Global Macro Charts & Commentary

RATES, EQUITIES, COMMODITIES, FX & CREDIT

October 17, 2022

UK Gilts Trading Like Crypto and BTPs

Late last week the UK government reversed course on their policies that had created
so much market instability, and installed a new chancellor, Jeremy Hunt. It is uncertain
if this will really calm the markets, but as of now gilts are less liquid than BTPs and the
30-day annualized volatility of 30-year gilt yields is well above that of crypto assets,
such as Bitcoin and Ethereum. To quote Churchill, “Never was so much owed by so
many to so few,” as the Conservative party single handedly created this chaos.

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Euro IG Bonds Finally an Alternative to Equities
Italian bank loan rates vs IG corporate yields

Euro IG bond yields are now higher than the Euro Stoxx dividend yield, proving a good
alternative to equities. In addition, throughout the Eurozone, given the steepness of the
rate curve, floating corporate loans appear much more attractive for corporations
versus issuing bonds, and in the last few months we have seen a significant fall in Euro
IG bond issuance. After so many years of issuing bonds with close to zero yields,
corporations have to once again pay for debt.

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EM Portfolio Flows Remaining Negative

Among the many financial stability risks highlighted by Fed Vice Chair Brainard is the
impact of higher interest rates and a stronger dollar on foreign economies, especially
EM economies. The charts above from the IMF show persistent portfolio outflows
across Asia. The impact of those flows on local markets act to further weaken those
economies, and in turn spill back to the U.S. in the form of weaker export markets.

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EM Asia FX Reserves Fell by $580 Billion YTD

Source(s): UBS

In one of the most dramatic drops since the 2008 Global Financial Crisis, EM Asia’s
FX reserves have fallen by more than $580 billion since the start of 2022. This
outsized drop is the result of the combination of the selloff in US/EUR interest rate
markets and FX intervention activity. The latter may also be weighing on asset swap
levels in the intermediate sector of the US Treasury curve

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Very Sticky Core CPI

The Core (ex. Food and energy) CPI print of 0.6% MoM, 6.6% YoY shocked the market
on Wednesday with the S&P 500 initially falling ~3% before ending the day up ~3%, as
short squeeze technicals created a buying frenzy. We closed the week lower, but
roughly flat, to Tuesday’s close, so a very limited net reaction to the print. Morgan
Stanley predicts that Core CPI will remain sticky for another month or two as shelter
inflation is likely to persist for a few more months, so it may not be until early next year
that we will see the Fed pivot. Expect more volatility into year-end.
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Widening of Long-Term (5y5y) Inflation Breakevens
3 -1

-0.5
2.8
Inflation Breakeven (%)

INVERTED AXIS
Real Rate (%)
0

2.6

0.5

2.4
1

Breakeven
Real Rate
2.2 1.5
1-Jan-22 4-Mar-22 5-May-22 6-Jul-22 6-Sep-22 7-Nov-22
Source(s): III Capital Management, Bloomberg LP

Since March, in response to the tightening of financial conditions by the Fed, long-
term real rates have risen from -0.5% to +1%. The rise has been as a result of both
an increase in the long-term nominal rates and a fall in inflation breakevens. Rather
worryingly, since the release of the September payroll number and the drop in the
unemployment rate back to cycle tights of 3.5%, long-term inflation breakevens have
started to rise again.

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Are We There Yet…

1y Real Fed Funds Rate (%)

Source(s): Barclays

In spite of the Fed implementing one of the most aggressive tightenings of monetary
policy in recent memory, the 1-year real Fed Funds (“FF”) rate remains below the
neutral FF rate as derived from the Holston, Laubach, Williams (“HLW”) model. This
contrasts with prior tightenings where, to quell inflation pressures, the real FF rate
needed to rise well above the HLW estimate. This would suggest that current level of
the 1-year real FF rate is insufficient to dampen inflation and that the Fed needs to
continue on its path to tighten monetary policy.
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Europe Facing Massive Real Income Shock

With wage growth at 2.5% and inflation heading to 10%, the eurozone faces a massive
real income shock. In Spain, for example, real wages are running at -8%. Despite
national government efforts to offset some of the impact from energy prices, consumer
spending across the eurozone will almost surely be negative in real terms for several
quarters.

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Euro Real GDP Growth Negative Until 3Q 2023?
GDP Growth (%Q)

Following the negative real wage shock facing Europe, overall real GDP is likely to
remain negative from 3Q 2022 to 2Q 2023. The ECB’s willingness to continue with rate
hikes (and QT as well) in the face of declining growth and employment will surely be
tested in the quarters ahead. In fact, a Reuters story last week placed the ECB staff
outlook on the terminal rate at 2.25%, at odds with the hawkish wing of the ECB that is
discussing bringing rates well above 3% (current market pricing).

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 Rising Credit Derivative and ETF Volumes

The persistent volatility in the credit markets this year has led to a significant rise in trading
volumes, as market participants look for ways to hedge their risk and take advantage of wider
spreads and local dislocations. The rise has been somewhat modest in single name CDS, as bid
offer spreads remain very wide, so most of the rise has been in index products where liquidity is
far superior. Note also a large rise in credit ETF index and especially option volumes, with
investors looking to hedge with cash products rather than derivatives, in light of cash markets
remaining flat or tight to derivatives. This in turn has led to limited borrow in the ETFs, with borrow
rates falling 3+% below overnight rates. This is especially pronounced in HYG as dealers look to
hedge HYG puts that they sell. Tranche volumes have fallen slightly, with investors focused on
smaller junior tranches in order to find convexity amidst the backdrop of persistent macro
uncertainty.
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Underwater CLO Warehouses are Shrinking
CLO Warehouse Balances ($bn, under- vs. above-water) Mark-to-market Losses in CLO Warehouses ($mm)

Source: MS Leveraged Loan & CLO trading desk

When loan prices fell sharply in May, all ~$50 billion of CLO warehouses went underwater,
meaning that they could not be liquidated without losses. Since then, some of these deals
have come to market with managers and warehouse investors providing incentives to CLO
equity investors in order for them to take on the underwater warehouse collateral while
financing at ever wider CLO debt spreads. Also, with carry accumulating and loan prices
staying just above $92, many of the warehouses are now above water, leaving ~$22 billion
that remain underwater with ~$880mm of mark-to-market losses. This is now similar in size
to what was experienced at the end of 2018 and in March 2020 indicating that, unless there
is significant further deterioration in the loan market, the CLO market will find a way to deal
with these underwater warehouses over time.
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Important Information

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