Regular readers will know that we are constantly on the lookout for ‘Canaries in the Coalmine’, early warning signs that there may be trouble ahead. Equity investors tend to look on the bright side but bond investors are always worried about something.
We may not be approaching another 2008 but it never pays to ignore the warning signs. We advised our investors to steer clear of Lehman Brothers well before the problems that subsequently ensued, based more on an uneasy feeling than any concrete evidence. When you’ve lived through 1994, 1998, 2001 and 2008 you get a feel for what to look for. Most often, the things you worry about turn out not to be as bad as you think, but us bond investors are paid to worry.
The expansion of the Fed’s balance sheet that started last month can easily be explained away, but 60 billion dollars per month is a lot. The Fed plans to buy US Treasury bills with the buying continuing until at least the second quarter of 2020. The pace of the Fed’s balance sheet expansion is much faster than it was in 2010 or 2012 for example. It also occurred around the time where the overnight funding rate had recently spiked above 10%.
Last month JP Morgan’s CEO Jamie Dimon commented that his firm had the cash and willingness to calm short-term funding markets, but didn’t. “We could not redeploy it into the repo market. We’d have been happy to do it,” Dimon said, “It’s up to the regulators to decide if they want to recalibrate the kind of liquidity they expect us to keep in that account.” If JP Morgan are up against constraints, other banks probably are too.
One possible explanation is that losses on riskier assets are forcing investors to reduce lower grade credit in favour of high grade bonds and US Treasuries. For example, press reports suggests that Japan’s biggest CLO investor, Norinchukin, holds 13% of their USD 586 bn portfolio in this risky asset class and is not reinvesting the proceeds when they mature. Given their size, that will likely put the CLO market under pressure and that is indeed what is happening at the moment with spreads much wider than similarly rated junk bonds. Maybe things will improve in due course, but until they do we have another canary in our coalmine to keep an eye on.