Tuesday, 22 July 2014

Credit - Perpetual Motion

"Oh ye seekers after perpetual motion, how many vain chimeras have you pursued? Go and take your place with the alchemists." - Leonardo da Vinci, 1494
Looking at the continuous new highs registered by the Dow Jones, we reminder ourselves of the quest of many scientists for perpetual motion when choosing this week's title:
"Perpetual motion is motion that continues indefinitely without any external source of energy. This is impossible in practice because of friction and other sources of energy loss. A perpetual motion machine is a hypothetical machine that can do work indefinitely without an energy source. This kind of machine is impossible, as it would violate the first or second law of thermodynamics." - source Wikipedia
Given that by now it is fairly evident that the Fed's balance sheet extension has had a significant impact on the performance in risky assets in general and the S&P 500 in particular as displayed in the below graph from Société Générale's recent report entitled "20 charts to understand the fragile equilibrium of US financial markets" published on the 15th of July, we wonder if indeed our "omnipotent" central bankers do not think they have indeed surpassed Leonardo da Vinci and invented "perpetual motion" in financial markets:
But we reminded ourselves of Adam Smith's quote in relation to real "price" formation:
"Labour was the first price, the original purchase - money that was paid for all things. It was not by gold or by silver, but by labour, that all wealth of the world was originally purchased."
Despite the fact that successful perpetual motion devices are impossible in terms of the laws of physics, the pursuit of perpetual motion remains popular particularly in the US central banking space we think.
So we decided to "ramble" around the definition of perpetual motion in financial markets and the lack of "labor participation" in the current on-going Fed induced rally when carefully choosing our title and came up with this:
"The Fed's perpetual motion machine of the first kind produces "income" without the input of "labor". It thus violates the first law of "thermo economics": the law of conservation of labor." - Macronomics
In fact the Fed's conundrum can be seen in the lag in wage growth given nominal wages are only up 2% yoy whereas real wage growth remains at zero. 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.

If a country has 100% debt to GDP, it means that this country has roughly bought growth at a 2% rate for 50 years which is the case for France given the last time the books were balanced was 1974. 
In this week's conversation we will discuss around the risks of "hyper-deflation" happening as well as looking at the potential trajectory during the summer for US yields.
As we have argued in our conversation the "Molotov Cocktail":
When somebody has too much debt and cannot reimburse it, how do you bail him out? Obviously by restructuring his debts, which imply losses for his creditors.

But when one lends him more money in order for him to pay back what he owes, he is not bailing him out but rather pushing him in a bigger hole! The game until now has been to "print" more money and to add more debt on the shoulders on the indebted ones, to gain some time in the hope that growth will resume and reduce de facto the weight of the existing debt burden and the additional new debt issued to support the initial debt troubles.

This is a big misunderstanding of debt dynamics and its effects on the economy. When debt becomes too big, which it is now the case in many parts of Europe, the servicing drains all the available cash flows and reduces the growth potential."

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. We hate sounding like a broken record but: no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits and debt levels. 

What we are of course concern in this much vaunted "Perpetual Motion" infatuation in financial markets is that we are still sitting tightly in the deflationary camp. In fact we expected further yield compression on US Treasuries as discussed in our conversation "the Vortex Ring" back in May this year:
"The lack of "recovery" of the US economy has indeed been reflected in bond prices, which have had so far in 2014 in conjunction with gold posted the biggest returns and upset therefore most strategists' views of rising rates for 2014 (excluding us given we have been contrarian)." - Macronomics

In our conversation"The Coffin Corner" we indicated the following:
"We found most interesting that the "Coffin Corner" is also known as the "Q Corner" given that in our post "The Night of The Yield Hunter" we argued that what the great Irving Fisher told us in his book "The money illusion" was that what mattered most was the velocity of money as per the equation MV=PQ. Velocity is the real sign that your real economy is alive and well. While "Q" is the designation for dynamic pressure in our aeronautic analogy, Q in the equation is real GDP and seeing the US GDP print at 2.5% instead of 3%, we wonder if the central banks current angle of "attack" is not leading to a significant reduction in "economic" stability, as well as a decrease in control effectiveness as indicated by the lack of output from the credit transmission mechanism to the real economy."
So seeing the 1st quarter US GDP print shocker at -2.9% made us wonder about the control effectiveness of the Fed. We can relate to some of the interesting points developed by Shelby Henry Moore III in his Bell Curve Economics long post
"In a vicious feedback spiral, as the GDP shrinks, the private sector income shrinks and needs more debt (or government subsidies) to pay the interest on prior debt, but the additional government debt spending destroys more of the useful production and capital of the private sector. The only way to make the marginal-utility-of-debt go positive, is to decrease the debt load back to a level where the private sector can produce more than its interest payments. At this terminal phase, both increasing or decreasing M (debt), shrink the GDP, i.e. hyper-deflation." - Shelby Henry Moore III.
Of course this is why extended QE in the US and the launch of QE in Europe would be highly destructive we think and could potentially lead to "hyper-deflation". 

When it comes to deflationary pressures we have been tracking the events in the shipping industry with great interest and in particular the numerous prices increases in the Drewry Hong-Kong-Los Angeles Container Rates - graph source Bloomberg:
"Drewry publishes its weekly Hong Kong-Los Angeles 40-foot container rate benchmark on Wednesday mornings EST. The benchmark provides insight into the price to ship a container across one of the busiest trading lanes and is therefore used as a proxy for the market. It fluctuates with changes in liner supply-and-demand dynamics and rate surcharges." - source Bloomberg
Another shipping indicator we have been following is of course the Baltic Dry Index as oversupply of vessels keeps hire costs below break-even levels. The index dropped 29.4% on average in 2Q from 1Q and  is 69.8% lower than the 10-year historical 2Q average, yet is 8.8% higher than 2Q13 levels. Panamax vessels declined 40.1% on average sequentially, and were down 19.6% yoy in 2Q.- graph source Bloomberg:
"The Baltic Dry Index, which tracks the costs of moving dry bulk freight via 23 seaborne shipping routes, has averaged 32.5% higher yoy this year through July 16. The index is a barometer of the health of the dry-bulk industry, as well as the broader global economy. It has declined roughly 34.5% yoy and down 66.4% from the recent December peak. The index should begin to rebound as seasonal trends, such as grain exports out of South America, take hold." - source Bloomberg
For us shipping is a leading deflationary indicator as we have argued in March 2012: 
"He who rejects restructuring is the architect of default." - Macronomics.
As we have argued in our conversation  in September 2012 "Zemblanity" (being "The inexorable discovery of what we don't want to know"):
"By keeping interest low to promote investment, like the Fed is currently doing, full employment would therefore be "attainable". For Keynes, the velocity of money would move together with the level of economic activity (and the interest rate)."
 As a reminder:
Our core thought process relating to credit and economic growth is solely based around the very important concept namely the accounting principles of "stocks" versus "flows":
"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."
Credit growth is a stock variable and domestic demand is a flow variable. We always asked ourselves the following when it came to the Fed's policies:
"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"
Back in our September 2012 conversation we came across this comment from a participant on a macro research forum from a prominent global research firm and we did find it very appropriate in relation to our past title analogy, namely "Zemblanity" and thought we had to share it at the time given we are at present discussing "Perpetual Motion" (which is impossible):
"Isn't QE3 in one sense a blow to the essence of America's prosperity, free markets and with that efficient capital allocation? Setting a target for unemployment rate by running the printing press sounds a lot like a planned economy. It might get us to the target (if not the drop in participation rate eventually will) but with that the economy risk be even more similar to Japan? Have we become so short sighted and spoiled that we can't face the hard facts of our previous reckless childish behavior? I can't think of any time in history when avoiding the truth ever was a sustainable choice. Only history will tell but FED, ECB, BOJ and BOE (soon BOC?) all being in the same boat makes you worried about unintended consequences.... I'm 100% long risk for the moment but long term I think this takes us further from a sustainable world."
And of course the credit "japonification" process has clearly been set in motion.
When it comes to our contrarian take on US yields since early January 2014 we argued the following in our conversation "Supervaluationism" back in May this year it comes from us agreeing with Antal Fekete's take from his paper "Bonds Defy Dire Forecasts but they are not defying logic":
"The behavior of the bond market has been consistent with Keynesianism. By his compassionate phrase “euthanasia of the rentier” Keynes meant the reduction of the rate of interest, to zero if need be, as part of the official monetary policy to deprive the coupon-clipping class of its “unearned” income. Perhaps it is not a waste of time to repeat my argument why, in following Keynes’ recipe, the Fed is acting contrary to purpose. While wanting to induce inflation, it induces deflation.
The main tenet of Keynesianism is that the government has the power to manipulate interest rates as it pleases, in order to keep unemployment in check. Keynes argued that the free market economy was unstable as it was open to the swings of irrational investor optimism or pessimism that would result in unpredictable and wild fluctuation of output, employment and prices. Wise politicians guided by brilliant economists − such as, first and foremost, himself  −  had to have the power “to prime the pump” (read: to pump up the money supply) as well as the power to “fine-tune” (read: to suppress) the rate of interest. They had to have these powers to induce the right amount of spending needed to put people to work, to entice entrepreneurs with ‘teaser interest rates’ to go ahead with projects they would otherwise hesitate to undertake. Above all, politicians had to have the power to unbalance the budget in order to be able to help themselves to unlimited funds to spend on public works, in case private enterprise still failed to come through with the money.
However, Keynes completely ignored the constraints of finance, including the elementary fact that ex nihilo nihil fit (nothing comes from nothing). In particular, he ignored the fact that there is obstruction to suppressing the rate of interest (namely, the rising of the bond price beyond all bounds) and, likewise, there is obstruction to suppressing the bond price (namely, the rising of the rate of interest beyond all bounds). Thus, then, while Keynes was hell-bent on impounding the “unearned” interest income of the “parasitic” rentiers with his left hand, he would inadvertently grant unprecedented capital gains to them in the form of exorbitant bond price with his right." - Antal Fekete

Capital gains in the form of exorbitant bond price? A game we have indeed played successfully given we have been learning a few tricks from our Keynesian magicians bankers as of late. We must confide we have indeed been playing this game and did in fact picked up some yield enticing junior financial subordinated bonds in late 2011 at a cash price of around 94.5, yielding around 14% at the time, to see the yield drop below 4%  these days and the cash price of our position rising by nearly 50% thanks to the generosity of our great "magicians" and given our observation of "Perpetual Motion" machine we decided at the time to buy this French Perpetual issue. We also suffered minimal volatility in the process as illustrated in the below Bloomberg graph:
Of course the main culprit behind our outsized gain is ZIRP (zero interest rate policy) given it has the effect of destroying capital. As the rate of interest is halved, the price of a long term bond is doubled.

Exorbitant government bond prices? The Core European bond market picture making new record lows such as the German bund 10 year yield at 1.14% and the French OAT 10 year at 1.56%, at the lowest level since 1746 - source Bloomberg:
"The continuing fall of interest rates in the 21st century, in the face of an unprecedented amount of Federal Reserve credit being created through bond purchases, is far from being illogical. Nor is the continuing bull market in bonds, now a third of a century old, is a conundrum to those of us who are not infected by the bug of Keynesianism. It is fully explained by the incentive to earn risk-free profits on a continuing basis, unconditionally offered to bond speculators by the policy of open market operations." - Antal Fekete, "Bonds Defy Dire Forecasts but they are not defying logic": 
In Europe of course, courtesy of our "Generous Gambler" aka Mario Draghi, ECB's president "whatever it takes" moment in July 2012 has indeed triggered the incentive to earn risk-free profits based on continuing "implicit" guarantees, a subject we discussed in our previous conversation last week.
Our dexterous "Generous Gamblerhas indeed been highly successful in propelling Spanish bonds gains above Germany. But what our "Generous Gambler" ignores is that generally hyper-deflation can lead to a deflationary spiral in which a deflationary environment leads to lower production, lower wages and demand, and thus lower price levels, which is continuing in Europe as far as we can see from the latest economic data releases.
Moving back to the important notion of the difference between stocks and flows we do agree with Antal Fekete's take in May 2010 in his article "Hyperinflation or Hyperdeflation" being akin to a Black Hole and the possibility of capital being destroyed thanks to ZIRP (as it is mis-allocated towards speculative endeavors) hence the risk of pushing to far the "Perpetual Motion" experience:
"Obviously, you need a theory to explain what is happening other than the QTM. I have offered such a theory. I have called it the Black Hole of Zero Interest. When the Federal Reserve (the Fed) is pushing the rate of interest down to zero (insofar as it needs pushing), wholesale destruction of capital is taking place unobtrusively but none the less effectively. Deflation is the measure of wealth in the process of self-destruction -- wealth gone for good. The Fed is pouring oil on the fire as it is trying to push long-term rates down after it has succeeded in pushing short term rates to zero. It merely makes more wealth self-destruct, and it makes the pull of the Black Hole irresistible.
But why is it that the inordinate money creation by the Fed is having no lasting effect on prices? It is because the Fed can create all the money it wants, but it cannot command it to flow uphill. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day. Their bets are on the house: if they lose, the losses will be picked up by the public purse. But why does the Fed under-write the losses of the bond speculators? What we see is a gigantic Ponzi scheme. The Treasury issues the bonds by the trillions, and promises huge risk-free profits to the bond speculators in order to induce them to buy. Most speculators believe that the Treasury is not bluffing and they buy. Some may believe that the Fed is falsecarding doubts and they sell. But every time they do they only see foregone profits. What we have here is a rare symbiotic relation between the government and the speculators." - Antal Fekete

Of course, what the ECB has done as well is tame the speculators and prevented so far a deeper adjustment in the European banking space leading to an outperformance of financial bonds versus equities. But, as we pointed out last week, the continuous need to raise capital for the European banking sector is facing more margin calls, meaning more need to raise capital and the need for more sovereign supports to avoid a depreciation of the liabilities. This infernal "Perpetual Motion" is no doubt delaying a very painful adjustment which could lead the European sector to produce more than what is need just to make the interest payments of the ever rising debt burden!

Therefore it appears to us that deflationary environment in Europe is continuing leading to lower production, lower wages and lower demand, and thus lower price levels.

Moving on the trajectory of US yields during this summer lull, we agree to a certain extent with Nomura's recent take on US treasuries in their note from the 18th of July entitled "Bonds over-reacting or forward looking?":
"Summers aren't the time to burn carry and be short duration - wait for the Fall
We started out the year with a strategic call for lower rates and that has largely run its course. However, we have constantly said that investors should not expect a v-shape rise in rates just because the rally in duration wasn't expected. We have been slowly shifting our trading profile, and for now we have a tactical play on this bond rally to carve out a low this summer versus it just having a one-touch feel to it, where most have been hoping the May dip of 2.4% on 10s, for a brief second, was the low for year; we don't.
As seen in Figure 1, the market participants have been fighting the urge of getting dragged into the air pocket created last year post taper was let out of the bag. However, the path of least resistance and our call until the September FOMC (where there is a risk for more hawkish news around exits and growth/rate expectations) is for 10s to go towards 2.35% and 30s towards 3.10% during the balance of the summer. 
August traditionally is a seasonally strong bond rallying month, and Q2 data excitement can burn out soon (where we are watching if next week's CPI flares out and if at the end of the month wage inflation take off or not). Meanwhile, although investors are not as short, mentally most investors want higher rates and there are some groups underinvested.
Lastly as we mention in our mid-year update, once rates start to normalize, given the lower fixed income supply projections in the second half, bond markets will be supported even as Fed exits, in our view. In Figure 2 we highlight that the Fed has obviously been the biggest buyer during QE; however, in the past other investors would come in and fill the void. 
Recently there has been a focus on China buying USTs and how that was probably another force driving rates lower. However, bank buying in the US has been just as equal of a force while Japan hasn‟t been buying as strongly lately. So that can all change if yields back up and actors like GPIF allocate abroad." - source Nomura

On a final note and as we posited at the beginning of our conversation unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively. As reported by Anna-Louise Jackson and Anthony Feld in their Bloomberg article from the 22nd of July entitled "Higher Wages Signaled by More U.S. Employees Quitting", the jury is indeed still out there when it comes to confirming the "escape velocity" of the US economy:
"More than 2.5 million U.S. workers resigned in May, a 15 percent increase from a year earlier, based on seasonally adjusted data from the Labor Department. These employees represent about 56 percent of total separations, the highest since November.
Such departures serve as a proxy for consumer confidence because people are more likely to quit when they have a new position secured or are convinced that another is readily available, said Nicholas Colas, chief market strategist at ConvergEx Group, an institutional equity-trading broker in New York. The most-recent quits data were “very positive,” which suggests sentiment finally has turned a corner, he said. The report is one that Federal Reserve Chair Janet Yellen has said she uses to judge the strength of the labor market.
The share of Americans who say business conditions are “good” minus the share who say they are “bad” turned positive in June for the first time since January 2008: 0.2 percentage points, up from minus 3.5 points in May, based on data from the Conference Board, a New York research group.
Feeling Emboldened 

“Consumer confidence has been the last piece to come back in this recovery,” Colas said. This suggests wages also could go up because as employees feel more emboldened to switch seats, their bosses may be willing to offer higher compensation in an effort to prevent such turnover, he said.
People working in the private sector could see stronger salary gains ahead, according to Bloomberg BNA’s Wage Trend Indicator, designed to predict and interpret compensation trends. This forward-looking index rose to 99.12 in the second quarter from 98.92 in the first, marking the third consecutive increase and highest level since March 2009.
Pay for these employees could increase more than 2 percent by year-end, according to Kathryn Kobe, an economist at Economic Consulting Services LLC in Washington, who helped develop and maintains the indicator. Wages rose 1.7 percent in the three months ended March 31, near a post-recession low of 1.3 percent,data from the Labor Department show." - source Bloomberg

What of course could derail this very "fragile" recovery is a renewed jump in gasoline prices. The latest US core CPI climbed 1.9 percent from June 2013, after a 2 percent increase in the prior 12-month period. Gasoline costs jumped 3.3 percent, their biggest gain since June 2013, accounting for two-thirds of the increase in total prices, today’s report showed, something to watch closely we think.

"I can calculate the motion of heavenly bodies, but not the madness of people." - Isaac Newton

Stay tuned!

Monday, 14 July 2014

Credit - The European Polyneuropathy

"Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly and applying the wrong remedies." - Groucho Marx

Following up on our June conversation "Deus Deceptor" where we indicated our deep concerns relating to France's economic situation, we think it is time for us to revisit our negative stance on France. On a side note we share Charles Gave from Gavekal latest views on this very "French" subject. Given it is the 14th of July and France's national day, it is time, we think to look at the growing evidence of a slowdown and turmoil brewing in the quarters ahead.

In relation to our chosen title, with problems brewing at the core of Europe, in France in particular, and continuity in banking woes in the periphery, we thought our title should reflect the continuation of European woes using a medical analogy such as "Polyneuropathy" which is a damage or disease affecting peripheral nerves, which can be acute or chronic, but we ramble again...

In this week's conversation we will discuss France in general and peripheral European banking woes in particular. (we already discussed France in 2012 in our conversation "France's Grand Illusion").

As we posited back in June on our main subject France:
The story for  the remainder of 2014 in Europe is still France:
This is what we argued in January 2013 and this is still what we are arguing now. While French politicians are benefiting from low rates on French debt issuance courtesy of on-going Japanese support, but, on the economic data front France is increasingly showing signs of growing stress

France should be seen as the new barometer for Euro Risk. With Industrial Production at -3.7% (implying a negative GDP print, see below), the French government is seriously in denial when it comes to growth assumptions: 1% in 2014 (down from 1.2%) and 2% in 2015 is way over optimistic we think. 

A sobering fact, services in the French economy represent around 80% of the GDP versus 76% for the rest of the European union. the latest read at 48.2 for Services PMI is indicating contraction (the lowest level reached in February 2009  was at 40.2).

France appears to us as the weakest link if we take for example World Manufacturing PMI (50 = no change on prior month) as an illustration of the troubles brewing ahead as illustrated by our friends from Rcube Global Asset Management with France standing clearly at the bottom:

Another worrying trend illustrated by our friends at Rcube Global Asset Management lies in the growing financing gap between France versus Europe:
Or one could also look at the Corporate Financing Gap as a percentage of GDP in various European countries as displayed by Rcube Global Asset Management:
"Investment will keep plunging since French corporates' debt to value added ratio is so high. Furthermore, the French corporate financing gap is massive (as per above chart). It means that French companies' financing needs are extremely high, not only historically, but also compared to other countries in both Europe and the rest of the world. With France in such a difficult situation, the ECB will be under increased pressure to join the WE club

Corporate margins are thus decreasing, and are the weakest in Europe:

The high corporate debt to added value ratio suggest also that investment will soon turn negative

The French housing sector looks also mispriced compared to the rest of core EU:

We would like to add some more illustrations on France being the weakest link in Core Europe.

The recent evolutions of European house prices in some European countries seem to illustrate the start of a weakness in French real estate prices - graph source Bloomberg:
In blue: France
In red: United Kingdom
In yellow: Spain

Also, French industrial production (white line), French GDP (orange line) and French Services PMI (blue line, data available since 2006 only) tell the story on its own, we think - graph source Bloomberg:
An industrial production at -3.3% equals zero growth. With industrial production at -3.7% you can expect a negative GDP print for France.

As we argued back in June:
"If the Services PMI contracts, it doesn't bode well for France's unemployment levels. Services represent the number one employment sector in France (34% of total employment in 2010 according to INSEE).

Normally "entrepreneurial economy" can do that well as long when they are entrepreneurs in the picture but in the special case of France, given French civil servants have done their best to "kill" the entrepreneurs in France with great success, the economy will continue to linger.

A tight credit channel, high inventory levels vs. order books, depressed consumer sentiment and a forced fiscal tightening create a dangerous economic environment for an already weak economy."

We have also plotted France Consumer Confidence against GDP and the evolution of the French government debt to GDP (inverted) - graph source Bloomberg:
Deteriorating Debt to GDP level rising while French Consumer Confidence Indicator sliding, it doesn't bode well for growth and unemployment levels.

On numerous occasions we have discussed France and our growing concerns such as in our conversation "In the doldrums" where we touched the subject surrounding credit-less recoveries:
So for us, unless our  "Generous Gambler" aka Mario Draghi goes for the nuclear option, Quantitative Easing that is, and enters fully currency war to depreciate the value of the Euro, there won't be any such thing as a "credit-less" recovery in Europe and we remind ourselves from another conversation "Squaring the Circle" that in the end Germany could defect and refuse QE, the only option left on the table for our poker player at the ECB:
"The crux lies in the movement needed from "implicit" to "explicit" guarantees which would entail a significant increase in German's contingent liabilities. The delaying tactics so far played by Germany seems to validate our stance towards the potential defection of Germany at some point validating in effect the Nash equilibrium concept. We do not see it happening. The German Constitution is more than an "explicit guarantee" it is the "hardest explicit guarantee" between Germany and its citizens. It is hard coded. We have a hard time envisaging that this sacred principle could be broken for the sake of Europe." - Macronomics

The reasons for Germany's racing ahead have all been explained not only in the title of a previous post of ours "Winner-take-all" in February 2013 but also in the contents should you want to dig further on the subject:
"In similar fashion to the winner-take-all computational principle, when ones look at the growing divergence between France and Germany when it comes to PMI, in the pure classical form, it seems only the country with the highest activation stays active while all other see their growth prospects shut down

On the topic of France and the "overvalued"  Euro, French Industry Minister Arnaud Montebourg has most recently validated our Groucho Marx quote from above as indicated by his latest staunch attack on the ECB as reported by Mark Deen and Helene Fouquet on their July 10 article in Bloomberg entitled "France's Montebourg Hits Out at ECB in Campaign-Style Speech":
French Industry Minister Arnaud Montebourg hit out at the European Central Bank, calling on it to buy bonds and weaken the euro in order to boost growth.
“We have the most depressed region in the world with a currency that has appreciated the most globally and a European Central Bank that has not respected its mandate,” Montebourg told an audience of executives in Paris, citing the risk of deflation. “No one should leave the economy in the hands of moralists and accountants.”
The remarks were made against the backdrop of a screen reading “economic patriotism” and “fight for growth” in a packed and darkened room that resembled Montebourg’s campaign meetings in the Socialist primaries of 2011 in which he placed third. He pledged to run again after his defeat to Francois Hollande. France’s next presidential election is due in 2017.
With a French economy that has barely grown in two years and euro-area inflation that remains at less than half the ECB’s target level, Montebourg is taking aim at policies that he says are letting France and Europe behind the rest of the world. “Growth is a political problem that will be achieved through political action,” he said. “To allow unemployment to remain high is to help the National Front and destroy Europe.” The National Front, which led the European parliamentary elections in France, is an anti-euro, anti-immigration party. “I only have one enemy; it’s conformism,” Montebourg said. Conformism “is not a candidate, it is ruling” the country, he said.
Hollande’s approval rating at less than 20 percent is at a record low for a French president" - source Bloomberg

From our conversation  "Squaring the Circle" here is the simple answer to Arnaud Montebourg's euro concerns in a very self-explanatory diagram:
As pointed out previously by our friend Martin Sibileau (who used to blog on "A View From The Trenches"), here is a reminder from his work which we quoted in our conversation "The law of unintended consequences" in Macronomics on the 25th of January 2012:
"With a more expensive Euro, Germany is less able to export to sustain the rest of the Union and growth prospects wane. At the same time, the private sector of the EU looks for cheaper funding in the US dollar zone, which will eventually force the Fed to not be able to exit its loose monetary stance. - Martin Sibileau
Europe's horrible circularity case - Martin Sibileau

By tying itself to Europe via swap lines, the FED has increased its credit risk and exposure to Europe:
"If the ECB does not embark in Quantitative Easing, the Fed will bear the burden, because the worse the private sector of the EU performs, the more dependent it will become of US dollar funding and the more coupled the United States will be to the EU." - Martin Sibileau

As a reminder from our previous conversation  "Squaring the Circle":
As a side note and in relation to the EU private sector seeking USD funding as displayed in Martin's chart above, in 2012 over a third of the US Investment Grade supply (net issuance in $430 billions) was from non-US issuers up from 25% in 2011. In 2013 we have seen about a third of the new issuance from non-domestic issuers (estimated net issuance for 2013 $400 billions).

Arguably in recent months, thanks to the US Fed tapering, the 1 year/1 year forwards for the US dollar and the Euro have increasingly diverged as displayed in the below Bloomberg chart:
But it looks to us that what the market is pricing indeed is a trigger at some point of QE in Europe because when it comes to the European Polyneuropathy, we think our friend's Martin Sibileau's above diagram depicts clearly the situation particularly when ones take into account that a huge amount of euro denominated assets remain to be sold. For instance, Société Générale reported on the 7th of July reported in a specific report on European banks entitled "Rise of the "zombie" assets", non-core banking represents a €1.5 trillion industry:
"Non-core banking: A €1.5trn industry 
European banks have become highly skilled in separating off the unwanted, the unsellable, and the unexplainable. Across our coverage, there is now €1.5trn of non-core banking balance sheet, consuming €80bn of tangible equity. These operations have had a major impact on profitability, dragging a full 4ppts off sector ROTE in 2013. Cleaning up the non-core will have a major bearing on when profitability will creep higher for the sector, in our view.
The major operations 
Five banks account for €1trn of the non-core balance sheet currently. This is where we believe restructuring the “bad parts” of the book has the most potential to drive profitability higher. These banks are UBS, Barclays, CBK, ING, and UCG. We are seeing progress, with ING recently completing the NN Group IPO and CBK disposing of a block of assets.
Raising the bid for “bad” assets 
We believe that the combination of ECB liquidity, lower funding costs, and improving confidence should raise the level of attractiveness for noncore operations. We have seen more robust financials IPO deal flow, and decent returns for distressed debt funds. This should help banks to run down the “bad”, and focus on the
Further assets could become non-strategic 
We expect restructuring and consolidation to become a major theme for European banks after the AQR. This could bring further operations into question, particularly if the disposal process becomes easier (or even profitable). There is the potential for further restructuring at CS (CIB), DBK, and UCG (CEE)." - source Société Générale.

We can also point out that European banks need to sell another $795 billion worth of property assets as reported by Bloomberg by Neil Callanan and Patrick Gower on the 14th of July in their article entitled "European Banks needs $795 billion Problem Property Loan Solution":
"European banks and asset managers plan to sell or restructure 584 billion euros ($795 billion) of riskier real estate as they try to clean up their balance sheets, Cushman & Wakefield Inc. said.
The region’s lenders, asset managers and bad banks, such as Spain’s Sareb, sold 40.9 billion euros of loans tied to property in the first six months, 611 percent more than a year earlier, the New York-based broker said in a report today. Transactions including foreclosure sales will reach a record 60 billion euros this year, Cushman & Wakefield estimates.
Lenders such as Royal Bank of Scotland Plc are accelerating loan-portfolio sales as borrowing costs fall from a year ago and economic sentiment improves. Lone Star Funds and Cerberus Capital Management LP are among U.S. investors that are taking advantage as sellers opt to offer bigger groups of loans, making it more difficult for smaller firms to make purchases, Cushman & Wakefield said." - source Bloomberg

As we have argued in our conversation "Mutiny on the Euro Bounty" in April 2012:
"More downgrades mean more margin calls, more margin calls means more liquidation and more Euros being bought and dollars being sold, with a growing shortage of AAA assets, Europe is moving towards mutiny on the Euro Bounty ship..."

Unless of course Mario Draghi goes for the nuclear option, Quantitative Easing, that is.

And as indicated by Martin Sibileau from his note from the 17th of October "The EU must not recapitalize banks":
"The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital."

What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

Of course it is! QE being the only card left but we have our doubt Germany will agree to play that card.

Moving on to the subject of lowering value of European peripheral banks liabilities generating further losses to same banks, needing more capital, the Banco Espirito Santo is a clear illustration once more of the above diagram. 
We already touched at length in our past credit conversations on the liability exercise management taken by many weaker peripheral banks in relation to raising capital to reach the 9% Core Tier 1 Capital target set up by the European Banking Association for June 2012 (see our conversations, "Peripheral Banks, Kneecap Recap", "Subordinated debt - Love me tender?" and "Goodwill Hunting Redux"):
"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

In fact in our conversation "Peripheral Banks, Kneecap Recap", Banco Espirito Santo was prominently featured given October 18 2011 Banco Espirito Santo had announced a capital increase in effect via its bond tender which meant at the time a 83.5% dilution for shareholders. This was followed by another capital increase of 1 billion euro announced mid-April, to be completed by early May (see our conversation "All Quiet on the Western Front").

We argued at the time:
"We believe additional debt to equity swaps will have to happen for weaker peripheral banks, similar to what we witnessed with Banco Espirito Santo in October 2011, as well as for German bank Commerzbank ("Schedule Chicken" - 25th of February 2012)."

As our good credit friend said in November 2011: 
"The path will be very painful for both shareholders and bondholders."

The BES (Banco Espirito Santo) situation, is indeed a reflection of the European Polyneuropathy and is by no mean without "consequences" as shown in the above diagram from Martin Sibileau and the effect of "margin calls" given that Espirito Santo's board as not only appointed a new CEO but its largest shareholder was forced to sell a stake in the Portuguese bank to meet a margin call on loans as reported on the 14th of July in Bloomberg by Joao Lima: in his article entitled "Espirito Santo Owner Sells Stake to Meet Margin Call on Loan":
"Banco Espirito Santo SA’s largest shareholder was forced to sell a stake in the Portuguese bank to meet a margin call on a loan, heightening market concerns about the group’s finances. Espirito Santo Financial Group SA said today it sold 4.99 percent of the bank, reducing its holding to 20.1 percent, to meet the call on the loan taken out during the bank’s 1.04 billion-euro ($1.4 billion) rights offering in June. Banco Espirito Santo, Portugal’s second-biggest lender by market value, fell as much as 11.9 percent in Lisbon trading.
The sale came as Chief Executive Officer Ricardo Salgado, the 70-year-old great-grandson of the bank’s founder, was replaced by Vitor Bento after the Bank of Portugal urged the lender to speed up changes to its executive management. The Espirito Santo family’s hold on the bank slipped further as
Moreira Rato, 42, head of the government’s debt agency, was named as chief financial officer.
Banco Espirito Santo roiled global markets on July 10 after another parent company, Espirito Santo International SA, missed some payments on commercial paper. The stock plunged 36 percent last week and its credit rating was cut by Standard & Poor’s and Moody’s Investors Service on July 11. German Chancellor Angela Merkel said at the weekend the market turmoil caused by the Portuguese bank underlined the euro region’s fragility." - source Bloomberg.

Of course what has started in earnest is the application of "bail-in resolutions" of subordinated bondholders of weaker European financial institutions if one looks at the BES story - graph source Bloomberg:
"Banco Espirito Santo's June capital raise boosted its regulatory capital buffer to 2.1 billion euros ($2.9 billion), according to a press release from the bank. This buffer may be considerably smaller under the macroeconomic assumptions of the adverse scenario in the forthcoming ECB stress tests. Concerns will also mount on the application of bail-in rules for bank debt, suggesting that investors may re-examine reported capital and debt prices for periphery lenders." - source Bloomberg

It isn't only happening in Portugal if one follows the events surrounding Austrian Hypo Aldria issues given the first Chamber of Austria's parliament, the Nationalrat, has given the green light to wipe-out subordinated lenders despite the debt being guaranteed by the state of Carinthia. When the game changes, you can expect politicians to change the rules. This is what makes the difference between "implicit" guarantees from "explicit" guarantees (The German Constitution is more than an "explicit guarantee" as stated above). The rest of Hypo Aldria's network such as its Balkan banking network has been put on for sale. Yet another effect of "margin calls".

For now it seems subordinated bondholders and shareholders are getting the "kneecap" treatment to raise much needed capital with the surge of "margin calls". When one looks at the debt distribution of Banco Espirito Santo with a small cushion of perpetual subordinated debt, one can legitimately wonder if senior bondholders will not suffer at some point a similar "treatment" - graph source Bloomberg:
"The reopening of senior subordinated debt markets to many periphery banks and nations has alleviated funding and deposit-cost pressures since 2013, though recent discussions on bail-in rules and the ECB stress tests have damped investor appetite. Banco Espirito Santo's plummeting debt value and share price suggest the cost of refinancing its 2.76 billion euros ($3.76 billion) of senior subordinated notes maturing in 2015 will have risen, likely also driving up funding costs for peers." - source Bloomberg

It appears to us that the cost of maintaining "zombie" entities afloat is getting pricier by the day. On a final note given European Growth and Consumer Confidence go hand in hand, we think we have reached a plateau as per the below Bloomberg graph:

"If there must be trouble, let it be in my day, that my child may have peace." - Thomas Paine

Stay tuned!

Monday, 7 July 2014

Credit - The Golden Mean

"Extreme positions are not succeeded by moderate ones, but by contrary extreme positions." - Friedrich Nietzsche

Looking at the much vaunted 288 K NFP print in conjunction with the 6.1% and the continuation of the rally in risky asset prices, it means of course that the "hunt for yield" will intensify in true "Cantillon Effects" fashion. We were expecting the 5 year European CDS index for Investment Grade, the Itraxx Main to close around 50 bps at the end of June, with the index at 57 bps today, we were not that far off, rest assured the "japonification" process in the credit space will continue further.  For us"Cantillon effects" describe increasing asset prices (asset bubbles) coinciding with "exogenous" liquidity induced central bank money supply. 

When it comes to choosing this week's title, we were inspired by Gavyn Davies' take on the diverging views between Janet Yellen at the Fed and the BIS take in his post "Keynesian Yellen versus Wicksellian BIS" which we read with great interest:
"Let us start with a few similarities between them. There is agreement that financial crashes that trigger “balance sheet recessions” lead to deeper and longer recessions than occur in a normal business cycle. There is also agreement that inflation is not likely to re-appear any time soon, and that the current recovery should be used to strengthen the balance sheets of the financial sector through regulatory and macro-prudential policy. That, however, is where the agreement ends.

The roots of disagreement can be traced back to the causes of the GFC. The BIS views the crash as the culmination of successive economic cycles during which the central banks adopted an asymmetric policy stance, easing monetary policy substantially during downturns, while tightening only modestly during recoveries (ie the Greenspan and Bernanke “puts”).

On this view, monetary policy has been too easy on average, leading to a long term upward trend in debt and risky financial investments. The financial cycle, which extends over much longer periods than the usual business cycle in output and inflation, eventually peaked in 2008. But, even now, the BIS says that the central banks are attempting to validate the long term rise in debt and leverage, instead of allowing it to correct itself. Excessive debt, it contends, is preventing the rise in capital investment needed for a healthy recovery. Financial and household balance sheets need to be repaired (ie debt needs to be reduced) before this can take place.

In contrast, the mainstream central bank view denies that monetary policy has been biased towards accommodation over the long term. Ms Yellen’s speech claims that higher interest rates in the mid 2000s would have done little to prevent the housing and financial bubble from developing. She certainly admits that mistakes were made, but they were in the regulatory sphere, where there was insufficient understanding of the new financial instruments that would eventually exacerbate the effects of the housing crash. Higher interest rates, she says, would have led to much worse unemployment, without doing much to reduce leverage and dangerous financial innovation." - source FT - Gavyn Davies

Our chosen title the Golden Mean reflects the great Aristotelian philosophical difference between both the Fed and the BIS given that, in philosophy, the 'golden mean' is the desirable middle between two extremes, one of excess and the other of deficiency. Whereas the Keynesian Fed is arguably one of excess (liquidity and ZIRP triggering "Cantillon Effects" aka bubbles), the other, the BIS, could be argued as one of deficiency (lack of sound financial regulation in the first place) but we ramble again.

A good illustration of this philosophical argument and Janet Yellen's perspective comes from Bank of America Merrill Lynch's Thundering Word note from the 2nd of July entitled "I'm so bullish, I'm bearish":
"Is the Fed Losing the Dot?
The Fed’s “print & regulate” mantra has boosted Wall St not Main St (Chart 1); the longer it takes for growth and rates to normalize, the greater the risk of speculative credit excesses (and a policy response to curb speculation). Our base case remains higher growth/yields/$. Bank lending; small business confidence hint at H2 macro; rate normalization. If so, expect an autumn correction in risk assets (hence “I’m so bullish, I’m bearish”). Either way, volatility will rise." - source Bank of America Merrill Lynch

What is truly interesting, we think, is the analogy that can be made from a financial markets perspective with the Eastern philosophy's take on the "Golden Mean". Thiruvalluvar, the celebrated Tamil poet and philosopher wrote in his Tirukkural of the Sangnam period of Tamizhagam about the "middle state" (the Golden Mean) which is to preserve equity. He emphasises this principle and suggests that the two ways of preserving equity is to be impartial and avoid excess.

Credit bubbles generated by ZIRP will not preserve equity, rest assured.

From our Wicksellian penchant, we would therefore argue that when it comes to the Fed's record, the Fed has repeatedly failed in being "impartial" and in "avoiding excesses" which led to one the biggest equity wipe-out in 2008 the world has ever known. We will therefore discuss in this conversation the slack in the unemployment since the great "reflation" trade and the materialisation of our past concerns justifying the tapering stance of the Fed.

Like the preeminent medieval Spanish, Sephardic Jewish philosopher Maimonides said:
"If a man finds that his nature tends or is disposed to one of these extremes..., he should turn back and improve, so as to walk in the way of good people, which is the right way. The right way is the mean in each group of dispositions common to humanity; namely, that disposition which is equally distant from the two extremes in its class, not being nearer to the one than to the other."

Of course given the rising "inequalities" given the "extreme" reflating policies followed by the Fed, no wonder that the "Golden Mean" has been broken favoring Wall-Street in the Process versus Main Street. Using Maimonides "philosophical take, the Fed has indeed been nearer a "class" rather than equally distant we think, with Wall Street and the owners of capital booming while Main Street and the workers struggling:
- source Bank of America Merrill Lynch, June 2014 - The Thundering Word.

Another illustration of the divergence between Wall Street and Main Street and how broken the "Golden Mean" is can be seen in the significant fall in the US Labor Participation rate compared to previous "recoveries" following US recessions as per the below Bloomberg graph:
We have long argued that the Fed is continuing on a "wrong" path and ignoring basic relationship such as Okun's law and the prolonged negative effects of ZIRP on the labor force (capital being mis-priced, it is mis-allocated to speculative purposes rather than productive purposes):
"In economics, Okun's law (named after Arthur Melvin Okun, who proposed the relationship in 1962.is an empirically observed relationship relating unemployment to losses in a country's production. The "gap version" states that for every 1% increase in the unemployment rate, a country's GDP will be roughly an additional 2% lower than its potential GDP." - source Wikipedia

In our conversation "The Last refuge of a scoundrel" back in September 2013 we argued the following:
"To that effect we wanted to illustrate more clearly this week the "Cantillon effect" of Bullard's effective way to conduct monetary "stabilization" policy, so, we plotted on Bloomberg not only the rise of the Fed's Balance sheet, but also the rise of the S&P 500, buybacks and of course the fall in the US labor participation rate (inversely plotted) - source Bloomberg (chart updated as of 7th of July 2014):
In red: the Fed's balance sheet
In dark blue: the S&P 500
In light blue: S&P 500 buybacks
In purple: NYSE Margin debt
In green: inverse US labor participation rate.
We think this graph clearly illustrates the Fed's conundrum in the sense that with the Fed's dual mandate of promoting "maximum employment" since 1978, it cannot promote both employment and sustain the "wealth effect" through capital growth with ZIRPThe Fed tried to increase jobs by lowering interest rates, weakening the dollar in the process, boosting exports but exporting inflation on a global scale, as well as lifting stock prices, playing on the wealth effect game.
Something will have to give.

ZIRP, we think is the main culprit."

We also added at the time:
"If capital cannot be re-allocated to "productive" endeavors, enabling companies to focus their resources on their core business, how can labor thrive in such a ZIRP environment? Please feel free to explain us how."

Of course companies have been focusing more on the wealth effect game leading to record stock prices and record buybacks as one can see from the performance of stock prices from companies which have boosted their stock prices through buybacks - graph source Bloomberg:
The performance of the US stock market has been artificially "boosted" by "de-equitization", namely the reduction of the number of shares courtesy of buybacks thanks to increase leverage, leading the "Golden Mean" to be even further damaged by the Fed's extreme reflating policy. 

When it comes to US unemployment figure at 6.1% and the latest NFP of 288 K we would like to re-iterate what we said in our conversation "Goodhart's law" in June 2013:
"When a measure becomes a target, it ceases to be a good measure." - Charles Goodhart

Conducing monetary policy based on an unemployment target is, no doubt, an application of the aforementioned Goodhart law. Therefore, when unemployment becomes a target for the Fed, we could argue that it ceases to be a good measure. - Macronomics

In the same conversation, we argued:
"We think that QE is not the core issue but ZIRP, which is in effect preventing creative destruction in a Schumpeter fashion and delaying much needed adjustments such as the ones needed from the European banking sector."

No wonder investing in European banks shares have been less profitable than investing in financial bonds from the European sector. In the deleveraging and credit "japonification", we expected financial credit to outperform. While the ECB has so far delayed deploying a QE buying spree in true Japanese fashion, no wonder investors have been more skeptical about the industry and its share prices as described by Bloomberg:
"European bank valuations show investors’ are skeptical about the industry.
Lenders in the Stoxx Europe 600 Index are trading near their lowest valuation in a year versus banks in developed economies worldwide, as the CHART OF THE DAY highlights. After reaching a seven-month high in January, the European group’s price-to-earnings ratio lost 5 percent to 47.55, compared with a 2 percent increase for lenders in the MSCI World Index.
While the European Central Bank introduced a negative deposit rate and announced targeted loans to stimulate lending last month, it held off on a securities-purchasing program. For European banks to rally, investors need to see the ECB buying assets, which it probably won’t do until after giving current policies more time, said Ian Richards of Exane BNP Paribas.
“It’s too early to be buying aggressively on the prospect of a euro-zone recovery,” Richards, the head of equity strategy in London, said by phone. “The prospect of supporting material credit growth and better earnings revisions in the banking sector is further down the line than the market had hoped.” U.S. regulatory probes and penalties that have slammed some European lenders are adding to concerns. Barclays Plc tumbled 14 percent in June, the most since May 2012, as New York’s attorney general said the bank lied to customers and masked how much high-frequency traders were buying and selling in its LX dark pool. BNP Paribas SA and Credit Suisse Group AG posted their worst quarterly performances in two years after being fined for U.S. sanctions violations and to help Americans evade taxes, respectively. “These one-offs in conduct issues keep on coming back and haunting the sector,” Richards said." - source Bloomberg

For us a bank is a second derivative of an economy. No growth, no stock performance.

When it comes to our contrarian take on US yields since early January 2014 we argued the following in our conversation "Supervaluationism" back in May this year:
"We recently pointed out the strength of the performance of US long bonds as well as the "Great Rotation" from Institutional Investors to Private Clients". As posited by Cam Hui on his blog "Humble Student of the Markets", the "great rotation" has indeed been triggered somewhat by defined benefit pension funds locking in their profits. One of the chief reason therefore behind this rotation has been coming from US Corporate pensions, as indicated by Gertrude Chavez-Dreyfuss and Richard Leong in Reuters in their article from the 24th of April entitled "US Corporate pensions bet on bonds even as prices seen falling":
"Major U.S. companies including Clorox and Kraft are favoring more bonds in the mix for their employees' defined benefit pension plans, even amid signs the three-decade bull run in bonds is on its last legs.
The $2.5 trillion U.S. corporate pension market enjoyed a robust recovery in 2013, paced by stocks, as the Standard & Poor's 500 Index rose the most since 1997. That helped pension funds close a funding hole that opened after the global credit crisis of 2008, so that the average corporate pension was funded at about 95 percent at the end of 2013, compared with 75 percent at the end of 2012, Mercer Investments data show.
Now that they're more confident that they have the money to meet their pension obligations, corporate pension managers are pulling back from the perceived risk of the stock market and buying U.S. government and corporate bonds, even though many expect bond prices to fall in coming years.
"Even if interest rates rise more than the market predicts, you do get the income component that offsets the price loss of those bonds," said Gary Veerman, managing director of U.S. Client Solutions Group at BlackRock in New York, which has $4.4 trillion under management, of which two-thirds are retirement-related assets. Veerman's group advises corporate treasurers how to manage their pensions.
The allocation to bonds by the top 100 publicly-listed U.S. companies in their defined benefit pension plans increased to a median of 39.6 percent in 2013 from 35.9 percent in 2010. Stock allocation in the plans fell to 40.9 percent in 2013 from 44.6 percent in 2010, according to global consulting firm Milliman." 
"Now they're in a position to say: 'I don't need all those equities because my funding status is in the mid- to low-90s,'" said Dan Tremblay, director of institutional fixed-income solutions at Fidelity unit Pyramis in Merrimack, New Hampshire, which manages more than $200 billion.

To further illustrate the "pension fund" effect and the increase in duration risk with the "great rotation" in 2014 from equities to bonds please find below the iBoxx U.S. Pension Index up 11% YTD which "validates" our previous take on the subject - graph source Bloomberg:
The chart tracks the iBoxx U.S. Pension Index, designed to mirror the performance of a typical plan with defined benefits.

What our "wealth effect" planners at the Fed should take into account is that rising stock prices may do relatively little to bolster the finances of corporate pension funds. Bonds matter because increases in projected distributions put even more pressure on yield hunting leading to an increase in duration risk exposure and high yield exposure. Volatility in funds’ asset value and relatively low interest rates have made managing pensions increasingly difficult for corporate managers, one of the solution they have found is shifting into bonds and away from stocks. Of course if the "magicians" at the Fed had respected the "Golden Mean" and prevented past and present excesses, funding gaps and overall pension pressures would have been avoided in the first place, but we are ranting again...

As a reminder from our conversation "Goodhart's law" in June 2013:
As indicated by CreditSights in their 29th of May 2013 Asset Allocation Trends - 2012 Pension Review:
"Key among the prevailing market realities in the post-financial crisis environment has been the extended period Quantitative Easing and the continuation of the Fed's prevailing zero interest rate policy and in the latest year's plan asset allocation data there was evidence of the effect this was having. As noted above, historically low interest rates have not only inflated the calculated liabilities of pension plans via the downward pressure on interest rates, they have also deflated assumed plan asset return rates as fixed income has increased as a percentage of plan assets." - source CreditSights.

So much for the great rotation, given, as indicated in the same report from CreditSights:
"One of the notable observations from our data analysis was that there was very little change in the allocation across the plans vs. the prior year. The median allocation to equity fell only marginally (from 50.8% to 50.0%) and the allocation to fixed income, rather than increasing, fell from 37.0% to 36.4%. This suggests that the trend towards Liability Driven Investment has slowed. While this, at least in part, likely reflects that the shifts made over the last seven years have better aligned many plans with their desired allocations, it also is undoubtedly influenced by the interest rate environment. Historically low interest rates across the full maturity spectrum make it an inopportune time to be increasing the allocation to fixed income assets (or to be increasing the duration of those assets in the portfolio!) " - source CreditSights.

Hence the reason of our Wicksellian stance relating to the distortion created by ZIRP, because of the increasing duration risk which has to be taken by players such as pension funds!

Moving on to the justification of the tapering of the Fed, we reminder ourselves of some of our previous observations:

First observation from our good credit friend in 2013 from our conversation "Simpson's paradox" as the Fed tries to re-establish somewhat the "Golden Mean":
"There have been a lot of talks recently about the FED decision to possibly reduce its liquidity injection at the end of the summer. Some market participants still think the FED will not taper as the economy is not yet on a very strong footing, and because the various thresholds announced by B. Bernanke (unemployment level, inflation,…) are still far from being reached. These arguments are undeniably right and strong, but one must consider other information prior to declare the “tapper” off.

First of all, B. Bernanke has explicitly announced that the FED will not look at economic data over the next few months, but rather at the trend which has developed.

Second, and more importantly, the FED currently owns about 33% of the outstanding US Federal debt. As funding needs of the US Treasury are diminishing following the sequester, there is less issuance and the FED ownership of bonds in percentage is rising quicker. Should the Central Bank continue buying the same amounts of bonds, it will own 40% of the outstanding in 2014, then north of 50% in 2015. The subsequent volatility on the interest rate market will increase drastically as the liquidity of the bond market disappears, and the currency could debase very quickly, creating a new crisis.

Third, and also a cause of concern, the bond market repo activity is facing an increasing number of failures (fails to deliver are on the rise exponentially) due to the large FED holding, which has ripple effect on the overall bond market activity. 

Fourth, and finally, economic growth in a society based on consumption requires credit. In order for credit to grow, or in other words banks to lend, collateral must be available. Since the 2007-2008 financial crisis, high quality collateral has slowly but surely become less available. If Central Banks continue to buy various government bonds (and US Treasuries are among those bonds), the available collateral will trend lower and the economy will stall, or worst spiral down as a credit crunch will occur at some point. So the FED has no other choice than to slow and even stop its QE if it wants the game to go on.

To resume, the FED may have more incentive to tapper and even stop its QE over time than to continue it, even if the economy slows down and some asset prices move lower. Apparently, it is the price to pay if one wants to avoid bigger problems in the future. The only remaining question is the following : “Is it the right time to do the tapper, or did the CB already crossed an invisible dangerous line?”  The way asset prices will behave and re-price in the coming weeks/months will give us the answer (nice retreat or collapse)."

One of the most important point validating our good credit friend's take on the tapering necessity and repo can be ascertained from Liza Capo McCormick article in Bloomberg on the 7th of July entitled "Bond Anxiety in $1.6 Trillion Repo Market as Failures Soar":
"In the relative calm that is the market for U.S. Treasuries, a sense of unease over a vital cog in the financial system’s plumbing is beginning to rise.
The Federal Reserve’s bond purchases combined with demand from banks to meet tightened regulatory requirements is making it harder for traders to easily borrow and lend certain desired securities in the $1.6 trillion-a-day market for repurchase agreements. That’s causing such trades to go uncompleted at some of the highest rates since the financial crisis.
Disruptions in so-called repos, which Wall Street’s biggest banks rely on for their day-to-day financing needs, are another unintended consequence of extraordinary central-bank policies that pulled the economy out of the worst financial crisis since the Great Depression. They also belie the stability projected by bond yields at about record lows.
“You have a little bit of a perfect storm here,” said Stanley Sun, a New York-based interest-rate strategist at Nomura Holdings Inc., one of the 22 primary dealers that bid at Treasury auctions, in a telephone interview June 30.
A smoothly functioning repo market is vital to the health of markets. The fall of Bear Stearns Cos., which was taken over by JPMorgan Chase & Co. in 2008 after an emergency bailout orchestrated by the Fed, and collapse of Lehman Brothers Holdings Inc., whose bankruptcy in September of that year plunged markets into a crisis, was hastened after they lost access to such financing." - source Bloomberg

Remember financial crisis are always triggered by liquidity crisis. From the same article:
"Liquidity Issues

“The effect of all the collateral issues we see now is an indication of not so much how things are, but how bad things will be when you really need liquidity,” said Jeffrey Snider, chief investment strategist at West Palm Beach, Florida-based Alhambra Investment Partners LLC, in a telephone interview June 30. “That’s when you get into potentially dire situations.”
The conditions for repo stress were on display last month. The 2.5 percent note due in May 2024 reached negative 3 percentage points in repo in the days preceding a June 11 Treasury auction of $21 billion in notes to finance government operations.

Dealer Constraints

Repo rates have been most prone to go negative, a situation known as specials in the market, in the days preceding an auction as traders who previously sold the debt seek to buy the securities to cover those positions.
In this week’s note and bond sales, the U.S. plans to auction $27 billion of three-year Treasuries tomorrow, $21 billion of 10-year debt on July 9 and $13 billion of 30-year securities July 10.
Signs of dysfunction are coming at a sensitive time for markets. The Fed is paring its stimulus and futures show traders expect the central bank may start raising interest rates in the middle of next year.
The concern is that dealers, which have pared inventories to meet more-stringent capital requirements required by the 2010 Dodd-Frank Act mandated by the Volcker Rule and Basel III, won’t have as much capacity to handle any surge in volumes or volatility.
Securities Industry and Financial Markets Association data show the average daily trading volume in Treasuries has fallen to $504 billion this year from $570 billion in 2007, even though the amount outstanding has risen to more than $12 trillion from $4.34 trillion.

Available Securities

Bank of America Merrill Lynch’s MOVE Index, a measure of expectations for swings in bond yields based on volatility in over-the-counter options on Treasuries maturing in two to 30 years, reached 52.7 percent on June 30, almost a record low.
The Fed is partly to blame. Through its policy of quantitative easing, it now owns about 20 percent of all Treasuries, or $2.39 trillion. Banks hold $547 billion of Treasury and agency-related debt.
In addition, the Fed’s holdings have shifted in ways that leave fewer central-bank-owned Treasuries available to be borrowed. The shifts were caused by Operation Twist during the November 2011 to December 2012 period when the Fed sold shorter-dated Treasuries and bought more bonds, plus self-imposed central-bank restrictions on holdings of specific maturities.

Stimulus Withdrawal

The Fed’s lack of certain holdings “appears to be driving the surge in fails, which has been concentrated in the on-the-run five- and 10-year notes,” Joe Abate, a money-market strategist in New York at primary dealer Barclays Plc, wrote in a note to clients on June 27. On-the-run refers to the most recently issued Treasuries of a specific maturity.
While the Fed has sought to cut risk in the repo market since the crisis, it still sees the chance that rapid sales of securities, known as fire sales, could disrupt the financial system. Fails reached a record $2.7 trillion in October 2008.
Repos are also important to the Fed because it has been testing a program in the market that is seen as a potential tool to withdraw some of its unprecedented monetary stimulus.
Eric Pajonk, a spokesman at the New York Fed, decline to comment on the Fed’s reaction to the movements in recent weeks in the repo market.
The amount of securities financed daily in the tri-party repo market has declined 18 percent an average $1.60 trillion May, from $1.96 trillion in December 2012, data compiled by the Fed show. In a tri-party agreement, one of two clearing banks functions as the agent for the transaction and holds the security as collateral. JPMorgan Chase & Co. and Bank of New York Mellon Corp. serve as the industry’s clearing banks.

 Supply Falls

Another difficulty in the repo market has been the decline in Treasury bill supply, with the U.S. having sold $264 billion fewer short-term bills in the April-through-June period than those that matured, according to John Canavan, a fixed-income strategist at Stone & McCarthy Research Associates in Princeton, New Jersey.
“The repo market itself provides lubricant to the entire Treasury market,” Canavan said in a July 3 telephone interview. “Bills are a key lubricant to the repo market, and the supply of bills has fallen sharply. If this situation were to continue longer-term, it would be a more substantial problem.”"  - source Bloomberg.

Second observation from our 2012 conversation "Zemblanity" (The inexorable discovery of what we don't want to know"): 

"In similar fashion to the current Japanese plight, the Fed will eventually discover soon that company debt sales will counter its bond buying plan"

As a reminder, back in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

So enjoy the final melt-up because if the Fed had indeed respected the "Golden Mean" there would not be greater risk of overshooting mean reversion on the way down. Of course timing is everything, but it looks to us we are indeed in the final innings of the great reflation trade.

On a final note in our previous conversation we voiced our concerns on the impact of the velocity of rising oil prices and their ability in triggering recessions, seeing US gasoline in at a 6 year high on Iraq, is,  requires close monitoring we think as it is a cause for concern - graph source Bloomberg:
"U.S. drivers will pay the most for gasoline over the July 4 holiday weekend in six years after the conflict in Iraq boosted crude oil last month, preventing the typical June decline in pump prices.
The CHART OF THE DAY shows how gasoline at $3.67 a gallon is the highest for this time of year since 2008. Retail prices rose 0.3 cent in June, compared with an average drop of 20.8 cents during the month in the past three years. While prices have slipped in the past five days, they probably won’t fall much more before the weekend as almost 35 million people hit the road, according to AAA.
“I’m not expecting any big changes,” Michael Green, a spokesman for Heathrow, Florida-based AAA, the biggest U.S. motoring organization, said by telephone from Washington. “We might see a drop of a few tenths of a cent.”
Regular gasoline in the U.S. costs 19.2 cents a gallon more than a year ago, dragged up by oil prices that jumped last month as fighting in Iraq threatened to cut off supplies from OPEC’s second-largest producer. International benchmark Brent crude rose $2.95 a barrel in June, and settled at $111.24 a barrel
on the 3rd of July.
The increase came just as the most people since 2007 made plans to travel over the July 4 holiday. About 34.8 million people will drive 50 miles or more from home during the five days ending July 6, up from 34.1 million last year, AAA estimates.
“Last year, prices peaked around March, and now they’ve peaked basically in June,” Sean Hill, petroleum economist for the Energy Information Administration, the Energy Department’s statistical arm, said by telephone from Washington. “This is all a function of what crude oil has done because of the Middle
East.”" - source Bloomberg

"The extreme limit of wisdom, that's what the public calls madness." - Jean Cocteau

Stay tuned!