Credit - Tokyo Drift

"As the blessings of health and fortune have a beginning, so they must also find an end. Everything rises but to fall, and increases but to decay." - Sallust, Roman historian

Watching with interest the continuation of the deflationary trend of peripheral yields in conjunction with the brewing turmoil in France given the recent dissolution of the latest government, we decided this week to use a relatively simple analogy, using the 2006 third opus of the "Fast and Furious" movie saga entitled "Tokyo Drift" as our title given the on-going "Japanification" process of Europe.

In fact, this "Japanification" process aka "Tokyo Drift" reminded us of our conversation from March 2012 entitled "St Elmo's fire" where we indicated the following:

"If Europe is moving towards a Japanese decade, there might be at least some solace for Spanish Golf players given that according to Bloomberg there has been a high correlation between Golf Membership fees and Tokyo land prices - source Bloomberg:"

The continuation of the European "adjustment" in similar fashion bodes well for European golfers but we ramble again...

Peripheral yields have been subdued even without the OMT being triggered. In similar fashion, the Euro has weakened without even QE being launched.

In this week's conversation, we will review the acceleration of the deflationary trend we are seeing and what to expect: QE or no QE?

Another sign of the "Tokyo Drift" in the European financial world can be seen in the Eonia which, as indicated by Morgan Stanley in their ECB Tender Tracker note from the 20th of August has been drifting towards Depo:

"Eonia fixing at new lows: Eonia has been fixing at record lows for the past two weeks, with spot Eonia currently being at 0.005% and 1y forward 1y Eonia at 0.042%."

"The next event the market will be watching out for is the first TLTRO take-up on September 18. At the press conference of the August ECB meeting, President Draghi quoted a lower range of the total take-up at the TLTRO from banks’ survey, i.e., €450-850 billion, compared to the ceiling of €1 trillion announced in June. While Draghi may have lowered the ECB’s expectation of the overall take-up at the TLTRO, our bank analysts’ estimates are at the lower end of the range – a total take-up of just €350-650 billion." - source Morgan Stanley

In fact 1 year 1 year Eonia has been trading down to -1.5 bps as of late.

When it comes to the "inflationary" trends in Europe, the deceleration of inflation has been intensified by the volatility in energy/food prices as indicated by Bank of America Merrill Lynch in their note from the 22nd of August entitled "Tracking deflation: more worries":

"HICP fell to 0.4% yoy in July, while it had been expected to be unchanged at 0.5% yoy. Looking at its components, the changes were driven by energy dropping aggressively from 0.1% yoy to -1% yoy. Alcohol and tobacco receded from -0.2% to -0.3% yoy, non-energy industrial goods were stable, while services grew 1.3% yoy, unchanged from June (Chart 6)." - source Bank of America Merrill Lynch

Another significant indicator of the deterioration of inflation expectations in Europe can be seen in spot inflation break-evens in the same report, showing the various maturities falling in concert:

"Spot inflation break-evens have resumed their fall and are now at levels close to 0.5% on a one- and two-year horizon. Five-year break-evens are also falling and stand at around 0.99%.

Forward inflation break-evens computed from swaps also started to fall again and, for the first time, the 5Y5Y forward has crossed the 2% line. - source Bank of America Merrill Lynch

Looking as well at the recent weakness of Euro versus the US dollar, it is for us the continuation of our "Generous Gambler" aka Mario Draghi being very apt in applying some of General Sun-Tzu's greatest concepts following his July 2012 OMT bluff:

“The supreme art of war is to subdue the enemy without fighting.” ― Sun Tzu, The Art of War

To that effect, Mario Draghi has once more played a very smart hand in lowering the Euro without even firing his QE bazooka. We agree with Morgan Stanley's comment from their latest FX Pulse note from the 21st of August that lowering the value of the euro was indeed an obvious monetary policy goal:

"No EUR Value

Meanwhile, the ECB’s policy tools to revive the ailing economy have become a constraint. Lowering the value of the EUR has become an obvious monetary policy goal, explaining why a declining EUR is now taken as a bullish sign by European asset markets. The weakening exchange rate is now an indicator of the success of the ECB’s easing approach. This interpretation makes sense as declining sovereign spreads failed to reduce peripheral private sector funding costs, as shown in Exhibit 3, and implicitly failed to raise private sector credit supply. 

Nowadays, low sovereign bond yields will help reduce the foreign value of the EUR. This is best illustrated by Exhibit 4 showing volatility-adjusted yield differentials no longer support peripheral bond markets."

- source Morgan Stanley

Indeed, declining peripheral yields have not transferred to peripheral private sector funding due to "crowding out" which we discussed a year ago in our conversation "Fears for Tears":

One of main reason of the relative calm in the European government bond market has been the "crowding out" of the private sector.

"Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments

It is fairly simple, in effect while the deleveraging runs unabated for European banks, most European banks have been playing the carry trade and in effect boosting their sovereign holdings by 30% since 2011 to record"

We also commented at the time:

"Yes, we all know that Mario Draghi's OMT "nuclear deterrent" has yet to be tested. But what we are concerned about is, as we indicated in our conversation "Cloud Nine", is the lack of credit growth in peripheral countries which are most likely to be exacerbated by the upcoming AQR 

As a reminder: AQR = Asset Quality Review, planned for 1st Quarter 2014 as a prelude to the ECB becoming the Single Supervisor for large euro area banks in 2H 2014. The AQR's intent is to review banks challenged loan portfolios and the need for capital increase.

"Until the AQR is completed and capital shortfalls identified and remedied, you cannot expect a significant pick up in lending." 

So QE or no QE?

Not yet.

We have to agree with Bank of America Merrill Lynch's take from the 19th of August entitled "Rates market still not priced for ECB QE as displayed in their Chart of the Day - 5y5y Euro inflation swap rate - breaking below the 2% level last Friday:

"Inflation swaps point to rising risk of no QE

Last but not least, the past two weeks saw a clear break in the relationship between forward nominal rates and breakevens, with a sharp fall in inflation forwards. While the rally in nominal forwards over the past few months used to be reflected in lower real rates, the last two weeks saw it translate into a drop in inflation forwards. The 5y5y inflation swap rate, closely monitored by the ECB as an indicator of long-term inflation expectations, has crossed the 2% on Friday, for the first time since October 2011 (Chart of the day). The drop in inflation forwards is even more noteworthy given that the end of July/start of August often sees firmness in breakevens because of July index events and the absence of supply." - source Bank of America Merrill Lynch

We also agree with Bank of America Merrill Lynch's comment on the heightened risk of "disappointment":

"Weak GDP but tighter spreads may seem consistent with QE…

Last week, the release of weaker-than-expected 2Q GDP for the Eurozone was still accompanied by a tightening in peripheral spreads. Many interpreted this as the market pricing in increased likelihood of QE. We would disagree with that view. While the weak data places more pressure on the ECB to act, we find the moves in peripheral spreads and other rates products inconsistent with the rates market discounting greater chance of QE. Unfortunately, there is no straight way to measure the probability that the market assigns to ECB QE, and even surveys have indicated a very large range of expectations, depending on investor class (Chart 5).

- source Bank of America Merrill Lynch

From a contrarian stance and from a risk reversal point of view, there is indeed a potential for a correction of the consensus long US dollar trade we think. Particularly when everyone is long gamma on EUR/USD as indicated by Bank of America Merrill Lynch in their note "Trading a new USD vol regime" from the 25th of August:

"There was significant demand for EUR/USD gamma over the last week as the pair weakened below 1.32. In the short term there is a strong likelihood of a rebound in the pair following the completion of a triangle breakout (Closing our tactical €/$ short). With short EUR/USD positioning at stretched levels, this rebound is likely to be volatile." - source Bank of America Merrill Lynch

But, then again, one of the real reasons behind the weakness in the Euro as of late has indeed been equity outflows as pointed out by Bank of America Merrill Lynch in their Liquid Cross Border Flows entitled "USD marching higher" from the 25th of August:

"Equity outflows drive EUR lower

Real money selling has been the main driver of EUR weakness in recent weeks, also reflected by outflows from Eurozone equities (Chart 5). 

The CFTC data shows EUR shorts near a two-year high and our quant and technical analysis warn of a short-term pause in EUR weakness. However, as long as the ECB avoids more aggressive easing, equity outflows could weaken the Euro in the medium term." - source Bank of America Merrill Lynch

Should the rebound in European equities accelerate, this could as well play for a rebound in the euro in the near term we think.

In similar fashion, the strong move of the US dollar versus the Japanese Yen appears to us slightly overdone and we might see as well some pull-back from a "contrarian" point of view but technicals, indeed appear less favorable for now when it comes to the yen trade.

From a credit perspective, we continue to believe in the safety of Investment Grade versus the risk of renewed volatility in the High Yield space. Our stance is as well confirmed by recent flows as described by Bank of America Merrill Lynch in their HY flows note entitled "Back to positive" from the 22nd of August:

"Safety over yield

European investors have poured more funds into high-grade and government bond focused funds over the last couple of months. On the other hand, investors have cut risk on more high-beta and growth related asset classes, like equities and high-yield credit. We present this dichotomy of trends in chart 2, by using the cumulative 4 week average flows per pair."

"Credit flows (week ending 20th August)

HG: +$2.0bn (+0.3%) over the last week, ETF: +$183mn w-o-w

HY: +$734mn (+0.3%) over the last week, ETF: -$94mn w-o-w

Loans: -$96mn (-1.1%) over the last week

High-yield flows are back in positive territory after 5 weeks and a total of $13.4bn of non-stop outflows. High-grade inflows remained upbeat, with another $2bn (almost) inflow for another week. High-grade fund flows have been a strong 7.1% of AUM, the strongest since 2010. On the ETFs side, flows continued to decouple, as high grade ETF funds continued to see inflows, while high-yield suffered another outflow over the last week."

- source Bank of America Merrill Lynch

Flows continue to validates Nomura's take on the golden age for credit we discussed back in 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets" which we mentioned again in our last conversation. We like being long duration in European investment grade credit.

On a final note, as far as the Tokyo Drift is concerned and Japan in particular, the continuation of the increase in bank lending in Japan warrants close monitoring we think when it comes to assess Japan's never ending fight against the "deflation beast" - graph source Bloomberg:

"Harmony makes small things grow, lack of it makes great things decay." - Sallust, Roman historian

Stay tuned!