Saturday, August 29, 2015

Weekly Commentary: "Carry Trades" and Trend-Following Strategies

The week commenced with yet another “flash crash.” The August 2015 version was notable for its ferocity and impressive global scope. Then there was the Dow’s 1,200 point “buy the dip” (and rip the bears’ faces off) rally from Monday’s lows. At Wednesday’s low point, the Shanghai Composite had sunk 18.7% from last Friday’s close, before a 13.4% rally left the index down 7.9% for the week. Currency markets, especially EM, were chaotic. From my perspective, the systemic nature of market dislocations provided decisive confirmation of the Global Financial Fragility Thesis.

Before diving into the present, let’s set the tone by reminding readers of an important but commonly unappreciated aspect of the Fed’s previous failed reflationary episode: Cheered on by “Keynesian” inflationist doctrine, the Fed specifically targeted mortgage Credit as the primary mechanism for post-tech Bubble system reflationary measures. In what was too surreptitious, government-directed mortgage Credit was unleashed to overpower deflation risks.

An historic expansion of mortgage debt ensued – too much of the risk intermediated, leveraged and obfuscated through sophisticated financial instruments and structures. Markets were distorted, risks were concealed and deep structural impairment was completely neglected. With the perception that Washington was backstopping mortgage Credit and housing, there was a breakdown in the market mechanism for pricing and allocating mortgage Credit. Fatefully, the marketplace completely lost its capacity to self-adjust and self-regulate. And that’s why they’re called Bubbles.

The Trillion dollar 2006 increase in subprime collateralized debt obligations (CDOs) financed near-panic buying of overpriced homes by borrowers of especially poor Credit standing. “Terminal Phase” excess doomed the boom. By early-2007, pricing for a rising mountain of subprime mortgage paper had nowhere to go but down. Ditto for home prices. Perceptions of “Moneyness” for mortgage Credit had diverged wildly from the rapidly deteriorating soundness of the underlying loans. The 2007 reversal of “hot money” from high-risk mortgage Credit marked a critical inflection point for the mortgage finance Bubble, securities markets and economies. Yet as cracks initially appeared and Bubble risks were illuminated, perceptions solidified that policymakers would never tolerate a housing crisis. And despite such frail underpinnings, it all appeared sustainable – that is, so long as new “money” perpetually flowed in. “Perpetual” simply does not apply to human emotions, markets or finance more generally.

I have argued that “global government finance Bubble” excesses have been unprecedented – surely multiples of previous Bubbles. Officials globally employed central bank Credit and government debt in a desperate attempt to reflate global securities markets, general price levels and economies. And especially germane to today’s backdrop, policymakers doubled-down on failing reflationary policies back in the summer of 2012. This gambit has failed. Before it’s over I expect spectacular failure. Finally, the extraordinary divergence between inflated market expectations and deflating fundamental prospect has begun the arduous normalization process. The perpetual “money” machine now sputters badly.

Trillions flowed into all types of securities, financial instruments and strategies in response to government policy measures. Like never before, savers abandoned zero returns for perceived low-risk “bond funds” and equities. “Money” flooded the world in pursuit of easy EM returns. The ETF industry ballooned to almost $3.0 Trillion. Hedge fund assets, as well, swelled to $3.0 Trillion, buoyed by the perception of an industry prudently employing low-risk “hedged” strategies.

“Moneyness of Risk Assets” has played a momentous role throughout the prolonged “global government finance Bubble” period. The Fed and global central banks inflated markets with Trillions worth of liquidity. Policymakers repeatedly intervened to quell incipient market unrest. With this as the backdrop, a huge industry – with enticing new products, structures and strategies - evolved around the world that promoted the notion that savers, investors and speculators could prosper as investors in global securities through liquid and safe (“money-like”) vehicles. And as evolving Bubble excess turned only more conspicuous, the market perception hardened that global officials would not tolerate another market crisis. Risks were too great.

This was particularly the case after 2012’s fateful “do whatever it takes” operations. In particular, ECB and Bank of Japan’s (BOJ) QE and currency devaluation measures incentivized what I believe to be historic “carry trade” speculative excesses. These extraordinary reflationary measures were complimented by – and actually depended upon - Chinese policies. China’s officials moved forward with aggressive fiscal and monetary stimulus, while at the same time standing firm with their currency peg to the dollar. For its part, the Fed was determined to rectify every incipient bout of market instability. The Fed ignored mounting market excess in favor of maintaining its interest rate peg at zero. And the bigger the global Bubble inflated the deeper the faith in the global central bank market backstop.

I have argued that the underlying finance fueling the global boom has been unsound and unsustainable – that it is based on (“Moneyness of Risk Assets”) false premises and flawed perceptions. Dangerous misperceptions and attendant market Bubble fragilities are coming home to roost.

Monday saw the Japanese yen (vs. the dollar) trade in a range of 118 to 122, ending the day up 3.0% versus the US dollar. Yen “carry” trades – shorting/borrowing yen to fund higher-yielding instruments in other currencies – were severely bludgeoned. Monday saw the Australian and New Zealand dollars fall about 5% against the yen. The Russian ruble sank more than 5% versus the Japanese currency. The Colombian peso (down 4.2% vs. the dollar) fell almost 7%. Monday’s panic saw the Brazilian real, Indian rupee, Malaysia ringgit, Indonesia rupiah, Turkish lira and Chilean peso all suffer significant declines versus the yen. “Bloodbath” was used repeatedly to describe Monday’s action throughout EM currencies and securities markets. And with the euro gaining 2.0% versus the US dollar, popular euro “carry trades” were only a slightly less debacle.

By Friday’s close, most markets had reversed course and, seemingly, much had been forgotten. After trading slightly below 118 on Monday, the yen weakened back to 121.71 (to the dollar) to close out the week. Most EM currencies and markets rallied sharply. Corporate debt markets, at the brink of serious liquidity issues on Monday and Tuesday, bounced back by week’s end. After trading up to 54 (high since the financial crisis) on Monday, the VIX (equities volatility) index had been cut in half (to 26) by Friday’s close.

In a replay of previous “flash crash” scares (2010, 2012 and 2013), market tumult was met quickly with comforting comments from global policymakers. Importantly, ECB and BOJ officials stated their willingness to do more as necessary. These signals were instrumental in reversing yen and euro strength, alleviating fear of chaotic “carry trade” deleveraging. Global risk markets traded this week tick-for-tick with the yen. Doing his part, New York Fed president Dudley stated that the case for a September liftoff was “less compelling.”

At the moment, Monday’s panic appears yet another textbook buying opportunity. Markets were extraordinarily “oversold.” As conventional thinking goes, selling was based on irrational fear as opposed to actual fundamental factors. And in true bear market fashion, it appears bullishness will remain deeply ingrained even as the global bust gathers powerful momentum.

The pattern is well known. “Money” pours into risk markets based on the notion of abundant liquidity and policymaker backstops. And these risk distortions ensure booming markets and the availability of cheap and liquid risk “insurance.” Over the years I’ve used the analogy of “selling flood insurance during a drought.” All bets are off, however, when torrential rains eventually arrive. The reinsurance market immediately dislocates as speculators attempt to dump risk and hedge insurance they’ve sold. The notion of cheap and liquid insurance – so integral to boom-time finance – is invalidated. In the real world, dislocation in the risk “insurance” marketplace – with potentially profound implications for markets and economies – has come to be called a “flash crash.”

I believe myriad global “carry trades” – speculative leveraging of securities – are the unappreciated prevailing source of finance behind interlinked global securities market Bubbles. They amount to this cycle’s government-directed finance unleashed to jump-start a global reflationary cycle.

I’m convinced that perhaps Trillions worth of speculative leverage have accumulated throughout global currency and securities markets at least partially based on the perception that policymakers condone this leverage as integral (as mortgage finance was previously) in the fight against mounting global deflationary forces.

Yet massive securities market leverage is viable only so long as perceptions hold that government policymakers have things under control. And therein lies latent fragility. This explains why Central banks around the world vow liquid markets. The Fed must remain ultra-loose near zero rates, while upholding the perception that Yellen, Dudley & Co. will adhere to Bernanke’s doctrine of “pushing back against a tightening of financial conditions” (aka market risk aversion). The BOJ must continue with its massive QE program, ready to “push back” hard against a strengthening yen. Similarly, the ECB must convey that it is willing to boost and broaden its securities purchase program as necessary, also pushing back to suppress euro rallies. Chinese officials must be willing to adopt “whatever it takes” fiscal and monetary stimulus to sustain their faltering expansion – economic activity essential to the overall global economy. And importantly, China must be resolute in defending its currency peg to the dollar. All the above are required to ensure stable market, financial and economic backdrops imperative to highly leveraged global “carry trades.”

I have posited that the global Bubble has burst. Fundamental to my analysis is that the above necessary conditions required to sustain global “carry trades” no longer exist. Faith has been broken that EM central banks retain the resources required to stabilize their currencies and ensure liquid securities markets. Importantly, confidence that Chinese officials have their markets, Credit system and economy under control has evaporated. Moreover, China’s recent devaluation badly undermined the perception of a strong and well-managed Chinese currency tied securely to the US dollar.

In previous bouts of “flash crash” market angst, policymaker assurances were successful in quickly quelling market worries and reversing illiquidity. A key dynamic has been repeatedly instrumental to market recovery and bull market resumption: global players respond to “risk off” upheaval by buying derivative “insurance” protection and boosting short positions and other hedges. And as we saw again this week, abrupt market reversals incite the rapid unwind of hedges and short positions. Short squeezes then quickly provide impetus for bullish panic “buy the dip” trading. This onslaught of buying power in the past spurred the global securities market bull to lunge upward.

There’s always been a game aspect to this trading dynamic. Markets disregard unfolding trouble for as long as possible. Eventually markets break abruptly lower, at least partially as a result of widespread hedging of market risk. Markets then reverse higher, with a large amount of put options and bearish derivatives expiring worthless. It’s been a repeating cycle. One of these days the markets may break lower when there are large quantities of bearish hedges in the marketplace. That is the scenario where “delta hedging” would see lower prices force additional selling (to hedge derivatives written) - that would then see lower prices and only more self-reinforcing selling.

Tuesday from The Wall Street Journal (Bradley Hope, Saumya Vaishampayan and Corrie Driebusch), under the headline “Stock-Market Tumult Exposes Flaws in Modern Markets:” “Monday’s mayhem exposed significant flaws in the new architecture of Wall Street, where stock-linked funds—as much as shares themselves—now trade en masse on U.S. markets. Many traders reported difficulty buying and selling exchange-traded funds, a popular investment in which baskets of stocks and other assets are packaged to facilitate easy trading. Dozens of ETFs traded at sharp discounts to their net asset value—or their components’ worth—leading to outsize losses for investors who entered sell orders at the depth of the panic. Products built to provide insurance for investors came up short. As a result of trading halts in futures tied to the S&P 500 index, it was difficult for investors to get consistent prices on contracts linked to them that offer insurance against S&P 500 declines.”

Bullish misperceptions regarding ETF liquidity are becoming too conspicuous to disregard. It is also clear that the hedge fund industry is really struggling in this market environment. Crowded Trades are a serious ongoing problem. Clearly, way too much “money” has flooded into the ETF and leveraged speculation universes. Too much has inundated sophisticated derivative strategies that too often incorporate some component of trend-following behavior. The scope of “money” following trend-following strategies is now an issue anytime markets are in the midst of a meaningful decline.

It’s an extraordinarily complex backdrop. Attempting to simplify things, a primary focus going forward will be the interplay between what I believe are faltering global “carry trades” and the massive amount of trend-following trading associated with bloated ETF, leveraged speculating community and derivatives complexes.

Previous market “flash crashes” quickly reversed course and worked to rejuvenated the bull market. Importantly, this was made possible by liquidity emanating from expanding global “carry trades” – notably from the yen and euro financing higher yielding EM and “developed” corporates, but also from “carry trade” leverage funneling “money” into the Chinese Bubble.

And the analysis has once again circled back to China. Chinese markets are broken and policymaking is discredited. Chinese officials may now appreciate the risk of breaking the peg to the dollar. At this point, however, maintaining the peg will require the People’s Bank of China to blow through it’s reserves to fund what will surely be massive financial outflows. And, suddenly, the market seems to have awoken to the likelihood that China and other EMs have evolved into major sellers of US Treasuries (and bunds, gilts, etc.).

It’s certainly worth noting the evolving dynamic in Treasury and “developed” sovereign bond trading. Treasuries just don’t benefit from “risk off” market tumult as in the past. Prices do, however, retreat quickly when “risk on” reemerges. This may prove an important dynamic. For one, despite the troubling global backdrop, Treasuries now appear to offer a less favorable risk vs. reward profile. Moreover, Treasuries these days seem to provide a less effective hedge against equities, corporate debt and EM market risks. And this may call into question the popular leveraged “risk parity” strategies that have proliferated in recent years.

One can go down the list these days and see serious cracks developing many of the most popular “investment” and speculative trading strategies. It sure appears the game is winding down. Is it possible that a lot of September put options and derivatives expire worthless? Of course. But that would basically change nothing. Global “Carry Trades” have begun a problematic unwind. Liquidity will now be an issue. When it becomes a real issue, there’s going to be serious problems associated with all these Trend-Following Strategies. QE4 will be unavoidable. But it will have to be quite large to have much impact.

August 23 – Financial Times (Henny Sender and Robin Wigglesworth): “Investing: Whatever the weather? The risk parity strategy pioneered by Ray Dalio and driving a $400bn industry faces a stiff test if the Fed raises rates: The popularity of All Weather has helped the number and size of risk parity funds to swell in recent years, especially in the wake of the financial crisis. AllianceBernstein, the US asset manager, estimated in a recent report that it is now a $400bn industry, and assuming an average 355% leverage ratio — derived from funds that issue public reports — control assets worth about $1.4tn. Even that figure is probably conservative, as it does not include discrete, in-house risk parity funds that have been established in some pension funds and insurers, which could easily bring the number up to $600bn, according to other analysts.”


For the Week:

The S&P500 gained 0.9% (down 3.4% y-t-d), and the Dow rallied 1.1% (down 6.6%). The Utilities were little changed (down 5.7%). The Banks slipped 0.3% (up 2.0%), while the Broker/Dealers recovered 0.6% (down 4.3%). The Transports increased 0.5% (down 13.5%). The S&P 400 Midcaps gained 0.2% (down 1.8%), and the small cap Russell 2000 increased 0.2% (down 3.5%). The Nasdaq100 rallied 3.5% (up 2.2%), and the Morgan Stanley High Tech index recovered 2.5% (up 0.7%). The Semiconductors surged 6.1% (down 10.6%). The Biotechs jumped 3.8% (up 13.6%). With bullion down $27, the HUI gold index sank 8.4% (down 29.2%).

Three-month Treasury bill rates ended the week at five bps. Two-year government yields were up 10 bps to 0.72% (up 5bps y-t-d). Five-year T-note yields rose eight bps to 1.51% (down 14bps). Ten-year Treasury yields jumped 13 bps to 2.18% (up one basis point). Long bond yields surged 17 bps to 2.91% (up 16bps).

Greek 10-year yields fell another 46 bps to 8.85% (down 90bps y-t-d). Ten-year Portuguese yields slipped a basis point to 2.59% (down 3bps). Italian 10-yr yields gained six bps to 1.91% (up 2bps). Spain's 10-year yields rose six bps to 2.06% (up 45bps). German bund yields surged 18 bps to 0.74% (up 20bps). French yields rose 14 bps to 1.09% (up 26bps). The French to German 10-year bond spread narrowed four bps to 35 bps. U.K. 10-year gilt yields jumped 27 bps to 1.96% (up 21bps).

Japan's Nikkei equities index declined 1.5% (up 9.7% y-t-d). Japanese 10-year "JGB" yields added a basis point to 0.37% (up 5bps y-t-d). The German DAX equities index rallied 1.7% (up 5.0%). Spain's IBEX 35 equities index gained 0.8% (up 0.7%). Italy's FTSE MIB index added 1.1% (up 15.7%). EM equities mostly rallied. Brazil's Bovespa index rose 2.9% (down 5.9%). Mexico's Bolsa rallied 2.7% (up 0.3%). South Korea's Kospi index rallied 3.3% (up 1.2%). India’s Sensex equities index sank 3.6% (down 4.0%). China’s Shanghai Exchange fell 7.9% (unchanged). Turkey's Borsa Istanbul National 100 index recovered 1.1% (down 12.9%). Russia's MICEX equities index jumped 3.4% (up 23%).

Junk funds this week saw outflows jump to $1.6 billion (from Lipper). Another $796 million was pulled from leveraged loan funds.

Freddie Mac 30-year fixed mortgage rates dropped nine bps to 3.84% (down 3bps y-t-d). Fifteen-year rates fell nine bps to 3.06% (down 9bps). One-year ARM rates were unchanged at 2.62% (up 22bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates down three bps to 4.03% (down 25bps).

Federal Reserve Credit last week contracted $13.8bn to $4.447 TN. Over the past year, Fed Credit inflated $70.8bn, or 1.6%. Fed Credit inflated $1.636 TN, or 58%, over the past 146 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt dropped $15.1bn last week to $3.342 TN. "Custody holdings" were up $48.6bn y-t-d.

M2 (narrow) "money" supply surged $33.4bn to a record $12.136 TN. "Narrow money" expanded $690bn, or 6.0%, over the past year. For the week, Currency increased $3.1bn. Total Checkable Deposits fell $12.8bn, while Savings Deposits jumped $44.3bn. Small Time Deposits slipped $1.6bn. Retail Money Funds were little changed.

Money market fund assets gained $9.0bn to a five-month high $2.695 TN. Money Funds were down $38bn year-to-date, while gaining $100bn y-o-y (3.8%).

Total Commercial Paper declined $7.3bn to $1.050 TN. CP increased $42bn year-to-date.

Currency Watch:

The U.S. dollar index gained 1.4% to 96.15 (up 6.5% y-t-d). For the week on the upside, the Mexican peso increased 1.4% and the Japanese yen 0.3%. For the week on the downside, the the New Zealand dollar declined 3.3%, the South African rand 2.7%, the Brazilian real 2.3%, the Australian dollar 2.0%, the British pound 1.9%, the euro 1.8%, the Swiss franc 1.8%, the Swedish krona 1.2%, the Norwegian krone 1.1% and the Canadian dollar 0.1%.

Commodities Watch:

The Goldman Sachs Commodities Index rallied 5.0% (down 12.5% y-t-d). Spot Gold fell 2.3% to $1,134 (down 4.3%). September Silver sank 5.0% to $14.55 (down 7%). September Crude rallied $4.77 to $45.22 (down 15%). September Gasoline slipped 1.6% (up 3%), while September Natural Gas increased 1.1% (down 6%). September Copper recovered 1.8% (down 17%). September Wheat fell 4.0% (down 18%). September Corn declined 0.6% (down 6%).

Global Bubble Watch:

August 27 – Bloomberg (Elena Popina): “This week, investors relived a nightmare. As markets from China to South Africa tumbled, they pulled $2.7 billion out of developing economies on Aug. 24. That matches a Sept. 17, 2008 exodus during the week Lehman Brothers went under. The collapse of the U.S. investment bank was a seminal moment in the timeline of the global financial crisis. The retreat from risky assets, triggered by concern over a slowdown in China and higher interest rates in the U.S., has taken money outflows from emerging markets to an estimated $4.5 billion in August, compared with inflows of $6.7 billion in July, data compiled by Institute of International Finance show.”

August 28 – Financial Times (Stephen Foley and Robin Wigglesworth): “The US mutual fund industry’s most famous emerging markets specialists have suffered an August Horribilis, as wild currency swings wiped billions of dollars off the value of their funds. Michael Hasenstab, manager of the $65bn Templeton Global Bond Fund, is down 6% since the start of August, as the tumbling peso hit the value of Mexican government debt, his largest single holding, and other currency bets also faltered. Meanwhile, widely owned EM equity mutual funds from OppenheimerFunds and Lazard have posted losses of more than 12% this month… ‘There were clear forced sellers, panic sellers, and fear on Monday,’ says Justin Leverenz, manager of the $30bn Oppenheimer Developing Markets fund, arguing that created buying opportunities.”

August 28 – Bloomberg (Oliver Renick): “Mom and pop are running for the hills. Since July, American households -- which account for almost all mutual fund investors -- have pulled money both from mutual funds that invest in stocks and those that invest in bonds. It’s the first time since 2008 that both asset classes have recorded back-to-back monthly withdrawals, according to… Credit Suisse. Credit Suisse estimates $6.5 billion left equity funds in July as $8.4 billion was pulled from bond funds… Those outflows were followed up in the first three weeks of August, when investors withdrew $1.6 billion from stocks and $8.1 billion from bonds, said economist Dana Saporta. ‘Anytime you see something that hasn’t happened since the last quarter of 2008, it’s worth noting,’ Saporta said… ‘It may be that this is an interesting oddity but if we continue to see this it could reflect a more broad-based nervousness on the part of household investors.’”

August 25 – Bloomberg (Ye Xie Liz McCormick): “China just gave investors one more reason to shun the most popular trading strategy in the $5.3 trillion-a-day currency market. Carry trades, or borrowing one currency cheaply to invest in a higher-yielding asset elsewhere, were already suffering the biggest losses since 2008 as the rout in emerging markets sent potential purchases tumbling. By cutting interest rates two weeks after its shock devaluation, China effectively crossed the yuan off investors’ shopping lists, too. Add to this a surge in volatility -- which is kryptonite for these transactions because it can wipe out the profit from the interest-rate differential -- and carry traders are finding fewer and fewer ways to make money. JPMorgan Private Bank and the asset-management unit of Bank of China both say the strategy’s best days are behind it. ‘It’s a terrible time to be long carry,’ said Joseph Capurso, a… strategist at Commonwealth Bank of Australia. ‘Increased volatility -- which I think we’ll stay with -- will continue to be terrible for carry. The period is over for carry trades.’ A Deutsche Bank AG index tracking carry trade returns has plunged 13% this year, on track for its worst annual decline since the 2008 financial crisis.”

August 25 – Bloomberg (Kevin Buckland and Hiroko Komiya): “A China-induced rout in global stocks lifted trader expectations of price swings in the yen against the dollar by the most since March 2011 on Monday as investors swarmed to the safest assets. The yen surged 3.1% to start the week, the biggest advance since May 2010, after the Shanghai Composite Index slumped 8.5%. At one point, Japan’s currency surged 2.76 yen to a seven-month high of 116.18 per dollar in the space of about a minute. Implied volatility over three months jumped by two percentage points, the most since an almost three percentage point increase after a meltdown at the Fukushima nuclear plant following a deadly earthquake four years ago. ‘The selloff in assets everywhere yesterday was as sharp as during the Lehman shock’ of 2008, said Daisuke Karakama, chief market economist at Mizuho Bank… ‘If a lot of investors are thinking that the next crisis has come, something like March 2011 looks insignificant for markets by comparison.’ Demand for protection against yen appreciation versus the dollar over the next three months climbed to the highest since February 2014.”

August 27 – Wall Street Journal (Rob Copeland): “Hedge-fund managers like to promise their investors protection from market swings. In the recent stock swoon, many were caught off guard. Billionaire managers such as Leon Cooperman, Raymond Dalio and Daniel Loeb are deeply in the red this month, left flat-footed by the quick plunge for stocks world-wide. Mr. Cooperman’s Omega Advisors posted a 12% decline this month through Wednesday and 10% this year. Mr. Loeb’s Third Point LLC and William Ackman’s Pershing Square Capital Management are also down big, erasing their gains for the year. Other traders suffered amid this week’s volatility. Monday, when the market collapsed more than 1,000 points in its largest ever intraday point decline, marked one of the worst days for many managers since the crisis. That is a hit to an industry that has for years excused its relative underperformance compared with benchmarks by promising that collections of bets on and against markets—a so-called long/short strategy—would insulate the impact of any future market gyrations.”

August 27 – Bloomberg: “China has cut its holdings of U.S. Treasuries this month to raise dollars needed to support the yuan in the wake of a shock devaluation two weeks ago, according to people familiar with the matter. Channels for such transactions include China selling directly, as well as through agents in Belgium and Switzerland, said one of the people, who declined to be identified… China has communicated with U.S. authorities about the sales, said another person. They didn’t reveal the size of the disposals. The People’s Bank of China has been offloading dollars and buying yuan to support the exchange rate, a policy that’s contributed to a $315 billion drop in its foreign-exchange reserves over the last 12 months. The $3.65 trillion stockpile will fall by some $40 billion a month in the remainder of 2015 because of the intervention, according to the median estimate in a Bloomberg survey. China selling Treasuries is “not a surprise, but possibly something which people haven’t fully priced in,” said Owen Callan, a Dublin-based fixed-income strategist at Cantor Fitzgerald LP. “It would change the outlook on Treasuries quite a bit if you started to price in a fairly large liquidation of their reserves over the next six months or so as they manage the yuan to whatever level they have in mind.’”

August 25 – Wall Street Journal (Carolyn Cui, Anjani Trivedi and Chiara Albanese): “China rattled global markets with the surprise devaluation of its currency this month, and Wall Street traders are betting that the adjustment isn’t over. Wagers that China’s yuan will weaken further against the dollar have surged since the People’s Bank of China loosened its control over the currency. Investors are betting the yuan will weaken 4% to 6.75 per dollar over the next year, adding to a 4.4% drop since Aug. 11… Pressure also is piling up on other currencies that could suffer knock-on effects. In the Hong Kong dollar options market, the cost of buying protection against a change in Hong Kong’s peg against the U.S. dollar, over the next month, has surged to its highest in over a decade. Traders and investors say the betting against currency pegs in Egypt, Hong Kong and Saudi Arabia accelerated after China’s devaluation and picked up further after Kazakhstan and Vietnam moved to free their exchange rates too…Trading volume in the renminbi forward market has increased about 60% since the PBOC announcement, according to an estimate by Riverside Risk Advisors… In the options market, where traders can buy protections against a weakening of the yuan, daily volume has jumped to $12 billion since the PBOC’s move, up from an average of $4.2 billion over the prior month, according to Riverside. The cost to insure against a weaker yuan has surged from $30,500 per $100 million to $1.7 million since the PBOC move, traders say.”

August 26 – Bloomberg (Lianting Tu Christopher Langner): “Options traders are betting the Hong Kong dollar’s peg is the most vulnerable it’s been in a decade as China’s shift to a freer exchange rate prompts speculation the city’s link will come under pressure. The currency’s one-year implied volatility, a gauge of expected price swings used to price options, has more than tripled to 3.2% since a surprise yuan devaluation on Aug. 11. That’s near the yuan’s reading on the day before it was weakened in a move that ended China’s de facto peg of more than four months. Hong Kong’s currency has been kept at about HK$7.80 per U.S. dollar since 1983.”

China Bubble Watch:

August 25 – Bloomberg: “China fell back on its major levers to stem the biggest stock market rout since 1996 and a deepening slowdown, cutting interest rates for the fifth time since November and lowering the amount of cash banks must set aside. The one-year lending rate will drop by 25 bps to 4.6% effective Wednesday, the… People’s Bank of China said…, while the one-year deposit rate will fall a quarter of a percentage point to 1.75%. The required reserve ratio will be lowered by 50 bps for all banks to cover funding gaps, it said.”

August 25 – Bloomberg: “Faced with a renewed stock market slide that has wiped out $5 trillion in trading value, China is again on the prowl for scapegoats. Authorities announced a probe of allegations of market malpractice involving the stocks regulator on Tuesday, while the official Xinhua News Agency called for efforts to “purify” the capital markets. The news service also carried remarks by a central bank researcher attributing the global rout to an expected Federal Reserve rate increase. The Shanghai Composite Index has plunged more than 40% from its peak, after concerns over the Chinese economy helped snap a months-long rally encouraged by state-run media. Authorities have repeatedly blamed market manipulators and foreign forces since the sell off began in June and led officials to launch an unprecedented stocks-support program. Now, after suspending that program, the administration has embarked on a new round of allegations and fault-finding.”

August 27 – Reuters (Kevin Yao): “China's devaluation of its yuan currency should not be made a scapegoat for the recent global stock market rout, a senior Chinese central bank official told Reuters… Instead, Yao Yudong, head of the bank's Research Institute of Finance and Banking, said concerns over a possible U.S. interest rate rise this year may have fuelled capital flight out of emerging markets. He said the U.S. Federal Reserve should delay any rate hike to give fragile emerging market economies time to prepare. ‘China’s exchange rate reform had nothing to do with the global stock market volatility, it was mainly due to the upcoming U.S. Federal Reserve monetary policy move,’ Yao said. ‘We were wronged.’ Yao's comments, which came on the same day that state media issued a number of commentaries defending China's policy making, show Beijing's sensitivity to suggestions it may have fumbled economic policy.”

August 28 – Reuters (Engen Tham, Shu Zhang and Matthew Miller): “China's largest banks warned of a tough year after posting their weakest half-yearly profit growth in at least six years as a slowing economy forces the lenders to make even more provisions for soured loans and squeezes interest income. State-owned Industrial and Commercial Bank of China (ICBC), China's largest bank by assets, and peers Bank of China (BOC), Agricultural Bank of China and Bank of Communications this week reported another spike in bad loans in the first half…”

August 26 – Bloomberg: “Remember putable bonds? Or debt insurers that collapsed in the U.S. in the wake of the global financial crisis? They’re back -- in China. Oceanwide Holdings Co. earlier this month sold the largest dollar-denominated putable security from Asia since 2003. Investors can demand the Beijing developer buy the notes back in three years, even if it doesn’t want to. HNA Capital Holding Co., a Beijing-based investment bank, sold $200 million of bonds Aug. 11 guaranteed by a Chinese insurer whose exposure to troubled debt doubled last year. China is reviving high-risk structures common in the run-up to the credit crisis, adding to concern corporate failures may spread after defaults mounted this year… The nation’s firms also sold 243 billion yuan ($38 billion) of asset-backed securities this year including two tied to stock margin loans. That’s three times the amount in the U.S. and almost 30 times offerings in Europe.”

August 26 – Bloomberg (Wes Goodman): “China’s margin debt has plunged by 1 trillion yuan ($156bn) from its June peak as stock traders close out bets using borrowed money amid a $5 trillion rout. Outstanding margin loans on the Shanghai and Shenzhen exchanges fell to about 1.25 trillion yuan on Monday from a record high of 2.27 trillion yuan on June 18. The Shanghai Composite Index has plunged 45% from its June peak… ‘The bull run was driven by leveraged funds, and the bull will cease to exist when leverage fades,’ Hong, an analyst at CIMB Securities in Hong Kong, wrote… ‘Range-bound consolidation would be the best-case scenario.’”

Fixed Income Bubble Watch:

August 26 – Bloomberg (Wes Goodman): “Investors scooped up Treasuries and dumped junk bonds in August, based on flows in exchange-traded funds. The result is that high-yield bonds yielded almost 650 bps more than U.S. government securities this week, the widest spread in three years. Investors are shunning the lowest-rated securities as they purge the riskiest assets from their portfolios amid a rout in stocks and commodities around the world. The listed bond fund that had the biggest outflows in August is the iShares iBoxx $ High Yield Corporate Bond ETF… It has fallen 3.5% this month. The iShares Short Treasury Bond ETF drew the most money, and it is little changed. ‘The financial markets are in chaos,’ said Will Tseng, a fund manager in Taipei for Mirae Asset Global Investments, which oversees $75 billion. ‘We’ve been cutting risk in our portfolios and adding Treasuries.’”

August 26 – Bloomberg (Christine Idzelis): “The latest rout in crude prices is coming at about the worst time possible for energy producers that have been relying on credit markets to keep drilling. That’s because banks that extended credit lines tied to the value of the companies’ oil reserves are preparing to recalculate how much they’re willing to keep lending. With crude prices more than 60% below their peak last year, lenders are poised to reduce those lines by 10% to 15% on average -- a move that could wipe out $15 billion of credit, according to estimates from CreditSights Inc. analyst Brian Gibbons. Unlike earlier this year, when drillers in need of fresh capital found debt investors anxious to capitalize on high yields, there’s little appetite for such deals this time around. About $7 billion of junk bonds issued by oil and gas producers in the first quarter to refinance debt have since lost 17%...”

August 26 – Bloomberg (Luca Casiraghi and Rakteem Katakey): “At a time when the oil price is languishing at its lowest level in six years, producers need to find half a trillion dollars to repay debt. Some might not make it. The number of oil and gas company bonds with yields of 10% or more, a sign of distress, tripled in the past year, leaving 168 firms in North America, Europe and Asia holding this debt… The ratio of net debt to earnings is the highest in two decades… Debt repayments will increase for the rest of the decade, with $72 billion maturing this year, about $85 billion in 2016 and $129 billion in 2017, according to BMI Research. About $550 billion in bonds and loans are due for repayment over the next five years. U.S. drillers account for 20% of the debt due in 2015, Chinese companies rank second with 12% and U.K. producers represent 9%.”

August 27 – Bloomberg (Laura J Keller and Michael J Moore): “Even Goldman Sachs Group Inc. hasn’t been left unscathed by the carnage in the market for distressed debt this year. Goldman Sachs has lost $50 million to $60 million on its distressed-trading desk in 2015, according to people familiar with the performance… Goldman Sachs’s distressed-trading desk, previously called distressed investing, is part of the firm’s credit-trading business along with investment-grade, high-yield and structured products. That unit has generated about a quarter of the bank’s fixed-income trading revenue over the past five years, or about $2.5 billion a year.”

U.S. Bubble Watch:

August 27 – Fox Business (Elizabeth MacDonald): “Should market regulators ride to the rescue and cancel problematic trades in exchange-traded funds that plunged in Monday's mayhem, just as they did other trades after the flash crash of 2010? Officials at the Securities & Exchange Commission and the New York Stock Exchange say they are looking into the issues surrounding massive ETF price plunges on Monday, as traders, investment bank executives, and analysts warn that the retail investors’ confidence in the market just got rocked… Many of the biggest and most popular exchange-traded funds owned by the little guys, the same ETFs touted on TV ads, saw colossal price swings in the chaotic minutes after Monday's opening bell, with prices plummeting 20%, even nearly 40%. Many funds saw their prices drop below the values of the indexes the ETFs are designed to track, even below the prices of the ETF's underlying stock holdings. The ETF controversy comes as these funds hit a record $2.93 trillion in assets last March, according to data provider ETFGI. ETFs are investment funds that trade on the stock exchanges. The majority are built to track major indices, like the S&P 500. Earlier this year, PricewaterhouseCoopers released analysis showing ETFs are on track to grow to $5 trillion in assets by 2020.”

August 27 – Reuters (Sam Forgione): “Investors in U.S.-based funds pulled $17.8 billion out of stock funds in the week ended Aug. 26, marking the biggest weekly outflows since mid-December of last year, data… Lipper… showed… Funds that specialize in U.S. shares posted $11.7 billion in outflows to mark their biggest withdrawals since early May, while funds that specialize in non-U.S. shares posted $6.1 billion in outflows to mark their biggest withdrawals since January 2008. Stock exchange-traded funds posted $15.2 billion in outflows, while stock mutual funds posted $2.6 billion in outflows. Taxable bond funds posted $2.6 billion…”

August 27 – Bloomberg (Lu Wang): “Volatility in the U.S. equity market is being whipped up by traders who don’t care what stocks are worth, according to an analyst at JPMorgan… Selling by ‘price insensitive’ investors employing strategies that take their cue from recent trends in stocks is worsening this week’s swings, according to Marko Kolanovic, a derivatives strategist at the… bank. In particular, he cited forced selling by traders who hold positions known on Wall Street as ‘short gamma,’ a bet that prices won’t move much. The research comes about a week after the Standard & Poor’s 500 Index was knocked out of a trading range that had supported it for about seven months. Sudden moves like that one spur computerized traders to buy and sell, exacerbating moves past what is justified by the economy and earnings, Kolanovic wrote. ‘Everybody knows about it,’ said Julian Emanuel, executive director of U.S. equity and derivatives strategy at UBS… ‘If you look back over the last five, six years, any time we have seen a period of excessive volatility like we’ve seen in the past two weeks, strategies such as those which typically are short gamma and basically need to rebalance at the end of the day.’ Kolanovic cited three types of quantitative strategies specifically: trend followers, risk parity traders and funds that adjust holdings when volatility in the market rises or falls. Such investors have hundreds of billions of dollars in assets and the power to move markets, he wrote.”

August 25 – Bloomberg (Tara Lachapelle): “The biggest threat to U.S. stocks right now may not be China, currencies or commodities prices. It might be American companies’ own merger appetite. Acquirers worldwide have already spent $2.2 trillion on transactions in 2015, putting the year on track for a record. The buying spree has been particularly audacious in the U.S., where acquirers are offering record prices relative to the revenue and profit they’re gaining from the deals. The result: Goodwill is surging. It jumped substantially this quarter, to $2.5 trillion for members of the Standard & Poor’s 500 Index… That’s a new record, and a sign that dealmakers are increasingly overpaying. Need more proof? American publicly traded companies are selling for 3 1/2 times their book value. In dollar terms, that’s $700 billion paid for assets that are worth only about $200 billion on paper.”

August 26 – Wall Street Journal (Michael Wursthorn and Annamaria Andriotis): “Loans backed by investment portfolios have become a booming business for Wall Street brokerages. Now the bill is coming due—for both the banks and their clients. Some lenders, including Bank of America Corp., are issuing margin calls to clients after the global market drubbing of the past week, forcing investors to choose between either putting up more money or selling some of the securities underlying the loans. Banks, meanwhile, are likely to take a hit to a key profit source if investors pull back from these loans as many expect.”

August 27 – Bloomberg (Kasia Klimasinska and Jeanna Smialek): “Stock market and commodity price declines are sweeping the globe, raising a question: If the U.S. economy lands in another hole, what tools does it have to dig itself out? Perhaps not many, or at least not as many as before the 2008 meltdown. U.S. debt stands at 74% of gross domestic product, compared with 35% in 2007, based on a Congressional Budget Office report… In recent years, the Federal Reserve has provided the stimulus that austerity-minded fiscal policy makers didn't. The central bank has held interest rates near zero since 2008 and carried out three massive asset purchase programs to boost the economy. Now, cutting interest rates wouldn't be an option in the face of a big downturn.”

Europe Watch:

August 26 – Bloomberg (Carolynn Look): “The European Central Bank is ready to expand or extend its bond-buying program if needed as a slump in commodity prices and risks to global economic growth threaten its inflation goal, said Executive Board member Peter Praet. ‘Recent developments in the world economy and in commodity markets have increased the downside risk of achieving the sustainable inflation path toward 2%,’ Praet told reporters… ‘There should be no ambiguity on the willingness and ability of the Governing Council to act if needed.’ The euro weakened after the comments, which echo remarks by ECB Vice President Vitor Constancio… and come just a week before the Governing Council will hold its next policy meeting.”

EM Bubble Watch:

August 25 – Bloomberg (Elena Popina): “This week, investors relived a nightmare. As markets from China to South Africa tumbled, they pulled $2.7 billion out of developing economies on Aug. 24. That matches a Sept. 17, 2008 exodus during the week Lehman Brothers went under. The collapse of the U.S. investment bank was a seminal moment in the timeline of the global financial crisis. The retreat from risky assets, triggered by concern over a slowdown in China and higher interest rates in the U.S., has taken money outflows from emerging markets to an estimated $4.5 billion in August, compared with inflows of $6.7 billion in July… It's lower stock prices that people are most worried about. Equity outflows from developing nations increased to $8.7 billion this month, the highest level since the taper tantrum of 2013…”

August 26 – Bloomberg (Lianting Tu Christopher Langner): “Credit quality in emerging markets is worsening the most since 2009 as resource-reliant governments, developers and banks grapple with record repayments. Ecuador, whose biggest export is oil, was cut one level to B this month by Standard & Poor’s as crude’s plunge threatens to worsen finances. The credit assessor reduced its grade on Chinese developer Greenland Holding Group Co. as leverage expands, and on Russian Standard Bank last month as the nation’s worsening economy pressures its capital. Developing-nation debtors face mounting default risks as they struggle with the highest borrowing costs since the global financial crisis, plunging local currencies and China’s slowing economy. Emerging-market downgrades are 4 times the amount of upgrades at S&P -- the worst ratio since 2009 - as a record $5.2 trillion of bonds comes due for the debtors this year…”

August 27 – Bloomberg (Noris Soto and Nathan Crooks): “Venezuela is preparing to issue bank notes in higher denominations next year as rampant inflation reduces the value of a 100-bolivar bill to just 14 cents on the black market. The new notes -- of 500 and possibly 1,000 bolivars -- are expected to be released sometime after congressional elections are held on Dec. 6… Many Venezuelans have to carry wads of cash in bags instead of wallets as soaring inflation and a declining currency increase the number of bills needed for everyday purchases. The situation is set to get worse. Inflation, already the fastest in the world, could end the year at 150%, said the official.”

Brazil Watch:

August 28 – Wall Street Journal (Paul Kiernan): “Brazil has entered its deepest economic downturn since the global financial meltdown of 2008-09, official data confirmed Friday. But unlike the previous crisis, economists say the current problems were caused by errant economic policy at home and that the road to recovery will be a long one. Brazil’s gross domestic product shrank 1.9% between April and June from the previous three months in seasonally adjusted terms, the Brazilian Institute of Geography and Statistics said on Friday. It was the second consecutive quarter of decline…”

August 27 – Financial Times (Geoff Dyer): “Brazil’s swirling political crisis gained momentum this week with new signs of friction between President Dilma Rousseff and her vice-president Michel Temer, who has been a crucial stabilising force within the government. Mr Temer’s decision to step down as the government’s point man with Congress has underlined the growing dispute within the governing coalition between the two main parties — Ms Rousseff’s Workers party (PT) and Mr Temer’s Brazilian Democratic Movement party (PMDB). At the very least, Mr Temer’s decision to partly distance himself from the government will add to the already considerable challenge Ms Rousseff faces in getting support in Congress for any aspects of her agenda. More ominously for the president, it could also signal the start of the disintegration of her governing coalition.”

August 26 – Bloomberg (Peter Millard): “Petroleo Brasileiro SA is seeking refuge in Brazil’s domestic bond market as overseas borrowing costs surge amid a plunge in the local currency has exposed a mismatch between its real-based revenues and dollar debt payments. The world’s most-indebted oil producer said it’s planning to sell 3 billion reais ($830 million) in local bonds. The move from the state-controlled company comes as crude prices trade near the lowest in a decade and after Brazil’s currency tumbled 27% this year, pushing up the cost of its debt. Yields on benchmark dollar bonds due in 2024 jumped to a record 8.71% this week amid a global selloff in emerging markets and heightened concern that Brazil won’t be able to maintain its investment-grade credit rating.”

Geopolitical Watch:

August 26 – Reuters (Manuel Mogato): “The United States plans to increase the number of military and humanitarian drills it conducts in the Asia-Pacific as part of a new strategy to counter China's rapid expansion in the South China Sea, the Philippine military said… Admiral Harry Harris, commander of the U.S. Pacific Command, highlighted key aspects of the Pentagon's freshly drafted Asia Pacific Maritime Security Strategy during talks with his Filipino counterpart…Colonel Restituto Padilla, a military spokesman, told journalists that the report outlined Washington's set of actions in the disputed South China Sea and East China Sea, focusing on the protection of ‘freedom of seas’, deterring conflict and coercion, and promoting adherence to international law.”

Russia and Ukraine Watch:

August 27 – Bloomberg (Evgenia Pismennaya): “Russia won’t participate in Ukraine’s debt restructuring, Finance Minister Anton Siluanov said… Ukraine agreed to a restructuring deal with creditors after five months of talks, Ukrainian Finance Minister Natalie Jaresko said. That includes a 20% writedown to the face value of about $18 billion of Eurobonds.”

Japan Watch:

August 27 – Reuters: “Japan's consumer inflation ground to a halt for the first time in more than two years and household spending unexpectedly fell in July, heightening pressure on policymakers to offer fresh fiscal and monetary support to underpin a fragile recovery. The gloomy data, coupled with soft exports blamed on China's slowdown, reinforces the dominant market view that any rebound in growth from a contraction in April-June will be modest. But with premier Shinzo Abe's stimulus measures having failed to significantly boost wages, exports and prices, analysts doubt whether additional monetary easing or fiscal spending will have much effect in reflating the economy.”

August 26 – Bloomberg (Ye Xie and Liz McCormick): “The Bank of Japan can achieve its 2% inflation target with the current level of monetary stimulus, even as it stands ready to adjust policy if needed, said Governor Haruhiko Kuroda. Kuroda said he’s watching risks from volatility in global financial markets and that the central bank has ‘many options’ should it need to increase easing. ‘At this stage, we have no concrete proposal for further accommodation,’ Kuroda said… ‘But if necessary, we will certainly make necessary adjustment.’”