Derivatives Trading Legend: "This Is The Signal That An Iceberg Is Dead Ahead"

After building out Merrill's mortgage trading floor basically from scratch, then moving to the buyside at Pimco, one year ago Harley Bassman, more familiar to Wall Street traders as the "Convexity Maven" - a legend in the realm of derivatives (he helped design the MOVE Index, better known as the VIX for government bonds) - decided to retire (roughly one year after his shocking suggestion that the Fed should devalue the dollar by buying gold).

But that did not mean he would stop writing, and just a few days after exiting the front door at 650 Newport Center Drive in Newport Beach for the last time, Bassman started writing analyst reports as a "free man", in which the topics were, not surprisingly, rates, derivatives, cross asset interplay and, of course, convexity.

And, in his latest note, Bassman takes on a topic that has become especially dear to the Fed and most market observers: the continued flattening of the yield curve, the timing of the next recession, and what everyone is looking but fails to see, or - as he puts it - what is truly different this time.

Bassman's full thoughts below:

The Path Forward

Let me offer a follow-up comment related to "Catch A Wave" from June 29, 2018. The Yield Curve, as described as the difference between the T2yr vs T10yr rates, will not invert until near the December FOMC meeting.  This is when to start the clock for the typical 18-month lead-time to a recession (sometime in mid-2020).

As such, I am not bearish on SPX; the front-loaded corporate tax cuts will provide near-term support for earnings while the debt balloon is deferred to the Millennials (who to their chagrin, forgot vote).

The most common push-back questions why not just execute the steepener (long 2s vs short 10s) in spot (or forward) space:  Positive carry and no option cost. The other frequent comment asks:  Why now?  If the curve will not invert until December, one should just wait until then for a better entry level.

My answer is "yes" on both counts, those are much better executions if you have certainty; but I am not so confident. 

While we are now quite familiar with Trump's negotiating style of 'bluster and retreat', it is quite possible that foreign leaders may actually take him seriously.  Thus, similar to how WW1 was the unintended conflict, a global trade war could be the unfortunate result of clashing egos which will accelerate the risk calendar.

As such, I am willing to pay a few pennies to effectively own a three-year option two years forward via the purchase of a full term five-year option. Additionally, using options (instead of futures or swaps) offers a limited-loss risk profile with more leverage and the comfort of not being stopped out.

Others have commented that "it's different this time"; that QE and unique FED policies will negate the inverted Yield Curve signal for a recession.  Indeed it is different this time:Historically the Curve has inverted from the FED jamming their policy rate higher; in contrast, this next inversion seems to be driven by the back-end coming down.

Asset prices are a signal, such a pity that sometimes this information cannot be discerned until after the fact. 

What is truly different this time is that past inversions have rotated around a ~5%-rate while this time we will rotate around a ~3%-rate. 

The signal that an iceberg is ahead is NOT that the FED is jamming the Yield Curve flatter, but rather that long-term interest rates have declined by 30bps through the most recent FED hike; and that this is occurring despite massively expanding supply thanks to Quantitative Tightening (QT) and the Tax Package.

Market pundits like to say: "They don't ring a bell at the top".  My retort is that they do, you are just not listening.

* * *

Recent transactions I have done:

• Buy five-year expiry Yield Curve options, versus Sell three-year put (payer) option on 20yr rate - K = 4.0%
• Sell Closed-end Funds invested in High Yield and Loan Buy Closed-end Funds invested in MBS and MLP
• Buy MXN currency funded by short EUR (MXN/EUR)

Why Trade War Is Now Set To Get Much Worse

In a note written on Monday, ahead of today's latest escalation by the US which unveiled a list of $200BN in incremental tariffs sending risks assets sharply lower and yet which was perfectly expected and previewed both here and elsewhere as it was part of Trump's escalating tit for tat trade war strategy as summarized in this chart shown first nearly three weeks ago...

...  Standard Chartered's new head of Global G-10 FX strategy Steven Englander made an accurate prediction: more tariffs are coming.

Englander first's point is that last Friday, as the original $34BN in tariffs were unveiled officially launching the trade war, is that shortly afterward, investors took a benign view of the first round of tariffs, for three reasons:

1. The US economy has a strong head of steam; China's economy is somewhat sideways or faltering a bit and its financial markets have been under pressure, leaving the US asset market more resilient
2. The current round of tariffs will likely have small effects
3. The EU is sounding more conciliatory

And, as he correctly added, these three factors also provided the Trump Administration with incentives for a more aggressive round of tariff imposition, for the following two reasons:

1. The tariffs so far are politically popular even in agricultural and industrial states
2. Tariff measures are very easy to reverse

But it was his next point, one which we have made numerous times and just this morning again most recently, that was most crucial and explains why the tit-for-tat trade war escalation between the US and China is only set to get much worse:

The temptation (primarily for the US but for trading partners as well) is to keep ramping up measures to convince the other side that they are serious about staying the course. Tariffs can be rolled back quickly when an agreement is reached.

And the punchline:

Because the long-term consequences are likely to be so modest and reversible, the incentive is to move aggressively in the short term. If tariffs are popular politically, there are even more likely to be extended. That said, with so much going on in this week politically in the US – the Supreme Court nomination and meeting with NATO and the Russian president— the focus may be elsewhere.

It was... for about 24 hours. Then, with the SCOTUS judge in the bag, and with Trump en route to NATO, the UK and Putin, the president decided to lob a bomb and blow up the market's uneasy peace that had hit just settled with 3 days to go until earnings season.

The bigger point is that, as Englander adds, "this cycle will stop when one side or both feel enough pain to back down."

Clearly, the US, with its "decoupled" economy and the S&P back to 2,800 is nowhere near "pain", as for China, it is more likely that Xi will first take a bullet than concede... unless of course the stock market crashes and a recession ripples across the country, starting the one thing Beijing is most afraid of: a middle-class revolt (points we made over the weekend).

As a footnote, Englander frames the argument as similar to that made by Sam Peltzman with respect to seatbelt usage. He argued (and produced evidence) that drivers would drive less safely because mandated safety devices reduced the consequences of an accident.

* * *

So what does this mean in practical terms? Well, as Englander claimed - correctly - even before today's $200BN in new tariffs were floated, "the US is likely to press its perceived advantage", to wit: 

The US will probably push the tariff cycle further because they see China as more vulnerable. The value of China's goods exports to the US is almost four times as high as US goods exports to China.

The ability of China to implement simple tit-for-tat tariffs on goods runs out at about USD 130bn (based on 2017 imports from the US). The US exports about USD 60bn of services, importing little, so China might match the US further, although taxing services is more complicated than taxing goods. China's greater exposure, combined with the perceived US economic and asset-market advantage, is likely behind the US Administration's view that tariff wars are 'easy' to win.

In simple terms this means that if the US extended tariffs to cover a wide range of goods, and - as the case may be - even cover more goods than China physically exports as Trump has bluffed (raising the stake as much as $800 BN in Chinese tariffs), China would quickly run out of room to tax US exports.

At this point its only recourse would be to implement additional non-tariff controls, which Englander - and everyone else - views as "a very serious escalation."

There are of course also other ways China could respond: Tariffs make it more expensive to buy goods, but so do exchange rate fluctuation, sales taxes and other events, like dumping some or all of one's Treasuries to demonstrate irrationality and threaten mutual assured destruction. In other words, "more expensive does not mean unavailable" and non-tariff measures have far more potential to disrupt supply chains and make goods unavailable, potentially raising prices sharply. That is precisely what China is contemplating right now

This is how Englander wrapped up his piece on Monday:

The very limited set of tariffs imposed so far, and the retaliatory measures by trading partners, are probably not enough to indicate who will blink first. The question is how a much broader second or third round of tariffs would be received.

One day later we may be about to find the answer now that $200BN in tariffs has been proposed.

However... before Trump considers the latest escalation salvo a trade war victory, there is a "but": the current enthusiasm for trade measures may be short-lived if prices on store shelves begin to rise sharply, as is sure to happen if a lengthy trade war evolves, with tariff levels ratcheting higher and higher.

For now, however, we are far from that point, and as such, the US Administration likely sees going a lot further in terms of tariffs as advantageous.

There is just one thing that can stop Trump in his tracks sharply and forcefully: a market crash.

* * *

As for the big question facing traders tonight, and into earnings season, it goes as follows: will China respond and if so, how? Luckily we know the answer: back in mid-June, Beijing said it would retaliate "forcefully"

"If the U.S. loses its senses and publishes such a list, China will have to take comprehensive quantitative and qualitative measures,'' the Ministry of Commerce said at the time.

As Bloomberg adds, it is China's Mofcom that has been tasked with formally retaliating against the U.S. on trade, so be on the lookout for statements from them. There's also the daily media briefing by the Ministry of Foreign Affairs in Beijing, where China tends to double down on its rhetoric in these instances. That's at 3 pm Hong Kong/Beijing time.

We doubt China will leave anyone in a state of suspense for too long.

The Corporate Bond Market Is Getting Junkier

Few investors realize the ticking time bombs populating what they believe are the safest parts of their portfolios.

Much has been made of the degradation of the $7.5 trillion U.S. corporate debt market. High yield offers too little, well, yield. And "high grade" now requires air quotes to account for the growing dominance of bonds rated BBB, which is the lowest rung on the investment-grade ladder before dropping into "junk" status. And then there's the massive market for leveraged loans, where covenants protecting investors have all but disappeared.

How does that break down? Corporate bonds rated BBB now total $2.56 trillion, having surpassed in size the sum of higher-rated debentures, which total $2.55 trillion, according to Morgan Stanley. Put another way, BBB bonds outstanding exceed by 50 percent the size of the entire investment grade market at the peak of the last credit boom, in 2007. 

But aren't they still investment grade? At little to no risk of default? In 2000, when BBB bonds were a mere third of the market, net leverage (total debt minus cash and short term investments divided by earnings before interest, taxes, depreciation and amortization) was 1.7 times. By the end of last year, the ratio had ballooned to 2.9 times.

Given the marked deterioration in fundamentals, bond powerhouse Pacific Investment Management Co. worries that "This suggests a greater tolerance from the credit rating agencies for higher leverage, which in turn warrants extra caution when investing in lower-rated IG names, especially in sectors where earnings are more closely tied to the business cycle."

In the event this warning rings a bell, be heartened that your memory is still largely intact. Investors blindly following credit rating firms' designations on subprime mortgages despite a clear degradation in the due diligence upon which the ratings were assigned ended up regretting such faith when the financial crisis hit.

So why not treat the BBB portion of the bond market for what it is: a high-risk slice of the corporate debt pie. Keeping count of "fallen angels," or those investment-grade bonds that are downgraded into junk territory, will become a spectator sport.

With that as a backdrop, add to the BBB market what are already designated high-yield bonds and leveraged loans and you arrive at $5 trillion, twice the size of what investors should realistically classify as money-good investment-grade debt. The leveraged loan market is generally where companies whose credit is so weak they can't access the high-yield bond market go to attain financing. It just exceeded the high-yield bond market in size, growing to $1.22 trillion compared with high-yield's $1.21 trillion, according to Fitch Ratings.

Query institutional investors and they will answer that they're increasingly guarded in their approach to the market. The investment community's suspicions are amply reflected in the awful performance put in by the investment-grade market this year, with the Bloomberg Barclays U.S. Corporate Bond Index dropping 2.80 percent through Friday. Among 19 major parts of the global bond market tracked by the Bloomberg Barclays indexes, only dollar-denominated emerging-market debt has done worse. 

The extra yield investors demand to own investment-grade corporate bonds instead of U.S. Treasuries is equally indicative of investor skepticism. At about 1.25 percentage points, the spread has expanded from an average of 0.85 percentage point in February to the widest since 2016. 

But ask yourself this question: How many small investors perceive the corporate debt market as two parts high-risk and one part low-risk? According to State Street Advisors, despite the underperformance of investment-grade funds, June saw continued inflows of $2.8 billion into the space while high-yield sustained outflows of $2 billion. Through the first six months of this year, investment-grade inflows totaled $5.6 billion while high-yield funds bled $5.9 billion. 

The reality is precious few retail investors conceive of the ticking time bombs populating what they believe to be the safest slice of their portfolio pie.

Global Sovereign Wealth Funds To Abandon Stocks Amid Trade War Tumult

As the hopes and dreams of the end of the trade war - that delusionally sustained around 800 Dow points of exuberance in the last few days - are dashed at the altar of Trump tariff reality,it appears the world's sovereign wealth funds are well ahead of the looming storm.

And away from 3 or 4 mega tech stocks, the broad US equity market is not 'breaking out' as many hope...

In an annual report by asset manager Invesco, over a third of sovereign investors plan to cut their equity exposure over the next three years after a strong run in 2017, citing trade wars, geopolitics and high valuations as headwinds to performance.

Reuters reports that the report, which is based on interviews with 126 sovereign investors and central bank reserve managers with $17 trillion in assets, found equities had overtaken bonds to become the biggest asset class in portfolios, averaging 33 percent. This is up from 29 percent in 2017.

Nearly half of sovereign investors are now incrementally or materially overweight equities, but while 40 percent said they were happy with the status quo, 35 percent plan to reduce their equity exposure over the medium term, Invesco noted.

Alex Millar, head of EMEA sovereigns at Invesco, said survey participants had been "pretty far-sighted" in highlighting the risk of a trade war early in the year.

"Equities had a good run last year, but this hasn't caused investors to change their long-term expectations – they think returns going forward will be tough," said Millar.

Maybe the sovereign wealth funds are part of the SMART money that is exodus-ing US equities at an unprecedented pace...

Ironically, as SWFs abandon stocks, Central Banks are venturing deeper into alternative assets and ramping up their risk-taking.

Government-backed agencies have traditionally focused on preserving capital, but, as Bloomberg reports, with some government-bond yields having slumped below zero, central banks are increasing their bets (of their trillions of dollars of foreign reserves) on higher-risk mortgage-backed securities, corporate debt, equities and emerging-market debt.

"Central bank reserve managers typically wake up in the morning figuring out how to avoid losing money," said Alex Millar, head of EMEA sovereign and institutional sales at Invesco Ltd. But now, "the requirement for return is creeping up."

"They've had to look for asset classes outside of their traditional comfort zone," Millar said. "They're beefing up their risk-management capabilities, their understanding of asset classes, having to educate their board on why they need to do that."

Central banks have earmarked an average of about 14 percent of their assets for non-traditional investments, the survey showed.

A Storm Is Brewing For U.S. Oil Exports

Two geopolitical developments in recent weeks - U.S. sanctions on Iran and the escalating U.S.-Chinese trade war - are set to reshuffle the U.S. oil flows to the world's fastest-growing oil market, Asia.

On the one hand, the United States is pressing Iran's oil customers to cut their Iranian crude imports by as much as possible. China is Tehran's biggest oil buyer, and India is its second. While India is reportedly preparing for a drastic reduction of Iranian oil imports, China will continue to buy Iranian oil.

On the other hand, China is threatening to impose a 25-percent tariff on U.S. crude oil and oil products after the U.S.-Chinese trade war took a turn for the worse in recent weeks. Such a tariff would make American crude oil uncompetitive in China, and U.S. oil sellers will have to find alternative buyers for their crude to replace the volumes they are currently selling to their second-largest oil customer after Canada.

India is an obvious possibility - its imports and demand are surging, and it may be willing to replace at least part of its Iranian oil imports out of fear that its companies and the sovereign could lose access to the U.S. financial system should it continue to buy Iran's oil.

But the problem with India possibly replacing Iranian oil with U.S. crude is that American light oil isn't a substitute for heavy high-sulfur Iranian crude.

India began regular U.S. imports last year, but the volumes are currently small, especially compared to the U.S. crude exports to China, EIA data shows. But in May, India's imports of U.S. crude oil jumped by nine times the April volumes—signifying that at least a partial switch is already underway.

"Shale crude is not an alternative to Iranian crude," Sandy Fielden, director of research for commodities and energy at Morningstar, told Bloomberg. "Indian refiners can't absorb all the U.S. oil that was going to China. They can import more, but can they process it?"

If China follows through with its threat to slap tariffs on U.S. oil imports, it would put downward pressure on the WTI Crude benchmark and widen its discount to Brent Crude, which could be make U.S. oil even more attractive to Indian buyers, according to Fielden.

Still, analysts doubt that the United States will be able to easily find alternative buyersfor the oil it has been selling to China.

India may raise its U.S. oil imports, but it would hardly be able to replace all the American oil that a Chinese tariff could possibly cut off.

"While China could secure the crude from alternative sources, such as West Africa which has a similar quality to U.S. crude, the U.S. would find it hard to find an alternative market that is as big as China," Suresh Sivanandam, senior manager, Asia refining, at Wood Mackenzie, said last month, commenting on the impact of possible Chinese tariffs on U.S. oil imports.

According to WoodMac, U.S. crude oil exports to China averaged around 300,000 bpd in the first quarter this year, accounting for just over 20 percent of all U.S. crude oil exports.

One Chinese buyer is said to have already suspended imports of U.S. oil, turning to Iran as one of its alternative sources of crude.

As far as India's imports of Iranian oil are concerned, there have been signs that buyers are preparing back-up plans in case they are unable to import Tehran crude when the sanctions hit.

India will first cater to its own national interest, its oil minister Dharmendra Pradhan said in an interview with BusinessLine published over the weekend.

"We will first look at our national interest. India's energy basket has multiple sources now. Our focus will be to see that our requirement is not affected, and to ensure this, we will do what we have to do. But, we will also keep a watch on global geo-politics," Pradhan told BusinessLine.

With geopolitics—tariffs and sanctions—reshuffling the oil interests and oil flows of the U.S., China, India, and Iran, India alone may not be enough to absorb the U.S. oil exports to China, currently America's second-largest single oil customer after Canada.