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 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."

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!