“More than 15% of debt raised in the U.S. high-yield bond market has carried a rating of CCC or below, the lowest ratings given, since the start of 2021. That’s the highest share since 2007.” (FT)
- In English, lesser-quality companies are able to find funding at terms favorable to them and less favorable to you and me. Here is an example: “Leveraged buyout firms have also used the strong demand to cut themselves bumper cheques from the companies they own. Innophos Holdings used a risky type of debt called a payment-in-kind note, which allows it to make interest payments with an IOU instead of cash, to raise $175m. It used the money to pay a dividend to its private equity owner One Rock Capital, which bought the company last year.” (Source: FT)
Venture capital firm buys a company using some of their equity and some debt. The company hires an investment banker and issues a new bond. The rating agency details the risks, giving Innophos Holdings bonds a low CCC rating. Investors, desperate for a higher yield due to the Fed’s zero interest rate policy, buy Innophos Holdings bonds (individuals, ETFs, and MFs flush with new cash from investors seeking higher yields). Innophos Holdings does not use the money to expand its business, improve its balance sheet, hire new employees… No, wait for it… The money passes through them to pay a dividend to its private equity owner
It’s legal. They can do it. But fools are stepping in and won’t know what hit them until the party ends. No one knows when, of course. I can see the private equity fund managers sitting in front of some congressional committee in Washington in the not-too-distant future.
The high-yield bond market has an excellent history of providing early warnings. I’ve shared the next few charts with you before. Keep them on your radar. Here’s what to watch out for:
The following chart dates back to 1998 and tracks the daily price of the PIMCO High Yield Fund. The green line is a 50-day smoothed moving average trend line. A buy signal occurs when the price line rises above the moving average line. A sell signal happens when the price drops below the moving average line.
Notable:
- The 2000-02 Tech Bubble. The PIMCO fund declined approximately 33%.
- The 2008-09 Great Financial Crisis. The PIMCO fund declined approximately 33%.
Inflation and the Fed
To fully explain why the Fed is now trapped, we must start with the inflation premise.
The Federal Reserve has consistently argued that monetary policy is a function of their two mandates: full employment and price stability.
While the Fed has stated they are willing to let “inflation” run hot, their biggest fear is a repeat of the runaway inflation of the 70s. However, the basis of the entire bull market thesis is low rates.
As Oliver Blanchard of the Federal Reserve recently stated concerning Biden’s $1.9 trillion stimulus package:
“How this number translates into an increase in demand this year depends on multipliers. If the average multiplier is 1 (which I think of as a conservative assumption), this implies that demand would increase by 4-times the output gap.
If this increase in demand could be accommodated, it would lead to a level of output at 14% above potential, which would take the unemployment rate very close to zero.
Such would not be overheating (i.e. inflation), it would be starting a fire.”
Using the money supply as a proxy, we can compare the money supply changes to inflation.
The chart below advances M2 by 9-months as compared to CPI and the Fed Funds rate. If the historical correlation holds, the Federal Reserve will start talking about tapering monetary policy, and hiking interest rates, within the next year.
Of course, the last time the Fed started discussing similar policy changes was in 2017, which lead to the great “Taper Tantrum” of 2018 when the markets lost 20% in 4 weeks.
While much of the media is currently suggesting that interest rates are about to surge higher due to economic growth and inflationary pressure, I disagree.
In 1980, the Federal Reserve became active in monetary policy, believing they could control economic growth and inflationary pressures. Decades of their monetary experiment have succeeded only in reducing economic growth and inflation and increasing economic inequality.
In a heavily indebted economy, increases in rates are problematic for markets whose valuation premise relies on low rates.
In an economy laden with $85 Trillion in total debt, higher interest rates have an immediate impact on consumption, which is 70% of economic growth.
Importantly, note that each time rates have risen substantially from previous lows, there has been a crisis, recession, or a bear market. Currently, with rates at historic lows, consumers are rushing out to buy houses and cars. However, if rates rise to between 1.6% and 2.2% on the 10-Year Treasury, economic growth will quickly stall.
In an economy that requires roughly $5 of debt to create $1 of economic growth, changes to interest rates have an immediate impact on consumption and growth.
1) An increase in rates curtails growth as rising borrowing costs slow consumption.
2) As of January 21st, the Fed now has $7.38 trillion in liabilities and $39.2 billion in capital. A sharp rise in rates will dramatically impair their balance sheet.
3) Rising interest rates will immediately slow the housing market. People buy payments, not houses, and rising rates mean higher payments.
4) An increase in rates means higher borrowing costs and lower profit margins for corporations.
5) Stock valuations have been elevated due to low rates. Higher rates exacerbate the valuation problem for equities.
6) The negative impact on the massive derivatives market could lead to another credit crisis as rate-spread derivatives go bust.
7) As rates increase, so do the variable rate interest payments on credit cards. With the consumer already impacted by stagnant wages, under-employment, and high living costs, a rise in debt payments would further curtail disposable incomes.
8) Rising defaults on debt services will negatively impact banks that are still not adequately capitalized and still burdened by massive bad debt levels.
9) The deficit/GDP ratio will surge as borrowing costs rise sharply.
I could go on, but you get the idea.
I believe it will ultimately be the level of interest rates that triggers some “credit event” that starts the “great unwinding.
The problem for the market going forward, as noted, is that markets have priced in a speedy recovery back to pre-recession norms, no secondary outbreak of the virus, and a vaccine. If such does turn out to be the case, the Federal Reserve will have a huge problem.
The “unlimited QE” bazooka is dependent on the Fed needing to monetize the deficit and support economic growth. However, if the goals of full employment and economic growth get quickly reached, the Fed will face a potential “inflation surge.”
Such will put the Fed into a very tight box. The surge in inflation will limit their ability to continue “unlimited QE” without further exacerbating the inflation problem. However, if they don’t “monetize” the deficit through their “QE” program, interest rates will surge, leading to an economic recession.
It’s a no-win situation for the Fed.
What Happened in Texas Last Week?
The cold snap tested Texas’s highly decentralized electricity model, where power plants don’t have incentive to build reserve capacity, but are rather paid for the energy that they sell. A widespread electricity failure ensued due to freezing natural gas pipelines, as well solar and wind generation that went offline due to the weather. High demand overwhelmed the state’s grid, and Texas’s energy mix will likely be reevaluated in the wake of the outages.
The polar vortex sent Texas temperatures to the lowest level in almost a century
US oil output tumbled as a result of the frigid weather.
Source: @markets Read full article
Here is an estimate of the decline.
Natural gas output tumbled amid outages.
Source: @markets Read full article
It’s by far the largest source of electricity production in Texas.
Source: @WSJ Read full article
US Economy
- The New York Fed’s manufacturing index (Empire) showed robust factory activity in the region this month.
- Manufacturers are upbeat on future business spending.
- Input costs are rising quickly, and businesses are boosting sales prices. But the spread between input and output price indices keeps widening. Will we see some margin pressures?
- Higher output prices indicate higher consumer inflation.
We are starting to see some of these trends showing up in the news.
Source: Reuters
- Next, we have some components of the PPI index.– Construction materials (driven by lumber):
Grains:
Oilseeds:
Cars and small trucks:
Medical services:
- Boosted by the US dollar weakness, import prices (ex. petroleum) are rising at the fastest pace since 2012.
- The FOMC minutes show that the central bank remains dovish despite signs of stronger growth and higher inflation.
- Housing inventories are tumbling.
- Freight activity continues to expand as shipping expenditures hit a record high.
- Jobless claims remain elevated with no signs of tapering.
- Blomberg’s economic expectations survey is rebounding.
- The COVID situation continues to improve.
Here’s an update on Covid-19 vaccination progress by country. Israel continues to lead the world by a considerable margin, followed by the UAE. The UK and US are well ahead of other large developed countries. Quick vaccinations may help the countries on the list, but the sad reality is the world economy can’t fully recover until most of the world is safe. And that’s going to take a while.
- According to the latest reports, the nation’s economy is heating up. Boosted by the last batch of stimulus checks, retail sales surged in January
Interesting
US population over 65
All Content is the opinion of Brian J. Decker
