overall, economic activity was seen somewhat weaker in the first quarter of 2018 compared to the previous quarter, as had been expected. Economic activity is expected to become more robust once again moving into the second and third quarters of 2018, however.

Current Conditions Index

Note: The CCI depicts the magnitude of the current stage of the business cycle. In other words, the high positive values seen in 2013 are indicative of the presence of an expansion with little likelihood for a recession, while current lower values are indicative of a later-stage expansion.

The Current Conditions Index showed a downshift in economic strength in the first quarter of 2018 compared to the last quarter of 2017, with the March 2018 value coming in roughly one unit lower than that seen in December. This fits with the narrative of the U.S. being in the late stage of this current economic expansion, as monetary policy begins to meaningfully tighten and the above-potential growth seen for much of 2017 moderates some.

Weighted Economic Leading Indicator

The Weighted Economic Leading Indicator, which aims to depict economic conditions with a roughly six month lead time, anticipated the current slow-down back in the second half of 2017. Since then, the indicator has ramped back up again, now substantially higher than lows recorded last year. This signals the likelihood of a rebound in economic strength in the second and third quarters of 2018, likely extending into Q4 (as it appears right now). However, the current values remain substantially below those seen from 2010-2013, indicating that this expansion is indeed nearing its end. Thus, while a rebound in economic activity is expected in 2018 Q2 and Q3, the risk of contractionary conditions will increase if this rebound cannot sustain itself.

New Housing Activity Index

The New Housing Activity Index confirms what the industry appears to be reporting amidst the current housing shortage- that housing activity is merely moving along, and is not at a robust level. As such, a continuation of the housing supply shortage is expected for the remainder of 2013. The index could move lower still if mortgage rates continue to rise, potentially turning away buyers already afflicted by rising home prices. Through 2018 Q3, however, the housing market looks to be stable.

Excess in Stock Markets Indicator

After peaking at nearly 20.00 in early 2018, the stock market gyrations in February sent the Excess in Stock Markets Indicator back on the decline. Despite this, the metric remains elevated, and still not far from the 30.00 watermark, historically a level reached when "excess" in stock markets was significant (i.e. the 1987 stock market crash). Given the spread between the red and blue lines, as well as the still-elevated nature of the metric, stock markets still look to have areas of excess present. Further volatility throughout 2018 can be expected, particularly against a backdrop of tightening monetary policy by global central banks and a late-stage expansion in the U.S.

Derived Recession Probabilities

Lastly, the two gauges of recession probabilities I maintain continue to stay well below the 50% mark. The primary Derived Probability gauge held steady month-over-month at ~27%, while the experimental companion to that gauge (the gray line) fell further to a more-than-two year low of ~20%. This fits in with the indicators reviewed above, highlighting the expectation of continued benign economic conditions through 2018 Q2 and Q3, potentially Q4 as well. This could certainly change with the advent of a U.S./China trade war, aggressive tightening of global monetary policy, or a sustained slowdown in the European Union and/or China.

Andrew

Vulnerability in the High Yield and Leveraged Loan Markets

This is a research report I wrote up earlier today on a specific vulnerability that worries me in the riskier areas of fixed income. 

Summary

Over eight years after the end of the Great Recession, the economic recovery that has slowly but surely powered the United States into a 4.1% unemployment rate and sent stock market indexes to dozens of record highs this year has now spread around the globe. With heavy-handed support from leading central banks, financial markets are thriving, with suppressed volatility and generally-positive economic data supporting both advanced and emerging economies. Unconventional monetary policies employed by G20 central banks, particularly the European Central Bank (ECB) and Bank of Japan (BOJ), have led to an asymmetric recovery in certain sectors of global financial markets, however, whether directly or indirectly. In this report, unconventional monetary policies will be connected to the increasing deterioration of covenants in riskier sections of the fixed income market, and concerns over systemic risk posed by such sectors of the fixed income market will be outlined.

            Introduction

In response to the 2007-2008 financial crisis and succeeding deep recession, central banks in advanced economies found that their conventional monetary policy tools were not as effective as desired. Faced with the zero lower bound dilemma, leading central banks asserted themselves into uncharted territory with the use of new monetary policy measures. The most visible and widely-discussed tool at hand was that of quantitative easing (QE), the process by which a central bank purchased their nation’s sovereign debt (for the ECB, up to 33% of each EU member’s sovereign debt), in a bid to stimulate the economy and lower borrowing costs for consumers. Through such QE operations, the G4 central banks (the Federal Reserve, the ECB, the BOJ and the Bank of England) purchased securities that sent their balance sheets to a combined 37.4% of their cumulative GDP.

Figure 1. Source: Bloomberg

            The composition of the balance sheets for each central bank vary, however. For example, the Federal Reserve invested its $4.5 trillion balance sheet primarily in Treasury securities, as well as agency debt and mortgage-backed securities (MBS):

Figure 2. Source: Bloomberg

            In contrast, the European Central Bank has accumulated nearly 33% of each European Union member’s sovereign debt, the threshold of which was set by the Bank and is unlikely to be increased due to German opposition to the continuation of QE. The ECB also undertook significant purchases of corporate bonds, a program which also is still ongoing. The Bank of Japan has employed the most unconventional monetary policy of the G4 banks, and perhaps of the world. Indeed, the BOJ now employs ‘Quantitative and Qualitative Easing’ (QQE) and ‘Yield Curve Control’ (YCC), as well as maintaining a benchmark interest rate of -0.4%. The YCC portion involves the Bank of Japan maintaining the 10-year Japanese government bond yield at a rate of around 0.00%. The Bank had stepped in with offers to buy an unlimited amount of bonds at a rate of 0.11% earlier this year, when the 10-year yield began climbing, in a motion similar to that of a central bank offering to defend its currency peg if necessary. As part of its QQE program, the Bank of Japan now holds significant stakes in the Japanese sovereign debt market, Japanese corporate debt, Japanese stocks and exchange-traded funds (ETFs), all in bids to suppress volatility and encourage consumer spending.

            The successes and failures of these varied monetary easing programs are not for discussion in this report. Rather, we aim to focus in on the Federal Reserve’s quantitative easing operations, and its consequences as reflected on riskier portions of the fixed income market- namely, leveraged loans and the high-yield corporate debt sectors.

            The Federal Reserve’s QE program was designed to decrease borrowing costs for consumers, and the suppressed nature of the 10-year Treasury note yield shows that this has happened.

Figure 3. Source: Bloomberg

            With Treasury yields continuing to plumb record low levels over the last several years due to the Federal Reserve’s QE, investors have been driven to riskier assets in their search for yield. A primary beneficiary of this tactic (a deliberate one, at that) has been the stock market, with the Dow Jones Industrial Average (DJIA), S&P 500 and Nasdaq Composite setting over 100 record closes combined this year. While this is due in large part to investor enthusiasm over the expected agenda of President Donald Trump, stock markets were strong and looking stronger in the months leading up to the 2016 presidential election.

            In a sign of investors’ search for yield, even riskier assets have seen stronger returns than stocks. A prime example of this is the return offered on Bank of America Merrill Lynch’s High Yield corporate bond index.

Figure 4. Source: Federal Reserve Bank of St. Louis – FRED.

            On an indexed basis, where the beginning of the 2007-2009 recession was set to 100, the S&P 500 has seen its value increase by a multiple of 1.8, through the end of October 2017. BAML’s High Yield Total Return Index, however, has seen its value more than double over the same period, appreciating by a multiple of nearly 2.2 through October 2017. It is no secret that investors who favored junk bonds over the last eight years have been handsomely rewarded- even today, the effective yield of BAML’s High Yield corporate bond index still tracks above the 10-year U.S. Treasury note, but that’s where the concern starts.

Figure 5. Source: Federal Reserve Bank of St. Louis – FRED

            The effective yield has hit record lows on multiple occasions since the end of the previous recession, with the most recent nadir in 2014, though even today junk bonds hold a slim premium over Treasuries.

            Let’s recall the purpose of a premium. We first recognize that U.S. Treasuries are the risk-free rate, as the U.S. government will not default on its debt (this has been called into question over the last decade, but for all intents and purposes, we will leave this assumption undisturbed). To hold an asset that is riskier than Treasuries, therefore, leaves investors demanding compensation for retaining that risk. Such compensation comes in the form of a premium, the higher yield compared to Treasuries. Relative to Treasuries, highly-rated investment grade corporate bonds (i.e. AAA-rated or AA-rated) will trade with a small premium to Treasuries, as they are quite unlikely to default. Riskier corporate bonds, such as A-rated bonds, will contain a larger premium with their correspondingly-higher risk, and so on. Junk bonds, sitting at the bottom of the ladder, are those with the highest risk, and thus the highest premium… until this economic expansion.

Figure 6. Source: Federal Reserve Bank of St. Louis – FRED

            Above is a graph depicting the spread between Moody’s Seasoned Baa-rated corporate bond yield and the 10-year Treasury note yield, in percentage points. While we remain above the record lows reached prior to the 2007-2009 recession, we continue trudging further down the scale. This depression of the spread indicates investors are willing to receive less of a premium to hold these risky bonds over U.S. Treasuries, as investors continue to hunt for yield.

            At first blush this chart is not all that impressive, but let’s view it in tandem with Figure 5. The Baa-10 year Treasury spread in Figure 6 is low, but the effective yield of BAML’s High Yield corporate bond index is at or near record lows. So, while the premium for Baa corporate bonds isn’t as low as it was in 2006, the actual yield of those Baa corporate bonds is lower, leaving investors with less income overall. That drive for income we discussed earlier only pushes investors deeper into riskier segments of the financial markets, and makes them more willing to take on risk to receive income. This is an intended consequence of the Federal Reserve’s QE program, but it’s a consequence that is beginning to lead to deteriorating credit conditions.

Credit Boom

            The Federal Reserve’s intent to make investors become more willing to take on risks has combined with the Federal Reserve’s lowering of borrowing costs to increase lending to make a dangerous entity in high yield bonds and leveraged loans. Let us first review the volume of total U.S. corporate bonds, U.S. leveraged loans, and U.S. high yield bonds in a historical sense, respectively.

Figure 1. Source: Bloomberg.

Figure 2. Source: Bloomberg.

Figure 3. Source: Bloomberg.

            It is not difficult to ascertain the trend in the broad corporate bond market. As shown in Figure 1, we are already well past the previous year-to-date record of U.S. corporate bond issuance, with just over $1.7 trillion in corporate debt issued through mid-November. The same is found in the leveraged loan market, with volume once again surging past the previous year-to-date record to clock in now at $1.2 trillion. We are not yet at a new year-to-date record in the U.S. high yield sector, currently in at $300 billion through mid-November. It remains to be seen if a new year-to-date record will be achieved in 2018 or later, but is unlikely to happen this year.

            The volume of these riskier loans is a testament to investors’ increasingly-frenzied hunt for yield. Unfortunately for investors, this has placed the bargaining power in the hands of the lender & debt issuer, given if one investor doesn’t like the terms, another investor that is more driven for income will take those same terms. This has led to a startling deterioration in the quality of investor protections on high yield and leveraged loan securities, as evidenced in the following quote from a Bloomberg article:

“Protections have gotten so lax in the $1 trillion market for U.S. leveraged loans that if an offering comes with decent covenants, lenders take it as a sign that something’s wrong with the deal.

“You do have to think twice when you see a loan with a covenant these days,” says Thomas Majewski, managing partner and founder of Eagle Point Credit Management.

It’s not a crazy assumption in a market where 75 percent of new loans are now defined as “covenant-lite,” meaning a company could, for example, rack up as much debt as it wants regardless of its performance. In such a lenient atmosphere, the reasoning goes, a loan must be a stinker if a borrower has to resort to promising even standard protections.”

            Source: https://www.bloomberg.com/news/articles/2017-09-21/safety-becomes-stigma-in-loan-market-that-s-ditching-covenants

Speaking from a common sense viewpoint, one could (and perhaps should) find it alarming that investors continue to eat up leveraged loans which come with increasingly fewer protections for investors. The phenomenon is not limited to the United States, either – in Europe, “cov-lite” loans have emerged as a popular security for those searching for income – despite a different name, the concept of less protection for investors is the same.

Moody’s, which publishes its Covenant Quality Index, has also noted the decline in protections for investors.

Figure 4. Source: https://www.bloomberg.com/news/articles/2017-09-21/safety-becomes-stigma-in-loan-market-that-s-ditching-covenants

            Another quote from the aforementioned article, this time from a Moody’s executive, once again strikes a risk-averse investor as quite alarming.

“ “It’s basically the worst it’s ever been in terms of loan covenant protections,” says Derek Gluckman, senior covenant officer at credit-rating firm Moody’s Investors Service. And that includes the heady pre-crisis year of 2007. ”

Conclusion

It is a sense of dread that many may have felt when looking back on the subprime mortgage industry after it succumbed during the financial crisis. Back then, investors were also hunting for extra income, and the issuance of such securities seemed to benefit all parties involved: the issuer, underwriter and trader for the associated fees and profits, and the homeowner for getting a home. But, of course, it all came crashing down when those investors began to realize just how deteriorated the subprime loans have become.

            It is important to distinguish between the subprime crisis, which was severely exacerbated by a lack of regulation and truly abhorrent lending practices, and this concern over riskier sections of the fixed income market. It remains to be seen how these deteriorating leveraged loans and high yield corporate bonds will fare when (not if) financial conditions begin to tighten. The Federal Reserve is expected to once again increase interest rates next month, and gradual tightening of monetary policy is also expected through the Federal Reserve’s balance sheet tapering. While it remains plausible companies are able to rein in the weakest links of such deteriorating credit instruments, history tells us it’s far more appetizing for both the corporation and the investor to put profits first and handle the consequences later.