Saturday, 21 September 2013

Credit - The last refuge of a scoundrel

"We love to expect, and when expectation is either disappointed or gratified, we want to be again expecting." - Samuel Johnson, English author.

While looking with interest the Fed losing its nerve or credibility in its "Forward Guidance" and generating with much abandon "uncertainties" on "Future Expectations" in regards to its "tapering" stance, we thought this week, we would make a veil reference to Samuel Johnson's famous quote:
"Patriotism is the last refuge of the scoundrel."

A scoundrel being by definition villainous and dishonorable, when one looks at the "Cantillon Effects" of Ben Bernanke's wealth effect, no doubt that the big beneficiaries of the Fed's liquidity "largesse" has benefited the most to Wall Street's "scoundrels" as so clearly illustrated by Bank of America Merrill Lynch in their recent note entitled "Tinker, Taper, Told Ya, Buy" from the 12th of September which we already displayed last week:

And if one looks at the recent inflows into the equities sphere, we wonder if equities have not become indeed "the last refuge of the yield/returns scoundrels" hence our chosen title.
"Biggest weekly inflows to equity funds on record ($26bn - Chart 1) driven by massive ETF inflows to SPY, IWM, EEM, GDX ahead of yesterday's dovish FOMC; big pre-FOMC short-covering 8th straight week of rotation/redemptions from bond funds: past 4 months $173 billion redemptions still pale in comparison to stunning $1.4 trillion inflows from Jan'09 to May'13 (Chart 2);
risk/surprise going forward is bond outflows continue despite Fed no taper (would imply Fed credibility down/risk premia up)" - source Bank of America Merrill Lynch - 19th September 2013 - The Flow Show - Record Equity Flows.

Of course, as we posited last week "Cantillon effects" describe increasing asset prices (asset bubbles) coinciding with "exogenous" liquidity induced central bank money supply. We were taken aback by Saint-Louis Fed Bullard comment:
“Using the pace of purchases as the policy instrument is just as effective as normal monetary policy actions would be in normal times,” he concluded.  “In other words, QE is an effective way to conduct monetary stabilization policy.”

We beg to differ from the Fed's view. We think not "tapering" by 5 billion as per market's expectations was a blunder and sent the wrong message. 

We agree with Bank of America Merrill Lynch from their report "Bubbling his way out of Trouble" from the 18th of September when they say the following:
"The liquidity supernova continues...and so does the Wall St. boom. In our view, the longer Main St. takes to recover, the greater the risk of asset bubbles. Equity fund inflows this week are running at record levels, investor cash levels are high, US stocks are at all-time highs and today Priceline became the first S&P 500 issue ever to trade above $1000." - source Bank of America Merrill Lynch.

This week we will therefore focus our attention to the increasing risks induced by the continued "dovishness" of our central bankers sorcerer's apprentices. 

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 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

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:
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 ZIRP. The 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. 

As reported by in their latest post "Could rising rates fuel credit growth in the US?", we also agree with Deutsche Bank, that moderately higher rates would indeed improve not only lending but labor, as well as pension liabilities for corporations from a long term perspective.
"This may seem counterintuitive, but Deutsche Bank’s researches argue that "moderately" higher rates may actually improve lending. This certainly contradicts the traditional school of thought followed by the Fed, who seemingly became spooked by the recent rate spike." - source

As we posited in our conversation "Alive and Kicking":
"Counter-intuitively, rising yields should benefit US companies suffering from ZIRP due to rising  Pension Funding Gaps which have not been alleviated by a rise in the S&P 500."

And a reminder from our conversation "Cloud Nine":
"If we look at GM and FORD which went into chapter 11 due to the massive burden built due to UAW's size of "unfunded liabilities", they are still suffering from some of the largest pension obligations among US corporations. Both said this week they see a significant improvement in their pension plans liabilities because of rising interest rates used to calculate the future cost of payments. When interest rates rise, the cost of these "promissory notes" fall, which alleviates therefore these pension shortfalls. So, over the long term (we know Keynes said in the long run we are all dead...), it will enable these companies to "reallocate" more spending on their core business and less on retirees. Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2."

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.

In continuation to's Deutsche Bank reference, from their note from the 20th of September 2013 entitled "Fed's fear of higher rates is overblown", we would like to point out some of their additional comments on the subject of higher rates:
"Higher rates are a source of strength, not weakness. To the extent that interest rates have risen on the expectation of less quantitative easing (QE) as the result of a healthier labor market, higher yields are a positive development because they reflect more robust economic conditions. The yield on the 10-year Treasury note is up about 100 basis points (bps) from its intrayear low. (Long-term corporate and mortgage rates are up by a similar amount over this timeframe.) Given that the move higher was mainly in response to better labor market data, which was the catalyst behind Mr. Bernanke’s comments that the pace of quantitative easing could begin to slow by year end, we do not believe it is currently having a deleterious impact on growth. As long as interest rates are increasing for the right reasons, in this case an improving labor market, then higher rates are a positive development for the economic outlook. Only when interest rates rise to prohibitively high levels will we begin to worry about their effect on the economy. In this case, we would be looking at long-term real yields up around 3.5% to 4%, but this situation will not happen until the Fed is actually well into a monetary tightening cycle. And even based on our above-trend growth forecast, with the unemployment rate falling to 7% by yearend 2013 and 6.4% by yearend 2014, monetary tightening is still a long way away. Thus, investors and the Fed should not agonize over the year-to-date rise in bond yields." - source Deutsche Bank.

What effectively the Fed has done in its latest blunder is to increase a probability of a much nastier bubble burst and a much more pronounce reaction from risky assets markets in the process. 

They have indeed made the problem down the line much bigger by not starting to take away the proverbial "punch bowl". We therefore agree as well with Deutsche Bank's concluding remarks:
"In conclusion, Fed policymakers refrained from taking a first small step toward policy normalization this week, as they remain fearful the economy is not strong enough to handle a slower pace of monetary accommodation. For reasons we discussed above, the backup in rates has not been significant enough to dent our expectations of an interest-sensitive led improvement in economic growth. Rates remain extraordinarily low, and if growth finally surprises to the upside later this year, a modest tapering of quantitative easing will commence. In the interim, long-term interest rates are poised to trend higher, reflecting these improving growth prospects. This runs the risk that when the Fed finally begins tapering, monetary policymakers witness a larger and more negative response than they might prefer." - source Deutsche Bank

And if history is could provide some "Forward Guidance" for US yields, we wanted to illustrate the evolution of the US 10 year yields from the 29th of September 1929 until the 29th of June 1949:
Graph source

Of course the key data the Fed is watching in order to start considering "dipping its toes" into normalization comes from housing as indicated by Deutsche Bank in their report:
"It would be highly unusual for builder sentiment to rise so aggressively if the sector were about to falter in the face of higher mortgage rates. The reason for this is because there is very little supply of newly constructed homes for sale and demand is recovering as the labor market normalizes and household income prospects improve. 
To be sure, higher mortgage interest rates make housing less affordable, all else being equal, but affordability is a function of house prices and income, as well. The National Association of Realtors’ Housing Affordability Index (also shown nearby) illustrates an important point in this regard. Despite the 125 basis point increase in mortgage rates year-to-date and a steep increase in home prices (10%+), housing affordability remains higher than at any point in the prior four decades—barring the ultrahigh ultrahigh levels of the past two-to-three years. 
Until affordability returns to average (or below), home buying conditions remain favorable for further improvement in prices and sales volumes." - source Deutsche Bank

Housing is indeed essential in order to assess the solidity of the "recovery" and as we reminded ourselves last week from our January conversation entitled "The link between consumer spending, housing, credit growth and shipping - A follow up":
"If there is a genuine recovery in housing driven by consumer confidence leading to consumer spending, one would expect a significant rebound in the Baltic Dry Index given that containerized traffic is dominated by the shipping of consumer products."

We therefore monitor credit and shipping very closely, but also the activity in the freight derivatives markets in order to gauge a potential rebound in global growth which seems to be anticipated as indicated by Bloomberg's recent Chart of the Day, to point to an anticipation in the global trade:
"Trading of freight derivatives is near a five-year high as hedge funds return to the market in anticipation that surging charter rates for the largest iron ore-carrying ships signal a global economic rebound.
The CHART OF THE DAY shows trading in forward freight agreements, used to bet on future shipping costs, reached the highest level since October 2008 this month, according to the Baltic Exchange, the London-based publisher of rates on global maritime routes. Hire costs for Capesize vessels jumped almost sixfold since the end of May, its data show.
Rates are rallying as China replenishes stockpiles of iron ore, a steelmaking raw material and the largest dry-bulk cargo hauled at sea. That’s drawing hedge funds and other investors back to the market, said Alex Gray, chief executive officer of Clarkson Securities Ltd., the derivatives unit of the world’s largest shipbroker. Capesize rates are still down 88 percent from the peak in June 2008.
“There’s no other commodity market out there that goes up five times multiples,” Gray said. “Freight is considered to be a very good bellwether for worldwide growth. Investors are looking at the freight market moving once again and saying, ‘Is this the beginning of something big?’”
While port congestion and delays are helping to lift rates, stronger Chinese demand can’t be ignored, Gray said. Steel production in China rose to a record 91.9 million metric tons in August, data compiled by Bloomberg show. Iron-ore imports gained to 69 million tons last month, within 6 percent of July’s all- time high, according to customs data.
Volume and open interest for dry-bulk freight swaps rose to 50,363 lots in the week ended Sept. 9, according to the Baltic Exchange. That was the highest level since the 50,445 lots tallied in the week of Oct. 20, 2008, its data showed. Daily Capesize rates as gauged by the exchange were at $29,186 yesterday, compared with $5,171 at the end of May." - source Bloomberg.

Of course when it comes to our market scoundrels and the Fed, gradually removing the "liquidity addiction" from our sugar-rushed equity markets is not going to be as easy as it was to initiate the "Cantillon effect" and its "inflationary" effects on risky assets as displayed in the below Bloomberg graph:
- source Bloomberg.

In similar fashion to QE2, QE3 triggered a significant rise in Inflation Expectations, but since the beginning of the "tapering" talks in May,  both inflation expectations as illustrated by the evolution of the 10 year US Breakeven and Gold have been sent packing, until the "untaper" time as of July which saw a significant rebound in both - graph source Bloomberg:
Of course, if you don't know where the Fed's compass is going to spin, you play the put-call parity game which is long gold (inflation and end of the dollar status) and long bonds (deflation).

Dollar index versus Gold - graph source Bloomberg:
The Fed postponing its "tap dancing" has led to a weakening of the Greenback and a bounce back of gold in the process.

On a final note, in these jitteriness, Japan has continued to shine, and we expect Japan to continue to do so to the benefit of our market scoundrels - graph source Bloomberg:

Helped by lower volatility and has indicated by tighter spreads in the Itraxx Japan - graph source Bloomberg:

For a simple reason: labor cash earnings growth - graph source - Datastream / Fathom Consulting:

"Knowledge is of two kinds. We know a subject ourselves, or we know where we can find information upon it." - Samuel Johnson, English author.

Stay tuned!

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