Higher funding costs to be a huge problem for lower quality assets in a highly leveraged world

Charlie Jamieson

The volatility genie has now been released and is unlikely to go back in the bottle as late cycle fiscal expansion in the US combined with higher global funding rates from the US Federal Reserve will have markets on their toes going forward.

The liquidation of the short volatility fund XIV (Velocity Shares Daily Inverse VIX) in February is a classic market moment and could well be the Bear Sterns peek behind the curtain before a larger Lehman crescendo. The now liquidated XIV product did exactly what it was designed to do, making a small amount of money each day being short volatility until in one single day everything was lost. Any ETF owners of riskt assets (particularly credit ETFs) should be wriggling in their chairs right now, for the XIV was a complete victim of its own success. Having a public mandate to be one way only in a risky market combined with very large amounts of money makes a product highly vulnerable to adverse market movements. The volatility community knew full well the thresholds required to trigger a XIV liquidation, and surely helped themselves to a grand feast pushing volatility higher and higher until the XIV fund was forced to enter the market and cover risk at one off spike high prices, thereby guaranteeing its own death spiral.

CREDIT ETFS HAVE SYSTEMIC WEAKNESS AND CAN EASILY BE TARGETED IN THE RIGHT (ADVERSE) CONDITIONS

JCB has long argued that higher funding costs will be a huge problem for lower quality assets in a highly leveraged world, as higher funding costs create an income shock in the near term, but also lift refinancing hurdles over time

As funding costs are rising and liquidity is being withdrawn (illustrated with LIBOR rates rising), investors need to think through liquidity sources, their individual liquidity needs going forward as the tide goes out, as well as the asymmetry of some current portfolio holdings.

Certain parts of the credit market (particularly ‘perceived’ high returning liquid credit and high yied) often re-price in an asymmetrical manner, we need look no further than a well known highly leveraged US infrastructure fund that recently lost around 40% of its value in a day after provisioning for higher funding and debt obligation costs (whilst within an equity product, the asymmetry is that credit (debt) and funding are directly related).

Warren Buffet’s famous quote of ‘’we will see who has been swimming naked when the tide goes out’’ is a great illustration for the current leveraged environment. In adding large US fiscal deficits to a late cycle environment, plus the addition or continuation of higher funding pressure via US rate hikes, the tide is most certainly going out right now for certain parts of the credit spectrum (ie lower parts of the capital stack). Often at the end of the cycle we get a systemic shock, a company or group of companies that fail unexpectedly from sailing too close to the wind.

The danger for credit ETFs comes from the massive credit liquidity gap that now exists between credit debt outstanding (which in the US has roughly doubled since GFC) and primary dealer inventories which have shrunk more than six fold. To put that in context, the credit liquidity gap is now twelve times the size it was going into the GFC, when credit products froze and were gated for long periods, on one twelfth of the liquidity mismatch. The rise of credit ETFs gives the market a host of products that they can collectively target in adverse circumstances, forcing them to rebalance into weakness (the XIV stop out will look like a Christmas party) without any circuit breakers seen in equity markets.

GLOBAL DATA PEAKING – VELOCITY TURNED NEGATIVE AS HIGHER RATES ARE BITING

JCB retains its view that the US Federal Reserve will likely hike interest rates three times in 2018 (this alone will keep pressure on low quality risk assets via funding costs), however, the extrapolation of the late 2017 environment is short sighted by some market pundits which need to consider the ‘flow’ of markets rather than just focusing on the ‘stock’.

Global economic data has been nothing short of great over the later part of 2017 and early 2018. However, the velocity of that data has now turned negative. That is not to say the data will not remain good, but markets price subtle changes quickly and global data has rolled from improving in 2017 to decaying in 2018.

Are higher interest rates starting to bite? Almost certainly the sell-off in US bond markets is having an impact. Some isolated recent global data to indicate this include; US durable goods orders -3.6%, US factory orders -1.4%, Germany factory orders -3.9%, and very weak global retail sales. London house prices have been dropping at the fastest pace since 2009 (Wandsworth/Fulham lost 15%), US mortgage applications -6.6%. Data has been decaying quickly with a large geographical reach.

STOCK BECOMES FLOW – QUANTITATIVE TIGHTENING STILL PRODUCES A MASSIVE BOND BUYER

2018 is shaping to be a pivotal year. Political policy is changing, monetary policy is being normalised and asset markets will be asked to stand alone with less Central Bank intervention. Higher volatility is almost certainly here to stay, making investors demand more in return for the higher volatility risk they must endure.

There is wide market concern about the withdrawal of Global Central Bank balance sheet accumulation, known as Quantitative Tightening (QT). This term was first used in early 2016 when the Chinese Central Bank was selling $100 Billion Dollars of US Treasuries a month to stem capital outflow from China. Many then wrongly assumed yields would rise sharply given the world’s biggest bond buyer (in China) had become a net seller. In fact yields fell and bonds rallied through this period as a ‘flight to quality’ bid emerged from the private system as other risk asset markets decayed.

Fast forward to 2018 and QT is again topical, as Central Banks have telegraphed a decline in balance sheet growth. However that isn’t the full story for the bond market, because the existing ‘stock’ of previous Quantitative Easing (QE) actually creates new ‘flow’. When bonds on central bank balance sheets mature, their proceeds have to be reinvested just to keep the 'stock' of balance sheet from shrinking. In other words, in QE the 'stock' generates 'flow' itself. And as the stock gets bigger, so do the reinvestment flows: in 2018 total QE reinvestment flows will be some USD $990 billion, vs USD $600 billion in 2016 and 2017. Those reinvestment flows already outstrip balance sheet expansion, with global central bank balance sheet expansion slowing down, reinvestment flows have already become larger than 'new' QE flows.

AUD INTEREST RATES NOW BELOW US TREASURIES ACROSS THE CURVE ON DIFFERING CYCLE AND BUDGETARY OUTLOOKS

JCB’s expectation that the RBA remains firmly on hold in 2018 whilst the US Federal Reserve continues to lift interest rates. We expect this interest rate decoupling to continue and as a result pressure to build on the AUD currency over the year.

The huge fiscal expansion in the US (despite being in 10th year of recovery) has forced US bond yields higher due to vastly increased US bond supply. This has taken Australian interest rates below that of the US across all key maturity points on term structure curves for the first time since 2000. The continued de-coupling of US and Australian interest rates reflects the vastly differing economic outlooks and budgetary positions between the two nations. Interestingly the last time these yield differentials were negative, the AUD was around 0.50 cents to a USD, rather than today’s 0.78 cents.


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