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Did you know that financial institutions all over the world are warning that we could see a “mega default” on a very prominent high-yield investment product in China on January 31st? We are being told that this could lead to a cascading collapse of the shadow banking system in China which could potentially result in “sky-high interest rates” and “a precipitous plunge in credit“. In other words, it could be a “Lehman Brothers moment” for Asia. And since the global financial system is more interconnected today than ever before, that would be very bad news for the United States as well. Since Lehman Brothers collapsed in 2008, the level of private domestic credit in China has risen from $9 trillion to an astounding $23 trillion. That is an increase of $14 trillion in just a little bit more than 5 years. Much of that “hot money” has flowed into stocks, bonds and real estate in the United States. So what do you think is going to happen when that bubble collapses?
The bubble of private debt that we have seen inflate in China since the Lehman crisis is unlike anything that the world has ever seen. Never before has so much private debt been accumulated in such a short period of time. All of this debt has helped fuel tremendous economic growth in China, but now a whole bunch of Chinese companies are realizing that they have gotten in way, way over their heads. In fact, it is being projected that Chinese companies will pay out the equivalent ofapproximately a trillion dollars in interest payments this year alone. That is more than twice the amount that the U.S. government will pay in interest in 2014.
Over the past several years, the U.S. Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England have all been criticized for creating too much money. But the truth is that what has been happening in China surpasses all of their efforts combined. You can see an incredible chart which graphically illustrates this point right here. As the Telegraph pointed out a while back, the Chinese have essentially “replicated the entire U.S. commercial banking system” in just five years…
Overall credit has jumped from $9 trillion to $23 trillion since the Lehman crisis. “They have replicated the entire U.S. commercial banking system in five years,” she said.
The ratio of credit to GDP has jumped by 75 percentage points to 200pc of GDP, compared to roughly 40 points in the US over five years leading up to the subprime bubble, or in Japan before the Nikkei bubble burst in 1990. “This is beyond anything we have ever seen before in a large economy. We don’t know how this will play out. The next six months will be crucial,” she said.
As with all other things in the financial world, what goes up must eventually come down.
And right now January 31st is shaping up to be a particularly important day for the Chinese financial system. The following is from a Reuters article…
The trust firm responsible for a troubled high-yield investment product sold through China’s largest banks has warned investors they may not be repaid when the 3 billion-yuan ($496 million)product matures on Jan. 31, state media reported on Friday.
Investors are closely watching the case to see if it will shatter assumptions that the government and state-owned banks will always protect investors from losses on risky off-balance-sheet investment products sold through a murky shadow banking system.
If there is a major default on January 31st, the effects could ripple throughout the entire Chinese financial system very rapidly. A recent Forbes article explained why this is the case…
A WMP default, whether relating to Liansheng or Zhenfu, could devastate the Chinese banking system and the larger economy as well. In short, China’s growth since the end of 2008 has been dependent on ultra-loose credit first channeled through state banks, like ICBC and Construction Bank, and then through the WMPs, which permitted the state banks to avoid credit risk. Any disruption in the flow of cash from investors to dodgy borrowers through WMPs would rock China with sky-high interest rates or a precipitous plunge in credit, probably both. The result? The best outcome would be decades of misery, what we saw in Japan after its bubble burst in the early 1990s.
The big underlying problem is the fact that private debt and the money supply have both been growing far too rapidly in China. According to Forbes, M2 in China increased by 13.6 percent last year…
And at the same time China’s money supply and credit are still expanding. Last year, the closely watched M2 increased by only 13.6%, down from 2012’s 13.8% growth. Optimists say China is getting its credit addiction under control, but that’s not correct. In fact, credit expanded by at least 20% last year as money poured into new channels not measured by traditional statistics.
Overall, M2 in China is up by about 1000 percent since 1999. That is absolutely insane.
And of course China is not the only place in the world where financial trouble signs are erupting. Things in Europe just keep getting worse, and we have just learned that the largest bank in Germany just suffered ” a surprise fourth-quarter loss”…
Deutsche Bank shares tumbled on Monday following a surprise fourth-quarter loss due to a steep drop in debt trading revenues and heavy litigation and restructuring costs that prompted the bank to warn of a challenging 2014.
Germany’s biggest bank said revenue at its important debt-trading division, fell 31 percent in the quarter, a much bigger drop than at U.S. rivals, which have also suffered from sluggish fixed-income trading.
If current trends continue, many other big banks will soon be experiencing a “bond headache” as well. At this point, Treasury Bond sentiment is about the lowest that it has been in about 20 years. Investors overwhelmingly believe that yields are heading higher.
If that does indeed turn out to be the case, interest rates throughout our economy are going to be rising, economic activity will start slowing down significantly and it could set up the “nightmare scenario” that I keep talking about.
But I am not the only one talking about it.
In fact, the World Economic Forum is warning about the exact same thing…
Fiscal crises triggered by ballooning debt levels in advanced economies pose the biggest threat to the global economy in 2014, a report by the World Economic Forum has warned.
Ahead of next week’s WEF annual meeting in Davos, Switzerland, the forum’s annual assessment of global dangers said high levels of debt in advanced economies, including Japan and America, could lead to an investor backlash.
This would create a “vicious cycle” of ballooning interest payments, rising debt piles and investor doubt that would force interest rates up further.
So will a default event in China on January 31st be the next “Lehman Brothers moment” or will it be something else?
In the end, it doesn’t really matter. The truth is that what has been going on in the global financial system is completely and totally unsustainable, and it is inevitable that it is all going to come horribly crashing down at some point during the next few years.
It is just a matter of time.
From Russ Certo, head of rates at Brean Capital
Two Roads Diverged
As we know, it has been a suspect week with a variety of earnings misses. Although I have been constructive on risk asset markets generally, equities anecdotally, as figured year end push for alpha desires could let it run into year end. New year and ball game can change quickly. Just wondering if a larger rotation is in order.
There is an overall considerable theme of what you may find when a liquidity tide recedes as most major crises or risk pullbacks have been precipitated by either combination of tighter monetary or fiscal policy. Some with a considerable lag like a year after Greenspan departed from Fed helm, or many other examples. I’m not suggesting NOW is a time for a compression in risk but am aware of the possibility, especially when Fed Chairs take victory laps, Bernanke this week. Symbolic if nothing more. Cover of TIME magazine?
I happen to think that 2014 is a VERY different year than 2013 from a variety of viewpoints. First, there appears to be a dispersion of opinion about markets, valuations, policy frameworks and more. This is a healthy departure from YEARS of artificiality. Artificiality in valuations, artificiality in market and policy mechanics and essentially artificiality in EVERY financial, and real, relationship on the planet based on central bank(s) balance sheet expansion and other measures intended to be a stop-gap resolution to tightening financial conditions, adverse expectations of economic activity, and the great rollover….of both financial and non-financial debt financing. Boy, what a week in the IG issuance space with over $100 billion month to date, maybe $35 billion on the week. Debt rollover on steroids.
Beneath the veneer of market aesthetics, I already see fundamental (and technical) relevance. This could be construed as an optimist pursuit or reality that markets are incrementally transcending reliance and/or dependence on the wings of central bank policy prerogatives. The market bird is trying to fly on its own with inklings of a return to FUNDAMENTAL analysis. A good thing, conceptually, and gradualist development of passing the valuation baton back to market runners. A likely major pillar objective of policy despite more than a few critics worried about seemingly dormant lurking imbalances created by immeasurable policy and monetary and fundamentally skewed risk asset relationships globally.
This exercise of summarization of ebb and flow and comings and goings of markets and policy naturally funnels a discussion to what stature of central bank policy currently or accurately exists? Current events. What is the accurate stage of policy?
I actually think this is a more delicate nuance than I perceive viewed in overall market sentiment. Granted, we have taken a major step for mankind, which is the topical engagement of some level of scope or reduction of liquidity provisioning,” not tightening.” Tip of the iceberg communique with markets to INTRODUCE the concept of stepping off the gas but not hitting the break. Reeks of fragility to me but narrative headed in right direction to stop medicating the patient, the global economy.
Some markets have logically responded in kind. The highest beta markets as either beneficiaries or vulnerable to monetary policy changes, the emerging markets, have reflected at least the optics of change with policy. More auditory than optics in hearing a PROSPECTIVE change in garbled Fedspeak. The high flyer currencies which capture the nominal flighty hot money flows globally affirmed the Fed message.
In literally the simplest of terms, the G7 industrialized, not peripheral; interest rate complex has simply moved the needle in form of +110 basis point higher moves in nominal sovereign interest rates. And there are a bevy of other expressions which played nicely and rightly conformed to the messages coming out of the central bank sandbox. But there are ALSO notable dichotomies, which send a different or even the opposite message.
I perceive a deviation in perception of message as some markets or market participants appear to be betting on taper or a return to normalcy in global growth or U.S. growth outcomes??? OR no taper, or conversely QE4 or whatever. Sovereign spreads have moved materially tighter vs. industrial and supposed risk free rates (Tsys, Gilts, Bunds) both last year and in the first three weeks of 2014. Something a new leg of QE would represent, not a taper. A different year!!!
There have been VERY reliable risk asset market beta correlations over the last 5 years and sovereign or peripheral spreads have been AS volatile and correlated as any asset class. These things trade like dancing with a rattle-snake. Greece, Spain, France etc. They can bite you with fangs. They have been meaningfully more correlated to high yield spreads and yields and to central bank balance sheet expansion as nearly any asset class. So, the infusion of central bank liquidity into markets has seen “relief” rallies in peripherals and one would think the converse would be true as well. The valuations have represented the flavor and direction of risk on/risk off or liquidity on/liquidity off reliably for many months/years.
But I THOUGHT markets were deliberating tapering views and expressions as validated by some good soldier markets BUT that is not necessarily what the rally in riskiest of sovereign “credits” is suggesting. The complex seems to be decoupling with Fed balance sheet correlation and message. Some are OVER 100 standard deviations from the mean! They are rich and could/should be sold. Especially if one was to follow the obvious correlation with the direction of central bank as stated.
But look to other arena’s like TIPS breakevens which also have been correlated with liquidity and risk on/off and central bank balance sheet expansion. Correlated to NASDAQ, HY, peripherals and the like. BUT this complex COUNTERS what peripherals are doing. They haven’t shown up to the punch bowl party yet. Not invited. This is a departure of markets that have largely and generally been in synch from a liquidity and performance correlation view.
Like gold and silver which got tattooed vis a vis down 35%+ performance last year MOSTLY, but not exclusively, due to perceptions of winds of central bank change. BUT even within a contrary, the fact that rallies in Spain, France, Greece, and Italy reflect more of central bank easing notions, the opposite of taper. In essence, the complex has gone batty uber-appreciation this year. Sure, many eyeball the Launchpad physical metals marginal stabilization no longer falling on a knife but the miner bonds and the mining stocks are string like bull with significant appreciation. This decidedly isn’t the stuff of taper which had the bond daddy’s romancing notions of 3% 10yr breaks, 40 basis point Green Eurodollar sell-offs, emerging market rinse, and upticks in volatility amongst other things.
Equity bourses appear to be changing hands between investors with oscillating rotations which mark the first prospective 3 week consecutive sell-off in a while. New year. This is taper light. Somewhere in between and further blurs the correlation metrics.
So, which is it? Are we tapering or not and why are merely a few global asset classed pointed out here, why are they deviating or arguably pricing in different central bank prospects or scenarios or outcomes?
I’m not afraid but I am intrigued as to the fact that there may some strong opinions within markets and I perceive a widely received comfortability with taper or tightening notions, negative leanings on interest rate forecasts, a complacency of Fed call if you will. And all of these hingings occur without intimate knowledge of the most critical variable of all, what Janet Yellen thinks? She has been awfully quiet as of late and there are many foregone conclusions or assumptions in market psyche without having heard a peep from the new MAESTRO.
Moreover, looking in the REAR view mirror within a week where multiple (two) Fed Governor proclamations, communicated and implicated notions which arguably would be considered radical in ANY other policy period of a hundred years. How to conduct “monetary policy at a ZERO lower bound (Williams) ” and “doing something as surprising and drastic as cutting interest on excess reserves BELOW zero (Kocherlakota).”
This doesn’t sound like no stinking taper? A tale of two markets. To be or not to be. To taper or not to taper. Two roads diverged and I took the one less traveled by, and that has made all the difference. Robert Frost.
Which is it? Different markets pricing different things. Right or wrong, the market always has a message; listen critically.