Author Archive for Sober Look

A Bubble is Forming in US Middle Market Leveraged Finance

by Sober Look

US middle market leveraged buyout (LBO) transactions are becoming increasingly frothy. According to the latest data from Lincoln International, risk-return fundamentals in the space are worse than they were in 2007. Here are some disturbing facts about leveraged transactions in US middle markets:

1. Leverage multiples (debt to EBITDA) are higher than at the peak of the bubble in 2007. In particular, leverage through the senior debt (dark blue) is now materially higher.


2. Yields on senior leveraged loans for middle market deals are now significantly lower than in 2007. Investors are not getting paid for taking on riskier loans.


3. Furthermore, private middle market company valuations (as a multiple of EBITDA) are at record levels.


4. Banks have all but exited leveraged loan origination, as institutions (shadow banking) have taken over. These institutions include loan funds (mutual funds and closed-end funds), BDCs, CLOs, hedge funds, insurance firms, pensions, etc. However, since the Fed is mostly looking at banks’ balance sheets, the central bank seems to be unconcerned about the froth in this market.

Source of capital

5. According to Lincoln International, there are signs that leveraged middle market firms are experiencing margin compression. That is worrisome given the amount of leverage these firms have.

Lincoln International: – While over 50% of companies are seeing revenue growth, the fact that over 50% are experiencing EBITDA declines suggests margin compression. For the sixth consecutive quarter, more middle market companies experienced EBITDA declines than gains.

The Fed has allowed for bubble to build in the US corporate sector – particularly in leveraged middle market companies. A broad hit to revenues could create a massive wave of failures, as firms become too leveraged to withstand such a shock. At the same time investors could face significant losses without being compensated for the risk they are taking. Let’s hope someone on the FOMC is paying attention.



Deutsche Bank: Ignoring Food Price Pressures Could be a Mistake

By Sober Look

Economists and central bankers tend to be less focused on what consumers pay at the grocery store because food and energy prices have historically been more volatile – remember, it’s just “noise”. However what they can’t ignore is how shoppers view inflation – i.e. inflation expectations. And food prices have a significant impact on households’ views on future inflation.

Deutsche Bank: – … food prices factor significantly into households’ perceptions of overall price pressures. This is illustrated in the following figure, which shows year-ahead inflation expectations from the University of Michigan Survey of Consumer Sentiment versus CPI food. In fact, it is worth noting that CPI food demonstrates a higher degree of correlation with one-year price expectations than either the headline or core metrics — and it similarly surpasses energy, core goods, core services and shelter. …  while forecasters are focusing on service-sector inflation in general and shelter inflation more specifically, they should be careful to not ignore mounting food price pressures, because this category could provide important insight toward the evolution of inflation expectations. If food price inflation accelerates, as we project, the stability of inflation expectations could degrade – and this would be a vexing development for monetary policymakers.

Food prices

Source: Deutsche Bank

Further Signs of China’s Slowing Property Markets

By Sober Look

China’s official housing index now shows home price appreciation slowing faster than some had anticipated.

China housing price appreciation

Other indicators are also pointing to weakness in China’s housing markets. For example the number of cities with falling prices has spiked sharply.

China housing

Furthermore, the steel rebar futures in Shanghai – an imporant real-time indicator of construction demand – remain under pressure.

Jan Steel Rebar

Jan steel rebar futures in Shanghai (

Related to this trend, China’s commercial floor space and the number of commercial buildings sold has declined materially (based on official reports).

Floor space and commercial buildings

There is no question that Beijing has the wherewithal and the will to support the housing market should things unravel faster than the government likes. Nevertheless, given how pervasive property markets are in the nation’s overall economy, concerns among global investors are rising with respect to China’s housing slowdown.

Scotiabank: – On the theory that where there’s smoke there’s fire (and it’s not just because I’m BBQing), weak company financing and concerns surrounding potential defaults in the shadow banking sector coupled with — and likely driven by — further evidence of falling property prices will only amplify the concerns.

US loan growth rate the highest since the recession

By Sober Look

US credit growth continues to accelerate, reaching the highest year-over-year pace since the Great Recession.

Loans and leases

In 2012 the growth was primarily driven by corporate debt (chart below) as banks remained cautious on real estate and consumer lending. While corporate loan growth remains strong – at around 11% per year – other sectors are now experiencing faster credit expansion.

Corporate loans (1)

In a complete contrast to the situation in the Eurozone, both real estate (particularly commercial) and consumer credit growth rates have improved materially this year. Consumer credit is no longer just driven by autos, with credit card debt picking up as well.

Real estate

Consumer loans

The only major headwinds for this trend currently are some of the geopolitical risks (Iraq, Russia, etc.). Consumers, companies, and banks are still fairly jittery and it won’t take much to dampen the supply of and/or the demand for credit.


Two indicators explain some of the recent volatility

By Sober Look

For those looking back at the last couple weeks and scratching their heads about all the volatility in US equity markets, here is a thought. Yes, we’ve had some new geopolitical risks such as the Russia sanctions as well as some fresh economic data from the US. But if you step back and look at the situation, very little has actually changed as far as market and economic fundamentals since the end of last month. So why such (relatively) sharp market moves? Here are a couple of indicators that may shed some light on this volatility.

Leverage in the equity markets has reached new highs recently as shown by margin debt levels. Even as a fraction of the overall market cap, margin buying has been quite significant. While such activity doesn’t necessarily lead to a significant correction (as some have been suggesting), it’s a sure way to get some real volatility going.


Another indicator that has been pointing to an environment that is ripe for some good market swings is the IMX index. It is basically a measure of how aggressively accounts are positioned across the TD Ameritrade platform. Unlike the bull/bear surveys, this index actually tells us what retail accounts are doing rather than how they feel about the market. And up to the last week of July, positioning has been increasingly aggressive.


When these measures are released for the month of August, they are likely to show a reduction in risk taking. While that would be a move in the right direction, it is only a matter of time before more of this speculative behavior in the market returns. The only way to cap such activities in a more sustained manner is for the Fed to begin raising rates, making leverage more expensive and cash positions more attractive.



Argentina Default Q&A

By Sober Look

We’ve had a number of questions on Argentina’s latest default. Here is an overview of the situation in a Q&A format.

Q:  Is Argentina officially in default?
A:  While Argentina’s government deposited the dollars for distribution to Discount bond holders, the interest was not distributed as scheduled last week. Missed coupon payment represents default, at least as far as S&P is concerned (classified as “selective default”).

Q:  Does Argentina recognize that it is in default?
A:  No. The Economy Minister Kicillof made it clear that as far as Argentina’s government is concerned there is no default because it has and will continue to make deposits with BNY Mellon (the trustee) to pay the coupon. The government blames the missed coupon payment on Judge Thomas Griesa’s ruling. That ruling held back payments to the bondholders who had accepted the renegotiation of Argentina’s debt in 2005 and 2010.

Q:  Why haven’t the funds been distributed?
A:  Funds would have been released if Argentina settled with the “holdouts” (those who didn’t agree to the 2005/2010 settlement). The holdouts sued for $1.6bn and the negotiations with the government failed to produce a settlement before the deadline last week, preventing the cash from reaching the bondholdrs.

Q:  Has the sovereign CDS (credit default swap) been “triggered” (have we had an “event of default”)?
A:  It is likely that we do indeed have an event of default under the ISDA guidelines. The event would fall under the category of “Failure to Pay”. Having deposited funds with the trustee does not prevent default under ISDA because Argentina has an obligation to make sure coupon payments reach the bondholders. And by choosing not to settle with the holdouts on time, the nation failed to deliver such payments. Ultimately it will be the ISDA Determination Committee that will make that call.

Q:  Can a settlement still be reached?
A:  Yes. The government is highly incentivised to reach an agreement in order to be able to access international debt markets. However prospects of a near-term solution are uncertain and the legal ramifications of a settlement are unclear. A number of analysts are suggesting that a settlement will not take place until at least early 2015.

Q:  Would an eventual settlement have an impact on the CDS?
A:  No. The coupon payment has been missed and that should be enough for the event of default trigger. However depending on the timing of the settlement, it could impact the recovery value on the CDS (by impacting the bond prices prior to the CDS settlement).

Q:  Why hasn’t Argentina’s government settled with the holdouts?
A:  There are a number of reasons, the most important of which is the government’s unwillingness to look politically weak by paying $1.6bn to some US hedge funds – far more than it paid other bondholders. Furthermore, it is Argentina’s current law that it can’t pay more to the holdouts than to the rest of the holders. Of course the law can be changed, but the government is unwilling to do so at this point.

Q:  What is the RUFO clause and what are its implications?
A:  RUFO stands for Rights Upon Future Offer, a clause written into the renegotiated bonds during the restructuring some years ago. It says that if Argentina’s government voluntarily offers better terms to the holdouts it would need to match those terms for all the bondholders. This sounds like another reason for Argentina not to settle, but it’s just an excuse. That’s because the “voluntary” term in the clause would keep RUFO from being triggered – since the settlement with the holdouts is not voluntary but mandated by the US court.

Q:  What are the economic consequences of Argentina not settling this by year-end or beyond?
A:   The consequences could be quite grim. As it is, the Argentina’s GDP is contracting again.

Argentina GDP

And the nation’s current account is deep in the negative territory.

Argentina Current account

Without access to international debt markets many domestic firms will struggle to survive and the country will slip into recession. Currency will come under further pressure and the spread between the official FX rate and the “parallel” exchange will widen sharply (currently the “unofficial” exchange dollars already trade at a 26% premium to the official rate). FX reserves would continue to decline, forcing a second devaluation. Inflation, which is believed to around 25-30%, will spike further. Violent social unrest is sure to follow. This is why Argentina should have every incentive to settle with the holdouts as soon as possible. Sadly, the risk that it won’t remains quite high.

Expect Higher Treasury Yields in Second Half of 2014

By Sober Look

While many investors refuse to accept this fact, we are clearly marching toward higher treasury yields later in the year and in 2015. Even after today’s bond selloff, we are still around the yield levels we had during the dark days of the government shutdown. Here are a couple of key factors that will drive yields higher from here.

1. Many are pointing to record low yields in Europe (see chart), suggesting that on a relative basis treasuries look attractive. Perhaps. But it’s important to make that comparison based on real rates rather than nominal. And given the disinflationary environment in the Eurozone (see chart), a significant rate differential between the US and the Eurozone is justified. After all, we’ve had a tremendous differential in nominal yields between the US and Japan for years. Furthermore, economic growth (and expectations for growth) in the euro area and in the US have diverged significantly (see chart). Today’s US GDP report confirmed that trend.

2. The net supply of treasuries is not static. In particular when it comes to treasury notes and bonds (excluding bills), the Fed has been the dominant buyer (see chart). With the Fed tapering, the net supply is expected to rise.

Net supply of treasuries


Foreign buying of notes and bonds has declined and is not expected to replace the Fed’s taper. It will be primarily driven by China’s rising foreign reserves. But given declining support from the Fed, China is likely to make bills (vs. notes and bonds) a larger portion of its purchases. And bill purchases will have a limited impact on longer dated treasury yields.

To be sure, we are going to have plenty of demand for treasuries going forward. But given such a spike in supply and improved growth expectations, something on the order of 50-75 basis points increase in the 10-year yield in the near-term is not unreasonable.
It is also worth pointing out that with the dealers remaining cautious holding significant inventory and the Fed out of the picture, higher volatility in treasuries becomes more likely.

3 reasons Yellen’s FOMC remains dovish

By Sober Look

What makes Janet Yellen and a number of other FOMC members so dovish with respect to monetary policy and in particular the trajectory of rate normalization? A Credit Suisse report sites 3 key factors, which Yellen calls  “unusual  headwinds”:

1. Tighter fiscal policy.

The combination of lower government spending and tax increases has created a drag on economic growth (see chart). This drag is now diminishing, but given the tepid recovery Yellen still views it as a headwind.

US gov spending

2. Relatively tight credit in the mortgage market.

Janet Yellen: – ” … it is difficult for any homeowner who doesn’t have pristine credit these days to get a mortgage. I think that is one of the factors that is causing the housing recovery to be slow. It’s not the only one, but I would agree with that assessment.”

A recent study by Goldman compared current lending conditions in the mortgage market with the 2000 – 2002 period (supposedly “pre-bubble” period). The results indeed seem to point to tighter lending standards at this time (see chart).

3. Low household wage growth expectations.

While US wages have been growing at around 2% per year, expectations for growth remain depressed.

Yellen (see House testimony video below): – ” … households have unusually depressed expectations about their own future income gains. And I think weighs on their feelings about their own household finances and is holding back consumer spending.”

Wage increase expectations

The Diminishing Returns of Fuel Efficiency

By Sober Look

As vehicles become more fuel efficient, the savings one obtains by further improving the mileage decline substantially. As an example, assume a driver saves $700 per year by switching from a 12 mile/gallon car to a 15 mile/gallon one. Now if that same driver has a car that gets 30 miles/gallon, she would need to switch to a 60 mile/gallon car in order to achieve the same $700 savings. In fact the incremental savings for each additional mile/gallon declines as the inverse square of a car’s fuel efficiency.

SavingsThis does not bode well for the future of alternative fuel automobiles. Saving $700 a year, as the example below shows, may not be worth paying additional few thousand dollars for a car that may be less convenient to “fill up”.

Furthermore, as traditional gasoline cars become more fuel efficient, the savings associated with switching fall off sharply. In another few years, unless gasoline prices shoot through the roof (which is not likely), alternative fuel cars (such as electric) will increasingly be more of a “luxury” item rather than a money saving form of transportation. It’s just basic math. 

EIA: – As light-duty vehicle fuel economy continues to increase because of more stringent future greenhouse gas emission and Corporate Average Fuel Economy (CAFE) standards through model year 2025, standard gasoline vehicles are expected to achieve compliance fuel economy levels of around 50 mpg for passenger cars and around 40 mpg for light-duty trucks. Diminishing returns to improved fuel economy make standard gasoline vehicles a highly fuel-efficient competitor relative to other vehicle fuel types such as diesels, hybrids, and plug-in vehicles, especially given the relatively higher vehicle prices projected for these other vehicle types.

Fuel efficiency

Window Dressing with Fed’s Reverse Repo Program

By Sober Look

If you are a bank or even a money market fund, you probably want your financials to show the maximum amount of your overnight liquidity placed with the Fed’s RRP rather than with other banks. Your balance sheet looks less “risky” this way. And since most financial reporting is done at quarter end (with mid-year and year-end being the most important dates), you want to place your cash with the Fed on the last day of the quarter for one night and then take it out.


Why not leave your liquidity with the Fed for a longer period? Because the Fed’s current RRP rate pays 5 basis points, while the private repo market is paying about double that. Of course as cash is pulled out of the repo markets for quarter-end and moved to the Fed or elsewhere, rates in the private markets rise. Once the cash comes back to the private markets at the start of the new quarter, the rates return to normal.


GC repo


The larger the RRP program becomes, the stronger this quarter-end effect will be. Welcome to the wonderful world of window dressing.

Fixed Income Risk Appetite Headed for Euphoria

By Sober Look

The global appetite for fixed income remains strong, driven by ongoing accommodation from central banks. The 10-year Bund yield touched fresh lows for the year today. The situation is similar for shorter maturities.

10 Bund yield

This yield compression is not limited to bonds. As an example, Asian commercial property yields are at new lows as well. For those who want some background on the meaning of “property yield”, here is a good overview.

Asia propery yields (2)

The Credit Suisse Duration Risk Appetite Index is once again headed for euphoria after being in panic territory just a year ago. 


Duration appetite index


The index measures investors’ appreciate for being long fixed income product – as they shift from taper fears last summer to frenzied buying today. The longer the current environment persists, the more difficult it will be for central banks to begin rate normalization.

Betting Against the FOMC Could end Badly

By Sober Look

In spite of the dovish tone from Janet Yellen at the press conference last week, the short term rates markets are betting that the Fed will become even more dovish in the months to come. Fed funds rates trajectory implied by the futures markets is significantly below the median projection by the FOMC.

Fed funds vs the Fed

Fed funds and eurodollar futures traders are playing the carry game – going long futures a couple of years out and riding them down the curve. The strategy had worked in the past. But is the Fed really going to turn more dovish? Barclays researchers believe that just the opposite will occur and the trajectory of rate hikes will steepen.

Barclays: – The “dots” also showed a faster pace for the hiking cycle. Notably, this occurred despite the fact that the revisions to the Fed’s inflation and UR [unemployment rate] projections were not very aggressive. We believe revisions are likely to continue in the same direction, i.e., lower UR and higher inflation; in turn, the path for the funds rate implied by the “dots” should continue to steepen.

The spread between the market and the FOMC is now close to extreme levels. The Fed’s projected rate “dots” have been rising, while the futures traders continue to ignore it.

Fed vs market

At some point however this is going to come to a head.

Barclays: – … on balance, the Fed’s embedded economic projections are not too aggressive. While Fed Chair Yellen’s dovish stance may be playing a role in keeping rate hike expectations muted for now, if inflation surprises to the upside, Fedspeak can take a far less dovish tone (note the abrupt change by the BoE).

Is the Recent US CPI Increase Just Noise?

By Sober Look

At her press conference yesterday, Janet Yellen dismissed the stronger than expected CPI report, as “noise”. She was quite clear. Inflation remains below the Fed’s target and is likely to stay there for some time.

Inflation sensitive assets such as gold however rallied in reaction to this dovish stance from the Fed.


If the CPI report from the US Bureau of Labor Statistics was “noise”, is there another indicator that can give us a sense of where prices are headed? Today’s Philly Fed report provided one such an indicator. The Manufacturing Prices Paid Index clearly showed firmer upstream prices.

Philly Fed Manufacturing Prices Paid Index

And market-based inflation expectations, while still relatively low, have definitely moved up recently.

5y Breakeven


Certainly the Fed wants to see this trend sustained for some time. After all, inflation remains at dangerously low levels in the euro area and we could see price increases stalling in Japan later this year (see discussion). But we have clear indications that at least for now, firmer inflation in the US is not just “noise”.

The BoJ’s Balance Sheet is About to go Parabolic

By Sober Look

The Bank of Japan’s balance sheet continues to expand at a fairly constant pace. Relative to the size of the GDP, this is already the largest QE program in the world. Yet some analysts believe that the BoJ will accelerate securities purchases later this year.

BOJ balance sheet

Here is why. Credit Suisse for example projects that Japan’s inflation rate has peaked and is about to begin declining. In fact CS researchers see a complete divergence between the BoJ’s own projection of inflation and reality. A number of other researchers (for example Scotiabank) agree.

Inflation projections

This potential decline in inflation dramatically raises the risk of Japan slipping back into deflation – something that the BoJ and the Abe administration have been desperately trying to avoid. As inflation begins to lag the BoJ’s projections, the central bank will accelerate QE to new highs.

CS: – As long as it sticks to its original commitment to achieve +2% CPI inflation by summer 2015, the BoJ is likely to decide on additional monetary easing once underperformance of the actual CPI inflation rate against its projection becomes visible.

The reason many researchers believe Japan’s inflation may have peaked has to do with the yen.



Chart shows dollar appreciating against the yen in 2013 (yen weakening)

As discussed earlier (see post), a great deal of the recent inflation improvements in Japan was the result of weaker yen, which declined sharply in 2013. But more recently the yen has been range-bound (and in fact strengthening against the euro), which will halt a great deal of the price increases we saw earlier. The inflation rate is therefore expected to begin declining.

But can inflation in Japan be sustained without further weakness in the currency? Such an outcome remains unlikely because there is no evidence that labor costs will begin increasing any time soon. It is difficult to sustain price increases without labor costs and wages rising as well.

CS: – We think policymakers are on the wrong track: we refuse to be optimistic about inflation being close to target at end-year given that unit labor costs fell by 2.5% over the last 12 months and seem set to be unchanged for the next year.

This tells us that at some point later this year, the BoJ will shift into an even higher gear. The central bank’s already bloated balance sheet will go “parabolic” in order to get back on track with the much publicized inflation target of 2%. The success if Abenomics depends on it.

Is the Bank of England about to surprise markets with a rate hike?

By Sober Look

It could happen sooner than markets currently expect …
Bank of England’s Mark Carney, June 13, 2014

Carney of course is talking about an interest rate hike in the UK. Indeed, as UK’s unemployment rate drops to new post-recession lows (see chart) and home prices continue to rise, the time to begin rate normalization is fast approaching. The Bank of England’s (BOE) policy trajectory is diverging sharply from that of the ECB – as reflected in short-term rate markets.

UK vs Germany 2y rates

The spike in the 2y UK gilt yield (above) was in reaction to Carney’s comment, while the drop in 2y German yield was in reaction to Draghi’s recent announcement of negative rates. Currencies had a similar reaction, as the euro tanked against the pound.


When do markets anticipate this first rate hike in the UK? According to the forward overnight index swap (OIS) curve, we are looking at early 2015 for the first increase – followed by a steady pace of hikes for at least 2 years. This is about half a year earlier than the expectations of the first rate increase in the US.

Forward rates

While some view this timing as appropriate or even too optimistic, Carney could in fact take action even sooner. The reason has to do with real rates (rates adjusted for inflation expectations). In spite of UK’s higher rates relative to other developed economies, the Bank of England’s current policy remains highly accommodative. Unlike in the US for example, where implied real government rates for maturities longer than 6 years are positive, the UK’s entire real yield curve is in the negative territory. This level of BOE accommodation puts additional pressure on Carney to pull the trigger on rates – and potentially surprise the markets.

UK real rates curve


 Citi (Michael Saunders): – In our view, this speech marks an important change of tone from the Governor, removing any sense that the MPC [Bank of England's Monetary Policy Committee] is on auto-pilot and locked into inaction until some distant preset date. We continue to expect that strong economic growth and the tightening labour market will prompt the MPC to start to hike before year end, with rates rising earlier, further and faster than markets currently price in.