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.

US Dollar Outlook, Week Ending 11/3

I'm making a post strictly for the U.S. Dollar this coming week because it seems we're approaching a possible inflection point for the currency. Technical indicators suggesting the dollar's recent rally is looking a bit hot, combined with a week of important economic data, suggest a selling opportunity for the dollar may be imminent.

Source: investing.com

A look at movements in the dollar index futures suggest some further strengthening in the currency is seen for the first day of the workweek, with Asian/Pacific trading starting to rev up as I type this (8:10pm Central Time). Since a relative nadir on October 11th, the dollar index has risen by nearly two index points, from 92.83 to 94.75. The biggest day of gains came on October 26th, with a jump of 1.01 index points. Needless to say, we've been in a bit of an uptrend over the last couple of weeks.

Source: investing.com

From a technical vantage point, the recent dollar rally has flipped the script from what we saw over the summer and earlier this fall, when the dollar was encountering one of its weakest periods in years. Both the pound and euro are starting to look a little too weak against the dollar right now, especially with EUR/USD dipping just barely below 1.16 in early trading to start this workweek.

Source: tradingeconomics.com

In terms of economic data, this week is looking to be a pretty significant one for the U.S. Seen among the high-impact data releases this coming week are a FOMC decision on Wednesday, where expectations are for the benchmark federal funds rate to be held steady at a range of 1.00% to 1.25%.

Source: CME Group

The big question for this meeting is going to be how policymakers view the likelihood of a December rate hike. As shown to the right, market participants view the probability of a rate hike at this week's FOMC meeting as practically nonexistent, but are pricing in a 97.2% chance of a 25 basis point hike in December. In other words, markets are viewing a December rate hike as all but certain, which leaves little room for any big upside dollar moves from this meeting. Instead, any hint of a more dovish shift in FOMC thinking on a December rate hike could hit the dollar and put an end to this recent uptrend.

The Federal Reserve has indicated they are taking into account the behavior of financial markets in their decisions- of course, to what degree is uncertain, but I would be surprised if there was to be any dovish shift. By historical valuations, stocks are indeed expensive, and I personally see the Federal Reserve as willing to turn a blind eye towards soft inflation and hike rates once or twice more to keep a very strong labor market and a frothy stock market in check. This was put on display a bit in the last few months when traders saw Federal Reserve chair Janet Yellen point to a December rate hike as more likely than previously thought.

The fun doesn't stop there, however. The employment report hits the newswires on Friday, 11/3, and everyone will be watching both the unemployment numbers and any hints of wage gains. Similar to last month, job gains numbers (currently forecasted at or over 300,000 jobs) could be volatile as businesses likely bounced back strongly in October after being hit hard in September from two major hurricanes.
Since this could be another volatile report, it wouldn't surprise me to see this week's USD direction be established by the midweek FOMC meeting. As that last sentence implies, though, the potential volatility of the report could also be a scene-setter, but we'll have to wait and see if that actually ends up being the case.

To summarize:

- Watch the 11/1 FOMC report for hints of a more dovish approach to monetary policy- market participants are nearly fully pricing in a December rate hike and USD could become vulnerable in a change of thinking.
- The possibility of another NFP report missing or beating forecasts by a large margin, like last month, is a source of uncertainty and will likely help set the tone for the week's performance of the dollar.

Andrew

Financial Markets & Economic Update - August 20, 2017

This update will analyze the current and projected states of financial markets and the broader economy.

Recession / Expansion Index

Source: Author

My Recession / Expansion Index, created with the use of 14 leading economic indicators, is indicating we have descended slightly from expansionary conditions in the medium-term to rather neutral economic conditions in the medium-term (Note: "Medium-Term" refers to the six to nine month outlook period, from June). The index remains in weak expansion territory in the sense that it is above the zero-line, but there is no longer a strong signal in favor of expansionary economic conditions in the 6-9 month timeframe.

The probability of an NBER-defined recession occurring in the next six months, derived from this index, is 0.00%, down from 4.40% in May 2017.

Below is a historical look at the Recession / Expansion Index to show its worth in anticipating prior recessions.

Source: Author

Financial Stress Index

Source: Author

My Financial Stress Index, created with an emphasis on the bond market, rose to a value of -5.066 in the week ended August 11, 2017. This is an increase from -5.204 in the week ended August 4, 2017. Values below -2.500 indicate "loose" monetary policy as implied by financial markets, while values above 2.500 indicate "tight" monetary policy. As such, we remain in a period of very accommodative financial conditions in the United States.

Below is a historical look at my FSI to show its worth in anticipating tighter financial conditions:

Source: Author

Excess in the Stock Market

Source: Author

My "excess" indicator, which measures the stock market against economic data in order to identify when stock markets are no longer underpinned by the associated economic data, does not signal "excess" (may also be referred to as a "bubble") for the month of June 2016. While data for July 2017 is shown here, not all economic data sets for the month have been input yet, and thus the value is subject to change. At the current trajectory, we may reach a signal of "excess" in the stock market in roughly six months, but of course this is subject to potentially drastic change.

Below is a historical look at the Excess Indicator to show its worth in showing periods of "excess" or "bubbles" in the stock market:

Source: Author

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To summarize:
• Recession / Expansion Index: Neutral - weakly expansionary conditions expected in the medium-term.
• Financial Stress Index: Highly accommodative monetary policy continued in the week ended 8/11/2017.
• Excess Indicator: Stock markets were not showing potentially significant levels of "excess" in the month of June 2017, and are not expected to show "excess" in July 2017.


Andrew