By: Doug Noland
Friday, December 19, 2014
It was an interesting week, including in the financial markets. We'll focus on these extraordinary market gyrations. I'll have nothing to say about the Federal Reserve, as I believe they actually had little to do with the markets.
The Russian ruble traded Tuesday as low as 79.17 to the dollar (after beginning the year at 33), before closing the week at 59.61. At Tuesday's record low, the ruble was down 20% for the day, before a late-session rally cut the loss to 5.4%. The ruble was under pressure again early-Wednesday, until major buying pushed the ruble to a 10.3% session gain. By the time of Putin's annual (three-hour) press conference on Thursday, the ruble and Russia bonds had miraculously stabilized. The world's risk markets rejoiced the thought of the deep-pocket Chinese resolving Russia's crisis: Bubble On.
If forced to venture a guess, I'd say the Chinese were actively supporting the ruble and Russian debt on Wednesday and Thursday. Early Thursday from Reuters: "China is closely monitoring the slide in the Russian rouble, the foreign exchange regulator said on Thursday, as the currency of one of its major energy importers struggles to avoid a free-fall... Chinese Foreign Ministry spokesman Qin Gang, speaking at a later news conference, added that he believed Russia would overcome its problems. 'Russia has rich resources, quite a good industrial base.
We believe that Russia has the ability to overcome its temporary difficulties,' Qin said."
And early Thursday from the South China Morning Post: "Russia May Seek China Help to Deal with Crisis: Russia could fall back on its 150 billion yuam currency swap agreement with China if the rouble continues to plunge... The deal was signed by the two central banks in October, when Premier Li Keqiang visited Russia. 'Russia badly needs liquidity support and the swap line could be an ideal too,' said Ban of Communications chief economist Lian Ping."
The South China Morning Post came later with additional articles, including "Beijing May Spend Bigger in Russia," and "Russia's Currency Crisis Poses Risks to Other Emerging Markets."
December 19 - Bloomberg: "China offered enhanced economic ties with Russia at a regional summit this week as its northern neighbor struggled to contain a currency crisis. 'To help counteract an economic slowdown, China is ready to provide financial aid to develop cooperation,' Premier Li Keqiang said... While the remark applied to any of the five other nations represented at the meeting of the Shanghai Cooperation Organization group, it was directed at Russia... Any rescue package for Russia would give China the opportunity of exercising the kind of great-power leadership the U.S. has demonstrated for a century -- sustaining other economies with its superior financial resources.
President Xi Jinping last month called for China to adopt 'big-country diplomacy' as he laid out goals for elevating his nation's status. 'If the Kremlin decides to seek assistance from Beijing, it's very unlikely for the Xi leadership to turn it down,' said Cheng Yijun, senior researcher with the Institute of Russian, Eastern European, Central Asian Studies at the Chinese Academy of Social Sciences in Beijing. 'This would be a perfect opportunity to demonstrate China is a friend indeed, and also its big power status.'"
I'll speculate that the Chinese were becoming increasingly nervous - nervous about Russia, nervous about EM and nervous about China. Global markets on Tuesday again found themselves at the precipice. The ruble collapse was inciting a more general flight out of EM currencies, bonds and stocks. Marketplace liquidity was evaporating - leading to brutal contagion at the Periphery and increasingly destabilizing de-risking/de-leveraging at the Core.
In short, Bubble Off was taking over - in yet another market "critical juncture." The ruble (miraculously) reversed course, EM rallied, global markets for the most part reversed and the "Core" U.S. equities market took flight. From Wednesday lows to Friday's highs, the Dow surged 800 points, or 4.7%. Bubble On. "Risk on" no longer does justice.
Most would likely challenge my view of the markets being on the "precipice" during Tuesday trading. Let me back up my claim. Tuesday trading saw a major Emerging Market CDS (Credit default swap) index jump to the highest level since the tumultuous summer of 2012. On Tuesday, the Brazilian real traded to a new nine-year low (trading down as much as 2.8% intraday). Interestingly, Brazil CDS surged to 268 intraday Tuesday, up from Friday's close of 212 and 153 to start the month.
Tuesday's high actually surpassed the 2013, 2012 and 2011 spikes - to the highest level since 2009.
It's worth noting that CDS traded to multi-year highs for the major Brazilian financial institutions. Banco do Brasil surged to over 420 on Tuesday before ending the week up 28 bps to 315 bps.
BNDES (Brazil's national development bank) CDS spiked higher Tuesday, before ending the week up 52 bps to 234. Banco Bradesco CDX traded to 300, before ending the week up 21 to 266 bps.
My thesis has been that the "global government finance Bubble" has burst at the Periphery.
EM sovereign, corporate and financial debt is the global "system's" weak link. Dollar-denominated EM debt in particular is unfolding crisis' "toxic" debt. Regrettably, Brazil is right in the thick of it.
Last week I wrote that the EM dollar-denominated debt dam had given way. This dynamic was clearly in play early in the week. Russia dollar bond yields traded as high at 7.88% Tuesday, up from the previous week's closing 6.76%. Ukrainian dollar yields surpassed 32.5% Tuesday, before ending the week at 26.52%. Venezuela dollar bond yields jumped to 27.85% on Tuesday, up from Friday's closing 24.28% - before ending the week at 22.29%. Brazilian 10-year dollar yields rose as high as 5.28%, up from the previous week's 4.82%. Turkey dollar yields traded as high as 4.88% on Tuesday, up from last Friday's 4.52%. Colombia yields jumped to 4.40%, up from the previous week's 4.16%.
Turkey (lira) bond yields this week traded at high as 8.60%, up from 7.62% to begin the month. The lira traded to a record low Tuesday. Indonesia yields rose to 8.48%, up from 7.70% to start December. The rupiah Tuesday traded to the lowest level versus the dollar since 1998.
South African yields this week traded as high as 8.12%, up from 7.60%. Tuesday saw the rand trade to the lowest level since 2000. Eastern European currencies were under notable pressure.
For the week, the Hungarian forint declined 4.3%, the Polish zloty 3.6%, the Czech koruna 2.5%, the Bulgarian lev 1.8% and the Romanian leu 1.7%. Iceland's krona fell 2.5% this week.
It wasn't just EM under pressure earlier in the week. Greek five-year yields traded to 9.80% Tuesday, up from the previous Friday's 9.65% close - to the highest level since the 2012 European crisis. Greek CDS traded as high at 1,178 - before closing the week at 1,025. Italian CDS traded to 165 bps Tuesday (10-month high), before ending the week about unchanged at 142. There's been an interesting divergence of late between declining sovereign yields and rising CDS prices in Italy, Spain and Portugal.
Part of my thesis back in 2012 was that a crisis of confidence in Italian debt was about to provoke a crisis of confidence in the European banking system and the euro. I believed a loss of confidence in European banks risked a major global crisis involving derivatives, counterparty issues and funding of leveraged speculation. A Bloomberg headline from Wednesday caught my attention: "SocGen [French bank Societe Generale] Default Swaps Jump to One-Year High on Russia Turmoil."
SocGen (subordinated debt) CDS traded to 225 bps on Wednesday (closed week at 200), after beginning the month at 171. An index of European (subordinated) bank CDS traded Tuesday almost back to the highs from October's market tumult. An index of European high-yield corporate debt also spiked Tuesday back to October Tumult levels. Basically, CDS has been rising just about everywhere. Japan CDS traded to 75 on Tuesday, having now more than doubled the level from September lows (to an 18-month high).
Here at home, 10-year Treasury yields traded to 2.01% Tuesday, the low going back to May 2013. The week saw more all-time record low yields in Germany (0.59%), France (0.87%), Spain (1.70%), Netherlands (0.74%) and Austria (0.75%), among others.
December 19 - Financial Times (Tracy Alloway): "Big investors have been buying hundreds of billions of dollars worth of exotic credit derivatives to protect themselves against the possibility that growing numbers of corporate bond issuers will default. Options that give investors the right to buy insurance against bond defaults have exploded in popularity this year as asset managers and hedge funds seek to affordably offset the risk of a big blow-up in credit. Trading volumes of the instruments -- known as credit index options or swaptions -- have jumped 148% in the past 12 months, with about $1.4tn of the instruments exchanging hands in 2014 compared with $573bn in 2013. 'You can buy a very leveraged bet that the market will collapse using credit index options,' said Andrew Jackson, chief investment officer at Cairn Capital. He added: 'That is definitely the hedge of choice for real money investors who don't really care that much about the level of volatility, but care about the amount of dollars they're paying to hedge against Armageddon risk.' Credit indices, such as Markit's iTraxx or CDX series, are credit default swaps (CDS) written on baskets of corporate credits that investors and traders may use to hedge, or offset, their exposure to corporate debt or to make bets on the way the underlying companies will perform. Credit index options act in a similar way to options on other assets, such as stocks, by giving the holder the right to enter into a CDS contract at a certain time in the future. According to Citigroup research, asset managers account for a quarter of the total credit index options volume, compared with 15% just a year ago."
Early-week instability evoked talk of the 1998 market crisis. A Bloomberg headline: "Memories of 1998 Rekindled in Routs From Russia to Venezuela." I was convinced in early-1998 that Russia was the likely next big domino to drop after the brutal 1997 collapse of the "Asian Tiger miracle economies." And I recall an FT article that highlighted the spectacular growth in derivatives to protect against a ruble decline. The knowledge that huge derivative "insurance" positions had accumulated convinced me that collapse was inevitable.
It's time to ponder the ramifications of accumulating hedges against "Armageddon risk" with potentially highly leveraged options and "swaptions" derivative instruments. This has become an important market issue. And it's troubling to see that the trading of these types of instruments has exploded right along with trading options on equity volatility indices (i.e. VIX, VXX, etc.).
Coincidently, I was listening to a conversation this week that went something like this: "Everyone is hedged (against market risk). Who is on the other side of these trades?"
Long-time readers know I am no fan of Credit and market "insurance." Cheap insurance invariably fuels excess on the upside of the boom, only later to ensure dislocation when the Bubble burst. Basically, Credit and market risks are uninsurable - they are neither random nor independent events (such as auto accidents and house fires). I won't this week dive back into this fascinating theoretical topic.
I believe options and swaptions on corporate Credit are exceptionally dangerous. I also believe they likely help to explain some of this year's (and this week's!) unusual market trading dynamics. Again, think "Bubble On, Bubble Off." Who is on the other side of the explosion of Credit and market insurance? Computers and models. If a customer buys an option on a CDS contract - a computerized trading system will dictate how much of the underlying instrument that must be either bought or sold to "hedge" the contract written. And as market prices change, "dynamic trading" strategies will adjust trading positions accordingly. If prices move little, there will be little to do on the trading/hedging side. If prices move a lot, there will be a major trading effort involved. Big price changes ensure a trend-following bias.
The implied leveraged in "Armageddon" trading strategies generally causes little issue. Think for example if you go out and buy a put option on the equity market 25% out-of-the-money (crash protection). For the most part, the (derivative counter-) party that wrote this market insurance has little to do or worry about - so long as the market is quiescent. But if the market suddenly is on a downward spiral, the computerized trading model will dictate that a short position be established as a partial hedge against the "insurance" written. If the market continues to decline, more selling will be required to ensure a trading position that will generate sufficient cash-flow (trading gain) to pay on the insurance contract. And as this "out of the money" option gets closer to the "strike" price, the amount of ("delta") trading necessary to hedge rises exponentially. But if the market then abruptly recovers, to avoid losses will require that this short market hedge be unwound into a rising market.
The Fed and global central bankers have had a profound role on derivatives markets. I would argue that many of these key financial "insurance" markets viable only because of central bank assurances of "liquid and continuous" markets. Certainly, the proliferation of these types of products would not be possible if not for the view that central banks will protect against market crisis. Who would write market and Credit insurance if they thought central banks weren't underpinning the markets?
The proliferation of Credit "insurance" over recent years is an especially fascinating issue. With unlimited central bank "money" printing, why not book easy profits by ensuring against Credit losses? Why not write "flood insurance" when central bankers are ensuring drought? Why not write CDS (default protection) contracts for easy returns? And those on the other side of the derivative trade can simply buy corporate debt (on leverage, of course), to provide the cash-flows to pay on the contracts. And with CDS "insurance" so cheap and liquid, it's perfectly rational for others to position aggressively long corporate Credit while purchasing option protection just in case of "Armageddon."
This has had a profound impact on Credit Availability and loose financial conditions more generally.
Actually, I think "do whatever it takes" central bank money printing coupled with zero rates has spurred risk-taking and a resulting historic Bubble throughout high-yield debt. CDS and derivatives more generally have played a profound role - creating significant unappreciated leverage on the upside of the boom. Now, with the global Bubble bursting, this "insurance" marketplace holds the potential to incite an abrupt tightening of Credit conditions (has it already started?) On the one hand, a widening of spreads and higher CDS prices will lead to some unwinding of derivative-related leveraged holdings. Worse yet, the proliferation of "out-of-the-money" option "Armageddon" protection will dictate that those that have written these derivatives short securities as the market and Credit backdrop deteriorates.
I believe that the Trillions of Credit "insurance" derivatives in the marketplace help to explain volatile and now generally unstable markets. It helps explain why high-yield CDS has gyrated over the past year - beginning the year just over 300 - jumping to 360 in February - sinking to about 290 in July, only to spike to 355 in August - to fall back to 310 in early September. Things turned only more interesting over recent months. CDS spiked to almost 370 in late-September and then drop back to 330 in early October. High-yield CDS then traded to 400 during the October Tumult, before again sinking back below 330 in late-November. CDS closed Tuesday at 406.
When the Russia currency and bond collapse unfolded in October 1998, derivative trading strategies played a significant role in overwhelming market selling pressure and resulting illiquidity. In the end, Russian banks that had written ruble insurance collapsed right along with the ruble and the Russian debt market. I have no doubt that derivatives and associated "dynamic" trading strategies will play a major destabilizing role in the unfolding global financial crisis.
And more from the FT: "The surge in trading of credit index options stands in stark contrast to the CDS market itself, which has been shrinking dramatically since the financial crisis. The derivatives were widely blamed for exacerbating the crisis and have since come under tighter regulatory scrutiny and control, including a requirement that they be 'cleared' through exchange-like central counterparties. Unlike CDS, options on CDS indices are not yet required to be centrally cleared.
'Every single month in 2014 experienced volume growth compared to the same period in 2013, which suggests the growth was not seasonal, or in response to one-off events in 2014,' the Citi analysts said. "Credit options are currently one of the fastest growing areas in credit derivatives."
There's a fascinating aspect of Periphery to Core dynamics that I believe today underpins "Bo, Bo." I've written extensively on how cracks (and even a bursting Bubble) at the Periphery work initially to funnel "hot money" flows to the bubbling Core. Importantly, this dynamic also promotes the accumulation of derivative risk "insurance" positions. First, trouble at the periphery provides impetus for the discerning to hedge mounting systemic risk. Second, an over-liquefied Core ensures readily available inexpensive insurance - cheap insurance that spurs late-cycle risk-taking and general complacency.
Indeed, this dynamic now plays a critical role in prolonged "blow off" excesses. Importantly, at the point where the Core begins to buckle this massive derivatives (hedging) trade will overhang system stability. The market cannot hedge market risk. There's no one with the wherewithal to "take the other side of the trade." The "other side" is instead a computer model, programmed to dump sell orders into faltering markets. Liquidity will inevitably become a critical problem.
A year ago this week I was invited to participate in a company event - a bull vs. bear debate. I presented my Bubble thesis, arguing against the bullish "house" view. I posed what I am convinced is a fundamental question: "Is the underlying money and Credit sound or unsound?" I also added the following: "I do not sit around worrying about my reputation or my career prospects. I am driven by two things: analytical integrity and the quality of my analysis." I would have it no other way.