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Fed Froth and Leveraged Loans - July 23, 2019

Regional Mixed Messages

 Like summer weather in Colorado, punishingly hot, dumping rain or snow, and perfectly mild within the hour, recent regional Fed data has been all over the spectrum. The Philadelphia Fed Manufacturing Business Outlook Survey showed improvements in general activity, new orders, shipments, and employment. Also, “most of the survey’s future activity indexes increased, suggesting improved optimism about growth for the next six months”. The Richmond Fed Survey of Manufacturing Activity saw the largest drop in local business conditions in the survey’s history. Many of the survey’s indexes hit multiyear lows, including the composite index and backlog of orders. And the Empire State Manufacturing Survey bounced out of negative territory amid mixed results. The new orders index rose but remained negative, while the shipments index dropped but remained slightly positive. Despite the large variation in current conditions reported across Fed jurisdictions, all three surveys found respondents to be optimistic about the future. We will see next Wednesday if the Fed agrees with the sunny forecast.  

 “May Not Be Sufficiently Liquid to Meet Demand”

 Janet Yellen warned back in February of her “concerns about leveraged lending”, commenting that “non-financial corporations have run up, really, quite a lot of debt.” The Bank of England tacitly agreed in its latest Financial Stability Report. Taking an entire section to analyze Leveraged Lending, the BoE not only discusses the rapid expansion of the leveraged loan market but also highlights potential pitfalls. In addition to worrying that “investors may not have been compensated for the risks they are taking”, the BoE warns that in times of stress “the leveraged loan and high-yield corporates bond markets may not be sufficiently liquid to meet demand from borrowers”.

While this would appear to be an exercise in the land of hypotheticals and only a concern for banks, there are a few things to know. First, though banks have most of the exposure to leveraged loans, “non-bank investors have significant holdings”. Second, stress could act as a positive feedback loop because “large-scale redemptions from open-ended funds could amplify price falls”. Third, anybody invested in M&G, Woodford or H2O has seen first-hand in recent weeks how, when it comes to liquidity problems, hypotheticals can become reality in the blink of an eye.