My Weekly Commentary: Periphery Fragility List

There’s a natural ebb and flow to financial markets. It can be clear-cut Greed versus Fear – but often it’s more leaning Risk Embracement or Risk Aversion. Yet these days, little is typical or “natural” when it comes to market behavior. Speculative Dynamics rule: What evolved over time into an unstable, policy-induced Risk On, Risk Off (“RoRo”) dynamic has regressed to a destabilizing Bubble On, Bubble Off (“BoBo”). Desperate policymakers have sunk to blatant promotion of Bubble On. And a protracted liquidity-fueled market dynamic ensures that “money” continues to gravitate to those with a propensity to embrace risk. Pushing the risk envelope has paid handsomely. Use of leverage has been amply rewarded. Popular derivative strategies have performed splendidly.

I have argued that protracted global securities market Bubbles have become increasingly fragile. As such, fledgling signs of risk aversion should be monitored closely. One of these days… Yet latent fragilities are easily masked during periods of risk embracement, speculative leveraging and attendant strong flows. It is the nature of self-reinforcing Bubbles to gain momentum over time. For good reason, market players have been convinced that persistent global fragilities guarantee that policymakers will do “whatever it takes” to sustain abundant market liquidity and risk embracement. The Greek “resolution” further emboldens the view that global markets command politics. The current backdrop of open-ended central bank liquidity ensures that once markets gather a head of steam the sky is the limit.

The powerful Periphery vs. Core Dynamic was prevalent again this week. The S&P 500 and the Dow traded at all-time highs, along with the small-caps and mid-caps. Nasdaq indices are rapidly approaching March 2000 peaks. The Bubbling “Core” is not limited to U.S. securities markets. UK’s FTSE 100 index this week surpassed the previous 1999 record level. Japan’s Nikkei equities index jumped 2.5% to a 15-year high.

“Do whatever it takes” Draghi has by this point incited a full-fledged mania in eurozone securities. The German DAX surged 3.2% this week to an all-time high – increasing 2015 gains to 16.3%. France’s CAC 40 jumped 2.5% to the highest level since May 2008. Stocks in Spain and Italy advanced 2.8% and 2.3%, respectively. Portuguese stocks surged 4.4%, Ireland 3.6%, Netherlands 3.0%, Belgium 2.5% and Denmark 3.5%. Greek stocks recovered 2.8%. It’s become a free-for-all.

Importantly, Bubble On at the Core for now encompasses the debt markets. A couple Bloomberg headlines this week made the point: “Riskiest Debt Has Busiest Start of Year as Investors Demand Higher Yields.” “Dash for Trash Back as Bonds Show Animal Spirits.” Investment-grade CDS this week traded to the lowest level since early-December. Junk CDS dropped to the lows since September. February junk bond returns were the strongest since 2013 (2.3% according to Bloomberg).

And, again, it is not just an American phenomenon. Bloomberg: “Italian Spread Shows Risk Premium Vanishing in Euro Area’s Bonds.” From my perspective, risk perceptions vanished some time ago. This week saw further astonishing yield declines. Italian 10-year yields were down 25 bps, Spain 24 bps and Portugal an incredible 40 bps. At 1.33%, Italian 10-year sovereign yields are a notable manifestation of global securities prices radically divorced from fundamentals. And then there are Japanese yields at 0.32%, French at 0.60%, Spanish at 1.26% and Portuguese at 1.81%. Simply incredible.

The booming Core easily draws attention away from the fragile Periphery. This week saw the Turkish lira slammed for 2.2% to a record low versus the dollar – pushing y-t-d losses to 6.9%. Turkey is vulnerable. The economy remains in a Credit induced boom (Istanbul home prices up 25% y-o-y!). Trade deficits have swelled and inflation has taken hold – a dynamic bolstered by the weak lira. Meanwhile, the central bank is under intense political pressure to cut rates.

February 26 – Reuters (Asli Kandemir and Orhan Coskun): “President Tayyip Erdogan’s broadside against the central bank has raised concern about the future of its governor and of respected Deputy Prime Minister Ali Babacan, an anchor of investor confidence in Turkey for more than a decade. Erdogan on Wednesday slammed the bank’s monetary policy as ‘unsuited to the realities of the Turkish economy’ after it failed to meet his repeated demands for sharper rate cuts than those it had made the previous day. He questioned whether the bank was under external influence… ‘If Babacan or Basci are forced out by the Erdogan loyalists I think the market reaction would be severe and brutal,’ said Timothy Ash, head of emerging markets for Standard Bank…, predicting agencies Fitch and Moody’s would consider ditching Turkey’s investment grade credit rating.”

Turkey’s 10-year lira yields jumped 50 bps this week to 8.23% (high since mid-December). Turkey has been near the top of my Periphery Fragility List. Similar to many EM economies, Turkey has luxuriated in six years of ultra-loose financial conditions. Debt has grown tremendously, too much of it dollar-denominated. Turkish bank borrowings have been instrumental in a 50% increase in external debt over the past four years.

Positioned up near the top of the Periphery Fragility List, this week provided added confirmation of mounting trouble for Brazil – the world’s seventh-largest economy. On a much greater scale than Turkey, Brazil’s six-year Credit boom has seen a dramatic increase in inflation, trade deficits and external debt. Brazilian corporations and financial institutions have added enormous amounts of dollar-denominated debt, borrowings that have become increasingly problematic with the real’s almost 20% decline against the dollar over the past year.

February 26 – Wall Street Journal (Will Connors and Paulo Trevisani): “A decision by a major credit-rating firm to downgrade to junk status the debt of Petróleo Brasileiro SA is stoking fears that Brazil’s sovereign rating could be next. Moody’s… late Tuesday slashed the debt of the company, known as Petrobras, two notches to Ba2, two steps below investment grade, on continued concern about the fallout from a corruption scandal and the state-run oil giant’s ability to pay down about $135 billion in debt. The downgrade was the third by Moody’s since October. Still, the size and timing of Tuesday’s cut surprised some analysts and sent the country’s leaders into a defensive crouch. Brazil’s largest company, Petrobras plays an outsize role in the nation’s economy, which is flirting with recession. Petrobras’s newfound junk status is ‘an unequivocal blow’ to the administration of President Dilma Rousseff , Eurasia Group analysts wrote… and ‘there is growing concern over a negative spillover effect in macroeconomic management and potentially in Brazil’s sovereign rating.’”

The Brazilian real’s big Friday bounce erased what would have been another week of losses. Yet despite Friday’s better performance, key Brazilian CDS prices rose again this week. Petrobras CDS traded above 610 Wednesday, up from 460 bps to end 2014 and the year ago 285 bps. Petrobras CDS averaged 185 bps during the four-years 2010-2013, a period when the company doubled its liabilities.

The expanding Petrobras fraud investigation seems to be moving closer to ensnaring the major state-directed Brazilian banks (up at the top of The Fragility List). Banco do Brasil CDS closed the week up 21 bps to 379 bps, after beginning the year at about 300 bps (2014 avg. 249). BNDES (Brazil’s national development bank) CDS jumped 11 bps to 295 bps, after beginning the year at 230 bps (2014 avg. 181). After trading above 13% during Monday’s session, Brazilian sovereign (real) yields ended the week at 12.31%. Brazilian sovereign CDS traded Friday at the highest level (253bps) since April 2009.

Foremost on the Periphery Fragility List, I have posited that dollar-denominated emerging market (EM) debt is a global Credit boom weak link. And no boom has generated external dollar-denominated debt comparable to China’s. Chinese external debt more than doubled over the past four years to approach $1.0 TN. The scope of “hot money” flowing into China in recent years to play an appreciating currency and enticing yields is unknown but surely massive. And with the historic Chinese Bubble now faltering, there are myriad forces working against the renminbi. In a period of intense currency wars, the Chinese peg to king dollar has become a major issue for China’s exporters. There is also the specter of a reversal of speculative flows, spurred on by deteriorating economic prospects and weakened Credit dynamics. And throw in the likelihood that wealthy Chinese have one eye on the exit, fully intending to exit a crumbling Bubble.

February 27 – Financial Times (Patrick McGee and Michael Hunter): “China’s renminbi has touched a 28-month low against the US dollar, the latest slide reflecting central bank activity and investment flows. On Friday the renminbi fell 0.17%, the largest downward move for the tightly-controlled currency in a month… The PBoC ‘fixes’ the currency’s mid-rate each day, allowing investors to then trade the currency 2% higher or lower. The decline in the renminbi continues pressuring Chinese companies that borrowed in US dollars and expected to benefit over time by paying back such debts via an appreciating domestic currency. The rising dollar has upended that strategy and mainland companies are paying down dollar debt to avoid incurring a loss, in turn further boosting demand for the US currency. Dariusz Kowalczyk, senior strategist at Crédit Agricole, said anecdotal evidence suggests there continues to be ‘very strong demand for dollars in the mainland market’ over recent days and weeks, pushing the currency to the low end of its trading band.’”

February 25 – Wall Street Journal (Andrew Browne): “China’s superrich are nervously watching as the Chinese currency weakens against the dollar. Because of the extreme concentration of money at the apex of Chinese society, national stability rests to an extraordinary extent in the hands of just two million or so families. They are the top 1% of urban households, and already, their confidence in China’s future under President Xi Jinping is shaky. Many are fleeing with their cash–not all of it, but enough to bid up prices of luxury real estate from Mayfair to Manhattan to Mission Bay, a waterfront neighborhood of Auckland, New Zealand. Financial authorities are trying to ensure that the remainder doesn’t disappear across the borders. A potential trigger for a disorderly exodus of capital, one that could threaten the entire fragile financial system, would be a precipitous decline in the value of the Chinese currency… There’s little doubt that the growing anxieties of China’s superrich also weigh on currency decision-making. Mr. Xi has shaken up the status quo with the fiercest campaign against corruption in modern times. That’s creating political tensions at the heart of the Communist Party. The Gilded Age is over: We’re in a new era of austerity. All this uncertainty has unsettled the owners of China’s great fortunes who are now focused on protecting their capital.”

The Chinese Credit Bubble has been historic, dwarfing the fateful Japanese Bubble from the eighties. Arguably, China’ Bubble today even exceeds its mirror image U.S. Bubble. I have also referred to the Chinese renminbi link to the dollar as the King of All Currency Pegs. The bullish consensus scoffs at notions of Chinese fragility. With an international reserve position of $3.8 TN (and shrinking), the belief is that China has more than sufficient “money” to stimulate the economy, recapitalize the banking system and support the renminbi. Yet with anecdotes suggesting mounting outflows and heightened nervousness, a destabilizing dislocation in renminbi trading becomes a real possibility.

How long will the PBOC be willing to use its nation’s reserves to allow speculators, fraudsters and Chinese elite to cash out of China at top dollar? Chinese officials confront great challenges that will require difficult decisions. So far, bullish sentiment remains impervious to the major uncertainties enveloping China’s economy, financial system and policymaking. The perception that Chinese officials have everything well under control could soon be challenged.

Meanwhile, signs of Bubble excess have become increasingly conspicuous in the U.S. – Silicon Valley, Manhattan, upper-end real estate around the country, subprime auto loans, jumbo mortgages, record corporate debt issuance, etc. Record stock and bond prices – record prices for anything that provides a yield. Record hedge fund assets, in the face of ongoing performance issues. Record ETF assets. Resurgent derivative markets. A couple other Bloomberg headlines caught my attention this week: “VIX Poised for Record Drop as Stable Oil Ignites Stocks” and “That Awkward Moment When Stocks Rise While Profits Fall.”

Friday from the New York Fed’s William Dudley, as he rationalized his cautious view toward commencing rate normalization: “If the transmission of monetary policy to the real economy is more variable and uncertain, as I believe it is, then monetary policy cannot be put on autopilot guided only by a fixed policy rule.”

Market-based Credit and discretionary monetary policy mix dangerously. Over this long cycle, market-based finance (as opposed to traditional bank lending) has come to dominate system Credit – along with market and economic performance. Policymakers have responded to resulting serial booms and busts with ever more obtrusive activism – including interest rate, liquidity, communication and monetization policies. Policy measures have reached previously unimaginable extremes – pro-speculation, pro-leverage, pro-Credit cycle and pro-maladjustment. It’s not that “the transmission of monetary policy to the real economy is more variable and uncertain.” The critical issue is instead that market-based Credit is inherently highly unstable. That the Fed and global central bankers have responded to this instability with progressively more experimental intervention and manipulation only ensures a momentous calamity. A rules-based policy approach incorporating disincentives for leveraged speculation and financial excess would over time work to restrain speculative cycles and resulting Credit booms and busts.

For the Week:

The S&P500 slipped 0.3% (up 2.2% y-t-d), while the Dow was unchanged (up 1.7%). The Utilities declined 0.9% (down 5.0%). The Banks slipped 0.2% (down 2.7%), while the Broker/Dealers gained 0.5% (down 0.7%). The Transports dropped 1.2% (down 1.3%). The S&P 400 Midcaps declined 0.7% (up 3.7%), and the small cap Russell 2000 added 0.1% (up 2.4%). The Nasdaq100 was little changed (up 4.8%), while the Morgan Stanley High Tech index slipped 0.3% (up 3.9%). The Semiconductors added 0.5% (up 4.0%). The Biotechs increased another 0.7% (up 12.9%). With bullion recovering $11, the HUI gold index rallied 4.2% (up 17.1%).

One-month Treasury bill rates ended the week at two bps and three month rates at one basis point. Two-year government yields slipped a basis point to 0.62% (down 5bps y-t-d). Five-year T-note yields dropped nine bps to 1.50% (down 15bps). Ten-year Treasury yields fell 12 bps to 1.99% (down 18bps). Long bond yields sank 12 bps to 2.59% (down 16bps). Benchmark Fannie MBS yields fell 12 bps to 2.74% (down 9bps). The spread between benchmark MBS and 10-year Treasury yields was little changed at 75 bps. The implied yield on December 2015 eurodollar futures dropped six bps to 0.77%. Corporate bond spreads narrowed. An index of investment grade bond risk declined two to 61 bps. An index of junk bond risk fell seven bps to a five-month low 320 bps. An index of EM debt risk declined two bps to 358 bps.

Greek 10-year yields sank 44 bps to 9.29% (down 46bps y-t-d). Ten-year Portuguese yields dropped 40 bps to 1.81% (down 81bps). Italian 10-yr yields fell 25 bps to 1.33% (down 56bps). Spain’s 10-year yields dropped 24 bps to 1.26% (down 35bps). German bund yields declined four bps to 0.33% (down 21bps). French yields fell eight bps to a record low 0.60% (down 22bps). The French to German 10-year bond spread narrowed four to 27 bps. U.K. 10-year gilt yields added three bps to 1.80% (up 4bps).

Japan’s Nikkei equities index jumped 2.5% to a 15-year high (up 7.7% y-t-d). Japanese 10-year “JGB” yields fell five bps to 0.33% (up one bp y-t-d). The German DAX equities index jumped 3.2% to record highs (up 16.3%). Spain’s IBEX 35 equities index rose 2.8% (up 8.7%). Italy’s FTSE MIB index gained 2.3% (up 17.5%). Emerging equities were mixed. Brazil’s Bovespa index increased 0.7% (up 3.2%). Mexico’s Bolsa jumped 1.5% (up 2.4%). South Korea’s Kospi index gained 1.2% (up 3.7%). India’s Sensex equities index was little changed (up 6.3%). China’s Shanghai Exchange jumped 2.0% in a holiday-shortened week (up 2.3%). Turkey’s Borsa Istanbul National 100 index dropped 1.6% (down 1.8%). Russia’s MICEX equities index was down 1.8% (up 26%).

Debt issuance was strong. Investment-grade issuers included Chevron $6.0bn, Daimler Finance $3.0bn, Williams Partners LP $3.0bn, JP Morgan $2.5bn, Eli Lilly $2.2bn, HSBC USA $3.3bn, Caterpillar Financial $1.15bn, American Express $850 million, Juniper Networks $600 million, Magellan Midstream Partners LP $500 million, Nissan Motor Acceptance $900 million, Kinder Morgan $800 million, Coach $600 million, Harley-Davidson $600 million, Kimberly-Clark $500 million, Xerox $650 million, Commonwealth Edison $400 million, Apollo Investment $350 million, Arrow Electronics $350 million, Discovery Communications $300 million, Tucson Electric Power $300 million, New York Public Library $185 million and TCF National Bank $150 million.

Convertible debt issuers included Rovi Corp $300 million.

Junk funds saw a fifth week of strong inflows, at $1.1bn according to Lipper. Junk issuers included Sabine Pass Liquefaction $2.0bn, MarkWest Energy Partners LP $1.15bn, CDW $525 million, Riverbed Technology $525 million, American Airlines $500 million and Nathan’s Famous $135 million.

International debt issuers included Uruguay $3.2bn, Bank of Tokyo-Mitsubishi $3.0bn, Bombardier $2.25bn, Westpac Banking $1.5bn, Swedbank $1.4bn, Royal Bank of Canada $1.4bn, Ivory Coast $1.0bn, LyondellBasell $1.0bn, Agrium $1.0bn, Nederlandse Waterschapsbank $1.0bn, Woodside Finance $1.0bn, Digicel $950 million and Cemex $750 million.

Freddie Mac 30-year fixed mortgage rates rose four bps to an eight-week high 3.80% (down 7bps y-t-d). Fifteen-year rates added two bps to 3.07% (down 8bps). One-year ARM rates slipped a basis point to 2.44% (up 4bps). Bankrate’s survey of jumbo mortgage borrowing costs had 30-yr fixed rates down four bps to 4.29% (up one bp).

Federal Reserve Credit last week declined $14.5bn to $4.459 TN. During the past year, Fed Credit inflated $342bn, or 8.3%. Fed Credit inflated $1.649 TN, or 59%, over the past 120 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt last week increased $3.7bn to $3.266 TN. “Custody holdings” were down $59bn over the past year, or 1.8%.

Global central bank “international reserve assets” (excluding gold) – as tallied by Bloomberg – were down $33bn y-o-y, or 0.3%, to $11.669 TN. Reserve Assets are now down $364bn from the August 2014 peak. Over two years, reserves were $682bn higher, for 6% growth.

M2 (narrow) “money” supply jumped $29.0bn to a record $11.810 TN. “Narrow money” expanded $659bn, or 5.9%, over the past year. For the week, Currency increased $3.3bn. Total Checkable Deposits gained $8.8bn, and Savings Deposits rose $15.5bn. Small Time Deposits were little changed. Retail Money Funds added $1.0bn.

Money market fund assets rose $10.3bn to $2.691 TN. Money Funds were down $42bn year-to-date.

Total Commercial Paper jumped $34.8bn to $1.027 TN. CP increased $15bn over the past year, or 1.5%.

Currency Watch:

The U.S. dollar index gained 1.1% to 95.29 (up 5.6% y-t-d). For the week on the upside, the South Korean won increased 1.3%, the Brazilian real 1.0%, the Taiwanese dollar 0.9%, the Swedish krona 0.6%, the Mexican peso 0.5%, the New Zealand dollar 0.5%, the British pound 0.3% and the Canadian dollar 0.1%. For the week on the downside, the Norwegian krone declined 1.8%, the Swiss franc 1.7%, the euro 1.6%, the Danish krone 1.6%, the Japanese yen 0.5%, the Australian dollar 0.4%, the Singapore dollar 0.2% and the South African rand 0.1%.

Commodities Watch:

The Goldman Sachs Commodities Index gained 1.2% (up 0.7% y-t-d). Spot Gold rallied 0.9% to $1,213 (up 2.4%). May Silver rose 1.5% to $16.56 (up 6%). April Crude fell $1.05 to $49.76 (down 7%). April Gasoline surged 7.4% (up 34%), while March Natural Gas dropped 8.0% (down 5%). May Copper jumped 3.9% (down 5%). March Wheat gained 1.4% (down 12%). March Corn slipped 0.2% (down 3%).

U.S. Fixed Income Bubble Watch:

February 24 – Bloomberg (Jody Shenn): “Way up in a Manhattan skyscraper, a band of Wall Street refugees is quietly staking billions of dollars on the American mortgage machine. Their pedigrees are A-list: Citigroup Inc., Bank of America Corp., Credit Suisse Group AG. Their job is to prowl for an edge in the $6 trillion market for home-loan securities, a place where, just seven years ago, greed and hubris collided in the worst financial crisis since the Great Depression. It might sound like some high-flying hedge fund, but it’s not. It’s Freddie Mac, the taxpayer-backed mortgage giant that collapsed in 2008, along with its larger cousin, Fannie Mae. Today, after multibillion-dollar bailouts, both effectively are still wards of the state. Which is why what’s happening inside Freddie Mac might come as a surprise. With little fanfare, the company has recruited traders from major banks and empowered some to place new wagers.”

February 26 – Bloomberg (Lucy Meakin): “They were once regarded as some of the safest assets. Now, in a world of record-low yields, Goldman Sachs Group Inc. says fixed-income investments have become dangerous. ‘The risk in bonds has gone up,’ Francesco Garzarelli… co-head of macro and markets research, said… ‘The sensitivity to small changes in yield expectations from here will command very sizable price swings, and I just think that makes fixed-income a very dangerous asset class.’ Yields on government debt from Japan to Portugal have dropped to all-time lows this year as the specter of slowing consumer-price growth prompted central banks to buy fixed-income securities and cut deposit rates even to below zero.”

U.S. Bubble Watch:

February 23 – Reuters (Jo Winterbottom and P.J. Huffstutter): “Across the U.S. Midwest, the plunge in grain prices to near four-year lows is pitting landowners determined to sustain rental incomes against farmer tenants worried about making rent payments because their revenues are squeezed. Some grain farmers already see the burden as too big. They are taking an extreme step, one not widely seen since the 1980s: breaching lease contracts, reducing how much land they will sow this spring and risking years-long legal battles with landlords. The tensions add to other signs the agricultural boom that the U.S. grain farming sector has enjoyed for a decade is over… Many rent payments… are due on March 1, just weeks after the U.S. Department of Agriculture (USDA) estimated net farm income, which peaked at $129 billion in 2013, could slide by almost a third this year to $74 billion. The costs of inputs, such as fertilizer and seeds, are remaining stubbornly high, the strong dollar is souring exports and grain prices are expected to stay low… In Iowa, the nation’s top corn and soybean producer, one real estate expert says that out of the estimated 100,000 farmland leases in the state, 1,000 or more could be breached by this spring. The stakes are high because huge swaths of agricultural land are leased: As of 2012, in the majority of counties in the Midwest Corn Belt and the grain-growing Plains, at least 40% of farmland was leased or rented out, USDA data shows.”

February 24 – Bloomberg (Alexis Leondis): “It’s shaping up as the year of the mega mortgage. Home loans from $1 million to $5 million were the fastest growing part of the jumbo market in January… Wealthy borrowers are seeking even bigger loans this year while luxury housing prices rise and lenders lure them with competitive terms. As first-time homebuyers struggle to qualify for mortgages in a market that’s shrinking after the housing collapse, lenders are providing more multi-million dollar loans… These borrowers are using the loans to purchase high-end homes in cities such as San Francisco and Miami, where prices have been climbing. ‘We’ve seen strong appreciation in most of the coastal markets,” said Brad Blackwell, portfolio business manager at… Wells Fargo & Co., the biggest jumbo lender. ‘The price rise will move more homes into the category that would need a larger loan.’”

February 23 – Bloomberg (Michael J. Moore): “While Goldman Sachs Group Inc. employees may get less compensation than in the past, many cashed in last year for a payday they’ve been awaiting since the depths of the financial crisis. Employees exercised options worth $2.03 billion in 2014. More than 96% of the contracts were granted as part of 2008 compensation. Last year marked the first time bankers were able to take advantage of those awards.”

Federal Reserve Watch:

February 27 – Bloomberg (Matthew Boesler): “William C. Dudley, president of the Federal Reserve Bank of New York, said he sees reason for caution on how soon or how quickly to raise interest rates. ‘Inflation is projected to stay for some time below the Fed’s objective of 2%,’ he said in prepared remarks on Friday in New York. He also cited ‘lingering headwinds’ from the financial crisis. Dudley was discussing an academic paper arguing the Fed should delay its first rate increase and then tighten more sharply thereafter. The paper investigates whether there is a ‘new neutral’ for long-term rates and finds it could range from a little over zero to 2%, adjusted for inflation. Dudley also repeated his view that raising rates too soon poses greater risks to the economy than lifting them too late.”

Global Bubble Watch:

February 24 – Bloomberg (Lisa Abramowicz): “More and more, exchange-traded funds that invest in corporate debt are a playground for hedge funds. Take the oldest bond ETF, BlackRock Inc.’s $21.7 billion investment-grade fund: Hutchin Hill Capital, a $3.2 billion manager, bought $431.4 million worth of shares in the last three months of the year. The position, more than 10% of Hutchin Hill’s assets, made the hedge-fund firm the ETF’s biggest buyer in the period…State Street Corp.’s $4.1 billion short-term junk-bond ETF shows a similar picture, with Pine River Capital Management buying $196.8 million worth of shares. Why are hedge funds putting so much of their assets into ETFs? It’s an easier way to slip in and out of illiquid corporate debt as trading slumps relative to the market’s size… The ‘fall in the liquidity of fixed-income markets has created incentives for investors to look to nontraditional sources of liquidity, such as ETFs and mutual funds,’ Barclays analysts Jeffrey Meli, Brian Monteleone, Eric Gross, Conor Pigott and Joseph Abate wrote… ‘This may result in a transfer of fire-sale risk into assets such as leveraged loans and investment grade and high yield bonds, as liquidity in the underlying investments of these funds deteriorates, exposing end-investors to run risk.’ In other words, if investors yank big amounts of money from these funds all at once, that may lead to a mass sale of the underlying, less-liquid debt that’ll cause ripple effects.”

February 24 – Reuters (Antoni Slodkowski): “With shrinking prospects at home and the threat of further yen weakness, Japanese companies are rushing to buy overseas and seem willing to pay top dollar, as shown by Japan Post’s $5 billion bid for Australia’s Toll Holdings. Over the long term, Japan’s demographics give a bleak prognosis for domestic demand; the population has been falling for a decade and is projected to drop from 127 million to 87 million by 2060, 40% of whom will be over 65. But bankers and analysts say a more immediate impetus to the dash for overseas growth is the fear, in an era of deflationary pressure and huge monetary stimulus from Japan’s central bank, that the weak yen will fall still further, making overseas targets more expensive if buyers don’t strike now. All of which demonstrates the counterweight to Prime Minister Shinzo Abe’s efforts to kickstart the stagnant economy after decades of deflation and insipid growth. The value of outbound Japanese acquisitions so far in 2015 is already at $27 billion, nearly half of the $56 billion total for all of last year… By contrast, the value of domestic deals has more than halved since 2011, last year hitting a 16-year low of $36 billion.”

February 23 – Bloomberg (Alastair Marsh): “Bonds of Italian bank UniCredit SpA offer similar yields to higher-rated Australia and New Zealand Banking Group Ltd. debt as European Central Bank stimulus distorts the region’s covered-bond and asset-backed securities markets. The difference in yields between similar-maturity covered bonds of the two companies has almost disappeared since the central bank began buying debt in October… The ECB has bought 48.7 billion euros ($55bn) of covered bonds and 3 billion euros of ABS as part of efforts to stimulate inflation in the region, pushing down rates on the euro-area securities that meet policy makers’ purchase criteria. That has prompted investors to look for higher-yielding assets denominated in other currencies or from borrowers in countries such as the U.K. and Australia… ‘The ECB is having a huge impact on the pricing of both covered bonds and ABS, even though the volume of purchases of the latter has been marginal,’ said Gareth Davies, the… head of European ABS research at JPMorgan. ‘Investors should simply be looking to buy everything the ECB doesn’t want.’”

February 26 – Financial Times (Andrew Bolger): “The heavily oversubscribed sale of a €5bn hybrid bond by Total , the French oil group — the largest such issue on a single day — last week marked another stage in the renaissance of this distinctive asset class. Thomas Flichy, head of European corporate hybrids at Barclays, says there is a wider range of companies choosing to issue debt in hybrid capital… Hybrids are in essence low-ranked bonds with some equity characteristics. They offer a relatively high yield, which is attractive to investors in an environment when central banks’ bond-buying programmes have suppressed returns. Hybrids almost disappeared at the height of the financial crisis… But the value of hybrid issuance by non-financial European companies bounced back to nearly $46bn last year, compared with just $425m in 2008…”

February 27 – Bloomberg (Grant Smith and Anthony Dipaola): “Three months after Saudi Arabia made clear it was going to let oil prices keep tumbling, the strategy is showing signs of working. U.S. drillers are idling rigs at a record pace, gutting investment plans and laying off thousands of workers. Those steps highlight how the Saudi-led OPEC decision on Nov. 27 to maintain output levels and protect its market share is having the desired effect — pushing prices down so far that they threaten to curb output in the U.S. and other non-OPEC countries… ‘It is having the effect that we would expect, which is a decline in investment and ultimately supply, and somewhat higher demand. We think this change is for good.’ The number of rigs drilling for oil in the U.S. dropped by 37 last week to 1,019, the fewest since July 2011… Since Dec. 5, a total of 556 have been taken out of service. Oil explorers… have announced spending cuts of almost $50 billion since Nov. 1.”

February 24 – Bloomberg (Jeremy Van Loon and Robert Tuttle): “The pain of crude’s collapse is beginning to bite in Alberta, from the oil-sands boomtown of Fort McMurray to the corporate boardrooms of Calgary. As the C$340-billion ($270bn) petro-economy confronts an oil market meltdown, a decade-long investment spree is being reversed, layoffs and spending cuts are in full swing… and everyone from oil drillers to real estate agents is feeling the pinch. In Fort McMurray, where the oil is so near the surface it oozes out of the ground in places and coats people’s boots, the mayor is reconsidering city projects. In Calgary, which boasted Canada’s biggest concentration of millionaires and one of the hottest real-estate markets, realtors just had their worst two months on record.”

ECB Watch:

February 25 – Financial Times (Robin Wigglesworth and Andrew Bolger): “A group of Europe’s biggest investors have written a letter to bankers bemoaning slipping standards in the continent’s high-yield bond market. A total of 21 fund managers… have penned a letter to the board of the Association for Financial Markets in Europe, asking the trade body to ‘refresh and expand’ guidelines from 2011. The letter raises issues such as the shortening of periods during which bonds cannot be repaid, less restrictive terms that protect investors when companies are taken over, poor disclosure standards and voting rights in a restructuring.”

Europe Watch:

February 25 – Financial Times (Ralph Atkins): “Greece’s exit from the eurozone would be as dangerous for the currency bloc now as it would have been at the height of the debt crisis, Jean-Claude Trichet, the former European Central Bank president, has warned. Grexit would be ‘an absolute drama for the people of Greece, and it would also, of course, be a big shock for the rest of Europe’, Mr Trichet told the Financial Times… Separately, Mr Trichet also warned that correction was likely in China’s economy that could have a ‘big impact’ globally, and of the fragility of the global financial system despite regulatory reforms since 2007… His comments… were a clear rebuttal of suggestions by some economists that a Grexit would be easier to manage than during Mr Trichet’s tenure at the helm of the ECB. They argue that the eurozone has since strengthened financial firewalls and that Mario Draghi, current ECB president, has policy tools in place to fight any threat of a eurozone break-up. But Mr Trichet said: ‘I would certainly not make that working assumption.’ But he argued that economists and financial strategists outside the eurozone have persistently underestimated the political forces holding the currency bloc together — pointing out that its membership has actually grown in the past eight years.”

February 25 – Bloomberg (Nikolaos Chrysoloras and Erik Schatzker): “Greek Finance Minister Yanis Varoufakis said he’s counting on the European Central Bank to help the country avert default when it runs out of money next month, while bank deposits are also starting to flow back. The ECB owes Greece almost 2 billion euros ($2.3bn) from the return of profits from its program of buying euro-region bonds to support the market, Varoufakis said… The government must make a payment to the International Monetary Fund in March. ‘So it could hand over this money to the IMF as partial repayment,’ he said… ‘I’m giving you examples, nothing has been decided. This is money we are owed. This is our money, an overpayment to the ECB.’ ECB President Mario Draghi told the European Parliament on Wednesday it’s a popular misconception that it’s up to his institution to return any profit from the Securities Markets Program. He said governments are in control of the funds.”

China Bubble Watch:

February 25 – Reuters: “China is dangerously close to slipping into deflation, the central bank’s newspaper warned on Wednesday, highlighting increasing nervousness in policymaking circles as a sputtering economy struggles to pick up speed despite a raft of stimulus steps. The article, published in Finance News, quoted the secretary general of the China Urban Finance Society Chan Xiangyang as saying that risk of deflation is greater than many appreciate… As a slowdown in China’s economy over the past year was accompanied by a chill in global demand, Beijing has stepped up measures to prevent the Asian economic powerhouse from stumbling.”

February 26 – Bloomberg: “China is preparing measures to counter a housing market slump and will roll them out if the economy needs support, people with knowledge of the matter said. The government could reduce down-payment requirements for second-home purchases… Another possible step would be to let homeowners sell properties without paying sales tax after two years, down from five years. China’s new-home prices posted a record year-on-year decline in January, according to Bloomberg Intelligence analysis of government data tracking 70 cities. Implementation of the new easing policies will depend on whether an economic downturn continues or worsens, the people said.”

February 24 – Financial Times (Tom Mitchell and Jamil Anderlini): “The amount of land used for new property developments in China fell more than 25% last year, reflecting sluggish demand that could exacerbate local governments’ debt burdens… China’s property sector is a key contributor to overall investment, which accounts for about half of the country’s gross domestic product and feeds demand for steel, cement and other commodities. While urban home prices in China have fallen for nine months, the full impact of the correction has yet to hit the broader economy and will probably cause a lot more pain when it does. Property investment increased more than 10% last year to Rmb9.5tn ($1.5tn)… compared with an 8% fall in sales as measured by gross floor area. Property sales in major cities in the week before the Chinese new year holiday…fell by about 20% from the corresponding week a year earlier.”

Russia/Ukraine Watch:

February 27 – Associated Press: “Cash-strapped Ukraine sought to buy time in its effort to ensure continued gas supplies from Russia, making a $15 million payment to Moscow on Friday as it waits for international rescue loans to arrive. But Moscow says the sum will cover only an additional day, leaving a potential cut-off looming Tuesday. That increases pressure on Ukraine to strike a deal at an upcoming meeting with Russian officials in Brussels on Monday, amid rising fears in Europe that energy supplies could be threatened by a shutdown to Ukraine. But with Ukraine’s economy on the brink of collapse and money from a 15.5 billion euro ($17.5bn) bailout deal from the International Monetary Fund that has not yet made it to Ukrainian coffers, it is unclear how capable — or how willing — Kiev is to strike a long-term deal with Moscow.

Geopolitical Watch:

February 27 – UK Independent (Zachary Davies Boren): “China has voiced its support for Russia’s handling of the Ukraine crisis, with prominent diplomat Qu Xing calling on the West to ‘abandon its zero-sum mentality’. According to state news agency Xinhua, the Chinese ambassador to Belgium said the West should take ‘the real security concerns of Russia into consideration’. Qu said the ‘nature and root cause’ of the crisis was the ‘game’ between Russia and western powers the United States and EU, and that a change of approach is required to resolve it. After nearly a year of relative silence on the subject, China’s intervention is striking, not least because it comes just as harsher sanctions against Moscow are being discussed.”

February 25 – Bloomberg (Mohammed HatemGlen Carey): “Yemen’s President Abdurabuh Mansur Hadi sought to rally supporters in the south after fleeing the capital Sana’a, which is under the control of Houthi rebels, as conflict threatens to split the impoverished nation in two. Hadi called on the internationally recognized government to relocate from Sana’a to Aden on the southern coast… The Shiite militia on Tuesday said Hadi, who’s backed by the U.S. and Saudi Arabia, has no legitimacy and warned that those following his orders will be held accountable. The standoff has raised the prospect of Yemen disintegrating like Libya, where two rival governments and their militias are fighting for control of cities, airports and oil fields. The conflict has exposed regional tensions between Saudi Arabia, which supports the predominantly Sunni forces of the government, and Iran, where officials have talked warmly of the Houthis, who follow the Zaydi branch of Shiite Islam.”

February 27 – New York Times (Shuaib Almosawa and Kareem Fahim): “The leader of the Houthi rebel group here, in an unusually combative speech Thursday that reflected frustration by the rebel movement at its deepening isolation, accused Saudi Arabia, Yemen’s powerful neighbor, of financing armed opponents and trying to divide the country… Yemen has been without a government since late January, when Mr. Hadi and his cabinet resigned under pressure from the Houthis. Now the country appears more and more splintered between competing fiefs in the north and south, raising fears that it will suffer the same fate as Libya, riven by increasingly bloody factional fighting between rival governments.”

February 26 – Reuters (Paul Carsten): “China has dropped some of the world’s leading technology brands from its approved state purchase lists, while approving thousands more locally made products, in what some say is a response to revelations of widespread Western cybersurveillance. Others put the shift down to a protectionist impulse to shield China’s domestic technology industry from competition.”

Brazil Watch:

February 25 – New York Times (Simon Romero): “Sao Paulo: Endowed with the Amazon and other mighty rivers, an array of huge dams and one-eighth of the world’s fresh water, Brazil is sometimes called the ‘Saudi Arabia of water’, so rich in the coveted resource that some liken it to living above a sea of oil. But in Brazil’s largest and wealthiest city, a more dystopian situation is unfolding: The taps are starting to run dry. As south-east Brazil grapples with its worst drought in nearly a century, a problem worsened by polluted rivers, deforestation and population growth, the largest reservoir system serving Sao Paulo is near depletion. Many residents are already enduring sporadic water cut-offs, some going days without it. Officials say that drastic rationing may be needed, with water service provided only two days a week. Behind closed doors, the views are grimmer. In a meeting recorded secretly and leaked to the local news media, Paulo Massato, a senior official at Sao Paulo’s water utility, said that residents might have to be warned to flee because ‘there’s not enough water, there won’t be water to bathe, to clean’ homes.”

February 26 – Bloomberg (Peter Millard): “Petroleo Brasileiro SA, the world’s most-indebted publicly traded oil company, said it’s seeking financing options and studying cost cuts following a downgrade to junk by Moody’s… Petrobras, as Brazil’s state-run oil producer is known, plans to release audited results ‘as soon as possible’ and is taking steps to preserve cash and cut its debt load… The company needs to sell at least $20 billion in assets and reduce capital expenditures to about $25 billion this year to improve finances, Bank of America Corp. said in a report.”

February 25 – Bloomberg (Filipe Pacheco and Ney Hayashi Cruz): “To appreciate just how bad things are in Brazil, consider this: its companies have suffered 27 rating downgrades in the first two months of the year. The number of upgrades? Zero. The tally illustrates how Brazil’s tottering economy and the widening bribery probe that pushed Petroleo Brasileiro SA into junk has eroded companies’ creditworthiness. From commodity producers to construction companies, virtually no industry has been spared. The last time Brazil had such a rash of downgrades was in 1999, when the nation was on the brink of default. ‘This is a truly unique moment in terms of debilitation and weak finances,’ Joe Bormann, a managing director for Latin America corporate finance at Fitch… ‘We expect downgrades to outpace upgrades in what could be a record this year. Prospects are not good at all.’ Moody’s… cut Petrobras to junk Tuesday by two steps to Ba2, or two levels below investment grade… The state-controlled oil producer has yet to determine how much it overpaid suppliers that allegedly paid bribes in return for contracts.”

February 26 – Bloomberg (Christiana Sciaudone and Peter Millard): “Rolls-Royce Plc and General Electric Co. are among oil-industry suppliers whose contracts in Brazil may be casualties of the spreading corruption scandal involving Petroleo Brasileiro SA. The two companies were set to make parts for seven drillships ordered by Petrobras’s rig supplier, Sete Brasil Participacoes SA. Sete said this week that EAS, the shipyard it hired to build those rigs, is canceling the contracts. The dropped order illustrates how far-reaching the effects of the corruption scandal at state-run oil producer Petrobras have spread. Sete is struggling to keep operating after an accusation of bribery this month by a former executive delayed the disbursement of a loan from Brazil’s development bank… ‘It’s one big mess,’ Kristian Diesen, an analyst at Pareto Securities AS, said… ‘Companies with assets or contracts in place are seeing increasing risk to their current backlog.’”

February 23 – Reuters: “Brazilian states and cities are scrambling to raise taxes and cut spending after years of excesses, nudging an already weak national economy closer to recession. Growing budget deficits, the biggest in more than a decade, have prompted some states to temporarily suspend payments to suppliers and freeze billions of reais in services and infrastructure projects, from road maintenance to healthcare facilities. The measures rippling through rich and poor, big and small states mirror President Dilma Rousseff’s own efforts to regain credibility with investors at the federal level after years of lavish government spending and tax breaks for select industries. While a return to fiscal rigor in states and cities may help Brazil keep its coveted investment grade credit rating, it could seriously hamper investment crucial for Latin America’s largest economy to avoid a painful recession this year… States’ outstanding net debt grew by 21% between 2010 and 2014 to nearly half a trillion reais, driven by a surge in public spending and federal government efforts to relax debt limits to increase investments.”

February 26 – Bloomberg (David Biller): “Brazil’s January unemployment rate rose to the highest level since September 2013, as the central bank continues to raise rates in the face of a stagnant economy… The jobless rate jumped to 5.3% from 4.3% a month earlier.”

EM Bubble Watch:

February 24 – Bloomberg (Isobel Finkel): “A former Miss World contestant is among the latest targets of prosecution for allegedly insulting Turkish leader Recep Tayyip Erdogan, as a crackdown on criticism extends to individuals on social media. Since Erdogan was elected president in August, 67 people have been charged with insulting him, about one case every three days, Diken news reported…A prosecutor has requested more than four years in jail for Merve Buyuksarac, a model who was Miss Turkey in 2006, for a satirical poem she posted on the photo-sharing site Instagram…”

February 27 – Bloomberg (Liau Y-Sing): “Malaysia’s task in propping up Asia’s worst-performing currency just got a lot tougher. The cost of options protecting against further ringgit declines approached a 1 1/2-year high on speculation 1Malaysia Development Bhd., the state investment fund, will need a bailout… ‘The market remains wary of 1MDB’s ability to repay its debt,’ Irene Cheung, a foreign-exchange strategist… at Australia & New Zealand Banking Group, said… ‘The ringgit is vulnerable to the near-term outlook for oil prices. A recovery is difficult.’ A weaker currency is a concern for Malaysia because it pushes up the cost of servicing the second-highest external debt burden among Asia’s developing nations. Further losses in the ringgit may hasten an investor exodus from Malaysian assets and hurt the government’s efforts to rein in its budget deficit.”

February 25 – Bloomberg (Robert Brand): “Facing 439 billion rand ($38 billion) of debt payments over the next six years, South Africa is borrowing further into the future at a time when costs look set to rise. Finance Minister Nhlanhla Nene said Wednesday he’s selling three new long-dated bonds, extending the maturity profile of the nation’s debt, as the Treasury seeks to spread out future repayments. The plan comes at a cost: while average yields on government securities are down 138 bps since April, South African 10-year yields remain the fourth highest among 24 emerging markets tracked by Bloomberg, and risk moving higher still… ‘That’s going to be very expensive debt,’ Abri du Plessis, who helps manage the equivalent of about $350 million at Gryphon Asset Management in Cape Town, said… ‘They’re just kicking the problem down the road. Unfortunately, one day we’ll have to take the pain.’ As interest rates fell amid record stimulus by developed nations during the global financial crisis, South Africa borrowed to spend itself out of its first post-apartheid recession in 2009.”

February 27 – Bloomberg (Archana Chaudhary): “More than half of India is facing high water stress as farmers and industries compete for the resource in the world’s second-most populous nation, according to the World Resources Institute. An analysis of 4,000 wells across India showed water levels fell 54% the past seven years… The northwestern states of Punjab and Haryana, which grow half of India’s rice and 85% of its wheat, are among the most water-stressed, according to WRI.”

February 27 – Bloomberg (Paul Wallace): “Nigeria’s naira is poised for its biggest monthly decline in more than six years as a delayed election and falling oil revenue batter investor confidence in the West African nation. The currency of Africa’s biggest economy and oil producer fell 0.6% to 203 per dollar… extending its loss since the end of January to 7.6%, the most since August 2008…”

Japan Watch:

February 26 – Reuters: “Bank of Japan Governor Haruhiko Kuroda said… there was no ceiling on how much the central bank would expand its balance sheet relative to the size of the country’s gross domestic product (GDP)… ‘We don’t have any particular ceiling,’ Kuroda said, when asked if there was a limit on expanding its assets. ‘We have not set a deadline for the current qualitative and quantitative easing. We’ll keep it in place until we achieve 2% price goal stably and sustainably. We cannot say until when or how much’ we will expand the size of the balance sheet. The BOJ’s balance sheet has expanded to 277 trillion yen ($2.33 trillion) as of Wednesday, nearly two-thirds the size of Japan’s GDP, due to its aggressive asset purchases, far exceeding that of major central banks.”

February 25 – Bloomberg (Masumi Suga): “Tokyo Electric Power Co. said it’s investigating the cause of a spike in radiation levels in drainage water that it believes subsequently leaked into the Pacific ocean from its wrecked Fukushima Dai-ichi nuclear plant north of Tokyo. The radioactivity increase was detected on Sunday, the company said… No workers were exposed and tests of radiation levels in sea water in the port adjacent to the plant showed no significant increase, the company said… Tepco, as the company is known, detected 23,000 becquerels per liter of cesium 137, from rainwater accumulated on the roof of the No. 2 reactor building, the utility said yesterday in a statement. The legal limit for releasing cesium 137 is 90 becquerels per liter.”

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