Thursday, 11 February 2016

Macro and Credit - The Vasa ship

"In the ocean of baseness, the deeper we get, the easier the sinking." - James Russell Lowell, American poet.
When in Paris on the 5th of January to present our winning Saxo Bank community from their latest Outrageous Predictions for 2016 to their French clients, we had a very interesting meeting with Steen Jakobsen, their chief economist, who at the time, suggested we look into the Vasa ship as an interesting analogy for a post title. This time around curiosity did not kill the cat, and we waited, we must confess, for the right time to use this very interesting analogy in our musings. Given the on-going onslaught in risk asset classes (except for our comforting long US bonds, long gold miners and other positions) and also because, as always, credit leads equities (this means to lower levels that is), we decided it was the right time to use Steen's suggestion in this Macro and Credit related musing of ours.

So why the Vasa ship for our chosen title?

The Vasa ship was a Swedish warship built between 1626 and 1628 on the orders of the King of Sweden Gustavus Adolphus as part of the military expansion he initiated in a war with Poland-Lithuania (1621–1629). The ship is famous for having foundered and sank after sailing only about 1,300 m (1,400 yd) into her maiden voyage on 10 August 1628. Richly decorated as a symbol of the king's ambitions for Sweden and himself, upon completion the Vasa ship was one of the most powerfully armed vessels in the world (like the Bank of Japan). However, it had a massive design flaw. Vasa was dangerously unstable and top-heavy with too much weight in the upper structure of the hull (total amount of debt in the world). Despite this lack of stability she was ordered to sea and foundered only a few minutes after encountering a wind stronger than a breeze. In similar fashion, Bank of Japan's attempt in playing the Negative Interest Rate Policy game (NIRP) card sounds to us eerily familiar with the tragic fate of the Vasa ship. Kuroda's attempt foundered straight from inception with the Japanese Yen rising to 114 and the Nikkei rout continuing seeing the Nikkei lose another 2.31% on the 10th of February to 15,713.39.

The fatal order to sail was the result of a combination of factors. One being the king's impatience in seeing the Vasa ship becomes its flagship of the reserve squadron at Älvsnabben in the Stockholm Archipelago. The other was the king's subordinates lack of political courage to openly discuss the ship's structural problems or to have the maiden voyage postponed. Although an inquiry was organized by the Swedish Privy Council to find those responsible for the disaster, but in the end no one was punished for the fiasco. In similar fashion we think the central bankers at the Bank of Japan, the Fed, the SNB, the ECB responsible for the mess we are in will not be punished for the upcoming fiasco but we ramble again...

In this week's conversation we will look again at the dangerous evolution we are seeing from idiosyncratic "sucker punches" towards "systemic" risk. We will also look at why in similar fashion to the Vasa ship, new monetary policies such as NIRP will fail because of dangerously unstable markets and their top-heavy load (global world debt).

Synopsis:
  • Central bankers' tricks are losing their "magic"
  • Credit - The tide has turned and we are moving from "idiosyncratic" risk to "systemic risk"
  • Final chart - Don't catch falling knives
  • Central bankers' tricks are losing their "magic"
As we pointed out recently in our conversation "Under pressure", our Generous Gamblers aka our central bankers are losing their magic we think:
"Additional easing monetary policies, but as shown recently in the various iterations of QE in the US, the Fed is getting "less bang for the buck". Basically the "magic" of our "Generous gamblers" is losing its power on driving asset prices to new heights. "Overmedication" could in fact lead in the end to "overdoses", we think." - source Macronomics, January 2016
 We also added:
"When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing.
The correlation between macro variables such as bund yields, FX and oil and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis." - source Macronomics, January 2016
It was bound to happen as per the Vasa ship (positive correlations leading to instability). From the inception of "unorthodox" monetary policies, the biggest issue which has yet to be addressed as brilliantly pointed out by William R. White, the chairman of the Economic and Development Review Committee (EDRC) at the OECD in Paris in a Bloomberg interview in similar fashion to the Vasa ship which was dangerously unstable because of too much weight in the upper structure of the hull, is the total amount of debt in the world.

In the light of Mr. William White's great interview we would like to rehash the quotes we have used in our March 2012 conversation "Shipping is a leading deflationary indicator"particularly in the lights of the very concerning comments made by AP Moller-Maersk's CEO on the current state of affairs of his company, seeing a situation worse than 2008:
"He who rejects change is the architect of decay. The only human institution which rejects progress is the cemetery."
Harold Wilson
"He who rejects restructuring is the architect of default." - Macronomics.
This is why Mr White's comments are so to the point. The longer you delay the restructuring, the lower will be the recovery value.

But, when it comes to central bankers losing their magic, the latest "results" in the markets from the Bank of Japan's implementation of NIRP speak for themselves. This is does not come as a surprise whatsoever. It was bound to happen and it is clearly pointed out by Bank of America Merrill Lynch in their FX Vol Trader note from the 10th of February entitled "Central Banks puts expire":
"Key takeaways
• As confidence in central bank puts erode, market participants are adjusting by paying for their own protection.
• Hedge demand has pushed vols indiscriminately higher. We view this as excessive and prefer to fade the move.
Markets adjusting to less stimulus

The painful adjustments taking place across global financial markets can partially be attributed to the re-pricing of central bank expectations. With Fed QE quickly becoming a distant memory and both the ECB and BOJ failing to deliver expansion packages, the market has been forced to learn to stand on its own two feet. As implicit central bank puts expire, the market must now pay for protection out of pocket, reflected in the structural shift in long-dated EURUSD and USDJPY risk reversals, which have both turned for USD puts (Chart 1). 

Like most forms of insurance, by the time the accident is being assessed, further coverage will be expensive. The demand for options has pushed FX vols towards the highs of the past couple of years. In our view, the indiscriminate demand for vol across all currencies and tenors is excessive and we prefer to fade the move." - 
Markets anxious, buying vol indiscriminately
Concerns about the health of the US economy and the European banking sector wreaked havoc on global markets this week. The broad anxiety is reflected in the indiscriminate vol purchases across currencies and tenors (Page 5, Table 3).

Gamma in general is performing, but our core view has been that barring some sort of crisis, it will be difficult to sustain volatility without a core divergence story." - source Bank of America Merrill Lynch

Also, as we posited in back in November 2014 in our conversation "Chekhov's gun", the changes in the communication of monetary policy have indeed taken a turn for the worse. This was clearly demonstrated by the SNB in 2015 and the surprise NIRP implementation by the Bank of Japan:
"What we find of interest is that both the Fed and the Bank of Japan have been trigger "QE " happy, As we have argued in our last conversation, investors' belief in central bankers' omnipotence and deity status enabling them to sustain over extended asset price levels is being threatened we think by the changes in the communication of the conduct of monetary policy as indicated by Richard Koo, chief economist at the Nomura Research Institute in his latest note:
"The problem is that treating monetary policy like currency intervention also has side effects. Over the last decade it has become standard practice around the world to conduct monetary policy with a minimum of surprises based on careful dialogue with market participants.Until the mid-1980s, monetary policy decisions tended to be made in closed rooms, something then-Fed chairman Paul Volcker was very good at. In Japan, it was even considered “acceptable” for authorities to openly lie in the lead-up to decisions on the official discount rate (or the timing of snap elections).Since the Greenspan era, however, transparency has gradually come to be viewed as a desirable characteristic in the conduct of monetary policy. This trend gathered momentum under the leadership of Mr. Bernanke, who had been making a case for greater transparency in monetary policy since his days in academia. During his tenure at the Fed, this view was reflected in the shortening of the time required for FOMC minutes to be released, the holding of press conferences by the Fed chair, and the release of interest rate forecasts by FOMC members.
Kuroda abandons forward guidance
It was because of this approach that the Fed has been able to conduct policy now known as forward guidance based on expectations of its future actions, something that had not been possible in the past. It was precisely because the Fed avoided surprises that market participants trusted it when it said it would keep interest rates at exceptionally low levels for a considerable amount of time.Policymaking evolved in this direction because of a growing awareness that monetary policy has a major impact on the economy and is fundamentally different from intervention on the currency market, which basically involves only a handful of participants.But with the 31 October easing announcement Mr. Kuroda deliberately chose to shock the markets. By doing so, he effectively removed forward guidance from the BOJ’s toolkit.When the head of the central bank enjoys surprising the market, market participants will no longer take anything he says at face value. Mr. Kuroda claimed in his Upper House testimony just three days before the announcement that the economy was making “steady progress” towards achieving the 2% price stability target even as he was secretly moving ahead with preparations for the surprise easing.

Ending QE will now be far harder for BOJ than for Fed
The BOJ governor’s decision to utilize the element of surprise could lead to major problems when it comes time to bring quantitative easing to an end. Careful dialogue with the market—including forward guidance—is essential when winding down such a policy, as the IMF has repeatedly warned.There is, of course, no guarantee that the exit from QE will proceed smoothly simply because the central bank maintains a close dialogue with the markets. Even Mr. Bernanke, with his reputation for being a good communicator, caused a great deal of turmoil in both the developed and the emerging economies when his remarks on 22 May 2013 concerning the possibility of tapering sent US long-term interest rates sharplyhigher.The Fed’s intensive forward guidance under both Mr. Bernanke and his successor, Janet Yellen, succeeded in calming markets by persuading them the Fed had no intention of raising rates in the near future. It remains to be seen how Mr. Kuroda will respond when he finds himself in the same situation.In summary, the BOJ’s shock announcement could make it far more difficult for the Japanese central bank to end quantitative easing than it has been for the Fed." - source Richard Koo, Nomura Research Institute
To some extent, both the Bank of Japan and the Fed have been fast QE gun drawers, but, when it comes to winding down QE, the exit from the program will not proceed that smoothly, rest assured." - source Macronomics, November 2014
Exactly! The Bank of Japan has painted itself in a corner (and soon the Fed will as well). The shock announcement of NIRP has led to an unexpected outcome and more "sucker punches" delivered in the form of falling Japanese equities and a sudden "risk reversal" on the Japanese yen. Remember, we told you in December in our conversation "Charles law" significant "risk reversal" opportunities would happen in 2016:
"We don't see conditions improving either in 2016 and last Monday was once again an illustration of "Blue Monday" in the works we think. With liquidity deteriorating and hydrogen having been used by our "generous gamblers" as a lifting agent in  "asset balloons", there is indeed no surprises in seeing a significant rise in idiosyncratic risk leading to significant price movements. 2015 saw an increase in the number of "sucker punches" inflicted to the "cross-asset" crowd. By no means 2016 is going to be different." - source Macronomics, 15th of December 2015
When it comes to the latest "sucker punch" delivered to the Japanese yen courtesy of Kuroda's NIRP, we read with interest Richard Koo, chief economist at the Nomura Research Institute in his latest note from the 2nd of February:
"Negative interest rates an act of desperation driven by failure of past accommodation
In my view, however, the adoption of negative interest rates is an act of desperation born out of despair over the inability of quantitative easing and inflation targeting to produce the desired results. That monetary policy has come this far is a clear indication that both ECB President Mario Draghi and BOJ Governor Haruhiko Kuroda have fundamentally misunderstood the ongoing recession.
To begin with, despite the all-out efforts of central banks in Japan, the US, the UK and Europe, neither quantitative easing nor inflation targeting were able to achieve their initial objectives.
The BOJ has now pushed back the date when it expects to achieve its inflation target from “around the second half of fiscal 2016” to “around the first half of fiscal 2017,” which would be fully four years into the Kuroda/Iwata era.
Failure of monetary easing symbolizes crisis in macroeconomics
This failure clearly demonstrates that the Japanese economy envisioned by Mr. Kuroda and Mr. Iwata at the time of their appointments when they pledged to step down if they failed to achieve 2% inflation in two years was very different from the reality. In short, their models were wrong.
The same mistake has been made repeatedly in the US, the UK and Europe. In each case the monetary authorities undertook extreme quantitative easing measures in an attempt to achieve inflation targets, yet price growth continues to run far below the target levels.
In view of the fact that some of the most talented, well-educated economists in these countries are working for these central banks, it is hard not to conclude that this global policy failure is less a reflection on the abilities of Mr. Kuroda and Mr. Draghi than a signal of a crisis in the discipline of macroeconomics itself.
Conditions in today’s real economy do not conform to macroeconomic assumptions
The definitive difference between the economics that they (and we) studied as university students and the actual economic experience of the US and Europe since 2008 and Japan since 1990 is that traditional economics assumes the private sector is everywhere and always trying to maximize profit. But today the private sector is trying to clean up its balance sheet by minimizing debt.
In terms of financial markets, traditional economics means there will always be borrowers as long as interest rates are lowered far enough. In today’s world, there are no borrowers no matter how low interest rates are taken.
Traditional economic theory and econometric models assume the private sector is always forward-looking and is always seeking to maximize profit. As such, there will always be someone willing to borrow money to invest as long as real interest rates are low enough. Given that assumption, the focus of economic policy is naturally going to be on the central bank’s monetary policy.
And if we assume that the private sector is always trying to maximize profit, fiscal policy (under which the government borrows money to spend) wastes precious private-sector savings and raises the risk that the private sector—which can use funds more effectively than the government—will not receive all the money it needs. That is the primary reason why fiscal deficits are so unpopular.
Traditional economics never envisioned a debt-minimizing private sector
The private sector will always seek to minimize debt after the collapse of a debt-financed bubble. Yet traditional economics not only did not foresee this kind of situation, but does not even have a term to describe it.
Traditional economics did not envision the sort of world we have been living in since 2008 because such conditions were never observed in western economies between the 1940s, when the discipline of macroeconomics as born, and 2008.
Until 2008, in other words, there were always willing private-sector borrowers in the US and Europe who responded to changes in interest rates. In such a world, monetary policy is effective and fiscal stimulus generally frowned upon since it has the potential to crowd out private investment.
Interest rates no longer relevant once people start minimizing debt
But after a debt-financed bubble collapses, the debt remains while asset prices fall, leaving many borrowers technically insolvent or at least struggling.
This is a frightening situation for a company to be in, inasmuch as its banks can shut it down at any moment. After all, banks are not allowed to roll-over loans to bankrupt borrowers, and all financing, including trade credits could disappear once the creditors and suppliers realize the true state of the borrower’s balance sheet. For a household, too, it is a dangerous state of affairs in which assets that had been set aside for emergencies or retirement suddenly disappear. The overriding priority for these businesses and households, therefore, is getting out of this situation as quickly as possible.
Emerging from this debt overhang requires businesses and households alike to focus on saving more and paying down debt. Whether interest rates are zero or even negative, people will continue minimizing debt until they have dug themselves out of the hole. The probability of their behavior changing because of a shift in interest rates is negligible.
When this state happens throughout the private sector, not only do private-sector borrowers disappear, but the private sector in aggregate may begin saving instead of borrowing.
Central bank cannot control inflation during a balance sheet recession
Once the private sector begins saving (and paying down debt) in aggregate, the money multiplier turns negative at the margin. The money supply—the money available for the private sector to use—not only does not increase but can actually decrease, regardless of how much base money the central bank supplies.
When the balance-sheet-constrained private sector chooses to minimize debt in spite of zero interest rates, the liquidity supplied by the central bank cannot come out of financial institutions and enter into the real economy due to lack of borrowers. I have dubbed this state of affairs a balance sheet recession, a term that is now heard quite frequently. Unfortunately, the vast majority of people—including Mr. Kuroda and Mr. Iwata—remain unaware of this economic malaise.
Those who do not recognize that balance sheet problems are keeping potential borrowers from borrowing believe the recession is attributable to insufficient monetary easing by the central bank. That leads them to espouse policies such as quantitative easing and negative interest rates. But no matter how far these policies are pursued, there is no reason why the economy should recover until the private sector overcomes its balance sheet problems and turns forward-looking again.
Professor Paul Krugman, who was the first to recommend that this state of affairs be addressed with inflation targeting and quantitative easing, has proposed that a 4% target should be adopted if a 2% target does not work. But the current situation is not one that can be addressed with such trivial adjustments. Interestingly, even Professor Krugman has come to admit that non-conventional monetary easing adopted up to now were “not a game changing tool.” (“Krugman: ‘Meh’ is grade Fed gets on QE,” published on Nov 9, 2015 on Market Watch.)
The theory that inflation is a monetary phenomenon that can be controlled by the central bank, since the central bank controls the supply of money, is valid in a world in which there is an ample supply of private-sector borrowers. But it is mere nonsense in the post-bubble-collapse world of a balance sheet recession, where this condition is not satisfied.
Gulf between real world and economy as envisioned by economists continues to widen
In that sense, the economies of Japan, the US, the UK and Europe now fall completely outside the realm of traditional economics, yet the vast majority of policymakers and economic agents continue to operate as though this were not the case, and the textbook world envisioned by economists still existed. This misunderstanding has complicated the situation greatly.
In other words, the equity and forex markets have responded directly to central banks’ negative interest rates and quantitative easing, but businesses and households in these countries refused until quite recently to borrow any money at all. The implication is that the exchange rates and share prices set by these markets are on very shaky ground.
As noted in the last issue of this report, forex traders over the past seven years have orchestrated heavy sell-offs of the currencies of countries announcing quantitative easing programs based on the assumption that the money supply in those countries would increase far more than the money supply of non-QE nations. But in reality, the money supply in all countries has been essentially stagnant as businesses and households continue to pay down debt.
In the same way, stock prices have appreciated each time further monetary easing measures have been announced, based on the assumption that those measures would increase the money supply and lift the economy. But the money supply has not grown meaningfully in any of these countries.
Although the forex and equity markets responded sharply to the BOJ’s negative interest rate announcement, the changes in the real economy that would justify such moves and nowhere to be seen. At some point, therefore, I would not be surprised to see a reaction in the forex and equity markets that helped to fill the gap between expectations and the real economy" - source Richard Koo, Nomura Research Institute
In similar fashion to the ill-fated design of the Vasa ship, the Bank of Japan has induced much more volatility in an already fragile situation. The best illustration of an economy "rebooting" after a total collapse of its financial sector remains Iceland we think. The pill was hard to swallow but in the end both inflation (2.10% as of January) and unemployment have been tamed (from 9.20% in May of 2010 to a low of 2.30% in December 2015):
.

- source TradingEconomics.com
The major issue that seems to lack the attention of our "Generous Gamblers", is that you have to choose your battle wisely. They cannot ignite inflation and reduce unemployment at the same time without an increase in wages and this would mean that corporate earnings would have to revert to the mean. Unfortunately CEOs seems to care these days more about their own bottom line rather through buybacks in order to trigger their alluring stock options. As we posited in the "Pigou effect" last year real wage growth is the Fed's greatest headache. We quoted Sir Jimmy Goldsmith at the time from the lengthy but great thoughtful reply called "The Response" (link provided) to the critics of his great his book "The Trap" which was eerily prescient:
"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " - Sir Jimmy Goldsmith
And lowering the standard of living of one's own nation has indeed been the results of the repeated foolhardiness of the Fed and its zealous "put".

Real wage growth is the issue for the US economy as we stated back in July 2014 in our conversation "Perpetual Motion":
"Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level." - source Macronomics, 22nd of July 2014
Of course, as underlined by William White in his stunning interview, another solution to make the marginal-utility-of-debt going positive would be to restructure private debts (Iceland) so that the ailing US households (14.24% of the population receiving Food Stamps) could indeed save more, invest and consume again, which is in essence the purpose of good allocation of debt to the real economy. Not into inane speculative endeavors which have been extensively encouraged by the various iterations of QEs and their inefficient "Wealth Effect" to the "real economy".


When it comes to understanding credit and the buildup in a liquidity crisis (which we reminded you a couple of days back that it always leads to a financial crisis) we would like to use again a previous extract from our conversation "Pigou effect"from Sir Jimmy Goldsmith in his work "The Response":
"The idea that accounts must balance, and that inflows must ultimately match outflows, is an accountant's idea.
But there is a fundamental misunderstanding here. If you make a loss, perhaps because you own a business that is trading unprofitably or because you have made a bad investment, you will not get rid of the loss by borrowing the amount needed to pay for it. You will have avoided or postponed a personal liquidity crisis, but you will still be poorer by the amount of the loss. You will also have to pay interest on the loan.
Alternatively, you might sell your house and rent somewhere else to live. You will have used the proceeds of the sale to pay your debts, but you will remain poorer by the value of the house. And in future, you will have to pay rent." - Sir Jimmy Goldsmith - "The Response"
Since 2008, the losses have not gone away, as we reminded you as well, European banks even with LTROs and QEs Nonperforming Loans (NPLs) have not gone away and there is still around €1 trillion of NPLs sitting on their balance sheets....

If you think NPLs are going to go away when we have mounting signs of headwinds for European growth with December Industrial Production coming at -1.6%  (+0.2% expected) for France, Italy -0.7% (+0.3% expected) and even the UK -1.1% (-0.1% expected), then think again.

In the current environment where we are seeing financial conditions tightening rapidly across the world as pointed out recently by the BIS for Emerging Markets and by the latest Fed US Senior Loan Officer Quarterly Survey, it means lack of credit will slow growth and therefore will not help out whatsoever the reduction of these NPLs. Furthermore, the stupidity is compounded by NIRP because banks cannot be profitable with a massive reduction in Net Interest Margins (NIM). That simple. So please, spare us the "value beta play" mantra because so many are trading under book value (most of the time banks balance sheets are such a black box, that you have a hard time detecting you what's being hidden). We are not buying it.

This brings us to our second point related to credit given our "2007" feeling. Credit is always leading equities and what we have been commenting  throughout our musings as we watched the credit cycle unfold, is in effect happening and it's we think it is still a cause for concern as the contagion is in effect spreading.

  • Credit - The tide has turned and we are moving from "idiosyncratic" risk to "systemic risk"
What we have been indicating during last summer were the many signs of the credit cycle maturing. The record wave of M&A in 2015 coincides clearly with the late stage of the cycle. This has been clearly illustrated by our friend Cyril Castelli from Rcube (he finally joined the twitter family and you can reach him there: @CyrilRcube):
"The M&A cycle leads the credit cycle. M&A mania =>weaker balance sheets =>tighter bank lending => wider credit spreads"
- source Rcube @CyrilRcube

When it comes to the potential "overshoot" in US High Yield, our friend Cyril Castelli from Rcube illustrated as well this potential:
"Excess leverage explains the US high yield crash. High Yield always overshoot. It won't be different this time"
- source Rcube @CyrilRcube 

We agree with our friend and given that initial spreads explain nearly half of 5yr forward returns, and that spreads themselves are a very good indicator of long-term forward returns, for both static and rolling investors, given credit investors like suffer from bipolar disorder and are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates, we will still tight until we see much more of an overshoot. Although, it doesn't mean that they are not "opportunistic" short term High Yield / distressed name out there but this necessitate some solid credit analysis in the first place. Relative value arbitrageurs did enjoy outsize returns ever since 2008 precisely because of the “uneconomic” distortions created in markets by central bank liquidity operations. The Barnegat fund, a New Jersey-based hedge which launched after the collapse of LTCM – the world’s most notorious relative value arbitrageur – returned 132.68 per cent in 2009, thanks to “the largest arbitrage ever” – in the US bond market, caused by the Fed’s quantitative easing. But this time around, it looks like the Fed is running low in terms of "ammunitions" particularly at the time where "idiosyncratic" risk is moving towards "systemic" risk.

This brings us to the continuous drift in credit. Not only are seeing a continuation of the flattening of the US yield curve, but credit is also affected given that according to CMA part of S&P Capital IQ, the 1 year CDX HY index is wider month to date by 81 bps and the basis (difference between the index and the single name constituents) is still very high at 79 bps apart:

- source CMA part of S&P Capital IQ

More interestingly, the continuous drift in credit is starting to point towards a more systemic risk environment as pointed out recently by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 8th of February entitled "The tide has turned":
"Connecting the dots
Does the recent weakness resemble the 2008 global financial crisis sell-off or the 2011/12 European crisis one? Are we still in an idiosyncratic risk world, or are recent developments pointing to a more systemic risk environment?
Our analysis shows that: (i) the recent sell-off in bank stocks and senior financials CDS, (ii) the continued weakness in EM/oil names and (iii) the fact that the recent sell-off is not driven by the tail anymore and it is more widespread, points to one conclusion: that the tide is turning. Risks are not idiosyncratic anymore; systemic risk is rising.
Currently the level of our selloff depth indicator - that has been steadily increasing over the past weeks - is the highest since the taper tantrum and is quickly approaching levels seen in 2008/9 and 2011/12.
In chart 1 we present the % of the iTraxx Main portfolio (125 constituents in total) that has moved more than 10bp wider over a 4-week period, while the broader market (average spread of the pool) credit spreads are also heading north.
o The higher the % of the index that contributes to a sell off the more systemic is the nature of the move wider.
o The lower the % of the index that contributes to the market weakness the more the idiosyncratic is the nature of the sell-off.
• Bank stocks are back to levels seen in 2012. The recent sell-off of bank stocks has added more pressure to financials credit spreads. Risks remain to the downside for the sector. Bail-in fears (see underperformance of Italian names over the past couple weeks), the ECB looking at NPLs (an area of focus this year), EM exposed fins still under pressure, Brexit risks looming for the UK names and weak Q4 earnings season (in particular for DB and CS), keep fins CDS better bid. With bank stocks at these levels, iTraxx Senior Fins will remain the key hedging instrument against increasing pressure in high-beta banks paper.
• US non-manufacturing econ data - even though still on expansionary levels -are deteriorating at the fast pace since 2008/9 period (chart 4).

Additionally, our rates strategy team points that their model shows that the OIS curve (adjusted for the zero-bound effect) is already inverted and therefore may already be pricing a recession
 • Oil prices are back at the $30 area; same as in 2008 (chart 5).
• Equity markets are punishing high risk (vs. low risk) stocks. The underperformance is the highest in years; only slightly away from the 2009 lows (chart 6).

 • The iTraxx Main constituents (5y CDS spreads) distribution exhibits extreme levels of skewness and kurtosis. Both these metrics measure the asymmetry of the portfolio's distribution. High level of skewness and kurtosis are typical characteristics of a fat-tailed distribution that prices high level of idiosyncratic risk.
o The higher (more positive) the skewness the thicker the tail on the wide end.
  o The higher the kurtosis, the thicker the tail and the higher the concentration around the index level, leaving not many names in between.
However, both these metrics have started to move lower over the past couple of weeks.
This clearly indicates a shift in market risks: from predominantly idiosyncratic as in 2008/9 (few wide names underperform, on balance), to more systemic risks as in 2011/12 (a broader widening). Note that financials did not feature even on the 50 widest names back in 2008. However, they dominated the widest names list in 2012.

• Weakness is now a broader issue - it is not the widest names that underperform.
We analyse the performance of single names CDS since the recent tights (early December'15). We find that the names that have underperformed (in %-move terms) are not necessarily coming from the tail. In fact we see a widespread weakness in names across the credit spectrum (chart 9). 
 - source Bank of America Merrill Lynch
"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up." - F. Scott Fitzgerald
As we posited in our conversation "Le Chiffre" aka Mario Draghi and given the market's anticipation for the ECB's next moves:
"QE on its own is not leading to credit growth, because as we have repeatedly pointed out in our musings, a lot of European banks, particularly in Southern Europe are capital constrained and have bloated balance sheet due to impaired assets.
Le Chiffre is probably "overplaying" it particularly when one looks at the poor effects on "credit growth" in Europe and "inflation expectations". - source Macronomics, October 2015
It seems that at least the European credit Vasa ship's structural flaws come from deeply impaired banks balance sheet bloated by significant NPLs which have yet to be addressed. Italy in particular is a base case as illustrated by Richard Koo earlier in the failings of QE when one looks at the Aggregate retail loan books as displayed in Société Générale November 2015 European Banks note entitled "A wake-up call":
- source Société Générale.

As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.

And no earnings thanks to NIRP means now, no reduction in Italian NPLs which according to Euromoney's article entitled "Italy's bad bad bank" from February 2016 have now been bundled up into a new variety of CDOs:
"Italian banks have already started setting up bad debt securitization platforms. Italy’s third biggest bank, Monte dei Paschi di Siena (MPS), sold a €1 billion portfolio of NPLs into a securitization vehicle financed by affiliates of Deutsche Bank in December. The state will now guarantee the senior debt of such operations. It is unlikely ever to have to honour the guarantee, as equity and subordinated debt tranches will take the first hit from any shortfall to the price the SPV paid for the loans.
The guarantee should attract a much broader array of investors to bonds issued by such vehicles, even if the banks still have to hold onto most of the riskiest tranches. However, the price could put off all but those banks with the highest funding costs.  The state’s fee for the guarantee will be based on CDS of issuers with similar ratings to the SPV tranche. To make sure the banks are not tempted to sit back and forget about the underlying loans, the price will rise over time – initially being based on three-year CDS, then five-year, then seven. As research from Milan-based Banca Akros points out, that’s hardly encouraging, given the time it takes to realise collateral in Italy." - source Euromoney
It looks to us like a nice new Vasa ship in the making...

Before we move on to our traditional final chart, here is another one courtesy of our friend Cyril Castelli from Rcube (from his twitter page: @CyrilRcube) showing that not only is AP Moller-Maersk a leading deflationary indicator but as we discussed in our post "The Cantillon Effects", the use of fine art might is an effective means to measure "bubbles" as art is removed from the capital structure of the economy. The performance of Sotheby’s, the world’s biggest publicly traded auction house has always been a good leading indicator and has led many global market crises by three-to-six months:
"Art & Shipping stocks lead the economic cycle. Recent price action of Sotheby's & Maersk is similar to 2000 & 2008."
- source Rcube - @CyrilRcube

If you think that we are bound for a "strong economic rebound" then you might want to hold off buying AP Moller-Maersk and Sotheby's because as per our final chart shows, it is never great to catch falling knives.

  • Final chart - Don't catch falling knives
Whereas we keep hearing about some tremendous values offered by some levels reached by some equities, given the points we have made on credit leading equities and credit moving from "idiosyncratic" risk to more "systemic" risk, we thought we would point out to Société Générale's take on "falling knives" in the below chart from their Global Style Counselling" note from the 9th of February entitled "We love a bargain but should you buy falling knives?":
"Performance of falling knivesWe start our analysis with a simple exercise, where we look at the relative performance of a strategy that buys companies that have seen 1) 20%, 2) 30%, 3) 40% and 4) 50% declines from their 12-month peak. As our portfolios might only include a handful of companies in some periods, we only take into account periods where we have at least 20 companies, and otherwise we assume a zero return. All portfolios are then rebalanced on a monthly basis, and our universe is based on FTSE World stocks since 1990.
As the chart below shows, despite some periods of strong outperformance (these periods are often referred to as the “dash to trash”), all portfolios eventually underperformed the market.
- source Société Générale 

Then again, you might want to check if indeed your "falling knife" doesn't boast the same structural flaws of the Vasa ship....
"Beware of little lending. A small leak will sink a great European ship." - Martin T. - Macronomics
Us thinking of Italy again...

Stay tuned!

Saturday, 6 February 2016

Macro and Credit - Common knowledge

"When dealing with people, remember you are not dealing with creatures of logic, but creatures of emotion." - Dale Carnegie, American writer

While playing the commenting "tourist" on a Macro-Man post relating to banking woes, we came across a very interesting comment from one of their readers relating to Central Banks, which we decided would make a good analogy for our post title:
"Eddie said...
 Wikipedia: Game of Common Knowledge
This might be a good way to think about CBs and their presumed or real abilities"
So we decided to investigate further given this fellow commentator piqued our curiosity and also because it has become quite a challenge for us to come up with relevant analogies, week after week in our musings (if you think of any of interest we could use in the near future, give us a shout). 

The concept of "Common knowledge" was first introduced in the philosophical literature by David Kellog Lewis in 1969 and was first given a mathematical formulation in a set-theoretical framework by Robert Aumann in 1976 according to the Wikipedia page. The idea and concept of the common knowledge is often introduced by some variant of the following puzzle:
"The idea of common knowledge is often introduced by some variant of the following puzzle:
On an island, there are k people who have blue eyes, and the rest of the people have green eyes. At the start of the puzzle, no one on the island ever knows their own eye color. By rule, if a person on the island ever discovers they have blue eyes, that person must leave the island at dawn; anyone not making such a discovery always sleeps until after dawn. On the island, each person knows every other person's eye color, there are no reflective surfaces, and there is no discussion of eye color.
At some point, an outsider comes to the island, calls together all the people on the island, and makes the following public announcement: "At least one of you has blue eyes". The outsider, furthermore, is known by all to be truthful, and all know that all know this, and so on: it is common knowledge that he is truthful, and thus it becomes common knowledge that there is at least one islander who has blue eyes. The problem: assuming all persons on the island are completely logical and that this too is common knowledge, what is the eventual outcome?
The answer is that, on the kth midnight after the announcement, all the blue-eyed people will leave the island." - source  Wikipedia: Game of Common Knowledge
We would like to offer a variation of the above which we think ties up nicely with Eddie's comment quoted initially about Central Banks and the current state of affairs:

In the island of central bankers there are k central bankers who have a credit crisis on their hands, and the rest of the central bankers do not have a credit crisis on their hands. At the start of the puzzle, not one central banker realizes he has a credit crisis starting. By rule, if a central banker discovers he has a credit crisis, he must act swiftly at dawn to counteract the deflationary bust coming. In the central banking island, each central banker knows every other central banker's credit situation but there is never a real discussion around the evolution of the credit markets.
At some point an outsider, the Bank of International Settlements (BIS) comes to the island of the central bankers and makes the following public announcement: "At least one of you has a credit crisis"
"Emerging market economies may be facing tighter liquidity conditions as cross-border lending to emerging economies, especially China, shrank in the third quarter of 2015 and U.S. dollar borrowing by non-bank companies in those economies was flat for the first time since 2009, according to the Bank for International Settlements (BIS).
    BIS General Manager Jaime Caruana said global liquidity – a term that captures the ease of financing in global financial markets –  shows that the stock of U.S. dollar-denominated debt of non-bank borrowers outside the U.S. was unchanged at $9.8 trillion from June to September and dollar borrowing by non-banks in emerging economies also was steady at $3.3 trillion.
    An even clearer sign that global liquidity conditions for emerging markets may have peaked comes from a decline in cross-border lending to China, Brazil, India, Russia and South Africa. In the third quarter of last year lending shrank by $38 billion to $824 billion from the second quarter, Caruana said in a speech at the London School of Economics (LSE)." - source Reuters, Emerging markets may be facing tighter liquidity – BIS, 5th of February 2016"
The BIS, furthermore, is known by all to be truthful, and all know that all know this, and so on: it is common knowledge that it is truthful, and thus it becomes common knowledge that there is at least one "islander" who has a credit crisis on his hands.

So dear readers, the problem is as follows, assuming all the central bankers on the island are completely logical and that this too is common knowledge, what is the eventual outcome?

For us it is very simple, a liquidity crisis always leads to a financial crisis. 

And this, dear readers is unfortunately "Common knowledge" and will nonetheless be the outcome because knowing that everyone knows does make a difference. When the BIS public announcement (a fact already known to all) becomes common knowledge, the central bankers having a credit crisis on their hands on their island eventually deduce their status but we ramble again...

On a side note we touched on central bankers and their "deity" status "Omnipotence Paradox"  back in November 2012:
"A deity is able to do anything that is in accord with its own nature (thus, for instance, if it is a logical consequence of a deity's nature that what it speaks is truth, then it is not able to lie)."
Therefore the concept of "Common knowledge" is central in game theory.

If a deity status is only attained if it is not able to lie (SNB, BOJ, ECB, FED...) then central bankers are not omnipotent except the BIS...

Back in 2012 in our conversation we also argued:
"The "unintended consequences" of the zero rate boundaries being tackled by our "omnipotent" central banks "deities" is that capital is no longer being deployed but destroyed (buy-backs being a good indicator of the lack of investment perspectives)."
 And in October 2014 in our conversation "Pascal's Wager" we argued:
"Pascal's wager was devised by 17th century French philosopher, mathematician and physicist Blaise Pascal (1623-1662). It posits that humans all bet with their lives either that God exists or not. In the investment world, we think investors are betting with their "life savings" that central bankers are either gods or not.

Pascal's Wager is of great importance and was groundbreaking at the time because it charted new territory in probability theory, making the first use of decision theory.
Pascal's Wager in the form of a decision matrix:
The only "rational" explanation coming from the impressive surge in stock prices courtesy of QEs and monetary base expansion has been to choose (B), belief that indeed, our central bankers are "Gods"." - source Macronomics, October 2014.

In this week's conversation, we will again look at the debilitation of the credit markets and what it entails according to the BIS "deity" and the central bankers islanders and the implications for "risk assets".

Synopsis:
  • Instability risk and large standard deviation moves - Rising positive correlations are a cause for great concern and so is the denial on the state of US growth
  • Credit - the liquidity canary, willingness to lend and the credit cycle
  • Final chart - The Bank of Japan is a Black Hole for JGBs


  • Instability risk and large standard deviation moves - Rising positive correlations are a cause for great concern and so is the denial on state of US growth
We would like to point out once more, like we did in our conversation "Positive correlations and large Standard Deviation moves" back in August 2015 the growing instability risk which creates large standard deviation moves thanks to rising positive correlations:
"Cushing's syndrome" aka central banking "overmedication" leads to a rise in "positive correlations. There is a growing systemic risk posed by rising "positive correlations.
Since the GFC (Great Financial Crisis), as indicated by the IMF in their latest Financial Stability report, correlations have been getting more positive which, is a cause for concern:

- source IMF, April 2015
This "overmedication" thanks to central banks meddling with interest rates level is leading to what we are seeing in terms of volatility and "positive correlations", where the only "safe haven" left it seems, is cash given than in the latest market turmoil, bond prices and equities are all moving in concert.
Regardless of their "overstated" godly status, central bankers are still at the mercy of macro factors and credit (hence the title of our blog). The correlation between macro variables (eg, bund yields, FX and oil) and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market." - source Macronomics, August 2015.

This rising instability risk we discussed previously can be once more ascertained by the rise in correlations across asset classes such as Chinese equities and selected asset classes as well as with oil prices, which are all well above averages as shown in the below charts from IIF:
- source IIF
We told you at the end of 2015, that, 2016 would be a year of high "risk reversal" opportunities. The large move experienced as of late such as the one seen this week in the US dollar are clearly an indication of the brewing instability in financial markets (not that you haven't been warned on numerous occasions on this very blog). These "sucker punches" should not come as a surprise. The herd mentality has made various exposures crowded trades, with very poor risk reward after all, as pointed out by our Rcube friends in their November guest post "US Equity / Credit Divergence: A Warning":
"Everyone is expecting higher equities due to lower yields and depressed food and energy prices. But when everyone is thinking alike, no one is really thinking…."
As contrarian investors we don’t like sitting with the crowd. The fact that a long dollar was too consensual, was to us a serious "red flag". Also, our fears that the raging currency war would clearly escalate (thank you Bank of Japan) shows that it has had a bigger impact on the Fed’s reaction function than people were thinking.

Under the zero lower bound (ZLB), monetary policy isn’t just about the price of money, but also its quantity. This is what we pointed out in December 2014 in our conversation "The QE MacGuffin":
"What we find of interest is that under the ZLB, many pundits have expected a recovery. When one looks at the commodity complex breaking down in conjunction with a weakening global growth picture which can be ascertained by a weakening Baltic Dry Index. No wonder yields in the government bond space are making new lows and that our very long US duration exposure we have set up early January (in particular via ETF ZROZ) has paid us handsomely and will continue to do so we think." - source Macronomics, December 2014
While in early 2015, we tactically booked our profits on our long duration exposure, as we have told you end of 2015, following the December FOMC we not only re-entered our tactical long duration exposure, but, we also added started adding on our "Gold Miners" exposure.

Why so?
We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", it is  again working nicely in 2016:
"If the policy compass is spinning and there’s no way to predict how central banks will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of central banks, the option-value of both gold and bonds goes up."
Easy as 1-2-3...

Long dated US government bonds from a carry and roll-down perspective continue to be enticing at current levels compared to the "unattractiveness" of the mighty German 10 year bund indicating a clear "japanification" process in Europe. By the way if you are a "credit investor, you sure want to be "duration" hedged in Europe and probably less so in the US...

Also, what we find of "instability" as of late and in response to the "bullish recovery" crowd we would like to point out towards the evident fragility of the "Consumer Discretionary" complex. Because if you want to talk about the "quality" of jobs created in the US and their consumer discretionary potential here is a chart we have built our from the Bureau of Labor Statistics (BLS) that tells it all, depicting the Employment Status by educational attainment:
- source Macronomics / BLS
And if you think this doesn't represent a "headwind" for consumer discretionary, we could as well point out from a "Common knowledge" perspective, the situation relation Food Stamps:

- source Macronomics / Bloomberg.
The American economy is doing so well that it can subsidies for free 45 million of Americans (14.24% of the population)...

In this context, the price action aka "sucker punchers on two bellwether "Consumer Discretionary" stocks namely Royal Caribbean on the 4th of February and Ralph Lauren are clearly indicative of the global mood in the consumer discretionary sector we think (it is not only in dwindling Rolex sales in Hong Kong):

- graph source Bloomberg

Now if low oil prices are a "boon" for US consumption, then this "boon" is clearly hiding under the mattress...
We wonder when it is coming to become "Common knowledge". 

Conclusion:  maybe you should "Get shorty" Consumer Discretionary stocks that is...

When it comes to "Common knowledge" and growth outlook, it seems we always follow the same trajectory:
We start with an overall 3% consensus for US growth and US 10 year yield end of the year targets of between 2.50% to 3%, then after a couple of months, it gets revised down to 1.50% / 2% and US yields get revised accordingly towards the same objective.

As a reminder, when it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:
"Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data." So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you."
We hope, at some point, this will become "Common knowledge" and that some sell-side pundits will stop defying this simple yet compelling "Wicksellian" logic.

When it comes to the importance of liquidity, stability and credit, the latest Fed's latest Senior Officer Lending Survey is showing that US regional banks are starting to close the credit flows (it is not only happening in Emerging Markets!). You need to understand how important this is. The BIS seems to understand this but, clearly the "islanders" are in denial hence the title of our second bullet point in our long conversation.

  • Credit - the liquidity canary, willingness to lend and the credit cycle
Whereas last week we pointed out again on the CCC credit canary's current state of affairs, being shut out entirely of the primary markets, whereas every pundits around are focusing on the correlation between oil and equities, earnings and additional sucker punches such as the one delivered to internet darling LinkIn corporation down by more than 40%, we would like to focus our attention on the real "elephant" in the China credit shop, namely liquidity.

When it comes to forecasting the default trajectory and in particular when one wants to assess the vulnerability of High Yield, we have pointed out that willingness to lend is paramount when it comes to the state of the credit cycle. On that particular subject we read with interest Bank of America Merrill Lynch's Securitization Weekly note from the 5th of February:
"Willingness to lend and the credit cycle
This week’s Senior Loan Officer Survey Report from the Fed for January (Chart 13) showed that lenders have gotten the message from capital markets: C&I and CRE credit is tightening on a net basis (8.2% and 5.6% of respondents, respectively).

It is noteworthy to us that the most closely related sectors, CLOs and CMBS, are those that are facing risk retention deadlines at the end of this year. As a reminder, the primary purpose of risk retention rules is to ensure that originators of loans are on the hook for the risk of the loans they originate. It may be too early to make the connection between the willingness to lend data and risk retention deadlines, but it seems fair to say that as the deadline draws closer, lenders are likely to further tighten lending standards, as they will own the risk. It is also noteworthy that the one sector exempt from risk retention rules, GSE mortgages, shows a fairly large number of respondents (-14.3%) that are loosening credit. We can see that this trend will be observed by investors in the risk transfer space and likely cause them to demand additional spread compensation for credit risk going forward. Credit card lending has not quite tightened yet (-1.9%), but it is getting close. GSE mortgages are the clear outlier on this chart.
We also layer on top of Chart 13 the high yield loan default cycle. Not surprisingly, tightening C&I and CRE credit has either coincided with (early 2000s) or led (2008-2009) a loan default cycle. The amount of tightening observed to date has been fairly minimal compared to the prior cycles. Nonetheless, if Liquidity Stress and credit market spreads continue in the direction they have been heading (higher), then more credit tightening and a more pronounced default cycle seem likely in the not too distant future.
Much should be revealed on this front over the next 1-2 months. Will some policy “fix” to liquidity stress be delivered, or will there be a disorderly move higher in liquidity stress? We shall see." - source Bank of America Merrill Lynch
As we pointed out in our introduction, liquidity crisis always lead to financial crisis, and yes, dear readers, credit always lead equities. When it comes to assessing "liquidity" risk, which we highlighted in our previous conversation, we think the situation is clearly pointing out to some deterioration. This is as well highlighted again in Bank of America Merrill Lynch we quoted as well in our previous conversation. We are indeed on the same page and share "Common knowledge":
"Liquidity stress: the canary in the coalmine
Introduction
Last week (“Things are bad, at risk of getting worse”), we discussed the BofAML Global Financial Stress Index (GFSI, Chart 1), noting that it is currently near the elevated levels of 2007-2008, right before the Great Financial Crisis (GFC). 

The message was that the GFSI signals some fragility for the financial system, which puts the system at risk of destabilizing quickly, perhaps due to policy error or some other shock. For securitized products credit sectors such as CMBS and CLOs, we think this means downside risks are still too high to look to take advantage of the spread widening that has occurred in recent weeks and months.
This week, we take a look at a sub-index of the GFSI, the Liquidity Stress index (Chart 2, IRISILIQ on Bloomberg), and consider the trends in liquidity stress and securitized products credit spreads over the past two years. We highlight in Chart 2 some of the key events that have occurred around the time liquidity stress has been rising: beginning of the taper by the Fed in early 2014, the Swiss and Chinese currency revaluations and Fed rate hike in 2015, and Japanese NIRP in 2016.
Chart 3 shows that, compared to the broader GFSI, liquidity stress has somewhat methodically and steadily risen over the past two years: while the GFSI has moved higher in fits and starts, liquidity stress has more persistently risen, only pausing its rise at times, before moving higher.
This persistence suggests to us that deteriorating liquidity is at the heart of and may be the primary driver of broader rising financial stress. If so, then continuation of the rising trend in liquidity stress may eventually lead to another spike in broader financial stress in the months ahead." - source Bank of America Merrill Lynch
Credit flows matters, because if indeed, the "credit tap" is about to be turned off, recovery and growth will be difficult particularly for China, in the absence of course of a sizeable real exchange rate depreciation. This would trigger a significant deflationary wave impulse for the rest of the world rest assured.

Also credit spreads are a more useful indicator of credit supply disruptions than credit quantities. The increase in spreads during the Great Financial Crisis (GFC) is symptomatic of unusual financial distress, and not just the reflection of the increased default risk faced by borrowers.
(See 2012 papers from Adrian, Colla and Shin, Gertler, Gilchrist and Zakrajsek quoted in a Bruegel Policy Contribution of February 2013, by author Zsolt Darvas in his note entitled "Can Europe Recover Without Credit?").

So watching what credit spreads are doing, given they are gently drifting wider à la 2007 is paramount we think. Much more important than being obnubilated by "oil prices".

When comes to assessing the state of the credit markets, we have to agree with DataGrapple's note from the 3rd of February entitled "It is still a bear grind":
"Credit indices have been weak throughout the session, and they were no different from all other risky assets today in that respect. The most striking feature of the move wider so far - over the last few days, but that is true since the beginning of the year - is that we have not seen any panic. Credit investors have not had their “coyote moment” yet, when they suddenly realise that they have gone over the edge and that they are hanging in the air. Some sessions have been brutal - iTraxx Main (ITXEB) widened by almost 6bps today and closed above 100bps at 104bps for the first time since 2013 -, but bases – the difference between the traded value of an index and the therotical value computed with the risk premia of its individual constituents - remain large across the board and it is still worth in excess of 50cts at the close on ITXEB. The latest DTCC statistics show that investors are still long risk on most indices. They are slowly bleeding in this steady bear grind." - source DataGrapple
When one looks at the closing prices for European Itraxx 5 year CDS indices with Itraxx Europe Main S24 (Investment Grade proxy) closing 5bps wider on Friday at 110 bps and Itraxx Crossover S24 closing 20 bps wider on the day to around 423 bps you get the drift...

Moving back to our liquidity concerns, we would like to point out once more to Bank of America Merrill Lynch's take from their Securitization Weekly recent note:
 "Liquidity stress: possible causes and “solutions”
The natural question that arises from Chart 1 is: why has liquidity stress risen so persistently since the beginning of 2014? No doubt, this is a complex question with no simple answers. Nonetheless, we think there are at least two plausible key drivers:
1. The post-crisis regulatory (Volcker) and capital (Basel) regime that has substantially raised trading restrictions and capital requirements for banks/dealers and, in so doing, reduced liquidity dealers can provide to markets.
2. Emerging market and high yield credit problems related to the collapse in oil prices, and commodities more broadly. With balance sheet scarce due to higher capital requirements, and capital charges high for poor credits, liquidity in stressed sectors perhaps naturally is the first to go.
The combination of these two factors has led to a somewhat vicious cycle and feedback loop, where poor liquidity is spreading, and liquidity problems appear to be turning into fundamental problems. Moreover, tightening of monetary policy by the Fed, first through tapering and now through tightening, may have been necessary from an economic perspective, but the tightening appears to be adding fuel to the fire of liquidity deterioration.
The next question that arises is: what can be done to stabilize liquidity, or even reverse the trend of liquidity deterioration? This is an even harder question to answer than the first one posed above on causality. Arguably, poor liquidity was part and parcel of the post-crisis design for the financial system: in a world of significantly higher capital requirements for dealers, nobody should really be surprised that balance sheet is scarce and liquidity is lower. This suggests there is no “fix” coming for cause #1 above; what we have now was in fact “the plan.” The only response to poor liquidity would be related to cause #2, the credit problems. We see two possible alternatives to watch for:
 1. A coordinated global policy response. Here we are referring to what BofAML Chief Investment Strategist Michael Hartnett is calling the “Shanghai Accord,” a coordinated policy response from G20 Finance Ministers and Central Bankers at the February 26-27 Shanghai meeting.
2. Coordinated oil supply cuts from OPEC and Russia, which would help alleviate the downward pressure on oil, and the associated credit stress. 
Barring developments on these fronts, further liquidity deterioration seems inevitable. If so, as the following discussion suggests, then securitized products credit spreads are likely to widen further. Moreover, the 10yr inflation breakeven rate is likely to head lower, creating downside risks for interest rates and upside risk for agency MBS prepayments.
 Liquidity stress, credit spreads and inflation breakevens
Next, we take a look at the relationship between liquidity stress and credit spreads, as well as the 10yr inflation breakeven. Given that credit spreads feed into the construction of the Liquidity Stress index, correlation between the index and credit spreads should be expected. Nonetheless, it is useful to take a look at how spreads in various credit sectors have trended in the past two years, as liquidity has inexorably deteriorated.
 We make the following observations:
• The HY CDX spread (Chart 5) seems to have tracked the deterioration in liquidity
over the past two years the most, starting in early 2014. The  modest narrowing of the spread in early 2015 appears to have been the anomaly.
• CLO BBB spread (Chart 6) tightening in the first half of 2015 appears especially anomalous.

In retrospect, deteriorating liquidity was a good signal that CLO spreads were at risk of significant spread widening. We missed the signal. At this point, CLOs currently appear to be “very cheap” on a fundamental basis, but if liquidity broadly continues to deteriorate, through correlation, CLO spreads are likely to continue to widen.
 • Like CLOs, BBB- CMBS (Chart 7) have played catch up on spread widening this year.

• Prime AAA auto ABS, often thought of as a highly liquid cash substitute, experienced disproportionate spread widening in 2015 (Chart 10), but has stabilized and even tightened over the past few months. 

We think the sector should be relatively strong from a defensive perspective going forward, but will not be immune from further spread widening if liquidity stress escalates further. Similarly, BBB subprime auto ABS (Chart 11) seems likely to widen further.
 • The correlation between liquidity stress and the 10yr breakeven inflation rate (Chart 12) is especially noteworthy, raising two important question: 1) is the collapsing breakeven rate just a reflection of deteriorating liquidity and, as the Fed suggests, not a particularly relevant indicator of future inflation (or more correctly, disinflation)? or 2) has the new regulatory/capital regime impaired liquidity so severely that it is heightening
disinflationary pressures, which the collapsing breakeven rate is correctly signaling? 

We’ll see whether the Fed is right on this one. But for now, the market is largely saying that deteriorating liquidity is disinflationary and further liquidity deterioration would bias interest rates lower. This means higher convexity cost for agency MBS, which leads us to recommend adding prepayment protection in the sector." - source Bank of America Merrill Lynch

And what does higher convexity means?
As a reminder: In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger because to avoid paying negative rates, investors have either taken more duration risk or more credit risk!

The negative convexity of High Yield callable bonds for instance enhance the downside during a sell-off. Furthermore, over the last 3.5 years, when spreads were at or below the current level (442bp), HY has widened 56% of the time over the next three months.

As we posited in our May 2015 conversation "Cushing's syndrome" expect as well lower liquidity:
"One key aspect of later stages in the cycle is unlikely to recur this time – liquidity. In the new regulatory environment dealers hold less than one percent of the corporate bond market. Previously dealer inventories grew to almost 5% of the market through the cycle. " - source Macronomics, Cushing's syndrome, May 2015.
This we think is the current state of affairs in the credit space, which is akin to a 2007 environment. We've seen it before and we think it is playing out again, hence our heightened attention to the Securitized markets.

As well we keep an eye also in what is happening in the land of the "setting sun" aka Japan as per our final chart and bullet point.

  • Final chart - The Bank of Japan is a Black Hole for JGBs

Finally when it comes to "liquidity", central bank meddling and common knowledge, what find of interest given Bank of Japan's latest jump in the NIRP bandwagon, is that when it comes to Japanese Government bonds aka JGBs, the Bank of Japan has become a Black Hole in JGBs, in effect Bank of Japan has vacuumed so many bonds that in effect it has become the market as displayed in our final graph we find in Bank of America Merrill Lynch Japan Rates Viewpoint note from the 2nd of February entitled "In BOJ-led JGB market, will target shift from quantity to real interest rates?":
"Chart 6 shows JGB transactions by major banks in the secondary market. Since the expansion of QQE, transactions have been running at a low level, now about ¥8.5trn monthly. Considering that monthly transactions were about ¥25trn before the expansion of QQE and before its introduction, transactions have declined sharply. This suggests that newly issued JGBs are absorbed by the BOJ without entering the secondary market.
Safe assets are usually considered to be those with high liquidity and low volatility, but a better description of the recent JGB market might be that it has simply lost activity. In the past, volatility has risen during low-liquidity phases in the JGB market, and we believe the current market needs monitoring because a slight move by investors could prompt a volatility increase. The introduction of negative interest rates has raised volatility, but for the time being yields will probably continue downward, albeit accompanied by higher volatility.
Sustainability of quantitative and qualitative easing with negative interest rates
The BOJ’s balance sheet has continued expanding, to the point where it reached about 76% of GDP at the end of 2015. This is a substantial figure compared to the about 25% accumulated by the FRB and ECB. In January 2015, when the Swiss National Bank (SNB) eliminated its ceiling on the Swiss franc’s exchange rate vs. the euro, its balance sheet was about 80% of GDP (it has expanded again recently, reaching about 90%). The meaning of a central bank’s balance sheet relative to GDP can be debated, and the assets held by the BOJ and SNB differ in kind, so a simple comparison is not possible. Nevertheless, the approach of the BOJ’s balance sheet to 80% of GDP is noteworthy. At the time, the SNB’s president described the situation as unsustainable. Even a central bank cannot go on expanding its balance sheet without limit.
Given that JGB supply-demand is tight and a shortage of sellers will gradually emerge, doubts are being raised about the BOJ’s ability to keep expanding its balance sheet at the current rate. The introduction of negative interest rates might shorten the viable period of the expansion. Also, the longer that balance sheet expansion continues, the more difficult that monetary policy normalization will become. As the BOJ’s purchasing operations go on, JGB yields are being lowered at ever-longer maturities. In other words, the longer that monetary easing continues, the more likely the JGB curve is to factor in monetary normalization as a very distant event. Therefore, when normalization comes, the probability of a strong reaction is rising." - source Bank of America Merrill Lynch
Yes indeed. Even a central bank cannot go on expanding  its balance sheet forever, and that's "Common knowledge". The problem is one need to assume that all our central bankers "islanders" are completely logical and not totally insane...

"Logic is like the sword - those who appeal to it, shall perish by it." -  Samuel Butler, British writer
Stay tuned!




 
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