Mrs. Watanabe and the Dao of the Sell-Off

Credit is in risk-off mode. And oh the salty, salty comments I have been hearing.

There are two three trends right now setting this up, all three interconnected. The dominant one is the Yen rally last week triggering fears of a big carry unwind. Regulatory constraints continue to dry up risky debt liquidity. IG is not affected much, here compared to how HY is being left out in the cold. Lastly, retail money is now flowing out of risky credit after a three blissful years. Don’t count the last one as unimportant: what they lack in size, then make up for in impact. Oh year, and the sell-off in the oil complex-which I've heard will BK the energy sector but is in my view overdone.

A carry trade unwind is enough to scare anybody, and this fear is written all over fixed income. Fixed income doesn’t give a crap about intraday moves in equity. Bonds are bought through a negotiation process full of transactions costs and wide spreads in the bid and ask. They are not sold on a transparent market like equities. Bond prices and trends are driven more by primordial trending forces that affect markets over longer time periods, not noisy chatter. The carry trade is one of those primordial forces born from decades of quasi-ZIRP.

Simply put:

  • An increase in the value of the yen (core FX) put pressure on carry bonds, moving them downward as traders unwind positions.

  • An increase in the value of carry bonds makes the carry trade appealing on a yield and price appreciation basis, putting upward pressure carry FX as traders finance positions with cheap core funding.

  • A decrease in the value of core FX makes the carry trade positive P&L, putting upward pressure the value of riskier FX bonds.

  • A sell-off in riskier FX bonds reinforces home FX appreciation and triggers a broader sell-off in FX debt, putting upward pressure on home FX and tightening CCCY funding.

Then Mrs. Watanabe, through the agency of Daiwa, Nomura, and their brethren, gets the itch again and parks the family money in FX bonds because of their appealing carry. It is agency part that causes the pain. The vehicle that Mrs. Watanabe buys is essentially a currency-hedged bond mutual fund with leverage. So when retail drawdown catches on even a little bit, the de-levered drop is palpable. And retail still thinks of this vehicle as a bond, not a bond fund. So when that bond fund “breaks the coupon” (lowers the fund disbursement) then retail really starts the drawdown. This vicious cycle really has no clear reversal point. Now you understand that Dao symbol at the top of the blog.

The reversal is a question of whether retail is acting as a swing trader or a position trader. All the Mrs. Watanabes have been through this so many times over the last 25 years that they all cash out with winnings and wait for the trend reversal that comes when bargain hunters pick up good yield income and gather wider interest. In short, they are position traders.

I think the theory that oil price collapse is going to blow up the HY space is, pardon the expression, total crap, but that never stopped a good story from creating mayhem. There is a lot of HY energy-related issuance of out there, but most of these producers hedge their production at least one year out and are adapting to the implosion by cutting production and cut expense (read employees), not by defaulting. Oil is seeing big volatility compared to the last three or four years, but nothing really special, as oil volatility on a twelve month basis is typically about 30-40% historically.

For the first time in a while we are seeing HY ETFs, my proxy for retail bond money, looking weak. HYG is probably the bell-weather, and HYLD is an actively managed product with a big allocation in the energy sector. This is the one getting pummeled.

Before anyone gets all ZeroHedge on this, take it in context. You are seeing some retail pain, but relatively speaking it is only that… pain.

On a capital appreciation basis, retail is seeing a definite shock, but not even one as severe as 2012. HYG doesn’t really Iook particularly fazed from the daily returns perspective: likely because on a total return basis, the situation is even less dramatic.

Given how contagious pain can be in credit, risk-off probably isn’t done yet. But I would say that we are in bargain hunting territory in the energy sector. The energy sector has already blown up.

Problem is that nobody has any cash to bid anything on bargains. Certainly not levered players, busted as they are. That’s right, it is real money… insurers, bond funds, pensions–all indirectly retail. Unlevered players like the Watanabe family will have to source the liquidity for a while.

So retail money is a small slice of the bond action, but they “carry” the seeds of trend reversals, pardon the pun. The real keys for a sustained trend reversal are continued core currency weakness (the yen especially), the Fed’s tricky job of tightening without destroying the bond market, and some good news about holiday spending. So far it’s been nothing short of dismal despite oil price relief.

The regulatory issues I will discuss in a separate post. This is actually a gigantic issue that is changing the entire credit market ecosystem, just on a very slow scale akin to geological time to clock-time. By the 2020s, relative valuation traders (read: a lot of the credit hedge fund space) will have to adapt or die.


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