Bank for International Settlements: Global Risk ON Financed by Record Leveraged Carry Trades and Margin Debt as Balance Sheets Deteriorate, Parabolic PSEi!

In their Quarterly Review (September 2017) released yesterday, the Bank for International Settlements (BIS) or the central bank of central banks described the latest global RISK ON phase

Excerpted from the BIS: (bold and underline mine)

A “risk-on” phase

As is typical for periods of low volatility and a falling dollar, a “risk-on” phase prevailed.

Against the backdrop of persistent interest rate differentials and a depreciating dollar,returns from carry trades rose sharply and EME equity and bond funds saw large inflowsduring the period under review (Graph 7, first panel). Speculative positions also pointed topatterns of broader carry trade activity: large net short positions in funding currencies, such as the yen and Swiss franc, and large net long positions in EME currencies and the Australian dollar (Graph 4, right-hand panel).

Equity market investors also employed record amounts of margin debt to lever up their investments. In fact, margin debt outstanding was substantially higher than during the dotcom boom and around 10% higher than its previous peak in 2015 (Graph 7, second panel).

 

While margin debt levels breached new records, traditional valuation benchmarks, such as long-run average price/earnings (P/E) ratios, indicated that equity valuations might be stretched. Recent market moves pushed cyclically adjusted P/E ratios for the US market further above long-run averages. Cyclically adjusted P/E ratios also exceeded this benchmark for Europe and for EMEs, though by a smaller amount (Graph 7, third panel). That said, given the unusually low bond yields, valuations may not be out of line when viewed through the lens of dividend discount models. Indeed, estimates of bond yield term premia remained unusually compressed, well below historical averages in the United States and drifting further into negative territory in the euro area (Graph 7, fourth panel). This suggests that equity markets continue to be vulnerable to the risk of a snapback in bond markets, should term premia return to more normal levels.

There were also some signs of search for yield in debt markets, as issuance volumes of leveraged loans and high-yield bonds rose while covenant standards eased. The global volume of outstanding leveraged loans, as recorded by S&P Global Market Intelligence, reached new highs (above $1 trillion). At the same time, the share of issues with covenant-lite features increased to nearly 75% from 65% a year earlier (Graph 8, left-hand panel). Covenant-lite loans place few to no restrictions on the borrowers’ actions and as such might signal a less discriminating attitude on the part of lenders while potentially fostering excessive risk-taking on the part of borrowers. According to Moody’s, the covenant-lite share in the high-yield bond market also increased while covenant quality declined to the lowest levels since Moody’s started to record these numbers in 2011.

While corporate credit spreads were tightening, the health of corporate balance sheets deteriorated. Leverage of non-financial corporates in the United States, the United Kingdom and, to a lesser extent, Europe has increased continuously in the last few years (Graph 8, first panel). Even accounting for the large cash balances outstanding, leverage conditions in the United States are the highest since the beginning of the millennium and similar to those of the early 1990s, when corporate debt ratios reflected the legacy of the leveraged buyout boom of the late 1980s. Anddespite ultra-low interest rates, the interest coverage ratio has declined significantly. While the aggregate interest coverage ratio remained well above three, a growing share of firms face interest expenses exceeding earnings before interest and taxes – so-called “zombie” firms(Graph 8, third panel).4 The share of such firms has risen especially sharply in the euro area and the United Kingdom. At the same time, the distribution of ratings has worsened (Graph 8, fourth panel). The share of investment grade companies has decreased by 10 percentage points in the United States, 20 in the euro area and 30 in the United Kingdom from 2000 to 2017. 5 The relative number of companies rated A or better has fallen especially sharply, while the share of worst rated (C or lower) companies has increased. Taken together, this suggests that, in the event of a slowdown or an upward adjustment in interest rates, high debt service payments and default risk could pose challenges to corporates, and thereby create headwinds for GDP growth.

Based on the BIS’s description, the Risk-ON climate can be summarized as record yield chasing asset boom financed by surging leverage as balance sheets deteriorates

Rings a bell?

Oh, the BSP’s free money has sparked a bacchanalian orgy at the PSE!

The Asia's most expensive stock market has just become even more offensively expensive!

China Yuan Weakens as BIS Says Foreign Exchange Markets have Systematically Failed

Friday, overseas stocks got hammered. The popular reason was that with recent polls suggesting that UK’s Brexit was suddenly in a commanding 10 point lead against Bremain, markets have viewed this as a surge in uncertainty.

By sector, the decline in US stocks was led by the energy (XLE -2.16%) and the financial industry (XLF -1.24%). While the S&P 500 was down (-.92%, year to date), the S&P Bank Index ($BIX) was slammed 1.74% (-2.6% week on week and -9.3% year to date). The NYSE Broker Dealer ($XBD) was hit -2.11% -3.63% w-o-w, -10.73% y-t-d)

The Stoxx Europe 600 Bank index plummeted 3.7% (-4.8% wow, -23.48% ytd) to approach a two month low. Deutsche Bank crashed 5.8% (-7.74% wow, -35% ytd). The FTSE Italia All Share Bank Index plunged 5.03% (down 5.85% wow, 43% ytd) now nears the 2012 lows. Now even before the Brexit poll announcement, Japan’s Topix Bank ETF dropped 1.31% (-3.2% wow and -29.44% ytd)

So while it may be true that Brexit (political risk) could have been a factor, there must be something else that must have been affecting financial stocks.

That other major factor must have been the Chinese yuan.

Last May 28, I wrote that the USD-yuan was making strides to hit its previous highs. While the Chinese went into a 5 day holiday to celebrate the Golden Week Spring Festival and because of this, the onshore yuan CNY was last traded to reflect on a rebound mostly in reaction to the weak US payroll data of the other week, the offshore yuan got clobbered.

By Friday, the offshore yuan (CNH) suffered its biggest weakly decline since March (Bloomberg). Importantly, the CNH appears to have outpaced the CNY which like in August and January incited a global asset convulsion.

And if you haven’t noticed, the strains on the China’s yuan have appeared like clockwork—every SIX months.

And why shouldn’t this happen? The January yuan (deflationary) strain has prompted the Chinese government to unleash a staggering USD 1 Trillion of Total Social Financing (lowest window)! And the magnitude of credit expansion perked up domestic liquidity which subsequently caused food inflation even when the general measure of inflation the CPI barely budged.

From the supply side alone, the flood of credit by itself should be indicative that the yuan is southbound or headed lower! 

Additionally, with the inundation of credit, the public went into a speculative binge. They revved up speculations in commodities such as iron ore and steel rebars—which eventually collapsed. Moreover, Chinese property prices have gone berserk.

So it is likely that such developments may have prompted those in the know to escalate capital flight.

Chinese May imports reported a minimal .4%. But that’s most likely because imports from Hong Kong skyrocketed by a nosebleed 242%!!! Much of these imports have likely been about over-invoicing of imported goods which serves as a way to go around capital controls to send capital abroad.

China’s reserves have most likely been propped up by derivatives, (forex swaps and futures contracts). And with such derivative tools being short term in nature, borrowed dollars will again need to be paid back or rolled over. So the 6 months cycle could have signified expiring contracts.

So even when Chinese reserves dropped by only $28 billion in May to just $3.19 trillion to its lowest level since 2011, current pressures reveal that China’s “dollar” strain may have been vastly understated.

Again China’s currency ailment could be a symptom or a manifestation of the escalating pressure on the US dollar “shortages” through wholesale finance, in particular fx swaps and forward contracts.

In a recent speech by Bank for International Settlement’s, Economic Adviser and Head of Research, Hyun Song Shin, Mr Hyun opined that a critical measure of the foreign exchange markets have broken down or in his words a “widespread failure”.

Such systematic failure which has become pronounced in the last 18 months have been seen through the Covered Interest Rate Parity (CIP)

Covered Interest Rate Parity is “a condition where the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium” (Investopedia)

In short, the relationship between interest rates and currency values has been rendered dysfunctional.

For an overview. A currency’s forward rate and the current “spot” rate provides for the implied interest rate on the US dollar. Thus the difference between Libor and FX swap-implied dollar interest rate is called “cross-currency basis”

And when the implied interest rate from the fx dollar swap is above Libor, then the borrower of dollars will be paying more than the rates at the open market.

The systemic failure or breakdown occurs when cross currency basis have consistently been in negative, or when the fx swap dollar borrowers are, as noted above, paying above the market rates.

Negative cross currency basis occurred during the Great Recession. Today it has been happening for the 18 months even “during the period of relative calm”

But such correlational breakdown has been anchored on a strong US dollar which is a symptom of tighter credit conditions. 

Mr Hyun*

The breakdown of covered interest parity is a symptom of tighter dollar credit conditions putting a squeeze on accumulated dollar liabilities built up during the previous period of easy dollar credit 

*Hyun Song Shin Global liquidity and procyclicality World Bank conference, “The state of economics, the state of the world” Washington DC, 8 June 2016 Bank for International Settlements

Ironically, the CIP breakdown has not been seen only in emerging markets but in the yen, Swiss franc and the euro. Yes negative rates economies!

And these accumulated dollar liabilities or “ dollar shorts” emanate from three aspects of the US dollar’s currency reserve and cross border transaction role: namely, trade finance, invoicing currency and funding currency.

As trade finance currency, hedging activities are usually channeled through US denominated bank credit.

As invoicing currency, borrowing and lending occurs on the currency from which trade has been denominated in. For instance, exporters who trade in US dollars tend to borrow US dollars to finance operations and real assets.

As funding currency, globalization of financial markets means that a significant number of financial- institutions (such as pensions) or investors invest or take advantage of trade or speculative arbitrages around the world. In doing so, they convert foreign currency to domestic currency where investments are made. This leads to currency mismatches which these institutions or investors apply hedge positions. And the hedging counterparty is typically a bank. And as consequence, the bank will likely resort to mitigating its currency risk exposure by borrowing dollars. In this way, dollar claims are counterbalanced by dollar debts.

In other words, dollar liabilities built the period of easy dollar credit are equivalent to dollar "shorts".

So when credit conditions tighten, the race to meet dollar obligations are magnified, hence fx borrowers to pay above market rates to cover dollar “short” positions or dollar liabilities. This leads to the systemic CIP failure. Thus the recent rise of the US dollar, which has been accompanied by the negative cross currency basis, means that global conditions have been tightening.

I might add that such correlational breakdown have also been tied with ZIRP, NIRP and QE which provided the “period of easy dollar credit” and the incentives to hedge and leverage up in USD.

Aside from the above mentioned strains, China’s weakening currency could be in part,  brought about dollar shorts and also in part from a stampede to meet such obligations.

The BIS’ latest outlook on China’s external credit conditions provides some clues [Bank for International SettlementsHighlights of the BIS international statistics (June 6, 2016)] "Cross-border bank credit to emerging market economies (EMEs) was down by $159 billion during Q4 2015, or 8% in the year to end-December 2015 – the sharpest year-on-year contraction since 2009” And this was largely due to China where “ The $114 billion decline in cross-border lending to China was the second quarterly drop in a row, and it pushed the annual growth rate down to –25%.”

Furthermore, “The $114 billion decline in cross-border lending to China was the second quarterly drop in a row, and it pushed the annual growth rate down to –25%.”

And for potential supply of dollar shorts “New data published by China confirm that banks on the mainland are becoming an increasingly important source of international bank credit. They are an especially important source of US dollar credit: their cross-border dollar assets totalled $529 billion at end-December 2015."

So if there is anything, the bank selloffs and yuan’s weakening are symptoms of the ongoing tightening credit conditions around the world.

And tightening credit conditions should extrapolate to a weaker economy and narrowing access to credit. This subsequently implies greater credit risk which should transpose into greater systemic fragility.

Is it a wonder now why George Soros made a huge bet on a market crash and called for a sell on Asia? 

International Currency Swap Markets Reveals of a Developing Credit Crunch!

Big trouble for risk asset bulls. US dollar shortages have been emerging all over.

From the Bloomberg: (bold mine)

A crunch is developing in international funding markets.

The cost to convert local currency payments in the euro area, U.K. and Japan into dollars has jumped amid speculation the Federal Reserve will raise interest rates in December. With other major central banks set to hold, or even loosen, monetary policy, the projected policy divergence is supercharging the usual year-end uptick in demand for dollar funding….

The one-year cross-currency basis swap rate between euros and dollars reached negative 39 basis points Wednesday, the largest effective premium for dollar borrowing since September 2012, according to data compiled by Bloomberg. The rate was at negative 37 basis points as of 11:31 a.m. London time.

The measure, which was closely watched by investors during the financial crisis as an indicator of stresses in the banking system, reached negative 138 basis points in 2008 following the collapse of Lehman Brothers Holdings Inc. While the increase this month is driven more by monetary-policy divergence it still has implications for global banks. It also means U.S. companies, which have been borrowing in euros to take advantage of historically low interest rates, must pay more to swap those proceeds back into dollars….

This rush for dollar fundraising across the globe this month pushed up the one-year cost for Japanese banks to the highest level since 2011. Meanwhile, the cost for U.K. banks has more than doubled in November. That’s unusual because the surge was mostly focused in the euro area and Japan the last two occasions that funding costs rose, according to George Saravelos, global co-head of foreign exchange research at Deutsche Bank AG in London.

Well, this seem more than just about the FED’s lift-off, although speculations about it have been exacerbating the current conditions.(see charts above)

This seems really more about those balance sheets overstuffed by debt as evidenced by the $9.6 trillion credit in US dollars to non-bank borrowers outside the United States at the end of Q1 2015 (BIS)

This excerpt from a study from the Bank for International Settlements illuminates on the current dynamic: (Global dollar credit: links to US monetary policy and leverage, BIS, Robert N McCauley, Patrick McGuire and Vladyslav Sushko January 2015)

First, evidence from 22 countries over the past 15 years shows that offshore dollar credit grows faster where local interest rates are higher than dollar yields, and this relationship has tightened since the global financial crisis. And the wider the gap between local 10-year yields and those on US Treasury bonds, the faster the next quarter growth in outstanding US dollar bonds issued by non-US resident borrowers. This finding is consistent with the observation that, since 2009, dollar credit has flowed to an unusual extent to emerging markets and to advanced economies that were not hit by the crisis, while it has grown at a slower pace in the euro area and the United Kingdom (UK). In sum, dollar credit has grown fastest outside the US where it has been relatively cheap.

Second, before the global financial crisis, banks extended the bulk of dollar credit to borrowers outside the US. Low volatility and easy wholesale financing enabled banks to leverage up to funnel dollar credit offshore. These findings are consistent with Bruno and Shin (2014b) and Rey (2013).

Third, since the crisis, non-bank investors have extended an unusual share of dollar credit to borrowers outside the US. Firms and governments outside the US have issued dollar bonds, and banks have stepped back as holders of such bonds. The compression of bond term premia associated with the Federal Reserve’s bond buying has induced investors to bid for bonds of borrowers outside the US, many rated BBB and thus offering a welcome spread over low-yielding US Treasury bonds. We also find that inflows into bond mutual funds offering a spread over US Treasuries played a significant role in spurring offshore dollar bond issuance. We interpret this as evidence of the portfolio rebalancing channel of the Federal Reserve’s large-scale asset purchases.

A key observation is that, following a brief spike in spreads in Q4 2008, spreads declined in the subsequent quarters even as the stock of offshore dollar bonds grew rapidly. Thus, while we cannot reject the “spare tire” argument of Erel et al (2012) and Adrian et al (2013) at the height of the crisis (ie firms substituting from supply-constrained bank financing to bonds, despite widening spreads), any such effect seems to have been short-lived. Instead, heavy bond issuance amid falling yields and narrowing spreads points to the importance of a largely policy-induced favourable supply of funds from bond investors beginning in early 2009.

We end with a discussion of the implications for policy. First, dollar debt outside the US serves to transmit US monetary easing into immediately easier financial conditions for borrowers around the world. Second, while policy in economies outside the US can raise the cost of dollar debt at home, the effect of such policy is limited by multinational firms’ ability to borrow dollars abroad through offshore affiliates. Third, the recent prominence of bond markets in supplying dollar credit introduces new risks to financial stability, and thus changes the way that we need to think about the policy challenges posed by offshore dollar credit growth.

Now a progressing feedback mechanism between onerous cross border debt levels AND a downshift in global economic performance has been increasing strains in the supply of US dollar. Combine these with Fed’s potential rate hike (policy asymmetry between US and the world), hence the brewing credit crunch storm.