Positioning Update: All Data Points to a Fed Rate Hike

Carry Currencies:

  • Big net short position on JPY is EM Local currency bonds supportive.

  • Big net short on EUR is risk off due to Greece

  • Big USD long is risk off

Commodities (CFTC):

  • WTI is net long at a high level

  • Gold is net long

Equities:

  • S&P500 is net close to neutral

  • Sector positioning is underweight staples, utilities, and telecoms as they are negatively correlated to rates. And long cyclical sectors, especially financials and industrials

Treasury Complex:

  • 5Y and 10Y shorts have been mostly covered in the week’s sell-off

  • Big net short on long bonds (25Y+)

  • Huge net long on the 2Y

Credit Flows:

  • Relative value hedge funds show reduced bond exposure considerably

  • Credit (Baa versus Aaa) and duration (10Y/5Yr) beta show a considerable rise in correlation

Fund Flows:

  • Retail money is buying the dip. Bond fund inflows amounted to $3.4 billion

  • Europe bond fund outflows were $3.3 billion in May and $300 million month to date

  • MBS inflows were $6 billion

  • Treasury outflows amount to $1.5 billion last week, $8 billion over the last two months

  • EM bond outflows were $800 million

  • IG had $500 million inflows and HY had $800 million in inflows

A Five-Year Archeology of the High Yield Markets with a View to the Future

The Fed has kept short term interest rates at near zero for six years in response to an interbank lending lock-up and a run in the wholesale funding market back in 2008. After three rounds of QE, the Fed has signaled it is done with easing and is ready to begin a tightening cycle.

I’m going to stay objective here. There is no point is saying the market is rigged or damaged. If there is one things that my Uncle Larry taught me, it is that the financial landscape truly does reinvent itself every five years or so. Let’s take stock of the changes that zero short rates have generated.

Credit in 2015 to totally different than Credit in 2007 (not counting Japan). The market in 2007 primarily consisted of private money making price-sensitive allocations of funds to risk assets. You had some central bank open market operations going on, but the degree of purchases and the kind of assets purchased have changed in 2015. Asset-backed securities are bought in large size, and the Fed and other central banks bought government paper across the entire yield curve. In short, you have a very price-insensitive buying of assets with a policy objective in mind, because private money has not accomplished hose objectives on their own. A part of this is just a shell game: over this period banks stepped back from taking risky loans, and reduced credit lines. The bond market filled in the gap to some extent. Even so, we are talking about massive liability increases on corporate balance sheets.

We see the same dynamics in emerging markets, only more so. Ambrose at the Telegraph reports that 15 years ago EM bonds issued in external currency (mainly USD) amounted to a $2 trillion market. Now EM USD bonds amount to $9 trillion of off-shore dollar debt. One can rightly say that EM economies now comprise over 50% of global GDP, and these bonds merely reflect that emerging markets are now truly integrated into the global financial system by way of the bond market. Not so fast. Keep in mind that these bonds are issued in dollars and EM authorities have no control over the price of this asset. Fair enough that emerging market corporates have the balance sheets to meaningfully tap the bond. But the market is ahead of itself. In the face of an asymmetry between tightening USD funding and an expensive EM market, the correction doesn’t seem over and finding the bottom won’t be pretty.

In short, the public price-insensitive buying has altered the incentives for the private players in credit markets, especially in the riskiest segment, high yield. Primary issuance in high yield is unprecedented. From 2009-2014, US high yield corporate issuance averages $269 billion per year. 2003-2008 saw about $150 billion in average annual issuance.

Investors have lapped this issuance up because they need meaningful returns even in an era of near zero short rates. So high yield reacted by issuing bonds with higher maturity. 2014 high yield bonds have an average maturity of 14 years; 2008 vintage bonds have an average maturity of 8.5 years. So now we are at the cusp of a Fed tightening cycle. We have large issuance with higher durations which imply higher price sensitivity to changes in interest rates.

Repricing is going to hit investors first and issuers last. That is to say: investors off-load their exposures when markets re-price risk and get blow-torched doing it. Smarting from these losses, issuers will be unable to roll their existing debt without compensating buyers in terms of yield. So for a while bonds were as attractive to money as sticks are to dogs. It will take years for this repricing process to be complete. And when it is over, credit markets will look completely different. Again.


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