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“Don’t Buy The Dip”: BofA Explains Why The Fed Has Lowered Its Put Strike

"Don’t Buy The Dip": BofA Explains Why The Fed Has Lowered Its Put Strike

One week ago, Bank of America’s derivatives team observed that "equity…

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This article was originally published by Zero Hedge

“Don’t Buy The Dip”: BofA Explains Why The Fed Has Lowered Its Put Strike

One week ago, Bank of America’s derivatives team observed that “equity investors are losing confidence in Buy The Dip” and warned that after suffering a “meaningful setbacks in recent weeks,” the coast appears far from clear. The bank pointed to recent episodes of increasing market fragility, and highlighted the recent market volatility manifesting in the second daily selloff of 3 standard deviations or more in just 7 trading days, only the 24th time since 1928 that the S&P experienced two or more 3-sigma shocks within 10 trading days.

Fast forward a week and BofA’s increasingly bearish derivatives team led by Riddhi Prasad and Benjamin Bowler has intensified their warning, and pointing to the market’s increasing trouble to rebound from its recent slump – it has now been 27 trading days without a record high, the longest such stretch since September 2020 – they note that momentum has been fading this fall, “and investor confidence in buying the dip may only keep waning the longer this sideways price action persists.”

In the absence of proactive buyers – such as retail investors who have recently turned their back on the market, or aggressive stock buybacks which are currently in a blackout period due to the coming earnings season –  the “market may for the first time since the Covid shock, need to test the Fed put in the next selloff,” BofA warns.

Then, of course, we have the Fed’s tapering. In an amusing interlude, BofA explains that the last time it warned that tapering is bearish, it got the usual “tapering is not tightening” platitudes from clients (spoiler alert: tapering is tightening as even Morgan Stanley now admits), adding that “the main pushback we received was that tapering asset purchases has a smaller economic impact than hiking rates, and is therefore a more minor threat than that of prior hiking cycles.”

In response, the strategists counter that investors’ should focus “not just on the way tapering and hiking change the underlying economics, but on their impact on investor sentiment in today’s environment. For instance, just like the S&P thrived against 3 rate hikes in 2017 but choked on the 2018 hikes, a tapering cycle today could turn out as painful for the equity market as a prior hiking cycle.”

Elaborating on that point, BofA starts with the obvious, namely “that unparalleled monetary policy contributed to the historic returns and valuations achieved post-Covid.”

But with tapering looming and lacking such explicit Fed support, and with momentum fading this fall, “the market may need a period of bad news to get the Fed back on its side or reach more attractive valuation levels. The longer the recent sideway action persists, the weaker the momentum and confidence that investors require to buy the dip.”

To be sure, the Fed will have one key lever to push stocks higher once tapering begins, namely jawboning about the timing of the first rate hike. That’s the lever Fed famously used to reverse falling stocks leading up to the first hike post-GFC. In October 14, St. Louis Fed President Bullard stepped in to calm markets fearful of a growth shock. In 2015, on the back of another bout of stock market weakness, Yellen pushed back a largely-expected hike around the Sep FOMC meeting and then delayed the next hike for an entire year.

However, BofA cautions, “the option to delay hiking rates doesn’t rule out a period of higher volatility”, as:

  1. we still haven’t seen how the market will react to the actual taper today,
  2. the change in Fed tune means the Fed put might have to be tested (vs. the dip getting bought in anticipation), and
  3. overshooting inflation might limit the Fed’s ability to rescue the equity market as easily as it did during the last taper/tightening cycle (with inflation breakevens today well above anything experienced in the last taper and tightening cycles).

In a potential double-whammy, the fact that fixed income markets are not pushing back against the Fed’s taper announcement lowers the Fed put strike, in BofA’s view. That’s because while traders generally tend to focus on equity market tantrums as the Fed’s signal to intervene, major U-turns in Fed stance were often encouraged by the bond market ‘disagreeing’ with the Fed’s plans.

For example, the 2013 taper tantrum was by far most felt in fixed income markets, while both inflation breakevens and expected rate hikes fell sharply as Powell raised rates through the second half of 2018, indicating that well ahead of the infamous Powell pivot they already knew he was on the right path.

Today, on the contrary, Eurodollar futures implied rates and inflation breakevens are rising in line with an uninterrupted hiking cycle ahead (Exhibit 9) – perhaps because investors don’t even bother to sell ahead of a market drop they know the Fed will step into and “rescue”, while rates vol has remained muted through the latest rise in long-term yields (unlike in the short-lived Treasury selloff of 1Q21; Exhibit 10). This price action – driven by bonds – has raises the Fed’s bar to easily change course if the equity weakness continues, and, as BofA warns, it calls into question where the Fed put strike is.

To summarize BofA’s argument, between the coming taper and frequent recent warnings about euphoric markets from both FOMC talking heads and even the IMF today cautioning about a risk of sudden and steep declines in global equity prices and home values, the risk is the Fed put strike is (much) lower than the market anticipates, as:

  1. Equity valuations & returns have accelerated to extremes post-Covid,
  2. The bond market is projecting tightening is needed and
  3. Risks of inflation overshooting are increasingly real, with 5yr inflation break-evens well-above any level witnessed during the 2014-2018 taper/tightening cycle.

As a result, Prasad warns that “the Fed may be less willing to so easily deviate from tapering plans and talk the market back up as during the last cycle, further adding to risks.” His conclusion – “bad news (delaying the Fed) would be the best news equities can wish for.”

Translation: It’s almost time for another crisis.

Tyler Durden
Tue, 10/12/2021 – 22:23

Author: Tyler Durden

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Lira Tumbles To New Record Low As Critics Blast Erdogan’s Ambassador Expulsion Scandal

Lira Tumbles To New Record Low As Critics Blast Erdogan’s Ambassador Expulsion Scandal

Following Erdogan’s Friday tirade, lashing out at…

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Lira Tumbles To New Record Low As Critics Blast Erdogan’s Ambassador Expulsion Scandal

Following Erdogan’s Friday tirade, lashing out at Western countries for issuing a joint letter demanding the immediate release of jailed Turkish billionaire philanthropist businessman and opposition politician Osman Kavala, which was followed by the president’s threat that he had ordered ten ambassadors – including the US – to be deemed ‘persona non grata’ by Turkey’s government, the Turkish lira weakened to another record low against the dollar after electronic trading reopened early in the Asian session.

Around 4pm ET Sunday afternoon, the lira tumbled 1.6% to a new record low against the dollar of 9.73 at the opening of Asian trading; this following the bigger-than-expected rate cut on Thursday despite rising inflation which sparked a furious selloff in the country’s currency as the move was widely derided as a dramatic and reckless and followed’s Erdogan’s erratic firing of three central bankers  the week prior.

The non grata designation targeted the ambassadors of US, Germany, France, Canada, Denmark, Finland, the Netherlands, Sweden, Norway, and New Zealand. Meanwhile, Turkish opposition leaders slammed Erdogan’s lashing out against the United States embassy and other allied Western countries as nothing but a major effort at distraction from Turkey’s economic tailspin and disaster in the making

Kemal Kilicdaroglu, leader of the main opposition CHP, said Erdogan was “rapidly dragging the country to a precipice.”

“I worry … for Turkish financial markets on Monday. The lira will inevitably come under extreme selling pressure,” said veteran emerging market watcher Tim Ash at BlueBay.

“And we all know that (Central Bank Governor Sahap) Kavcioglu has no mandate to hike rates, so the only defense will be spending foreign exchange reserves the CBRT does not have.”

Typically such a designation of foreign ambassadors results in their prompt expulsion from the country, but as of Sunday night that doesn’t appear to have happened yet, suggesting this may be yet more jawboning from Erdogan. It wouldn’t be the first time the president has failed to follow up on his threats: in 2018, he said Turkey would boycott U.S. electronic goods in a dispute with Washington. Sales were unaffected. Last year, he called on Turks to boycott French goods over what he said was President Emmanuel Macron’s “anti-Islam” agenda, but did not follow through.

As Reuters adds, citing a diplomatic source, a decision could be taken at Monday’s cabinet meeting and that de-escalation was still possible. Erdogan has said he will meet U.S. President Joe Biden at next weekend’s G20 summit in Rome. Erdogan has dominated Turkish politics for two decades but support for his ruling alliance has eroded ahead of elections scheduled for 2023, partly because of high inflation.

Emre Peker, from the London-based consultancy Eurasia Group, said the threat of expulsions at a time of economic difficulties was “at best ill-considered, and at worst a foolish gambit to bolster Erdogan’s plummeting popularity”.

“Erdogan has to project power for domestic political reasons,” he said.

Erdogan’s anger erupted after the ambassadors of Canada, Denmark, France, Germany, the Netherlands, Norway, Sweden, Finland, New Zealand and the United States issued a joint statement on Oct. 18, calling for a just and speedy resolution to Kavala’s case, and for his “urgent release”.

Soner Cagaptay from the Washington Institute for Near East Policy tweeted: “Erdogan believes he can win the next Turkish elections by blaming the West for attacking Turkey — notwithstanding the sorry state of the country’s economy.”

Tyler Durden
Sun, 10/24/2021 – 16:20

Author: Tyler Durden

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What’s Behind The Eerie Calm In Corporate Credit

What’s Behind The Eerie Calm In Corporate Credit

By Vishwanath Tirupattur, global head of Quantitative Research at Morgan Stanley

Over the…

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What’s Behind The Eerie Calm In Corporate Credit

By Vishwanath Tirupattur, global head of Quantitative Research at Morgan Stanley

Over the past few weeks, risk markets have been buffeted by volatility from a wide array of sources. It was around a month ago that the regulatory reset in China and near-term funding pressures on select property developers roiled global markets, as investors fretted over the systemic implications for global growth. A mixed US jobs report along with sharply higher commodity prices intensified the debate around stagflation. Rhetoric from multiple central banks has been increasingly hawkish. The combination of these concerns has resulted in substantial market gyrations. Relative to a month ago, the S&P 500 Index declined by about 4% before recovering to up 6%. The shape of the Treasury yield curve has twisted and turned. The benchmark 10-year Treasury interest rate went from around 1.30% to around 1.70%, and market pricing of the timing of a Fed rate hike has come in sharply.

Amid these substantial moves, corporate credit markets on both sides of the Atlantic have largely stayed calm. Credit spreads in investment grade, high yield and leveraged loans across the US and Europe have hovered near 52-week tights, with surprisingly limited volatility.

Credit market beta relative to equity markets remains very low. Market access for companies across the credit spectrum has remained robust, as indicated by strong issuance trends, running at or ahead of the pace a year ago. What explains this stark difference between credit and other markets? The answer boils down to meaningfully improved credit fundamentals and elevated balance sheet liquidity, leading to a decidedly benign outlook for defaults over the next 12 months, if not longer.

Our credit strategists, Srikanth Sankaran and Vishwas Patkar, have highlighted that the balance sheet damage from COVID has been reversed. At the end of 2Q, gross leverage in US investment grade credit had declined sharply to 2.4x, back to pre-COVID levels. Net leverage is now below pre-COVID levels, while interest coverage has risen sharply to a seven-year high.

The trends in the high yield sector are even more impressive and the improvement broad-based, driven not just by the rebound in earnings but also negative debt growth. At 3.87x, the median leverage of high yield companies in our coverage universe for 2Q21 is down 0.5x Q/Q and 0.89x Y/Y. After four consecutive quarters of declines from the 2Q20 peak, median leverage now sits below the pre-COVID trough. That 71% of the issuers are reporting lower gross leverage Q/Q reflects the broad-based improvement.

Encouragingly, the size of tail cohorts has also begun to normalize – the share of issuers reporting 6x+ leverage is down 7 percentage points on the quarter. On the median measure, debt balances were 3.9% lower Y/Y while LTM EBITDA was 17.5% higher. Median interest coverage increased in the quarter to 4.68x (+0.52x Q/Q), with a solid 82% of issuers posting improved coverage. Cash-to-debt ratios remained close to record highs at 15.6%. Even in LBO land, while 2021 has been a bumper year for acquisition activity, with transaction multiples and debt multiples at record highs – usually a source of concern for leveraged loan and high yield bond investors – unprecedented equity cushions have resulted in a better alignment of sponsor and lender interests, helping to alleviate concerns.

These improvements in credit fundamentals explain the low-beta behavior of credit versus equity markets. Earnings and margin concerns matter for credit investors, too, but the intensity and breadth of balance sheet repair matter more. Furthermore, given the sharp rally in stocks, equity cushions in capital structures have increased and leverage as measured by debt-to-EV has declined.

What are the implications for investors? A lot, of course, is in the price. With credit spreads near the tight end of the spectrum, we are more likely to see them widen than tighten.

Indeed, the base case expectation of our credit strategists is for modestly wider spreads. However, the strength in credit fundamentals suggests that the outlook for defaults is benign and likely below long-term average realized default levels. Thus, we prefer taking default risk to spread risk here, leading us to favor high yield over investment grade and, within high yield, loans over bonds. For the more sophisticated investor seeking double-digit returns, the best expression of this view would be through equity tranches of collateralized loan obligations (CLO). Structural leverage as opposed to repo leverage, cash flows that are front end-loaded, multiple embedded refinancing options, all combined with the expectations of benign defaults, make CLO equity tranches a particularly interesting opportunity.

Tyler Durden
Sun, 10/24/2021 – 16:40

Author: Tyler Durden

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Shadow Inflation: Shipping Costs Are Up Way More Than You Think

Shadow Inflation: Shipping Costs Are Up Way More Than You Think

By Greg Miller of FreightWaves,

Name something that costs far more than it…

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Shadow Inflation: Shipping Costs Are Up Way More Than You Think

By Greg Miller of FreightWaves,

Name something that costs far more than it did before the pandemic that simultaneously gives you far less value for your money than it used to.

Of all the goods and services in the world, it’s hard to find a better pick than ocean container shipping. As rates have skyrocketed, delivery reliability has collapsed amid historic port congestion. Ocean cargo shippers are paying more than they ever have before for the worst service they’ve ever experienced.

The true COVID-era inflation rate for ocean shipping, when adjusted upward to account for lower quality, is much higher than the rise in freight rates.

Rates spike, quality plummets

For businesses that rely on imports and exports, ocean shipping is a necessity, not a luxury, so pricing rises if demand exceeds supply regardless of how bad the service is. U.K.-based consultancy Drewry recently upped its forecast and now predicts that global container rates will increase by an average 126% this year versus 2020, including both spot and contract rates across all trade lanes.

Norway-based data provider Xeneta sees most long-term contract rates in the Asia-West Coast route averaging $4,000-$5,000 per forty-foot equivalent unit, double rates of $2,000-$2,500 per FEU at this time last year. Spot rates have risen much more than that, both in dollar and percentage terms. The Freightos Baltic Daily Index currently assesses the Asia-West Coast spot rate (including premium charges) at $17,377 per FEU, 4.5 times the spot rate a year ago.

Daily assessment in $ per FEU. Data: Freightos Baltic Daily Index. Chart: FreightWaves SONAR (To learn more about FreightWaves SONAR, click here.)

Service metrics have sunk as rates have risen. Denmark-based consultancy Sea-Intelligence reported that global carrier schedule reliability fell to 33.6% in August, an all-time low. In August 2019, pre-COVID, reliability was more than double that. Sea-Intelligence calculated that the global delays for late vessels was 7.57 days, almost double the number of days late in August 2019.

Charts: Sea-Intelligence. Data sources: Sea-Intelligence, GLP report issue 121

U.S.-based supply chain visibility platform Project44 highlighted the diverging paths of pricing and quality by contrasting its data on average days delayed with Xeneta’s short-term rate data. Between August 2020 and this August, project44 found that the monthly median of days delayed on voyages from Yantian, China, to Los Angeles increased 425%, from 2.46 days to 12.93. Over the same period, average short-term rates jumped 102%.

Chart: p44. Data sources: p44 and Xeneta

Shadow inflation

Neil Irwin of The New York Times recently wrote about “shadow inflation”when you pay the same as before for something that’s not as good as it used to be, so you’re effectively paying more. A pre-COVID example of shadow inflation: the infamous Lay’s potato chip incident of 2014. Lay’s intentionally included about five chips less per bag, lowering content from 10 ounces to 9.5, yet still charged $4.29 per bag, meaning customers were paying (and Frito-Lay was making) 5.3% more per ounce of chips.

The opposite — and until COVID, far more common — scenario is when product quality rises faster than pricing, decreasing effective inflation, as in the case of computers and other tech products. This downward effect on inflation is incorporated into the Consumer Price Index (CPI) via so-called hedonic adjustments.

As recounted by Irwin and Full Stack Economics author Alan Cole, COVID flipped hedonic adjustments in the other direction, toward lower quality per dollar paid, the equivalent of inflation. Pointing to restaurants and hotels, Irwin wrote, “Many types of businesses facing supply disruptions and labor shortages have dealt with those problems not by raising prices (or not only by raising prices), but by taking steps that could give their customers a lesser experience.”

According to Cole, “Over the last 18 months … goods and services are getting worse faster than the official statistics acknowledge,” implying that “our inflation problem has actually been bigger than the official statistics suggest.”

Shadow inflation and container shipping

Ocean container shipping is an extreme example of the “services are getting worse” trend, despite enormous freight-rate inflation.

Measuring quality adjustments to inflation is inherently difficult, which is why very few CPI categories have hedonic adjustments. One way to do a back-of-the-envelope estimate of ocean shipping shadow inflation is to focus on time: the longer the delays, the less quality, the higher the cost fallout, the higher the effective inflation above and beyond the rise in freight rates.

Jason Miller, associate professor of supply chain management at Michigan State University’s Eli Broad College of Business, suggested using accounting of inventory carrying costs to measure the time effect.

“If I already own a product and I took possession of it overseas at the port of departure, and it’s on my balance sheet and it’s just sitting on the water, then in inventory management, there is a charge incurred every day it’s not sold,” he explained.

Miller explained, “There is the cost of capital. Every $100 in inventory is $100 that can’t be allocated elsewhere for a more value-producing purpose. There is also the cost due to obsolescence. It’s essentially opportunity costs. The longer the delay, the more additional costs from stockouts [as shelves empty] or the need to buy more safety stock.”

Rate rises affect different shippers differently

Whether it’s price inflation from rate hikes or indirect shadow inflation from slow service, different shippers are affected very differently.

On the rate side of the equation, Xeneta data shows a massive $20,000-per-FEU spread between the lowest price paid by large contract shippers in the trans-Pacific trade and highest price paid by small spot shippers.

Erik Devetak, chief data officer of Xeneta, told American Shipper, “We see the very bottom of the bottom of the long-term market at approximately $3,300 per FEU, although there are very few contracts at this price. On the other hand, we see the short-term market high up to $23,000 per FEU, again, in rare situations.”

In the latest edition of its Sunday Spotlight report, Sea-Intelligence analyzed how rate hikes affect different shippers and found a huge competitive advantage for larger shippers given this gaping freight spread.

Sea-Intelligence, using Xeneta data, estimated that a large importer on contract (in this case, in the Asia-Europe trade) shipping a 40-foot box with $250,000 of high-value cargo would see freight costs rise from 0.5% of the cargo value a year ago to 1.8% currently — an easily digestible increase. A small shipper in the spot market moving the same load would see freight costs jump from 0.7% of cargo value to 6.2%.

Sea-Intelligence then ran the same exercise with a low-value cargo worth $25,000. It said that in this case, the large contract shipper’s freight-to-cargo-value ratio rose from 5% last year to 18% currently, while the small spot shipper’s freight-to-cargo-value “exploded” from 7% to 62%.

Service delays affect different shippers differently

Rising rates affect high-value cargo the least because the freight rise equates to a small proportion of the cargo value. But with shadow inflation from voyage delays, it’s the opposite, according to Miller. Shipments of high-value goods get hit much harder than low-value goods.

Accounting carrying costs are derived from cargo value. The higher the cargo value, the higher the carrying costs. “Where these delays especially matter is for high-value imports,” said Miller. “It’s ironic. The importers that are least affected by high spot prices are the ones who are getting really hurt most by the delays.”

One example: A large importer pays $4,000 in freight under a contract to ship a high-value cargo of $250,000 worth of electronics in a 40-foot box. There is a 30% annual carrying cost, in part due to high obsolescence risk, thus a carrying cost of $205 per day, so a 10-day delay would equate to an accounting cost of $2,050, adding 51% on top of the freight cost.

A contrasting example: A small importer pays $15,000 in the spot market to ship a low-value cargo of $25,000 worth of retail products in a 40-footer, with a 20% annual carrying cost. A 10-day delay would equate to an accounting carrying cost of $137, just 1% more on top of the freight rate.

It’s not just high-value cargoes that suffer from delays, Miller continued. Obsolescence risk is key. On the high end of the value spectrum, that relates to goods like electronics; on the low end, to things like holiday items and seasonal fashion.

Another major factor: whether the delayed import item is a component in a manufacturing process. In that case, the cost of ocean shipping delays can be enormous, dwarfing the increase in freight rates.

American Shipper was recently contacted by a manufacturer that has a vital component of its production process trapped in containers aboard a Chinese container ship that has been at anchor waiting for a berth in Los Angeles/Long Beach since Sept. 13.

“When imports are actually inputs into a production process, and if a stockout is going to shut down a plant, you are now facing a huge opportunity cost,” warned Miller.

Tyler Durden
Sun, 10/24/2021 – 15:30

Author: Tyler Durden

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