Stellar 3Y Auction: Highest Bid To Cover Since Sept 2015, Foreign Demand Surges

Unlike last month"s ugly 3Y auction, today"s just concluded sale of $24 billion in 3 year paper was stellar, stopping through the When Issued 1.934% by 0.2bps, a surge in buyside demand as the Bid to Cover jumped from 2.76 to 3.15, the highest since September 2015, while Indirect Bidders took down the most since August.

The details: the high yield was 1.932% vs six previous auction average 1.572%, it stopped through the WI of 1.394%.

The Bid-to- cover was 3.15, up from 2.76 in October, and well above the previous six auction average of 2.88.

Dealers were awarded 33.6%, slightly below the six previous auction average 35.2%, and down from 37.5% last month, while Direct bidders took down 7.4%, below last month"s 9.0%, and down from the six previous auction average 8.8%.  Finally, foreign central banks and reserve managers, i.e., Indirect bidders were awarded 59.0% vs the 6auction average 56.0%, and up from 53.5% last month. It was also the highest Inidrect award since August 2017.

Overall, a very solid auction and one which sets the stage for today"s second, benchmark bond auction of 10Y paper set for 1pm.

Tailing 2Y Auction Prices At Highest Yield Since September 2008 As Foreign Buyers Stay Away

With 2Y yields having jumped sharply in recent week, it was not surprising that today"s auction of $26 billion in 2Y paper would have a high yield, and sure enough, printing at a high yield 1.765%, the highest since September 2007, tailing the When Issued 1.763% by 0.2bps, and well above the six previous auction average of 1.410%. This was the third consecutive tailing 2Y auction.

The internals were hardly impressive, with the bid-to- cover of 2.725, lower than both last month"s 2.74 and also below the six previous auction average 2.91.  In fact, it was the lowest since January"s 2.682%, with total bids of $72.3bn for $27.4bn in notes sold vs six previous auction average of $78.0b in bids for $28.3b in notes sold.

Also not surprising perhaps is that foreign buyers were less than enthusiastic, with Indirect bidders awarded only 41.9% of the auction, down sharply from last month"s 48.2%, and below the 6 month moving average of 51.7%. It was also the lowest since December 2016. Dealers were awarded almost the same, or 41.2%, far higher than the six previous auction average 32.7%. Finally, direct bidders received 17% of the auction, roughly in line with the 17% average of the prior 6 auctions.

Overall, the auction confirms that investor interest for the short-end of the curve is waning, and suggests that more rate hikes by the Fed are coming, which in turn will push the 2Y yield even higher, further steepening the yield curve in the coming days.

The Perfect Storm (Of The Coming Market Crisis)

Authored by Lance Roberts via RealInvestmentAdvice.com,

It is always refreshing to step away from the keyboard for a few days and hit the “reset button,” which is exactly what I did last week. My wife and I took a quick trip to Mexico to get a little sun on our face while we wiggled our toes in the sand.

I came back astonished.

Over my 30-odd years of working with money in various capacities, I learned to “shut-up and listen.” This is particularly the case when you are in an airport lounge or packed like sardines in a missile-shaped tube hurling through the air at 35,000 feet.

People love to talk…if you let them.

I had a dozen “listening sessions” with a wide variety of people who each told me roughly the same thing summarized as follows:

1. The market is a “can’t lose” proposition.


2. So is “Bitcoin” (even though they had no idea what it really is when I asked them.)


3. The market is only going higher from here because the Fed won’t let it go down.

You get the idea.

And just when I thought I was sure I had the most bullish views wrapped up – Kevin Matras fro Zack’s Research hit my inbox with the following:

“The S&P will double. And not just eventually. But over the next 5 years (or sooner).

 

Sounds like a Herculean task on the surface, but it’s really not. In fact, the market only needs to gain on average of 14.9% per year in order to do so. That’s not such a stretch given the market has been averaging 14.9% per year since this bull market began in early 2009, even though GDP (prior to this year) has only been increasing at an anemic 1.48% annual rate.

 

My 5-year doubling thesis also means that we won’t see another recession until stocks double again, nor will we see another bear market until stocks double again.“

So, there you have it.

No bear market until the market racks up another 2600 points and dwarfs every other economic growth cycle in history.

Meanwhile….Back On Earth

Before I go further, let me clarify one thing.

As a portfolio manager, I am neither bullish nor bearish. I don’t really care which way the market is headed personally. If it is rising, as it is now, I am long equities. When it reverses that trend, I will either be short equities and long bonds and cash.

That’s my job.

My job is also to pay attention to the risks that could quickly remove large chunks of investment capital from my client’s portfolios. Like any professional gambler knows, you can only play the game as long as you have a “stake” to play with. Lose your capital, and you lose the game. 

The Perfect Storm Cometh

In the movie, “The Perfect Storm,” George Clooney plays the Captain of the “Andrea Gail.” The Captain, after having a bad start to the fishing season, convinces his crew to go out one last time and they venture well past their usual fishing grounds leaving a developing thunderstorm behind them. After ignoring repeated warnings, a desperate Captain, and crew, head into a confluence of two powerful weather fronts and a hurricane in order to cash in on their bounty.

They all died.

Investors today, after having missed out on the first few years of the current bull market cycle, have now decided to throw all caution to the wind and ignore the repeated warnings in hopes of attaining the “riches” they have been promised.

And, like the “Andrea Gail,” they are currently heading into a perfect storm.

Storm One

Currently, there are many articles pointing our various risks in the market. One that caught my attention over the weekend was a note on the volatility index by Kevin Muir.

“For the longest time, I felt the concerns from the VIX were overblown. For years, market pundits have been bandying about charts meant to scare investors about the potential dislocation in the VIX market. I even wrote a piece called, The VIX Article no one will like.”

He is right.  For the last several years, each time the volatility index hit new lows, there were fears of a massive reversal on the horizon. Yet stocks marched higher while the volatility index made even lower lows.

But Kevin goes on to make an important point:

“Yet the frenetic pace of VIX shorting has intensified to a level that frightens me. There is now $1.2 billion of market cap of the inverse VIX ETF XIV, with another $1.3 billion of SVXY (another inverse ETF). This is insanity.

 

If we get a sharp move higher in VIX, there will be a snowball effect. If it is big enough, monster positions, like $2.5 billion of short VIX ETFs will have to be bought back in a hurry. And let me break it to you, there is no one large enough to take the other side of that trade. At least no one willing to do it without extracting many pounds of flesh first.”

Kevin is absolutely correct.

The only question is how far does it have to rise before the “margin calls” begin to occur. More importantly, volatility runs very long cycles which, unsurprisingly, follow the psychological investment cycles of the market from fear to greed back to fear.

But that is not the only problem.

Storm Two

Once the $VIX trade begins to fail, investors will find themselves almost immediately confronted the “high-yield bond storm.”

American corporations are levered to the hilt with total corporate debt surging to $8.7 trillion – its highest level relative to U.S. GDP (45%) since the financial crisis. In just the last two years, corporations have issued another $1 trillion of new debt NOT for expansion but primarily for share buybacks to boost bottom line earnings per share.

Note: This is also why “repatriation” won’t lead to massive economic growth, wages or employment. Instead, it will go to share buybacks, dividends, and executive compensation. 

For the last 9-years, the Fed’s “zero interest rate policy” have left investors chasing yield and corporations were glad to oblige. The end result is the risk premium for owning corporate bonds over U.S. Treasuries is at historic lows.

I have written for some time that during the next market reversion, the 10-year rate will fall towards “zero” as money seeks the stability and safety of the U.S Treasury bond. However, corporate bonds are an entirely different issue. When “high yield,” or “junk bonds,” begin to default, as they always do, which is why they are called “junk bonds” to begin with, investors will face sharp losses on the one side of their portfolio they “thought” was supposed to be safe. 

Let the panic selling begin.

As shown below, when the rout begins, the yields on junk bonds sharply deviate from that of the U.S. Treasury bond. Again, the 10-year Treasury rate is not going higher anytime soon, but everything else likely will.

Storm Three – The Hurricane

Of course, as investors begin to get battered by the “volatility and junk bond storms,” the subsequent decline in equity valuations begins to trigger “margin calls.” 

As the markets decline, there will be a slow realization “this decline” is something more than a “buy the dip” opportunity. As losses mount, the anxiety of those “losses” mounts until individuals seek to “avert further loss” by selling.

There are two problems forming.

The first is leverage. While investors have been chasing returns in the “can’t lose” market, they have also been piling on leverage in order to increase their return.

It is often stated that margin debt is “nothing to worry about” as they are simply a function of market activity and have no bearing on the outcome of the market.

That is a very short-sighted view.

By itself, margin debt is inert.

Investors can leverage their existing portfolios and increase buying power to participate in rising markets. While “this time could certainly be different,” the reality is that leverage of this magnitude is “gasoline waiting on a match.”

When an “event” eventually occurs, it creates a rush to liquidate holdings. The subsequent decline in prices eventually reaches a point which triggers an initial round of margin calls. Since margin debt is a function of the value of the underlying “collateral,” the forced sale of assets will reduce the value of the collateral further triggering further margin calls. Those margin calls will trigger more selling forcing more margin calls, so forth and so on.

That Sinking Feeling

Unwittingly, investors have compounded their risks by piling into exchange-traded funds under the mistaken assumption it is an “easy way to invest.”

Over the past 9-years, the number of ETF’s available to investors has now eclipsed the number of stocks available for them to invest in. This leads to a liquidity problem and the risk of a “disorderly unwinding of portfolios.” As the head of the BOE, Mark Carney, warned:

“Market adjustments to date have occurred without significant stress. However, the risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.”

The issue of liquidity is not a small one.

Investors mistakenly assume there is ALWAYS a buyer at the price at which they wish to sell. 

This is wrong.

While the answer is “yes,” as there is always a buyer for every seller, the question is always “at what price?” 

At some point, that reversion process will take hold. It is at that point where the storms all collide into a massive wave of panic driving selling. It will not be a slow and methodical process, but rather a stampede with little regard to price, valuation or fundamental measures.

It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause catastrophic spreads between the current bid and ask pricing for ETF’s, junk bonds, and option pricing. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments.

Don’t believe me? It happened in 2008 as the “Lehman Moment” left investors helpless watching the crash.

Over a 3-week span, investors lost 29% of their capital and 44% over the entire 3-month period. This is what happens during a margin liquidation event. It is fast, furious and without remorse.

Currently, with complacency and optimism near record levels, no one sees a severe market retracement as a possibility. But maybe that should be warning enough. 

Where the majority of mainstream punditry gets it wrong, in my opinion, is they keep saying we “can’t have another ‘great financial crisis’ again” because things are different.

That’s true.

NO market “mean reverting” event has EVER been based on the same issues that caused the previous event.

The next event won’t be the same as any past event either.

Only the outcomes remain the same.

The “perfect storm” is coming.

Before You Book That Vacation, JPM Warns Multiple Spoilers Are Converging In November

One week ago, Jan Loeys - the person who wrote "The JPMorgan View" for 15 years - announced his exit, as he transitioned from tactical asset allocation to longer-term strategy, and that he would be handing over the authorship to John Normand, and soon Nikos Panigirtzoglou and Marko Kolanovic, but not before summarizing what he has learned in 30 years of investing in a must-read bulletin which he published last week.

In any case, this weekend it was Normand"s turn to regale JPM"s countless retail and institutional clients with a preview of the upcoming key "spoilers" which according to Normand boil down to 3: a reality check on US tax reform, weaker-than-expected China data, and a Russian rethink on extending oil cuts. Not surprisingly, JPM focuses on the first issue, because as Norman writes, "tax overhaul seems the most complicated market driver given its fluid composition and tortuous legislative process."

By contrast, China’s slowdown looks familiar and was already part of our economists’ baseline; hence, our neutral recommendation on base metals ex aluminum. The November 30th oil producers’ summit is not a drop-dead date for extending their year-old agreement, but we took profits anyway on a long Brent trade last week because oil’s geopolitical premium looked excessive.

For those curious what the largest US bank thinks will be dominant events over the balance of the month, here it is straight from the horse"s mouth.

How much tax reform is priced?

 

Readers of The J.P. Morgan View may realize that this edition is the first in 15 years without Jan Loeys as lead author. Jan has transitioned from tactical asset allocation to longer-term strategy. The View will now be authored by a different team, which hopefully maintains Jan’s succinctness and relevance while introducing complementary approaches to cross-asset strategy.

 

The growth trade that has dominated markets since late summer – higher yields, equities and commodities; tighter credit spreads and lower volatility – has stalled for a third-consecutive week, depending on one’s benchmark. US small cap stocks, probably the best barometer of US tax reform hopes, peaked in early October. Base metals began moving lower a week later. Most major stock indices are flat-to-down over the past week while credit spreads have widened (US high-grade +5bp, US high yield +20bp) and volatility has rallied (VIX +2%, VXY +0.5%) To be sure, these retracements are trivial relative to what risky markets have delivered year-to-date: returns are still running at least twice their long-term average for most equity markets, and in some EM sectors (local bonds, FX carry).

 

Multiple spoilers are converging in November, such as a reality check on US tax reform, weaker-than-expected China data, a Russian rethink on extending oil cuts. We’ll focus on the first issue, because tax overhaul seems the most complicated market driver given its fluid composition and tortuous legislative process. By contrast, China’s slowdown looks familiar and was already part of our economists’ baseline; hence, our neutral recommendation on base metals ex aluminum. The November 30th oil producers’ summit is not a drop-dead date for extending their year-old agreement, but we took profits anyway on a long Brent trade last week because oil’s geopolitical premium looked excessive.

 

The central question around tax reform should be What’s priced? Obviously the higher the expectations, the less upside on stocks and maybe bond yields and the dollar into year-end if Congress meets its somewhat unprecedented timetable of passage by Christmas. Conversely, another stalemate as befell healthcare reform could trigger a decent correction. We call Congress"s schedule somewhat unprecedented because proper tax overhaul like Reagan"s involving both lower rates and simplification required over 10 months to agree, as measured from the first House vote to Presidential signature. Just cutting taxes has been easier: Clinton’s initiatives in 1997 and Bush"s in 2001 and 2003 only required two months.

 

The Trump Administration has proposed Reagan-like reform, but our economists’ view has been that Congress will probably only manage Bush-like cuts. This means $1.5trn of gross unfunded tax reductions over 10 years, but more like $1trn net due to expiring provisions. These sums translate into little growth impulse once considered in annual increments, then discounted further to account for household and corporate tendencies to save some portion of tax givebacks. JPM Economics didn"t raise 2017 or long-term growth estimates after Trump"s election, nor after his tax proposal emerged in October. We’re still at 2.2% yoy for 2018.

 

 

Strangely given surging news trends around the tax topic, most survey and market-based measures suggest limited optimism. For example, consensus growth expectations (Blue Chip survey) have barely moved since the election. In January 2017, forecasters expected 2018 US growth of about 2.4%; that projection only risen to 2.5% since. It’s true that the S&P500’s forward P/E multiple has risen by about two points since the election, but EPS projections for 2018 (IBES basis) have not – they’ve been in a $146-$148/share range since November 2016. The implied 10% year-on-year growth in earnings next year would match 2017’s pace, even next year should deliver stimulus. By contrast, our Equity strategists think that just lowering the statutory corporate tax rate from 35% to 20% would add $12/share boost to any baseline.

Hunting Angels: What The World"s Most Bearish Hedge Fund Will Short Next

It"s not easy being "the world"s most bearish hedge fund", a description we first conceived nearly three years ago, and one look at Horseman Capital"s returns over the past three years confirms it: after generating market-beating returns for much of its existence, things went bad in 2015, and much worse in 2016...

... when the Fund had a record net short equity position of over -100%, just as the market ripped higher after the Trump election.

That said, 2017 has been much better for Horseman and its CIO Russell Clark, who correctly timed the year"s two big short trades so far: the mall REIT and the shale shorts.

Unfortunately, his other positions stood in the way, and as of the end of October (a good month with 2.04% in P&L), the fund is just 0.25% up on the year. Worse, after a period of calm, steady, upward grinding monthly performance for much of the previous several years, Horseman"s sharpe ratio has cratered, as the monthly return variance surged, with a -6% month following two +7% months as a result of gross leverage that has never been higher, even if the net equity position - while still largely short - is far more manageable than it was in 2016.

Still, having been well ahead of the pack on the two big shorts of 2017, most money managers are always curious what if anything Clark - and Horseman - are shorting next. Well, they are in luck, because in his latest letter, he unveils the answer: according to Clark, the next major source of alpha will be shorting fallen angel bonds.

In his November letter to clients, Clark explains why he is hunting for soon to be "fallen angels", and where he got the idea from. And after more fund managers read the following excerpt, we have a feeling that the next big leg lower in not only junk, but also crossover credit, is imminent:

Mifid II will come into force soon, and a lot of research that used to be free, will need to be paid for. This has been a reason to ask ourselves some serious questions, namely what research do I read, and what has made me the most money. Strangely the research that has been most profitable for me, will remain free even post Mifid II as it is publicly available. The International Monetary Fund produces Global Financial Stability Reports. The stand out report for me was the April 2008 report that highlighted Eastern European banks vulnerability to wholesale funding. I shorted many of the banks named in the report. Most fell 70% to 90% subsequently.

 

What does the most recent issue of the Global Financial Stability Report have to say? It notes that BBB bonds now make up nearly 50% of the index of investment grade bonds, an all time high. BBB bonds are only one notch above high yield, and are at the greatest risk of becoming fallen angels, that is bonds that were investment grade when issued, but subsequently get downgraded to below investment grade, or what is known these days as high yield. It then points out that investors have never been more at risk of capital loss if yields were to rise. In addition, it notes volatility targeting investors will mechanically increase leverage as volatility drops, with variable annuities investors having little flexibility to deviate from target volatility. Another interesting point was that mutual fund share of the high yield market in the US have risen from 17% in 2008 to 30% today, and notes that investors outflows have become much more sensitive to losses than they used to be.

 

So my favourite research (love the price!) is telling me that US investment grade debt is very low quality, and could produce some large fallen angels. It then goes on to tell me that mutual funds are much larger in the high yield market than they used to be. It also tells me low rates means the capital losses are much higher than they used to be. And that investors in high yield mutual funds are much flightier than they used to be! Essentially the IMF are telling me that if you get a large enough fallen angel, the high yield market will freak out, and volatility will spike causing volatility targeting investors to dump leveraged positions. Sounds good to me - but with growth so good and the market so strong, how on earth would we get a fallen angel?

 

To find a potential fallen angel, I looked through the holdings of investment grade bond ETFs to find large BBB bond issuers. The biggest of the BBB issuers happened to be the large telecommunication companies. The sector has over USD300bn of BBB rated debt compared to a high-yield market of USD 1tn. I am not a debt specialist, but I have noticed that falling share prices tend to be good lead indicators on debt downgrades, and the US telecommunication sector has not been participating in the market rally this year. The story looks good to me, and it comes via my favourite research source. US debt markets look in trouble to me, whether that has any effect on broader equity markets remains to be seen.

Aside from this rather original idea, some other notable changes in Horseman"s industry exposure are noted: while both the retail and E&P shorts are still there, they have been notably tamed, and of note are two other major shorts (both in the US): one in real estate (we assume this is a play on the adverse impact of rising rates on real estate valuations), and the healthcare sector, a short whose thesis is quite interesting and we will reveal tomorrow.

For those wondering, the top 10 positions by % of NAV are the following:

Needless to say, we wish Horseman much success with a prompt realization of his BBB-short, especially since it appears that his LPs are starting to get cold feet, and the fund"s AUM has shrunk by half from $2.8 BN  one year ago...

... to less than half, or $1.2BN currently.

"Nightmare On Bond Street": HY Turmoil Leads To Third Largest Junk Outflow In History

Following this month"s drop in junk bond prices and the 40 bps spread widening in high yield last week - the largest since November 2016 - Bank of America has come up with an apt title for its weekly fund flow report: "Nightmare on Bond Street"...

... and with good reason: last week, US junk bond funds and ETFs reported a $4.43bn outflow this past week - the third largest outflow on record and the largest since August 2014. This follows a smaller $0.94Bn outflow the prior week. Non-US HY contributed an additional $2.3bn worth of redemptions, bringing the global junk outflow figure to -$6.7bn, also the 3rd largest ever.

The near record outflows accompanied the second most aggressive round of selling in the US junk bond market in 2017. The weakness in performance only trails a sell-off that occurred in March, when spreads widened by 61 points in less than three weeks according to FT.

“It was very much a flows driven sell-off last week and in the beginning of this week,” said Tim Schwarz, a credit analyst with Investec Asset Management. “We saw a lot of . . . pockets of illiquidity.”

According to EPFR, roughly half of the US HY withdrawals came last Friday, when more than $2bn left the space in one day. Since then, the outflows have been slowly declining each day, from $585mn on Monday to $494mn yesterday. Somewhat surprisingly, large outflows such as the most recent bout are not correlated with subsequently weak performance. In fact, out of the 15 largest-ever daily high yield outflows recorded, next 3 month returns have been positive 10 times, with an average annualized return of 7.2%. According to BofA, this is likely because most of the spread widening occurs just before the flood of withdrawals, providing an opportunity to capture excess returns should the selloff prove to be temporary. Indeed, as BofA"s credit strategist note, given Thurdsday"s strong secondary performance, "we think such is likely to be the case in last week"s episode as investors have once again embraced a buy-the-dip mentality."

In contrast, EPFR also reports that flows for other fixed income asset classes were relatively stable. However, the large outflows from high yield and loans resulted in a net $1.32bn outflow from all bond funds and ETFs, after a $2.27bn inflow in the prior week.

Inflows to high grade were little changed at $3.31bn, down from $3.41bn a week earlier. Inflows to short-term fixed income increased (to $0.65bn from $0.27bn) while inflows outside of short-term declined (to $2.66bn from $3.15bn). Inflows were higher for high grade funds (to $1.83bn from $1.52bn), but lower for ETFs (to $1.48bn from $1.89bn). Inflows to global EM bonds weakened to $2.66bn from $3.15bn, mostly driven by local currency funds / ETFs. Inflows to munis instead improved to $0.34bn from $0.28bn. Finally, inflows to money markets were close to flat at $0.02bn, down from a $7.58bn inflow in the prior week.

Speaking to the FT, Robert Cusack, a PM at WhaleRock Point Partners, said that the recent high-yield sell-off could be short lived, likening it to the brief but rapid move higher in credit premiums earlier this year. But Cusack added that he is still looking to reduce exposure to the asset class.

“It’s a topic each week in our investment committee meetings and we have been discussing the risk reward in high yield now,” he said. “Our next move is to reduce our exposure in high yield.”

Meanwhile, there were no problems in equity land: flows to stocks improved to a $3.2 billion inflow, which however once again masked an ongoing divergence, as $9.9bn of this amount went to ETFs. Active, i.e., human managers, saw another outflow, this time for $6.7 billion as the non-ETF financial sector continues to die a slow, painful death.

Albert Edwards On The Selloff: "Comparisons With October 1987 Are Entirely Justified"

Last week, when equities were still blissfully hitting daily record highs, we showed the one "chart that everyone is talking about", or if they weren"t they soon would be: the sharp, sudden disconnect between the junk bond and stock market ...

... a disconnect which - as we showed at the time - was last observed in mid-August 2015, just days before the infamous ETFlash crash. Fast forward to day, with stocks suddenly hitting air pockets around the globe and rapidly catching down to junk yields...

... when this enveloping divergence between the conflicting narratives by equities and bonds was the center piece of Albert Edwards latest letter to clients. In it, the SocGen strategist highlights the ZH chart and, ever the pragmatist, wonders why it took not only stocks, but junk bonds so long to react to the steady deterioration in underlying balance sheet quality, a topic discussed most recently by his colleague Andrew Lapthorne...

...  who showed that "interest coverage for the smallest 50% of US companies is near record lows, at a time when interest costs are extremely depressed and when profits are at peak." Lapthorne"s conclusion, which echoed what the IMF said earlier in the year, "It is difficult to envisage a scenario in which this ends well."

Albert picks up on this theme in his latest note released today, and writes that "investors are beginning to punish the corporate debt and equity of highly indebted US companies. We have highlighted consistently that excess US corporate debt is probably the key area of vulnerability that could bring down the QE inflated pyramid scheme that the central banks have created."

To demonstrate this point, Edwards shows another bizarre "balance sheet debauchment" divergence, one between surging leverage, and record low junk bond yields, to wit:

... we think the high yield corporate bond market should have been revolting against balance sheet debauchment some time ago. That would be the normal state of things with net debt/profit ratios so very high (see chart below but note bottom-up data shows a far higher peak than this top-down Fed data but peaks normally occur as profits fall in recession).

As the chart above suggests, junk bond yields would have to be double current levels to be aligned with "fair value" as imputed by the current state of the corporate balance sheet, however with the ECB purchasing billions in corporate bonds every month, this clearly won"t happen for a long time.

Edwards also show a chart revealing why the US is unique among the major developed regions: only there has corporate debt bloated to levels last seen during the great financial crisis. As for the reason, we just discussed it earlier: all bond issuance has been used to fund stock buybacks, pushing the S&P to all time highs.

And speaking of the final frontier, i.e. equities, which are always the last to get any memo, Edwards"s biggest concern is the sheer euphoria and that various sentiment indices - such as the record expectations of higher market moves 12 months forward as per UMich - have reached extremes of bullishness which have rarely been seen. One among these is the Investor Intelligence Sentiment Survey.

CNBC reports that “the roaring stock market has professional investors riding high, so much so that it"s rekindling memories of the 1987 crash. In terms of sentiment, the difference between bulls and bears hasn"t been this high in 30 years, according to the latest Investors Intelligence reading… Investor Intelligence editor John Gray noted, sentiment readings have roughly followed their 1987 pattern. Then the bulls  peaked (near 65%) with initial market highs early that year and they returned to above 60% levels months later after more index records. In 1987 stocks crashed a few months after that. A repeat of that scenario suggests potential significant danger for over the remainder of 2017!" – see see chart below. Strangely we only recently compared the current conjuncture with 1987 in terms of valuation excess combined with extreme macro and market bullishness .?

Between the recent reality check for junk bonds, and the sudden decline in equities, Edwards believes that "comparisons with October 1987 are entirely justified." Still, there have been so many headfakes in the past 9 years, could this be just the latest one? Here are Edwards" 2 cents on how to decide:

"the market itself can signal a top. For example, I remember in early 2000 our then Japan Strategist, Peter Tasker, warning that the tech heavy Jasdaq index had turned down sharply ahead of the Nasdaq March 2000 peak. I also remember our technical analyst pointing out the significance of the Nasdaq Composite failing to follow the lead of the Nasdaq 10 to make a new high at the end of March 2000. These proved to be early warning signs of the subsequent September peak in the S&P. In short, the 2000 bear market was clearly flagged if you knew how to read the technical and macro runes. The same was true in 2007. Is the market?s current behaviour already ringing a bell to warn investors intoxicated by risk appetite that the party is over and it is time to head to the exits before the stampede starts?"

Not to put too fine a point on it, Albert, but everyone would like to know the answer.

Junk Bond ETFs Have Rough Two Weeks: Deals Pulled, Outflows Rise

Submitted by Mish Shedlock

Volatility has returned, at least in the junk bond market. JNK, the Barclays High Yield Bond ETF, and HYG, the iShares High Yield Bond ETF, both had the steepest decline in three months. Is this another buy the dip opportunity, or is risk avoidance about to take hold?

Cracks Widen

Reuters reports U.S.Junk Bond Sector Ends Rough Week On Calmer Note.

Cracks in the red-hot U.S. high-yield bond market are starting to widen, with two junk-rated companies pulling their deals on Friday and U.S.-based high-yield funds suffering their second consecutive week of cash withdrawals.

“Folks have become super negative on risk all of a sudden,” said Greg Peters, managing director and senior portfolio manager at PGIM Fixed Income.

On Friday, coal producer Canyon Consolidated Resources became the second junk-rated company to pull a bond sale this week amid a bout of volatility in credit markets. NRG Energy pulled its junk bond offering on Thursday as spreads across the asset class widened sharply and the two main junk bond ETFs reached seven-month lows.

Bank of America Corp analysts said in a note on Friday that volatility in high-yield has been “driven primarily by a confluence of several meaningful and yet only loosely related events,” including the collapse of the Sprint Corp and T-Mobile U.S. Inc merger, the U.S. Justice Department’s challenges to the AT&T Inc and Time Warner Inc merger, a credit downgrade for Teva Pharmaceutical Industries Ltd and other industry-specific news along with the potential for tax reform to be delayed.

The analysts also said the flatness of the yield curve has been hurting high yield, partly by hurting bank stocks, which benefit from a steeper yield curve that allows them to borrow cheaply, lend at higher rates and profit from the difference.

JNK Daily

HYG Daily

Another Dip Buying Opportunity?

The declines look meaningful, but if you crunch the numbers, the total decline over the past two weeks is just over one percent. Monthly charts make it appear as if nothing happened at all.

JNK Monthly

HYG Monthly

On a monthly basis, it"s hard to label these moves as "dips". Then again are things expected to rise forever?

Yield Curve

Analysts stated "flatness of the yield curve has been hurting high yield."Starting mid-2016, the ETFs rose 20 out of 23 months with the yield curve flattening throughout 2017.

Volatility Not Started

Volatility has not yet started, despite claims to the contrary.Is this the start of a meaningful decline?I do not know, nor does anyone else. But I do suspect that cracks will appear first in the credit markets.

"The Leaders Are Crashing" - It"s Not Just Junk Bonds That Have Given Up

We have been warning about significant divergences between equity prices and other asset classes for a few weeks (most notably the decoupling from equity risk and credit risk, junk bonds), but as BofA notes its not just these assets that are breaking away from soaring Nasdaq levels, in fact many of the rally"s leaders are crashing... in a way we have not seen recently.

High yield risk has suddenly decoupled from equity markets...

And Jeffrey Gundlach has been warning something"s got to give. Based on the past two days, looks like we have our answer.

Stocks fell around the world a second day and high-yield bonds headed for a fourth straight loss, resuming a historic correlation that the hedge fund manager on Wednesday had warned was alarmingly out of whack.

“JNK ETF down six days in a row, closing near its seven month low,” the DoubleLine Capital LP co-founder wrote on Twitter Wednesday. “SPX up five of last six days, closing at an all time high. Which is right?”

In fact the correlation between these two leaders has crashed...

In the past decade, there were only three other instances where the relationship between JNK and mega-cap tech broke down to this degree. Each time, the two assets began to resume their positive correlation within four to 12 days, data compiled by Bloomberg show.

But given the last few days in equities and credit... High Yield Bond prices (HYG) are at 8 month lows...

On record dollar volumes of trading...

Gundlach is calling a win...

“A material pullback would be something we need to watch for, as a deteriorating credit market has led each of the largest equity pullbacks since 2014,” said Frank Cappelleri, a senior equity trader and market technician at Instinet LLC.

 

“With divergences once again apparent now, the bulls face their latest test.”

It"s not just credit risk, but equity risk has decoupled from equity prices too...

VIX has started to creep higher but has further to go to fit with credit risk...

But it"s not just high yield bonds, price leadership has been stung in recent days: Oct 26th/27th ECB announced "tapering", Brent broke $60/b…concerns of "peak policy" stimulus & "peak profits"caused toppling of credit, bank, tech "leadership"; sell-off sequence past few weeks = 1st EMD, 2nd HYG, 3rd SX7E, 4th BKX, and #5 SOX...

As BofA"s Michael Hartnett notes, watch EMD & HYG in particular...needs to stabilize... but the recent pullback also follows insane gains...

FAANG+BAT market cap up $1.5tn YTD, a sum larger than entire market cap of DAX ($1.4tn); and Aug saw all-time low yields in US HY tech bonds (4.3% H0TY) & EU HY corp bond yields hit low in Oct (2.1% HE00, i.e. lower than yield on US Treasuries).

Finally, in case you think this is all much ado about nothing. The last time we saw such a divergence between credit and equities was in Aug 2015...

Just two weeks before the huge ETF  flash crash.