By Christopher Balding, Professor of Economics at Peking University, HSBC Business School, and blogger at Balding’s World.
One of the major questions facing investors and analysts of the Chinese economy is how to size up credit… or more specifically the non-performing loan risk lurking in the system.
About a year ago — a few days before Opec spooked the world with its decision to wage war on shale producers with an oil production race to the bottom, but following a few months of steady oil declines post the Fed’s decision to start signalling an upcoming tightening path — we speculated regarding a what if scenario based on the hypothetical eventuality of no petrodollars :
So, hypothetically, the world has reached its current credit limit. Which, again hypothetically, explains this kind of thing. From Citi’s credit maven, Matt King:
Put aside, for now, any fears you may have that it will be hard to sell corporate bonds at reasonable prices should lots of other people also want to sell corporate bonds.
A chart of the US high yield debt default rate, the Federal Funds Rate, and high yield spreads over time suggests years of time before anyone need fret about credit quality. Or as Robert Michele of JP Morgan Asset Management puts it:
Credit cycles don’t end because of a lack of liquidity; they end because default rates rise. That generally happens after the US Federal Reserve has finished raising rates and has removed the proverbial punchbowl. When we look at the high yield market today based on spreads versus the US Fed funds rates versus defaults, we see that issues in credit tend to come approximately 12 to 18 months after the Fed rate cycle is completed, hence the three to five year time frame we’re predicting, if we presume the Fed will do about 2 years of tightening after starting later this year.
Deutsche Bank’s annual study of defaults has landed. Thoughts on how the next cycle for corporate borrowers might be affected by flatter yields curves below, but first a reminder of just how little money has been lost to bad debts since 2009.
We can’t overstate how low overall defaults are. The 2010- 2014 cohort is the lowest 5-year period for HY defaults in modern history (quality adjusted). To protect for default risk in BB and Single-B rated bonds over this period, investors would have only required 27bps and 94bps respectively. Current EUR/USD BB spreads are 301/350bps and Single-Bs 598/527bps. Indeed in CDS, Crossover now has 10 full years of default history. The peak 5 year default period was the 12% seen in Series 8-10 (late 2007 to late 2013). Relative to its ratings, average default risk for this index should now be around 20%. So this reiterates that recent history and average history in default terms remain remarkably far apart.
Rhetorical question, just to share this chart from Dominik Winnicki and team at Barclays (click to enlarge)…
Is that the calming fragrance of sanguinity? Perhaps. Lets return to the bond market and the state of answers to the question: what will happen if, when, maybe, interest rates go up instead of down.
The fear, simply put, is that at some point there will be an awful lot of sellers of bonds, and very few natural buyers. For the corporate bond market in particular, banks don’t hold as many bonds as they used to, and can’t take the sort of risks that buying big piles of bonds when everyone else is selling would imply.
If you are in a job, say manager of a bond mutual fund, where you have to give customers their money when they ask for it, this might make you nervous. If when maybe that day comes. Read more
Over in Mac McQuown’s Sonoma Valley workshop, courtesy of Bloomberg Markets…
McQuown says his eBond will enable investors to jettison their credit risk because the swap, which is essentially a form of insurance, will cover their losses should the debtor fail. To garner such protection now, an investor must purchase a swap separately to cover a bond. Read more
Could the real cause of today’s financial malaise have less to do with greedy bankers, bad regulation and poor monetary policy, and more to do with the effects of the information technology age on banking?
That at least is the argument proposed in a new book, “The end of banking – money, credit and the digital revolution” by Jonathan McMillan, a collective pseudonym for two authors who are keeping their identities secret, but who hail from the world of banking and academia.
Not to say the financial system was free of instability before the IT age, it’s just that the way in which the instability was dealt with was entirely different. Read more
Who doesn’t like to start the day with a nice hot cup of vindication? There will be plenty of time to recognise those who have been warning about a lack of real liquidity and the chance of real volatility later. For now the question is what to do?
Credit strategist Alberto Gallo of RBS, who has been on team no-liquidity for a while, says wait and see.
What do we do now? We wait a bit longer. Our high yield macro-spread model shows cash should trade at around 500bp in € vs 400bp currently. European high yield spreads are still below last year’s tantrum levels, while US HY spreads are just getting there (508bp). Compared to previous bull market selloffs, this isn’t a short one – but could still last for a while longer.
Cross-posted from Lex Live — which is Lex’s new, free (you don’t even have to register) blog giving an insight on what Lex writers are reading and thinking…
Not that negative zone – Europe: Read more
If you buy this…
… keep reading. Read more
From UBS’s Wang Tao on the sharp slowdown in Chinese credit creation last month (with our emphasis):
China’s July credit data came in sharply weaker than expected. July new RMB lending declined to 385 billion from 1.1 trillion in June. More importantly, new total social financing (TSF) was only RMB 273 billion, led by the drop in new bank lending and a 400 billion shrinkage of bank bill acceptances. As a result, credit growth slowed visibly and our credit impulse plummeted (Figure 1).
Given recent signs of further policy easing and persistently low interbank rates, the market has been expecting additional monetary and credit support. Today’s credit data are therefore a negative surprise. However, we do not believe these data reflect a credit tightening by the PBC – as evidenced by recent policy intentions expressed by the Politburo and the central bank, as well as ample interbank liquidity and strong credit growth in June which surprised on the upside.
RBS have joined the chorus of concerns about dangers in credit markets from thin trading volumes and a lack of risk takers making markets.
The bank also, it turns out, has a measure for trading lubricacity:
Our Liquid-o-Meter shows liquidity in the credit markets has declined around 70% since the crisis, and it is still falling. We define liquidity as a combination of market depth, trading volumes and transaction costs: all have worsened. We also measure the premium for illiquidity: it is at a record low, meaning investors are not getting paid to take liquidity risk.
More on the topic of liquidity, which we’re choosing to understand as the ability to buy or sell when you want to without paying a lot for the privilege. Markets composed of rational, or at least reasonably calm, buyers and sellers. That sort of thing.
From San Francisco comes a video of JP Morgan’s Jan Loeys, shot in the straight-to-camera style of a 1970s news bulletin which lends the whole thing a certain gravitas. The message is to think about liquidity, and to prepare for its possible absence. Read more
You may detect a sceptical tone there, but the question is real: does it matter if something unexpected occurs in the world of credit and rates?
We’ve been on this point for a while — assessment of risk is sticky, until it’s not — but were struck by a recent conversation with a market maker about his clients:
Everyone is acting like an LTCM.
How much forecasting, we wonder, amounts to ‘the present, plus or minus a bit’.
Not because it is a bad way to make predictions, rather that if there has been little change for a long time in something like benchmark interest rates, the expectation for change itself is likely to shrink. Eventually it becomes hard to imagine anything much different from the present at all.
Thoughts which arise thanks to Gary Jenkins, Chief credit strategist for LNG Capital, who draws our attention to an unscientific poll taken at the recent European Leverage Finance Conference. Read more
We detect a theme. It may be that with financial markets becalmed a new subject is needed. Perhaps it reflects the way Piketty has become an instant bookshop-to-shelf classic, but something has investment strategists reaching for insight from an eighth century theologian.
“And those people should not be listened to who keep saying the voice of the people is the voice of God, since the riotousness of the crowd is very close to madness.” — Alcuin to Charlemagne, 798 A.D. Read more
That’s the title of the latest from Matt King, one of the credit strategists we dubbed “bearullish” earlier this year.
King is short-term bullish on credit but, in his own words, “for all the wrong reasons”. He believes that the combination of the remarkably supportive liquidity environment of the past few years and the lack of better alternatives will remain in place for a while — even as credit fundamentals keep deteriorating and valuations become less and less attractive. Read more
Some expansive credit-related thoughts arrive from Alberto Gallo at RBS, for a quiet May Day when Europe’s capitalists take the day off in honour of its workers.
In short, its the safe stuff that may not be safe anymore as/if/when the continent’s economy expands: Read more
Returning to that theme of sticky risk, the search for yield and returns and what happens when the Federal Reserve et al point towards the exit, here are some charts of the divergence between fundamentals and markets courtesy of Matt King at Citi.
The point, as ever, is that while the Fed is handing out donuts then you want to grab your share. But everyone has been eating free food for a long time now, and there are a lot of fat and happy credit investors to fit through the door when the donuts run out… Read more
Our broad US outlook for 2014 is that it represents an inversion of the situation from the start of last year: while the conditions for economic growth in the US now seem better than they were then, the prospects for debt and equity markets are much more complicated.
It’s easy to understand this flipped dynamic in equities. After a 30 per cent return in the S&P 500 last year, stocks are widely thought to be either fairly priced or perhaps a little overpriced, making it tough to know what happens next. Read more
From where this blogger is sitting WMPs do a pretty good job of summing up the different ways of looking at what is going in China at the moment. On the one hand you have those who see WMPs more as “off-balance-sheet deposit rate liberalisation, with a twist of risk” which are a useful tool on the liberalisation path, and on the other hand you have the Weapons of Mass Ponzi-focused brigade. Read more
We don’t know exactly what next year’s Asset Quality Review will involve yet, but we are starting to get a picture of what investors think about the ECB’s forthcoming burrow through bank balance sheets.
In short, given that it might not be all over until the end 0f 2014, everyone is feeling pretty good about the banks right now, and that might explain a surge of appreciation for European stocks. Read more
On the danger or not of China’s inflation rate:
Is this hundreds of basis points safer than the Greek government?
You might well ask. Read more
We missed this speech by Lord Hope, the former Deputy President of the UK Supreme Court, last week. Shame.
It covers the plight of Rangers Football Club, the Insolvency Act 1986; why legal textbook writers don’t have to be dead before you can cite them any more; and the implications of the court’s May decision in the Eurosail case — one of the most important judgments for securitisation law in years. Read more
These sorts of charts have been bothering a lot of people lately, including us:
This one, via UBS’ George Magnus, shows China’s debt back near a 2009, stimulus-era ratio. Only, this time, it’s without the stimulus-era boost to the economy. Read more
Every strategist around, it seems, was expecting an increase in China’s growth rate after the recent credit surge. Of course… it didn’t happen.
Yet much of the reason for those expectations of credit tightening are still there: credit really surged, particularly in March. Read more