Home loan rates heading higher as funding costs rise, competition eases

From The Australian Financial Review.

Mortgage rates are set to rise for both fixed and variable rate borrowers this year as global interest rates shoot higher, competition eases and capital rules begin to bite.

“Borrowers should assume we are at the bottom of the interest rate cycle – in fact we are probably already past it,” housing finance expert Martin North of Digital Finance Analytics told The Australian Financial Review.

Australia’s banks have cited higher funding costs as a reason for increasing fixed-rate home loans. On Monday National Australia Bank became the last of the big four banks to lift fixed-rate loans in recent months, citing higher funding costs as it raised rates on two, three and four-year mortgages.

The main cause of these higher funding costs for fixed-rate loans was a sharp rise in Australian medium-term bond rates from September to December as rising commodity prices, rising inflation and a shift in global monetary policy rhetoric forced traders to question the thesis that rates would stay low indefinitely.

Bond rates kicked up again following the election of Donald Trump in the US, forcing the three-year Australian swap rate to 2.35 per cent from an all-time low of 1.75 per cent in September. Australian interest rates rates tend to closely track movements in global bond rates and are expected to rise further this year, which will force costs higher for prospective borrowers seeking a fixed interest rate.

“Capital markets have seen a price hike since Trump, and as a result banks are having to pay more for wholesale funding – a critical element in bank funding,” Mr North said.

While rates on standard variable mortgage loans are not impacted by medium-term moves in the bond market, they too could edge higher this year if traders’ bets that the Reserve Bank is more likely to hike than lower interest rates prove correct.

For most of last year bond markets had priced in cuts for this year, but as global bond rates have shot higher rate cuts have all been but priced out – with markets prescribing just a one in 13 chance that the cash rate will fall this year. Meanwhile, traders are attaching a one in three probability that the Reserve Bank will raise the cash rate to 1.75 per cent before the end of the year.

Mr North said the global outlook and initial indications of the policy stance of new Reserve Bank governor Phil Lowe mean rate reductions appear unlikely.

“It depends on the Reserve Bank’s view on inflation versus property [risks from lower rates],” Mr North said. “Investment loans are hot, so I think it’s an even bet as to whether they raise rates.”

Australian Bureau of Statistics figures released on Tuesday showed mortgage lending to investors, which has concerned regulators, jumped by 4.9 per cent in November, up from 1.5 per cent in October – to the highest level since July 2015.

While base interest rates are likely to have the largest bearing on borrowing costs, other factors such as wholesale and deposit funding costs and capital requirements, and the level and intensity of competition among the banks for new loans will influence mortgage rates too.

Mr North, however, said that the signs are that competition pressures are easing, which will remove the downward pressure on home loan rates evident last year.

“The banks have realised that the deep discounting we saw in 2016 was a race to the bottom, so the banks are going to be sassier from here and that means higher rates,” he said.

Another potential upward force is the chance of further increases in capital when the Basel committee on banking supervision finalises its Basel III capital framework.

Mr North said this year will be characterised by differentiated pricing between customers with low risk, ‘low loan to value’ borrowers, that is, those who have a higher deposit, receiving favourable rates while riskier ‘high loan to value’ borrowers will pay more.

“The thing about Basel is it’s translating more of the portfolio risks into capital calculations so different types of borrowers attract different charges,” he said.

One positive for borrowers is that two important components of bank funding costs have moderated.

Concerns have been raised that banking rules that come into effect in early 2018 and prioritise retail deposits over other forms of funding will increase competition for savings, forcing up deposit costs. From January next year Australia’s banks will have to meet a prescribed ‘net stable funding ratio’ aimed at limiting the risk of a bank run by funding their loans with stable sources such as deposits.

So far, however, the evidence is that banks are not competing aggressively for savings, by increasing term deposit rates, as they were six months ago.

Analysis compiled by Deutsche Bank this week shows that deposit margins, measured as a spread over the bank bill rate, had declined significantly from August, when they rose to about 0.40 percentage points over the bank rate to below 0.20 percentage points. Online saving rates have also declined in recent weeks.

“While deposits remain a headwind to margins, these trends illustrate the continuing easing of deposit spread pressures,” Deutsche analyst Andrew Triggs wrote.

Wholesale bank funding costs, as measured by credit spreads, also appear to have moderated despite significant market uncertainty.

The cost of insuring against the default of a major Australian bank’s debt for five years is now around 64 basis points, its lowest level for 18 months, and well below the 10-year average of 100 basis points. Australian bank credit default swaps are a proxy for wholesale funding costs.

ASIC needs a win in 2017, but it’s not likely to come from the banks

From The Conversation.

In a pre-Christmas interview, Greg Medcraft, Chairman of the Australian Securities and Investments Commission (ASIC), looked forward to 2017 and talked tough:

What we want for people to appreciate is that there is nowhere to hide (when it comes to corporate crime).

With new(ish) money from the government, ASIC plans to hire loads of new people and spend big on “data analytics”. [Has no one told ASIC about the problems Centrelink is having with “big data”?

Medcraft was fairly happy with ASIC’s track record in 2016,

In the 12 months to the end of June we undertook 1400 high-intensity surveillances, finished 175 investigations, convicted 22 criminals, jailed 13 people, removed 136 people from the financial services industry.

Sounds impressive until one realises that most of those prosecuted were small fry (dodgy car dealers and the like) and the big end of town has barely been touched. At best it received a tiny tap on the wrist.

2016 was not a good year for ASIC.

In February, the long running scandal of manipulation of the key BBSW base rate burst into the open thanks to investigative journalist Adele Ferguson, and in March, ASIC took ANZ to the federal court. The action against ANZ was repeated later in the year with similar civil proceedings against Westpac and later against NAB. ASIC has not denied that CBA remains in its sights in the BBSW case.

The civil actions over BBSW have been a disaster for ASIC.

First, having to take regulated banks to court is considered in regulatory circles to be a failure. If a resolution for misbehaviour cannot be imposed, it really should be negotiated as it has been in other base rate manipulation cases overseas, with more than US$10 billion of fines and remediation being imposed on international banks for manipulation of LIBOR.

Second the major banks have ASIC over a barrel, admittedly a barrel they chose to lie over themselves. Banks have much more money than regulators to employ legal heavy hitters to drag proceedings out, and have chosen to do so rather than risk a banking royal commission.

In March, another disaster befell ASIC when Adele Ferguson unearthed the CommInsure scandal in which the insurance subsidiary of CBA was found to have dudded policy holders out of insurance compensation that they were entitled to.

As regards CommInsure, ASIC not only should have been searching for the rampant misconduct that was unearthed by the media, it should have taken action over serious misconduct. However, ASIC did what ASIC does best – start a multi-year investigation, which at the end of 2016 has not gone very far.

In April, it got worse. In a “capability review”, the government found that ASIC was a dysfunctional, overworked and under-resourced organisation. With an election on the horizon, Kelly O’Dwyer, the minster responsible, kicked the can down the road, and, hanging Medcraft out to dry, renewed his contract for only 18 months, rather than the usual three years. However, O’Dwyer did reverse the ASIC budget cuts put in place by her predecessor.

In May, ASIC was involved in yet another example of financial misconduct involving major banks being blindsided by dodgy mortgage providers. To its credit, ASIC had initiated the case against the dodgy brokers in 2015, but utterly failed to address the due diligence problems that were unearthed at the major banks. Again, the small fry got fried and the big fish swam away.

The middle of the year was busy for ASIC, mainly keeping its head down during the federal election and ignoring calls for a banking royal commission to address, problems most of which ASIC should have been tackling anyway.

After the election, a new problem hit the headlines. The big four banks were found to have sold products to some customers through their adviser network, with a fee for ongoing advice, but the advice had never been given.

ASIC blamed the problems on “cultural factors”, a topic that Medcraft had been banging on about for some time but obviously has been able to do little about. The latest culprits are so-called “subcultures”, or basically staff who don’t listen to management. ASIC would have been aware of such problems if its staff had read the groundbreaking research on risk culture by Professors Elizabeth Sheedy and Barbara Griffin.

For ASIC, 2016 ended in embarrassment, with ANZ and Macquarie banks being held to account for manipulating base rates. It was the Australian Competition and Consumer Commission (ACCC), not ASIC, which punished the culprits. In his end of year interview, Medcraft said “fining ‘bad apples’ is OK but you have to deal with the tree”, but so far ASIC has given no clue as to what it is going to do about the trees in this particular instance of gross misconduct.

ASIC’s final act of 2016 was farcical. Just before Christmas, the regulator announced that it had accepted an “enforceable undertaking” from the CBA and NAB in relation to the banks’ manipulation of wholesale spot foreign exchange (FX) rates. Overseas, regulators have extracted more than US$10 billion of fines from multiple banks for the so-called Forex fraud and indicted traders, but ASIC could manage fines of only A$2.5 million for each bank to shut down the case, with no one held to account.

It puts in context Medcraft’s comment to the Australian that “If you think about enforcement, you have to have penalties which actually hurt. They can’t be a feather”. Feathery fines of a few million dollars will hardly cause the big banks to “hurt”, unless it’s from laughing.

In his first interview of 2017, Medcraft hinted that he was prepared to roll over and run up the white flag on BBSW. He signalled to the banks that the climb down over Forex showed he was “pragmatic” and that

we’re always open to a settlement … but any settlement has to be credible.

Unfortunately, ASIC has lost what little was left of its credibility in 2016. The regulator could do worse than listen to its own advice to banks:

It gets back to individual accountability. We have to make sure that, where it’s needed, you have a whole-of-management accountability, which is critical.

But if no one else pays attention to ASIC, why should it listen to its own advice?

Author: Pat McConnell, Honorary Fellow, Macquarie University Applied Finance Centre, Macquarie University

Have The U.S. Stock Bulls Got It Wrong?

From Bloomberg.

Amundi SA, Europe’s largest money manager, says investors who have driven U.S. stock markets to record highs in expectation of fiscal stimulus from the Trump administration may be in for a surprise.


While a pivot to government spending and tax cuts may prolong the economic expansion in the U.S., Republican lawmakers will insist that fiscal measures don’t push up the deficit, Didier Borowski, the Paris-based asset manager’s head of macroeconomics, said in an interview. Even if President-elect Donald Trump succeeds in delivering stimulus, it won’t have an impact before next year, he said.

“Following the vote for Trump, markets have reacted as if there were only upside risks,” Borowski said in an interview in Munich. “U.S. equity markets could go further into bubble territory as risks are becoming increasingly asymmetric. That would be an opportunity to reallocate funds to bond markets.”

Trump’s surprise victory in the U.S. presidential election in November has driven investors out of bonds and into equities, accelerating a massive flow of funds that some investors say may last for years and spell the end of the multi-decade rally in bonds. The value of global equities climbed to $68 trillion from about $65 trillion the day before the election. Bonds have lost about $2 trillion in that time.

Financial market observers and investors are split about the continuation of that trend, sometimes named the “great rotation” from bonds to stocks, with Charles Schwab Corp.’s chief global strategist Jeffrey Kleintop anticipating the it has years to run. Amundi, which is controlled by Credit Agricole SA, says a more likely scenario is that bonds may rebound because growth will probably continue at a slow pace.

“Global uncertainties are at an unprecedented level with Brexit, Trump and elections in Europe,” Borowski said, adding the biggest risk would be a trade war between the U.S. and China. “The bond market isn’t dead yet. There are many unpredictable risks still looming and that’s why we really doubt that bond yields can jump that much. Investors will keep an exposure to U.S. Treasuries as a safe haven.”

Investors may also return to Europe, once the outcome of elections removes political uncertainty in the region, he said.

“Some investors have stayed clear of Europe following Brexit,” Borowski said. “At some point in the coming months we will be reassured concerning the political risks in Europe, especially in France, where we don’t expect French National Front leader Marine Le Pen to be elected.”

Amundi was created in 2010 when Credit Agricole and Societe Generale SA combined their asset-management businesses. It went public in 2015 to fund its international expansion as Societe Generale sold its stake.

Amundi agreed in December to buy Pioneer Investments from Italy’s UniCredit SpA for about 3.5 billion euros ($3.7 billion) in cash, bringing assets to more than $1.3 trillion and making it the world’s eighth-largest asset manager.

US Housing Finance Agencies Will Benefit from Cut in FHA Mortgage Insurance Premiums

Moody’s says on Monday, the US Department of Housing and Urban Development (HUD) announced that the Federal Housing Administration (FHA) will reduce by 25 basis points insurance premiums that borrowers pay on single-family mortgages. The premium cut is credit positive for US state Housing Finance Agencies (HFAs) because it will make FHA-insured mortgage loans more affordable to borrowers and increase HFA loan originations. The premium reduction will apply to new loans closing on or after 27 January.

HFAs are charged with providing and increasing the supply of affordable housing in their respective states for first-time homebuyers. The FHA, unlike other mortgage insurance providers, insure loans with loan-to-value ratios of up to 97%, which is key to the HFA lending base, given that first-time homebuyers often have limited funds for down payments.

The 25-basis-point decrease in the FHA’s insurance premium, which we expect will save new homeowners as much as $500 a year, also increases the competitiveness of HFA mortgage products. A lower FHA cost will attract more borrowers and stimulate stronger FHA loan originations at a time when mortgage interest rates are rising. As of 30 June 2016, FHA mortgage insurance provided the biggest share of the insurance on HFA pools, constituting approximately 38% of Moody’s-rated HFA whole-loan mortgages (see Exhibit 1), compared with 17% of mortgages utilizing private mortgage insurance.

HFA portfolio performance will strengthen because more loans will benefit from FHA insurance coverage. FHA insurance offers the deepest level of protection against foreclosure losses relative to other mortgage insurers because they cover nearly 100% of the loan principal balance plus interest and foreclosure costs. Additionally, the FHA provides the strongest claims-paying ability relative to private mortgage insurers. Although private mortgage insurers maintain ratings of Baa1 to Ba1, FHA insurance is backed by the US government.

The reduced FHA premiums will also benefit HFA to-be-announced (TBA) loan sales, which are secondary market sales using the Ginnie Mae TBA market. All loans utilizing Ginnie Mae must have US government insurance, and the FHA provides a substantial share of this insurance. Higher TBA sales will increase in HFA margins given that TBA sales have been a major driver of loan production and volume, contributing to an all-time high 17% margin in fiscal 2015, which ended 30 June 2015 (see Exhibit 2).

Will the ‘Trump rally’ continue through 2017?

From The Conversation.

So far, investors appear to be giving Donald Trump their vote of confidence.

After his election as the 45th president of the United States, the U.S. Dollar Index rallied around 4 percent through the end of the year, while the Dow Jones Industrial Average approached 20,000 for the first time in its history and the Standard & Poor’s 500 was up just under 5 percent.

So now that investors have finished their usual year-end review of where to put their money, one question is on everyone’s mind: Will the so-called Trump rally continue in 2017?

In early November, I wrote an article based on my study showing that how stocks reacted in the first few days after a president’s victory would likely determine their performance for the rest of 2016 – which turned out to be true in Trump’s case.

In a similar vein, a separate study I published in 2009 demonstrated that how a stock market performs in the January a president takes office could portend its fortunes for the remainder of the year.

So will that also turn out to be true for Trump?

‘As January goes’

In that study, which I called “The ‘Other’ January Effect and the Presidential Election Cycle,” I combined two lines of research.

First, going at least as far back as the 1940s, the so-called January effect is a well-known bias in individual stock behavior in which stocks that lose value at the end of the year tend to reverse those losses in January.

The other January effect, which I use in my study, refers to evidence published in 2005 suggesting that January’s returns hold predictive power for the remainder of the year.

More specifically, this effect claims that when stocks go up in January, they tend to continue to climb for the rest of the year, and vice versa – regardless of the impact of other usual drivers of stock market returns. On Wall Street, this effect is often dubbed: “As January goes, so goes the year.” For the rest of the article, for simplicity’s sake, I’ll call this the January effect.

Second, I combined this January effect with the four-year presidential election cycle (PEC) to see how it influenced January’s predictive abilities. The PEC refers to a cycle in which U.S. stock market returns during the last two years of a president’s term tend to be significantly higher than gains during the first two years. This cycle is especially true for the third year of a president’s term, which has almost always been positive.

For my study, I wanted to see if the timing of the presidential cycle (first year, second year, etc.) affected January’s predictive abilities. I studied monthly returns (without dividends) of the S&P 500 over the 67-year period from 1940 through 2006.

January’s predictive power

Overall, my results were consistent with the paper noted above demonstrating that positive returns in January typically portended gains during the other 11 months of the year, as well as the opposite.

They further showed, however, that January’s predictive power is most convincing during the president’s first and fourth years in office. Since, at the moment, we care most about the first year of a president’s term, I’ll focus on those results.

Over my sample period of basically 17 election cycles, I found that during the president’s first year in office, average returns for the 11 months following a positive January were 12.29 percent, while a negative January led to average losses of 7.91 percent over the remainder of the year. That’s a difference of more than 20 percentage points – or over US$200,000 on a $1 million investment.

Furthermore, I found that a positive or negative January predicted returns for the remainder of the year almost 90 percent of the time, suggesting a very strong correlation.

Recent results have been split

Since my study was published, there have been two more elections, one of which ran contrary to the January effect, while the other confirmed it.

After President Barack Obama won the 2008 election, the S&P 500 lost 8.6 percent during his inaugural month of January. But the market rallied for the remainder of the year by about 35 percent.

Conversely, after his reelection in 2012, stocks returned around 5 percent in January 2013 and, consistent with the other January effect, the market climbed another 23 percent over the remainder of the year.

What’s behind this?

So what’s driving the effect?

Exactly what drives this effect is a topic of debate. For example, I tested whether it may be driven by monetary policy, which did not seem to be the case.

A common argument for the PEC is that it reflects investor views of fiscal policy, which is why returns during the second two years of the cycle tend to be higher than the first two. Yet my most significant results were for the first and fourth years.

Nonetheless, while I did not specifically test for fiscal policy influences, it seems valid since my results showed that January’s effect appears to be the most reliable during the president’s incoming year in office. The effect wasn’t nearly as pronounced during the other three years.

So far, that seems to be the case at the moment as the “Trump rally” appears to be a response to anticipated fiscal policy.

What to expect in 2017

Of course, there is never complete certainty in the markets, especially with an unavoidably small sample size like 17 election cycles. Still, the results of my study provide compelling evidence that, particularly in the president’s first year in office, January’s returns appear to capture information that is valuable for anticipating returns for the remainder of the year.

As of Jan. 10, the S&P 500 was up about 1.5 percent for the year and near its record high of 2,282, while the Dow continued to flirt with that magical 20,000 number.

While January’s full-month returns are not yet known, history strongly suggests that investors would be wise to closely monitor the S&P 500. If January 2017 remains positive for U.S. stocks, returns for the remainder of 2017 may very likely also be positive. The opposite can also be expected.

So for investors looking ahead in 2017, as January goes, perhaps so will the remainder of 2017.

Author: Ray Sturm, Associate Lecturer of Finance, University of Central Florida

Soaring property prices put sophisticated investors in harm’s way

From the Sydney Morning Herald.

Investors whose wealth has increased through soaring property prices and rising assets face being pushed into riskier financial products as they gain sophisticated investor status, experts say.

While it may seem like an attractive option for investors to attain a “sophisticated investor” certificate allowing them to participate in complex share placements, exotic bonds and exclusive private equity deals, experts are calling for an urgent rethink of the criteria.

“There are alarming levels of financial illiteracy across all Australian demographics,” says Mark Brimble, chair of the Financial Planning Education Council and lecturer at Griffith University.

“We can’t just assume that because someone has a certain value of assets and income that they understand these products.”

As it stands, investors with net assets – including their residential property – of $2.5 million and/or a gross income of least $250,000 a year for the last two years qualify for an SI certificate signed by an accountant. This enables them to participate in pre-IPOs, IPOs and receive tax benefits for investing in Early Stage Innovation Companies (ESICs), among other things.

But as house prices have soared – the median in Sydney is up 65.9 per cent since 2012 and Melbourne is up 48 per cent – it is much easier for people to qualify for this status.

“These criterion were meant to be a significant hurdle for people,” says Peta Tilse, managing director of Sophisticated Access and founder of Cygura, a centralised online platform for sophisticated investor certification and validation.

“But it’s become very outdated and thanks to the booming property market, including the family home, opens that sophisticated investor door right up,” says Ms Tilse.

The Australian Securities and Investments Commission (ASIC) offers client consumer protection to retail investors where financial advisors deliberately miscategorise their clients or when companies fail to properly disclose their businesses. However these protections are not available to sophisticated investors.

Another law, established in 1991, automatically upgrades an investor from retail to wholesale or sophisticated if they invest $500,000 or more in one particular product.

“It’s a law not many people know about and it was made when the average full time earnings were $19,000 per year, rather than the $80,000 now,” says Ms Tilse.

What the Fed Rate Rise Means for Corporate Debt in Emerging Markets

From The IMF Blog.

In December 2016, the U.S. Fed raised interest rates for the first time in a year, and said they planned more increases in 2017.  Emerging market currencies took a bit of a dive, but overall investors didn’t overreact and run for the doors with their money.  For the bigger picture, you can read IMF Chief Economist Maurice Obstfeld’s blog that outlines how the U.S. election and Fed decision will impact the global economy.

One aspect that makes emerging markets more vulnerable is their corporations are loaded down with debt in both local and foreign currency—to the tune of roughly $18 trillion—fueled in large part by low interest rates in the United States.  This debt now makes them vulnerable to the expected interest rate increases in 2017. Will firms be able to roll over their debt?

The debt balloon

The debt of nonfinancial firms in emerging markets has quadrupled over the past decade, with bonds accounting for a growing share (Chart 1). The considerable increase in corporate debt raises concerns, given the link between the rapid build-up in leverage in emerging markets and past financial crises.


Our new paper suggests that:

  • Debt accumulation was more pronounced for firms which are more dependent on external financing. Likewise, relative to other types of firms, small and medium-sized enterprises disproportionately increased their leverage.
  • The impact of U.S. monetary policy on debt growth was greater for sectors that are more heavily dependent on external funding in financially open emerging markets with relatively more rigid exchange rate regimes.
  • Global financial conditions affected emerging market firms’ growth in debt in part by relaxing corporate borrowing constraints.

Where is debt highest

Corporate debt in emerging markets has climbed faster in more cyclical sectors, with the greatest growth seen in construction (Chart 2). The striking increase in leverage within the construction sector is most notable in China and Latin America. In addition, firms that took on more debt have, on average, also increased their foreign exchange exposures.


Rating Revisions Dispute Thin Spreads – Moody’s

Interesting piece from Moody’s today which warns:

Do not confuse the stunning rally by high-yield bonds since early 2016 with a commensurate enhancement of the fundamentals governing high-yield credit quality. Be aware of how the same overvaluation that now inflates share prices may also be responsible for an exaggerated narrowing of high-yield spreads.

According to almost every explanation of the high-yield bond spread, a recent composite speculative-grade bond yield of roughly 6% now undercompensates investors for default risk. The accompanying high-yield bond spread of 404 bp was the thinnest since the 396 bp of September 23, 2014. However, September 2014’s 2.2% EDF (average expected default frequency) metric for US/Canadian high-yield issuers was significantly lower than the 3.6% of January 4, 2017. Indeed, the combination of the 3.6% high-yield EDF and its -80 bp drop of the last three months predicts a 450 bp midpoint for the high-yield bond spread that exceeds its recent 404 bp.

Of all the major drivers of the high-yield bond spread, only an exceptionally low VIX index supports the possibility of even less compensation for default risk. More specifically, the recent VIX index of 12.0 predicts a 360 bp for the high-yield bond spread. (Figure 1.)

Market behavior of the past year suggests that the VIX index will continue to give direction to the high-yield bond spread. Nevertheless, high-yield spreads could widen amid a climb by the market value of US common stock if a narrowly focused equity rally is incapable of reversing a worsening outlook for high-yield defaults.

Downgrades jump relative to Q4-2016 rating changes

Fourth-quarter 2016’s widening of the gap between high-yield downgrades and upgrades was very much at odds with a pronounced narrowing by the high-yield bond spread. Downgrades supplied 68% of the number of credit rating changes affecting US high-yield companies in 2016’s final quarter. Previously, after dropping from Q1-2016’s current cycle high of 82% to Q2-2016’s 62%, downgrades’ share of US high-yield credit rating revisions would then sink to Q3-2016’s 54%.

The latest upswing by the relative incidence of high-yield downgrades cannot be ascribed to the oil and gas industry. To the contrary, the relative incidence of high-yield downgrades actually increased after excluding oil and gas related revisions largely because of Q4-2016’s financially-driven, as opposed to fundamentally-based, oil and gas company upgrades. More specifically, downgrades’ share of high-yield credit rating revisions excluding all changes closely linked to oil and gas would soar from Q3-2016’s 48% to Q4-2016’s 70%, where the latter was the highest such ratio since the 72% of Q1-2016.

When comparing the US high-yield rating revisions of 2016’s third- and fourth-quarters, a -48% plunge in the number of upgrades stands out. By contrast, the number of high-yield downgrades barely dipped by -4%.

After excluding revisions that were purely event driven, the number of high-yield upgrades attributed to improved fundamentals sank by -46% from the third to the fourth quarter, while downgrades stemming from worsened fundamentals edged higher by 1%.

Spreads may widen unless net downgrades subside

When the high-yield bond spread averaged 379 bp during the year-ended September 2014, not only were fundamentally driven high-yield downgrades -40% fewer, on average, compared to Q4-2016’s pace, but fundamentally-driven upgrades were +29% more numerous. Moreover, in terms of quarterly averages for all US high-yield credit rating changes, the year-ended September 2014 showed -29% fewer downgrades and +41% more upgrades compared to Q4-2016’s results. And yet the high-yield spread is now the narrowest since September 2014?

Notwithstanding the jump by downgrades’ share of US high-yield credit rating revisions both with and excluding oil and gas related changes, the high-yield bond spread still narrowed considerably from a Q3-2016 average of 551 bp to Q4-2016’s 477 bp. Moreover, as noted earlier, January 4, 2017’s high-yield bond spread of 404 bp was the thinnest since September 2014, where the latter was at the end of the just cited yearlong span of a much lower ratio of downgrades to upgrades.

The record warns of a wider high-yield bond spread unless fourth-quarter 2016’s excess of high-yield downgrades over upgrades narrows substantially. As statistically inferred from the relatively strong correlation of 0.80 between the high-yield bond spread’s quarter-long average and the moving two-quarter ratio of net high-yield downgrades to the number of high-yield issuers, H2-2016’s ratio favors a 536 bp midpoint for the high-yield bond spread. Moreover, if the net high-yield downgrades of 2016’s final quarter persist through the end of September 2017, the projected midpoint for the high-yield spread widens to 560 bp. (Figure 2.)

Equity strength enhances credit quality

The fact that the high-yield spread is now much narrower than what might be inferred from the recent excess of high-yield downgrades over upgrades underscores the critical importance of today’s superb financial market conditions to the current thinness of spreads. The considerable support now supplied to the high-yield bond market by an exceptionally low VIX index of 12.0 cannot be overstated. Once financial market conditions deteriorate, the high-yield bond market’s vulnerabilities will become apparent.

Nevertheless, today’s ample amount of systemic liquidity can facilitate a strengthening of high-yield credit quality. Injections of common equity capital enhance corporate credit quality either by (i) deepening the capital base that shields creditors or (ii) funding the retirement of outstanding debt.

Common equity capital is more likely to be secured at an attractive cost during a broad based equity rally. When the US equity market was flat to lower during the six-months-ended March 2016, only two upgrades were ascribed to injections of common equity capital. However, a subsequent rally by US shares has helped to boost the number of common-equity injection upgrades to the 32 of the final nine months of 2016.
In addition, a well-functioning equity market also boosts the number of upgrades stemming from mergers, acquisitions and divestments. After averaging 23 per quarter during the year ended September 2015, the number of upgrades linked to M&A slumped to 12 per quarter amid the soft equity market of the six-months-ended March 2016. Thereafter, stocks thrived during the final nine months of 2016 and the number of upgrades attributed to M&A rebounded to 24 per quarter, on average. Of special importance to financially-stressed high-yield issuers is how broad stock market rallies often facilitate asset divestitures that fund the retirement of outstanding debt.

Credit quality worsened amid huge equity rally of 1998-2000

The breadth of an equity market rally matters. Despite the 18.5% average annual surge by the market value of US common stock during the two years ended March 2000, the US high-yield default rate climbed up from March 1998’s 2.7% to March 2000’s 6.3%, the moving two-quarter ratio of net high-yield downgrades to the number of high-yield issuers soared higher from Q1-1998’s -2.5% to Q1-2000’s +7.7%, and the high-yield bond spread widened from Q1-1998’s 338 bp to Q1-2000’s 522 bp.

Instead of benefiting from the very strong showing by the market value of US common stock, the high-yield bond market was weighed down by the accompanying -5.9% average annual decline incurred by Value Line’s geometric stock price index, which offers insight regarding the breadth of an equity market rally. Despite the equity market’s outsized gains of the two-years-ended March 2000, the gains were narrowly focused according to the slide by the Value Line index. By contrast, the 17% surge by the Value Line index from Q1-2016 to Q4-2016 was actually greater than the accompanying 14% increase by the market value of US common stock.

As revealed by the statistical record since 1994, the high-yield bond spread’s year-over-year change in basis points shows a stronger inverse correlation of -0.82 with the yearly percent change of the Value Line index relative to its comparably measured correlations of -0.76 with the Russell 2000 stock price index and -0.67 with the market value of US common stock.

Moreover, another possibly revealing aspect of 1998-2000’s equity rally was how it occurred despite a relatively high VIX index. Though the methodology determining the VIX index has since changed, after advancing from a 1993-1996 average of 13.9 to March 1998’s 20.2, the VIX index averaged an even higher 22.7 in March 2000.

In conclusion, an extension of the ongoing high-yield rally may require a further overvaluation of the US’s already richly priced equity market. Until downwardly revised earnings outlooks proliferate, the path of least resistance for share prices may be higher. Thus, high-yield bond spreads may continue to ignore the less than favorable trend of credit rating revisions.

What Is This “Neutral” Interest Rate Touted by the Fed?

From Mises Wire.

There’s a lot of talk these days about the so-called “neutral” (or “natural” or “terminal”) interest rate projections of the Federal Reserve. In fact, their projection of this number is a key argument in their ongoing decision to keep rates at historically very-low levels for what has been an extended period of time. (Specifically, Federal Reserve officials have argued that the neutral interest rate has sharply declined in recent years, meaning that apparently ultra-low interest rates do not really signify easy monetary policy.)

What is this neutral rate? The neutral rate, it is argued, is simply the federal funds rate at which the economy is in equilibrium or balance. If the federal funds rate were at this mysterious neutral rate level, monetary policy would be neither loose nor tight, and the economy neither too hot nor too cold, but rather just chugging along at its long-run optimal potential. The underlying theory is that loose monetary policy — where the Fed’s policy rate is set below the neutral rate — can temporarily stimulate the economy, but only by causing price inflation that exceeds the Fed’s desired target (which, by the way, eventually causes overheating and a crash). On the other hand, if the Fed is too tight and sets the policy rate above the neutral rate, then unemployment creeps higher than desired and price inflation comes in below target.

In short, the neutral interest rate is one where the central bank is not itself distorting the economy. Monetary policy would really be nonexistent, as the Fed would not be altering the interest rate resulting from a free market discovery process between borrowers and savers. (This of course raises the question, why do central planners need to fabricate something that would naturally exist in their absence?) This is near where Yellen actually thinks we are these days, hence she sees little urgency in raising rates and thus lessening what, on the face of it, looks like a very loose current monetary policy.

The Theory of the Neutral or Natural Rate

Much of this neutral rate talk at the Fed is supposedly supported by the work of Swedish economist Knut Wicksell (1851–1926), who argued that the “natural” interest rate would express the exchange rate of present for future goods in a barter economy. If in practice the banks actually charged an interest rate below this natural rate, Wicksell argued that commodity prices would rise, whereas if the banks in practice charged an interest rate above the natural one, then commodity prices would fall. But that’s where Wicksell — often associated with the free-market Austrian school of economics — would cease to recognize his own ideas in current central bank thinking. Wicksell’s natural rate was a freely discovered market price in an economy, which reflected the implicit (real) rate of return on capital investments. For Wicksell, the natural interest rate was not a policy lever to be manipulated, in order to hit some employment or output goal. Yellen and the other Fed economists writing on this topic have conveniently (and probably unwittingly) co-opted Wicksell into their own Keynesian (and exceedingly un-Austrian) framework.

Can the Neutral Rate Be Used to Tweak the Economy?

That’s the theoretical explanation of the neutral or natural rate. From a more practical standpoint, one must ask: How do we even know what that neutral rate is? The neutral rate is, by its current definition, inherently unobservable, as there is no discovery process in short-term interest rates (and there hasn’t been for as long as any of us have been around). Central banks calculate the neutral rate based on their formulas and identifying assumptions about output gaps and what interest rates, according to those models, will close those gaps. Here we have an immense circularity problem: Policymakers think they know the neutral rate because the assumptions of their interventionist model that they impose on the data say so, not because they have any insight that the market would actually clear at that rate, sans intervention. There is an underlying assumption that “markets, left on their own, are wrong, while our model is right.” Moreover, they are using observable data as model inputs that are the result of interventions that are already in effect. There are no controlled experiments in economics. Only market participants, acting freely in borrowing and lending at whatever interest rates make sense for that borrowing and lending, can ever discover what the neutral rate should be.

(To give a specific example: One of the key alleged pieces of evidence that the neutral rate has fallen in recent years is the sluggish growth of productivity. But suppose the ZIRP of the Fed itself has been choking off real savings and distorting credit allocation among deserving borrowers, and hence has crippled sustainable growth in output? In this case, the Fed models would conclude, “Nope, our policy rate hasn’t been too low, look at the weak productivity growth,” confusing cause and effect.)

In fact, the circular logic is such that economists are far from an agreement on the current calculation, and their admitted model estimation errors are enormous. Contrary to Yellen’s recent monetary policy ruminations, reputable estimates using two different approaches have concluded that the Fed has set policy rates below the neutral rate since 2009.

Things get worse. It’s not merely that we can’t know in real-time what the neutral rate is; we can’t even know after the fact. Suppose the Fed gradually hikes rates, and then the economy crashes. Dovish Keynesians would no doubt say, “We told you not to tighten! The neutral rate was obviously lower than the Fed realized, and they just raised the policy rate above it.” But this isn’t necessarily so. It could be that the policy rate had been below the neutral rate for years, fostering a giant asset bubble which eventually had to collapse. Both theories are consistent with the observed outcome of modest rate hikes leading to a crash.

The great Austrian economist Friedrich Hayek stressed the role of market prices in communicating information to firms and households, and the impossibility that central planners can ever effectively calculate those prices. If the Fed’s economists think they are able to estimate what the neutral interest rate is, then we can dispense with prices altogether. The Fed’s economists can estimate the “neutral wage rates” for various types of labor, the “neutral commodity prices” for various inputs, and so forth, and issue comprehensive plans for the economy, all calculated in kind.

Of course, this is absurd. The point is, in a capitalist economy, the interest rates themselves — as determined in a competitive discovery process in the bond and credit markets — are central to the coordination of the economy. To assume experts at the Fed could determine the proper, optimal interest rate, without that discovery process, is to assume away the real-world information problems that we all can agree market prices solve. Indeed, perhaps this is why our economic problems persist?

China Hits a Fork in the Road

From The Automatic Earth

The end of the year is always a time when there are currency and liquidity issues in China. This has to do with things like taxes being paid, and bonuses for workers etc. So it’s not a great surprise that the same happens in 2016 too. Then again, the overnight repo rate of 33% on Tuesday was not exactly normal. That indicates something like a black ice interbank market, things that can get costly fast.

I found it amusing to see Bloomberg report that: “As banks become more reluctant to offer cash to other types of institutions, the latter have to turn to the exchange for money, said Xu Hanfei at Guotai Junan Securities in Shanghai. Amusing, because I bet many will instead have turned to the shadow banking system for relief. So much of China’s financial wherewithal is linked to ‘the shadows’ these days, it would make sense for Beijing to bring more of it out into the light of day. Don’t hold your breath.

Tyler on last night’s situation: ..the government crackdown on the credit and housing bubble may be serious for once due to fears about “rising social tensions”, much of the overnight repo rate spike was driven by the PBOC which pulled a net 150 billion yuan of funds in open-market operations..”. And the graph that comes with it:


It all sounds reasonable and explicable, though I’m not sure ‘core leader’ Xi would really want to come down hard on housing -he certainly hasn’t so far-, but there are things that do warrant additional attention. The first has to be that on Sunday January 1 2017, a ‘new round’ of $50,000 per capita permissions to convert yuan into foreign currencies comes into effect. And a lot of Chinese people are set to want to make use of that, fast.

Because there is a lot of talk and a lot of rumors about an impending devaluation. That’s not so strange given the continuing news about increasing outflows and shrinking foreign reserves. And those $50,000 is just the permitted amount. Beyond that, things like real estate purchases abroad, and ‘insurance policies’ bought in Hong Kong, add a lot to the total.

What makes this interesting is that if only 1% of the Chinese population -close to 1.4 billion people- would want to make use of these conversion quota, and most of them would clamor for US dollars, certainly since its post-election rise, if just 1% did that, 14 million times $50,000, or $700 billion, would potentially be converted from yuan to USD. That’s almost 20% of the foreign reserves China has left ($3.12 trillion in October, from $4 trillion in June 2014).

In other words, a blood letting. And of course this is painting with a broad stroke, and it’s hypothetical, but it’s not completely nuts either: it’s just 1% of the people. Make it 2%, and why not, and you’re talking close to 40% of foreign reserves. This means that the devaluation rumors should not be taken too lightly. If things go only a little against Beijing, devaluation may become inevitable soon.

In that regard, a remarkable change seems to be that while China’s always been intent on keeping foreign investment out, now all of a sudden they announce they’re going to sharply reduce restrictions on foreign investment access in 2017. While at the same time restricting mergers and acquisitions by Chinese corporations abroad, in an attempt to keep -more- money from flowing out. Something that has been as unsuccessful as so many other pledges.

The yuan has declined 6.6% in value in 2016 (and 15% since mid-2014), and that’s probably as bad as it gets before some people start calling it an outright devaluation. More downward pressure is certain, through the conversion quota mentioned before. After that, first there’s Trump’s January 20 inauguration, and a week after, on January 27, Chinese Lunar New Year begins.

May you live in exciting times indeed. It might be a busy week in Beijing. As AFP reported at the beginning of December:

Trump has vowed to formally declare China a “currency manipulator” on the first day of his presidency, which would oblige the US Treasury to open negotiations with Beijing on allowing the renminbi to rise.

Sounds good and reasonable too, but how exactly would China go about “allowing the renminbi to rise”? It’s the last thing the currency is inclined to do right now. It would appear it would take very strict capital controls to stop the currency from plunging, and that’s about the last thing Xi is waiting for. For one thing, the hard-fought inclusion in the IMF basket would come under pressure as well. AFP continues:

China charges an average 15.6% tariff on US agricultural imports and 9% on other goods, according to the WTO.

Chinese farm products pay 4.4% and other goods 3.6% when coming into the United States.

China is the United States’ largest trading partner, but America ran a $366 billion deficit with Beijing in goods and services in 2015, up 6.6% on the year before.

I don’t know about you, but I think I can see where Trump is coming from. Opinions may differ, but those tariff differences look as if they belong to another era, as in the era they came from, years ago. Lots of water through the Three Gorges since then. So the first thing the US Treasury will suggest to China on the first available and convenient occasion after January 20 for their legally obligatory talk is: let’s equalize this. What you charge us, we’ll charge you. Call it even and call it a day.

That would both make Chinese products considerably more expensive in the States, and open the Chinese economy to American competition. There are many hundreds of billions of dollars in trade involved. And of course I see all the voices claiming that it will hurt the US more than China and all that, but what would they suggest, then? You can’t leave this tariff gap in place forever, so what do you do?

I’m sure Trump and his team, Wilbur Ross et al, have been looking at this a lot, it’s a biggie, and have a schedule in their heads for phasing out the gap in multiple steps. Steps too steep and short for China, no doubt, but then, I don’t buy the argument that the US should sit still because China owns so much US debt. That’s a double-edged sword if ever there was one, and all hands on the table know it.

If you’re Xi, and you’re halfway realist, you just know that Trump will aim to cut the $366 billion 2015 deficit by at least 50% for 2017, and take it from there. That’s another big chunk of change the core leader stands to lose. And another major pressure point for the yuan, obviously. How Xi would want to avoid devaluation, I don’t know. How he would handle it once it can no longer be avoided, don’t know that either. Trump’s trump card?

One other change in China in 2016 warrants scrutiny. That is, the metamorphosis of many Chinese people from caterpillar savers into butterfly borrowers. Or gamblers, even. It’s one thing to buy units in empty apartment blocks with your savings, but it’s another to buy them with money you borrow. But then, many Chinese still have access to few other investment options. That’s why the $50,000 conversion to USD permission as per January 1 could grow real big.

But in the meantime, many have borrowed to buy real estate. And they’ve been buying into a genuine absolute bubble. It’s not always evident, because prices keep oscillating, but the last move in that wave will be down.


If I were Xi, all these things would keep me up at night. But I’m not him, and I can’t oversee to what extent his mind is still in the ‘omnipotent sphere’, if he still has the impression that in the end, come what may, he’s in total control. In my view, his problem is that he has two bad choices to choose from.

Either he will have to devalue the yuan, and sharply too (to avoid a second round), an option that risks serious problems with Trump and other leaders (IMF), and would take away much of the wealth the Chinese people thought they had built up -ergo: social unrest-.

Either that or he will be forced, if he wants to maintain some stability in the yuan’s valuation, to clamp down domestically with very grave capital controls, which carries the all too obvious risk of, once again, serious social unrest. And which would (re-)isolate the country to such an extent that the entire economic model that lifted the country out of isolation in the first place would be at risk.

This may play out relatively quickly, if for instance sufficient numbers of people (the 1% would do) try to convert their $50,000 allotment of yuan into dollars -and the government is forced to say it doesn’t have enough dollars-. But that is hard to oversee from the outside.

There are, for me, too many ‘unknown unknowns’ in this game. But I don’t see it, I don’t see how Xi and his crew will get themselves through this minefield without getting burned. I’m looking for an escape route, but there seem to be none available. Only hard choices. If you come upon a fork in the road, China, don’t take it.

And mind you, this is all without even having touched upon the massive debts incurred by thousands upon thousands of local governments, and the grip that these debts have allowed the shadow banks to get on society, without mentioning the Wealth Management Products and other vehicles in that part of the economy, another ‘industry’ worth trillions of dollars. I mean, just look at the growth rates in these instruments:


There’s simply too much debt all throughout the system, and it’s due for a behemoth restructuring. You look at some of the numbers and graphs, and you wonder: what were they thinking?