Wednesday, 17 August 2016

Macro and Credit - The Cult of the Supreme Being

"The supreme quality for leadership is unquestionably integrity. Without it, no real success is possible, no matter whether it is on a section gang, a football field, in an army, or in an office." -  Dwight D. Eisenhower, American president

Looking at the continuation in the rally in risky assets and watching with interest our friend Michael Lebowitz getting blocked on Twitter by Narayana Kocherlakota, the former president of the Federal Reserve Bank of Minneapolis, we made the following sarcastic comment that if you are not a "cargo cult" follower you get blocked. While being a "cargo cult member" entails various ritualistic acts such as "wealth effect" via QE not manifesting itself in the appearance of material real economic recovery, we could have used this very reference for our title analogy but, given our previous reference to the French Revolution in our last conversation, it made us want to dig further into history when it comes to selecting an appropriate title. 

The Cult of the Supreme Being (French: Culte de l'Être suprême) was a form of deism established in France by Maximilien Robespierre during the French Revolution. It was intended to become the state religion of the new French Republic and a replacement for Catholicism and its rival, the Cult of Reason. It can be easily argued that the Cult of Reason, namely reasonable/rational central banking has indeed been replaced by the Cult of the Supreme Being, namely the "cult of the central banker". The Cult of Reason distilled a mixture of largely atheistic views into an anthropocentric philosophy. No gods at all were worshiped in the Cult—the guiding principle was devotion to the abstract conception of Reason which seems to have been totally ditched by our central bankers "deities" as of late. For Maximilien Robespierre, "The Cult of the Supreme Being" was said to have contributed to the Thermidorian Reaction and the ultimate downfall of Robespierre and his execution.

Furthermore, in our July conversation "Confusion" we made another reference to French economist Florin Aftalion 1987 seminal book entitled "The French Revolution - An Economic Interpretation" given the extension of Negative Interest Rate Policy now in German banks affecting retail deposits above the €100,000 threshold, the words of revolutionary figure Louis Antoine de Saint-Just, one of Robespierre's closest ally during the French revolution who ended up guillotined the very same day on the 28th of July 1794 are very interesting in relation to "monetary creation" and "assignats" we have discussed in our recent musings:
"There is no money-saving going on nowadays. We have no gold, and yet a state must have gold; otherwise it is basic commodities that are piled up or kept back, and the currency loses more and more value. This, and nothing else, lies behind the grain shortage. A labourer, having no wish whatsoever to put paper money in his nest-egg, is very reluctant to sell his grain. In any other trade, one must sell in order to live off one's profits. A labourer, however, does not have to buy anything, for his needs have nothing to do with trade. This class of persons was accustomed to hoarding every year, in kind, a part of the produce of the earth, and nowadays it prefers to keep its grain rather than to accumulate paper" - Louis Antoine de Saint-Just.

No offense to the Supreme Being Cult members out there, but, in our book, NIRP is insanity as there cannot be productivity and economic growth without accumulation of capital, because simply put, NIRP is killing capital (savings).

In this week's conversation we will look at the continuation of the rally thanks to inflows which validates our short-term "Keynesian" stance. We do remain though medium to long-term "Austrian" when it comes to assessing the credit cycle and the slowly but surely tightening noose of financial conditions as displayed evidently in the below chart from Bank of America Merrill Lynch CMBS weekly note from the 12th of August entitled "Bad news is once again good news; remain overweight":

"Through the rest of 2016, we expect several headwinds to CRE price growth will remain. For instance, underwriting standards look set to continue to tighten. Over 44% of respondents to the most recent Senior Loan Officers Survey, which was released last month, indicated they were tightening underwriting standards (Chart 24), although the OCC’s most recent semi-annual risk report says differently. Regardless, with the topic squarely on the regulators’ radar screens, we think it is only a matter of time before underwriting standards begin to tighten, particularly for smaller local and regional banks. " - source Bank of America Merrill Lynch.

Of course the evolution of US Senior Loan Officers Survey is worth tracking as it will clearly impact going forward the default rate and the US High Yield asset class. For now, everyone is "dancing", but, we think, it's worth "dancing" closer towards the exit we think, hence our recommendation in favoring "Style" over "Substance", namely US Investment Grade over US High Yield or playing simply the "beta" game.

  • Macro and Credit - The melt-up is "Breaking bad" thanks to "cult members" inflows
  • Macro and Credit  - While credit spreads are grinding tighter, quality is eroding faster
  • Final chart: US Investment Grade credit - Growing duration mismatch between cash and synthetic

  • Macro and Credit - The melt-up is "Breaking bad" thanks to "cult members" inflows
When looks at the continuing rally into risky assets and particularly "credit", one would indeed conclude that the cult of the Supreme Being is alive and well particularly in the light of some long dated corporate bonds trading in the region of $200 cash price. As indicated by the Financial Times in their article "Latest bond rally eye sore: one for the price of two", "Bondzilla" the NIRP monster is getting bigger every day thanks to the Supreme Being cult members:
"The Bank of England’s recent stimulus splurge, including a move to buy corporate paper, has driven the market prices for several sterling corporate bonds up to more than two times their initial face value, even for those unlikely to qualify for the central bank’s shopping list, writes Joel Lewin.
The price of US industrial conglomerate General Electric’s 2039 sterling bond, for example, has rocketed to a record high of 215.5 pence on the pound. That’s up from 165p at the start of the year and 100p when it was issued in 2009.
The yield has plunged from more than 10 per cent in 2009 to a low of 1.805 per cent.
Coupons aside, paying £215.50 today to be repaid £100 in 2039 amounts to a capital loss of 5 per cent every year for the next 23 years. Tasty.
“It’s another sign of how far central banks have pushed things,” says Luke Hickmore, a senior investment manager at Aberdeen Asset Management.
National Grid Gas’ 2044 bond has surged from 154p at the start of the year to 205p.
While those are the only two sterling corporate bonds* past the 200p mark at the moment, according to Bloomberg data, a number of others are on the brink." - source Financial Times

In conjunction to cult members being induced price wise by their Supreme Being, putting aside any reason or rational thinking, flow wise, the latest move by the Bank of England has also added fuel to the fire leading to some "overdrive" in spread tightening but inflows as well! This can be clearly seen in the United Kingdom credit markets as shown by Bank of America Merrill Lynch in their Follow the Flow note from the 12th of August entitled "Thank you Carney – Largest inflow ever":

"The state of play: IG > EM > HY >Equities
In a world dominated by central banks’ QE programs, BoE has been the latest to join – or re-join – the party. Last week’s inflows into sterling IG funds were the largest ever.
Since the ECB announced the CSPP, $30bn has flown into IG funds. And from February’s risk assets lows, equity funds have lost $82bn. During the same period, EM debt funds have been boosted by $28bn of inflows. 

High grade funds recorded their 22nd week of inflows. Despite getting into August, inflows to the asset class remained strong. High yield funds retraced back from negative territory with a marginal inflow. As shown in chart 13, inflows emanated mainly from global and European funds, while US-focused high yield funds recorded outflows.

Government bond funds recorded their second week of inflows. Money Market funds flows also remained positive for a second week.
Outflows from European equity funds continued for a 27th consecutive week. The intensity of the outflows – which peaked in mid-July – has been slowing down over the past four weeks.
EM global debt funds recorded a sixth week of inflows, but the summer season is taking its toll on the flow strength. Commodity funds recorded their 16th consecutive inflow, the 31st so far this year, and the highest in four weeks.
Looking at duration, all parts of the IG curve recorded strong inflows. Short-term funds recorded their third consecutive inflow, slightly lower than the previous week, but still high in AUM % terms. Mid-term IG funds had their seventh week of inflows, while longterm ones had a sixth positive week." - source Bank of America Merrill Lynch

We might be sounding like a broken record, at least for our "Cult of Reason" members, but, the "Supreme Beings" of various central banks are not only pushing investors outside their comfort zone into credit risk they should not be taking, they are also pushing them into increasing significantly duration risk rest assured. Some are indeed racing into the "beta" transformation game into "alpha", in a dwindling liquidity world, this will not end well, but, for the time being it's "rally monkey" time for the Cult of the Supreme Being Members.

While we are indeed tactically bullish for "religious" reasons, we do think that we are witnessing the final melt-up in risky assets given that many signs are starting to add up when it comes to gauging the state of the credit markets. 

When it comes to "Bondzilla" the NIRP monster now close up to $13.4 trillion, we expect the Japanese to come back into play in September thanks to additional "unconventional" measures from the Bank of Japan, and their "zealous devots". 
In a world turned upside down by rising "financial repression", Bondzilla's growth is evidently more and more "Made in Japan". This can be clearly seen in the below Nomura chart from their Flow Monitor note of the 8th of August entitled "Lifers’ foreign bond investment reached a record high":
"Japanese foreign portfolio investment accelerated in July. Excluding banks, Japanese investors bought JPY3287bn (USD32.2bn) of foreign securities in July, a much higher pace than in June. Life insurance companies’ foreign bond investment continued to accelerate, although we judge most was on an FX-hedged basis. Toshins also increased foreign investment in July. On the other hand, pension funds decreased their foreign investment. Although retail investors’ foreign investment is likely to stay weak for now, their risk appetite for foreign investment should improve thanks to the supplementary budget. Pension funds will probably remain dip-buyers, but their additional capacity to buy foreign securities also increased. 

Foreign portfolio investment stayed strong in July 

According to the International Transactions in Securities for July, released on 8 August by the MOF, Japanese investors bought a net JPY6,365.6bn (USD62.4bn) in foreign securities (equities and intermediate and long-term bonds). Since banks were major net buyers of foreign bonds at JPY2,685.7bn (USD26.3bn), this represents a sharp gain over the previous month (JPY2,453.0bn in net buying). If we eliminate the bank accounts that carry out FX-neutral short-term trades, net buying amounted to JPY3,286.5bn (USD32.2bn) in July. This is a major increase in net buying over the previous month (JPY2,311.7bn in net buying; Figure 1).

The breakdown by asset shows that Japanese investors were net buyers of JPY522.8bn (USD5.1bn) in foreign equity, flat over the JPY525.6bn in net buying the previous month. At the same time, they were net buyers of JPY2,763.7bn (USD27.0bn) of foreign bonds, up sharply over the previous month (JPY1,786.1bn in net buying).
Lifers bought foreign bonds at the highest pace
Life insurers bought a net JPY2,037.8bn (USD20.0bn) in foreign bonds, the highest net buying since these data began to be compiled (Figure 2).

This is also the eleventh straight month of net buying. With 20yr JGB yields near 0%, foreign bond investment has picked up sharply as lifers look for even slightly higher yields. Although JGB yields have risen to the 0.3% range again, we expect foreign bond investment to continue at a pace of more than JPY1trn per month if yields remain at current levels.
That said, we expect most of their foreign bond investment to be hedged. Although USD/JPY rose to the 107 range in mid-July in response to heightened expectations of BOJ easing, lifers took a cautious view of the July BOJ policy board meeting. They likely bought hedged foreign bonds and also increased currency hedges. Accordingly, despite a large amount of foreign government bond investment, upward pressure on USD/JPY should be minimal, in our view. Nevertheless, some lifers seem to be starting to buy unhedged foreign bonds at rates near JPY100.
With the US presidential election about to get under way in earnest, we see little chance of investments in unhedged foreign bonds picking up significantly. We expect lifers to continue investing primarily in hedged foreign bonds in the near term. " - source Nomura

While the ECB and now the Bank of England are in the corporate bond buying business making the "fun" going "uphill" thanks to the "wealth effect" and in no way flowing "downhill" to the "real economy" that is, the Japanese investor crowd is ratching up its bidding as the competition for financial assets rises.

A good illustration of the success of the Cult of the Supreme Being, when it comes to "capital destruction" can be seen in Japanese's net household savings rate thanks to "financial repression" as well as major demographic headwinds as illustrated in the below chart from Deutsche Bank's Japan Economics Weekly note from the 5th of August entitled "Inconsistency of policy to promote 'savings into investment'":

"Japanese households have been said to be persistently highly risk-averse, with a strong preference for financial assets with principal guarantees. This tendency has been structural, both in the bubble era and now. Financial flows from households since the end of the 1990s show continued inflows into principal-guaranteed financial assets, including cash, deposits, government debt, insurance, pensions and corporate bonds, with the exception of 2006-08. In the most recent years, fiduciary trusts have become popular, mainly for inheritance reasons, although inflows to these assets remain small.
The Japanese government plans to expand the eligibility for the personal defined contribution pension system (personal DC) to house wives, employees in the government sector, and those in the private sector whose employers are equipped with corporate pensions. The eligibility is said to expand by 26m people. The personal DC account has tax benefits of 1) fully deductible contributions from income, 2) no tax on investment returns and 3) taxdeductible benefits after retirement. These are much more generous than NISA (Nippon Individual Savings Account), which was introduced in January 2014, with active accounts of 2.9m. NISA’s sole tax advantage is #2 above. We believe that financial inflows from households into the expanded personal DC will likely be JPY3.1tr a year, twice the size of the inflows via NISA. However, a large part of these new inflows should go into principal-guaranteed assets.
We are curious about the effect of the introduction of these investment schemes with tax benefits on the household saving rate, which has been stuck near zero over the past ten years. Considering various strong headwinds against target savers, such as lack of income growth and inability to save, strong preference for principal-guaranteed assets, persistent low interest rates, QQE for more than three years and the introduction of negative rates in January, we believe that the households could view this expanded personal DC as a tailwind to mitigate those headwinds. This could lead to a continued rise in the household saving rate that began in 2015 well into 2017 and beyond, and might pose a downside risk in the near-term economic outlook
The proposition of ‘savings into investment’ contains misleading elements. Investing (in flow terms) in financial assets is nothing more than giving up current-period consumption out of disposable income for saving (in flow terms), regardless of its destination (say, bank deposits or equities). The proposition of mobilizing households’ financial assets (in stock terms) worth JPY1,700tr into investments does forget that these financial assets have already been deployed to the final borrowers, regardless of its channels (i.e., directly through capital markets or indirectly via financial intermediaries). There is no guarantee that the use of these funds by the current borrowers is inefficient and that by alternate borrowers is efficient." - source Deutsche Bank

We will not go back into the false "rethoric" from "The Cult of the Supreme Being" related to the "Savings glut" as we have already touched on this very subject in February in our conversation "The disappearance of MS München". Put it simply, no offense to the "zealous devots" of the "Supreme Beings" but in our book (and also in Claudi Borio's book from the Bank for International Settlements), "financing" doesn't equate "savings", at least in our cult, "The Cult of Reason" that is. If NIRP is killing "savings", there cannot be "proper" financing" to the "real economy" as stipulated earlier on in our conversation.

Furthermore, we keep hammering this, but, our "core" macro approach lies in distinguishing "stocks" from "flows". When it comes to dealing swiftly with "stocks" of Nonperforming loans (NPLs) such as in Italy via "flows" of liquidity, it looks to us that the "Supreme Beings" do not understand that "liquidity" doesn't equate solvency.

Moving one to our second point, while the rally is "technically" driven thanks to "financial repression" thanks to the mischiefs of the "religious cult", we continue to believe we are in the last inning of this credit cycle, making us continue to believe in quality and capital preservation rather than chasing yield for the sake of it.

  • Macro and Credit  - While credit spreads are grinding tighter, quality is eroding faster
As we pointed out at the beginning of our conversation, we will continue to monitor closely US Senior Loan Officers Surveys in the coming quarters as it has always been driving the default rate in the past. Of course "flows" are driving the relentless search for yield while "credit tourists" are punting for "beta" but, nevertheless, we do believe that no matter our "zealous" the members of the "Cult of the Supreme Beings" are, the credit cycle is slowly but surely turning. On that note we read with interest Wells Fargo Securities latest Credit Connections note from the 12th of August entitled "The Linchpin":
"Credit spreads remain in a sideways pattern with a bias to grind tighter. We expect this trend to persist as we work through the dog days of summer. With Q2 earnings largely complete, coming in modestly better than expected, and most central banks on holiday, the market has little to focus on other than the regular flow of economic data and the technical underpinnings of demand and supply. On balance, the technical backdrop remains the dominant thread and remains supportive of a firm market tone as inflows to credit more than outpace bond issuance. Conversely, credit quality continues to slowly, but persistently erode as companies borrow money at a much faster pace than they earn it. To be fair, the steady drop in the cost of borrowing has helped alleviate some of the pressure. But with most of the proceeds going toward share buy backs and dividends, the funding gap within the corporate sector continues to expand and leverage is on the rise. Finally, corporate credit valuations look stretched by most traditional measures. Indeed, according to our proprietary fair value model, the current high yield (HY) yield-to-worst (YTW) of approximately 6.37% is about two standard deviations rich. However, when you consider that HY YTW is approximately 600% above the risk free rate, it is easy to understand why the "reach-for-yield" trade continues in an otherwise expensive market. As such, we continue to advocate a Neutral/Market Weight allocation to IG and HY credit to capture current yield, and emphasize sectors that offer "defensive carry." These include IG and HY Communications, IG Utilities, IG Consumer Staples and HY Consumer Discretionary.

Corporate bond prices have been on a steady march higher this year as interest rates have plunged, yield curves have flattened and credit spreads have narrowed following the ramp-up and expansion of quantitative easing (QE) outside the U.S. Although the U.S. Fed has not participated directly in these types of programs, its lack of action and continued dovish stance has effectively endorsed a dramatic loosening of credit conditions around the world (Exhibit 1). As such, the linchpin holding the bullish trade in corporate bonds together is on-going dovish central bank policy. To the extent it continues, credit investors should expect “more of the same,” namely, higher prices, lower yields, flatter curves and tighter credit spreads.
However, should central banks start to dial back, or simply slow, their stimulative policies, then bond prices and credit spreads could be in for a sharp reversal. To be clear, we expect "more of the same," albeit at a slower pace, as sluggish growth and tame inflation should keep dovish policies in place for the time being.

- source Wells Fargo Securities

There could no better illustration of all the "fun" playing "uphill" in the bond market that is, than the above chart. You can indeed put aside the "Great Rotation" marketing ploy by some pundits given, as we stated before, the only "riskless" game for now, worth playing thanks to the "Supreme Beings" is the bond market.

While "The Cult of the Supreme Being" is still thriving, credit investors should be well advised to read the wise words of one of the members of the "Cult of Reason, namely Nassim Taleb from his recently published note entitled "The Most Intolerant Wins: The Dictatorship of the Small Minority":
"The market is like a large movie theatre with a small door. 
And the best way to detect a sucker (say the usual finance journalist) is to see if his focus is on the size of the door or on that of the theater. Stampedes happen in cinemas, say when someone shouts “fire”, because those who want to be out do not want to stay in, exactly the same unconditionality we saw with Kosher observance." - Nassim Taleb

Whereas credit risk is increasing, giving the lower for longer mantra thanks to the macro fundamentals backdrop playing out and financial repression, not only as we have highlighted credit investors have been extending credit risk, they also have extended their duration risk, increasing in effect the duration mismatch between US cash investment grade and its synthetic credit hedge tool the CDX IG series 26 5 credit index as per our final point and final chart below.

  • Final chart: US Investment Grade credit - Growing duration mismatch between cash and synthetic
While we have been recommending since the beginning of the year to favor quality over quantity (High Yield and size of the coupon that is...) through US Investment Grade credit and extended duration us, being in the camp of "lower for longer", credit investors have had no choice bit to take on both more credit risk as well as duration risk thanks to "The Cult of the Supreme Being". Our final chart comes as well from Wells Fargo Securities latest Credit Connections note from the 12th of August entitled "The Linchpin" and illustrate the growing duration mismatch between "cash" and "synthetic":
"While IG26 is a reasonable, liquid hedge for IG cash bonds, it does have some limitations. 
First, there is a meaningful duration differential. IG26 has a current duration of about 4.7 years, compared to the cash bond index of 7.5. Not only is there a difference in aggregate duration, there is a meaningful difference is where that duration comes from. Increasingly, the spread duration in the cash index is being driven by the long end of the curve, where durations continue to extend due to lower coupons.

Implications for Investors 

First, to fully hedge out a market-based cash portfolio with 7.5 years of duration, would require an extra 60% of protection to result in a CR01 neutral portfolio. The extra hedging costs would still leave the trade positive carry as even an additional 60% would only cost 114 bps based on today’s current index levels. For IG investors hedging CR01 is, in many ways, just as valuable as hedging the default risk, as the risk of spread widening is more clear and present for IG companies than actual defaults.
A second consideration is the contribution to duration within the IG market. With the long end being so key to IG investors, movements in the shape of the credit curve are also important. As a result, CDX, while a reasonable proxy for the overall IG market, can be less effective in periods of significant under- or outperformance from the long end of the market. For example, the overall market widened 32 bps in 2015, as front-end spreads widened 19 while long-end spreads widened a full 43 bps. By contrast, IG CDX widened only 22 bps." - Wells Fargo Securities

This means that as hedging tool, one would need to compensate for the extended duration rise in the cash market and needs to buy more "protection" to hedge a cash investment grade credit portfolio if ones wants to be "duration neutral" that is.

Finally for our parting quote, when it comes to "The Cult of the Supreme Being" we would like to end up our conversation with yet another extract from Florin Aftalion's 1987 seminal book entitled "The French Revolution - An Economic Interpretation", over the issues and discussions surrounding the "assignats" and what the abbé Maury, a deputy on the Right had to say about them at the French National Assembly during the French Revolution:
"What is one doing when ones creates a paper currency? One is stealing at sword point. Every man in France who owes nothing, and to whom everything is owed, is a man ruined by the paper currency. Have we the right to bring about the ruin of even a single one of our fellow citizens?" - Abbé Maury, extract from "The French Revolution - An Economic Interpretation" by Florin Aftalion, 1987

Stay tuned!

Friday, 5 August 2016

Macro and Credit - Thermidor

"The seed of revolution is repression." - Woodrow Wilson, American president

Watching with interest the disappointment unfold thanks to Bank of Japan's holding pattern, pushing us to quickly take our loss and cut our small short yen exposure, while looking at the news that France was about to harvest the least wheat in 28 Years, it reminded us for our title analogy, the French Republican Calendar implemented during the French revolution and used by the French government for about 12 years from late 1793 until 1805, with Thermidor (or Fervidor) starting the 19th or 20th of July and coming from the Greek "thermon" meaning "summer heat". On many printed calendars of Year II (1793–94), the month of Thermidor was named Fervidor (from Latin fervens, "hot"). Looking at the performance of European banks stocks since the beginning of the year and following the publication of the "stress tests", we do think indeed that our title is indicative of a build up in "summer heat", at the same time it is as well indicative of the significant performance in credit which was yet given another boost thanks to the latest Bank of England raft of decisions. 

What is of interest in the Republican calendar was the tentative in the alteration of time measurement we think:
"Each day in the Republican Calendar was divided into ten hours, each hour into 100 decimal minutes, and each decimal minute into 100 decimal seconds. Thus an hour was 144 conventional minutes (more than twice as long as a conventional hour), a minute was 86.4 conventional seconds (44% longer than a conventional minute), and a second was 0.864 conventional seconds (13.6% shorter than a conventional second).
Clocks were manufactured to display this decimal time, but it did not catch on. Mandatory use of decimal time was officially suspended 7 April 1795, although some cities continued to use decimal time as late as 1801." - source Wikipedia
This was part of a larger attempt at decimalisation in France (which also included decimal time of day, decimalisation of currency, and metrication). When we look at the effects of Negative Interest Rate Policy aka NIRP, we can only think about the attempt of central bankers towards "decimation" of European bank stocks, decimation meaning to destroy a great number or proportion of. On a side note France introduced "decimilisation" of the franc in 1795 to replace the "livre tournois", abolished during the French Revolution whereas the United States introduced decimal denomination from the outset of home minted currency in 1792 with the dollar being equal to 100 cents.

Of course our use of a French revolutionary calendar term is as well a reference to our previous conversation from September 2012 "Pareto Efficiency" where we indicated the following when it comes to "wheat prices" and "revolutions":
"Historically the highest prices touched by wheat prior to the French Revolution were in 1789. Between 1780 and 1788, the average price for  a "setier" of wheat (setier was an old French units of capacity equating to 156 liters), was stable between 19 pounds and 13 shillings and 25 pounds and 2 shillings. Between 1786 and 1787 the price was stable at 22 pounds a setier. In 1788 it rose by 15% but in 1789 it rose by 36% in one year, touching 34 pounds and 2 shillings. The harvest for 1788 was one third lower and this impact was sufficient enough to trigger the doubling of prices in the period 1788-1789. Just before "Bastille Day" on the 14th of July, there was a tremendous storm on the 13th of July 1789 which caused massive destructions to crops.
Wheat prices in "pounds per setier" units on the 24 of June every year from 1728 until 1789, source - "Le prix du blé à Pontoise en 1789" by Dr Florin Aftalion.
The proper French revolutionary period (1789-1794) was characterized by poor harvests and very similar meteorological factors witnessed in 1788 and 1789, namely very hot spring-summer periods with very bad weather followed by very cold winters (-21 degrees Celsius in Paris during the winter of 1788), of course any similarities with this year's meteorological events are purely fortuitous given we are rambling again...Are we?" - source Macronomics, September 2012
Now, going towards 2017 with first the Italian referendum in October, then with some important elections taking place next year in both France and Germany, we are wondering if indeed "Thermidor" will not lead to yet another summer of discontent in 2017 given the the significant rise of populism tied to the "War on Inequality" mentioned recently by Michael Hartnett's team in the latest Bank of America Merrill Lynch Thundering Word note from the 29th of July entitled "Fiscal Flip...Get Real":
"Long View
The policy baton is passing from Monetary to Fiscal stimulus in 2016/17. Central bank
rate cuts ending. New policies to address populist desire for "War on Inequality"
emerging. Policy response will be combination of:
1. Redistribution…stagflationary: winners…TIPS, munis, low-end consumption (retail,
payments, tax services); losers…brokers, luxury, growth stocks; yield curve bear
2. Protectionism…deflationary: winners…government bonds, gold, volatility, high
quality defensive stocks; losers…banks, multinational companies; yield curve bull
3. Keynesianism…reflationary (with “helicopter money): winners TIPS, commodities,
banks, value; losers…bond substitutes; yield curve bear steepens.
Fiscal flip reflects policy intent to reduce deflation, wealth inequality and wage
insecurity. Success means rotation from “deflation” to “inflation” assets; note real
assets (commodities, collectables & real estate) now at all-time lows relative to financial
assets (stocks & bonds) – Chart 1.
- source Bank of America Merrill Lynch
Could this rotation from "deflation" to "inflation" trigger indeed a surge in commodities? We wonder...

The only issue is once the "Inflation Genie" is "Out of the Bottle" as warned by Fed's Bullard in 2012, it is hard to get it back under control:
“There’s some risk that you lock in this policy for too long a period,” he stated.  ”Once inflation gets out of control, it takes a long, long time to fix it”
As we have repeatedly pointed out, the money is flowing "uphill" where all the "fun" is namely the bond market, not "downhill" to the "real economy" as shown by the latest yet unsurprisingly dismal US GDP print. This of course leading to a "pre-revolutionary" mindset setting in, leading to the rise of "populism" and the deafening sound of "helicopter money" and fiscal profligacy as the "elites" and their central bankers are starting in earnest to "panic" somewhat. We will touch more on this in our conversation.

In this week's conversation we would like to reiterate, like many others our concern relating to the continuation of tightening financial conditions as per the US Senior Loan Officia Survey relative to the rally seen so far in US High Yield thanks to massive inflows from the retail crowd. While we remain tactically short term bullish, or "Keynesian", we do feel fundamentally "medium term" bearish" or "Austrian" given current "credit valuations" do not reflect the deterioration in economic fundamentals. On that note we were not surprised at all by the latest US GDP print, given in January 2016 in our conversation the "Ninth Wave" we indicated:
"Whereas we disagree with Bank of America Merrill Lynch is with their US economy views, we believe that the US economy is weaker than what meet the eyes and that their economists suffer from "optimism bias" we think (more on this in our third bullet point), but nonetheless high quality domestic issuers are definitely credit wise a more "defensive" play.
We think that for "credibility" reasons, the Fed had no choice but to hike in December given the amount spent in its "Forward Guidance" strategy and in doing so has painted itself in a corner. We ended up 2015 stating that 2016 would provide ample opportunities in "risk-reversal" trades. The latest move by the Bank of Japan delivered yet another "sucker punch" to the long JPY crowd. Obviously, should "risk" decide to reverse course in 2016, there will be no doubt potential for significant rallies in "underloved" asset classes such as Emerging Market equities. But, for the time being, the macro picture is telling us, we think that regardless of how some pundits would like to spin it, not only is the credit cycle past "overtime" and getting weaker (hence our earlier recommendations in our conversation) but, don't forget that there is no shame in being long "cash". It is a valid strategy." - source Macronomics, January 2016
When it comes to our positioning relative to the US recessionary crowd, we believe that a flattening of the US yield curve is never a good sign, particularly for the financial sector which has been vaunted by some as a "compelling" buy.

Why is so?

Underperformance by the banking sector always is a bad sign for markets and the economy; it suggests that the credit mechanism is clogged, with knock-on effects for the rest of the economy, that simple.

  • Macro and Credit - Is it High Noon for US High Yield tourists?
  • Macro and Credit  - Investing Greed leaning towards Investment Grade
  • Final chart: Bank stocks under pressure? Blame central banks

  • Macro and Credit - Is it High Noon for US High Yield tourists?
For tracking credit availability, you need to use the central banks’ credit surveys. The most predictive variable for default rates remains credit availability. 

For the US you need to follow the Senior Loan Officer Survey of 60 large domestic US banks and 24 US branches and agencies of foreign banks. This is updated quarterly such that results are available in time for FOMC meetings. Questions cover changes in the standards and terms of the banks' lending and the state of business and household demand for loans.

As we pointed out in our November conversation "Ship of Fools", credit investors are often too complacent when it comes to assessing the stage of the credit cycle and when it comes from the retail crowd aka the US High Yield tourists, they have been pouring "inflows" at a very late stage of the "game":
"Furthermore, despite their alleged high degree of sophistication, credit investors have a very weak predictive power on future default rates. This was largely discussed by our Rcube friends in their long March 2013 guest post entitled "Long-Term Corporate Credit Returns":
Spreads moves between June 2007 and October 2008 (from 250bp to 2000bp in just 16 months) were a great illustration of this manic-depressive behaviour (which can also be related to Minsky’s model of the credit cycle)." - source Rcube
From a medium term perspective and assessing the "credit cycle" we believe the latest US Senior Loan Officer Survey points to yet another "warning" sign in the deterioration of the on-going credit cycle which has been so far pushed into "overtime" by central banks with ZIRP and their various iterations of QEs.
"When default rates are low, credit investors believe that stability is the norm, and start piling up on leverage, inventing new instruments to do so (CLOs, CDOs, CPDOs etc.). This recklessness leads to mal-investment, and sows the seeds of the next credit crisis." - Macronomics, November 2015
Lather, rinse, repeat. 

While it isn't yet "high noon" per se for the US High Yield tourists, the latest publication of the US Senior Loan Officer Survey confirms clearly a deteriorating trend in financial conditions which is indeed down the line (most likely in 2017) a recipe for a serious "repricing" of the asset class as a whole. To re-iterate our November call, we remain short-term "Keynesian" bullish / long term "Austrian" bearish when it comes to assessing the current stage of this credit cycle. This should provide sufficient proof for us not being labelled "perma-bears" or having a "pessimism bias" but, rather a "realistic bias" we think.

When it comes to assessing global credit conditions, we share our concerns with UBS and read with interest their latest Global Credit Strategy note from the 2nd of August entitled "Q2 Lending Conditions: Why did lenders tighten?":
"Q2 Lending Conditions: Why did lenders tighten?
A critical linchpin in our frameworks for assessing credit spreads, defaults and the read-through to macro implications is the state of lending conditions. And, to cut to the chase, recent releases could aptly characterize current conditions as increasingly uncomfortable, albeit not alarming. The improvement in our non-bank liquidity indicator since March has stalled, with the latest reading rising from 7 to 9.1 – principally due to less robust issuance of lower-quality high yield debt since April. In our view, this gauge is superior to the Fed's SLOS survey tracking bank liquidity conditions given nearly 80% of corporate funding is done via non-banks. That said, our non-bank indicators have now largely converged with the Fed's bank liquidity gauge, with net tightening of credit standards on C&I loans to SMEs increasing from 5.8 to 7.1 in the latest survey (Figure 1).

Notably, we do not believe the latest SLOS survey results were significantly affected by the UK's Leave vote (as banks received the survey on June 28, and responses were due by July 12). For C&I lending conditions, the rationales given from bank loan officers for shifts in lending standards continued to be dominated by net tightening attributed to a weaker economic outlook and industry problems versus net easing due to competition; however, in terms of shifts there were fewer officers reporting industry specific problems (e.g., energy, but prior to the latest decline in oil prices) as a reason for tightening, more respondents citing lower risk tolerance and higher regulatory concerns as rationale for tightening, and more noting increased competition as a driver of easing (Figure 2).

And lower risk tolerance and greater regulatory pressures would be consistent with sentiment from the latest Shared National Credits (SNC) review, which continues to highlight concerns related to an elevated level of special mention and classified (i.e., higher risk) loans which may increase defaults this cycle and the prevalence of incremental facilities allowing greater sharing of priority claims which may lower recovery rates1 . In terms of our key forecasts, our HY spread forecast increases from 660bp to 666bp (vs 566bp current), our HY default forecast is unchanged at 5 – 5.5% by mid-2017, and our credit-based probability of recession rises to 33% from 31% (over the next 12mos).
Why the discomfort? First, the persistent albeit moderate tightening trend in C&I liquidity conditions bears watching as the relationship is not linear; i.e., further increases in net tightening from current readings will disproportionately increase spreads, defaults and recession risks in our models, respectively, when compared with commensurate decreases in net tightening (e.g., see recession gauge sensitivities on net tightening – Figure 4). 
Second, our prior concerns related to significant easing of lending standards and rising credit risks in other sectors seem to be trending in the wrong direction2. In particular, lending standards for commercial real estate (CRE) loans contracted further, with aggregate (debt-weighted) net tightening of 27% from 20% the prior quarter (CLD to 31% from 25%, nonfarm nonresi to 18% from 12%, and multifamily to 44% from 36%). While not cited, we believe the tightening reflects increased regulatory scrutiny (e.g., 2006 CRE guidance, risk retention requirements) as well as concerns around lax lending standards and lofty valuations. 
At current levels, the significant tightening observed in CRE standards, which is historically reasonably well correlated with C&I standards (as we have detailed previously), is near historical extremes (as per Figure 4).
Aside from commercial lending, the mosaic from consumer and residential sectors has been more benign in prior surveys. However, there were some signs of less easing in consumer loans – with net tightening in auto loan standards moving from -6.3 to 0 (while in credit cards net tightening was -5.6 vs -5.7 the prior quarter). Banks reported higher spreads on auto loans, and higher spreads and lower credit scores for credit card loans. For residential loans, the SLOS survey overall signaled marginally less easing – i.e., the second derivative is negative. However, like C&I loans, residential lending is primarily driven by non-bank lending (Figure 5).
In turn, the Fed's SLOS survey results should be taken with a grain of salt. One alternative, which encompasses non-bank lending, is the AEI's change in its National Mortgage Risk Indices (NMRI) 3 . This metric, updated monthly and based on actual loan origination risk metrics, suggests that while banks are reducing risk in residential originations (for FHA/VA/RHS primarily), non-banks are increasing risk in a bigger way – causing a net easing of credit conditions in resi. This point illustrates that non-bank lending standards are increasingly (if not more) important than bank lending conditions in some asset classes and, in particular, in instances when the signals can diverge. And, in this instance, continued easing in residential mortgage credit conditions is one development which is helping offset the more persistent, marginal to moderate tightening in lending standards across other asset classes. In short, for now the prognosis is increasing discomfort, but not alarm." - source UBS
Whereas the SLOS survey doesn't yet point out to "High Noon" for our US High Yield tourist friends from the retail space, we do think that the evolution of tightening financial conditions is a harbinger for things to come in 2017, namely spread widening and a rise in defaults. We do agree with UBS and share their increasing discomfort. 

As well, on the deterioration of the credit cycle, we read with interest Oaktree's insights in their special edition "Navigating cycles":
"Bruce Karsh: How does this credit cycle resemble and differ from past credit cycles?  
Rajath Shourie, Co-Portfolio Manager, Distressed Opportunities: The down-leg of the current cycle feels most like the down-leg we experienced in the early 2000s, when too much capital came into a popular industry; that industry blew up; and the dislocation spread to other industries. In the early 2000s, telecom was the darling industry that went bust. Today it is energy. In the early 2000s, a majority of the high yield bonds issued by telecom companies defaulted, and unless oil prices make a major recovery, today’s exploration and production companies are likely to face a similar fate.
Jordon Kruse, Co-Portfolio Manager, Global Principal: I’ll focus on a comparison of the current downleg to the one we experienced in 2008-09. They are similar in that both followed long periods of significant debt issuance, but different in that there is far less systemic risk today than there was in 2008-09. A major driver of that risk was the substantial amount of bad mortgage securities held by large financial institutions that played a major role in the financial system at large.
Bruce Karsh: What is your expectation for defaults this year?  
Sheldon Stone: The 2016 default rate for U.S. high yield bonds is projected to increase to between 5 and 6%. This compares to the 2015 default rate for U.S. high yield bonds of 2.8% and the 30-year average of 4%. While this 2016 estimate is higher than what we’ve seen since 2009, it is not meaningfully higher than normal observations. As you would likely guess, defaults this year already have been—and will be—heavily impacted by oil prices. I believe that easily two-thirds, or maybe even three-quarters, of the defaults this year will stem from energy-related issuers. 
Bruce Karsh: Outside of China, what factors do you think are exerting the greatest impact on the current market environment?  
Sheldon Stone: The obvious ones are low energy and commodity prices; however, those are linked to China. The other one worth highlighting is liquidity. Current trading markets are significantly less liquid, causing rapid changes from a buyer’s market to a seller’s without large trading volumes. We estimate that today, banks are carrying about 20% of their 2007 peak inventory of senior loans and high yield bonds.  As a result, banks are now looking for trades to cross, rather than putting their capital at risk.  It doesn’t take much selling these days to move bond prices a fair amount. 
Rajath Shourie: I completely agree with Sheldon. Prices have recently been declining dramatically because there’s a buyers’ strike at play, not because there is a lot of supply from forced sellers." - source Oaktree insights, July 2016
When it comes to "liquidity, to that effect we would like to repeat the quote used in the conversation "The Unbearable Lightness of Credit":
Today investors face the same "optimism bias" namely that they overstate their ability to exit.
“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
Excess stimulants have compressed yield spreads too fast leading to "unhealthy" rapid bond prices gain such as the gains seen in single A credit in the United Kingdom following's the Bank of England early "Christmas present" for the speculating crowd. Yes indeed, the fun is "uphill", in the bond market.

When it comes to "Thermidor" or "investment heat", when it comes to "investment grade" credit, the summer heat is truly "on". This leads us to our second point below.

  • Macro and Credit  - Investing Greed leaning towards Investment Grade
While we have been predicating for the right reasons to stick with quality Investment Grade credit since the beginning of the year (particularly as per our last post on Senior Unsecured bank credit rather than equities...), even recommending a long duration exposure to the asset class, the ECB playing the "corporate credit game" now being followed as of late by the Bank of England points towards even more "fun" running uphill to this particular segment, or, to put it bluntly, "Investment Greed" is leading to "Investment Grade". When it comes to "flows", the "summer heat" is indeed "on" during our "Thermidor" period rest assured as pointed out by Bank of America Merrill Lynch in their latest Follow The Flow note from the 5th of August entitled "Largest inflow into IG funds ever":
"Large outflows from equities; large inflows into IG 
Inflows into high-grade have accelerated. Over the past four weeks inflows have been almost doubling on a w-o-w basis. However, while inflows into credit have been strong, equity funds have been suffering continuous outflows over the past 26 weeks. Should the recent trend continue, the inflows that came into the asset class since 2015 would be erased in the next 10 weeks or so (Chart 1).  
High grade funds recorded their 21st week of inflows and the highest ever since the start of our data set (table 1).

Flows into the asset class have doubled w-o-w, and propelled the year to date cumulative inflow to over $13bn. High yield funds however reported a substantial outflow, the first in five weeks. The outflows were a mix of global, US and European-focused funds. More in chart 13. 

Government bond funds flows switched to positive after two weeks of outflows. Money Market funds flows also turned positive after three weeks of outflows. 
Flows into equity funds remained in negative territory for the 26th consecutive week. Almost $80bn has left the asset class over that period." - source Bank of America Merrill Lynch
So much for the much lauded "Great Rotation" story from "equities" towards "bonds". When it comes to having some "fun" uphill, Fixed Income is still "the place to be" and when it comes to "greed", Investment Grade credit rules the game for now thanks to central banks joining as well the "party".

While equities are making news highs while flows are making new lows, we think that we haven't seen yet the lows of the current credit rally in investment Grade à la 2006. On this particular point we agree with JP Morgan's take in their Credit Market Outlook and Strategy from the 28th of July when it comes to US Investment Grade:
"Credit has not reached a low in spreads while equity indices are at all-time highs 
One of the interesting cross market dynamics recently is that equity markets are reaching new highs while HG bond spreads have been range bound well off of their tightest levels. This month the Dow and S&P reached new peaks and the Nasdaq came close. The JULI spread is at 171bp, 83bp above the pre-crisis low of 89bp (29th July, 2005) and 49bp above post crisis low of 122bp (24th June, 2014). There are several logical explanations for this divergence in performance, but we still believe the trend is for tighter spreads.

The most important explanation is that HG bond yields rather than spreads are the key valuation metric for many now (particularly overseas investors), and they are almost at a record low. The JULI yield is 96bp lower YTD and at 3.32% as of Wednesday it’s just 6bp off its record low of 3.26% reached on July 8th of this year.
The second explanation is the much higher weighting of banks in credit (24.4%) vs in the S&P (5.2%). The banks index of the S&P is not at its post crisis peak – it is 16.4% below the peak reached on 22nd July, 2015.
JULI Financials are at 172bp, 96bp above where they were when JULI spreads were at a pre-crisis low and 54bp above the JULI post-crisis low point. Banks have lagged in both equity and credit markets, but it matters more in credit markets. The third explanation is that 30.5% of the JULI comes from issuers outside the US. Of this 29% is EM and 71% is DM. This subset of the JULI is at a spread of 183bp, which is 93bp and 38bp above where it was vs the pre and post crisis low spread points for the index. Excluding EM these figures are 81bp above and 54bp above for Yankee
issuers." - source JP Morgan.
Whereas we think equities have much more less room to rise in the US, we do think we are going to see additional melt-up in and records been broken in the US. When it comes to "valuation" and "rotation", we do think that in this "japanification" and "Thermidor" period, the trend is indeed, your friend and there is more "fun" to come given "greed" is still running high in the context of "financial repression". 
While we keep noticing the deterioration in "financial conditions" as pointed out by the US Senior Loan Officers Surveys (SLOS), we still recommend a "rotation" towards "quality". This recommendation was made again in our previous conversation when it comes to bank exposure and "senior unsecured credit" was less volatile than merely chasing "beta".

When it comes to "greed" and "Investment Grade" credit, we continue to favor US Investment Grade credit and we do think that having the ECB, the Bank of England and the Bank of Japan, competing with their local investment base when it comes to chasing assets, we do think that once more US credit will strongly benefit from investors in September after the summer lull or "Thermidor" period. 

We therefore agree with Bank of America Merrill Lynch's take from their Credit Market Strategist note from the 29th of July entitled "Kuroda and Draghi and Yellen":
On balance we view recent developments in global monetary policies from the major central banks as positive for the US HG corporate bond market. At this week’s FOMC meeting the Fed was not as hawkish as investors had feared – specifically they did not prepare investors for a September rate hike. Recall that last year - prior to starting the rate hiking cycle at their December meeting - the Fed had warned the market of that possibility explicitly in the statement from their previous (October) meeting.
In Europe, as our European credit strategist, Barnaby Martin, highlights (see: Resistance is futile), the ECB appears on a mission to deflate credit spreads in the European corporate bond market. This has to drive even more European investors into the US corporate bond market – probably when they come back from vacations in September (Figure 3). 
Furthermore, unlike the BOJ the ECB has plenty of ammunition left that – if deployed – would help drive US credit spreads tighter. This includes changes to its capital key (Figure 4) that would direct QE purchases away from bunds toward assets that have more credit risk (see: Brexit pushing Draghi out the curve?).
So we continue to expect accelerating foreign purchases of US corporate bonds during the last part of the year driven by Europe, while Asian buying remains steady – which means strong.
(Reverse) Yankees are coming 
In additional to accelerating European demand for US corporate bonds starting in September, we should we expect accelerating reverse Yankee issuance (i.e. US companies coming abroad in non USD currencies). Given what the ECB is doing this is certainly the case for the EUR market (Figure 5), but with global yield starvation we expect increasing reverse Yankee issuance in other currencies too (Figure 6). 

That should further support USD credit spreads just like we saw for the banking sector this month post-earnings." - source Bank of America Merrill Lynch
If indeed "greed" is "good" then obviously there is more room when it comes to spread tightening in US Investment Grade thanks to somewhat to some "crowding out" due to to central bankers competing with investors in this "unhealthy" yield chasing game. We can as well anticipate a significant return of the Japanese investor crowd to foreign bond markets while the Bank of Japan, while on hold, is preparing for some more "unconventional" bazooka in September when we will eventually revisit our short yen exposure.

When it comes to "crowding out" and the ECB, we read with interest Bank of America Merrill Lynch's European credit strategist Barnaby Martin note "Resistance is futile" from the 28th of July highlighting how central banks are pushing outside of their comfort zone "yield hogs" towards more credit risk and/or higher duration exposure:

"Honesty doesn’t pay 
Spreads took another leg tighter last Monday as CSPP ISINs were disclosed. We sense “doubters” threw in the towel. But we think disclosure rubs both ways. While the aim is to facilitate securities lending – and aid credit market liquidity – we fear the sheer size of CSPP buying has heightened investors’ nervousness over credit market liquidity.
As chart 1 shows, investors are already starting to have concerns over the growth of negative yielding corporate debt across the globe. Note the weakness in European corporate bond spreads over the last 2 days despite equities being up…

How has credit market liquidity fared through CSPP life?  
Chart 2 shows the average bid-offer spread (in bp) for investment-grade corporate bonds. We split the universe up into  CSPP eligible non-eligible (non-banks) and  CSPP purchased bonds. 

We think that the picture shows some encouraging but also some concerning developments: 
• What’s clear is that the announcement of CSPP on March 10th initially caused mass confusion in the market. Bid-offers surged and liquidity deteriorated meaningfully in non-financial bonds. Yet, bid-offers remained steady in parts of the market that were expected to be untouched by Draghi (note the calm in  non-eligible bid-offers).
• From March 10th until CSPP buying began (June 8th), credit market liquidity improved noticeably. Bid-offers tightened for all parts of the market as CSPP was deemed to be the policy that would rejuvenate the corporate bond market.
• But since June 8th, bid-offers have widened and liquidity has deteriorated again. True, Brexit took place on June 23rd, but nonetheless there has been a drift higher in bid-offers since Draghi started buying credit. And if anything, liquidity seems to have deteriorated further for  eligible and  purchased names, post the ISIN publication last week.
So while the aim of CSPP disclosure was to preserve credit market liquidity, the initial signs seem to point to something more worrying: that the ECB’s dominance in corporate bond buying is in fact becoming counterproductive for market health.
We think that this will be another reason why investors will want to accelerate their movement into non-eligible parts of the credit market post the summer break. Not only are non-eligible sectors relatively attractive spread-wise now, but they also offer an attractive combination of yield and volatility, we think, compared to CSPP purchased sectors" - source Bank of America Merrill Lynch
In similar fashion than the Bank of Japan has completely destroyed the liquidity in its Government Bond Market (JGBs), the ECB is as well in the process of wreaking havoc in the liquidity of the Corporate bond market and has now been joined in a similar process by its neighbor the Bank of England. 

When it comes to the "Thermidor" period, we do live in pre-revolutionary times we think and wonder how long markets are going to cope with this financial repression.

On a final note and in our final chart and in continuation to last week's conversation surrounding bank "valuations", we would like to point out how interest policies of our "omnipotent" central bankers and now with NIRP are destroying slowly but surely "bank capital".

  • Final chart: Bank stocks under pressure? Blame central banks
We will not re-iterate why we dislike banks stocks and in particular European banks stocks given the "japanification" process and the significant on-going deleveraging. If there is indeed some clear culprits when it comes to "capital destruction" thanks to Zero Interest Rate Policies (ZIRP) and now with Negative Interest Rate Policies (NIRP), the blame is entirely on the shoulders of our "generous gamblers" aka central bankers and their experiments. 
This is clearly illustrated in our final chart displaying the correlation between interest rate policies and bank stocks as pointed out by this chart from Bank of America Merrill Lynch from their Credit Derivatives Strategist note from the 5th of August entitled "Corporate ‘QE²’ - When CBPS met CSPP":
- source Bank of America Merrill Lynch
As a "bonus chart" we will point out to yet another chart from Bank of America Merrill Lynch's European credit strategist Barnaby Martin note "Resistance is futile" from the 28th of July chart displaying that the "fun" has been going "uphill", namely to the bond market and in particular German Bunds:
- source Bank of America Merrill Lynch

For the "real economy", downhill that is, we are not too sure they are getting their share of the "fun", which does indeed explain the rise in inequalities, populism and the rising prevailing "pre-revolutionary" mood in many parts of the world.

Back in November 2014 in our conversation "Chekhov's gun" we argued the following:
"Our take on QE in Europe can be summarized as follows: 
Current European equation:  
QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). 
“Hopeful” equation:  
QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?
When it comes to the Current European equation, we note with interest that civil unrest is a rising global trend." - source Macronomics, November 2014
Obviously our "Hopeful equation" suffered from "Optimism bias" and we argued at the time:
"Our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015) " - source Macronomics, November 2014
Increasingly it looks to us that we are moving towards the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). That's our take and our "realist bias" for now unless of course we finally get a wake-up call from the political class leading to the realization of our "Hopeful" equation but we would not bet on it for the time being.

"Those who make peaceful revolution impossible will make violent revolution inevitable." - John F. Kennedy

Stay tuned!

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