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>>> Calls Persist for Negative U.S. Yields Even as Fed Signals Pause
Bloomberg
By Vivien Lou Chen
November 3, 2019
https://www.bloomberg.com/news/articles/2019-11-03/calls-persist-for-negative-u-s-yields-even-as-fed-signals-pause?srnd=premium
Belly of curve could go below zero by 2021: BofA’s Braizinha
Moody’s Analytics also raises prospect of sub-zero yields
The Federal Reserve may be hinting at a pause in its policy easing, but Bruno Braizinha at Bank of America Corp. sees a risk that yields on some Treasuries will go negative by 2021 as the U.S. central bank cuts rates all the way to zero.
While that may seem like a remote scenario to some, the strategist says the market can’t ignore the possibility that 5- and 7-year yields -- both presently within a few basis points of 1.60% -- could fall below zero. He says now’s the time to hedge against that prospect.
Braizinha wrote about the risk of sub-1% yields in the U.S. just ahead of August’s historic Treasuries rally, which drove 10-year yields as low as 1.43% on Sept. 3. That rate has since rebounded to around 1.71%, but his central view is that the benchmark yield will go even lower -- to around 1.25% -- in the next three months. In addition to that, he also sees the Fed being forced to return to near-zero rates amid a deterioration in the American economy and an eventual realization by investors that a U.S.-China trade deal won’t be a panacea.
Yields in belly of Treasury curve have fallen over the past year
“It’s important to acknowledge those risks and not overlook these scenarios,” he said by phone. “All the positive sentiment on trade is fading, and what’s changed now is that it’s more likely that at some point the Fed is going to have to cut again.”
A day after the Fed signaled a pause on Oct. 30, yields plummeted across the curve. In Braizinha’s view, the moves reflected a bias that permeated the bond market based on expectations for worsening economic data, lower yields and a flatter curve.
Yields regained some of that ground on Friday amid stronger-than-expected American jobs data and positive developments on the U.S.-China trade relationship, although a poor reading on the Institute for Supply Management’s factory gauge created a slightly more mixed view.
To get to negative yields in the belly of the curve, Braizinha says the Fed would need to push its target to around zero -- from 1.50% to 1.75% currently -- like it did a decade ago in the midst of the global financial crisis. Rates on Treasuries out to around three years would then be “anchored around 10 basis points to 15 basis points” in his view, while demand for dollar duration would send 5- and 7-year yields negative.
The Bank of America analyst, who recommends betting on 30-year Treasuries in anticipation that yields will go much lower, is not alone in contemplating negative Treasury yields.
Ryan Sweet, head of monetary policy research at Moody’s Analytics, said he also sees a risk that Treasury yields could go below zero if the U.S. falls into recession. And, according to him, this could happen even if the Fed doesn’t cut its target below zero.
In the options market, meanwhile, some traders have been hedging in the past month against the possibility of U.S. policy rates heading to zero or even negative levels.
Bank of America currently expects one additional Fed rate cut in the first quarter and “there are still many hurdles to get to negative interest rate policy in the U.S.,” according to Braizinha. One of these is that “it is not clear that it worked as it was intended” in other economies.
“What I find more likely is that we reach a policy exhaustion point where the Fed cuts down to near zero, which requires only six 25-basis-point moves, and the curve continues to be pressured by lower long-term inflation expectations and global duration demand,” he said.
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>>> Fed’s Plan to Buy Treasury Bills Could Be an Expensive Ordeal
Bloomberg
By Alex Harris
October 11, 2019
https://www.bloomberg.com/news/articles/2019-10-11/fed-s-plan-to-buy-treasury-bills-could-be-an-expensive-ordeal
Bank to buy $60 billion of 5- to 52-week securities per month
Short-term investors may be reluctant to part with securities
The Federal Reserve’s attempt to keep U.S. funding markets calm by rebuilding its cache of bank reserves could be expensive.
The Fed said Friday it will begin buying $60 billion of Treasury bills per month -- with maturities ranging from five weeks to a year -- at least through the second quarter of 2020 to improve its control over the benchmark rate it uses to guide monetary policy. It’s the central bank’s latest measure meant to prevent a repeat of the mid-September turmoil that rocked money markets.
But the Fed may have to pay up to convince people to part with the securities since investors are clamoring to hold bills. Money funds’ holdings of them topped $1 trillion in September, according to Peter Crane, president of Crane Data LLC. “Funds love them,” Crane said.
Debbie Cunningham, chief investment officer of global money markets at Federated Investors Inc., said if the company started to sell Treasury bills, it may be from shorter-dated holdings that it can easily invest in the market for repurchase agreements.
“That will be the exception rather than the norm,” Cunningham said in an interview. “They’re going to have to be buying them from other participants.”
Money-market funds continue to see inflows
Money-market reforms from 2016 spurred record inflows into government funds, driving demand for assets like repurchase agreements, Treasury bills and short-term agency debt. Regulations also require daily and weekly liquidity thresholds for money-market funds, and T-bills can satisfy those requirements.
“Everybody’s got bills somewhere, but it’s shaking those out in size that the Fed wants,” said Blake Gwinn, strategist at NatWest Markets. “I’m wondering what kind of premium the Fed is going to have to pay to get them.”
Even though primary dealer holdings of Treasuries are about $190 billion, their T-bill levels are quite low by comparison: around $7 billion. There’s not enough bills to buy just from the primary dealers, and so the Fed is going to have to convince other investors -- like money funds or corporations -- to part with their T-bills.
However, money markets -- particularly the government ones -- need the Treasuries, both as an investment vehicle, but also because they satisfy fund liquidity requirements. Fed purchases could drive yields down. If a money manager’s objective is to generate as much yield as possible for investors, why sell to the Fed at a lower rate? All that’s going to happen is the fund has to reinvest it in bills at a lower rate, reducing the yield the fund offers investors.
In addition to the Treasury bill purchases, the central bank said Friday that it will continue to conduct overnight and term repo operations through January, if not longer. The Fed has done liquidity injections like these since Sept. 17, and they’ve helped calm this vital funding market.
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>>> QE, or Not QE? Impact of Fed Bond-Buying Will Depend on Treasury
Bloomberg
Rich Miller
October 11, 2019
https://www.bloomberg.com/news/articles/2019-10-11/qe-or-not-qe-impact-of-fed-bond-buying-will-depend-on-treasury?srnd=premium
Shift in Treasury sales to bills might depress long-term rates
Powell insists Fed not undertaking quantitative easing
The Federal Reserve insists its planned hoovering-up of Treasury securities is a “technical” measure that isn’t quantitative easing and won’t meaningfully impact the economy. But that may depend on how the Treasury Department responds to the central bank’s plan.
If the Treasury reacts by stepping up its issuance of Treasury bills and cutting back on sales of longer-dated securities, that would tend to put downward pressure on long-term interest rates -- which is exactly what the Fed’s crisis-era QE programs were intended to do.
But if the Treasury keeps its issuance plans the way they are now, then the Fed’s massive buying risks squeezes in the bills market that could push up prices.
“The impact the Fed’s purchases have is dependent on what the Treasury Department does with issuance,’’ Drew Matus, chief market strategist for MetLife Investment Management, said in an email.
“If they boost bill issuance and cut note and bond issuance, it could have a stimulative effect on the economy,’’ said Matus, who once worked on the New York Fed’s open market desk that implements the central bank’s interest-rate intentions.
Fed to ramp up purchases of Treasury bills, but is it QE?
The interplay between the politically-independent Fed and Treasury highlights the difficulties of carrying out monetary policy in a world where rates are low and central banks are more dependent on asset purchases to manage their economies.
A Treasury spokesman declined to comment on what the department intends to do. The Treasury is slated to announce its quarterly refunding plans on Oct. 30, a few hours before the Fed concludes a policy meeting.
The Fed said on Friday that it will begin buying $60 billion of Treasury bills per month to improve its control over the benchmark interest rate it uses to guide monetary policy after turmoil rocked money markets in September.
Purchases will continue “at least into the second quarter of next year,’’ the central bank said in a statement.
“If you stretch purchases into the second quarter, that amounts to at least $400 billion,’’ said Thomas Costerg, senior U.S. economist at Pictet Wealth Management in Geneva.
In foreshadowing the Fed’s decision earlier this week, Chairman Jerome Powell repeatedly maintained that any planned securities buying would not be a resumption of QE.
Not QE
“In no sense is this QE,’’ Powell told the National Association for Business Economics conference in Denver on Oct. 8.
Under quantitative easing, the Fed bought bonds to lower long-term borrowing costs and boost stock prices and the economy during and after the financial crisis.
Powell argued that the Federal Open Market Committee was not out to spur the economy by resuming growth of its balance sheet, as was the case under its crisis-era buying campaign.
Fed to buy $60 billion of Treasury bills per month
Instead, it is responding to last month’s strains in short-term money markets by supplying more liquidity in the form of bank reserves.
As if to hammer that message home, the Fed is creating those reserves through purchases of bills with a maturity of one year or less, rather than buying longer-term Treasury debt, as it did under QE.
“The committee’s apparent concern with how the public would perceive today’s announcement seems heightened enough to conclude that it was a primary consideration in deciding which sector of the Treasury market they would purchase,’’ Michael Feroli, chief U.S. economist for JPMorgan Chase & Co., said in a note on Friday.
Trump Attacks
Some of that concern may also be political. President Donald Trump has repeatedly accused the Fed of keeping monetary policy too tight and at various points has urged it to resume asset purchases.
Some Fed watchers concur with Powell’s assessment of what the Fed is up to.
“This is not QE or even QE lite,’’ Krishna Guha, vice chairman of Evercore ISI, said in an Oct. 8 note. “The central bank is responding to market demand for central bank reserves with minimal duration as it did before 2007.’’
The September scramble for reserves was triggered by a combination of corporate tax payments and the settlement of Treasury debt sales that temporarily sent the rate on overnight securities repurchase agreements as high as 10%.
Wrightson ICAP LLC chief economist Lou Crandall said that a lot depends on how the Treasury responds.
“If they cut coupon issuance, then guess what, this is QE,’’ he said. If the Treasury doesn’t, then it runs the risk of spawning turmoil in the bills market.
“I don’t know which of their allergies give them the worst rash,’’ he said in discussing the Treasury’s options.
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>>> Top Two Threats to the Treasury Market’s Big Year Are Converging
Bloomberg
By Emily Barrett
October 12, 2019
Sell-off puts best Treasuries performance since 2011 at risk
Yields may climb with progress on trade talks, Brexit
https://www.bloomberg.com/news/articles/2019-10-12/top-two-threats-to-the-treasury-market-s-big-year-are-converging?srnd=premium
Two serious threats to this year’s stellar performance in Treasuries are closing in on the market: steps toward a U.S.-China trade deal and a light at the end of the Brexit tunnel.
Treasury yields took flight this week on hints of a partial trade pact, and late Friday President Donald Trump said he and his counterpart Xi Jinping could sign an accord as soon as next month. Prospects for a deal between the U.K. and European Union also looked firmer, as the EU’s chief negotiator signaled readiness to delve into the details of an Oct. 31 exit.
All year, investors have known that the case for Treasuries largely hinged on these major geopolitical quandaries. Now, credible progress on both could catch Treasury bulls seriously offside, and derail a market on track for its best annual return since 2011.
If a worst-case scenario is no longer in play, global growth could improve, the Federal Reserve could be less inclined to ease, and yields in major government bond markets could have more scope to rise.
“There was a decent long in the market that is going to get tested,” said Gary Cameron, portfolio manager at Garda Capital. “I don’t think we have a bear market, but the buy-dips environment we’ve been in since last September is late stage.”
Cameron expects that if this week’s positive signals are sustained, the U.S. 10-year yield could hit 1.90%. The benchmark ended Friday at 1.73%, after rising 20 basis points this week, its second-biggest sell-off this year. Moreover, traders in futures markets have been paring back their wagers on further Fed easing. Pricing of fed fund contracts show that the odds of a cut this month have gone from near-certain to close to a coin flip.
Investors will get plenty of live feedback from central bankers on how they’re viewing the geopolitical landscape next week. Highlights will be toward the back end, with speeches from New York Fed President John Williams and Vice Chairman Richard Clarida, who’s signaled openness to a further easing this year. Both have emphasized the Fed’s data-dependent stance.
Foremost among the potentially market-moving economic reports on the way is retail sales, which investors will watch for confirmation that consumption can continue to support U.S. growth. Economists are looking for Wednesday’s report to show a 0.3% monthly increase in spending for September, slowing from 0.4% the prior month.
“Retail sales will be pretty important,” said Cameron, adding that “the U.S. is the last bastion of reasonable growth it seems in the world right now.”
What to Watch
Monday is Columbus Day, a recommended holiday for the U.S. bond market.
Here’s the economic calendar:
Oct. 15: Empire manufacturing
Oct. 16: MBA Mortgage applications; retail sales; NAHB housing market index; business inventories; Federal Reserve Beige Book; Treasury International Capital flows
Oct. 17: Building permits; housing starts; Philadelphia Fed business outlook; initial jobless claims; industrial/manufacturing production and capacity utilization; Bloomberg consumer comfort; Bloomberg economic expectations
Oct. 18: Leading index
Fed speakers are prevalent:
Oct. 15: St. Louis Fed’s James Bullard; Atlanta Fed’s Raphael Bostic; Kansas City Fed’s Esther George; San Francisco Fed’s Mary Daly
Oct. 16: Chicago Fed’s Charles Evans; Dallas Fed’s Robert Kaplan; Fed Governor Lael Brainard
Oct. 17: Evans, Governor Michelle Bowman; New York Fed’s John Williams
Oct. 18: Kaplan; George; Vice Chairman Richard Clarida
Here’s the Treasury auction schedule:
Oct. 15: $45 billion of 3-month bills; $42 billion of 6-month bills
Oct. 17: 4- and 8-week bills; $17 billion 5-year TIPS reopening
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>>> A $40 Billion Pile of Leveraged Loans Is Battered by Big Losses
By Katherine Doherty
October 9, 2019
https://www.bloomberg.com/news/articles/2019-10-09/a-40-billion-pile-of-leveraged-loans-is-battered-by-big-losses
Sudden drops reflect growing distaste for shakier issues
Energy leads list of losers with $12 billion of loans affected
Barely noticed in a corner of the financial markets, leveraged loans originally worth about $40 billion are staging their own private meltdown.
Loans tied to more than 50 companies have lost at least 10 percentage points of face value in just three months, according to data compiled by Bloomberg. Some have dropped a lot more, with lenders lucky to get back just two-thirds of their investment if they tried to sell.
The list is growing as lenders and credit raters lose patience amid the slowing economy with borrowers that took on mountains of debt to fund private equity buyouts, dividends and other transactions that didn’t improve earnings.
The companies range across sectors, from energy to health care to communications. The biggest losers as of Tuesday included Amneal Pharmaceuticals LLC, whose $2.7 billion loan due 2025 has sunk to about 80 cents on the dollar, and Seadrill Operating LP, whose $2.6 billion loan maturing in 2021 fetches around 53 cents. The biggest losses in terms of total value included Deluxe Entertainment Services Group Inc., whose first-lien loan dropped as much as 77 cents in three months to 12.5 cents -- more than $600 million.
Cuspy Corporations
It’s hardly a full-blown apocalypse for the junk-rated leveraged loan market, which totals $1.2 trillion. But it does reflect a shift in sentiment, and perhaps a latent market risk, as speculation about a recession spurs investors to flee shaky names.
“People want the well-performing loans, and are more wary of taking chances on the situations that have turned negative,” said Andrew Sveen, co-director of bank loans at Eaton Vance Management.
Energy is the hardest-hit sector on the list, with more than $12 billion of loans falling more than 10 cents on the dollar. Consumer and health care follow, comprising around $8 billion and $5 billion of loans outstanding, respectively.
Leveraged Losers
Some of the drops track the slide in a borrower’s financial fortunes, and some were made worse by downgrades to the CCC bucket by ratings firms.
In turn, the downgrades can trigger selling by money managers who are limited from holding such names once they fall below a certain ratings threshold. This includes collateralized loan obligations, groups of loans that asset managers package into bonds. Most CLOs can’t hold more than 7.5% of their portfolios in loans rated CCC.
The CLO market has mushroomed in recent years as investors have clamored for higher yields, and CLOs are the biggest holders of loans to junk-rated companies. Concerns are mounting about how the structures owning so much of corporate America’s debt will react if a recession hits and more downgrades hit.
When now-bankrupt Deluxe Entertainment was looking for a loan to keep it afloat, its lenders, comprised mostly of CLOs, were prohibited from providing the company with more capital because of legal limitations. Their hands were tied after the company was downgraded three notches to CCC- by S&P Global Ratings. Deluxe wound up in Chapter 11 bankruptcy.
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>>> Repo Market Is Telling Washington That Deficits Still Do Matter
Bloomberg
By Liz McCormick and Saleha Mohsin
October 8, 2019
https://www.bloomberg.com/news/articles/2019-10-08/mmt-is-all-the-rage-but-repo-spike-shows-deficits-still-matter?srnd=premium
Bond dealers choke on Treasuries as U.S. goes deeper into red
‘There’s no down time on the supply front,’ FTN’s Vogel says
These days, you’d be hard-pressed to find many people in Washington who are all that worried about the U.S. budget deficit. Republicans seem more interested in tax cuts, Democrats have ambitious spending plans for everything from health care to infrastructure, and Modern Monetary Theory, a manifesto for free-spending governments, is all the rage in progressive circles.
But on Wall Street, bond dealers provided a small, but pointed reminder that, just maybe, debt and deficits do matter after all.
It came in the form of a sudden spike in interest rates for repurchase agreements, or repos, a normally obscure part of finance that keeps the global capital markets spinning. Plenty of factors helped cause liquidity to dry up, but one that’s getting more attention is concern that dealers are starting to choke on Treasuries as the U.S. government goes deeper into the red.
The argument goes like this: Primary dealers, which are obligated to bid at U.S. debt auctions, have absorbed more and more Treasuries to finance the Trump administration’s tax cuts as investor demand has waned. Typically, they rely on repos to fund those purchases by putting up the debt as collateral.
The problem is that with the financial system already inundated by over $16 trillion of Treasuries, banks constrained by crisis-era rules have fewer incentives to participate in repo. Simply put, there was too much new debt flooding the financial system and not enough money, causing lenders to jack up repo rates. The Federal Reserve has moved to inject much-needed cash on a temporary basis, but if left unchecked, the flood of supply in coming months and years could ultimately result in higher borrowing costs for the U.S.
“There’s no down time on the supply front,” said Jim Vogel, a strategist at FTN Financial who’s been following debt markets for over three decades.
The Treasury’s next slate of debt sales comes this week, with a combined $78 billion of 3-, 10- and 30-year auctions starting Tuesday. Yields on the benchmark 10-year note are currently at 1.52%.
Of course, supply wasn’t the only issue. The situation was compounded by corporate tax payments that also siphoned cash out of the banking system.
And to be fair, nobody is suggesting the U.S. faces any imminent problems financing itself. Everywhere you look, government borrowing costs in bond markets around the world are at historic lows. The dollar remains the world’s reserve currency, and with the global economy showing signs of weakness, investors are still likely turn to Treasuries for safe harbor.
Economists Worry That MMT Is Winning the Argument in Washington
Nevertheless, the mid-September repo upheaval is a clear sign there might actually be limits on just how much debt the U.S. can take before triggering more frequent disruptions. Deficits aren’t exactly new, but they do add up. Since the crisis, the market for Treasury debt has roughly tripled in size.
And the fiscal balance has only gotten worse under President Donald Trump. The deficit surpassed $1 trillion in the first 11 months of the fiscal year, which just ended last month. And the Congressional Budget Office forecasts the shortfall this fiscal year will exceed $1 trillion. That all means the Treasury will need to keep increasing its debt auctions to fund the budget shortfalls.
In the coming decade, debt as a percentage of the gross domestic product will reach 100%, CBO estimates show. That would be greater than any time since just after World War II. Before the financial crisis, debt-to-GDP was about 40%.
The growth was more than manageable in the years after the crisis because the Fed bought significant amounts of Treasuries (from dealers post-auction) with its quantitative easing, or QE. Some argue the Fed used QE to “monetize” the debt, which pumped trillions of dollars worth of cheap cash into the banking system and kept U.S. funding costs artificially low. Whatever the case, there’s little doubt the buying helped dealers clear their inventories.
That started to change in late 2017, when the Fed began to gradually unwind those purchases, reduce the size of its balance sheet and drain the excess cash held in bank reserves. The Fed now holds roughly $3.9 trillion in assets, down from $4.5 trillion in January 2015. More than half of the total is in Treasuries.
Without the Fed, which was arguably the biggest buyer of U.S. debt during the QE era, dealers have had to pick up the slack. In May, primary dealers’ outright positions in Treasuries reached an all-time high of almost $300 billion -- more than double what they were the previous year.
What’s more, post-crisis rules have led banks to prefer cash over Treasuries, which contributed to the liquidity issues in repo markets, according to Michael de Pass, head of Treasuries trading at Citadel Securities.
“The Fed has shrunk its balance sheet in a meaningful way, resulting in reduced reserves in the system,” he said. The cash squeeze has “been further exacerbated by increased issuance, resulting in high levels of Treasury collateral settling into the market.”
Dealers aren’t getting as much help from foreign investors to soak up all that additional supply. Big creditors like China and Japan have slowed their buying of Treasuries in recent years. Overall, the share of foreign official holdings has shrunk to just over 25% this year, from a high of about 40% in 2008.
Foreign holders' share of U.S. debt pile has been falling
That waning appetite been reflected in the amount of bids investors submit versus the actual amount sold, known as the bid-to-cover ratio.
According to an analysis by John Canavan, Oxford Economics’ lead analyst, the ratio for 3-, 10- and 30-year debt sold each month has fallen to 2.39. That’s down from 2.89 times in January 2018, just before the Treasury began boosting its sales, and far lower than a high of 3.48 times in December 2011.
So-called auction tails, which occur when yields on debt issued at auction exceed prevailing levels in the market at the time of sale, have become more common as well. In layman’s terms, it’s a sign investors need to be paid more to take on new debt. That’s been true especially for longer-maturity debt, like the 10-year note and the 30-year bond.
“The debt has become more difficult to digest as the rise in Treasury issuance is outpacing the rise in demand, and overall there’s been a decline in recent years in foreign demand,” Canavan said.
Ratio of bids relative to amount sold at auction has waned
There’s little to suggest the U.S. will suddenly decide to embrace fiscal restraint, either under Trump or a Democratic administration.
So for many market watchers, the most likely near-term solution to the supply problem is for the Fed to start increasing its debt purchases in a systematic way once more. (Following the recent repo turmoil, the Fed has been providing repo financing on a temporary basis.)
Historically, pumping lots of cash into the system has come with the risk of spurring too much inflationary pressure. But after a decade of ultra-low inflation, that isn’t much of a concern today. The purchases would not only replenish bank reserves and help dealers off-load Treasury collateral, but it would also keep a lid on funding costs as the U.S. runs up the deficit.
Former Fed officials Joseph Gagnon and Brian Sack say the central bank should buy enough Treasuries to build up a buffer of extra reserves, with outright purchases totaling $250 billion over the next two quarters.
“More Fed buying may finally give some relief to the supply issues that the market so needs,” Vogel said.
Fed's pile of Treasuries to rise even faster in balance sheet expansion
When it comes to financing America’s deficit though, it’s not the Fed that Julius Baer’s Markus Allenspach is worried about.
“There’s going to be saturation by investors at some point,” said Allenspach, head of fixed-income research and a member of the firm’s investment committee. “Yes, there is a global search for yield, but we believe we may be past the peak of this hunt for safe assets.”
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>>> CLOs Stuffed Full of Private Debt to Risky Companies Are Booming
Bloomberg
By Lisa Lee
October 2, 2019
https://investorshub.advfn.com/secure/post_new.aspx?board_id=31578
Middle-market collateralized loan obligation assets hit record
Some warn lack of transparency, liquidity puts buyers at risk
It’s a marriage between two of Wall Street’s hottest products.
Collateralized loan obligations -- typically chock-full of broadly-syndicated debt -- are increasingly being stuffed with private loans made to highly leveraged medium-sized companies with limited access to bank financing. Known as middle-market CLOs, the asset class has ballooned to $57 billion, from just $20 billion six years ago. Five new entrants this year -- including Owl Rock Capital and PennantPark Investment Advisers -- suggest issuance is only set to increase.
The frenzied growth is another example of how banks, insurance companies and pension funds continue to reach for higher-paying securities in the face of almost $15 trillion of negative-yielding debt around the world. Middle-market CLOs can offer premiums of as much as 200 basis points versus their garden-variety peers, in part due to the reduced liquidity that comes with direct lending, which bypasses traditional capital markets. Analysts say the products could saddle investors with even steeper losses if credit conditions sour.
“Some investors want the excess return to take on the illiquidity of the underlying middle-market loans,” said Michael Herzig, a portfolio manager at THL Credit. “You can’t trade a middle-market CLO the way you can broadly-syndicated ones. You really have to be diligent and careful when you structure.”
Reaching New Heights
Outstanding U.S. middle-market CLOs have surged to a record $57 billion
About $10.4 billion of new middle-market CLOs have priced this year, according to data compiled by Bloomberg, near last year’s pace, which was the fastest since the financial crisis. Still, that’s dwarfed by about $80 billion of traditional CLO issuance. The $57 billion of middle-market CLOs outstanding compares to more than $600 billion of the conventional variant.
There are plenty of distinctions between middle-market and more typical CLOs that pool syndicated loans. For one, the firms that make the private loans are also the ones that oversee the securitizations. The combination of origination, underwriting and management fees is a potentially lucrative setup.
But the arrangement also means they’re forced to keep a slice of the securities they offer in what is known as risk retention. These are rules intended to align lender and investor interests -- largely to prevent a repeat of the subprime mortgage fiasco.
“In a middle-market CLO versus one in the broadly-syndicated market, the active management isn’t centered on discretionary trading of the loans within the portfolio,” said Vivek Mathew, head of asset management and funding at Antares Capital, one of the largest middle-market lenders with $26 billion of assets. “It’s originating the loans and actively managing the underlying assets from a credit perspective, including working them out if they begin to struggle.”
Major Players
Middle-market loans also tend to carry more safeguards -- known as covenants -- than broadly-syndicated loans, where investors have recently started to push back against some of the riskiest financings.
Only about 30% of middle-market debt is covenant lite, versus 70% to 80% for loans sold to investors, according to Michael Boyle, a managing director at Bain Capital Credit.
On the other hand, the underlying debt in middle-market CLOs tends to be smaller in size, as many borrowers have annual earnings of $100 million or less. That makes the debt significantly less liquid compared to traditional loans. In addition, it makes the CLO bonds themselves harder to sell.
“If you decide you don’t like what the CLO manager is doing, you’ll pay a higher price to exit the position,” said Dave Preston, a CLO analyst at Wells Fargo.
The anatomy of a CLO: A look inside the deals funding corporate America
Many of the new entrants issuing middle-market CLOs are already major players elsewhere, including business development company FS KKR Capital and conventional CLO manager THL, which sold its first middle-market securitization in March.
The A rated chunk of Bain Capital’s middle-market collateralized loan obligation from August pays an interest rate of 3.6% over the London interbank offered rate, according to data compiled by Bloomberg. The similar-rated tranche of its most recent conventional CLO from September yields 2.85% over the benchmark. Corporate bonds with comparable rankings pay an average of about 2.64%, according to Bloomberg Barclays index data.
Still, some are steering clear of middle-market CLOs given the difficulty conducting due diligence on the underlying companies. Investors have good reason to be wary, according to Jason Merrill, an investment specialist at Penn Mutual Asset Management, which oversees about $28 billion, largely on behalf of insurers.
“One of the lessons we were supposed to learn from the financial crisis is that it’s important to understand the collateral and understand the risks,” Merrill said. “We do deep analysis when we look at credits, and that’s harder to do with middle-market CLOs,” he said, adding that it has “caused us to shy away from the middle-market space.”
That’s why it’s critical for investors to choose a firm whose lending and management approach aligns with their own, according to Bain Capital’s Boyle.
“There’s less collateral overlap than in the broadly-syndicated market,” said Boyle. “Finding the right asset manager really matters.”
For now, there’s little sign of a supply slowdown anytime soon. Middle-market lenders say CLO issuance is an increasingly popular source of term financing as they seek to expand their private-credit business. And fundraising for North America-focused direct lending is booming.
New money reached $6 billion in the third quarter, bringing this year’s total to $22.6 billion, according to London-based research firm Preqin. That compares to $16.2 billion a year ago. Fundraising typically jumps in the fourth quarter, and cash raised may come close to the record $36.3 billion of inflows in 2017.
“There’s been more competition but there’s still growth opportunity in direct lending,” said Craig Packer, co-founder of Owl Rock, which manages $13 billion of assets. We’ve seen investor appetite for our CLOs, and we expect to do more.”
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>>> Wall Street Falls in Love Again With Companies Loaded Up on Debt
Bloomberg
By Sarah Ponczek and Molly Smith
September 29, 2019
It’s a victory of sorts for the Fed as officials cut rates
Inexpensive financing will help most indebted companies
https://www.bloomberg.com/news/articles/2019-09-29/wall-street-falls-in-love-again-with-companies-loaded-up-on-debt?srnd=premium
The Federal Reserve’s new round of interest-rate reductions just might be working. At least, that’s what one obscure, but key, stock market indicator suggests.
For the first time since 2016, companies with fragile balance sheets are outperforming their sturdier peers and the broad market, a pair of Goldman Sachs indexes show. That’s a clear sign that the rate cuts are shoring up investor confidence in heavily indebted companies -- the segment of corporate America that’s perhaps most at risk to any downturn that hits the U.S. economy.
The outperformance is so stark that a pure measure of leverage is the top equity factor this year among 10 styles tracked by Bloomberg. It’s a big turnaround for traders who had recently pushed relative valuations for financially solid firms to a 16-year high.
The change in heart comes as the Fed seeks to stoke growth by reducing borrowing costs, reacting to signals that the U.S. economic expansion is slowing. With long-term Treasury yields reaching a record low last month, investors may be betting that all that inexpensive debt financing will help those companies expand and drive future earnings growth.
“Money is a lot cheaper to borrow and close to free in some cases,” said Sylvia Jablonski, the head of capital markets at Direxion, which manages $13 billion. “As long as that goes into the investment of the firm and helps the firm grow and increases capex in a positive way, then I think it could be something that’s positive for those firms.”
Companies with weak balance sheets have outperformed sturdier peers
Take the performance of Edison International and Carmax Inc., for example, members of the S&P 500 Index with some of the highest ratios of net debt to earnings, according to data compiled by Bloomberg. Both are up more than 30% this year, trouncing the S&P 500’s 18% return.
That’s not to say there’s hasn’t been a ton of hand wringing about soaring corporate debt levels and the fallout to come when things go south. Even the Fed’s rate cut, while helpful in the short term, runs the risk of merely delaying the reckoning that will surely arrive for overzealous borrowers.
Goldman Sachs pointed out that net leverage -- which measures how much companies owe for every dollar of earnings after subtracting cash on hand -- for the median company in the S&P 500 spiked to a record in the second quarter. JPMorgan also flagged growing debt levels this month as a risk, saying leverage metrics are worsening.
But rather than fret, equity investors are taking a chance on riskier firms. A Goldman Sachs basket of companies with weak balance sheets has bested a gauge of strong balance sheet firms for four straight months. Up 20% year-to-date, the group of firms with more fragile finances is on track to beat the S&P 500 for the first time since 2016.
The U.S. economy is growing at a pace above interest rate levels
One reason for the faith? Extremely low borrowing costs. A divided Fed cut interest rates for the second time in two months on Sept. 18, reducing its federal funds target by a quarter percentage point to a range of 1.75% to 2%.
Interest rates in the U.S. aren’t high compared to the pace of economic growth, a dynamic that means companies should be able to easily meet debt payments, according to Joseph LaVorgna, the chief economist for the Americas at Natixis.
“If yields remain under nominal activity, a broad-based pickup in corporate defaults is unlikely,” he wrote to clients this month.
Companies have been on a refinancing tear in September, issuing bonds with lower interest rates and buying back more expensive securities. The U.S. investment grade market, with about $155 billion priced this month, has already surpassed last September’s total, and more companies are looking to refinance with borrowing costs still low.
Of course bond investors are still being selective. In recent weeks, riskier companies have been forced to either offer higher interest rates or dangle sweeteners to drum up demand. At least four planned sales this month have been yanked from the market entirely.
Investment-grade and high-yield corporate borrowing costs near record lows
The latest bout of strength in highly levered stocks may also be evidence of a trade gone too far instead of any particular love for finance chiefs who have borrowed a lot.
Earlier this year, valuations of firms with healthy finances versus those of their weaker peers had reached some of the highest levels since 1980, and Goldman Sachs said the phenomenon was due for a reversal amid more accommodative monetary policy.
And of course not all investors are keen on highly leveraged stocks. Sandy Pomeroy, manager of the Neuberger Berman Equity Income Fund, is sticking to companies with “squeaky clean” balance sheets. Whittier Trust, with $13.5 billion of assets under management, has a bias toward high quality growth shares.
“Leverage is not a winning stock picking attribute,” Sandip Bhagat, Whittier Trust’s chief investment officer, said in an interview at Bloomberg’s New York headquarters. “The higher the leverage, the lousier the fundamentals, the lower quality the company is depicting. Don’t get tricked by it.”
But Barbara Reinhard, head of asset allocation for multi-asset strategies at Voya Investment Management, and Michael Kelly, global head of multi-asset at PineBridge Investment, both pointed to a thawing of trade tensions between the U.S. and China as supportive for highly indebted companies.
“A more predictable trade environment will lead to better business conditions, so you have some deeper pockets of credit and the stock market finding buyers,” said Kelly, whose firm manages $97 billion. “It’s a little safer to wander out in the waters.”
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>>> Why I'm Worried About the Repo Market
It’s hard to predict how the financial system will handle shocks.
Bloomberg
By Narayana Kocherlakota
September 25, 2019
https://www.bloomberg.com/opinion/articles/2019-09-25/why-i-m-worried-about-the-repo-market
(Narayana Kocherlakota is a Bloomberg Opinion columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.)
The recent unrest in money markets, which briefly caused short-term interest rates to get out of the Federal Reserve’s control, won’t undermine the central bank’s ability to achieve its longer-term economic goals. That said, it does signal that something’s very wrong with the financial system.
To understand what’s going on, let’s return to a simple model. Suppose there’s only one big bank. It has a choice of what to do with most of its assets: It can keep them on deposit at the Fed, earning the interest rate that the central bank pays on excess reserves; or it can take more risk and earn more return by investing in securities or loans. In this world, all the assets earn the same “risk-adjusted” return, which the Fed effectively determines by setting the interest rates on excess reserves.
Now let’s take a step closer to reality. There are two groups of banks, “tight” ones that hold few excess reserves, and “flush” ones that hold a lot. Flush banks can lend reserves to tight banks in the federal funds market, a focal point of the Fed’s monetary policy. As long as this lending happens freely, all assets will still have the same risk-adjusted return, and the one-bank model will still be a good indicator of how the many-bank world will respond to the Fed’s policies and to various shocks.
In recent days, though, that crucial free-lending condition hasn’t held. On the contrary, a convergence of events -- a deadline on corporate-tax payments and the settlement of a big Treasury auction -- created a sudden and severe shortage of reserves. As a result, interest rates diverged sharply in markets where they should be the same. In the repo market, where participants borrow and lend against the collateral of Treasuries and other securities, they shot up above 5%. And in the federal funds market, they breached the upper bound of the Fed’s 2%-to-2.25% target range.
The deeper issue is that, since the 2008 crisis, regulatory reforms -- such as requirements that banks hold a certain amount of liquid assets, and maintain a minimum leverage ratio (equity capital as a percent of total assets) -- have constrained the ability of flush banks to lend, and of tight banks to borrow. Such constraints interact in complicated ways with financial market conditions. For example, European banks must report their leverage ratios as of the last day of each quarter, so they reduce their repo activity to make those ratios look better. As a result, even when excess reserves seem abundant, funding costs for banks may exceed the interest rate that the Fed controls.
This isn’t necessarily a problem for the Fed’s monetary policy, because the central bank can inject cash into various markets to bring interest rates into line. That’s precisely what the Fed has been doing in the repo market. And it can make the fix more permanent by creating what’s called a standing repo facility, which means the Fed will inject sufficient funds every day, as needed, to ensure that the federal funds rate stays in what it deems the appropriate range.
What’s harder to understand is how money markets will respond to future shocks. As the experience of the past couple weeks has shown, the simple single-bank model no longer works. Reserves are siloed in the flush banks, so the financial system is acting more like it has $1.3 billion in excess reserves than the actual $1.3 trillion. The design of regulation has disrupted some of the system’s most basic functions. The people who oversee it all should be far from sanguine about what the repercussions might be.
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>>> Repo Market’s Liquidity Crisis Has Been a Decade in the Making
Bloomberg
By Liz McCormick, Matthew Boesler, and Craig Torres
September 22, 2019
https://investorshub.advfn.com/secure/post_new.aspx?board_id=31578
It sounds crazy: even National Public Radio is talking about repo rates.
In normal times, not even Wall Street thinks too much about the arcana of short-term money markets.
But over the past week, the Federal Reserve has had to work unusually hard to rein in a key policy rate after overnight repo lending dried up. Suddenly, everyone is asking the same question: what does it mean?
The answer is sobering. Despite assurances by the Fed and others to the contrary, the stress in the market for repurchase agreements, or repos, has exposed some fundamental weaknesses in the nation’s financial system which have been a decade in the making. While they don’t pose a significant problem during good times, the risk is clear: without a permanent fix, sudden cash shortages could lead to broader financial market turmoil in a downturn.
“The machine of liquidity management is just not oiled anymore,” GLMX Chief Executive Officer Glenn Havlicek, who runs a trading platform for repo securities and has four decades of experience in funding markets.
The repo market is important because it serves as the grease that keeps the global capital markets spinning. In a repo, firms borrow cash from each other by putting up securities like Treasuries as collateral. When the agreement expires, the borrower “repurchases” the collateral and returns the cash, though in practice repos are often rolled over day after day.
Hedge funds often use repos to finance purchases of higher-yielding assets, while dealers that are obligated to bid for Treasuries at U.S. debt auctions use them as a way to avoid putting up their own capital.
Participants point the finger at two structural changes that have drained too much cash from the system and made the repo market more prone to seizing up: crisis-era monetary policies and financial regulations designed to curb risk-taking. They contend that those two forces, rather than a mere confluence of technical factors, are what’s really behind this past week’s disruptions.
The first has to do with the unwinding of the Fed’s quantitative easing program, or QE. Simply put, after buying trillions of dollars of bonds to pump cheap money into the banking system, the Fed reversed course and started reducing its holdings (and thus draining cash) in October 2017 as the economy strengthened. It stopped altogether last month.
Fed was forced to temporarily expand balance sheet after 1.5-year unwind
The problem is that, in reducing the asset side of its ledger, the Fed has also had to shrink its liabilities to balance its balance sheet. Those liabilities consist of currency in circulation, which has naturally increased with the economy, and bank reserves, which have fallen.
Of course, that in itself wouldn’t be enough to cause a scarcity of cash in the banking system since firms in aggregate still have over a trillion dollars in reserves. But because of post-crisis rules such as Dodd-Frank and Basel III, banks have been forced to set aside much of those same reserves to meet the more stringent requirements, putting a strain on the available cash they can use. What’s more, capital constraints have made taking large positions in short-term money markets far less lucrative.
“The Fed wanted the market to restructure to a new equilibrium and institutions to figure out how to fund themselves,” said Julia Coronado, president of Macropolicy Perspectives. But “if you have an excess reserve system, you are by definition a primary source of liquidity. And when you squeeze funding markets, you are usually squeezing hedge funds and other investors that may have to cut positions which can spark broader volatility.”
JPMorgan CEO Jamie Dimon summed up the conundrum last week, saying that “banks have a tremendous amount of liquidity, but also have a tremendous amount of restraints on how they use that liquidity.”
The swelling U.S. deficit caused by President Donald Trump’s tax cuts hasn’t helped matters. For one, the money that investors and dealers lend to the government in the form of bond purchases takes money out of the banking system. For another, dealers at Treasury auctions have increasingly turned from lenders to borrowers in the repo market to absorb the additional supply. This year, net issuance will reach roughly $1.2 trillion, after $1.3 trillion last year, according to JPMorgan. In 2017, it was less than half that.
Growing budget deficit pushed inventories of Treasuries to record highs
Those liquidity constraints came into full view over the past few days when corporate tax payments, big Treasury auctions and maneuvers by financial firms to manage their capital requirements prior to quarter-end drained cash available for repo transactions. The overnight lending rate quickly shot up to 10% and the Fed temporarily lost control of its benchmark rate.
In the past, the Fed has disputed the idea that its balance-sheet unwind left bank reserves in short supply. And at his post-policy news conference on Sept. 18, Fed Chairman Jerome Powell sidestepped questions about whether he felt bank regulations were a catalyst for the market turmoil.
Instead, the Fed has opted for a temporary fix. On Friday, the New York Fed announced a series of overnight and term operations over the next three weeks to boost short-term liquidity. That follows four straight days of repo transactions, something it hasn’t done in a decade.
A number of investors, strategists and at least one former Fed official have come out to warn that more may need to be done.
“Maybe we have gotten some hints that reserves are no longer ample,” said Michael Feroli, JPMorgan’s chief economist. “The longer the Fed goes without making changes, the more often you might have these type of incidences.”
Earlier this year, TD Securities’ Priya Misra predicted the Fed would have to resume its bond purchases as a permanent solution. She says this past week’s events have convinced many of her skeptical clients to come around to the idea. They are now asking her “how much” the Fed will need to buy.
While no decisions have been made, Boston Fed President Eric Rosengren acknowledged last week that permanently expanding the Fed’s balance sheet is one option on the table and the one he personally prefers. (The other two being continued ad-hoc interventions or a so-called standing repo facility, which would make cash loans available on a daily basis.)
Growing the balance sheet might also be the easier one, particularly after the New York Fed stumbled out of the gate as it tried to come to the rescue on Tuesday, says GMLX’s Havlicek.
“The repo market isn’t used to being prime time,” in terms of liquidity management, he said. And, the Fed is “out of practice.”
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Back to QE - >>> Potter Warns Fed May Have to Buy More Debt to Calm Market
Bloomberg
By Matthew Boesler and Alex Harris
September 20, 2019
https://www.bloomberg.com/news/articles/2019-09-20/potter-said-to-warn-fed-may-have-to-buy-more-debt-to-calm-market?srnd=fixed-income
Former head of NY Fed’s trading desk speaks with BofA clients
Recommendations go beyond New York Fed’s announcement Friday
A former top Federal Reserve official, who oversaw the U.S. central bank’s trading desk, has warned that the type of actions taken so far to quell this week’s turmoil in money markets may not be enough to keep conditions calm and fresh debt purchases may be needed.
Simon Potter, the former New York Fed executive, made the remarks during a conference call that Bank of America hosted for its clients, according to three people who listened.
Potter cautioned that policy makers may have to expand the central bank’s balance sheet through outright purchases of U.S. Treasury securities, to ensure stable liquidity conditions at the end of the quarter as well as at year-end, said the people, who declined to be named because the call was private.
The recommendation follows a week of intense upheaval in money markets during which short-term interest rates spiked and pulled the Fed’s policy benchmark rate outside its target range. It also goes beyond what the New York Fed has promised so far to keep the situation in check going forward.
A spokeswoman for the New York Fed declined to comment on Potter’s remarks. Potter and Bank of America also declined to comment.
The reserve bank announced later Friday that it would offer so-called term repurchase agreements over the upcoming quarter-end, which would allow financial institutions to borrow cash from the Fed either overnight or for two-week periods, secured by Treasury collateral.
Potter was abruptly dismissed in May by New York Fed President John Williams, who assumed the top post at the bank in June 2018. The departure of Potter, a 21-year veteran of the institution, raised concerns about Williams -- a widely-respected monetary economist -- because of his relative lack of experience with financial markets. The New York Fed has yet to announce Potter’s successor.
The New York Fed was forced to intervene in money markets with overnight cash loans for the first time in a decade on Tuesday, Wednesday, Thursday and Friday to contain short-term interest rates. Surges in the rate on overnight repo loans normally occur only at quarter-end and sometimes month-end.
This mid-month jump was attributed to a confluence of events that knocked cash reserves in the banking system out of balance with the volume of securities on dealer balance sheets: a corporate tax payment date, settlement of last week’s Treasury auctions, and last week’s bond-market sell-off, in which investors sold securities back to dealers.
From the beginning of last year to July, the Fed partially unwound the $4.5 trillion portfolio of bonds it had amassed in the years following the financial crisis. The reduction drained cash reserves from the banking system.
This week’s turmoil raised questions about whether the Fed went too far in removing cash from the financial system, and focused attention on when the central bank would begin resuming balance-sheet expansion to keep pace with the needs of a growing economy.
“We’re going to be very closely monitoring market developments and assessing their implications for the appropriate level of reserves and we’re going to be assessing, you know, the question of when it will be appropriate to resume the organic growth of our balance sheet,” Fed Chair Jerome Powell told reporters Wednesday after the central bank cut interest rates for a second time this year.
“It is certainly possible that we will need to resume the organic growth of the balance sheet earlier than we thought,” Powell said.
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>>> Get a Grip. The Fed Can Handle the Repo Market
The central bank has plenty of options.
Bloomberg
By Bill Dudley
September 20, 2019
https://www.bloomberg.com/news/articles/2019-09-20/how-the-fed-can-handle-the-repo-market?srnd=premium
Chill out.
Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.
One of the world’s most important interest rates has had a tumultuous week. Thanks to a sudden shortage of dollars in a separate market, the federal funds rate – the focal point of the U.S. Federal Reserve’s monetary policy – briefly breached the 2%-to-2.25% range that the central bank was targeting.
The aberration has generated a lot of concern. My advice: Don’t worry, the Fed can handle it.
Let’s start with what happened. The cash crunch occurred in a large and central piece of the financial system -- the “repo” market, where participants borrow and lend money against the collateral of various securities. Banks, hedge funds and other investors use it as a source of funds to buy U.S. Treasuries and other assets. Corporations and money-market funds use it as a safe place to park cash and earn a return.
Early this week, a confluence of events threw the repo market out of whack. First, until last month, the central bank had been paring down the securities portfolio it built up after the 2008 crisis, and this process had been soaking up the cash reserves that banks keep on deposit at the Fed. Second, a September 15 deadline for paying corporate taxes further depleted reserves. Finally, the settlement of a large Treasury auction created added demand for cash to pay for the government securities. When the cash flows into the Treasury’s account at the Fed, this drains reserves from the banking system. The imbalance of supply and demand caused repo rates to spike above 5% on Tuesday, more than double the level of the previous week. This, in turn, affected rates in the federal funds market, where banks lend reserves to one another.
The incident is not a harbinger of deeper market problems or a larger crisis. Rather, it provides a useful signal for the Fed, which has been seeking the right level of reserves for the smooth functioning of financial markets. For a long time, this wasn’t an issue: The Fed’s securities purchases, known as quantitative easing, had ensured that the supply of cash was always more than needed. Now, though, as the central bank has reduced its holdings, it’s discovering that various changes have increased the amount of reserves that banks want to hold. These include liquidity regulations, which require banks to hold more cash-like assets, and the Fed’s decision to pay interest on reserves, which makes it less costly for banks to leave cash parked at the central bank.
So what should the Fed do? It has a number of options, some of which will take longer than others to implement.
The primary short-term fix is what the Fed has already been doing: providing the cash that the market needs. Specifically, the New York Fed’s open market desk has increased the supply of reserves by lending money against securities in the repo market. This is one way that the desk can help ensure that the federal funds rate stays within its target range. The Federal Open Markets Committee in Washington D.C. sets the target, and the New York Fed is supposed to hit it. When this doesn’t happen, that’s a problem. I experienced this first hand when I was the System Open Market Account Manager during the financial crisis.
Another short-term fix is to reduce the rate that the Fed pays on reserves. On its own, this won’t address the imbalance in the repo market. But it will help prevent the pressure on repo rates from pushing the federal funds rate above the top end of the Fed’s target range. The Federal Open Markets Committee did this on Wednesday, when it lowered the interest rate on reserves by 0.30 percentage point - 0.05 percentage point more than it lowered its target for the federal funds rate.
One longer-term fix is for the Fed to boost its securities holdings more permanently, thereby increasing the supply of reserves to a level somewhat above the underlying demand from banks. Chairman Jerome Powell hinted at this on Wednesday, and I expect the central bank to announce something in the near future. There probably wasn’t sufficient time to prepare a detailed proposal this week, given that the pressure in the repo market wasn’t evident until Monday. And officials will have to communicate carefully, so the move won’t be confused with quantitative easing. Although the Fed’s balance sheet grows in both cases, the intent is completely different. To signal this, the Fed could focus on adding shorter-term obligations such as Treasury bills, as opposed to the longer-duration assets typically involved in QE.
Fourth, the Fed will likely consider a standing facility for the repo market – in which the central bank would stand ready to lend against Treasury or agency securities at a rate generally above the market and the federal funds target. This would provide a safety valve to mitigate upward pressure on repo rates. Fed officials have been exploring such a mechanism for some time. This week’s events should increase support for putting it in place.
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>>> Fed Injects Cash for Third Day as Calm Returns to Funding Market
Bloomberg
By Liz McCormick and Alex Harris
September 18, 2019
https://www.bloomberg.com/news/articles/2019-09-18/fed-plans-to-intervene-in-repo-market-for-a-third-straight-day?srnd=premium
Thursday’s $75 billion dose followed similar amount Wednesday
Fed’s actions this week are easing pressure in a key market
The Federal Reserve added a third dose of liquidity to a vital corner of the funding markets Thursday, helping rates retreat further as investors warn that fresh bouts of stress remain possible in the weeks ahead.
The New York Fed injected another $75 billion Thursday through an overnight repo operation. That followed a dose of the same size on Wednesday and $53.2 billion on Tuesday. The operations, commonplace in pre-financial crisis times, temporarily add cash, with the Fed taking government securities as collateral.
The latest addition of liquidity -- with the Fed making clear it’s ready to do more as needed -- follows the Federal Open Market Committee’s move Wednesday to reduce the interest rate on excess reserves, or IOER, by more than their main interest rate -- all attempts to quell money-market stresses.
The operations have calmed the funding market, with repo rates declining to more normal levels after jumping to 10% Tuesday, four times where it was last week. Overnight general collateral repurchase agreement rates continued to retreat Thursday, trading around 2%, according to ICAP. Still, most investors say more Fed action is needed for a permanent fix, with gauges of dollar funding costs measured through the current swaps market showing pressures building again given disappointment over the steps the central bank took.
The effective fed funds rate was set at 2.25% as of Wednesday. It was at 2.30% Tuesday, above the top of the Fed’s target range of 2% to 2.25% before policy makers lowered their benchmark rate on Wednesday.
“We expect these episodes of funding stresses to become more frequent with demand for funding and U.S. Treasury supply forecast to increase heading into year-end and the Fed’s reserve levels likely to drop further,” Jerome Schneider, head of short-term bond portfolios at Pacific Investment Management Co., wrote in a note Wednesday with his colleagues.
Given the added supply, banks’ holdings of Treasuries have risen and are increasingly being financed by money market funds investing in repo, which leaves “U.S. funding markets more fragile,” Schneider wrote. He said this adds to other reasons why the Fed needs to do more to engineer a long-term fix.
After policy makers wrapped up a two-day meeting Wednesday, Fed Chairman Jerome Powell said the central bank will keep doing these repo operations if that’s what it takes to get markets back on track. He spoke hours after the effective fed funds rate busted through the central bank’s cap, evidence Powell and his colleagues were losing their grip on one of their most important levers for controlling the financial system.
Fed’s First-in-a-Decade Intervention Will Be Repeated Wednesday
With Repo Market Still on Edge, Fed Preps Second Blast of Cash
‘This Is Crazy!’: Fed’s Repo Madness Sends Wall Street Reeling
Fed Injects Liquidity Into Markets as Key Rate Busts Through Cap
Powell also said the Fed would provide a sufficient supply of bank reserves so that frequent operations like the ones they’ve done this week aren’t required.
The only way “to permanently alleviate the funding stress is to rebuild the buffer of reserves in the system,“ according to Morgan Stanley strategist Matthew Hornbach.
Relying on repo operations doesn’t resolve the issue of reserves declining as the Treasury rebuilds balances, Hornbach wrote in a note. Having regular operations will also increase market uncertainty as the Fed could halt purchases at any time, while the size of its buying will have to expand over time as reserves drop, he said.
“It is certainly possible that we’ll need to resume the organic growth of the balance sheet sooner than we thought,” Powell said, referring to the central bank potentially buying securities again to permanently increase reserves and ensure liquidity in the banking sector.
Many strategists had predicted the Fed would take even more aggressive measures to reduce the pressures. One idea that’s gotten a fair amount of attention is something called a standing fixed-rate repo facility -- a permanent way to ease funding pressures, as opposed to the ad-hoc operations the Fed has used this week. Many analysts even predicted a Wednesday announcement that the Fed would start expanding its balance sheet.
That didn’t happen. However, with the Fed apparently ready to keep injecting liquidity whenever it’s needed, “it’s enough for now,” said Jon Hill of BMO Capital Markets.
“This week’s dramatic moves in the short-term funding markets serve as a case in point for the need to carefully consider liquidity in the financial system,” Rick Rieder, global chief investment officer of fixed income at BlackRock Inc., wrote in a note.
“All of this funding market gyration points to the increasingly obvious fact that the end of Fed reserve draining is insufficient to stabilize these markets,” he said.
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>>> A Divided Fed May Be Reluctant to Forecast More Cuts
Bloomberg
By Steve Matthews
September 18, 2019
https://www.bloomberg.com/news/articles/2019-09-18/divided-fed-reluctant-to-forecast-more-cuts-decision-day-guide?srnd=premium
FOMC expected to lower rates but dots may send hawkish signal
Oil-price spike reinforces sense geopolitical risks are rising
Under pressure from Wall Street and President Donald Trump, the Federal Reserve is widely expected to reduce interest rates on Wednesday for a second straight meeting, but its sharply divided policy panel may be reluctant to forecast further cuts.
The Federal Open Market Committee is likely to lower rates a quarter percentage point to insure against risks from a global slowdown and uncertainty over Trump’s trade policies, while forecasting no more reductions this year, according to economists surveyed by Bloomberg.
The meeting comes a day after the Fed’s New York branch injected billions of dollars in cash to quell a surge in short-term rates that was pushing up its benchmark rate, threatening to drive up borrowing costs for companies and consumers. The spike, while not suggestive of an imminent financial crisis, highlighted how the Fed was losing control over short-term lending.
The policy statement and updated quarterly forecasts will be released at 2 p.m. in Washington and Chairman Jerome Powell will brief the press 30 minutes later.
“It is a very divided group,’’ said Carl Tannenbaum, chief economist with Northern Trust Corp. in Chicago. “If participants are not seeing a deterioration in growth, how far are they willing to push? It is not a sure thing they will do more.’’
Markets have priced in nearly 1% point of cuts over the next year
The median interest-rate projections in the “dot plot’’ -- which displays the forecasts of the 17 Fed policy makers -- is likely to be unchanged for December after Wednesday’s expected cut, according to the Bloomberg survey. By contrast, investors are projecting another quarter point reduction by the end of this year.
Kansas City Fed President Esther George and Boston’s Eric Rosengren are likely to dissent, as they did against the rate cut in July, favoring no move. Another possible dissenter is St. Louis Fed President James Bullard, who may favor a half-point cut in the face of rising uncertainties.
What Bloomberg Economists Say
“Bloomberg Economics expects policy makers to cut rates in steady 25 basis-point increments until the yield curve is no longer inverted. We believe this means rate cuts in September, October and December -- although officials may hesitate to fully telegraph such intentions.”
-- Carl Riccadonna, Yelena Shulyatyeva, Andrew Husby and Eliza Winger
That said, most economists surveyed by Bloomberg expect the FOMC statement to stick with language that signals a bias to continued easing, probably via references to uncertainty over the outlook and a commitment to “act as appropriate” to sustain the expansion.
Division at the Fed
After a period of quiet and consensus, FOMC dissents are on the rise
“There are two fundamentally different views of the economy,’’ said Lindsey Piegza, chief economist at Stifel Nicolaus & Co. Inc. in Chicago. That will be reflected by a “growing in the dispersion of the dots and increasingly muddying the policy message for investors.’’
A small cut won’t be applauded by Trump, who last week said the Fed’s “boneheads’’ should reduce rates to zero or lower.
Read more: Key Trump Quotes on Powell as Fed Remains in the Firing Line
Volatility in oil prices after attacks on key Saudi Arabian facilities over the weekend reinforces the growing risks in the global economy, though the FOMC may be reluctant to adjust views to fast-changing events.
The committee could ratify the view that rates will be lower for longer by edging its estimate of the so-called neutral rate which neither spurs nor brakes the economy. It has fallen to 2.5% from 4% in early 2014 amid a global decline in borrowing costs that’s seen them slip into negative territory in Europe and Japan.
Falling Rates
FOMC median estimate of long run or neutral funds rate has steadily dropped
Statement Language
FOMC divisions make drafting the statement a challenge. Recent data have supported its forecasts for more than 2% economic growth this year, and some reports have surprised to the upside. Yet U.S. payroll growth has slowed and manufactured contracted in August for the first time in three years.
“They have been using boilerplate language ‘solid’ in describing the labor market, but that’s becoming harder to support and could be downgraded,” said Neil Dutta, head of U.S. economics at Renaissance Macro Research. Market measures of inflation expectations could also be downgraded, he said.
FOMC may tweak message after jobs slowdown last month
Powell, who in July referred to the rate cut as a “mid-cycle adjustment’’ rather than a long string of cuts, is likely to be asked about Trump’s call for zero rates and ex-New York Fed President Bill Dudley’s recent controversial column suggesting his former colleagues don’t cut rates to avoid enabling the trade war.
IOER, Balance-Sheet Tweaks
The Fed may announce a couple of technical adjustments to its balance sheet and the interest it pays banks on reserves after a sharp rise in money-market rates led the New York Fed to take action on Tuesday via its first overnight injection of cash in a decade.
It could make another adjustment to the interest rate it pays on excess reserves by reducing it by more than amount it cuts the fund rate. IOER is currently at 2.1% and the Fed may lower that by a bit more than the amount it cuts the target range for its benchmark federal funds rate -- currently 2% to 2.25% -- to better anchor money market rates.
Read more: Fed’s First-in-a-Decade Intervention
Separately, following the Fed’s decision in July to call an early halt to the gradual shrinking of its balance sheet, it may also say it is going to start allowing it to grow again to keep pace with growth in the economy, said Jonathan Wright, a professor at Johns Hopkins University and former Fed economist. The Fed has previously discussed this in terms of a process that could begin further down the road.
A third option to reduce pressure in money markets could be a new tool called a standing overnight repo facility. Such an instrument has been previously discussed and the FOMC was briefed on it in June, though minutes of the meeting showed that policy makers wanted more work done to figure out what it would do and how it would work.
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>>> Fed Injects Liquidity Into Markets as Key Rate Busts Through Cap
Bloomberg
By Alex Harris and Liz McCormick
September 18, 2019
https://www.bloomberg.com/news/articles/2019-09-18/overnight-u-s-funding-rate-at-2-8-elevated-for-a-third-day?srnd=premium
The Fed will buy up to $75 billion of securities later Wednesday morning.
U.S. money markets showed some signs of calm as the Federal Reserve injected another $75 billion of liquidity and key rates pulled back from troubling levels.
Although the U.S. money-market interest rate remained elevated for a third straight day -- after spiking to a record 10% Tuesday -- it came back down to 2.8% early Wednesday even before the Fed accepted billions of dollars worth of Treasuries and other securities.
Now attention turns to this afternoon’s Federal Open Market Committee decision to see what, if any, further action policy makers take to calm the overnight lending business and ensure higher rates don’t harm other parts of the economy.
They’ll likely have to do something because the New York Fed said Wednesday that the effective fed funds rate busted through policy makers’ 2.25% cap the day before, coming in at 2.3%. That’s bad because it shows the Fed losing its grip on short-term interest rates, undermining its ability to guide the financial system.
“These money markets are a very powerful part of the financial system and everything flows through,” said John Herrmann at MUFG Securities in New York. “What the Fed has been doing so far to address the issues is like being a fire department chasing the fire instead of sort of installing fire hydrants through facility. They need to do more.”
The Fed dose of cash Wednesday follows a $53.2 billion liquidity injection Tuesday, the first in a decade and an attempt to restore order within the underpinnings of U.S. markets.
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>>> Fed’s First-in-a-Decade Intervention Will Be Repeated Wednesday
By Liz McCormick and Alex Harris
September 17, 2019
https://www.bloomberg.com/news/articles/2019-09-17/new-york-fed-announces-operation-to-ease-money-market-rates?srnd=premium
Central bank is taking action after a key lending rate spiked
Turmoil signals the Fed is losing control of short-term rates
The Federal Reserve took action to calm money markets, injecting billions in cash to quell a surge in short-term rates that was pushing up its policy benchmark rate and threatening to drive up borrowing costs for companies and consumers. The central bank also said it’s willing to spend another $75 billion Wednesday.
While the spike wasn’t evidence of any sort of imminent financial crisis, it highlighted how the Fed was losing control over short-term lending, one of its key tools for implementing monetary policy. It also indicated Wall Street is struggling to absorb record sales of Treasury debt to fund a swelling U.S. budget deficit. What’s more, many dealers have curtailed trading because of safeguards implemented after the 2008 crisis, making these markets more prone to volatility.
Money markets saw funding shortages Monday and Tuesday, driving the rate on one-day loans backed by Treasury bonds -- known as repurchase agreements, or repos -- as high as 10%, about four times greater than last week’s levels, according to ICAP data.
More importantly, the turmoil in the repo market caused a key benchmark for policy makers -- known as the effective fed funds rate -- to jump to 2.25%, an increase that, if left unchecked, could have started impacting broader borrowing costs in the economy. Because that’s at the top of the range where Fed officials want the rate to be, they are likely to make yet another tweak to a key part of their policy tool set -- something called the interest on excess reserves rate -- to try to get things back on track when they meet Wednesday to set their benchmarks.
But the central bank didn’t wait until then to do something, resorting to a money-market operation it hasn’t deployed in a decade. The New York Fed bought $53.2 billion of securities on Tuesday, hoping to quell the liquidity squeeze. It appeared to help. For instance, the cost to borrow dollars for one week while lending euros retreated after almost doubling Monday.
Late Tuesday, the New York Fed said it would conduct another overnight repo operation of up to $75 billion Wednesday morning.
For repo traders, hedge funds and others that rely on that market for financing, the intervention came none too soon.
“There’s been a sea change in markets, and it’s one the Fed needed to respond to,” said Lou Crandall of Wrightson ICAP. “In the current market environment, there is just not enough elasticity in the repo market to handle the big seasonal swings of the banking system. The Fed needed to come in now and alleviate the immediate problem, while it is also working on long-term solutions.”
The central bank has considered introducing a new tool, an overnight repo facility, that could be used to reduce pressure in money markets. No decision has been announced. Another long-term remedy would be growing the Fed’s balance sheet again to permanently increase reserves in the banking system. But for now, if the rate remains elevated, expect more temporary liquidity injections, Crandall said.
The New York Fed declined to comment on the events of this week.
Actions like the Fed took Tuesday were once commonplace, but stopped being so when the central bank expanded its balance sheet and started using a range of rates to implement its policy in the aftermath of Lehman Brothers’ 2008 collapse.
Securities eligible for collateral in the Fed operation include Treasuries, agency debt and mortgage-backed securities. In an overnight system repo, the Fed lends cash to primary dealers against Treasury securities or other collateral.
Surges in the repo rate normally occur only at quarter-end and sometimes month-end. This mid-month surge was attributed to a confluence of events that knocked cash reserves in the banking system out of balance with the volume of securities on dealer balance sheets: a corporate tax payment date, settlement of last week’s Treasury auctions, and last week’s bond-market sell-off, in which investors sold securities back to dealers.
Fed adds liquidity to keep fed effective below its target range
“This is certainly painful for firms that have to fund positions,” said Thomas Simons, an economist at Jefferies LLC. “So it’s difficult for the dealer community. But it’s not systemically threatening.”
Beyond the technical forces driving the spike in repo rates, the move is also a sign that excess reserves in the banking system are dwindling, according to Tom di Galoma, managing director of government trading and strategy at Seaport Global Holdings LLC.
“This made the repo market ripe for dislocation,” he said.
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>>> Unhinged Money Markets Trigger Fed Action to Alleviate Stress
Bloomberg
By Elizabeth Stanton
September 17, 2019
https://www.bloomberg.com/news/articles/2019-09-17/new-york-fed-announces-operation-to-ease-money-market-rates?srnd=premium
N.Y. Fed takes $53.2 billion of securities in repo operation
Surge in funding rates led to New York Fed’s Tuesday move
The Federal Reserve Bank of New York injected funds into the banking system via an overnight repurchase-agreement operation for the first time in a decade, amid a rare mid-month surge in U.S. money-market rates.
The operation to keep the fed funds rate within its target range closed at 10:10 a.m. New York time, for $53.2 billion, the New York Fed said in a statement. The operation was initially canceled because of technical difficulties. Securities eligible for collateral included Treasury, agency debt and mortgage-backed securities.
In an overnight system repo, the Fed lends cash to primary dealers against Treasury securities or other collateral. The operation was “commonplace before the expansion of the Fed’s balance sheet in 2009,” according to a research note by Wrightson ICAP, which became its primary tool for implementing monetary policy.
The New York Fed declined to comment.
The interest rate for overnight loans collateralized by Treasury securities, which normally stays in the vicinity of the Federal Reserve’s target for the federal funds rate, spiked on Tuesday to a record level above 8%. It then settled back down around 2.5%, according to BMO. The squeeze pushed the effective fed funds rate up to 2.25%, in line with the top of the Fed’s target range of 2% to 2.25%.
Surges in the repo rate normally occur only at quarter-end, sometimes month-end. The mid-month surge was attributed to a confluence of events that knocked cash reserves in the banking system out of balance with the volume of securities on dealer balance sheets: a corporate tax payment date, settlement of last week’s Treasury auctions, and last week’s bond-market selloff, in which investors sold securities back to dealers.
“This is certainly painful for firms that have to fund positions,” said Thomas Simons, an economist at Jefferies LLC. “So it’s difficult for the dealer community. But it’s not systemically threatening.”
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>>> King Dollar Is Left, Right and Center of Emerging-Market Malaise
By Constantine Courcoulas
August 31, 2019
https://www.bloomberg.com/news/articles/2019-08-31/king-dollar-is-left-right-and-center-of-emerging-market-malaise?srnd=premium
Trade-weighted dollar index hit an all-time high in August
Dollar strength makes search for local-currency carry futile
The prospect of ever looser U.S. monetary policy is little consolation for emerging-market investors grappling with a resurgent dollar.
Rather than weaken, the world’s reserve currency has strengthened against all but one major emerging-market peers since the Federal Reserve cut interest rates in July. Earlier this month, the trade-weighted dollar index touched an all-time high, pushing past a peak seen in 2002.
Meanwhile, speculation that China may be using the yuan as a tool in the trade spat with the U.S. is bolstering havens, a sign that the worst for emerging-markets probably isn’t over.
Never before has the dollar been as strong vs major trading peers
The dollar’s ascent undermines the modus operandi for investors in the developing world. Borrowing where rates are low to invest in higher-yielding emerging-market assets is futile if the dollar’s strength wipes out gains. And it creates headwinds for large swaths of debtors in the developing world, where companies and governments rely on foreign funding for growth.
“My big concern is about the dollar. At the moment, when people want certainty, when they want a safe haven they tend to go to the dollar,” said Paul McNamara, a London-based fund manager who helps oversee $9.4 billion in assets at GAM UK, in Bloomberg TV interview on Tuesday. “That tends to be a tough environment for emerging markets.”
Traders who went long local-currency government debt in the developing world after the Federal Reserve’s decision at the end of last month will have have suffered a more than 2% loss, according to a Bloomberg Barclays index, even as global bond markets rallied.
READ MORE:
Falling EM Currencies Herald End of Renaissance for Carry Trade
Investors Slam on Brakes in Emerging Markets as Risks Escalate
Dollar Rising Into a Possible U.S. Recession Could Be a Bad Omen
Dr. Copper Has Ominous Prognosis for Emerging-Market Currencies
Dollar Demand
The market has now fully priced another 25 basis-point cut by the Fed in September, yet the dollar’s unwavering strength reflects the special status America enjoys at times of heightened global unease: it issues U.S. Treasuries, the biggest and most liquid market for safe government debt.
“It’s hard to argue against the dollar in the short term,” said Chris Turner, the head of foreign-exchange strategy at ING in London. “With so many event risks, such as trade escalation and European politics, we suspect investors will increasingly focus on capital preservation rather than the search for yield.”
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>>> U.S. Yield Curve Steepens as Mnuchin Considers Longer-Term Bonds
Bloomberg
By Emily Barrett and Masaki Kondo
August 28, 2019
https://www.bloomberg.com/news/articles/2019-08-28/u-s-yield-curve-steepens-as-mnuchin-endorses-longer-term-bonds?srnd=premium
30-year yield reversed drop that sent it to a record low
Treasury is yet again considering 50- and 100-year debt
The U.S. yield curve steepened after Treasury Secretary Steven Mnuchin said the government is seriously considering extending its debt profile well beyond the current three-decade maximum.
The gap between five- and 30-year Treasury yields widened to 59 basis points, from 56 basis points just before the news broke late Wednesday. The ultra-long bond’s rate climbed to 1.97%, reversing a decline that had driven it to a record low of 1.90% earlier in the day.
Thirty-year yield shoots up as Mnuchin's comments hit wire
The Treasury Department revealed two weeks ago that it was yet again mulling 50- and 100-year bonds, which would let the government lock in historically low rates for longer. “If the conditions are right, then I would anticipate we’ll take advantage of long-term borrowing and execute on that,” Mnuchin said Wednesday in a Bloomberg News interview in Washington.
“There was no need for Mnuchin to make remarks that could prompt selling of Treasuries,” said Hidehiro Joke, a bond strategist at Mizuho Securities Co. in Tokyo. “He might have tried to lift long-dated yields given that the yield curve inversion is seen as a sign of recession and cools sentiment.”
Read More: Mnuchin Says Ultra-Long Bonds Under ‘Very Serious Consideration’
Heavy buying of the 30-year bond has driven the sharpest monthly decline in that yield since 2011, as investors have sought safety from global market volatility in one of the few major government markets offering positive yields.
The idea of ultra-long bonds fell flat when it was last floated in 2017, but this may be an auspicious time to revisit it. The world’s spreading pile of negative-yielding securities -- which stands at about $16 trillion -- is driving investors further out global yield curves, in part to finance retirees’ longer lifespans.
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Muni Bonds - >>> ‘It’s Just Dirt’: Anything Goes in Today’s Muni Bond Market
Bloomberg
By Amanda Albright
August 21, 2019
https://www.bloomberg.com/news/articles/2019-08-21/muni-bond-buyers-are-desperate-risky-borrowers-are-cashing-in?srnd=premium
Yields on riskiest muni-debt drop to 4%, the lowest on record
That is pushing investors into increasingly exotic deals
Last month, a risky, new deal hit the municipal-bond market. It came from a small borrower in Colorado that was looking to finance the construction of 1,200 luxury homes in the foothills of the Rocky Mountains.
It was an odd time for such a project. Denver’s decade-long housing boom was beginning to show signs of cooling and, moreover, rival developers had already raised record sums to turn vast tracts of land into new communities. “There’s no houses to see,” said Nicholas Foley, a municipal-bond fund manager at Segall Bryant & Hamill in Denver. “It’s just dirt.”
No matter. The buy orders poured in anyways and, in the end, about $20 million worth of bonds had been sold for yields as low as 4.75% on 30-year maturities -- similar to the rates that investors once only reserved for relatively risk-free market behemoths like California or New York.
The Federal Reserve’s decision to lower benchmark borrowing costs is keeping the U.S. awash in cheap credit. That has fueled a surge in corporate borrowing, bankrolled takeovers of debt-laden companies and, increasingly, sparked concern that some of those leveraged loans have become too risky. That angst has also seeped into the $3.8 trillion market for municipal bonds, a corner of the financial world that traditionally has served as a refuge for individual investors seeking steady, low-risk returns.
With the steep drop in yields wiping out the tax advantages of some tax-exempt securities, investors are hunting for higher payouts. That’s driven yields on the riskiest tax-exempt securities down to about 4%, the lowest since at least 2003, and in turn spurred an increase in sales from the most default-prone segments of the market. Shopping malls, centers for novel health-care treatments, factories seeking to turn trash into fuel and speculative real-estate developments like the one outside of Denver -- all have recently sold tax-exempt debt through local government agencies.
Yields on high-yield muni bonds have reached record lows
At the same time, investors are receiving less return for the risk, with the gap between yields on top-rated and junk-grade debt holding near where they stood at the end of 2007.
“There is so much money coming in -- even if 90% of the market rejects it, if 10% wants to buy, they are able to get it done,” said Dan Solender, a partner at Lord, Abbett & Co.
The municipal-debt market remains one of the world’s safest, with only 0.16% of those rated by Moody’s Investors Service defaulting between 2009 and 2018, compared with 6% of corporate bonds. Yet many of the riskiest deals aren’t rated and could leave investors -- including those with stakes in mutual funds -- exposed to potential losses if the economy stalls.
During the 2008 credit crisis set off by the last recession, the municipal junk-bond market was roiled as the slowdown rippled through the economy. More than $8 billion of debt issued through state and local government agencies defaulted that year, the most for any year dating back to 1980, according to Richard Lehmann & Associates. When funds unloaded the riskiest securities, high-yield municipal bonds tumbled, saddling investors with a loss of 27% until the market rebounded in 2009.
The lowest-rated municipal securities have rallied this year, delivering gains of nearly 10%, as plunging yields worldwide leave investors hunting for ways to get higher returns. Mutual funds focused on high-yield tax-exempt debt have pulled in cash every week since early January, with about $384 million added in the week ended Aug. 14, according to Refinitiv’s Lipper US Fund Flows data.
That has increased demand for new issues, driving down the extra yields that the riskiest borrowers pay and allowing some to weaken the protections given to bondholders in the securities contracts.
AMG Vanadium LLC sold $307 million of debt through an Ohio agency to build a factory that will turn waste into a product that’s used in the production of steel. The company, which is responsible for paying on the debt, didn’t give bondholders a mortgage on its property in the event it defaults, as is commonly done. The sale was oversubscribed anyway, allowing the underwriter to price the 30-year securities for a yield of 4.28%. The bonds continued to climb after they were sold.
Investors bought up $1.75 billion in unrated municipal bonds for Virgin Trains USA’s private rail project in Florida. A California factory seeking to create a wood alternative has tapped the market more than once. The new sales-tax-backed debt issued this year by Puerto Rico has gained, pushing the price above full face value, even though the island was rocked by protests that forced the resignation of the governor and has yet to emerge from a record bankruptcy.
“It is a very aggressive market -- but to say that it is frothy means that this is the end of it, and I don’t know,” said Matt Fabian, a partner with Municipal Market Analytics, an independent research firm. “A year from now, we might be yearning for the discipline of 2019.”
Some money managers have started to pull back. Vanguard Group Inc. has cautioned against taking too much risk as the economy’s record-long expansion makes a recession look overdue. Goldman Sachs Group Inc. earlier this year shifted a record amount of its high-yield municipal fund into investment grade debt, anticipating that some of the projects financed by the securities may run into distress.
Through July, about 33 municipal bond issues defaulted, the fastest pace since 2015 and up from 21 during the same period in 2018, according to Fabian’s firm. That included a California plant that converts medical waste into hot gases, recyclable metals and glass, just years after issuing the unrated debt in 2016 and 2017.
But with the market still delivering outsize gains, mutual funds have a powerful incentive to stay put, given that they’re judged by the performance relative to their peers.
Guy Davidson, chief investment officer of municipal investments at AllianceBernstein, said he’s grappled with the performance of the company’s so-called high-income municipal fund. It’s up 9.7% this year, beating nearly 90% of its peers. “You go, gosh, is it time to take money off the table?” he said.
He hasn’t, anticipating that the high-yield market will be supported by the still-growing U.S. economy. “A bubble implies it’s supposed to pop,” he said. “Fundamentally, it doesn’t feel like there’s things that are going to make it pop.”
Foley, the Denver-based portfolio manager, was once a big buyer of tax-exempt bonds issued to build new housing developments in his booming state, but he has since stopped amid signs that the market has gotten frothy.
Last year, such Colorado land districts sold $1.3 billion in bonds, the most since at least 2005. The securities, which are typically unrated, are repaid by assessments levied on homeowners and offer few protections to investors if the housing market goes south. In the case of the Castle Rock, Colorado development, even if the district skips interest or principal payments, it won’t count as a default, limiting bondholders’ legal power to recoup some of what they’re owed.
Real-estate backed bonds were hit hard by the housing bust over a decade ago, when a wave of them defaulted in Florida. That also happened in California in the 1990s and in Colorado the decade before.
Colorado’s real estate market has boomed over the past decade, leaving Denver’s higher above their pre-recession peak than any other major metropolitan area, according to ATTOM Data Solutions. But there have been some signs that the frenzy is slowing down, as it has elsewhere: in June, only about 12% of homes had competing offers, down from half a year earlier, according to Redfin. And the number of homes on the market rose 28%, according to a local realtors report.
The Castle Rock debt used a limited-tax structure, meaning that failing to levy the property tax pledged to the bonds triggers an event of default.
That security pledge helps ensure that investors eventually get paid on their investments, said Sam Sharp, a managing director at D.A. Davidson & Co., which underwrites the majority of Colorado dirt bonds. The use of surplus funds also provides protections, he added.
“The structuring we do is mindful of how cyclical the real estate market can be,” he said.
Foley said it helps that his firm doesn’t run a high-yield municipal-bond fund and can instead move in and out of securities when they reach “irrational” points.
“If you make a real call against the high-yield market, you’re making a big call that can cost you your job if it doesn’t go right,” Foley said. “The easy thing to do is keep buying more and more high-yield.”
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>>> World's First 30-Year Bond With Zero Coupon Flops in Germany
Bloomberg
By John Ainger
August 21, 2019
https://www.bloomberg.com/news/articles/2019-08-21/germany-sees-anemic-demand-for-30-year-bond-sale-at-zero-coupon?srnd=premium
Nation sells 824 million euros versus 2 billion euro target
‘It is technically a failed auction,” says Danske’s Sorensen
Germany Sees Anemic Demand for First 30-Year Bond at Zero Coupon
The world’s first 30-year bond offering a zero coupon struggled to find buyers, signaling that negative yields across Europe may finally be taking their toll on investor demand.
Germany failed to meet its 2-billion-euro target ($2.2 billion) for the auction of notes maturing in 2050, selling only 824 million euros. It’s another sign that the global bond rally may be coming to a halt now that more than $16 trillion of securities around the world have negative yields.
German 30-year bond yields have plunged into negative territory
“This shows that there is less demand for 30-year bonds at negative yields,” said Marco Meijer, a senior fixed-income strategist at BNP Paribas SA. Still, Meijer doesn’t “see yields rising a lot in Europe.”
The whole of Germany’s yield curve is now below zero -- the first major market exhibiting such a trait -- meaning the government is effectively being paid to borrow out to 30 years. That’s a reflection of dwindling expectations for inflation and growth over the coming years, while the European Central Bank is widely forecast to introduce a new wave of monetary stimulus next month.
The sale comes as Germany is priming the pumps for extra spending should an economic crisis hit. While the nation is confined to strict laws on running a fiscal deficit, Finance Minister Olaf Scholz suggested Germany could muster 50 billion euros ($55 billion) should a recession hit. The economy contracted in the second quarter.
German 30-year yields rose three basis points to -0.12% as of 1:20 p.m. in London. Those on 10-year securities climbed two basis points to -0.67%.
The auction was at a record-low average yield of -0.11%, while the Bundesbank retained nearly two-thirds of the debt on offer. The real subscription rate -- a gauge of demand that accounts for retentions by the Bundesbank -- fell to 0.43 times against 0.86 times at the previous sale of similar maturity bonds on July 17.
Commerzbank AG had expected demand to come from life insurers and macro investors before the sale, despite the yield curve flattening in recent weeks. Long-dated German bonds are still attractive for U.S. investors, when hedged for currency swings, offering around a 2.6% yield, relative to around 2% on a 30-year Treasury.
“It is technically a failed auction,” said Jens Peter Sorensen, chief analyst at Danske Bank AS. “I am not all worried about this -- as investors can always just buy in the future and do not need to participate in auctions.”
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>>> U.S. Weighs Selling 50- and 100-Year Bonds After Yields Plummet
By Alex Harris and Emily Barrett
August 16, 2019
https://www.bloomberg.com/news/articles/2019-08-16/u-s-treasury-to-do-market-outreach-again-on-ultra-long-bonds-jzejo2qu?srnd=premium
Treasury conducting an outreach on ultra-long debt issuance
Announcement follows slide in 30-year yield to record low
With interest rates on 30-year U.S. debt hitting all-time lows this week, the government is once again considering whether to start borrowing for even longer.
The U.S. Treasury Department said Friday that it wants to know what investors think about the government potentially issuing 50-year or 100-year bonds, going way beyond the current three-decade maximum.
The government stressed that no decision has yet been made on ultra-long bonds, explaining that it’s looking to “refresh its understanding of market appetite.” The idea was broached before, back in 2017, but was shelved after receiving a less-than-warm reception.
“This comes up every now and again,” said Gennadiy Goldberg, U.S. rates strategist at TD Securities. “Every time the takeaway is, there simply isn’t enough demand at that tenor, or at least there hasn’t been in the past.”
The announcement follows a plunge in the 30-year yield to a record low this week below 2%, and also comes in the wake of many other nations opting to extend their borrowing profiles with so-called century bonds. Investors have snapped up 100-year bonds issued by the likes of Austria, although the experience of Argentina underscores some of the potential pitfalls of buying such long-maturity debt.
The yield on America’s current benchmark 30-year bond spiked to its highs of the day and the curve steepened following the Treasury announcement. The 30-year rate climbed as much as 8 basis points on the day to 2.05%, before ending the session at around 2.03%. The yield spread between the U.S.’s longest-maturity debt and its two-year note widened the most in five weeks on Friday.
30-year Treasury yields sank to a record low
The Treasury’s group of market consultants, the Treasury Borrowing Advisory Committee, has long been unenthusiastic on the prospect of an ultra-long issue, said Bruno Braizinha, director of U.S. rates research at Bank of America.
The challenge for the Treasury would be to offer a yield attractive enough for the typical investor base of pension funds and institutions, while keeping a lid on the cost of borrowing for U.S. taxpayers.
By Braizinha’s estimates, the yield on a 50-year issue would be expected to come in around 10-30 basis points above the 30-year rate.
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>>> A Decade of Low Interest Rates Is Changing Everything
Cheap money has transformed the world of borrowers, savers, bankers, money managers, and retirees.
Bloomberg
By Liz McCormick
July 23, 2019
https://www.bloomberg.com/news/articles/2019-07-23/a-decade-of-low-interest-rates-is-changing-everything?srnd=premium
It’s hard to wrap your head around just how low U.S. interest and bond yields are—still are—a decade after the Great Recession ended. Year after year, prognosticators said that rates were bound to go back up soon: Just be ready. That exercise has proved to be like waiting for Godot.
In 2018, Jamie Dimon, chief executive officer of JPMorgan Chase & Co., put Americans on alert to the likelihood of higher interest rates. He said the global benchmark for longer-term rates, the yield on a 10-year Treasury bond, could go above 5%. Right now it’s just a hair above 2%. Thirty-year mortgage rates are a fraction of long-run averages, and companies too are paying very little to borrow. All that cheap money has been helping the economy along. On the other side of the ledger, bank depositors are getting paid only a fraction of 1% on their savings.
The longevity of low rates has upended long-standing assumptions about money and reshaped a generation of investors, traders, savers, and policymakers. The Federal Reserve has tried to push the U.S. into a higher-rate regime, raising rates nine times since 2015, when the key short-term rate was near zero. But now the central bank appears ready to reverse course and start cutting again when it meets at the end of July. “This is the new abnormal,” says David Kelly, chief global strategist at JPMorgan Asset Management, which oversees $1.8 trillion. “Normally when you are in this phase of an expansion, you have a rising inflation problem, a Federal Reserve overtightening to slow the economy, and businesses that can’t afford to borrow. None of that is true right now.”
Investors are betting that a quarter-percentage-point rate cut is all but certain, according to prices in the futures market. Fed Chair Jerome Powell reinforced those views with remarks to Congress on July 10 and 11. He cited rising global risks, low inflation, and weakening business investment and manufacturing. Depressed U.S. rates come as other central banks, including the European Central Bank, have turned more dovish—even with their rates already set below zero.
relates to A Decade of Low Interest Rates Is Changing Everything
Fed chairman Jerome Powell.PHOTOGRAPHER: ANDREW HARRER/BLOOMBERG
Anne Walsh, chief investment officer of fixed income at Guggenheim Partners, says there’s been “a paradigm shift of epic proportion for investors.” Not only are short-term rates low, but long-dated bond rates are minuscule, too, suggesting that investors see little likelihood of rates—and the economic conditions they reflect—changing anytime soon. (Bonds’ yields fall as their prices rise.)
Borrowers of all kinds have been clear benefactors of this sea change, with many nations and companies locking in low rates for as long as a century. Belgium and Ireland have sold 100-year bonds, as did Austria this year at a yield of 1.171%. In 2015, Microsoft Corp. sold 40-year bonds and the University of California issued 100-year debt. Subdued rates have also buffered the U.S. Treasury from rising interest costs on the federal debt.
For banks, the squeeze in long-term rates isn’t ideal. That’s because they tend to fund long-term investments with short-term debt, so they prosper when long-run rates are significantly higher than short ones. In the U.S., banks have still been able to profit, with the top five firms cracking $30 billion in quarterly earnings for the first time. But some big commercial banks have warned that lower interest rates are weighing on their outlooks for revenues from lending.
Individuals have had to get used to earning paltry rates. The national average rate on savings accounts is 0.10%, little changed from four years ago and down from 0.30% in 2009, according to data from Bankrate.com. In 2000, well before the financial crisis, the rate was 1.73%. “We never got to the would-be promised land with respect to higher rates,” says Mark Hamrick, senior economic analyst at Bankrate.com. “This has been the difference for savers between having more money and not.”
The problem is the same for institutions that manage savings on behalf of others. Pension funds, overseeing trillions in retirees’ future cash, have been ratcheting down return expectations. The 30-year Treasury bond, a favored debt security, yields about 2.5%—compared with an average 6.5% since the 1970s. Even a record rise in stock prices hasn’t solved the low-return problem for pension funds, because many of them cut their allocations to equities after the financial crisis. Ben Meng, chief investment officer of the California Public Employees’ Retirement System, said in June that the expected return for his pension portfolio over the next 10 years would be 6.1%, down from a previous target of 7%.
Where low rates really bite isn’t in current returns but in the future gains investors can reasonably expect. Interest rates set a kind of baseline for the return on all assets. As they fall, bond values rise and stocks often do, too. But once rates have settled at or near rock bottom, there’s less room for that kind of price appreciation.
All this has sent investors looking under every available rock for more return—even if it means taking more risk. The fear is this could lead to the formation of bubbles and eventually destabilize the financial system. “Institutional investors are out there in the great truffle hunt for yield,” says Walsh, at Guggenheim. “This is particularly true of large institutions, like banks and insurance companies and pension funds. These firms are searching for yield and potentially taking on unintended risk because that is what they need to do.”
It’s a global phenomenon. Japan Post Bank Co., the banking unit of Japan Post Holdings Co., a publicly traded company that’s majority-owned by the government, held $577 billion in bonds outside its low-yielding home market in March. Norinchukin Bank, a cooperative that invests the deposits of millions of Japanese farmers and fishermen, has $69 billion in collateralized loan obligations—essentially, loans to companies with less-than-stellar credit—in the U.S. and Europe.
While some Fed officials wish they could get back to more-normal rates, so they have more room to ease again in the future if they need to fight a downturn or fresh financial crisis, they seem to have their hands tied. For all the problems low rates may cause, policymakers see them as a stimulant to growth. Although unemployment rates are very low, the economy took an agonizingly long time to recover from the financial crisis. And now a slowdown in global growth and headwinds from Trump’s trade war have made risks to U.S. output too strong to ignore.
This has some wondering if we’ve been thinking about the economy all wrong. “The traditionalist views on monetary policy and monetarism are really being questioned,” says Mark Haefele, chief investment officer at UBS Global Wealth Management, referring to to the notion that central banks always have the ability to juice the economy—or put the brakes on it—when needed. “That has led to a wide range of alternative theories including Modern Monetary Theory, and just how to re-stimulate growth.” According to MMT, for example, government policymakers should be willing to run bigger deficits, at least until a boom in demand causes inflation to kick in.
The surprising persistence of low rates has even quietly reordered the hierarchy on Wall Street. Hedge fund managers may still be glamorous on shows like Billions, but in real life they’ve had to fight to retain clients. Partly that’s because many hedge fund managers thrive on volatility, and in a world where the dreaded spike in interest rates has never arrived, there’s been too little of that for them. The long fall in rates has made it easier so far to earn money with simple investments such as stock and bond index funds. Meanwhile, cheap financing costs and rising asset values have been a boon for private equity firms. Investors have committed about $4 trillion to them in the last decade, according to data from research firm Preqin Ltd.
In 2009, bond powerhouse Pacific Investment Management Co. saw all this coming, when they dubbed their multiyear investment outlook “the new normal” and predicted lower long-term yields. They saw the same issues the Fed and central bankers around the world are grappling with now: slow growth, a combination of technological innovation and low-cost global labor that eases inflationary pressure, and a glut of savings as the populations of rich countries age. Looking ahead, with many of those 2009 factors remaining, “the new wrinkle is concern around global trade and countries looking more inward,” Pimco Group Chief Investment Officer Dan Ivascyn says. “Yields can absolutely go a lot lower.”
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>>> How ‘Transition Bonds’ Can Help Polluters Turn Green
Bloomberg
By Tom Freke
July 14, 2019
https://www.bloomberg.com/news/articles/2019-07-14/how-transition-bonds-can-help-polluters-turn-green-quicktake?srnd=premium
It makes sense that green bonds are meant for green companies. But there aren’t that many of them -- not enough to meet the rising demand from investors who want their money to have a positive impact on the environment. So what if some of that money went to finance green activities by less-than-green firms, such as oil companies, coal miners and agricultural businesses? A new concept that’s gaining traction, dubbed for now as transition bonds, could vastly expand the green credit field, and could help cut pollution where it needs to be cut. The risk is that they could provide cover for companies not fully committed to shifting quickly away from their carbon-spewing ways.
1. What would one be like?
A new class of bonds, transition bonds would finance projects aimed at helping the seller switch to a cleaner way of doing business, particularly if they help the climate. For example, an energy company could use them to finance efforts to capture and store its carbon emissions or to move from coal to gas-fired power plants. There’s no consensus yet on what types of commitments companies would need to make, though it’s expected that borrowers would need to sign up to specific targets, as well as broader sustainability goals. Investors would demand transparency, adding further pressure on companies to make public their impact on the environment and detail measurable ways in which they plan to bring their businesses in line with goals set in the Paris Agreement on climate change.
2. How is that different from a green bond?
It’s different because rather than focusing solely on the use of the proceeds or the profile of the issuer, a transition bond is about an issuer’s behavior: are they committing to becoming greener? By contrast, a green bond is restricted to financing for projects that are environmentally friendly. A focus on behavior is an approach that’s already taken off in the loan market. There, a new product called sustainability-linked loans allows borrowers to win a reduction in interest costs by hitting certain targets, such as cutting pollution or reducing food waste. They are one of this year’s fastest-growing debt asset classes.
3. Why aren’t green bonds an option?
The rules don’t prohibit oil producers and coal miners from selling green bonds, but it’s not a great option because some investors doubt those bonds are really green. Investors and banks are increasingly taking a company’s overall profile and commitment to reducing their carbon footprint into account when considering anything labeled “green,” while distancing themselves from non-renewable investments. In 2017, the first green bond sale by a major oil company, Spanish firm Repsol SA, divided the green-bond industry and the securities weren’t included in major green bond indexes. Better, say advocates of transition bonds, for those companies to have their own separate asset class.
4. What’s are the next steps?
There needs to be a wide-ranging discussion between banks, investors, policy makers and companies to decide whether it’s a good idea and how to proceed. In an effort to jump-start the conversation, Axa Investment Managers in June published proposals for transition bonds, arguing that they should be structured similarly to green bonds and be accompanied by a high level of transparency by issuers. French bank BNP Paribas SA has said it supports the the idea. Last year a body representing some Canadian companies also published proposals for transition bonds.
5. What are the challenges?
The suggestion comes at a time when the question of what makes a green bond is still being debated. There is still no single standard for green bonds, although the European Union recently published proposals for a code, potentially superseding the well-followed green bond principles used by trade body ICMA. With skepticism persisting about green bonds, getting people to trust that a transition bond is a solution, not just a marketing trick, may be tough. To avoid accusations of greenwashing -- making misleading claims about how effective at tackling climate change a project is -- there would need to be well-defined criteria for eligible projects and transparent reporting requirements.
6. What’s at stake?
An average of as much as $3.5 trillion worth of investments are needed every year through 2050 to build the necessary clean energy infrastructure to keep global warming in check. This could be the moment when green bonds go mainstream. But currently they only make up a small fraction of the market, with a cumulative $698.5 billion of green bonds sold, according to research by BloombergNEF. If more firms can seek financing based on environmental goals and more big investors swing behind the asset class, transition bonds could see growth similar to that seen in sustainability-linked loans.
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>>> The Black Hole Engulfing the World's Bond Markets
Bloomberg
By John Ainger
July 13, 2019
https://www.bloomberg.com/news/articles/2019-07-13/the-black-hole-engulfing-the-world-s-bond-markets-quicktake
It is growing.
There’s a multitrillion-dollar black hole growing at the heart of the world’s financial markets. Negative-yielding debt -- bonds worth less, not more, if held to maturity -- is spreading to more corners of the bond universe, destroying potential returns for investors and turning the system as we know it on its head. Now that it looks like sub-zero bonds are here to stay, there’s even more hand-wringing about the effects for mom-and-pop savers, pensioners, investors, buyout firms and governments.
1. Why invest in a bond that will lose you money?
Typically, bonds are the safest assets on the market, so many investors seek them out at times of heightened market stress, say a U.S.-China trade war or tensions in the Persian Gulf. A bond can have a modestly positive coupon when issued by a government, institution or company, but once it starts trading, high demand by investors can push its price up -- and therefore its yield down -- to such an extent that buyers no longer receive any payment. Some funds track government bond indexes, meaning they must buy the bonds regardless of the yield. And some investors can still make positive returns on these bonds when adjusted for currency swings.
2. How much is being bought?
Negative-yielding debt topped $13 trillion in June, having doubled since December, and now makes up around 25% of global debt. In Germany, 85% of the government bond market is under water. That means investors effectively pay the German government 0.2% for the privilege of buying its benchmark bonds; the government keeps 2 euros for every 1,000 euros borrowed over a period of 10 years. The U.S. is one of the few outliers, with none of its $16 trillion debt pile yielding less than zero, but across the world, strategists are warning that the problem may get worse.
3. Why is this reason for worry?
Negative rates are at odds with basic principles of the global finance system. “One important law of financial logic –- if you lend money for longer, you should see a higher return –- has been broken,” wrote Marcus Ashworth, a Bloomberg Opinion columnist covering European markets. “The time value of money has essentially disappeared.” (Has it ever: The so-called century bonds issued by Austria two years ago, which mature in 2117 and initially offered a 2.1% return, now yield about 1.2%.) All this can push investors into riskier bets in the hunt for returns, raising the chances of bubbles in financial markets and real estate.
4. Who benefits from negative rates?
Governments, for one. The incentive to borrow money is never greater than when you are being paid to do so. Germany, for example, is being subsidized to issue debt over the next 20 years, though that does not necessarily mean it will boost spending. Companies that issue bonds also reap the benefits of record-low borrowing costs. So do private-equity firms, which typically use leverage to acquire companies and see greater opportunities when (and where) capital is cheap. Homeowners with variable-rate mortgages also have reason to celebrate.
5. Who gets hurt?
Pension funds and insurers, traditionally big investors in government bonds, are in a particular predicament: Their liabilities grow steadily as clients age, but often they are required not to take on big risks. Banks see their margins squeezed. They’re earning next to nothing from lending but still need to offer depositors a rate above zero to keep their business. In Germany, the ECB has come under political pressure for hurting the returns of savers. Central banks could run into the problem of hitting the so-called “reversal rate” -- the point at which low borrowing costs start to harm rather than help the economy, should banks start to restrict loans. That could deepen any slowdown.
6. How did we get here?
Several of Europe’s central banks, otherwise unable to spur growth in the aftermath of the 2008-2009 financial crisis, cut interest rates below zero in 2014. Japan soon followed. The idea was to spur lending by charging financial institutions, rather than rewarding them, for parking money that otherwise could be put to use in the real economy. Since 2016, the ECB’s benchmark rate has been -0.4%, meaning banks lose 4 euros to store 1,000 euros there. The sub-zero rates were supposed to be temporary but have endured. Traders are betting that the ECB will push its deposit rate ever more negative this year, driving record levels of bond yields below zero.
7. Why have negative rates lasted so long?
More than a decade on from the credit crisis, inflation is still scarce, with wages increasing only modestly despite large drops in unemployment. The ECB, for example, isn’t expected to get to its close-to-2% inflation target over the next decade, according to a market-derived measure. And the yield difference between U.S. three-month bills and 10-year Treasuries is inverted, an indication that an economic contraction may be coming. Aside from the U.S. Federal Reserve, few central banks that slashed interest rates during the credit crunch have managed to raise rates, meaning that during the next downturn they are likely to head further into negative territory.
8. Where’s all this heading?
In Europe, there are fears that the continent is following the path of Japan’s so-called lost decade, where policy makers struggled to revive anemic growth and inflation. Central banks have been keen to iterate that they still have tools in their locker to combat any slowdown, including rate cuts and more quantitative easing. For markets, waning volatility is bad for trading. Geopolitical tensions over trade, and Britain’s exit of the European Union will keep driving investors into the safest assets, meaning demand will remain high for negative-yielding debt. But the push to find juicier returns with riskier bets raises the prospect of further fund failures or a new crisis.
The Reference Shelf
Why buyers of negative-yielding debt aren’t necessarily fools.
QuickTakes on negative interest rates, yield curve inversion and central bank independence.
Bloomberg Opinion columnist Marcus Ashworth delved into the implications of "this tectonic shift in fixed income."
The crisis at Danske Bank illustrates the full extent of damage from negative rates.
An ECB paper on negative rates not being unproductive once they reach the zero lower bound.
Pimco are among a growing clamor of voices that Europe is becoming “Japanified.”
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>>> Jerome Powell Just Locked in a July Rate Cut
If he had any inkling to hold steady this month, his testimony needed to shake bond traders from their 100% certainty about easing. Instead, he only added to their resolve.
Bloomberg
By Brian Chappatta
July 10, 2019
https://www.bloomberg.com/opinion/articles/2019-07-10/jerome-powell-leaves-no-doubt-about-fed-rate-cut-in-july?srnd=premium
The question now is whether the central bank stops at just one.
Federal Reserve Chair Jerome Powell had a chance Wednesday to push back against both over-aggressive bond traders and Trump administration officials who were pounding the table for interest-rate cuts. He had the cover of not just a strong rebound in the U.S. labor market but also the backing of regional Fed presidents like Patrick Harker and Loretta Mester, who had already advocated this month for keeping the central bank’s lending benchmark unchanged.
Instead, in prepared remarks to U.S. lawmakers, he told the bond market and the president that a quarter-point rate cut is a sure thing at the end of the month.
Rather than highlighting the strength of the U.S. economy, Powell seemed to make every effort to note all the possible risks and where it’s falling short. Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott, noted that in his description of the current economic situation and outlook, Powell wasted no time brushing off the first-half performance:
The economy performed reasonably well over the first half of 2019, and the current expansion is now in its 11th year. However, inflation has been running below the Federal Open Market Committee's (FOMC) symmetric 2 percent objective, and crosscurrents, such as trade tensions and concerns about global growth, have been weighing on economic activity and the outlook.
This is more or less a snapshot of Powell’s stance throughout the remarks. They’re far more pessimistic than expected, focusing on trade tensions and the slowing global economy and what that sort of uncertainty might mean for the U.S. “There is a risk that weak inflation will be even more persistent than we currently anticipate,” he said. That’s an abrupt change of tune. So much for those “transitory” factors subduing price growth that the Federal Open Market Committee saw just two months ago. Or that the latest reading of the consumer price index is still to come this week.
In a way, this is what markets expected all along. The odds of a quarter-point interest-rate cut have been stuck right around 100% since last week’s jobs data. But Powell’s unambiguous move toward the dovish contingent of the Fed, which thinks an “insurance cut” is necessary, is nonetheless new information. To be clear, this was not a “hint” of a July rate cut. It was a declaration.
In No Uncertain Terms
Powell chooses not to preserve the option to hold interest rates steady this month
As I wrote last week, Powell had a real opportunity with this testimony to shake bond traders from their 100% conviction. In fact, he was probably the only Fed member who could do it. My Bloomberg Opinion colleague Conor Sen and I recently discussed this idea of what it would take to break through the 100% mark, imagining this sort of conversation among two traders heading into Powell’s testimony:
Trader 1: I really don’t think the Fed will cut rates this month. I should bet on that.
Trader 2: Of course the Fed will cut. Markets have priced in a 100% chance. They’ve never disappointed in that scenario and they won’t this month either.
Trader 1: But the jobs numbers were strong, other Fed officials have signaled they’re not fully on board with a cut, inflation is still decent and stocks are at all-time highs.
Trader 2: Yes. Still, the markets have priced in a 100% chance of a cut. They’ve never disappointed in that scenario and they won’t this month either.
Trader 1: But…
Trader 2: The markets have priced in a 100% chance of a cut. They’ve never disappointed in that scenario and they won’t this month either.
Trader 1: OK, you’re right. I’ll just wait to see if the odds fall below 100% before betting.
Obviously, with those sorts of conversations on trading desks around the world, no one ends up taking the first step toward pricing out an interest-rate cut. That sort of inertia requires someone like Powell to break it. It didn’t happen, and that was by design.
It’s hard to pinpoint what precisely persuaded Powell capitulate to easing sooner rather than later. Some will probably cite his comments that “an ounce of prevention is worth a pound of cure” as evidence that he was leaning toward lowering rates in July all along. That wasn’t my read, and I wasn’t alone. Bloomberg Economics and Bank of America Corp. were among those expecting the Fed to hold steady this month, and Citigroup Inc. this week reiterated that a July interest-rate cut wasn’t a done deal.
It will be worth watching how Powell answers questions about the central bank’s independence and its ability to withstand political pressure. There’s simply no escaping the fact that the Fed is about to lower interest rates after months of President Donald Trump demanding it do so, all the while chiding policy makers for being clueless and suggesting he has the power to fire or demote Powell. This White House views the stock market as a referendum on its economic policies, and, thanks to Powell, the S&P 500 reached another record on Wednesday, eclipsing 3,000 for the first time.
The debate on lowering interest rates in July is over. Now, traders will move on to ponder whether the Fed can really do just one for insurance, or whether this is the beginning of an extended easing cycle that will once again bring U.S. yields back toward all-time lows.
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>>> Trump Picks Two Fed Nominees Likely to Support Easier Policy
Bloomberg
By Josh Wingrove and Rich Miller
July 2, 2019
https://www.bloomberg.com/news/articles/2019-07-02/trump-says-he-ll-nominate-christopher-waller-for-federal-reserve?srnd=premium
Waller serves as official with St. Louis Federal Reserve Bank
Shelton has served as an informal adviser to president
After a yearlong assault on the Federal Reserve and its chairman, President Donald Trump has tapped two wildly different economists to the central bank’s board who seemingly have one important thing in common.
They’re both likely to support the president’s call for lower interest rates.
One, Christopher Waller, is the more conventional choice drawn from within the Fed’s own ranks. The other, Judy Shelton, has spent decades outside mainstream economics and has already faced criticism for some of her unconventional views on monetary policy.
Waller is director of research for St. Louis Federal Reserve Bank President James Bullard, who was the only dissenting vote in favor of a rate cut at the Fed’s meeting in June. Shelton, who has been an informal adviser to Trump, has publicly said the central bank should reduce rates.
“It seems like both are going to be in favor of lower rates, and sooner rather than later,” said Kathleen Bostjancic, an economist at Oxford Economics in New York. “They are much more dovish, and obviously that’s what President Trump wants.”
Trump, who announced his picks within minutes of each other on Twitter Tuesday, has recently struggled to find candidates for the Fed that are acceptable to senators who must confirm nominees. The president previously advanced four people for the two remaining open seats on the board of governors. None of them made it, raising questions about the White House vetting process for his picks.
“It was a great pleasure to meet with the president this afternoon,” Shelton said in an email on Tuesday night. “This president really gets it. His pro-growth economic agenda should not be undermined by wrongheaded ‘Phillips Curve’ thinking that punishes productive economic growth and subverts continued gains while turning a blind eye to the currency impact of ‘additional stimulus measures’ by other central banks. We have high employment and low inflation; so much for the supposed trade-off.”
The Phillips Curve holds that there’s an inverse relationship between unemployment and inflation.
Senate Confirmation
As a high-ranking Fed staffer, Waller may have a better chance of passing muster with lawmakers than some of Trump’s previous contenders. As for Shelton, the Senate has already confirmed her in her current role as the U.S. executive director for the European Bank for Reconstruction and Development.
Her unorthodox views, though, could attract opposition.
In an interview with Bloomberg in May, she said she was “highly skeptical” that the goals for the Fed set by Congress -- the pursuit of maximum employment, stable prices and moderate long-term interest rates -- were relevant.
The White House has conducted the search for Fed candidates as Trump has repeatedly blasted Fed Chairman Jerome Powell over the Fed’s interest rate increases. The president has told confidants that he believes he has the authority to replace Powell as Fed chairman, demoting him to the level of board governor, according to people familiar with the matter. But Trump said he doesn’t plan to do it. The president chose Powell as Chair, replacing Janet Yellen last year.
Trump’s eagerness to get rid of Powell makes both of these nominees potential chairs-in-waiting, a factor that may also affect their confirmation process in the Senate. Powell has said he intends to serve his full four-year term and that “the law is clear” on that issue.
Earlier this year, Trump advanced two supporters for the Fed board, Stephen Moore and Herman Cain, but both withdrew their names after they came under criticism.
St. Louis Fed
Waller, who declined to comment Tuesday on his nomination, is a Ph.D. economist who previously served as a professor of economics at the University of Notre Dame before joining the St. Louis Fed in 2009. His key research focus has been on monetary and macroeconomic theory and the political economy.
Waller was approached by the White House last month about the job and met with Trump Tuesday, said Karen Branding, a spokeswoman for the St. Louis Fed.
The overture came after the White House talked to his boss, Bullard, about joining the Fed board of governors himself. But Bullard told reporters last month that he’s happy in his current position.
The two men are close and have co-authored monetary-policy papers. Waller shares, and helped to develop in 2016, Bullard’s dovish view that policy is in a new regime in a world with low inflation and high savings -- where higher interest rates are not needed.
“We didn’t see any overheating in the economy coming, and so the question was, why are we raising rates,” Waller recalled in a June interview with Bloomberg. “We didn’t see any reason to raise rates just for the sake of raising rates.”
Waller also said that he doesn’t worry about pushing the unemployment rate too low and sparking higher prices. “We don’t buy into the Phillips curve story that low unemployment causes inflation. Look at Japan,” he said.
Fed Policy
Shelton has a doctorate in business administration from the University of Utah with an emphasis on finance and international economics. She previously worked for the Sound Money Project, which was founded to promote awareness about monetary stability and financial privacy.
In her interview with Bloomberg in May, Shelton questioned the use of the Fed’s basic interest-rate tool to adjust the price of money, and thereby guide an economy toward a sustainable level of growth.
“A Fed that is too eager to artificially put in an interest rate that isn’t close to what the market would be suggesting is not so good,” she said at the time. “I would try to be the voice saying, are you sure you know better than the markets?”
Shelton has also in the past argued for a return to a gold standard, fixing the value of the U.S. dollar to a weight of gold, a system the U.S. followed to varying degrees until 1976. If appointed to the Fed, however, Shelton said she would not call for a return to the gold standard or for a sudden abandonment of other established policies.
After raising interest rates last year in the face of criticism from Trump, Powell and fellow Fed colleagues are widely expected to cut rates at their next meeting at the end of this month.
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>>> Saudi Buying of U.S. Treasuries Has Soared Since Trump Election
As Trump continues to defend the embattled crown prince, the kingdom has everything to gain from playing nice.
Bloomberg
By Liz McCormick
June 30, 2019
https://www.bloomberg.com/news/articles/2019-06-30/saudi-buying-of-u-s-debt-has-soared-since-trump-s-election?srnd=premium
By now, President Donald Trump’s bromance with Mohammed bin Salman of Saudi Arabia is well documented. The platitudes and chummy photo-ops. The billions of dollars in U.S. arms sales. And, of course, the willingness to brush aside evidence implicating the crown prince in the murder of journalist Jamal Khashoggi.
But what’s gone largely unnoticed is just how enthusiastic the kingdom has been in snapping up America’s debt.
After aggressively culling its holdings of U.S. government debt for most of 2016, Saudi Arabia has amassed an even larger position since Trump’s election in November that year. Based on the latest reported figures, the nation nearly doubled its ownership of Treasuries to $177 billion. No major foreign creditor has ramped up its lending to the U.S. faster.
Coincidence? Perhaps. After all, you could probably marshal any number of plausible explanations for the timing of the oil-exporting nation’s buildup that don't involve some political quid pro quo. Rising petrodollar revenue. Risk aversion. A shift out of negative-yielding bonds. And considering how big the U.S. deficit has grown because of Trump’s tax cuts, the amounts involved won’t move the needle all that much when it comes to America’s financing needs.
Whatever the case may be, however, this much is clear: as Trump continues to defend Prince Mohammed in the face of growing criticism on a whole host of issues, from the Saudi-led war in Yemen to his alleged role in the gruesome killing of Khashoggi, the kingdom has everything to gain from appearing to lend financial support to its most important ally — even if it isn’t intentional. That's particularly true after talk surfaced in May that China, the largest foreign creditor to the U.S., might be considering the unlikely move of dumping its Treasuries to punish Trump over his trade war. (Though at the Group of 20 summit in Osaka, the two countries declared a truce, at least for now.)
“It’s a relationship where one hand washes the other,” said Martin Indyk, a distinguished fellow at the Council on Foreign Relations and a former U.S. special envoy to the Middle East during the Clinton administration. Buying of Treasuries could be a “manifestation of the closeness of the relationship.”
Indyk was quick to note he doesn’t have any particular inside knowledge on the situation and the Treasury market is a natural destination for Saudi Arabia’s petrodollars anyway. But he suggested that as tensions between the U.S. and Iran escalate, it also makes sense Trump would want the Saudis to boost production to keep oil prices in check. More output means more petrodollars, which can then be recycled back into Treasuries.
The numbers stand out. From the end of October 2016, the last month before Trump’s election, through April of this year, Saudi Arabia upped its ownership of Treasuries from $97 billion to $177 billion, Treasury Department data show. The 83% jump was by far the biggest among the top 12 foreign creditors in percentage terms. (The U.K., a banking center whose figures are seen as a proxy for hedge funds and other global investors, had the biggest absolute gain. Its holdings rose from $207 billion to $301 billion.)
The buildup is also noteworthy because of just how dramatically Saudi Arabia reduced its holdings in the months leading up to the election. In the first nine months of 2016, the kingdom slashed its ownership of Treasuries by almost 30% in its most aggressive retreat in over a decade.
Quid Pro Quo?
A big part of the drawdown had to do with Saudi Arabia’s fiscal crisis at the time, when the monetary authority burned through tens of billions of dollars to plug its biggest budget deficit in a quarter-century. Yet there was also plenty of speculation about Saudi Arabia’s political motivations as well.
In April of that year, the New York Times reported that Saudi officials warned the Obama administration and members of Congress it would sell off $750 billion worth of Treasuries and other American assets if lawmakers passed a bill allowing the kingdom to be held liable in U.S. courts for the Sept. 11 terror attacks. (It ultimately became law after Congress overrode President Barack Obama’s veto.) That came after America took tentative steps toward a rapprochement with Saudi Arabia’s archrival Iran, highlighted by the landmark nuclear deal under Obama that Trump pulled out of last year.
So with Trump, the kingdom has every incentive to play nice.
Besides breaking with tradition to visit Saudi Arabia on his first foreign trip, Trump and Jared Kushner, his son-in-law and senior adviser, have forged close, personal relationships with the crown prince, who’s known as MBS. At the G-20, Trump met the kingdom’s de facto leader for breakfast on Saturday, calling him a “friend” and praising their “great relationship.”
Crucially, Trump has repeatedly downplayed Prince Mohammed’s role in Khashoggi’s killing inside the Saudi consulate in Istanbul, in spite of CIA intelligence that led lawmakers to unanimously assign blame to him. (Saudi government officials have denied that he had anything to do with the murder.) In May, Trump even bypassed Congress to approve a $2 billion arms sale to Saudi Arabia over bipartisan objections. While the Senate blocked the move, Trump will likely use his veto to push the deal through.
Critics say that by repeatedly giving Saudi Arabia the benefit of the doubt, Trump has provided cover for Prince Mohammed — once feted as a progressive reformer — to crack down on dissent at home and wage a brutal war in Yemen, which has led to over 200,000 deaths, according to the United Nations.
Granted, there are reasons to think that Saudi Arabia’s investments in Treasuries have nothing to do with politics. From the end of October 2016 through April this year, the price of Brent crude oil rose just a shade over 50%, a boon for the coffers of the world’s largest oil-exporting nation.
Saudi Arabia may also be shifting its exposure away from lower-yielding European bonds, according to Marc Chandler, chief market strategist at Bannockburn Global Forex. After all, 10-year Treasuries currently yield about 2%, versus roughly -0.33% for German bunds. And as the world’s safe-haven asset, it’s not hard to see Saudi Arabia moving into U.S. government debt as a hedge for weakening global growth.
“I suspect this is partly a debt management issue” rather than from any political motive, Chandler said. “Especially since there hasn't been a rise in Saudi Arabia's (foreign) reserves.”
Indeed, even as the country’s holdings of Treasuries have jumped, its foreign-reserve assets have hardly budged. It’s a potential sign that Saudi Arabia is funneling more cash to plug its deficit as it ramps up domestic spending.
Yet in some ways, Saudi Arabia’s ownership of U.S. government debt has always been influenced by political considerations. For more than four decades, how much the kingdom actually held was kept secret from the public as part of a strategic agreement brokered during the Nixon administration. The unique arrangement bound together two countries that shared few common values, reshaping U.S.-Saudi relations for generations. It was only in May 2016 that the U.S. began releasing a detailed breakdown of Saudi Arabia’s holdings in response to a Freedom of Information Act request filed by Bloomberg News.
Brad Setser, a former Treasury official who’s currently a senior fellow at the Council on Foreign Relations, takes a nuanced view.
Like a handful of other countries, Saudi Arabia has traditionally held its Treasuries across a number of global financial centers, according to longtime observers. And it’s likely the official tally understates the true size of the kingdom’s holdings, which is masked behind those of other countries. The recent uptick suggests to Setser the country now has less reason to obscure its investments from broader view than it did in the past.
“Whether it’s that they’re best friends with Trump or feel more comfortable overall — the portion of the Saudi reserves that is showing up in the U.S. data has clearly been going up over time,” Setser said.
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>>> Not Even the Fed Can Keep the Dollar Down
Demand for havens as the global economy slows will more than offset any weakness from lower U.S. interest rates.
By Komal Sri-Kumar
June 28, 2019
It’s the dollar’s time to shine.
https://www.bloomberg.com/opinion/articles/2019-06-28/trump-can-t-stop-the-dollar-from-getting-stronger?srnd=premium
The Bloomberg Dollar Spot Index is poised for its worst month since January 2018. The good news for those bearish on the greenback is that it probably has further to go. The bad news is that the downward trend won’t likely last very long and the path of least resistance is higher.
There are numerous reasons for why the dollar has been under pressure lately. At the top of the list are the Federal Reserve’s dovish pivot and President Donald Trump’s increasingly vocal desire for a weaker currency, abandoning the U.S. government’s long-held doctrine that a strong dollar is in the nation’s best interests.
What the bears may not appreciate is how forcefully the U.S.’s major trading partners may respond to keep their currencies from appreciating against the dollar and having their exports become less competitive. If the Fed does cut interest rates, the odds are high that the European Central Bank and Bank of Japan would follow suit, supplementing those moves with further asset purchases. The People’s Bank of China could reduce commercial banks’ required reserve ratios, causing the yuan to depreciate against the dollar.
Second, it should be noted that major central banks are responding to a deteriorating outlook. The International Monetary Fund forecasts global economic growth will be the worst since the financial crisis amid the escalating trade wars. The very real possibility of a recession in the U.S. and euro zone, as well as decelerating growth in emerging markets, are likely to push investors toward a defensive posture in their portfolios, prompting capital to flow to traditional havens such as the dollar.
A third reason for a stronger dollar is the volatility in exchange rates that would arise from any currency war and the potential for Trump to implement even more tariffs against the U.S.’s trading partners as the campaign for the 2020 presidential elections heats up. Exchange-rate uncertainty is negative for trade and capital flows since exporters and investors have to hedge their currency risk through expensive swap operations.
The experience from the last recession supports expectations for an initial weakening of the dollar followed by subsequent appreciation. The dollar depreciated significantly in the first several months of 2008 even though it was not widely recognized that the U.S. economy had already entered a recession. The Bloomberg Dollar Spot Index fell from 951.7 at the beginning of that year to 917.7 by the end of June. This occurred as the Fed cut its target for the federal funds rate several times starting in September 2007 and the ECB’s policy rate remained unchanged. But by March 9, 2009, the dollar index had surged to 1,144.2, its peak for the cycle.
Will History Repeat?
The dollar rallied in 2008 even as the Fed was cutting interest rates
Not coincidentally, that was also the day U.S. equity averages bottomed during the Great Recession. The purchasing power of the euro fell from $1.58 in June 2008 to $1.26 in March 2009. This occurred as central banks cut interest rates several times after the Lehman Brothers bankruptcy in September 2008.
Various cautionary signs for the U.S. economy, including a slowdown in both housing and manufacturing activity, and inversions in parts of the U.S. Treasury market’s yield curve, suggest a rapid worsening in the outlook. A Federal Reserve Bank of New York Index puts the probability of a recession over the next 12 months at 30%, the highest since mid-2008.
In addition to its impact on the value of the dollar, weaker economic activity will also play a role in domestic markets. In particular, look for the risk aversion that encourages global investors to seek refuge in the dollar to also lead in an increased demand for Treasury securities, pushing the yield on 10-year notes down from the current level of around 2% to 1.50%. Any exogenous events that may occur at about the same time as a recession – a conflict in the Middle East conflict or increased U.S.–China hostilities over the South China Sea, for example – would accelerate the rush into Treasuries.
Here, also, there is precedent. The yield on 10-year Treasuries reached its peak in the current economic cycle of 4.27% in June 2008. Six months later, as the magnitude of the financial crisis became clear, the yield had more than halved to 2.05%.
The message for traders is that time is running out to profit from dollar weakness. As a haven, history shows that that dollar will strengthen in times of turmoil in markets and economies. This time should be no different despite the wishes and best efforts of the Trump administration.
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Komal Sri-Kumar is the president and founder of Sri-Kumar Global Strategies, and the former chief global strategist of Trust Company of the West.
>>> Powell’s Concern Over Zero Rates Expected to Lower Bar for Fed Cut
Bloomberg
By Craig Torres
June 16, 2019
https://www.bloomberg.com/news/articles/2019-06-16/powell-s-concern-over-zero-rates-seen-lowering-bar-for-fed-cut?srnd=premium
Fed chairman says extending expansion an ‘overarching’ goal
No interest rate move expected when officials meet this week
Chairman Jerome Powell’s frequent assurance that sustaining the U.S. economic expansion is the Federal Reserve’s “overarching’’ goal is opening the door to potentially aggressive interest-rate cuts.
The timing, size and whether such moves are indeed in his plans may become clearer when Powell and his colleagues meet on Tuesday and Wednesday in Washington.
While investors are agitating for the Fed to shift, economists don’t see a move this week and are divided on whether officials will cut at all in 2019. The median estimate of Bloomberg’s most recent survey shows a quarter point reduction in December, though it was a close call.
Policy rate has been closer to zero compared with any expansion since 1950s
The suspicion of a number of Fed watchers, though, is that the hint of a slowdown would be enough for the Fed to move, and that policy makers will acknowledge that readiness this week. One reason is that the chairman has signaled he’s concerned about how just low rates still are, meaning it may be better to act sooner and avoid a recession than wait and find the economy slumping with the Fed having limited room to act.
Prospects for a shift have mounted in recent weeks as President Donald Trump’s trade war with China has escalated and the U.S. economy had displayed some signs of weakness.
“They will be very reactive if the data even confirms a small amount of slowing,’’ said Priya Misra, global head of interest rate strategy at TD Securities. “They are going to be more pre-emptive and more aggressive. They will open the door for a rate cut’’ at the meeting this week.
That perspective of Fed policy has a lot to do with Powell’s perception of risk at a time of high uncertainty and Trump’s dispute with China.
The Fed’s benchmark policy rate has never been this low during a prolonged economic expansion in records going back to the 1950s. That means when the next recession occurs rates will be closer to the zero limit: in effect, U.S. central bankers have less room to cut.
The Fed chairman described the zero boundary as “the preeminent monetary policy challenge of our time, tainting all manner of issues’’ in a speech in Chicago this month.
Fed watchers read those words as a new trigger point for the central bank. It won’t take an overwhelming confirmation of weakness in data for the Fed to ease, in their view, and a sense that risks are particularly heightened might be enough to prompt a move.
“The bar for precautionary cuts is lower if you are worried about the zero lower bound,’’ said Michael Gapen, chief U.S. economist at Barclays Plc, which predicts 0.75 percentage points of easing this year, one of the most aggressive calls on Wall Street.
That said, economists are still parsing how much weight the Fed will put on the economic data in hand versus risks and uncertainties, and there isn’t much consensus. Twelve firms expect at least one cut this year, the Bloomberg survey showed, while 12 expect two cuts. Sixteen firms expected no cut at all, and two projected a hike.
“I am hard pressed to figure out what all the fuss is about,’’ said Ward McCarthy, chief financial economist at Jefferies LLC, who expects rates to remain unchanged this year. “I think the slowdown’’ in the data now “is the slowdown we are going to get.’’
Monthly job growth in 2019 has slowed to an average of 164,000, down from 230,000 in the first five months of 2018. Job openings remain near record highs and consumption is holding up, but concerns over tariffs have hit household confidence. It all paints a picture of an economy that’s down-shifted a bit with inflation below the Fed’s 2% target.
“We see weak inflation impulses,’’ said Julia Coronado, founder of MacroPolicy Perspectives LLC, who forecasts two rate cuts this year. “It is not like the consumer has rolled over, but you are now seeing a slowing in the pace of growth that makes the economy look more vulnerable to the uncertainties ahead.’’
Perhaps the biggest source of uncertainty is Trump. World leaders meet in Osaka for the G-20 summit later this month, and investors hope for fresh trade talks between the U.S. and China.
Anything short of a clearly positive reset between Trump and Chinese President Xi Jinping would weigh on business confidence and investment as it could upset supply chains and roil markets. That risks a steeper slowdown in U.S. growth that Fed officials won’t tolerate, warned Barclays economists, who predict a 0.50 percentage point cut as soon as July.
Fed independence will also be on Powell’s mind. Trump has relentlessly attacked the central bank for months for having tightened too far, including a fresh broadside on Friday.
If rates were lowered back to zero, the Fed would have to return to emergency-era policies such as buying bonds, an unpopular measure with lawmakers of both parties.
“In the long wake of the crisis, they just don’t have that much political capital to fall back on. Add to that unprecedented presidential pressure and party polarization and it gets ugly,” said Mark Spindel, co-author of a recent book about the Fed’s relations with Congress. “They are the only game in town -- and they are without deep pockets or ammo” to address the next recession.
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>>> Treasuries Are on Biggest Rally Since 2008 as Fed Rate-Cut Seen
Bloomberg
By Ven Ram and James Hirai
June 3, 2019
https://www.bloomberg.com/news/articles/2019-06-03/treasuries-are-on-biggest-rally-since-2008-as-fed-rate-cut-seen?srnd=premium
Markets Haven't Seen Full Impact of U.S.-China Trade War, JPMorgan Says
Treasuries to Continue Bull Run Amid Negative Enthusiasm: Credit Suisse
Investors are chasing bond yields lower at the fastest pace since the global financial crisis on conviction that the Federal Reserve will cut borrowing costs to contain the fallout from trade tensions.
The yield on two-year Treasuries is headed for the biggest two-day decline since January 2008 after China extended retaliatory tariffs to cover more than two-thirds of imports from the U.S, with Beijing also warning students about the risk of studying in America. Meanwhile, JPMorgan Chase & Co. slashed its targets for U.S. yields on concern that the trade war with will crimp economic growth and force the Federal Reserve to cut interest rates.
Short-dated Treasury yield has fallen for five straight days
“The latest developments this week are likely to have lasting damaging effects on business confidence,” JPMorgan analysts led by Matthew Jozoff and Alex Roever wrote in a note. “Growth concerns are unlikely to dissipate over the near term, and could in fact build further.”
Read More:
JPMorgan Slashes U.S. Yield Forecasts on Trade-War Shock (3)
Fed Funds Futures Now Show Two Quarter-Point Cuts by Year-End
Treasuries Rally Led by Front End as Rate-Cut Pricing Firms
Bond Traders Lift Rate-Cut Bets as Tariffs Threaten Growth (1)
Yields on two-year U.S. Treasuries slumped as much as eight basis points to 1.84%, the lowest since December 2017, while those on 10-year notes fell five basis points to 2.07%. That means the extra yield investors get to hold the longer-dated debt is a mere 23 basis points, reflecting pessimism about the outlook for the world’s largest economy.
Yields across the euro area were also lower, with the rate on 10-year German bunds falling one basis point to a record-low minus 0.21%.
JPMorgan predicted that 10-year Treasury yields will slide to 1.75% by the end of the year, compared with an earlier outlook for 2.45%. It sees the two-year yield falling to 1.40%.
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>>> Why markets are looking for clues on an 'insurance cut' from the Fed
by Brian Cheung
Yahoo Finance
April 29, 2019
https://finance.yahoo.com/news/fomc-preview-may-insurance-cut-fed-184747060.html
Could the Federal Reserve provide clues on whether or not a rate cut is in its crystal ball for 2019?
That’s a question that market participants and Fed watchers are asking ahead of this Wednesday’s Federal Open Market Committee (FOMC). In the FOMC’s last meeting in March, policymakers signaled no rate hikes for 2019, spurring chatter about whether or not the next move would be to cut the benchmark interest rate.
As of Monday morning, fed funds futures were pricing in a 47.7% chance that policymakers cut by at least 25 basis points by the end of its September 18 meeting. Some are arguing for the Fed to make an “insurance cut” to get ahead of a possible recession.
Chicago Fed President Charles Evans told The Wall Street Journal April 22 that he could support that insurance if inflation readings came in low. He elaborated that the Fed, which has consistently undershot its 2% inflation target, may be pushing “restrictive” monetary policy if measures of core personal consumption expenditures start coming in around 1.5%.
“Anything that’s sustainable, that looks like it’s moving downward, not upward, I would be extremely nervous about,” Evans said. “And I would definitely be thinking about taking out insurance in that regard.”
In the most recent reading of core PCE - the Fed’s preferred measure of inflation which strips out food and energy - had prices increasing by only 1.6% year-over-year in March.
JPMorgan Chase’s Michael Feroli wrote April 26 that this meeting could see the first dissent under Chairman Jerome Powell, possibly from St. Louis Fed President James Bullard. Feroli said he could see the committee focusing on muted inflation pressures.
“The only feasible candidate to dissent is Bullard; while not our baseline it wouldn’t be too surprising if he voted to cut rates,” Feroli said.
Bullard told Yahoo Finance April 17 that he is pleased with the Fed’s “flat rate outlook” given the lack of inflationary pressures.
1997 all over again?
Analysts are zoning in on inflation to see if the Fed’s next move will be a rate cut.
Evans and Vice Chairman Richard Clarida have referenced the 1997-1998 stretch where the Fed pivoted from raising rates to a “wait-and-see” policy approach while the Asian financial crisis was heating up.
In 1998, the Fed cut rates by 75 basis points amid the Russian default. The Fed characterized that first cut as “insurance against the risk of a further worsening in financial conditions.”
Earlier this month, Clarida acknowledged the Fed’s history with “insurance cuts” on CNBC but said committee members “certainly don’t see a recession right now.”
A February survey from the National Association of Business Economics had 10% of economists predicting a recession in 2019 and 42% of economists predicting a recession in 2020.
Powell is likely to field questions about the possibility of an insurance cut in the meeting.
In a note April 26, TD Securities wrote that Powell will likely insist that inflation will gradually rise to its target over the next year or two, but said the chairman would be open to data that says otherwise.
“It would take both a sizable (to 1.5% or lower) and persistent (likely three months or more) drop in core PCE inflation to get the Fed to start to seriously discuss cutting rates.”
Barclays agreed that for the time being the Fed does not need to seriously consider a cut, pointing to the GDP report for the first quarter showing the U.S. economy growing by 3.2%.
“In our view, the Q1 GDP report and other components of the March data flow are likely to leave the Fed feeling that the outlook has improved somewhat since the committee last met.”
The May FOMC meeting will conclude at 2:00 p.m. ET on Wednesday, May 1.’
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>>> The Fed Will Have to Risk More in the Next Recession
Among the options: Tolerating faster inflation or dropping helicopter money.
Bloomberg
By Noah Smith
April 17, 2019
https://www.bloomberg.com/opinion/articles/2019-04-17/the-fed-will-have-to-risk-more-in-the-next-recession
Almost 10 years after the Great Recession ended, the growing threat of a new economic slowdown raises a troubling question: When the next recession strikes, what can the world’s central banks do? With interest rates low and their balance sheets still loaded with assets bought to fight the 2008 crisis, do they have the tools to respond? This column is one of six looking at that question.
When the next recession comes, will the Federal Reserve have the resources needed to fight it off? The experience of the past decade suggests that people should curb their expectations.
Predicting recessions is a fool’s game. Many thought one was imminent when stocks fell at the end of 2018, but markets and confidence recovered. That said, worrying signs abound. China is slowing down, trade tensions persist and a key indicator in the bond market is flashing yellow. Around the world, corporate debt looks high and increasingly risky:
On the Edge
An increasing share of U.S. corporate bonds are rated just above junk
So if a recession does materialize, what can the government do? With Donald Trump in the presidency, fiscal stimulus seems unlikely, unless it comes in the form of more tax cuts (which aren’t a very effective form of stimulus). That leaves the Fed. But with interest rates still under 3 percent, the central bank doesn’t have much room to cut rates to fight a recession:
Still Low
The Fed will therefore probably have to resort to unconventional measures. What will they look like?
The obvious steps are the things the Fed did during the Great Recession. One, called quantitative easing, involves buying lots of bonds in an attempt to push down long-term interest rates. Another, forward guidance, entails promising to keep interest rates lower for longer after the recession ends.
It’s not obvious how effective either of those approaches really is. Many of the central bankers who carried out quantitative easing, such as former Fed chairman Ben Bernanke, think it had a big effect. But other macroeconomists, such as Columbia University’s Michael Woodford, question whether it even managed to push down long-term interest rates, much less affect the real economy. QE is primarily supposed to work through portfolio rebalancing -- reducing interest rates on government bonds makes investors switch to private bonds and stocks, which lowers companies’ cost of capital and prompts them to invest more. Some studies find evidence that this actually happens, others don’t.
Forward guidance is flawed, too. It seems unlikely that investors, businesses and consumers really make decisions by thinking about the distant future. On the contrary, theories that assume people are very forward-looking generate strange results, implying that the theories probably are not right.
Also, forward guidance has a credibility issue: Who really thinks that the Fed will keep its promise to keep interest rates lower 10 years from now? How could anyone know whether it was even keeping its promise once the 10-year mark arrived? During the period from 2008 through 2013, Bernanke promised several times to keep interest rates low for a long time. Are rates now historically low because the Fed is keeping Bernanke’s promise, or would they have been low anyway? It’s hard to tell.
So while the Fed will probably employ both QE and forward guidance in the next recession, it should also be trying to expand its unconventional toolbox.
One option is to follow the example of the Bank of Japan. Under Governor Haruhiko Kuroda, the BOJ bought both corporate bonds and shares in Japanese companies, until it owned 3.8 percent of the country’s entire stock market as of May 2018. This troubles many business leaders, who claim that the central bank drove private investors out of markets. The BOJ has since moved away from such asset purchases, though neither BOJ actions nor Japan’s negative nominal interest rates have enabled the economy to hit the country’s 2 percent inflation target.
Another approach is to tolerate more inflation. Officials at the Federal Reserve Bank of San Francisco have called for the U.S. central bank to explicitly commit to overshooting its own 2 percent inflation target, so that investors stop perceiving the target as a hard ceiling. Alternatively, it could explicitly raise the inflation target to 4 percent. Knowing that the Fed would accept more inflation might be a credible way of shifting people’s and businesses’ expectations, encouraging them to spend and invest before prices go up.
A final approach would be so-called helicopter money: The Fed would distribute money directly to citizens, in the hope that they would spend it. This is akin to fiscal stimulus, but financed by new money creation rather than by federal spending. It’s a radical approach that would probably require legal changes, but some believe it could be powerful. Others worry it could end up unleashing a spiral of inflation. Either way, helicopter money seems likely to be a very last resort, used only in a very large recession like the one that hit a decade ago.
The Fed has tools to fight the next recession. But its options are shrinking, and the efficacy of new approaches is in doubt. People might be wise to expect less help from the central bank the next time the economy goes south.
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>>> Saudi Aramco demands $100 billion for debut global bond
4-9-19
Business Insider
by Callum Burroughs
https://www.msn.com/en-us/money/companies/saudi-aramco-demands-dollar100-billion-for-debut-global-bond/ar-BBVLiCm?OCID=ansmsnnews11#page=2
Saudi Aramco's debut bond sale could be one of the largest ever in emerging markets after drawing in $100 billion in orders.
It's part of a transparency push on behalf of Saudi Arabia as part of a will-they-won't-they over the company's plans for an initial public offering, which it shelved last year.
The bond issuance reflects the company's reluctance to go public after being shunned by investors at a Saudi event dubbed "Davos in the desert" last year, following the murder of journalist Jamal Khashoggi.
The deal, run by major Wall Street firms including JPMorgan, Morgan Stanley, Citigroup, and Goldman Sachs alongside HSBC and NCB, also shows that financial institutions haven't cooled on the kingdom.
Investors are keen for yield in the current trading environment, making the $10 to $15 billion issue a magnet for big financial institutions.
It's further evidence of the appeal of Saudi Arabia's vast oil reserves to investors after the country brought in $7.5 billion in sovereign bonds earlier this year despite overwhelmingly negative reactions to the government after Khashoggi's death.
Saudi Aramco reported $111.1 billion in net income last year,according to Moody's, making it more profitable than Apple, Amazon, and Alphabet combined. The company filed for its international bond debut on Monday, a $10 billion issuance following a doubling of its profits after oil prices rose last year.
It's the first major opportunity for investors to scrutinize the offering of one of the world's largest energy companies given the usually secretive nature of Aramco's disclosures. Saudi Aramco accounted for approximately one in eight barrels of crude oil produced globally from 2016 to 2018, according to the prospectus.
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>>> To Shoo Away the Bond Market's Doves, Inflation Needs to Show Up
By Emily Barrett
April 7, 2019
https://www.bloomberg.com/news/articles/2019-04-07/to-shoo-away-the-bond-market-s-doves-inflation-needs-to-show-up?srnd=premium
Traders’ positioning for Fed cut jibes with inflation outlook
This week’s CPI data unlikely to change investors’ minds
It’s going to take a lot to dispel the bond market’s view that the world’s biggest economy needs stimulus, but some consistent signals on inflation would help.
The rebound in March payrolls may have allayed concern that U.S. growth is headed for a ditch, and supported the updraft in yields seen last week. But the weaker-than-expected wage growth in Friday’s employment data still left futures markets reflecting a 70 percent chance of a quarter-point Federal Reserve rate cut this year.
That’s well out of step with the central bank’s current signaling, that it will pause through 2019 and potentially hike again next year.
“For the market to begin pricing in a hike, we will need to see persistent inflation pressures,” said Noelle Corum, a portfolio manager in the fixed-income group at Invesco Advisers Inc. Her expectation is that inflation will quicken enough by year-end to justify another rate increase.
Benchmark 10-year Treasuries yield 2.5 percent. That’s up about 16 basis points from the 15-month low set in March as last week also brought encouraging signs on growth from China. Friday’s U.S. figures also confirmed that the American jobless rate remains close to the lowest in decades.
Inflation Undershoot
While bond prices may seem out of step with the tight labor market, they jibe pretty well with investors’ grim outlook for inflation, says Martin Hegarty at Garda Capital Partners. He says the pricing in inflation markets translates to a sustained undershoot on the Fed’s preferred inflation gauge, a phenomenon that would typically justify easing. The central bank’s target for that measure is 2 percent. It’s now at 1.4 percent.
Consumer prices probably rose 1.8 percent in March from a year earlier, according to the median forecast in a Bloomberg survey before this week’s report. In the market for Treasury Inflation-Protected Securities, traders see that clip continuing for the next five years.
The market outlook for U.S. inflation is mired below 2%
“We think the path of inflation priced into the TIPS market is too low,” particularly with officials planning to revisit their inflation-targeting framework, said Hegarty, a global fixed-income portfolio manager focused on inflation markets.
Investors are about to get more insight into the Fed’s thinking on how it’s meeting its inflation mandate. This week brings the minutes from last month’s policy meeting, after which traders ramped up easing bets in response to the Fed’s downward revisions to economic and interest-rate projections.
Entrenched View
As for market drivers, this week’s inflation data may fail to force traders out of their dovish positions.
Hegarty says a 0.3 percent monthly increase in the core consumer price index, which excludes volatile food and energy prices, could get the market’s attention. That reading would be above consensus and a pickup from 0.1 percent in February. On an annual basis, core consumer inflation probably remained at 2.1 percent.
If the inflation data fizzle, the best catalyst to push traders to a more neutral position on rates would have to come from overseas, he says. He’s focusing on data on Chinese manufacturing and he’ll also be watching European CPI figures this week.
“One of the biggest things that I’d focus on when looking at how we can price out any cuts in the front end of the U.S. curve would be looking at global activity data.”
What to Watch
The main events are the International Monetary Fund’s updated economic forecasts on Tuesday, and the Fed minutes and CPI data Wednesday
For U.S. economic releases:
April 8: Factory orders; durable goods
April 9: NFIB small-business confidence; JOLTS job openings
April 10: MBA mortgage applications; consumer prices
April 11: Producer prices; jobless claims; Bloomberg consumer comfort
April 12: Import, export prices; U. of Michigan consumer confidence
Some Fedspeak ahead:
April 9: Fed Vice Chair Richard Clarida speaks
April 10: Fed minutes
April 11: Clarida in Washington; St Louis Fed’s James Bullard on economic and monetary policy; Vice Chairman for Supervision Randal Quarles; Minneapolis Fed’s Neel Kashkari holds Q&A on Twitter; Fed Governor Michelle Bowman on community banking
Here’s the schedule for Treasury auctions:
April 8: $42 billion of 3-month bills, $36 billion of 6-month bills
April 9: $38 billion 3-year notes
April 10: $24 billion 10-year reopening
April 11: 4- and 8-week bills; $16 billion 30-year reopening
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>>> Risky Company Debt Is Getting Riskier
Protections built into loans and bonds are being steadily eroded, but investors keep buying.
Bloomberg
By Sally Bakewell and Lisa Lee
April 4, 2019
https://www.bloomberg.com/news/articles/2019-04-04/risky-company-debt-is-getting-riskier?srnd=premium
One night in 1982, a group of bankers from Drexel Burnham Lambert gathered at the Quilted Giraffe, a nouvelle cuisine restaurant in New York frequented by Warren Beatty and Jackie Onassis.
The financiers were there to celebrate a junk-bond deal that got away. They’d worked with Sparkman Energy Corp. for months, but the natural gas pipeline company had stopped returning their calls. Contractual terms that Drexel was proposing for the bond, particularly investor protections known as covenants, had been deemed too strict, says Vince Pisano, an attorney who worked on the deal.
At the dinner, Pisano recalls, some bankers wore custom-made belt buckles that featured Sparkman’s logo—crossed out with a slash. They were luckier than they realized at the time. Five years later, Chairman Wallace Sparkman would reach a settlement with the U.S. Securities and Exchange Commission, neither confirming nor denying participating in an alleged kickback scheme.
Few at the dinner recognized that Sparkman’s decision to insist on looser bond terms was a sign of what would come decades later. The legal framework that Pisano and his colleagues were creating in the 1980s helped fortify what would become a more than $2 trillion market in junk bonds and loans. But in the last few years, that framework of covenants, once routine for the riskiest borrowers, has come under severe attack.
Lenders Lose Some Security
Private equity firms such as Apollo Global Management and KKR & Co. have fought to make it easier for the companies they own to take on more debt soon after borrowing, and for debtors to sell off assets and pay the proceeds to shareholders. For a decade they had already chipped away at other provisions in loans known as “maintenance covenants”—requirements that a corporate borrower meet specific performance hurdles or else be forced to renegotiate terms or even repay debt.
Private equity firms “began to select their investment banks based in part on who could get the loosest high-yield covenants,” says Kirk Davenport, a former partner at law firm Latham & Watkins who also worked for Drexel on early junk-bond deals. “And once they figured that out, the race to the bottom was on.”
Moody’s Investors Service says covenants for bonds and loans generally are at or near their weakest levels since the ratings firm started tracking them nearly a decade ago. When the economy slows, lenders could suffer much bigger losses than in previous downturns, say strategists at UBS Group AG, who estimate that lenders might recover less than half their money instead of 75 percent to 80 percent because of eroded protections.
Lenders to Caesars Entertainment Operating Co., the casino company that filed for bankruptcy in 2015, are familiar with this problem. The company changed its covenants in 2014 when it took out a $1.75 billion loan, raising the limit on how much debt it could take on that would give lenders a first claim on assets if the company went under. The new covenants helped allow Apollo and TPG Capital LP, the private equity firms that bought Caesars in 2008, to strip assets from creditors’ reach before the casino company went under, a court-appointed bankruptcy firm found in 2016. A spokesman for Apollo declined to comment.
Investors complained about the terms on a series of bond and loan sales last year, but they still bought the debt. In one September sale, KKR & Co. helped finance its buyout of Envision Healthcare Corp. with debt that contained provisions making it easy for KKR to sell the most profitable portion of the company’s business, leaving lenders with the less attractive part. KKR declined to comment.
Private equity firms and their lawyers often note that not having maintenance covenants gives a company more leeway to survive a stumble. Otherwise lenders, entitled to demand higher interest at the first sign of weakness, might push the borrower into bankruptcy in the rush to recover their money.
“A number of companies have gone from being a high-yield issuer and back to investment grade because they have been allowed to operate their business in a way that an inflexible covenant package would have prohibited them from doing,” says William Hartnett, a partner at law firm Cahill Gordon & Reindel LLP who also represented Drexel on its early deals.
Covenants were once required mainly by banks’ loan departments, which were armed with workout teams that specialized in squeezing more money out of troubled companies to ensure the lenders got paid back as much as possible. Strong covenants can be a real advantage in those situations. Institutional investors, which today account for most of the loan market, are more likely to sell out fast instead of sticking with a distressed borrower. According to S&P Global Market Intelligence’s LCD unit, almost 80 percent of the outstanding loans in the market lack maintenance covenants, in deals dubbed “covenant lite.”
“No one wants a company to default,” says Thomas Majewski, managing partner and founder of Eagle Point Credit Management, which manages $2.6 billion. “With covenant lite, we believe there will be fewer defaults and we expect those to happen later, so we will still receive our interest.”
Still, weaker covenants have emboldened companies to take steps that aren’t purely about survival. Some strip away collateral before a default to benefit equity investors at the expense of lenders. In 2017, preppy clothing retailer J.Crew Group Inc. moved its valuable trademarks out of the reach of creditors when it restructured debt. As decades-long norms that were once spelled out in contracts are eroded, lenders and equity investors increasingly find themselves clashing in courts. “Lenders may need to resort to the courts more and more in the next downturn,” says Michael Nechamkin of Octagon Credit Investors. —With Davide Scigliuzzo
Bakewell and Lee cover corporate finance and leveraged lending for Bloomberg News in New York.
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>>> Wall Street Is Getting Cut Out of Bond Market It Long Dominated
Bloomberg
By Matthew Leising
April 1, 2019
https://www.bloomberg.com/news/articles/2019-04-01/wall-street-is-getting-cut-out-of-bond-market-it-long-dominated?srnd=premium
Investors slowly embrace electronic corporate bond trading
All-to-all trading is a clear sign of moves to come in market
The banks that have stood in the middle of the corporate bond market for decades are increasingly getting pushed aside.
Electronic marketplaces like MarketAxess Holdings Inc., Tradeweb Markets LLC and Liquidnet Holdings Inc. say that more of the company bond trades that happen on their platforms are between investors directly, without banks necessarily being involved. Known as all-to-all trading, this shift may weigh on revenues for banks that have long profited from being either buyers or sellers in just about every trade in the $9.2 trillion market.
For more than a decade, corporate-bond traders resisted efforts to carry out more transactions electronically even as most other corners of financial markets embraced the move to computerized buying and selling. But that’s slowly been changing as new rules have forced dealers to act more like machines, linking up buyers and sellers in almost real time as an exchange would, instead of buying securities from investors and hanging onto them.
For MarketAxess, 27 percent of corporate bond trades were on its all-to-all platform Open Trading in the fourth quarter, up from 3 percent at the start of 2014, the company said. On Liquidnet’s all-to-all platform, more than 90 percent of volume is between investors. Electronic trading is still a relatively small part of a market dominated by dealers, but its share of trading is growing.
Machine Madness
Open Trading volume jumped in the last three months of 2018
The switch to all-to-all trading may accelerate from here. The post-crisis regulations that have made it more expensive for dealers to hold onto corporate bonds have resulted in dealer inventories of the securities shrinking more than 55 percent over the last five years.
Surging levels of company debt have made many investors fearful that a corporate credit apocalypse is coming, and whenever the market starts to weaken, more money managers may look to offload securities however they can. It also saves investors money by eliminating the middle man: MarketAxess says clients cut $53.7 million in transaction costs in the fourth quarter by using Open Trading.
“It is the model of tomorrow for fixed-income trading,” said Rich Repetto, an equity analyst at Sandler O’Neill & Partners LP. All-to-all is gaining favor with investors because it gives them a new option of anonymously seeking any counterparty to their trade, not just a handful of dealers who know who you are and set their prices accordingly, he said. “All-to-all represents significant advancement in automation in the market.”
Read More: Growing Love for BBBs; Cutting out Wall Street
Investors polled by Greenwich Associates agreed, overwhelmingly saying all-to-all protocols would be the biggest factor helping trading over the next two years. Just as money managers have spent decades cutting their trading costs in equities, they’re looking to lower expenses in bond trading.
“We’ve opened the architecture so anyone can trade with anyone else,” Richard McVey, chief executive officer of MarketAxess, said in an interview. “The cost savings when they find a natural match are meaningful.”
More coverage of the changing bond market:
To Coax Bond Traders Into Robotic Era, Banks Tap Stocks Veterans
Bond Dealers Say Hedge Funds Gatecrashed Their Exclusive Club
Meet the Robot Who Knows How to Trade Bonds Better Than You Do
Banks don’t have to panic yet. Electronic bond trading made up 26 percent of the market in the third quarter, according to Greenwich, but those trades are pretty much confined to transactions under about $4 million, which often aren’t profitable enough to be worth a bank’s time. Bigger trades, like those above $50 million, are still done with a bank over the phone or through instant-messaging.
One hurdle for many investors with moving to electronic trading is being sure they’re getting the best possible price and that it makes sense to trade now. A single company can have hundreds of individual bonds outstanding, many of which may not have traded for weeks or months. Money managers often need some hand holding and reassurance that they’re making the right call on big trades, Kevin McPartland, head of market-structure research at Greenwich Associates, said in an interview.
“People want to talk to people, and know they are doing the right thing” on transactions that are $50 million or $100 million, McPartland said.
That concern has been an issue for the scores of firms that have been trying for years to make more corporate debt trading electronic. Getting the right mix of participants has also been an obstacle. Goldman Sachs Group Inc. started and folded GSessions earlier this decade, while BlackRock Inc. found tepid support for its platform because too many customers were looking to buy, and not enough wanted to sell. In 2013 the asset manager linked up with MarketAxess to get access to Open Trading users.
New startups are trying to tackle some of those concerns. Elefant Markets Inc. is a digital broker-dealer that streams bond prices as often as every 10 seconds, based on three internal and external pricing signals. It allows money managers to get prices on a security continually throughout the day, which is harder when dealing with calling an actual human.
“It allows clients to have price information where there was none,” said Cactus Raazi, president at Elefant Markets, in an interview.
Falling Revenue
Banks are already grappling with dropping revenue in corporate bond trading. The world’s 12 largest dealers collected $2.2 billion from company bond and loan trading last year, down from $2.8 billion in 2017 and $3.9 billion the year before, according to data from Coalition Development Ltd., a financial analytics firm. The figures include junk debt but exclude distressed.
Electronic trading is only getting more important for fund managers doing their daily jobs, said Mike Nappi, a senior corporate bond trader at Eaton Vance Corp., which has $445 billion of assets under management. Eaton Vance was an early adopter of one of MarketAxess’s auto-execution tools for corporate bond trading.
“Years ago I would start making calls to trade. Now I do electronic trades at the same time as voice trades and need them to keep my head above the water,” Nappi said.
The pressure may increase as improvements in pricing data give asset managers more confidence that they aren’t getting ripped off when they want to trade without a bank. (Bloomberg LP, the parent of Bloomberg News, has a bond trading platform of its own.) All-to-all trading also makes electronic execution easier by opening up the possibility of dealing with firms or banks you don’t have a trading history with, said Chris Bruner, head of U.S. credit for Tradeweb. Tradeweb introduced all-to-all trading in March 2017, and saw a similar percent of its trades to MarketAxess done in that fashion in the fourth quarter. All-to-all won’t take over the U.S. corporate bond market overnight, but is an increasingly important part of it, he said.
“The all-to-all networks are really meaningful ways clients obtain liquidity,” he said. "It’s here to stay, it’s a big benefit to the market and it should continue to grow.”
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>>> Global Bond-Market Investors Are Getting Really Nervous
Bloomberg
By Emily Barrett, Ruth Carson, and John Ainger
March 30, 2019
Weaker credits, emerging markets gain appeal as yields tumble
‘Difficult to put money to work,’ says Pelosi at Antares
https://www.bloomberg.com/news/articles/2019-03-30/global-bond-market-revelers-cast-sober-eye-toward-cycle-s-end?srnd=premium
The Bloomberg Barclays Global Aggregate index has earned 2.3 percent through March 28, its best quarter since mid-2017. But with yields sinking across major sovereign markets, investors now face a dilemma. Buying government bonds at these levels is perilous because economic data may improve, while taking more risk could leave investors nastily exposed to a global downturn.
Jim Caron at Morgan Stanley Investment Management sees an opportunity to pick up yield after the Federal Reserve’s dovish pivot, which he says has unleashed value in lower-quality corporate debt. Emerging-market dollar bonds and local Mexican debt look more inviting for Charles Diebel at Mediolanum Asset Management. But Tano Pelosi at Antares Capital expresses a common refrain: With the U.S. expansion almost a decade old and the yield curve flashing recession warnings, investors should tread carefully.
Benchmark 10-year yields have fallen a long way
“It’s getting very difficult to put money to work,” said Sydney-based Pelosi. “We need to preserve capital here now, we need to be taking insurance where we can.”
This is a long way from the rallying cry of post-crisis investing, when weak growth and accommodative central banks spurred a hunt for yield. There’s more trepidation than thrill-seeking in today’s markets, and it’s not only the growth outlook that could derail these strategies.
Cash Pile
Prospects for a China-U.S. trade resolution are in flux, and a calamitous Brexit is a possibility. Investors may be confident that the Fed is out of action next quarter, but the gulf between the central bank’s views and the market’s leaves plenty of room for volatility.
“We’re not getting paid a lot to take credit risk, so we’re taking less of it,” said Jason Brady of Thornburg Investment Management, which oversees $44 billion. “With the curve inverted, we’re holding more cash at the moment and less excited about the opportunity set.”
The percentage of cash has doubled to around 12 percent in recent months in the Santa Fe, New Mexico-based firm’s Strategic Income Fund. Thornburg has also moved to higher-quality credit in two other portfolios over the past year.
High yield corporate bond spreads have tightened this year
While few seem convinced that the global economy is on the brink of recession, they’re not ready to contradict the market view that the world is in a worse place than it appeared just six months ago.
“Versus 2018, our stance is very different,” said James Athey, money manager at Aberdeen Standard Investments in London. “We’re owning safety essentially,” he said, and positioning for the end of the economic cycle. That includes bets on yield-curve steepeners in the U.S. and disinflation in the euro area and U.K.
Some who are venturing further out the risk spectrum sound downright reluctant.
“Japanese investors have little choice but to continue pouring their money into European bonds,” said Satoshi Nagami at Sumitomo Mitsui Asset Management, citing meager domestic yields and unattractive hedging costs to invest in the U.S. The Tokyo-based portfolio manager said French bonds would probably remain popular, and investors could look at the peripheries such as Spain, though he draws the line at Italy.
Italy’s Lure
Judging by the strong performance of Italian debt recently, stronger stomachs are prevailing, however. Italy’s 10-year yield has fallen almost a half-percentage point since early February, to 2.49 percent. It’s still about 260 basis points above its negative-yielding German counterpart.
“We continue to trade Italy from the long side given the high real yields on offer,” said Nicholas Wall, a money manager at Merian Global Investors in London, though they’ve trimmed their position on rallies in recent months.
One view these investors have in common is that whether or not a market shock or economic slump are nigh, central banks have investors’ backs. For Wall, this is a reason to avoid volatility trades that might otherwise flourish at the end of a cycle.
“While we’ve had the spike higher recently, we believe central banks will come out in force to push volatility lower if it feeds into financial conditions,” he said.
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>>> There’s No Sugarcoating Corporate Debt
It looks like borrowers are gaming the ratings firms, and not for the first time.
By John Authers
March 12, 2019
https://www.bloomberg.com/opinion/articles/2019-03-12/there-s-no-sugarcoating-corporate-debt-jt590u95?srnd=premium
Corporate America is debt-strapped.
Leverage this.
If you are looking for reasons to worry about the stock market, few things beat U.S. corporate leverage. Excluding banks, which have very different dynamics, corporate debt has never been greater as a percentage of gross domestic product.
The following chart comes from Deutsche Bank AG chief global strategist Bankim Chadha, who last week attempted in a report to show that the corporate debt issue had been overstated. He makes some very valid points, but it still appears we should be concerned about the debt that companies have taken on while interest rates have been historically low.
Chadha argues that we should be more interested in net debt, which subtracts out cash holdings, and compares that to profits rather than GDP. After all, it is from profits that the debt must ultimately be repaid. This leads to a radically different picture:
He also points out that leverage is heavily concentrated in the most relatively safe and boring sectors, led by utilities and real estate, which have reliable cash flows:
This, along with a lot of other very impressive number-crunching, stands up Chadha’s headline: “Is Corporate Leverage High? No, It’s A Sector Story.” In particular, it is a story about utilities.
On this basis, it seems there’s far less to worry about. Among the larger companies in the S&P 500, the debt has largely been taken on by those companies best placed to pay it back. The problem of over-leverage is not as sweeping or systemic as it appears.
But there are still reasons for concern. Deltec produced the following analysis last month. Rather than compare to profits, which many believe to be unrealistically high, the following chart compares investment-grade net debt to earnings before interest, tax, depreciation and amortization, which is a decent measure for cash flow. Non-financial corporates look almost as leveraged on this measure as they have at any time since the peak hit during the dot-com boom two decades ago. Excluding the tech sector, where companies are able to borrow against impressively high cash flows, corporate investment-grade debt looks as though it is at a historic high. Even if the debt is primarily taken on by companies with relatively strong cash flows, it is worth asking why they did not borrow so much before:
To illustrate this problem in a slightly different way, try this chart from Andrew Lapthorne, the chief quantitative strategist at Societe Generale. In the era of quantitative easing following the financial crisis, net debt has increased far faster than cash flows:
True, the problem was ameliorated a little by last year’s big repatriation of cash, but it is still an issue. A further issue highlighted by Deltec and others is the obvious and persistent dilution of credit quality. Just look at this:
Debt with the highest AAA ratings has almost ceased to exist. And the greatest increase in debt volume by far has come in the lowest-quality investment-grade credits and in below-investment-grade. It looks like corporate borrowers are gaming the ratings firms (and not for the first time) by making sure they borrow as much as they can while not suffering the downgrade that would lead to higher borrowing costs. While Chadha’s numbers are for the larger companies in the S&P 500, Lapthorne produces this alarming data showing that the net debt of the smaller companies in the Russell 2000 has run far ahead of their cash flows:
This is alarming, even if it does not imply a risk of imminent disaster for the S&P 500. The presence of leverage increases risks and it is plain that a lot of companies have taken the opportunity to stretch themselves to an unprecedented extent. Even if this corporate leverage doesn’t drive investors out of equities broadly, balance-sheet quality is likely to be a critical issue for anyone picking stocks. Avoiding the many companies that have over-levered looks imperative.
>>>
>>> Leveraged Loan Investors Worry Good Times Will Soon Haunt Them
Boomberg
By Lisa Lee
January 4, 2019
https://www.bloomberg.com/news/articles/2019-01-04/leveraged-loan-investors-worry-good-times-will-soon-haunt-them?srnd=premium
Fresh worries about collateral protection on big LBO loans
Loans from Refinitiv, Envision have dropped amid fear
One of the safest ways to invest in junk-rated companies is starting to look pretty risky.
Money managers have grown increasingly concerned about loans to high-yield corporations over the last month as early signs of slowing global growth have emerged. Investors are starting to realize that a key safeguard that protects them, namely the collateral they can seize if a company goes under, gives them less cover than they thought.
In December these worries helped push down prices in the $1.3 trillion leveraged loan market, hitting the debt that financed some of the biggest buyouts of 2018. In the go-go credit markets of the last two years, companies won unprecedented power to sell businesses, move operations to different units, and use other tactics to move assets out of the reach of lenders before defaulting.
“Collateral is a big long-term risk,” said Chris Mawn, head of the corporate loan business at investment manager CarVal Investors. “You think you’re secured by a Cadillac, but three years from now, it turns out you’ve got a Chevy.”
The loose contract provisions that money managers have agreed to over the last two years mean that when borrowers actually do start going under en masse, creditors are likely to end up with fewer assets to liquidate, and ultimately bigger losses. Private equity-backed firms have generally been the most aggressive borrowers when it comes to pushing for the right to move around collateral.
Getting Worse
A measure of leveraged loan covenant deterioration spikes to near record
When Blackstone Group bought out a majority stake of Thomson Reuters Corp.’s financial terminal business last year, its $6.5 billion loan offered it wide latitude to sell assets and pull cash from the company. Soon after that Bloomberg reported that the business, dubbed Refinitiv, was looking at offloading its currency trading unit, among others. These concerns along with broader market volatility helped push the bid on these loans as low as 93.375 cents on the dollar in December, from their initial sale price of 99.75 cents.
Loans sold to help finance another leveraged buyout in September for Envision Healthcare have similarly fallen, to 93.75 cents from their original 99.5 cents. Investors have grown more worried that private equity owner KKR can easily sell off a more profitable portion of the company’s business and leave lenders with the less attractive part, according to people with knowledge of the matter.
Sometimes loan investors don’t realize the extent of the rights they’ve given to a corporation and its private equity owners until assets are taken away. The contractual provisions that allow greater flexibility, known as covenants, may be spread through a lengthy lending agreement. Only careful consideration of how different lending terms interact with each other reveals what a company can do.
“There are covenants that put together can make a loan like an equity,” said Jerry Cudzil, head of credit trading at money manager TCW Group Inc., which oversaw $198 billion of assets as of Sept. 30. Equity usually has the last claim on assets when a company is liquidated, making it the riskiest kind of investment in a company.
More Risk
Weaker collateral protection is just one factor that makes loans to junk-rated companies much riskier in this cycle than they’ve been in previous downturns, and one factor spurring investors to pull money from leveraged loan funds. Companies have more debt relative to their assets than they had in the past, which means that if a failed corporation liquidates, the proceeds have to cover more liabilities.
On top of that, a higher percentage of loan collateral is intangible assets -- about two thirds, up from about 60 percent in 2009, according to UBS Group AG. Those kinds of assets, like brand names, are harder to value and liquidate than tangible assets. And more borrowers have just loans and no other form of debt this time around, meaning if the company fails, there are fewer other creditors to absorb losses.
Add it all up, and Moody’s Investors Service reckons that investors will recover just 61 cents on the dollar when first-lien term loans go bad whenever the market turns, well below the historical average of 77 cents.
Credit Brief: Fear and Loathing in Leveraged Loans
A key to loosening investors’ hold over collateral has been tweaking the tests that determine if a company is earning enough relative to its debt obligations, known as leverage. As long as corporations are generating enough income, managers often have the freedom to move assets around and pull money from the company, among other things. Companies have been easing the requirements for these tests, making it easier for them to clear the hurdles and keep their flexibility.
“These leverage tests are like a master key that unlocks all these flexibilities,” said Derek Gluckman, analyst at Moody’s, “and the master key is working better and easier.”
J. Crew
One of the first signs of the potential trouble ahead for loan investors came from J. Crew Group. In 2016, the preppy clothing retailer told lenders it was moving intellectual property including its brand name into a new unit that was out of the reach of creditors as part of a restructuring, a process it completed in July 2018. Litigation ensued, as angry lenders said that collateral was being taken away from them. But the company has showed signs of recovering, and its term loan now trades at 92 cents on the dollar, up from around 55 cents in November 2017.
J. Crew’s efforts seem to have inspired other private-equity owned retailers as well. PetSmart Inc. and Neiman Marcus Group Inc., for example, have shuffled online businesses into different units where lenders can’t reach them.
“If new terms get through, all the private equity firms and their counsels start to claim that the new term is becoming standard in the market and they point to the precedent,” said Justin Smith, an analyst who looks at high-yield lending agreements at Xtract Research. “There are too many lenders who don’t care enough about covenant packages or don’t pay attention.”
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'Leveraged Loans' sound ominously like what happened with the mortgage market in the years prior to the 2018 collapse. Layers of derivatives have been piled on top of the underlying asset, which has been 'securitized' into CLO/Collateralized Loan Obligations (sound familiar?). This creates a false sense of reduced risk, just like the CMO, CDO, and other derivatives that blew up in 2008.
Ominously, the safety features for Leveraged Loans (covenants) have been gradually removed, just as happened with mortgages when they created subprime and low doc/no doc. And to make things worse, these loans are floating rate, and rates are moving up.
Big US corporations are now up to their eyeballs in debt from a decade of cheap borrowing to fund share buybacks. What happened to General Electric ($100 billion in debt) could be a preview for the next big financial unraveling -
>>> How Leveraged Loans Are (and Aren't) Like Junk Bonds
Bloomberg
By Lisa Lee
October 1, 2018
https://www.bloomberg.com/news/articles/2018-09-30/how-leveraged-loans-are-and-aren-t-like-junk-bonds-quicktake
The leveraged loan market has doubled in size since 2012. Plenty of investors think they know why: Loans are just like safer versions of high-yield junk bonds and likely return more as interest rates rise. It’s true that leveraged loans and junk bonds share similarities. Both were pioneered by Michael Milken in the 1970s. Both finance corporations with less-than-stellar investment ratings. Both are traded over the counter, and the total market for each is about $1 trillion in the U.S. But peer more closely and you’ll find stark differences. A bond is a security with features that allow it to trade and settle more easily. A loan is a contract between a lender and a borrower; each one is different. Rookie investors may learn the details only after suffering nasty losses.
1. What makes a loan leveraged?
It’s made to a company deemed to be risky because it has a lot of debt compared to its income and cash flow. The risk is determined by ratings agencies -- a Moody’s Corp. credit rating of Ba1 or lower or Standard & Poor’s rating of BB+ or lower. In exchange for making these dicey loans, which are secured by physical assets, investors earn a defined amount of interest -- the so-called margin -- on top of the prevailing Libor benchmark rate. This increases as the loan gets riskier. If the company tumbles into bankruptcy and is restructured or liquidated, leveraged loans are usually supposed to be paid off before junk bonds. Traditionally, banks were the main lenders, but now most of these loans are sold to investors.
2. What’s a junk bond?
A high-yield bond made to the same risky companies. These bonds, nicknamed “junk,” became widely used in the 1980s thanks to Drexel Burnham Lambert and transformed the financial landscape. They fueled debt-financed buyouts of U.S. corporations such as the landmark $26 billion hostile takeover of RJR Nabisco in 1989 and fanned the growth of a private equity industry that grew into firms like Blackstone Group LP, Carlyle Group, and Kohlberg Kravis Roberts (now KKR & Co, Inc.).
3. Why are investors confusing the two?
Leveraged loans have started to look more like junk bonds, as their restrictions have eased and a trading market has developed. Leveraged loans were once normally protected by contract clauses called maintenance covenants that allowed lenders to monitor the borrowing company’s performance and take action, like forcing the sale of assets, if earnings deteriorated. During the financial crisis of the last decade, many companies with leveraged loans saw earnings plummet. Some were able to make the case to investors that this wasn’t their fault and they needed these covenants eliminated. Investors agreed. These loans with looser rules, known as covenant-lite, gradually spread and now represent 80 percent of new issuance. They’ve become so common that many investors shy away from making loans with strict covenants, figuring that if a borrower needs to agree to that many restrictions, the loan could be dicey. Since high-yield bonds don’t have maintenance covenants that give investors oversight over performance, investors and borrowers began to view covenant-lite loans similarly.
Loans Fly Off the Shelves
4. How do loans and junk bonds differ?
Junk bonds are securities traded under the authority of the U.S. Securities and Exchange Commission. They follow federal mandates, such as trades having to close within three business days. Leveraged loans are not regulated by the SEC, since they are transactions between borrowers and lenders. So getting cash from a loan trade can take weeks and as long as two months. Leveraged loans are usually less volatile than high-yield bonds because the majority of loans are bundled into collateralized loan obligations, or CLOs, which pay regular returns while spreading the risk of default among many investors. This provides steady support for loan prices. In turn, high-yield bonds are typically seen as having more liquidity, the ease of selling and buying an asset, though the bigger-sized loans are becoming just as easy to trade.
5. What’s happening now?
The leveraged loan market is growing while the junk bond market is shrinking. Borrowers, especially private equity shops, now prefer covenant-lite leveraged loans to finance deals since they’re not burdened with a lot of lender oversight, can be paid down at will, and are cheaper than junk bonds. The leveraged loan market has been able to keep up, mostly through CLOs sold to institutional investors. With fewer junk bonds being created, their buyers are being pressured to accept ever-riskier terms at slighter spreads.
6. What could go wrong?
After years of low interest rates, there has been a big increase in the issuance of bonds and loans by risky U.S. companies, at ever-more-favorable terms for the borrowers. As portfolios have ballooned and investment options dwindled, complacency about default risk has spread. Now that interest rates are rising, already shaky companies with big debt loads will find it harder to make payments; some will stop altogether. Because leveraged loans have evolved dramatically since the last recession, it’s unclear how much investors will recover on distressed loans or how much liquidity there will be if loan prices decline across the board. Leveraged loan investors looking to sell at signs of trouble might have to watch prices fall substantially before they could complete their transactions. The long delay in settling a trade could be especially problematic for mutual funds holding these loans, since they promise to pay their clients immediately. Liquidity problems are why the Bank of International Settlements and other watchdogs have sounded alarm bells over leveraged loans.
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>>> A $9 trillion corporate debt bomb is 'bubbling' in the US economy
Companies are carrying a $9 trillion debt load, posing a potential threat should rates continue to rise and the economy weaken.
Most Wall Street bond experts think the issue is contained for the next 12 to 18 months, though one says the market's "angst" is "not misplaced."
A principal worry is over companies teetering between investment grade and junk that could cause market trouble should their standing deteriorate.
by Jeff Cox
CNBCcom
21 Nov 2018
https://www.cnbc.com/2018/11/21/theres-a-9-trillion-corporate-debt-bomb-bubbling-in-the-us-economy.html
At first glance, it looks like a $9 trillion time bomb is ready to detonate, a corporate debt load that has escalated thanks to easy borrowing terms and a seemingly endless thirst from investors.
On Wall Street, though, hopes are fairly high that it's a manageable problem, at least for the next year or two.
The resolution is critical for financial markets under fire. Stocks are floundering, credit spreads are blowing out and concern is building that a combination of higher interest rates on all that debt will begin to weigh meaningfully on corporate profit margins.
"There is angst in the marketplace. It's not misplaced at all," said Michael Temple, director of credit research at asset manager Amundi Pioneer. "But are we at that moment where this thing blows sky high? I would think that we're not there yet. That's not to say that we don't get there at some point over the next 12 to 18 months as rates continue to move higher."
Essentially, the situation can break in two ways: a good-news case where companies can manage their debt as the economy stabilizes and interest rates stay in check, and the other where the economy decelerates, rates keep heading up and it's no longer so easy to keep rolling that debt over.
There's one worrying trend where companies on the edge of the investment-grade universe lose their standing and turn into high-yield or junk, sending rates — and defaults — significantly higher. And there's a more positive case where the U.S. continues to outperform the rest of the world and corporate debt problems are limited to overseas and specific companies that aren't systemically important.
"The answer hinges on how long we have until the credit cycle turns, how long we have until interest rates have gotten to the point where they start to snuff out economic activity," Temple said. "If we were of the opinion that interest rates are already too high for the economy to stand and the recession was going to happen sometime next year, then I would say we've got a real big problem here."
As things stand, though, he thinks conditions are still favorable for the corporate credit market.
"In our view, economic activity will probably moderate next year, but at a very high level," he said. "That's not enough to cause the chaos that I just described."
Nearly doubling the debt
Over the past decade, companies have taken advantage of low rates both to grow their businesses and reward shareholders.
Total corporate debt has swelled from nearly $4.9 trillion in 2007 as the Great Recession was just starting to break out to nearly $9.1 trillion halfway through 2018, quietly surging 86 percent, according to Securities Industry and Financial Markets Association data. Other than a few hiccups and some fairly substantial turbulence in the energy sector in late-2015 and 2016, the market has performed well.
In fact, Fitch Ratings forecasts bond defaults for 2019 at the lowest since 2013, with leveraged loans at the lowest since 2011.
Such high debt levels are "certainly something to take notice of," said Eric Rosenthal, Fitch's senior director of U.S. leveraged finance. "In terms of the systemic risk, at the moment it's not there."
One reason markets worry about debt is that there's not as much cash around to cover it. The cash-to-debt ratio for corporate borrowers fell to 12 percent in 2017, the lowest ever.
Still, there's reason for optimism.
Fitch estimates that new investment grade issuance was $531 billion through the third quarter, a more than 15 percent drop from the same period a year ago. High-yield issuance also has declined to $138 billion, a 32 percent drop from 2017.
The 2017 tax breaks also appear to be helping. Companies saw their nominal tax rates reduced from 35 percent to 21 percent and apparently are using a large chunk of the windfall to knock off some debt.
Since the tax cut took effect, the top 100 corporate nonfinancial companies have spent $72 billion of new cash flows to debt payments, a bit behind the $81 billion that went to shareholder returns through buybacks and dividends, according to Moody's Investors Service.
"Companies are spending a much larger percentage of incremental dollars on debt reduction," the ratings agency said in a report. "What we see when we look at the annual net borrowing activity is a big swing from issuers changing from a net borrower each year pre-tax overhaul to a net-payer of debt post-tax overhaul."
Investors still willing to buy
For the debt that is issued, investor demand remains strong if beginning to wane a bit.
One measure of how willingly the market is snapping up bonds, particularly those lower in quality, is through covenant quality, or the amount of protections being demanded in case of default. Moody's reports that its Covenant Quality Indicator has held at its lowest level of classification for 18 straight months and is just off the record set in August 2015.
At the same time, that could be a trouble sign as balance sheet strength becomes more important.
"The high-yield sector, every way we look at it, just seems pretty overvalued and not worth the amount of risk that you're taking," said George Rusnak, co-head of global fixed income for the Wells Fargo Investment Institute. "What we're seeing now is some spreads widening, which will be more impactful on high yield. We could see triple-B credits, some of them, move from investment grade to high yield."
That slide from low investment grade to junk is one of things that scares markets. General Electric is the highest-profile case to have that potential, though company officials insist they are doing everything they can to make sure that doesn't happen.
GE is the scapegoat for downside, says Zoe Financial CEO. Should a company that big slide, it would reshape the high-yield market. Investors would be counted on to snap up those bonds, but could demand even higher yields to do so.
"It sets up for a liquidity trap. You get an underappreciated risk that becomes a catalyst," Rusnak said. "The second wave of buyers that are holding high yield realize they have more risk than they thought ... and it's kind of a downward spiral."
Well Fargo itself is retreating from the space, with a neutral position on investment grade corporates and an unfavorable outlook on high yield.
"There is a lot of leverage. You could argue they took what the market gave them, to take on the leverage at lower interest rates," Rusnak said. "The question is will they be able to sustain. In a lot of cases they will, but there will be some bubbling up of challenges."
The leveraged loan threat
One of those other challenges also comes from the leveraged loan market, a growth area that now tops high yield in total issuance with $1.3 trillion.
Sen. Elizabeth Warren spoke publicly about the threat in a recent public hearing, with the Massachusetts Democrat warning Randal Quarles, the Federal Reserve's vice chair of supervision for the banking industry, that leveraged loans pose an economic threat on scale with subprime loans from a decade ago.
"The Fed dropped the ball before the 2008 crisis by ignoring the risks in the subprime mortgage market," Warren said.
Simon Macadam, global economist at Capital Economics, also said leveraged loans, which generally are issued to lower-quality borrowers that already have a substantial debt load on their balance sheets, pose a danger.
"The main concern is a drop in lending standards," Macadam said in a note to clients. "In the US, the share of leveraged loans with no requirements for borrowers to meet regular financial tests, such as maximum leverage and minimum interest coverage ratios, has risen from around a quarter in 2007 to a record high of 80% today."
However, Macadam said that "for the time being" there are "at least three sources of comfort" for why the danger won't become systemic: "manageable" corporate debt loads, stronger bank capital, and an expected tempering of interest rate rises. Capital has an out-of-consensus forecast that the Fed will begin reducing rates into 2020 as the economy weakens.
Currently, the Fed is expected to approve a rate hike in December and has forecast three more in 2019.
Company by company
Indeed, fixed income strategists who spoke to CNBC were almost unanimous in their belief that problems with corporate debt will be far more company-specific than systemic.
"From a higher-level 30,000 feet, most U.S. corporates are in pretty good shape," said Yvette Klevan, portfolio manager for global fixed income at Lazard Asset Management. "The economy is still very strong. Tax reforms are beneficial. Looking into next year, overall debt servicing should be very stable and not problematic. We see a lot of opportunities in the market."
The current climate is likely more conducive to active management, or selecting individual issues, rather than following broad indexes, Klevan said. Passive taxable bond funds currently hold more than $1 trillion in total assets.
The current climate shows "how important it is to do your homework," she added. "From my perspective, it's key to have diversification."
Lazard has found value in "green bonds," which focus on companies that invest in environmentally sustainable ways.
That's not to say there isn't danger out there, but Klevan does not see it in a macro sense for the U.S.
"We all have to be very mindful of this buildup of debt everywhere, over the past especially five to seven years," she said. "Overall, and I say this probably from a sovereign standpoint, debt can be a tax on growth. So that's going to have a big impact in the medium term on a lot of countries."
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>>> Fed's Bullard warns of recession risk in raising rates
Reuters
August 24, 2018
By Ann Saphir and Howard Schneider
https://finance.yahoo.com/news/feds-bullard-warns-recession-risk-002836440.html
JACKSON HOLE, Wyo. (Reuters) - St. Louis Federal Reserve Bank President James Bullard on Friday raised new alarm bells over the U.S. central bank's plan to keep raising interest rates, warning that even one more rate hike could set the stage for recession.
Bullard, who spoke to Reuters on the sidelines of a conference here for global central bankers and economists, said the yield curve on U.S. Treasuries suggests investors see slower growth after this year and no danger of inflation ahead.
Earlier in the day, Fed Chair Jerome Powell gave a talk signaling more interest-rate hikes are ahead, and the yield curve reached its flattest since before the financial crisis.
Part of Powell's rationale for raising rates is that with unemployment at 3.9 percent, inflation will not stay low forever, so rates need to rise somewhat.
"The thing is, we would be deliberately inverting the yield curve, because we think our models are right and we think the market's wrong," Bullard said. "We don't have to do that, we don't have to walk the plank in this situation because inflation is not high, inflation expectations are not exploding.
"We can afford to wait and see and inflation does start to move up, well, we can move up," he added.
An inverted yield curve, when short-term borrowing costs rise above long-term ones, has preceded nearly every U.S. recession in recent memory.
After Powell's remarks, traders narrowed the gap between two-year and 10-year Treasuries to 19 basis points, the lowest since 2007.
That is less than the 25 basis points by which the Fed is expected to raise its benchmark short-term rate in September and again in December.
Asked if a rate hike at the Fed's next policy meeting in September could invert the yield curve, Bullard said, "That's a possibility, maybe, depending on how hawkish it was read by the market. But probably not that early, it's probably something like late this year, or next year."
Bullard first publicly raised a red flag over the yield curve last year on Dec. 1. At that time the gap between the two-year and 10-year was 58 basis points.
Since then the Fed has raised rates three times, and the gap has narrowed as longer-term rates have not risen in tandem with short-term rates.
Markets are pricing in two more rate hikes this year, and one next year, less than the three rate hikes the Fed currently forecasts for 2019. Policymakers will release fresh forecasts for future rate hikes at its September rate-setting meeting.
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If This Level Breaks, 10 Year Yields Spike to 3.50%, Then 4.05%
10 year bond yields are hammering on the 3.10% level. This was the pivot high from 2013 and current resistance. However, should the 10 year yield break over 3.10%, there is no resistance until 3.50%, then 4.05%. While to average investors it may mean little, to smart traders this is huge. The stock market could literally lose 25% of its value if rates spike to 4.05% as big money runs for yields versus the risk of stocks. In addition, U.S. debt payments will spike, likely causing an S&P warning and possible default. The Federal Reserve has put us in a corner where easy/cheap money is the only way to survive. This is a major catastrophe waiting to happen. In my opinion it is not IF rates jump to 3.50 and 4.05%, it is when?...
Gareth Soloway
InTheMoneyStocks
>>> This Bond Bull Market Still Has Legs
By James Rickards
January 29, 2018
https://dailyreckoning.com/bond-bull-market-still-legs/
This Bond Bull Market Still Has Legs
I started in the Treasury bond business in 1985 after a 10-year career in commercial banking. I retired as a senior officer of Citibank that year at a relatively young age and made the move to Wall Street.
My firm was Greenwich Capital Markets, one of a select group of “primary dealers” allowed to transact directly with the Federal Reserve. Monetary policy is conducted through open-market operations run by a trading desk at the Federal Reserve Bank of New York.
Being a primary dealer just means you have passed rigorous screening by the New York Fed in terms of credit, capital, operations, management and other criteria.
Importantly, as a primary dealer you have to make a continuous two-way market in all maturities of U.S. Treasury and government-backed mortgage securities across the yield curve. You are expected to buy when others are selling and to sell when others want to buy.
That market-maker role is how the Fed insures liquidity in the Treasury market and is the price a firm must pay for the privilege of being named a primary dealer.
Greenwich Capital was small but mighty. We did not have the capital size of other primary dealers like Goldman Sachs or Morgan Stanley, but we did have a reputation as having some of the smartest sales and trading staff around. We punched above our weight as a market maker.
As the firm grew, we were frequently ranked in the top five and sometimes No. 1 in certain parts of the yield curve, particularly 10-year Treasury notes. Our customers were the biggest firms in the world such as PIMCO, MetLife and giant foreign banks based in Japan and Germany.
As a member of the executive committee at Greenwich, part of my job was staying in the good graces of the Fed and making sure nothing jeopardized our primary-dealer status. If the Fed had ever pulled our name off the primary-dealer list, our customers would have abandoned us the next day.
I became a regular in meetings at the Federal Reserve Bank of New York. That experience served me well years later, in 1998, when I had to negotiate the bailout of Long Term Capital Management sponsored by the New York Fed.
There was something else highly memorable about my time at Greenwich Capital. It was a money machine! The firm typically had returns on equity of 20–40%.
That was partly because we were smart, savvy and hardworking. But there was another reason. Our firm had caught the wave of the greatest bond bull market in history. It was hard not to make money.
This 30-year chart below shows the declining path of interest rates on the 10-year Treasury note from 1988–2018.
This bull market in bonds actually began in 1981 after Paul Volcker pushed short-term interest rates over 20%, the highest since the Civil War, to kill the runaway inflation of the late 1970s and early 1980s.
Although there were rallies and drawdowns along the way, and plenty of chances to lose money — such as the bond bloodbath of 1994 — the overall trend is clear. Bond yields have fallen and bond prices have rallied for over 30 years:
To understand why this bond bull market was such a source of profits for Wall Street, including my old firm, a bit of simple bond math is in order.
The first point is that bond prices move inversely to yields. If interest rates are going down, bond prices are going up and vice versa. A declining interest rate environment is heaven-sent for a bond dealer with inventory or an investor with bonds in her portfolio. That’s what the chart shows.
The second point is that the amount of capital gain on a bond in a declining rate environment increases as the absolute level of rates declines.
For example, a 1% rate decline from 2% to 1% produces a much larger capital gain than a 1% rate decline from 8% to 7%. The reasons are highly technical and involve concepts such as “duration” and “convexity.”
You don’t need to understand any of those technicalities to understand that in a declining rate environment, you not only have capital gains, but those gains expand as rates fall to lower levels.
The third point is the difference between nominal rates and real rates. The nominal rate is just the amount of interest that the bond actually pays. The nominal rate on a 4% bond is 4%; what you see is what you get. The real rate is the nominal rate minus inflation. If the nominal rate is 4% and inflation is 2%, then the real rate is 2% (4 – 2 = 2).
That difference between nominal and real rates seems simple until you get into a strange situation where inflation is higher than the nominal rate. Then the real rate is negative.
For example, if the nominal rate is 4% and inflation is 5%, then the real rate of interest is negative 1% (4 – 5 = -1).
The U.S. has never had negative nominal rates (Japan, the eurozone and Switzerland have), but it has had negative real rates. In the early 1980s, nominal interest rates on long-term Treasury securities hit 13%. But inflation at the time was 15%, so the real rate was negative 2%. The real cost of money was cheap even as nominal rates hit all-time highs.
If you’re an economist or analyst trying to forecast markets based on the impact of rates on the economy, then you need to focus on real rates.
Rates of 13% when inflation is 15% are actually stimulative. Rates of 3% when inflation is 1% are actually contractionary. In these examples, 2% is a “high” rate and 13% is a “low” rate once inflation is factored in.
The situation today is much closer to the latter example.
The yield to maturity on 10-year Treasury notes is currently around 2.7%, the highest since the yield briefly touched 3% at the end of 2013. Inflation as measured by the PCE core deflator (the Fed’s preferred measure) is currently about 1.5% year over year. Using those metrics, real interest rates are about 1.2%, relatively high by historic standards.
The key question for analysts is whether these high real rates are justified by growth expectations and expectations of higher inflation, or whether they will act as a drag on growth in a weak economy that cannot bear such high rates.
A lot depends on the answer to that question.
Right now that ratio of stock returns to bond returns is near a quarter-century high. The last two times this ratio showed similarly elevated levels were just before the dot-com crash in 2000 and just before the stock market meltdown in 2008.
There are essentially two ways for this extreme ratio to normalize.
The first form of normalization would be if stock values decline sharply and bonds rally on lower rates (producing larger capital gains) and a flight to quality. This is what happened after 2000 and 2008.
The second form of normalization would be if bond returns soar on much higher interest rates. Those rate increases would have to be extreme to offset capital losses from the same rate increases. Stocks would crash in the face of those much higher rates. This is what happened in 1980–82, which at the time was the worst U.S. recession since the Great Depression.
The stakes could not be higher. In either scenario we are looking at a potential stock market correction (at best) or crash (at worst).
The Fed is tightening monetary policy not because the economy is robust but because they are desperate to normalize interest rates and their own balance sheet to prepare for the next recession.
It takes 3–4% in interest rate cuts to pull the U.S. economy out of a recession. Right now the Fed policy rate is 1.5%. The Fed needs to get that rate to at least 3.25% to be able to cut rates sufficiently in the next recession. The Fed won’t get there until late 2019 or early 2020 at their current tempo of rate hikes.
If the Fed has to stimulate the economy before rates get to 3.25%, they will run out of room to cut rates before the job is done. That will force the Fed to print money again in a new quantitative easing program, “QE4.”
That’s why the Fed needs to trim its balance sheet — so they can blow it up again.
In short, the Fed is raising rates and reducing the money supply at the wrong time for the wrong reason. The Fed is preparing for the next recession but will probably cause a recession by trying.
Meanwhile, the Treasury market is stuck in its own feedback loop. Rates rise on expectations of growth and inflation, but those rate increases slow growth and cause disinflation, which brings rates back down again. Wash, rinse and repeat.
We’ve seen this cycle eight times since Bernanke’s “taper talk” in May 2013. Another Fed flip-flop is coming later this year.
Rates were higher in late 2013 than they are today in expectation of growth and inflation. What happened?
The economy sank into a near recession in 2014 and 2015 before rebounding in 2016 and 2017. This is the cycle of higher and lower rates the Fed can’t seem to escape.
The conundrum will be resolved soon. Higher rates will slow the economy and put the Fed on pause.
The total return ratio between stocks and bonds will normalize, with stocks losing ground and bonds as the big winner.
I can’t give you an exact date when it happens, but it’s best to be prepared in advance.
Regards,
Jim Rickards
for The Daily Reckoning
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Bank cd’s moving up quick, wtf is going on ?
Boy do I make friends real quick! Lmfao....
Hedgebunny, >> specialized in kickn mm hedge specialist ask <<
Hey, whatever works :o)
I traded biotech for years, but am now a 'recovered' trade-aholic. Now very conservative, but am always susceptible to falling off the wagon and ending up back in the casino, lol..
Just going through all your boards you moderate for useful info, thanks!
— — - I specialized in kickn mm hedge specialist ask, I watch chit stocks with low share structure and no dilution. When broker’s mm start to load, I like to pizzzzz them off and take their shares............ lmfao.........
BUT YOUR DIFFERENT, YOUR KNOWLEDGEABLE....... U ALIEN, is that why u have no vowel in yur name? Just wondering because I am an alien and we don’t use vowels in our names either, just constanents and numbers......lmao...... let’s hang out! Lol........
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