Wednesday, 17 December 2014

Guest post - A Chinese "Déjà-vu"?

"Right now I'm having amnesia and deja vu at the same time." - Steven Wright, American comedian
The situation we are seeing today with major depreciation in EM currencies is eerily similar to the situation of 1998, with both China and Japan at the center of the turmoil.

On that subject, we share our concerns with our good friends at Rcube Global Asset Management  which they discussed in their Global Macro Monthly Review in December. Please find below their take on the Chinese situation reminiscent of the 1998 Asian crisis:
"The current situation in China is similar to the Asian tigers in the late 1990s. We will first describe the chain of events that led to the crisis and then look at China today and explain why not only the domestic conditions of the country are strikingly close to what they were for the Asian economies back in 1997, but also how close the international environment looks when compared with the late 1990s.
The NY fed published a paper co‐authored by Giancarlo Corsetti, Paolo Pesenti and Nouriel Roubini
in 1999 called “What caused the Asian currency and financial crisis?” that we have used for comparison purposes with today’s situation in China.
It starts by stating “Central to a full understanding of the root of the Asian crisis is the multifaceted evidence on the structure of incentives under which the corporate and financial sectors operated in the region in the context of regulatory inadequacies and close links between public and private institutions… At the corporate level, political pressures to maintain high rates of economic growth had led to a long tradition of public guarantees to private projects, some of which were effectively undertaken under government control, directly subsidized or supported by policies of directed credit to favored firms and or industries. “
At the time, government intervention in favor of troubled firms gave investors the impression that return on investment was almost guaranteed and that corporate defaults were unlikely to happen.
As a result, capital flowed to the region. As investment spiked compared to savings, the current account of these economies dropped sharply. Capital was plentiful at the time. The sharp drop in developed countries’ interest rates (Japan in particular) explained the large financial flows into the region, which were offering more favorable rate of returns.
By borrowing extensively abroad to finance local project, banks channeled these flows into the domestic economies. At some point, because the investment boom was confined to nonproductive sectors (commercial and residential construction as well as inward-oriented services) the rate of return on these investments started to drop, which became evident as the share of nonperforming loans begin to rise swiftly.

The final nail in the coffin came from the Japanese yen, which lost 45% against the US dollar between May 1995 and August 1998. Not only the Tigers had lost a substantial export market for their products since Japan had turned from boom to bust, but they were also losing market share against Japanese firms due to the JPY debasement. China had devalued its currency by 50% in 1994,
grabbing, like Japanese firms, new export market share in the process. Since most of their currencies were pegged to the US dollar, their real effective exchange rate appreciated
substantially, further deteriorating their competitiveness.
As the average return on investment dropped further, and NPLs kept on rising, capital inflows turned into outflows. Currencies started to weaken. Banks were doubly hit by rising NPLs and by the currency effect, having amassed large amounts of foreign currency debt.
The negative feedback loop accelerated, resulting in crashes in real estate, stock markets and currencies.
We believe that China’s situation is comparable if not worse than that of the Asian Tigers in the mid-90s. Growth has been almost entirely driven by an investment boom which, as a share of GDP, is significantly higher than where the Tigers were back then.
Just like for these economies, the interconnection between the public and private sphere is large. The government has directly or indirectly subsidized specific industries, and has until this year almost guaranteed a zero default rate. Furthermore, the investment boom has been concentrated in n onproductive assets, namely real estate construction.
Most of the balance was directed at industries that were tied to the property boom: steel, cement, aluminium. These sectors are now facing severe overcapacity. Standard & Poor's estimates that between 30 and 40% of all corporate loans are backed by property and land as collateral, so falling real estate increases the risk of a credit crunch.
The Chinese capacity of utilization rate has dropped to 70%. The investment bubble, just like for the Tigers, has been financed with cheap - and until recently plentiful - credit. China now has the largest corporate debt pile in the world, having surpassed the US last year ($14.5 Trillion vs $13.1 for the US). 
The BIS December quarterly report released recently reports that the outstanding stock of cross border claims on China stood at the end of Q2 2014 at just over $1.1 trillion. The current annual growth rate of claims on China is 50%, and the stock of claims has been multiplied by 10 in less than 8 years. China is by far the largest EME borrower for BIS reporting banks. As recently as 2009, China was not even among the BIS reporting banks' top 5 foreign EME exposures. The last phase of the the investment boom (since 2010) has therefore been increasingly financed by capital flows. 
 Claims of BIS reporting banks on emerging market economies outstanding stock.

On that subject, the largest drop on record in capital flows in Q3 (change in FX reserves - Current Account + net FDIs) is particularly worrying. The current account has dropped by 8% points of GDP since 2008 (investment rising much faster than savings).

Furthermore, the BIS report also reveals that capital flows associated with non-financial corporations have increased markedly over the past few years through three different channels.
First transfer have surged within firms. Second, trade credit flows to EMEs have increased significantly. Finally, the amount of external loan and deposit financing to EMEs provided by non-banks has grown considerably. This simply means that EMEs non corporates have used their offshore subsidiaries to obtain funds from global investors through bond issuance and have repatriated the proceeds through one of the three channels mentioned above.
The reports states: "Chinese firms have primarily issued $ denominated bonds abroad, whereas non-Chinese companies account for a sizeable proportion of offshore Renminbi bond issuance. Very often, these non-Chinese entities will swap their CNH proceeds into US dollars. In doing so, they are taking advantage of the cross currency swap market to obtain dollar funding at lower costs...Similarly, cross currency swaps offer Chinese firms a channel to get around the tight liquidity conditions in China by swapping their US dollar proceeds from bond issuance into RMB and remitting to their headquarters."
International debt securities issuance in $bn
 Source BIS international statistics 
 China has been by far the main recipients of these types of capital flows. Part of these flows should be considered as foreign denominated debt since there is a currency risk. Even though classic measures of foreign external debt remain low, the currency mismatch is probably much higher - another similarity with the Asian Tigers.
 International issuance of EME based non-financial groups
 Source BIS international statistics 
For the first time, selective defaults happened this year. Shanghai Chaori Solar Energy Science & Technology Co was the first Chinese corporate bond default in March. In September, Anhui Wanjiang Logistics Group missed payments. The company cited banks' unwillingness to extend loans to the steel industry as the reason for the non-payments. Sinosteel, the state owned company, recently said that it was having difficulties paying back some lenders as a resuly of unpaid bills from customers. As local governments refuse to close down some steel mills for fears of fueling unemployment, China's steel production keeps rising, making the problem even worse (increasing overcapacity). This issue is similar in many over indebted industries (cement, construction, shipbuilding, etc.). 


The domestic economy is slowing down as a result of a weaker investment cycle. Additionally, two major export markets have also slowed down: Japan and Europe. Combined, they represent about 25% of Chinese exports. The Japanese Yen devaluation is making Chinese exports much less competitive, the nominal trade weighted Yuan has appreciated by 10% over the last 6mth only, 25% since 2011 and by 45% since 2005.
As the rising share of non‐performing loans starts hitting banks, and the already strained credit channel tightens further, more defaults will become visible. Foreign commercial banks, which are always late in a credit boom, are seeing their share of non‐performing loans rise very quickly. Unlike domestic banks that can hide NPLs, or are subsidized by the government, foreign banks’ data seems to be a much more reliable source of information. Standard Chartered PLC has been severely hit by its exposure to the main Asian economies and China in particular.

Capital outflows will intensify. In the face of a crisis, governments always choose devaluation over reforms. We don’t think it will be different this time.
Just like in 1997 for the Asian economies, it is the combination of domestic weakness, weaker export markets (replace Japan then by Europe and Japan today) and a loss of competitiveness that reveals the crisis. Similarly to 1997, it is the JPY devaluation that could tip over the boat (the magnitude and the velocity of the JPY crash being equal). The Euro weakness is not helping either.
 Just like in 1997, the FED is about to raise interest rates, which is lifting the US dollar. But we believe that the sharp improvement in the US current account is shrinking rapidly the amount of dollar liquidity. The international liquidity environment is thus much tighter than in 1997 despite Japan QE and the coming European action. One US dollar of QE is not equal to 1 Euro or 1 Yen of QE.


When put into context, investors today are looking at the EUR and JPY debasement from a bullish perspective for world stock markets. We think the reality is different. Combined, these two economies, equaled about 125% of the US economy in dollar terms 4 years ago, they barely represent 100% of the US GDP today (in $ terms). That is not good for world exports outside these zones, and most particularly China.
 China, just like the Tigers at the time, is losing market share at a time when its economy is slowing down.

This will prove unbearable when unemployment starts rising, which looks inevitable given the link between the investment cycle and job creation over the last 15 years. If, as we expect, China’s investment share of GDP drops by the same magnitude as the Asian tigers witnessed (around 20 points in a few years) the damage on employment could be massive.

As the investment boom turns to bust, the most likely collateral consequences outside China will be a crash in commodity currencies and industrial commodities that have been so tightly correlated during the boom phase.


The recent spike on Chinese stocks is motivated by a plunge in interest rates and commodity prices, but macro momentum is weakening, which is visible by a flattening yield curve and widening corporate credit spreads. As a consequence, it is very likely that Chinese stocks will reverse course by early next year if not sooner.


From a longer term perspective, China is likely to eventually become the world's dominant economy (even in nominal terms). This is simply because of the fact that its population is four times larger than the population of the US. However, we believe that this "Long March" will be a lot bumpier than most expect.
The issues plaguing China's economy (unproductive investments, corruption, cryonism etc.) are well known and documented. Given these structural problems, it is interesting to observe the degree of admiration exerted by China's system on many Western countries.
We can draw an interesting parallel with the views many economists held about the Soviet Union until the 1980s. In the successive edition of his textbook "Economics: An introductory Analysis", Paul Samuelson (Nobel prize winner in 1970) kept updating a chart showing that the USSR was poised to catch up with the US in terms of GDP due to the latter's higher growth rate (the convergence date was always 40 years later).

This anecdote does not only illustrate that even the most brilliant minds are subject to the "extrapolation bias", but also that planned economies can create the illusion of high growth rates for a very long time until reality bites..."

"The whole world is run on bluff." - Marcus Garvey, Jamaican publisher

Stay tuned!

Thursday, 11 December 2014

Credit - The QE MacGuffin

"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

In continuation to our conversation "Chekhov's gun",  and with the on-going hope for our "Generous Gambler" aka Mario Draghi to unleash QE in Europe, given the growing German dissent from Bundesbank's Jens Weidmann and German Finance Minister Wolfgang Schaeuble as well as some other members of the ECB council, we reminded ourselves for our chosen title of yet another cinematographic analogy, the MacGuffin. The MacGuffin technique is common in films, especially thrillers: 
"Usually the MacGuffin is the central focus of the film in the first act, and thereafter declines in importance. It may re-appear at the climax of the story, but sometimes is actually forgotten by the end of the story. Multiple MacGuffins are sometimes derisively identified as plot coupons." - source Wikipedia
In similar fashion our "Generous Gambler" has very aptly used this technique with the previous OMT and now with QE. Great film director Alfred Hitchcock explained the term "MacGuffin" in a 1939 lecture at Columbia University:
"It might be a Scottish name, taken from a story about two men on a train. One man says, "What's that package up there in the baggage rack?" And the other answers, "Oh, that's a MacGuffin". The first one asks, "What's a MacGuffin?" "Well," the other man says, "it's an apparatus for trapping lions in the Scottish Highlands." The first man says, "But there are no lions in the Scottish Highlands," and the other one answers, "Well then, that's no MacGuffin!" So you see that a MacGuffin is actually nothing at all." - Alfred Hitchcock
It seems to us that the much vaunted OMT was in fact a MacGuffin, namely, nothing at all. The OMT MacGuffin was a successful ECB apparatus for snaring bond investors into buying peripheral debt. Benoît Cœuré, described it: 
"OMTs are an insurance device against redenomination risk, in the sense of reducing the probability attached to worst-case scenarios. As for any insurance mechanism, OMTs face a trade-off between insurance and incentives, but their specific design was effective in aligning ex-ante incentives with ex-post efficiency." 
So despite never being used, the OMT instrument was evaluated to have been a successful instrument, in true MacGuffin fashion.

For filmmaker and drama writing theorist Yves Lavandier, in the strictly Hitchcockian sense, a MacGuffin is a secret that motivates the villains. In our investment world the villains are yield scoundrels and central bankers as we have argued in our conversation "The last refuge of a scoundrel":
"A scoundrel being by definition villainous and dishonorable, when one looks at the "Cantillon Effects" of Ben Bernanke's wealth effect, no doubt that the big beneficiaries of the Fed's liquidity "largesse" has benefited the most to Wall Street's "scoundrels""
In Europe, the carry players, namely peripheral banks, benefited from the LTROs as well as the MacGuffin OMT to continue to invest massively in their respective domestic bond market.  As a reminder the German Constitutional Court expressed doubts about the legality of OMT under German and EU law. The European Court of Justice heard the case in October 2014, but has not yet issued its ruling.

For us, in the end, the discussions surrounding QE in Europe are indeed akin to a MacGuffin given the definition of Princeton's Wordnet defines a MacGuffin as simply "a plot element that catches the viewers' attention or drives the plot of a work of fiction".

In this week's conversation we would like to share again our concerns in relation to a particular type of rogue wave (currency crisis) we discussed in November 2011, the three sisters, that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:
"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: Wave number 1 - Financial crisis Wave number 2 - Sovereign crisis Wave number 3 - Currency crisis In relation to our previous post, the Peregrine soliton, being an analytic solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), it is "an attractive hypothesis to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace" - source Wikipedia." - Macronomics - 15th of November 2011
We would like also like to discuss in this conversation the never ending struggle between inflationary forces and deflationary forces, given it looks to us that deflation is indeed appearing to have the upper hand we think.

Wave number 3 - Currency crisis:
We voiced our concerns in June 2013 on the risk of a rapid surging US dollar would cause with the Tapering stance of the Fed on Emerging Markets in our conversation "Singin' in the Rain":
"Why are we feeling rather nervous?
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?
It is a possibility we fathom." - Macronomics - June 2013
At the time we stated that we were in an early stage of a dollar surge, in fact the global total returns YTD for the US dollar is 10.8%.

The situation we are seeing today with major depreciation in EM currencies is eerily similar to the situation of 1998, with both China and Japan at the center of the turmoil. On China specifically we will go into more details next week with a guest post from our friends at Rcube Global Asset Management.

In relation to the expected continued dollar surge in 2015 we read with interest Societe Generale FX Outlook H1 2015 entitled "Life Below Zero":
"Lots of USD upside, but Fed will want to rein rally inA year ago in “The reluctant dollar” we predicted that the US dollar would win by elimination in 2014. On a spot basis, the dollar has been the world’s best year-to-date performing currency (okay, we left the Sudanese Dinar aside). The Fed’s broad trade-weighted US dollar index is up some 7% year-to-date and our equal-weight USD/G10 and USD/EM indices are up by more than 10% each (Graph 1).
 Not bad. Our in-house economic views overwhelmingly support further dollar strength in 2015. There is plenty of room to the upside (Graph 2).
 We are confident about the view, but occasionally lose sleep on: 1) the fact that it is consensual, and we don’t like sitting with the crowd; and 2) fears that the raging currency war may have a bigger impact on the Fed’s reaction function than our economists think."
Central banks in the driving seat.
Graph 3 shows the year-to-date (YTD) change in 1y2y G10 rates relative to 1y2y USD, and the YTD spot currency move.

If the correlation does not appear to be as strong as it has often been in the past, this is to an extent because at the zero lower bound (ZLB), monetary policy isn’t just about the price of money, but also its quantity.
Typically the JPY undershoot is a function of the BoJ printing more money – don’t fight that trend, particularly when that policy looks increasingly impotent. The NOK has undershot too, thanks to the falling oil price. The SEK has done even worse, on fear the Riksbank would do more than just cut rates. AUD, NZD and GBP have been resilient (above the regression line) and might have some catch-up to do on the downside."            - source Societe Generale
Of course 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.

The Baltic Dry Index, indicative of a weakening growth outlook as of late - graph source Bloomberg:

The demise of the commodity complex in conjunction with weaker industrial production in Europe as well as a clear degradation in the shipping outlook are all elements highlighting the deflationary forces at play we have been so vocal about in our numerous conversations around the "japanification" process.

There has been no doubt a growing divergence between fundamentals from the real economy with asset prices levels courtesy of central banks meddling. While our central banks deities so far have benefited from the benefit of the doubt on the promise for some of more generosity in the form of a QE MacGuffin in Europe, we would have to agree with Societe General's take from their FX outlook on central banks meddling:
"It’s broken, and they don’t know how to fix itIt is remarkable that after so many years of super easy monetary policy, the global economy still feels wobbly. On the positive side the US continues to recover and the lower oil price will provide a boost to global growth in H1 2015. Yet the growth multipliers seem to be much weaker still than they have been historically, highlighting a lack of confidence, be it because of post-crisis hysteresis, the demographic shock, the excessive levels of non-financial debt, etc.‘Secular stagnation’ is the buzz word. The theory encompasses two ideas: 1) potential growth has dropped; 2) there is a global excess of supply, or a chronic lack of demand. If true, the implications are clear. First, excess supply creates global disinflation forces. Second, to fight lowflation and to help demand meet supply at full employment, central banks may need to run exceptionally easy monetary policy ‘forever’. In other words, real short-term rates need to remain very low, if not negative.
Life below zero. At the ZLB, central banks do what they know: they print money. But such policy seems to follow a law of diminishing marginal returns. It has worked well for the US, because the Fed had a first-mover advantage, and the support from pro-growth fiscal policy and a swift clean-up of the household and bank balance sheet. The BoJ and ECB aren’t as lucky. Let’s consider three transmission channels: 1) The portfolio channel. By pushing yields lower, central banks force investors into riskier assets, boosting their prices. But trees don’t grow to the sky. And the wealth effect on spending is constrained by high private and public debt. 2) The latter also gravely impairs the lending channel. And with yields already so low, it’s questionable what sovereign QE can now achieve. 3) The FX channel. This is where the currency war starts, as central banks try to weaken their currency to boost exports and import inflation. It however is a zero-sum game that won’t boost world growth.-The battle to win market shares highlights a fierce competitive environment, which tends to depress global inflation. Adding insult to injury, oversupply in commodities, especially oil and agriculture, currently add to the deflationary pressure. That leads central banks to get ever bolder, when instead they’d need to be more creative (e.g. a bolder ABS plan from the ECB would be far more effective than covered and government bond purchases) and get proper support from governments (fiscal policy, structural reforms).
Looking for a 2015 surprise. The BoJ has just sped up the race to the bottom. It may just help spread out the currency war. Consider Asia ex-Japan FX. It has been resilient relative to CEEMA and Latam (Graph 7), with the Chinese yuan (CNY) an anchor. But is has started to weaken in H2 2014, with the KRW, MYR and SGD weakening some 5-7% vs USD. For a long time China was happy to see CNY strengthen vs USD, as long as the latter was falling vs other currencies. 
But the trade-weighted CNY is now soaring, along with that of the USD (Graph 8). 
The CNY REER is up 27% over five years. It is increasingly difficult for China to afford such strengthening, given the local economic slowdown and deflationary pressure (PPI around -2% for almost three years)." - source Societe Generale
Of course, what Societe Generale is highlighting is what we discussed this year in April, namely "The Shrinking pie mentality":


"When the economic pie is frozen or even shrinking, in this competitive devaluation world of ours, it is arguably understandable that a "Winner-take-all" mentality sets in. Shrinking economic growth resulting from the financial crisis means that, from a demographic point of view in Europe with a shrinking working age population, low birth rates and a growing population of older people, it means to us that Europe does indeed face a critical choice: meet their unfunded pension liabilities and go bust, or cut drastically in entitlements in order to compete with emerging countries that don't have these large "legacy" costs associated with aging developed countries." - source Macromics, April 2014
When it comes to currency wars and currency crisis, we do expect China to seek a weaker yuan in order to deflate its epic credit bubble as we pointed out as well in our April 2014 conversation:
"In similar fashion, the US would thrive on a strong revaluation of the yuan, which would no doubt precipitate China into chaos and trigger a full explosion of the credit bubble in China, putting an end to the "controlled demolition" approach from the Chinese authorities. A continued devaluation of the yuan, would of course be highly supportive of the Chinese attempt in gently deflating its credit fuelled bubble, whereas it would export a strong deflationary wave to the rest of the world, putting no doubt a spanner in the QE works of the Fed, the Bank of Japan and soon to be ECB."
 As we posited before, if it is time for a pullback, get some greenbacks, at least that's what Dr Copper,  the metal with the economics Ph.D, is telling us as of late.

When it comes to dollar global liquidity, we agree with Societe Generale's take from their FX outlook, watch the US current account:
"It will soon be the ECB’s turn to embrace ‘proper’ (i.e., sovereign) QE. But the chances of ECB bond-buying doing much for bank lending or for demand are very remote. Bond yields will fall – but only a bit, given how low they are already. Equities will rise but, likewise, only slightly.
The main effect of QE will be to weaken the euro, but a big enough fall to really boost exports is hard to imagine yet. And the effect on inflation expectations is likely to be quite limited. So the danger, as ever, is that we see QE but don’t see much economic benefit. So, we’ll see more QE. And so on. So both the ECB and the BOJ response to low US rates is very different from what we saw in the last US recovery. Meanwhile, the big driver of dollar weakness pre-2008 – capital outflows to higher-yielding currencies and assets – is substantially weakened by the fact that these are now correcting from excessive valuations. And finally, the US current account deficit, which was almost 6% of GDP in 2006, is now 2.25% and falling even as the US economy outperforms.
 The US current a/c deficit is melting thanks to the shale oil revolution
All of this is enough to make us believe that we are at the start of a period of further dollar strength, even if real US interest rates will rise modestly, not dramatically. The dollar’s rally could be much bigger if asset markets suffer a major loss of confidence or if those trying to revive inflation expectations through currency weakness take that policy to its logical conclusion and engineer a downward spiral. Imagine a world with USD/JPY back in real terms at 1982’s level – USD/JPY 140 at today’s rate. What would that do for the rest of Asia, including perhaps for China? Imagine what happens if ECB QE has absolutely no impact and the ECB finds itself, in a year’s time, with inflation still at or below zero? Furthermore, if a falling euro or yen drives inflation expectations up and therefore real rates down (which is one of the major benefits of it), while a stronger dollar anchors US inflation expectations and supports real rates, then currency trends could tend to become self-sustaining until they overshoot – and that happens when US real rates become a drag on activity, which would probably take a big currency move.
All of which is to say that a very strong dollar is not inconceivable, even if it’s more likely that there is a 5-10% gain. In other words USD/JPY 120-130, EUR/USD 1.10-1.20, GBP/USD 1.1.40-1.50." - source Societe Generale
When it comes to oil and the velocity of the fall, we would like to re-iterate what we said in April 2013 in our conversation "The Awful Truth":

"In numerous conversations, we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced. The decline in the oil price to a nine-month low may prove to be another sign of deflationary pressure and present itself as a big headwind. Why is so?
Whereas oil demand in the US is independent from oil prices and completely inelastic, it is nevertheless  a very important weight in GDP (imports) for many countries. Monetary inflows and outflows are highly dependent on oil prices. Oil producing countries can either end up a crisis or trigger one.
Since 2000 the relationship between oil prices and the US dollar has strengthened dramatically.  As we highlighted in our conversation in May 2012 - "Risk-Off Correlations - When Opposites attract": Commodities and stocks have become far more closely intertwined as resources have taken on a greater role with China's economic expansion and increasing consumption in Emerging Markets."

A structural slowdown in economic activity like we are seeing is accentuating the fall in oil prices we think. Declining profitability and misdirected investments into unproductive assets and infrastructure projects have been triggered by years of Zero Interest Rate Policy (ZIRP) in Developed Markets (DM). This is having negative consequences in Emerging Markets given oil demand growth has been exclusively supported by strong EM growth. Lower GDP growth trend is therefore pushing for lower oil prices. 

We concluded our April 2013 as follows:
"Is Copper finally is telling us something about the real world, which equity markets are not currently focused on in true Zemblanity fashion, Zemblanity being "The inexorable discovery of what we don't want to know"? We wonder...
And, what if the trigger will be in Asia like in 1997 (as suggested by Albert Edwards recently) and not Europe after all? We wonder as well..."
Moving on to the subject of deflation having the upper hand, we think Bank of America Merrill Lynch's graph of 5-year 5-year forward breakevens (%) from their Liquid Insight note from the 9th of December 2014 entitled "Anchors Away", indicates the strength of the deflationary forces at play:
"Breaking bad
In recent years inflation hawks have been warning that aggressive monetary policy could cause inflation expectations to become “unanchored”. After all, stable expectations are not a birthright, but must be earned with a demonstrated track record of success. Unfortunately, there is building evidence that inflation expectations have already become unanchored; however, the unanchoring is to the downside.
The most obvious evidence is the plunge in 5-year 5-year forward breakevens in the Euro Area and the US (Chart of the Day). Euro Area breakevens are now even lower than during the 2008 crisis. US breakevens have not quite plumbed those depths, but are about 50bp or 70bp lower than normal. Both ECB and Fed officials have downplayed the drop. For example, in a speech on December 1, New York Fed President William Dudley argued that “despite some softness in market-based measures of inflation compensation, inflation expectations still seem well-anchored and this should also work to pull inflation gradually higher.”
We disagree and see four reasons to take this drop seriously. First, some survey measures of inflation expectations already shows signs of eroding. For example, in the Consumer Sentiment survey normally inflation expectations for five years ahead bounce around 3%, but now they have dipped to 2.6%. This is the lowest since the 2008-09 crisis." - source Bank of America Merrill Lynch.
We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed":
"If the policy compass is spinning and there’s no way to predict how governments 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 governments, the option-value of both gold and bonds goes up."

But what has been clear with the demise of the commodity complex during the summer has been as well validated by the capitulation in inflation hedges trade as shown recently by Bank of America Merrill Lynch in their Flow Show note from the 4th of December entitled "Chasing Winners, Selling Inflation":
"Selling inflation hedges: redemptions from TIPS ($0.7bn – largest in 14 months), EM equities ($2.8bn - largest in 8 weeks), bank loans & precious metals"
- source Bank of America Merrill Lynch
When it comes to deflationary environment and defaults, we will re-iterate what we have argued in  July 2012 in our conversation of Jul 2012 entitled "Hooke's law":
"Moving on to the "unintended consequences" of this low yield environment will have to corporate balance sheets, to some extent, it tends to explain, why defaults tend to spike in a low rate deflationary environment such as today. The fall in interest rates increases bond prices companies have on their balance sheets, exactly like inflation (superior to what an increase of 2% to 3% of productivity and progress) destroys the veracity of a balance sheet for non-financial assets. The conjunction of low interest rates with higher taxations will undoubtedly damage companies, particularly in Europe, and in a country like France, for instance, where public expenditure as a % of GDP is much higher (57%) than in Germany (45%)." - Macronomics July 2012
High inflationary environments allow corporations to inflate away their nominal debt as their assets (and revenues) grow with inflation, leading to lower default rates but, Low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike.

The end of a low volatility period tends to a strong and sudden crash in prices, that is what you can fathom from Bayesian learning which leads to strong rise in asset prices courtesy of central banks generosity.

In credit markets, liquidity can fast become a problem and losses can be sudden and acute as witnessed this summer with the Phones4U debacle witnessed in the UK High Yield space as displayed by Societe Generale from their High Yield and Crossover Compass in December:
"Fixed income credit investment is as much about avoiding the losers as spotting the winners, and the growth in the number of discrete borrowers accessing the European High Yield market makes this task harder by the day. Juicy though the credit spread may have appeared at the time, investors in the Sterling bonds of Phones 4U must rue the day that they took exposure to the UK mobile phone retailer. Now in administration, even modest exposure will have impacted portfolio returns given how far and fast the senior and PIK notes fell when Vodafone and EE announced in quick succession that they were terminating their distribution agreements with the high street retailer.

Since the early September sell off of Phones4U bonds, the retail sector has come under continual pressure as investors take a second look at their holdings and consider just how robust some of these businesses are in the context of a continuing weak economic environment across Europe. Poor trading results can rapidly snowball into a rout as a “shoot first, ask questions later” approach by investors runs head long into poor secondary market liquidity." - source Societe Generale
Credit has always been a leading indicator. Recently widening spread as clearly indicated by our good friends Rcube Global Asset Management. in their note "US Equity / Credit Divergence: A Warning",  have been indeed signaling a sign of caution. We would add that the European High Yield market is as well showing some divergence as well as displayed by Bank of America Merrill Lynch's graph from their Thundering Word note of the 4th of December entitled "I'm a Commodity...Get Me Out of Here":
- source Bank of America Merrill Lynch

QE in Europe appears to be the central focus in true MacGuffin fashion but, rest assured that the widening in credit spreads and the deterioration of the economic outlook regardless of how the fall in oil prices is being presented in positive fashion by many pundits, deserve, we think much more attention.

On a final note, we leave you with a chart for Bank of America Merrill Lynch latest Thundering Word note entitled  "I'm a Commodity...Get Me Out of Here" displaying the stock price of ailing Italian oldest banking giant Banca Monte Dei Paschi di Siena:
- source Bank of America Merrill Lynch

We still believe in what we argued in our conversation "Pascal's Wagerabout the ultimate fate of Banca Monte Dei Paschi di Siena bondholders and shareholders alike:
"We believe that the path will be very painful for both shareholders and bondholders of MPS and that not only subordinated bondholders but seniors as well will face the music in the case of MPS, making MPS the precedent for future bail-in processes in the European banking landscape."

"The hardest tumble a man can make is to fall over his own bluff." - Ambrose Bierce, American journalist
Stay tuned!



Wednesday, 26 November 2014

Credit - The Hidden Fortress

"Even if it seems certain that you will lose, retaliate. Neither wisdom nor technique has a place in this. A real man does not think of victory or defeat. He plunges recklessly towards an irrational death. By doing this, you will awaken from your dreams." - Yamamoto Tsunetomo, Hagakure: The Book of the Samurai

Watching with interest, Japan hit again with recession, with Shinzo Abe's response by delaying the sales-tax increase while the GPIF increasing its share of risky assets, with neighboring China throwing as well the proverbial gauntlet with both a surprise rate cut as well as with its rising up-and-coming industrial technologies and industrial companies, we reminded ourselves of one of our favorite film directors of all time Akira Kurosawa's 1958 masterpiece "The Hidden Fortress" when choosing our title as an analogy. After all, Kurosawa's movie is all about epic self-discovery and heroic action as described by Armond White in The Criterion Collection in 2001: "Kurosawa always balances valor and greed, seriousness and humor, while depicting the misfortunes of war."

In our investment world it is all about balancing valor and greed while we, pundits continue to depict the misfortunes of currency wars we think.

What is as well of interest in our chosen analogy and movie reference is that in the movie, the two peasants heroes while driven by their ecstasy for gold end up with only one single Ryō gold coin: "A Ryō was a gold currency unit in pre-Meiji Japan Shakkanhō system. It was eventually replaced with a system based on the yen." - source Wikipedia. On a side note movie buffers like us know that Georges Lucas was heavily influenced by Kurosawa's movie which inspired him to create the lowliest characters C-3PO and R2-D2 in Star Wars. 

The Currency Museum of the Bank of Japan states that one Ryō had a nominal value equivalent 300,000-400,000 Yen, but was worth only 120,000-130,000 Yen in practice, or 40,000 Yen in terms of rice which but half of what an ounce of gold is in terms of weight (16.5 g vs 31.103 g). From an historical point of view it is interesting to note that in 1695 during the Togugawa shogunate, the government decided to debase the Ryō. By 1736, the government decided to stimulate the economy and raise prices, again by debasing the gold content of the Ryō until it was abolished in 1871 and replace by the yen but we ramble again...

When looks at the YTD returns of various cross-asset classes, as presented by Bank of America Merrill Lynch in their Thundering Word report of the 7th of November 2014 entitled "Humiliation, Hubris & Gold", one could fathom that the real "Hidden Fortress" has indeed been the US dollar:

In this week's conversation and in continuation to our musings relating to central bank intervention we will look at why the "japanification" process has been favorable to the on-going rally in credit as well as how the market has been playing the banking sector deleveraging through credit rather than through equities (a pure capital structure play we think).


While there has been a lot of noise recently around the SPX vs HY US widening spread as clearly indicated by our good friends Rcube Global Asset Management. in their note "US Equity / Credit Divergence: A Warning", this credit uneasiness is also visible in Europe with Investment Grade / High Yield renewed divide - graph source Bloomberg:

Itraxx Main 5 year CDS index versus Itraxx Crossover 5 year CDS index - roll adjusted as of the 20th of November 2014:

What has also been of interest in 2014 when it comes to the performance of credit, yet another "Hidden Fortress" we think, has been the total return performance in the US of High Grade versus High Yield in terms of Total Return as displayed in a chart from Bank of America Merrill Lynch from their 2015 2015 HG Outlook entitled "Un-reaching from yield":
"As our title suggests we expect US high grade corporate credit to come under pressure next year as the Fed begins its rate hiking cycle. The exemplary behavior of credit spreads in recent years stands as the key consequence of strong inflows to the asset class. As inflows disappear/turn to outflows we expect extended periods of spread widening – and high spread volatility - as interest rates go up, and thus continued positive correlation between interest rates and credit spreads" - source Bank of America Merrill Lynch

Of course we agree that one of the top main reasons in the behavior of credit spreads has indeed been strong inflows in the asset class as indicated by Bank of America Merrill Lynch in their recent Follow the Flow note entitled "Quality is king" from the 21st of November:
"Non-stop flows into ‘safety’
More of the same for another week it seems. More inflows into high-grade credit funds, and more outflows from equity funds in Europe. Note that euro IG cash is now trading at 2007 levels. So far this year more than $60bn has been added to high-grade funds, while equities have seen inflows of only $14bn. If the recent trend of outflows from equity funds continues at the same pace for the rest of the year, cumulative flows might be close to flat.
Government bond funds have continued to see outflows for a fourth consecutive week, with money-market funds down for a second week in a row. Note that over the last week, only high-grade credit and loan funds have seen inflows.

Credit flows (week ending 19th November)
HG: +$2.0bn (+0.3 %) over the last week, ETF: +$669mn w-o-w
HY: -$700mn (-0.3%) over the last week, ETF: +$20mn w-o-w
Loans: +$41mn (+0.5%) over the last week
Flows into high-yield funds dipped into the negative territory. After a short stint of inflows European HY funds saw a $700mn outflow. YTD outflows now point to $2.5bn. Should HY flows remain in negative territory for the rest of the year that would mark the first year since 2011 of negative flows for the asset class. On the other side, high-grade credit with another $2bn+ inflow last week is set to have its best year according to EPFR data.
Mid and long-term high-grade funds continued to see strong inflows, while short-term funds suffered moderate outflows, as investors are reaching for quality yield.
- source Bank of America Merrill Lynch

In total YTD inflows in Investment grade represents $60 billion versus only $14 billion in equities. So much for the "Great Rotation" story of 2014...

When it comes to the gradual move towards higher quality in the credit rating spectrum, this adds validity to what we argued back in October in our conversation "Sprezzatura":
"When it comes to the "credit clock" and leverage in the High Yield space, since mid-2013 the net leverage has increased at a faster space. This is confirming the gradual move of institutional investors from low beta towards higher quality while retail investors continue to be significantly exposed to lower quality credit."

In fact, as per Bank of America Merrill Lynch AAA-rated US corporate bonds (9% annualized) outperformed CCC-rated bonds (2%) validating the “flight to quality” theme and quality credit being a somewhat a "Hidden Fortress".

In terms of the impact the rate hiking cycle we have a preference with scenario number two from Bank of America Merrill Lynch's 2015 US HG Outlook entitled "Un-reaching from yield":
"Why the rate hiking cycle is different for credit this time
There are three reasons why we are particularly concerned about the rate hiking cycle this time. First, we are at the tail end of an unprecedented five years of zero interest rates, which led to an unprecedented reach for yield. Thus we are about to see an unprecedented un-reach from yield. Second, dealer balance sheets have collapsed due to new regulation, and are thus unable to mitigate a situation with heavy outflows. Finally, the less stable mutual fund/ETF ownership share of our market has jumped compared with the 1990s (Figure 5).
#1 risk to our outlook – Upside to the economy
The #1 risk to our outlook is that the US economy really takes off and leads to a more rapid rate hiking cycle and much higher long term interest rates. To us the economy looks really strong, and the November reading on Philly Fed being the highest since December 1993 (Figure 6) reminds us about the biggest risk scenario for 2015 – a repeat of 1994, where a strong economy forced the Fed’s hand and financial market conditions became disorderly. 
In that scenario we think HG credit spreads could widen to 200bps, taking global credit spreads wider too. That could lead to excess and total return losses of about 200bps and 8%, respectively.

#2 risk – Downside to the economy
We also find it entirely possible that that the US economy slows down meaningfully from here to around 2%-2.5% GDP growth in 2015 (compared with our house forecast of 3.1%). This #2 risk to our outlook would mean that the rate hiking cycle is pushed beyond 2015, and that global investors may become sufficiently comfortable with US interest rate risk that we get a big global reallocation into US fixed income, given ultra-low global yields. Such scenario could lead to lower interest rates and much tighter credit spreads – say, as tight as100bps, with US HG spreads compressing significantly to EUR HG spreads. This provided that the economy does not slow too much. In this scenario HG excess and total returns could be as much as +330bps and +9%, respectively

#3 risk – Upside to the global economy
As #3 risk to our outlook we have that strong US economic growth pulls up the global economy. As we have argued, the US is a relatively closed economy and thus unlikely to be pulled down meaningfully by the weak global economy. However, the US economy is big enough that its imports can serve as an important driver of global economic growth. The problem with this scenario is that it lessens the downward pressure on long term US interest rates asserted by the weak global economy. That means more outflows from credit and further credit spread widening." - source Bank of America Merrill Lynch

When it comes to credit and liquidity, it has been a recurring theme in our musings. On the subject of liquidity we agree with our good friend and former colleague Anthony Peters, strategist at SwissInvest and regularly featured in IFR from his last post entitled "A confidence in crisis":
"Bloody, ugly

ICMA, the International Capital Markets Association – I am honoured to be sitting on one of its committees – has just published a paper titled “The current state and future evolution of the European investment grade corporate bond secondary market: perspectives from the market”. It is based on a series of interviews with senior market participants from both sides of the street. We might nod knowingly at most of its conclusions but it finely articulates knowledge and concerns of the bond markets for those who don’t fully understand them but who are, nevertheless, responsible for their governance.

It is a fine piece of work by Andy Hill but it carries one big and stark warning which is that most players are patently aware that debt markets are living in a liquidity fed vortex and that nobody has a clue what might happen when if, as and when the cheap money is withdrawn. What they are certain of, it would seem, is that whatever the outcome might be, it will be pretty bloody and ugly." - source IFR - Anthony Peters

A good illustration from this report pointed out by our good friend is the RBS Liqui-o-Meter graph measuring market liquidity we think:
"The RBS Liquid-o-Meter, which attempts to quantify US bond market liquidity, suggests that liquidity in the US credit markets has declined by 70% since the crisis, and continues to worsen. Anecdotal evidence suggests that this is equally applicable to the European corporate bond markets.
The RBS ‘Liquid-o-Meter’ attempts to quantify bond market liquidity by combining measures of market depth, trading volumes, and transaction costs. Currently it is only modeled for US markets." - source ICMA report "The current state and future evolution of the European investment grade corporate bond secondary market: perspectives from the market.

As we posited in the conversation "The Unbearable Lightness of Credit":
Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital

We remind ourselves from the wise word from our friend and credit mentor Anthony Peters when it comes to liquidity:
"Somewhere out there, the next big bubble is forming and it will catch the unwary cold. Banks no longer have the risk capital to make big markets in all issues, least of all unconventional ones, and investors would be well served to ask themselves now where the pockets of liquidity will be when they are most needed. Don't disregard the old definition of liquidity as being something which, when needed, isn't there. I can't say where that there will be but I can be pretty certain that it won't be in corporate perp land. I rest my case." - Anthony Peters - IFR - Investors queue up for perp walk

From the same Bank of America Merrill Lynch's 2015 US HG Outlook entitled "Un-reaching from yield" here is another illustration of the lack of liquidity premium in the credit space:
"When the tide goes out
Currently we think that investors are not getting paid sufficiently for taking liquidity risk. Furthermore the most obvious consequence of the lack of retail inflows and institutional outflows, when short term interest rates go up, is that liquidity deteriorates. Hence we prefer positioning in liquid bonds.
For credit the most prominent unintended consequence of increased financial regulation is reduced liquidity via the collapse in dealer balance sheets (among other things, Figure 12).
As we have argued, that means high grade credit spreads should be permanently wider as the fair liquidity premium is much higher – in the appendix we update our analysis to estimate potential cycle tight HG spread levels of 100bps, compared with 79bps during the previous cycle.
However, this effect has been masked as strong technicals from significant inflows to HG, and credit spreads moving toward new tights meant investors were forced to reach for yield in off-the-run names and maturities. As a consequence, again, the liquidity premium has collapsed (although very recently there has been a small increase, Figure 13).
However, with the Fed expected to hike interest rates next year obviously inflows are destined to weaken and even turn to outflows. That means the liquidity premium is going to widen back out to – we estimate – about 10% of on-the-run spreads as a rule of thumb. Hence we continue to think investors are better off in liquid on-the-runs, as they are not being compensated for taking liquidity risk.
This also means that our HG index spreads of presently around 130bps are artificially tight. In fact, if our index is priced under next year’s deteriorating liquidity conditions we think spreads would be about 10bps wider (given that the vast majority of bonds are illiquid). That represents formidable headwinds for HG credit next year. Add a rate hiking cycle to much worse liquidity conditions and we look for HG credit volatility to increase significantly next year from currently around 44% (1m ATM options on the CDX IG) to 80% - thus exceeding levels seen last year during the taper tantrum" - source Bank of America Merrill Lynch

The Hidden Fortress in the credit space lies therefore in high quality and liquid bond we think.

Moving back to the subject of the potential downside to the US economy, what we find of interest is that the "Cantillon Effects" have indeed generated positive correlations. The world is much more intertwined macro wise.

The "japanification" process and the growing risk posed by "positive correlations" is a subject we touched in our conversation "Misstra Know-it all" back in September 2013 and we referred to Martin Hutchinson's take on these correlations:
"Negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. 

Since central banks worldwide are now pursuing the same easy-money policies as the Bernanke Fed, the same correlations are appearing elsewhere, with the exception of the majority of emerging markets, where economic reality remains in play." - source Asia Times, Martin Hutchinson

We commented at the time that the credit markets and equities markets were no exception to "rising forced correlations". In recent years, credit and equities have correlated closely, but, as credit has moved towards a lower bound, Investment Grade for instance have become even more sensitive to interest rates movement, making it incredibly likely that any rate rises will have a large impact given the disappearance of the interest rate risk buffer in the asset class given the on-going spread compression supported by large inflows into the asset class.

As we reminded ourselves from the conversation "The Monkey's paw" when discussing too much liquidity in the world:
"It seems to us the central bank "deities" are in fact realising the dangers of using too much the "Monkey's paw" in the sense that the Fed paved the way for "mis-allocation" and the rise in inflows into the credit space, but that even the Fed's generosity cannot offset the rising risks of a broad exit in a disorderly fashion in credit funds given that the Fed's role is supposedly one of "financial stability"." 

Back in August 2013 in our conversation "Alive and Kicking" we argued the following when it comes to convexity and bonds:
 Moving on to the subject of convexity and bonds, how does one goes in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":
"CDS benefits from positive convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays

As a reminder:
Convexity measures how duration changes as yields change. For a positively convex bond, the duration increases as the yield declines, and decreases as the yield rises. Positive convexity means that the price increase for a given decline in yields is greater than the price decrease for the same rise in yields. Non-callable bonds are positively-convex. Bonds with traditional call options, such as preferreds, and mortgage-backed securities, or some specific callable high yield notes are generally negatively convex. If you expect yields to rise, you should avoid bonds with long duration, such as those with longer maturities and lower coupons, and favor bonds that have shorter duration and higher yields. In periods were you can expect higher volatility in yields, you should avoid low or negative convexity bonds such as callable bonds in the High Yield space.

We concluded at the time:
"With positive convexity from using CDS, the sensitivity of the price to yield changes (i.e., duration) works in your favor whereas with negative convexity, duration works against you as the price of the bond is becoming more sensitive to yield changes. The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..."

Of course another issue to take into account is the liquidity in the CDS space which has been affected as well by the new regulatory environment and the fact that recently one of the largest player in the single names CDS trading space, Deutsche Bank has decided to exit entirely the business, which is no doubt another headache for the credit players looking for duration risk mitigating tools.

When it comes to interest rates risk and positive correlations we find of interest that all global sovereign rates declined together in 2014. Most investors were positioned for higher interest rates, we were not. 

Several factors come to play when asserting the reason behind the global decline. On this subject we read with interest Bank of America Merrill Lynch recent Liquid Insight note entitled "The world is flat":
"Is this a coincidence or a trend?
Is the global decline in rates a mere coincidence in 2014, or is it a recurring theme? Chart 1 illustrates the time series of 10y rates in the US, Euro area, UK, Japan, Canada and Switzerland, suggesting strong co-movement over time. 
To see the strength of the correlation, we conduct a Principal Component Analysis (PCA), and compute the fraction of total variance that can be explained by the first principal component (PC). On average, the first PC can explain 85% of total variance in global rates over the last 10 years. 

As one would expect, during crisis periods such as the Lehman collapse (2008) and the European peripheral crisis (2010-12), the fraction is particularly high. There is either a growth shock or a flight quality move, which spills over across markets. However, the first PC has remained very high in 2013 and 2014 even though we are not at a crisis period per se. This suggests recently global rates seem to be as correlated as they were during crisis periods. This could reflect deeper inter-linkages in the macro economy as well as financial markets globally post crisis. Some research also suggests uncertainty shocks such as the Lehman crisis can put downward pressure on terminal rates globally." 

What drives co-movement across global rates?
A recent IMF study3 attributes co-movements in global rates to the usual three 
factors: level, slope and curvature. Interestingly, the authors associate these 
factors with a clear economic interpretation of global inflation, global growth and 
future financial and economic instability, respectively.

Since global growth and global inflation are closely related to US growth and US 
inflation, it is important to differentiate whether the correlation in global rates is 
merely a reflection of correlation of macro fundamentals, or whether global factors 
provide additional information. In other words, do global factors impact US rates 
beyond US growth and inflation factors? This question is of particular interest 
currently as growth dynamics seem to be diverging, with the US outperforming 
much of the developed world.
To this end, we compare two regressions: In one, we only include US growth 
measures as proxied by the PMI indices. In another, we include global PMI in 
addition to US PMI measures. Regression results are tabulated in Table 1 and 
Table 2. 

When we take account of global PMI, the fit improves, and R-square 
increases from 12% to 30%. This signals that global PMI provides explanatory 
power for US rates that go beyond US PMI measures. Another way to see the 
relevance of global PMI is that the coefficient in front of global PMI is significant 
(with t-stat 3.72). These results suggest that global growth measures provide 
additional information for US rates beyond US growth measures.
This finding does not contradict our previous finding that 10y German rates do not granger cause 10y US rates. While granger causality examines whether lagged 10y German rates provides explanatory power for 10y US rates in addition to lagged 10y US rates, the discussion above focuses on macroeconomic fundamentals that drive movements in 10y US rates. It is quite possible that lagged 10y German rates do not contain new marginal information of global growth over lagged values of 10y US rates.

Market implications: Mind the globe
Even though US domestic factors of a narrower output gap and slowing demand from price inelastic sources argue for higher US rates currently, we think investors should be mindful of global factors. The recent weakness in global growth (as evidenced from global PMI) and inflation can prevent a significant move higher in US 10y rates. By the same logic, any pick-up in global growth or inflation will likely have a disproportionate effect on US rates, all else being equal.- source Bank of America Merrill Lynch.

Given the disappearance of the interest rate risk buffer in the investment grade asset class, mind the volatility gap in 2015 and hedge accordingly.

Another factor explaining the global trend in lower yields has of course been the role played by Japan and its pension funds allocation, in particular the GPIF which is reducing its domestic bonds exposure aggressively while pursuing a higher share in risky assets: domestic equities, foreign equities as well as foreign bonds as disclosed its July-September quarter financial results published on the 25th of November and as reported by Nomura in their note entitled "GPIF still has room for a portfolio shift":
"The GPIF, the biggest pension fund, announced its Jul-Sep quarter financial result today. The share of domestic bonds in its portfolio declined to 49.6%, the lowest share ever, from 53.4% the previous quarter (Figure 1). 
The share undercut 50% for the first time and it was lower than the minimum share under the old target portfolio. We estimate that the share fell to 52.3% by end-September owing to valuation effects. Thus, the fund reduced its domestic bond exposure aggressively, more than valuation effects suggest. Trust accounts, which manage pension fund money, were net sellers of JGBs in August and thus, the decline is not necessarily surprising" - source Nomura

We note that the allocation to international bonds from end of June at 11.1% increased to 12.1% and given the maximum target portfolio new target has increased from 16% to 19% and the target portfolio is set at 15% therefore there is room for further yield compression we think in the global sovereign space.

Moving to another case of "Hidden Fortress", we continue to think US treasuries are compelling, particularly in the long end as we believe the US is far from normalizing and investors might yet again be disappointed in 2015.

The potential catalyst for US Treasuries has been summed up nicely by Societe Generale in their November publication entitled "The Japanization of the US economy? What if the US follows Japan (and the Eurozone) down the rabbit hole of deflation?":
"Potential catalysts for US Treasuries:
• Differential between US, Eurozone and Japan rates are at historically high levels, in part based on the belief that US can avoid global deflation
• What could push US into same vicious spiral as Europe and Japan?
• Consensus has not priced in risk of deflationary conditions in the US
• Deflation in the US would be very bullish for US Treasuries but there are additional factors driving capital flows into US Treasuries
1) Chinese official sector buying Treasuries - underinvested in Treasuries since Fed started QE-III
2) ECB negative discount rate policy drives EM reserves out of € into US reserve deposits
3) Return of the geopolitical crises; Greece and Venezuela/Argentina induced by China
4) US dollar should continue to appreciate, which is disinflationary and compresses rates
5) US elections – GOP control over Congress leads to lower deficits, lower growth
6) Lack of alternative, dollar denominated, risk free assets
7) Mortgage pre-payment hedging – Mortgage investors have to buy Treasuries to hedge pre-payment risks
8) Fed will likely remain more dovish than many currently forecast
9) Demographics - Surging retirement of 75ml baby boomers will drive investments into Treasuries
10) Regulation – Fed and US regulators forcing financials to hold more Treasuries"- source Societe Generale

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". Investors should had bought Treasuries if they had anticipated the Federal Reserve reduction in its purchases, based on the last two times that the biggest buyer of bonds stepped back from the market (The yield declined by 126 basis points between the end of the first round of Fed purchases in March 2010 and the beginning of the second round in November that year).
When it comes to Europe, the deleveraging continues and amounts to goldilocks period for credit particularly in the banking space whereas banking equities will continue to underperform we think.

We pointed out in our conversation "Actus Tragicus" the attractiveness of European investment grade credit:
"While it is true that the "interest rate buffer" in case of a surge in rates is nearly exhausted in the current low yield environment, but the environment for investment grade credit is still favorable as highlighted again last week:
"This somewhat validates Nomura's take on the golden age for credit we discussed back in 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets":
"-Corporates around the world have been deleveraging for longer than most people realise, starting around the time of the tech bubble in 2000.
-Deleveraging is generally bad for equities, but good for credit assets.
-In the US, Europe and Japan, credit has outperformed equities by any reasonable measure (e.g. volatility, drawdowns, absolute).
-As credit is far less volatile than equities, some leverage is sensible. Even leveraged credit can be less risky than unleveraged equities." - source Nomura
We also argued at the time:
"We therefore do think (and so far flows in US investment grade are validating this move) that interest rate differential will indeed accelerate inflows towards US fixed income, contrary to Bank of America Merrill Lynch's views. We do not expect a rapid rise in US interest rates but a continuation of the flattening of the US yield curve and a continuation in US 10 year and 30 year yield compression and therefore performance, meaning an extension in credit and duration exposure of investors towards US investment grade as per the "Global Credit Channel Clock" (although the releveraging of US corporates means it is getting more and more late in the credit game...)."

The continued underperformance of European banks equities versus credit can be explained by the simple underlying mechanism of capital arbitrage as explained by Exane BNP Paribas Research in their note from the 13th of November entitled "How the market plays the banking sector deleveraging":
"The relative fall in banks’ shares vs credit reflects a capital structure analysis
The banking sector has underperformed the whole market by 9% since the beginning of November. At the same time, the credit spreads of banks have accompanied those of the whole market. This is a normal capital structure pattern. The market anticipates a value transfer from equity holders to debt holders. This is the case when a company or a sector reduces its leverage, for example through disposals, capital increases, or improved market conditions. Such moves reduce the risk borne by debt holders but reduce the speculative time value of equity holders."
The underlying mechanism
The banking system arbitrage is so simple that it can be explained using the Merton model, notwithstanding the model can be refined. To allow for complex capital structure analysis and arbitrage, we generally use our proprietary ALRG™ model.
The simplified Merton view states that the sole driver of a firm’s value is its asset value. As long as the asset value covers the nominal of the debt, the firm continues to operate. If not, the firm is liquidated and the proceeds go to the debt-holders.

Debt and equity are seen as options on the assets.
– The debt holder gets back the nominal debt value if the company is solvent and receives the residual value of the assets in the event of default; the payoff of the position is MIN (debt, asset). The equity value is seen as a call option on the assets, the amount of debt is the strike.
– The equity holder owns the net asset value if the company is solvent but loses everything in the event of default; the payoff is MAX (0, asset - debt). The credit spread is the premium of a put option on the assets, the amount of debt is the strike.
The equity (call option) value includes intrinsic value (asset value less the amount of debt) and time value (speculative value).
The put option has no intrinsic value, as long as the value of the assets is greater that the debt amount. Yet, it essentially has time value.

A deleveraging is a very simple move: the strike is lowered. Doing so, the risk borne by debt holders is reduced. This is reflected by the value of the put option sold by the bond holder. With a lower strike, its value is lower. And of course, due to the call/put parity, this value is taken from the equity holder. The speculative value of equities is reduced.

In the real world, things are more complex and worse:
1) Banks hold an implicit guarantee “offered” by central banks and/or governments. Its value is reduced by the deleveraging. This is the target of the too-big-to-fail regulation. Consequently, the deleveraging also has a negative impact on assets value, increasing the transfer from equity to debt holders.
2) Like any other company, a bank has to bear significant operating costs – which do not come down with reduced leverage. The expected equity return is reduced, but the costs to obtain this return will remain the same.

To offer a caricature, a “perfect” bank would only hold treasury bonds and would be fully financed with equities. In this case, the shareholder’s return is defined by the treasury yields minus operating expenses and taxes. This is not a very good investment." - source Exane BNP Paribas Research

On a final note we leave you with a chart for Bank of America Merrill Lynch latest Thundering Word note entitled "Humiliation, Hubris & Gold" which displays Europe earnings as % of global earnings:
"The Berlin Fall
25 years on from the Fall of the Berlin Wall and Europe is arguably one recession away from severe political and social stress. 24,512,000 men and women are currently unemployed across the continent and anti-establishment political parties are surging in popularity across the continent. Monetary convergence between 1989 and 1999 (as disinflation from Eastern Europe and the promise of good fiscal behavior initiated a decline in interest rates toward German levels) and the monetary union of 1999 and 2008, has been replaced by a monetary divorce as bond markets price-in various sovereign risks. Meanwhile, Europe’sshare of global profits has collapsed (see Chart 4)." - source Bank of America Merrill Lynch

When it comes to QE in Europe in general, and the ECB in particular, we think our last quote resume appropriately the "Japanication" situation:
"If you keep your sword drawn and wield it about then no one will dare approach you and you will have no allies. But if you never draw it, it will dull and rust and people will assume that you are feeble." - Yamamoto Tsunetomo, Hagakure: The Book of the Samurai

Stay tuned!