Stresses In The Bond and Funding Markets: Update 2.0

We are now a couple of weeks on from the last update we wrote looking at the actions the Fed had taken to stabilize bond and funding markets. Given last Thursday began with further announcements of expanding efforts to help, it seems a good time to revisit where things stand now. The commercial paper program is now up and running and we should be seeing the first of the “Economic Impact Payments” hitting household accounts right around now.

First, a recap of the most recent actions. April 9th saw the Fed announce actions to provide up to $2.3 trillion in loans to support the economy. They are doing this in a few ways, financing the loans banks are making to small businesses under the Paycheck Protection Program. This is the program that gives small businesses a direct incentive to keep workers on the payroll, via loan forgiveness if all employees are kept on the payroll for 8 weeks post the first disbursal. Coupled with the expanded Unemployment Insurance benefits, the goal is to minimize the income shock as much as possible to workers by either increased benefits to laid off workers or aiding companies in paying wages to keep people employed through this period.

FRA-OIS spreads. This is a spread of a forward rate agreement to swap fixed interest payments at some point in the future compared with the overnight index swap rate. Think of it as a measure of the risk or cost for banks to borrow in the future relative to a risk free rate. A forward TED Spread. It reached almost 80bps, and has since settled in around 50bps. Still a bit high, but notably lower.

FRA-OIS update2

Source: Bloomberg

The Fed’s Commercial Paper Funding Facility became operational in the first half of April. This facility was announced earlier in the month – per the NY Fed – “to enhance the liquidity of the commercial paper market by increasing the availability of term commercial paper funding to issuers and by providing greater assurance to both issuers and investors that firms and municipalities will be able to roll over their maturing commercial paper.” The facility is a Special Purpose Vehicle, funded through the Department of the Treasury to hold commercial paper. Eligible issuers also include municipalities, and an issuer is able to repurchase its own outstanding commercial paper and finance it through the SPV. This space took a while longer to show signs of healing, and has a ways to go still, but some positive signs in the rates below.

CommercialPaper update2

Source: Bloomberg

On-the-run/Off-the-run Treasury spreads. Benchmark points on the yield curve – those at the 2y, 5y and 10y point for example – are of particular interest to market participants and are generally the most liquid parts of the curve, and have futures contracts tied to them. The US Treasury curve has many bonds of all maturities, including bonds that have similar characteristics to the benchmark points – like a bond maturing a month before or after the current benchmark point. Being so close in terms of maturity and having the same risk free issuer, these bonds normally trade more or less in lockstep. At the height of the bond market dislocations, they began to move apart. The resumption of very large scale US Treasury purchases from the Fed have worked in reducing the anomalies in this space. The chart shows a measure of the pricing dislocations – a number between -1/+1 is normal, we are now back in that range.

OffTheRun update2

Source: Bloomberg

Cross currency swap rates.The chart below shows Japanese Yen (JPY) funding costs. Roughly speaking this measures the extra cost over unsecured rates to swap JPY for USD at some future point. A Japanese company may swap JPY for USD today, with a 3m term. The cost of this should normally be the difference in relative unsecured lending rates (Libor etc). In periods of funding stress, a premium appears, which is the basis. The Fed eased the terms of its existing major swap lines and broadened the countries that can access the liquidity to include Brazil, Mexico, Australia South Korea and Australia amongst others. The updated chart for Japanese Yen shows the strain reducing substantially.

CrossCurrencySwaps update2

Source: Bloomberg

Credit spreads moved out aggressively in March. The Fed actions to launch two credit facilities backing corporate credit markets, a Primary Market Corporate Credit Facility for new bond and loan issuances and a Secondary Market Corporate Credit Facility to provide liquidity for outstanding corporate bonds has so far worked to narrow spreads and calm nerves.

creditspreads update2

Source: Bloomberg

At pixel time for the last update the Fed was rolling out a plan to lend as much as $500 billion to states and local government to aid them through this period. Spreads continue to stabilize here, and we are starting to see a return to issuance, with about double the number of offerings the next couple of days than last week.

Munis update2

Source: Bloomberg

One other area to keep an eye on as it pertains to credit availability, and also as it acts as something of an accelerant to activity. Mortgage spreads. These have moved wider on credit concerns, plumbing problems with mortgage buyers and refi demand. Part of the goal of lowering rates is to allow for widespread refinancing of mortgages and lower rates to grease the wheels of housing more generally. The more mortgage rates can track government rates down to new lows, the better. The chart below shows the difference between the Bankrate 30Y Mortgage National Average Rate and the US Ten Year Government bond.

mortgagespreads update2

Source: Bloomberg

So what to make of all these actions? Well first, time to update some priors. Even though rates were low, the Fed had room to act. Is it out of room now? We doubt it. If one has learned anything it is that a newly minted, awfully acronym-ed, facility can spring up and get funded fairly quickly. But don’t take our word for it – Fed Chair Powell literally went on the Today Show and told us – ‘We’re not going to run out of ammunition’. It is also worth noting that it is easier politically for programs to be extended in time and buying power now that they are here than it is to get them over the finish line first time round. To our eye, the policy actions from both the Fed and Congress are like using a pole to cross a ravine. It doesn’t matter how deep the ravine is, scary as it is to look down, it matters how wide it is. The real economy beginning to open up in the next couple of months will be welcome relief for all – many more quarters like this and the Fed and Congress will have to go back to the drawing board.

 

 

Stresses In The Bond and Funding Markets: Update

We wanted to post an update to our previous entry on Stresses in the Bond and Funding Markets and the Fed response. Over the last few days we have seen substantial easing in some of these markets as central bank actions have begun to filter through. Not all markets see the plumbing impacts immediately, as it can take some time for money to reach the target. Payments have to settle, loans extended, bond market programs fired up with funding and the like. The charts below are the same ones we showed before, in the eye of the storm (or at least we hope that was the eye).

FRA-OIS spreads. This is a spread of a forward rate agreement to swap fixed interest payments at some point in the future compared with the overnight index swap rate. Think of it as a measure of the risk or cost for banks to borrow in the future relative to a risk free rate. A forward TED Spread. It reached almost 80bps, and has since settled in around 50bps. Still a bit high, but notably lower.

FRA-OIS update

Source: Bloomberg

Commercial Paper markets continue to be wide. The Feds Commercial Paper Funding Facility becomes operational in the first half of April. This facility was announced earlier in the month – per the NY Fed – “to enhance the liquidity of the commercial paper market by increasing the availability of term commercial paper funding to issuers and by providing greater assurance to both issuers and investors that firms and municipalities will be able to roll over their maturing commercial paper.” The facility is a Special Purpose Vehicle, funded through the Department of the Treasury to hold commercial paper. Eligible issuers also include municipalities, and an issuer is able to repurchase its own outstanding commercial paper and finance it through the SPV. Watch this space.

CommercialPaper update

Source: Bloomberg

On-the-run/Off-the-run Treasury spreads. Benchmark points on the yield curve – those at the 2y, 5y and 10y point for example – are of particular interest to market participants and are generally the most liquid parts of the curve, and have futures contracts tied to them. The US Treasury curve has many bonds of all maturities, including bonds that have similar characteristics to the benchmark points – like a bond maturing a month before or after the current benchmark point. Being so close in terms of maturity and having the same risk free issuer, these bonds normally trade more or less in lockstep. Late last week, they began to move apart. The resumption of very large scale US Treasury purchases from the Fed have worked in reducing the anomalies in this space. The chart shows a measure of the pricing dislocations – a number between -1/+1 is normal, we are now back in that range.

OffTheRun update

Source: Bloomberg

Cross currency swap rates.The chart below shows Japanese Yen (JPY) funding costs. Roughly speaking this measures the extra cost over unsecured rates to swap JPY for USD at some future point. A Japanese company may swap JPY for USD today, with a 3m term. The cost of this should normally be the difference in relative unsecured lending rates (Libor etc). In periods of funding stress, a premium appears, which is the basis. The Fed eased the terms of its existing major swap lines and broadened the countries that can access the liquidity to include Brazil, Mexico, Australia South Korea and Australia among others. The updated chart for Japanese Yen shows the strain reducing substantially.

CrossCurrencySwaps update

Source: Bloomberg

LIBOR spreadsmeasure the spreads in different maturities of LIBOR rates. These can shift with expectations of upcoming monetary policy action, but generally speaking need to be kept orderly for markets to function well. As the market expected and wanted a cut to zero, rates moved considerably, this arguably called for the Fed to pull forward its planned cut. The Fed cut for second time on Sunday March 15th (and then cancelled the regular March meeting).

LiborSpreads update

Source: Bloomberg

The Fed’s goal here is to implement monetary policy – where stresses arise they will try and squash them. The capital ratios that are binding – reduced. Discount window stigma – gone. Overseas dollar costs going up – swap lines. Mortgages rates up a little – $200bn of MBS purchases. Treasury curve one-the-run/off-the-run blowing out, $500bn to fix. FRA-OIS spreads – squashed. Commercial paper blowing out – fire up the program. At times like these one starts to hear that the Fed must now be out of bullets. Rates are zero after all and what more can they do? Well people have said this for a while and here we are. The Fed is immensely powerful in dealing with this type of event, and clearly this time has acted very quickly and in particularly large size. As we write, another story comes up highlighting the impact on a different area where the Fed is now active, in corporate bonds. AAA CLO spreads have halved in two days. Municipal bond spreads were another area shifting out. The chart below shows the AAA muni yield as a percentage of the same duration US Treasury (relevant due to the different tax implications). So what did the Fed do – squashed it.

Munis update

Source: Bloomberg

Stresses In The Bond and Funding Markets

The last few days have seen some stresses in the bond and funding markets. The charts below illustrate a few of these, we then detail why the Fed intervened and cut again. The stresses are coming at a time when markets are fearful of the size of the sudden stop in economic activity we are witnessing due to actions being taken to defeat the coronavirus pandemic. Some sections of the economy are seeing large and fast drops in revenues, with a double whammy hit to the oil patch driven by the Saudi/Russia/OPEC actions in the oil price. Businesses are beginning to draw on revolving lines of credit in order to weather the storm. Markets are dropping, also contributing to the disruptions as positions are unwound into illiquid markets. At times like these, disruptions can be seen in different places.

FRA-OIS spreads. This is a spread of a forward rate agreement to swap fixed interest payments at some point in the future compared with the overnight index swap rate. Think of it as a measure of the risk or cost for banks to borrow in the future relative to a risk free rate. A forward TED Spread.

FRA-OIS

Source: Bloomberg

Commercial Paper markets began to show signs of strain. This is a lifeblood market that companies use to borrow short term and fund everyday expenses at terms of under a year. Having rates increase and access to funding drop at a crucial time is a clear threat to the ability of the real economy to weather a storm. Given the impact of states shutting down for short periods, companies need to be able to borrow to cover real economic weakness.

CommercialPaper

Source: Bloomberg

On-the-run/Off-the-run Treasury spreads. Benchmark points on the yield curve – those at the 2y, 5y and 10y points for example – are of particular interest to market participants and are generally the most liquid parts of the curve, and have futures contracts tied to them. The US Treasury curve has many bonds of all maturities, including bonds that have similar characteristics to the benchmark points – like a bond maturing a month before or after the current benchmark point. Being so close in terms of maturity and having the same risk free issuer, these bonds normally trade more or less in lockstep. Late last week, they began to move apart. An example below – the green/red column shows a Z-Score of individual bond spreads of similar maturities roughly 10 years out.

OffTheRun

Source: Bloomberg, 3/16/2020

Cross currency swap rates. The chart below shows Japanese Yen (JPY) funding costs. Roughly speaking this measures the extra cost over unsecured rates to swap JPY for USD at some future point. A Japanese company may swap JPY for USD today, with a 3m term. The cost of this should normally be the difference in relative unsecured lending rates (Libor etc). In periods of funding stress, a premium appears, which is the basis.

CrossCurrencySwaps

Source: Bloomberg

LIBOR spreads measures the spreads in different maturities of LIBOR rates. These can shift with expectations of upcoming monetary policy action, but generally speaking need to be kept orderly for markets to function well. As the market expected and wanted a cut to zero, rates moved considerably, this arguably called for the Fed to pull forward its planned cut. Below is overnight vs 1 month.

LiborSpreads

Source: Bloomberg

The Fed delivered a second inter-meeting cut on Sunday in response to the coronavirus and to try and alleviate these funding stresses to allow better transmission of monetary policy. The FOMC lowered the federal funds rate by 100bps to a target range of 0 to 0.25 percent, as well as providing forward guidance, noting that they expect “to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”

Alongside this, the FOMC announced a program to purchase assets of $700bn, split $500bn in Treasury securities and $200bn in agency mortgage backed securities. The statement spoke of wanting to ‘support smooth market functioning’. These purchases began yesterday. Note that in QE3 the peak pace was some $85bn per month. Make no mistake – these purchases are huge. The FOMC also made a plethora of changes to other parts of the plumbing aimed at improving the efficacy of market plumbing and conducting policy, including lowering the discount window spread, reducing the rates on OIS on swaps with foreign central banks and eliminated reserve requirements. Today they have announced the establishment of a Commercial Paper Funding Facility.

The Feds goal here is to implement monetary policy – where stresses arise they will try and squash them. The capital ratios that are binding – reduced. Discount window stigma – gone. Overseas dollar costs going up – swap lines. Mortgages rates up a little – $200bn of MBS purchases. Treasury curve on-the-run/off-the-run blowing out – $500bn to fix. FRA-OIS spreads – squashed. Commercial paper blowing out – fire up the program. Did it work? Well it is early, but so far it looks like some of these have eased. They are worth keeping an eye on. By way of example, the easiest one to keep an eye on updated through todays close. FRA-OIS dropped a lot today.

FRA-OIS v2

Source: Bloomberg

Correlation Is Not Causation

Drummed into applied math students everywhere. It even has its own website, with this gem on how margarine consumption is correlated with divorce rates in Maine.

correlation

Should be true enough in markets as well. But in reality, at least in pockets, it isn’t always true. Stocks have always in part been driven by relative valuations. Stat-arb was a big thing some twenty years ago when computing power was starting to be applied to stocks. Pairs trading based on common risk factors makes some sense, Ford and GM operate in the same business after all, it makes sense they should be broadly be impacted by the same broad industry and economy trends. When computing power jumped later, factor investing came to dominate. Grouping stocks based on different attributes has some merit. At their heart, the old quants had valuation firmly in the mix of parameters. Many of the newer factors and machine learning quants have thrown out what ultimately matters. Price – or rather ‘value’. Low vol investing doesn’t care whether a stock is priced for perfection or not. Quality takes no account of what that pricing implies going forward, just that its metrics are stable. Momentum will push junk yields far below default rates and not even notice. As long as the quants see the property they like, regardless of valuation, away they go. They operate as if they are just observers, quietly taking a look from afar and being able to interact without impact. The Hawthorne effect is the phenomena where the behavior of subjects is altered due to the awareness of being observed. The quants in places are not observing any longer, and their impact is self-fulfilling, for a time anyways. There is plenty to be gained from applying stats and metrics to markets, but it is surely important to not take it too far.

You can see this today (September 9, 2019). ‘Value’ stocks are up a lot, not particularly based on the merits of the underlying businesses, but because other types of stocks are down. When stocks are held for their correlation properties, strange things happen. Like the butterfly that flaps its wings and causes a distant thunderstorm. It’s easier to make a case that at least today, retail stock Gap is up big because Boris Johnson chose to shut down parliament. Not often thought of as a butterfly, but bear with the logic here. Boris shut parliament…which catalyzed votes to stave off ‘no deal’ Brexit…which caused Gilts to fall…which drove global bonds to fall…which pushes growth stocks, utility stocks and REITS down…which makes value stocks jump. Seem strange? It should. But the stock market acts this way more and more. Factor investing and ETF baskets that segment stocks into groups are big drivers of prices, particularly when smaller names get larger weights in factors. We need to get back to a more fundamentally driven world.

Spicy English

Two things have become clear, thanks to the slightly spicy English of Mario Draghi. To set the stage, it’s October 26th, 2017, and we wait for the latest announcement from the ECB. US 10s are near recent high yields, breaching the tough resistance of 2.40%. The Euro has come off the boil, and stocks everywhere are near the highs. Out comes the text, and Mario does not disappoint, hitting all his lines right on cue. Rates will remain low; however, the ECB will slow down asset purchases, in a measured way, starting next year. Then comes the press conference, and he confidently walks it back. Yes, the economy is doing well, but if we don’t see some inflation, we are fully prepared to hit the gas again. Boom. Bonds and Bunds rally, rates fall, Euro gets creamed, stocks take off. And the two things are….

Continue reading

Why Financial Conditions Are Easing…

Two years ago, Dudley was spooked by tightening financial conditions.  Now, they can’t figure out why they are so loose.

I think there is a simple explanation.  Two years ago rates were so low that credit could not go any lower, as they would go below the default rate.  So it looked like financial conditions tightened.  Now, as the fed raises rates, credit has stayed at the same price, so it looks like financial conditions are getting looser.  Here is a chart of auto loans.  Rate has not changed.  Unless the central banks buys credit (as they have done in Europe, forcing HY below UST), the nominal rate cannot go any lower, but won’t go up right away either. If you are at the default bond in credit, do measures of financial conditions fail to make sense?

Despite three Fed hikes over the past year, the rates on new-vehicle loans remain near multi-decade lows.

source: https://fred.stlouisfed.org/series/RIFLPBCIANM60NM#0

The Doldrums

In the great series of historical novels about the British Navy in the Napoleonic era by Patrick O’Brian, and the associated movie Master and Commander, there is a poignant scene where the ship is stuck in the Pacific doldrums, sails limp at the mast for days. The crew looks for a scapegoat, a Jonas, to blame for their misery, and they find one in a hapless midshipman. For the good of the ship he grabs a cannonball and jumps over the side. A prayer is said, the wind returns, and off they go. Complacency is the buzzword of the day, but the winds will return as they always do, and the catalyst will be as much a surprise to the market as to the midshipman who found himself carrying a cannonball.

I am habitually early for meetings. The other day I had some time to sit outside the offices of a major investment bank at the start of the business day. It’s an evergreen notion for me … a scene repeated at all the banks and funds all around the world, hundreds of well educated, motivated, energetic young people all chasing the same pool of alpha. And I wonder, is there enough to feed all these hungry strivers? Risk premium is durable, varied and growing, alpha is zero sum and rare. At Mount Lucas, our approach is to own that risk premium in many flavors through our quantitative trading. Just this month we added a new flavor, a momentum based multi asset credit basket. It fits nicely with the other risks in our capital markets allocation. We continue to search for alpha in the realm of long term behavioral biases. I have to admit it’s tough going, particularly in the doldrums, but the opportunities are there, and we await a stiff breeze to see them realized.

 

Mount Lucas employs a number of different strategies each with their own investment objectives and risk profiles.  Any reference to a strategy or strategies mentioned above may or may not be indicative of all of Mount Lucas’ products.”

The Speed of Change – Buying Puts and Calls

Value investing can be counter-intuitive at times.  Acting against our own intuitions is not an easy thing to do; it’s uncomfortable.  We form our thoughts and reasons based on what we see and experience in the present, and extrapolating our present situation into what the future holds is something we all do.  Predicting the trajectory of long-term trends that have already begun is not rocket science, but investing requires you to be right about the trend, as well as the timing of that trend.

Bill Gates wrote the following a while ago

‘we always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten. Don’t let yourself be lulled into inaction.’

It comes to mind as I think about some of the stocks we hold, some of the stocks that are doing really well and the difference between a great company and a great investment. There is a lesson in the drivers of value investing and how it interacts with momentum, and more broadly on real visceral fears that are out there, manifesting themselves in the politics of both the left and the right. One way to think of value vs growth investing is as extrapolations of the current set of worries out to the future. Everyone remembers the Blockbuster video example, killed off by Netflix, and see that story writ large across big chunks of the rest of the economy and stock market. Disrupted businesses are everywhere – just this week Hertz announced a bad set of numbers, sequential declines in revenues and a bigger than expected loss. The stock got hit hard. On the other side? The new ride sharing services, Uber and Lyft, raising money at high valuations as people extrapolate to a future of self-driving on demand cars, and no place for old school Hertz. Amazon making it tough for big box retail is another example. Tech, robots and AI are coming for jobs and business as we know it.

Many instances of these seem perfectly valid, and it’s easy to paint the picture. The likes of Amazon, Netflix and Tesla are amazing businesses that have changed the world and achieved incredible things. The issue we have is that they seem priced for ever greater levels of growth into perpetuity, and don’t seem to take into account what we think is one of the key reasons value investing works – the people running the businesses are scared as well, and where they can, they fight back. Some will be unable to. But not all. Take General Motors and Tesla. General Motors trades around a 5 PE and pays a dividend north of 4%, and the last couple of years has about $9bn in income. The numbers are a bit different for Ford, but the picture about the same. That income is an enormous amount of firepower. The people running these businesses are not stupid, and I’ll bet are more worried about electric vehicles and driverless cars than you or I. The market focuses on Tesla and the incredible way it’s broken into the car market, its Gigafactory, and its solar roof product. They are extrapolating a future whereby Tesla hits the big time with its $35k Model 3 and kills off Ford and GM – at these prices that’s what is implied. Relating it to option buying, by buying Tesla investors are effectively buying calls on this amazing future – things need to get to this new world quicker, and it needs to be more amazing than it seems now. They may be right, but boy are those calls expensive here. With GM and Ford, we see value investing as akin to buying puts on the speed and scale of this societal change, and think that the extrapolation has gone too far – and doesn’t take into account the firepower of the businesses. If the transformation doesn’t happen, takes longer, or investors decide to pull financing from the Tesla project (and they sure will need a lot of funding to build out the scale the stock price is banking on) maybe things looks different and old Detroit transforms itself. That $9bn pays for a huge amount of R&D to fight back – indeed when you look at it, the first few firms to get an electric vehicle to market at a mass market price point have already done so. They Chevy Volt, the electric Ford Focus, the Nissan Leaf. GM is hiring 1000 engineers in Silicon Valley to expand Cruise Automation, the self-driving car unit it spent some $600m on last year. Ford is doing similar, investing $1bn in a self-driving car firm in Pittsburgh.  GM is into the battery game as well, opening battery factory in Shanghai. One can make the same case with Walmart and Amazon – Walmart has some $20bn in operating income, and an e-commerce business growing at 30% a year. At its root, Walmart isn’t too far from being an Amazon warehouse with a door and a checkout – it has a brand name, incredible logistics and supply chains – and won’t go down without a fight.

All of this isn’t to say that Tesla and Amazon aren’t incredible companies pushing the world forward – they certainly are. What they also do though, is to bring others up with them, galvanizing competitors into action. Capitalism in all its glory. We think the markets are extrapolating the future too far in both directions – the new kings Tesla and Amazon and their ilk to the high side and older world names to the low side. Back to the Bill Gates quote, investors are focused on the first part, over estimating the next two years at the expense of how things will look in ten years. The people in Detroit and Bentonville are focused on the second part, and not being lulled into inaction. Buying old Detroit at valuations like this is hard, it goes against the story of change. What you are doing by buying is really selling a put on the speed and scale of the change. We’ve seen a movie like this before at the turn of the century. New world growth expectations were out of hand and the growth premium over that five year period was enormous. The following five years were reversed, as value investing outperformed strongly. The chart below has some details on it. That’s how value investing works, in cycles, and it works because it’s uncomfortable.