Dec 4. The Price of Risk (or Raising the ‘G-A-S’ factor)
Trichet [in 1994] declared that monetary union would permit the elimination of risk premiums. In the middle of the following decade he appeared to have been right: Greek government bonds, for instance, yielded virtually the same as German gov’t bonds of the same maturity, and for a brief period in 2007, Spanish gov’t bonds yielded slightly less than their German equivalents. Why? Because the traditional determinant of cross country bond yield differentials among developed countries, expectations of currency appreciation or depreciation, no longer applied within the monetary union. Ergo bond yields should be equalized. The great- and very, very obvious- mistake in this reasoning was that monetary union simply converted currency risk (the risk that a certain govt’s bonds might be devalued in terms of another currency) into credit risk (the risk that a government might simply be unable to pay its creditors). Astonishingly, the credit rating agencies took Trichet at his word: they actually upgraded , on entry into the monetary union, countries with lower ratings than Germany’s. Why? …It seems there were two factors. One was an implicit assumption that if such countries got into trouble, Germany would somehow bail them out. The second … was that the mechanisms of the Maastricht Treaty… would make everyone financially sound.
–Bernard Connolly, The Rotten Heart of Europe
Draghi’s famous “Whatever it takes…” line in July 2012, followed the Trichet doctrine: If there is certainty in the institutional support of the the euro, then yields across countries will be suppressed. (Below is the 18 second clip of Draghi).
https://www.youtube.com/watch?v=tB2CM2ngpQg
If malinvestment and ensuing bad debts had their gestation with the indoctrination of the euro, they’ve been further encouraged and allowed to fester with QE programs and China’s shadow lending.
Later today we will know the results of the Italian referendum. Though I think Renzi will lose, I don’t know how the market will price all of the various scenarios. What I think I do know however, is this: the suppression of yields and spreads, due to transfers of risk to the public sector and to central banks appears to be at ‘the beginning of the end’ phase. The implication is that the price of risk must shift higher.
This reminds me of a Kyle Bass interview from years ago, when he mentioned a particular lending institution (I forget which) where he said the executives of the firm were personally, financially, at risk for some portion of loans made. As Bass put it, “It really raises the ‘give- a- sh-t’ factor” regarding who you lend to.” I think the G-A-S factor is rising across the investment landscape.
The month of November (since Trump’s election of course) has encompassed a sea change in terms of projections of economic growth. Yields have soared, with ten year treasuries hitting 2.49% before closing the week at 2.39%. The five year note reached 1.93%; 1.80 to 1.85 had capped fives since the taper tantrum surge in 2013, with that level being tested twice in 2014 and twice in 2015. The 2/10 treasury spread ended the week near the year’s high at 128.3, up over 50 bps from the year’s low of 75. Even 10 yr JGBs closed near a high of 3 bps, having been -30 in July. In euro$’s there is continued buying of calendar spreads, especially from reds to blues (the 2nd to the 4th year). One year euro$ calendar spreads have likewise firmed, with the peak spread, March’17/March’18 nearly reaching ½% (high was 48), a level not seen in one-yr calendars since the very beginning of the year. An article on ZH suggesting a ‘Hindenburg Omen’ [link below] notes 236 New Highs and 74 New Lows on the NYSE. In my mind, those relatively high numbers on both extremes are simply an indication of euphoria or despair over perceived winners and losers from a new administration.
The big mover on the week was oil, which rose 12% and is near the high of the year. This move of course, is due to a production cutting agreement by oil producers, but in keeping with the theme of unshackled growth and construction, note that copper has risen 25% in the month of November. I’ve previously shown that inflation expectations are closely related to the price of oil, which is underscored by the chart below. Note once again that the price of oil one year ago was dropping like a rock; if the price stays here (around $51) into the new year, the yoy change will have more than doubled.
There’s a bit more to the oil story that increases its importance this week. The rally in oil this year has been instrumental in the decline of credit spreads in the US. In the beginning of the year, the credit quality of the oil sector crashed with the price of the commodity, and all corporate spreads rose on the spillover. For example BBB Corporates to treasuries peaked in the beginning of this year around 230, near the high of mid-2012. But that spread now sits at just 159, near the low for this year. However, HYG and JNK etfs are not making new highs, and the SPX index encountered some profit taking this week, in spite of the surge in oil. Both Gross and Gundlach have suggested that the Trump rally has run out of steam.
The key points to keep in mind going forward are these. Deleveraging since the 2007-09 crisis has not occurred anywhere, except in the US household sector in mortgages (the outstanding amount has declined from a high of $10.6T to $9.6T currently). Every other category in the US flow of funds data has increased, with the total (HH + Business + Gov’t) going from $33.2T in 2007 to $46.3T currently, with the majority increase due to the Gov’t category. It is going to be difficult (though certainly not impossible) for growth to truly accelerate given the overhang of debt loads.
There are several ways out. Grow, or restructure, or slash the value of the underlying currency. The latter two mean accepting lower values on outstanding debt. As rates increase – the result of the morphine of central bank support slowing to trickle – these factors are exaggerated. This means that assets with previously positive correlations may begin to break down. For example, higher oil might be perceived as inflationary and negative for both bonds and stocks. It might mean that credit spreads are at their nadir and may begin to firm from here. It might mean that demand for US funding by emerging economies becomes more problematic. Regardless of the results of the Italian referendum, I expect the US curve to continue its steepening trend, and I further think that all dips in implied vol should be bought.
