After an extraordinary August, markets are showing no inclination for stability to begin September. Jumping 1.3% Thursday on news of an October restart of trade talks, the S&P500 gained 1.8% for the week. The S&P500 ended the week less than 2% from all-time highs. The Semiconductors surged 4.2%, increasing 2019 gains to almost 36%. The Nasdaq100 advanced 2.1% (up 24.1% y-t-d), now also less than a couple percent from record highs. The Broker/Dealers jumped 2.7%.
Liquidity moves markets!Follow the money. Find the profits!
Not uncharacteristically, the more dramatic market trading dynamics were visible throughout fixed-income. Curiously, Thursday’s bout of “risk on” (and much stronger-than-expected ADP and ISM Non-Manufacturing reports) finally captured the attention of safe haven bonds. Ten-year Treasury yields surged nine bps to 1.56% – which equated to a painful 1.8% one-day drop in the popular iShares Treasury Bond ETF (TLT). Intraday, TLT was down as much as 2.4%. Bullish pundits were quick to dismiss a single-session yield jump. But of the crowd piling into bond ETFs, how many are unaware of how quickly money can be lost in “safe” bonds?
“Biggest Bond Rout in Years Whiplashes Bulls Who Were Right,” read a Bloomberg article (Liz McCormick) headline. Jumping 9.5 bps to 1.53%, two-year Treasury yields posted their largest one-day jump since February 2015. At one point up 14 bps, two-year Treasuries were on the cusp of the biggest single-session spike in a decade. Interestingly, the implied yield for December Fed funds futures was little changed for the week at 1.61%.
Investment-grade corporate bonds were under pressure as well. The iShares Investment-Grade Bond ETF (LQD) was down as much as 0.9% intraday before ending Thursday’s session with a loss of 0.7%. While declining almost 1% early in the trading day, the “risk on” backdrop pushed junk bond indices into positive territory by the close.
After trading at a record low negative 0.74% in Tuesday trading, German bund yields spiked to as high as negative 0.575% during Thursday’s session (before ending the week at negative 0.64%). Safe haven Swiss bonds were similarly unstable. After trading as low as negative 1.05% in Wednesday trading, Swiss 10-year yields surged to negative 0.90% – before closing Friday at negative 0.95%.
Curiously, there were bond rallies that didn’t miss a beat. This week’s 12 bps drop in Italian 10-year yields narrowed the spread to German bunds by 18 bps to a 16-month low 151 bps. Greek 10-year yields declined three bps, narrowing the spread to bunds to a near decade-low 222 bps. I’ll assume there have been some bearish bets on Italian and Greek yields and spreads that have “blown up.”
Argentine 30-year dollar bonds had a wild ride. After opening Monday trading at 16.69%, yields spiked to as high as 18.25% in Tuesday trading before reversing course and closing out the week at 13.55%. The Argentine peso rallied 6.6% this week, reducing 2019 losses versus the dollar to 32.5%.
And while risk showed its face in (most) bond prices, corporate debt issuance was nothing short of incredible. A Bloomberg headline described the week: “A $150 Billion Global Corporate Bond Binge Is Smashing Records.”
September 6 – Financial Times (Joe Rennison): “Companies across the world, from iPhone maker Apple to German financial technology group Wirecard, sold more bonds this week than ever before, abruptly waking the market from its summer slumber to take advantage of historically low borrowing costs. Investors lapped up more than $140bn of new corporate bonds, marking the biggest weekly volume to hit global markets on record, according to… Dealogic. The debt binge was fuelled by investment-grade companies in the US where $72bn was raised across 45 deals in a single week, roughly equalling the total issued in the whole of August. ‘We have had a month of issuance in three days,’ said Andrew Brenner, head of international fixed income at National Alliance Securities. ‘There is tremendous demand out there.’”
September 4 – Wall Street Journal (Matt Wirz and Nina Trentmann): “Apple… joined U.S. companies including Deere & Co. and Walt Disney Co. in a recent sprint to issue new bonds, taking advantage of the steep decline in benchmark interest rates and a surge in investor demand. Apple launched its first bond deal since 2017, selling $7 billion of debt. All three companies issued 30-year bonds with yields below 3%, a first for the corporate debt market. Twenty-one companies with investment-grade credit ratings issued bonds totaling about $27 billion on Tuesday, said Andrew Karp, head of investment-grade capital markets at Bank of America Corp. ‘That’s equivalent to a busy week for us—in one day,’ he said.”
September 5 – Bloomberg (Brian W Smith and Michael Gambale): “U.S. investment-grade bond issuance is hitting $74 billion for this week, the most for any comparable period since records began in 1972. Thursday’s $20 billion total adds to the $54 billion already sold, thrashing the week’s forecast of $40 billion. With a rally in Treasuries pushing the high-grade bond yield to a three-year low of just 2.77%, companies are borrowing cheap money now to refinance more expensive debt, spurred by a positive tone in global markets.”
September 6 – Financial Times (Joe Rennison): “…In a further sign of investors’ increasingly desperate search for yield, Restaurant Brands, which owns the Popeyes and Burger King chains, was set to issue an 8.5-year bond with a coupon under 4% on Friday, entering a tiny club of junk-rated issuers that have managed to sell debt below that level — and breaching what is typically expected from ‘high yield’ issuers. ‘The conventional heuristics are getting tossed out of the window,’ said John McClain, a portfolio manager at Diamond Hill Capital Management. ‘These are paltry returns.’”
It’s difficult to envisage a more manic bond market environment – at home or abroad. In Europe, it’s tulip mania reincarnated, with a third of European investment-grade bonds now trading with negative yields. Draghi had best not disappoint the markets next Thursday. And when he comes through, markets will raise the stakes even higher for next month. From the Financial Times (Robert Smith): “JPMorgan’s analysts say September is shaping up to be the ‘first issuance window where negative yielding bonds are a common feature, rather than an occasional oddity’. ‘In our view, investors still have cash to deploy, and few other alternatives to buy,’ they say.”
September 5 – Bloomberg (Hannah Benjamin): “Sales of new bonds in Europe will pass 1 trillion euros ($1.1 trillion) on Thursday, earlier in the year than ever before as companies take advantage of ultra-low borrowing costs ahead of potential year-end volatility to raise funds. BT Group Plc, Continental AG and Snam SpA joined the deluge on Thursday, fanning what may be the busiest week for corporate issuance since March 2018. The day’s 13 offerings marketwide will also likely lift sales for the year above 1 trillion euros, about six weeks earlier than last year and two weeks quicker than 2017’s record…”
Beijing was determined to do its share to make the week noteworthy.
September 6 – Bloomberg: “China’s central bank said it will cut the amount of cash banks must hold as reserves to the lowest level since 2007, injecting liquidity into an economy facing both a domestic slowdown and trade-war headwinds. The required reserve ratio for all banks will be lowered by 0.5 percentage points, taking effect on Sept. 16… The PBOC also cut the reserve ratios by one percentage point for some city commercial banks, to take effect in two steps on Oct. 15 and Nov. 15. The cuts will release 900 billion yuan ($126bn) of liquidity, the PBOC said, helping to offset the tightening impact of upcoming tax payments. That is more than the previous cuts in January and May, which released 800 billion yuan and 280 billion yuan, respectively, the PBOC said…”
Though China’s latest cut in bank reserve requirements was well-telegraphed, it along with the restart of trade talks pushed the Shanghai Composite 3.9% higher. The renminbi rallied 0.56% versus the dollar. But before we get too excited by the “release” of an additional $126 billion of lending power, keep in mind that Chinese Credit in 2019 has been expanding abundantly. After seven months, Total Aggregate Financing had already increased $2.022 Trillion, running 26% ahead of comparable 2018. Reserve reductions can be expected to somewhat extend China’s historic mortgage finance and apartment Bubbles.
And on the topic of mortgage finance Bubbles…
September 5 – Wall Street Journal (Andrew Ackerman and Kate Davidson): “The Trump administration said it would support returning mortgage-finance giants Fannie Mae and Freddie Mac to private hands, a development that could keep the companies at the center of the housing market for decades to come. The principles announced Thursday represent a major reversal from what leaders of both parties over the past decade promised—to abolish the companies, which guarantee roughly half the U.S. mortgage market. The approach, which doesn’t require approval by Congress, would mark an important win for investors who have been betting politicians wouldn’t follow through on those promises. Treasury officials said they would aim to privatize the government-controlled firms without making it tougher and more expensive for people to get mortgages.”
September 5 – Wall Street Journal (Aaron Back): “America’s mortgage-finance system isn’t going to change in a fundamental way for the foreseeable future. That is the inescapable—though to many parties deeply disappointing—takeaway from the U.S. Treasury Department’s housing reform plan… Mortgage guarantors Fannie Mae and Freddie Mac, which have been wards of the state for 11 years, are likely to remain so for some time. For years a debate has raged over how to deal with the companies that back most mortgages in the U.S. Some, especially holders of their volatile shares, want them recapitalized and released from government control as soon as possible. Others want a fundamental reform of the system, which would require new laws and likely include an explicit government guarantee for the mortgage-backed securities they issue. The Trump administration is trying to straddle the two camps by recommending that Congress get to work on the more fundamental reforms while the executive branch gets started recapitalizing and releasing the companies. But exhortations to Congress are likely to fall on deaf ears. Meanwhile, the route to recapitalizing the companies outlined in the report is tentative and vague. The report uses the term ‘Congress should’ 40 times.”
A factor fundamental to the predicament was captured succinctly by Barron’s (Bill Alpert): “Both Fannie and Freddie now have negative net worths. The Treasury would like to end their government conservatorship and have them stand on their own. But to capitalize them well enough to weather another financial crisis could require a couple of hundred billion dollars.”
Predictably, Washington has failed to resolve the serious systemic risk posed by the GSEs, risk made disastrously clear in 2008. Indeed, the Trump administration has followed Obama’s in lacking the fortitude to even commence the process. It’s been more than a decade since the crisis and resulting Fannie and Freddie government receivership. At the minimum, these two failed institutions should have shrunk. But after ending 2008 at $8.167 TN, Total GSE Securities (chiefly Fannie and Freddie’s) closed out Q1 at a record $9.147 TN.
It’s worth noting GSE Securities surged $626 billion since the end of 2016 – in what is reckless late-cycle growth for institutions with zero capital buffers. But as a wing of the Department of Treasury (and a probable target of the Fed’s next QE program), GSE debt and MBS have enjoyed insatiable demand. In one of history’s great debt issuance booms, combined outstanding Treasury and GSE securities have increased $3.0 Trillion over just the past ten quarters.
In theory, it would be prudent to push hard for less Washington monopolization of mortgage Credit. But at this point, the idea of “privatizing” Fannie and Freddie would simply be a return to the disastrous system of privatizing profits while nationalizing risk. There is simply no mechanism to effectively privatize this risk, as markets will invariably recognize these bigger than ever colossal institutions as much too big to fail.
Confident in the Washington backstop, GSE securities will continue to trade with meager risk premiums. This distortion creates extraordinarily attractive profit opportunities for equity investors clamoring for a so-called “privatization.” As before, cheap financing costs and the gross under-reserving for future losses would create the illusion of sound and highly profitable institutions. These “private” companies would surely reward investors with strong earnings growth and dividends, ensuring a hopelessly insufficient capital base for the downside of the cycle.
The Trump administration punted. Yet I would prefer to see these institutions remain under the Treasury umbrella rather than be part of some sham “privatization.” The administration should, however, at the very minimum demand a moratorium on expansion. It would take years, but Fannie and Freddie exposures could be meaningfully reduced. I won’t hold my breath. Cheap mortgage Credit has been a staple for U.S. economic and financial systems now going on three decades. One of many historic market distortions that these days passes as normal and sustainable.
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