‘It’s A New Kind Of Leverage’: Keepin’ The ‘Faith’ With The ‘King’

Today is your lucky day.

Because today, Citi’s Joseph Faith and Matt King are back with a new update on markets gone central-bank-crazy.

When last we checked in on the dynamic credit duo, they were busy reminding you that someone is going to have to absorb $1 trillion in securities next year after the ECB starts to reduce its asset purchases.

And by “someone”, Faith and King mean “the private sector” or, more poignantly, price sensitive investors (as opposed to central banks, which are by and large price insensitive). If you missed the post linked above, here is the critical quote:

Next year looks very different. We project that the private sector will have to absorb c.$1tn of securities – the highest number since 2012. The main driver for this is our anticipated reduction in ECB purchases from €780bn this year to €150bn in 2018. The faster pace of Fed balance sheet reduction we can now expect cements our impression that next year will see a big shift away from the current status quo. Assuming that Fed balance sheet reduction begins in September, the US market will have to absorb a further $450bn of supply in addition to the gap left by the ECB.

No matter how you look at this, it presents a challenge to risk assets that have benefited from a perpetual policymaker bid.

In short, we’re about to step off what one might characterize as a QE “cliff” and if you want to visualize why this is a problem, look no further than the following chart:

AssetPurchases

As outlined in “‘The Cliff’: Central Banks Have Pulled Back Before, And Here’s What Happened,” this doesn’t necessarily have to be some kind of catastrophe.

But the key thing to understand is that, to quote a separate Citi note, “since 2008, there has not been a period when aggregate AE central bank balance sheets have contracted.”

CBs

Ok, so that bring us to the latest from Faith and King who begin by noting that when it comes to € credit (and remember, there’s an argument to be made that when it comes to resiliency, no asset class has been more bulletproof than credit), we’re “partying like it’s 2007.”

There’s a particularly interesting discussion in the note about the differences between then and now, but in the interest of keeping your attention, we’ll cut to the chase.

Recall this tweet from a couple of weeks ago:

That was important – which is why we mentioned it. And which is why we checked it for veracity with a strategist at another bank. He concurred.

Now consider what that excerpted passage from Barclays says and then compare it to this from Faith and King, out Monday (obviously, one is about USD credit and the other about € credit, but it’s the same dynamic):

A different kind of leverage

Sceptics may argue that the system is much less levered now than in 2007, and (insofar as it goes) this is true. Back then, the response to tight spreads on what was believed to be low-risk assets was to lever up – by taking exposure through a hedge fund buying on margin and benefiting from European banks’ lack of constraint on leverage ratios, or by buying a structured product which leveraged the underlying assets.

But even if the leverage may have been a source of risk, we are not so sure that it all led in the direction of spread tightening. To the extent that higher gross CDS notionals (Figure 14) are a crude reflection of this increased leverage, much of the trading being done involved relative value relationships – shorts as well as longs – in a way that simply doesn’t happen today.

Indeed, it feels to us as though markets were much more two-way back then than they are now. In some sense the additional leverage clearly did add to systemic risk – it is impossible to look at the 2008 liquidity squeeze and argue otherwise – but we are doubtful that today’s oneway reach-for-yield, in which many investors have almost despaired of relative value as a concept, is as much safer as regulators like to think.

FaithKing

Probably the biggest source of “artificial tightening through leverage” back in 2007 was the volume of synthetic CDO issuance. Synthetic CDOs (CSOs) effectively created negative net supply, as net protection selling by investors forced dealers to buy bonds to hedge their books, dragging both CDS and cash spreads tighter in the process. From 2003-2006, global delta-adjusted CSO issuance ran around $300bn/year; in 2007, this increased over $600bn.

But the comparable number today is the buying from global central banks. This too produces an “irresistible force” driving spreads tighter, which investors feel powerless to resist.

And the volumes are much larger still, averaging around $1.2tn/year (Figure 15) relative to CSOs’ $3-600bn. Admittedly this is spread across asset classes, with the CSPP in isolation amounting to only €80bn – but to take the latter number would to our minds grossly understate the additional demand created in credit. While it’s essentially impossible to isolate an undistorted credit spread in either case, the fact that the increasingly finite demand of central banks is what has facilitated such tight spreads in the first place is hardly reassuring.

Not to put too fine a point on it, but that’s a brilliant way to look at things.

Central banks are the new CDOs in terms of the “irresistible force” they’re exerting on credit and, more to the point, the extent to which they are artificially compressing spreads.

Boom.

*******

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