Wednesday, 24 December 2014

Merry Christmas and a Happy New Year to all!

This year Macronomics is celebrating its fifth year of existence. Time flies. The blog started early December 2009.

On that special occasion, we would like to extend our thanks for the support we received on our blogging journey and to our growing number of our readers (thanks for your praise in 2014). 

We would also like to thanks our good friends from Rcube Global Macro Asset Management for their numerous qualitative and quantitative contributions throughout 2014.

We also would like to extend our thanks to our good cross-asset friend "Sormiou" for providing us with his great insights on the subject of volatility and his regular comments, and interesting exchanges we had during the course of 2014.

We are looking forward to hearing more of him in 2015 given the clear potential for more volatility to come in 2015 in that respect.

While we had some good calls and bad calls in 2014, we are please to say that our long duration play in early 2014 was, in retrospect, one of the best we ever made. 

We were indeed part of a small crowd of pundits who had their "macro" right. In fact,  the ETF ZROZ which has been one of the tool we have used to play the trade, is about to end the year as the best performing ETF in the Fixed Income category

We will stop here in blowing our own trumpet given the investment seas can be treacherous indeed and as they say in latin: "Arx Tarpeia Capitoli Proxima" ("one's fall from grace can come swiftly").  

As part of our New Year resolutions for 2015, we endeavor to bring you more "macro" thoughts using of course our trademark analogies and ramblings. 

As part of your own New Year Resolutions for 2015, we would suggest you make one to be to interact more with us on our posts via comments or via Twitter in 2015. Don't be shy next year! We are therefore looking forward to hearing more from you, dear readers, in 2015.

Anyway, it's Turkey time and Santa Claus time, thanks again to all of you for following us. 

We wish you all and your families a Happy New Year in advance.


"It is a fine seasoning for joy to think of those we love" - Molière

Stay tuned in 2015 for more of our ramblings!

Wednesday, 17 December 2014

Guest post - A Chinese "Déjà-vu"?

"Right now I'm having amnesia and deja vu at the same time." - Steven Wright, American comedian
The situation we are seeing today with major depreciation in EM currencies is eerily similar to the situation of 1998, with both China and Japan at the center of the turmoil.

On that subject, we share our concerns with our good friends at Rcube Global Asset Management  which they discussed in their Global Macro Monthly Review in December. Please find below their take on the Chinese situation reminiscent of the 1998 Asian crisis:
"The current situation in China is similar to the Asian tigers in the late 1990s. We will first describe the chain of events that led to the crisis and then look at China today and explain why not only the domestic conditions of the country are strikingly close to what they were for the Asian economies back in 1997, but also how close the international environment looks when compared with the late 1990s.
The NY fed published a paper co‐authored by Giancarlo Corsetti, Paolo Pesenti and Nouriel Roubini
in 1999 called “What caused the Asian currency and financial crisis?” that we have used for comparison purposes with today’s situation in China.
It starts by stating “Central to a full understanding of the root of the Asian crisis is the multifaceted evidence on the structure of incentives under which the corporate and financial sectors operated in the region in the context of regulatory inadequacies and close links between public and private institutions… At the corporate level, political pressures to maintain high rates of economic growth had led to a long tradition of public guarantees to private projects, some of which were effectively undertaken under government control, directly subsidized or supported by policies of directed credit to favored firms and or industries. “
At the time, government intervention in favor of troubled firms gave investors the impression that return on investment was almost guaranteed and that corporate defaults were unlikely to happen.
As a result, capital flowed to the region. As investment spiked compared to savings, the current account of these economies dropped sharply. Capital was plentiful at the time. The sharp drop in developed countries’ interest rates (Japan in particular) explained the large financial flows into the region, which were offering more favorable rate of returns.
By borrowing extensively abroad to finance local project, banks channeled these flows into the domestic economies. At some point, because the investment boom was confined to nonproductive sectors (commercial and residential construction as well as inward-oriented services) the rate of return on these investments started to drop, which became evident as the share of nonperforming loans begin to rise swiftly.

The final nail in the coffin came from the Japanese yen, which lost 45% against the US dollar between May 1995 and August 1998. Not only the Tigers had lost a substantial export market for their products since Japan had turned from boom to bust, but they were also losing market share against Japanese firms due to the JPY debasement. China had devalued its currency by 50% in 1994,
grabbing, like Japanese firms, new export market share in the process. Since most of their currencies were pegged to the US dollar, their real effective exchange rate appreciated
substantially, further deteriorating their competitiveness.
As the average return on investment dropped further, and NPLs kept on rising, capital inflows turned into outflows. Currencies started to weaken. Banks were doubly hit by rising NPLs and by the currency effect, having amassed large amounts of foreign currency debt.
The negative feedback loop accelerated, resulting in crashes in real estate, stock markets and currencies.
We believe that China’s situation is comparable if not worse than that of the Asian Tigers in the mid-90s. Growth has been almost entirely driven by an investment boom which, as a share of GDP, is significantly higher than where the Tigers were back then.
Just like for these economies, the interconnection between the public and private sphere is large. The government has directly or indirectly subsidized specific industries, and has until this year almost guaranteed a zero default rate. Furthermore, the investment boom has been concentrated in n onproductive assets, namely real estate construction.
Most of the balance was directed at industries that were tied to the property boom: steel, cement, aluminium. These sectors are now facing severe overcapacity. Standard & Poor's estimates that between 30 and 40% of all corporate loans are backed by property and land as collateral, so falling real estate increases the risk of a credit crunch.
The Chinese capacity of utilization rate has dropped to 70%. The investment bubble, just like for the Tigers, has been financed with cheap - and until recently plentiful - credit. China now has the largest corporate debt pile in the world, having surpassed the US last year ($14.5 Trillion vs $13.1 for the US). 
The BIS December quarterly report released recently reports that the outstanding stock of cross border claims on China stood at the end of Q2 2014 at just over $1.1 trillion. The current annual growth rate of claims on China is 50%, and the stock of claims has been multiplied by 10 in less than 8 years. China is by far the largest EME borrower for BIS reporting banks. As recently as 2009, China was not even among the BIS reporting banks' top 5 foreign EME exposures. The last phase of the the investment boom (since 2010) has therefore been increasingly financed by capital flows. 
 Claims of BIS reporting banks on emerging market economies outstanding stock.

On that subject, the largest drop on record in capital flows in Q3 (change in FX reserves - Current Account + net FDIs) is particularly worrying. The current account has dropped by 8% points of GDP since 2008 (investment rising much faster than savings).

Furthermore, the BIS report also reveals that capital flows associated with non-financial corporations have increased markedly over the past few years through three different channels.
First transfer have surged within firms. Second, trade credit flows to EMEs have increased significantly. Finally, the amount of external loan and deposit financing to EMEs provided by non-banks has grown considerably. This simply means that EMEs non corporates have used their offshore subsidiaries to obtain funds from global investors through bond issuance and have repatriated the proceeds through one of the three channels mentioned above.
The reports states: "Chinese firms have primarily issued $ denominated bonds abroad, whereas non-Chinese companies account for a sizeable proportion of offshore Renminbi bond issuance. Very often, these non-Chinese entities will swap their CNH proceeds into US dollars. In doing so, they are taking advantage of the cross currency swap market to obtain dollar funding at lower costs...Similarly, cross currency swaps offer Chinese firms a channel to get around the tight liquidity conditions in China by swapping their US dollar proceeds from bond issuance into RMB and remitting to their headquarters."
International debt securities issuance in $bn
 Source BIS international statistics 
 China has been by far the main recipients of these types of capital flows. Part of these flows should be considered as foreign denominated debt since there is a currency risk. Even though classic measures of foreign external debt remain low, the currency mismatch is probably much higher - another similarity with the Asian Tigers.
 International issuance of EME based non-financial groups
 Source BIS international statistics 
For the first time, selective defaults happened this year. Shanghai Chaori Solar Energy Science & Technology Co was the first Chinese corporate bond default in March. In September, Anhui Wanjiang Logistics Group missed payments. The company cited banks' unwillingness to extend loans to the steel industry as the reason for the non-payments. Sinosteel, the state owned company, recently said that it was having difficulties paying back some lenders as a resuly of unpaid bills from customers. As local governments refuse to close down some steel mills for fears of fueling unemployment, China's steel production keeps rising, making the problem even worse (increasing overcapacity). This issue is similar in many over indebted industries (cement, construction, shipbuilding, etc.). 

The domestic economy is slowing down as a result of a weaker investment cycle. Additionally, two major export markets have also slowed down: Japan and Europe. Combined, they represent about 25% of Chinese exports. The Japanese Yen devaluation is making Chinese exports much less competitive, the nominal trade weighted Yuan has appreciated by 10% over the last 6mth only, 25% since 2011 and by 45% since 2005.
As the rising share of non‐performing loans starts hitting banks, and the already strained credit channel tightens further, more defaults will become visible. Foreign commercial banks, which are always late in a credit boom, are seeing their share of non‐performing loans rise very quickly. Unlike domestic banks that can hide NPLs, or are subsidized by the government, foreign banks’ data seems to be a much more reliable source of information. Standard Chartered PLC has been severely hit by its exposure to the main Asian economies and China in particular.

Capital outflows will intensify. In the face of a crisis, governments always choose devaluation over reforms. We don’t think it will be different this time.
Just like in 1997 for the Asian economies, it is the combination of domestic weakness, weaker export markets (replace Japan then by Europe and Japan today) and a loss of competitiveness that reveals the crisis. Similarly to 1997, it is the JPY devaluation that could tip over the boat (the magnitude and the velocity of the JPY crash being equal). The Euro weakness is not helping either.
 Just like in 1997, the FED is about to raise interest rates, which is lifting the US dollar. But we believe that the sharp improvement in the US current account is shrinking rapidly the amount of dollar liquidity. The international liquidity environment is thus much tighter than in 1997 despite Japan QE and the coming European action. One US dollar of QE is not equal to 1 Euro or 1 Yen of QE.

When put into context, investors today are looking at the EUR and JPY debasement from a bullish perspective for world stock markets. We think the reality is different. Combined, these two economies, equaled about 125% of the US economy in dollar terms 4 years ago, they barely represent 100% of the US GDP today (in $ terms). That is not good for world exports outside these zones, and most particularly China.
 China, just like the Tigers at the time, is losing market share at a time when its economy is slowing down.

This will prove unbearable when unemployment starts rising, which looks inevitable given the link between the investment cycle and job creation over the last 15 years. If, as we expect, China’s investment share of GDP drops by the same magnitude as the Asian tigers witnessed (around 20 points in a few years) the damage on employment could be massive.

As the investment boom turns to bust, the most likely collateral consequences outside China will be a crash in commodity currencies and industrial commodities that have been so tightly correlated during the boom phase.

The recent spike on Chinese stocks is motivated by a plunge in interest rates and commodity prices, but macro momentum is weakening, which is visible by a flattening yield curve and widening corporate credit spreads. As a consequence, it is very likely that Chinese stocks will reverse course by early next year if not sooner.

From a longer term perspective, China is likely to eventually become the world's dominant economy (even in nominal terms). This is simply because of the fact that its population is four times larger than the population of the US. However, we believe that this "Long March" will be a lot bumpier than most expect.
The issues plaguing China's economy (unproductive investments, corruption, cryonism etc.) are well known and documented. Given these structural problems, it is interesting to observe the degree of admiration exerted by China's system on many Western countries.
We can draw an interesting parallel with the views many economists held about the Soviet Union until the 1980s. In the successive edition of his textbook "Economics: An introductory Analysis", Paul Samuelson (Nobel prize winner in 1970) kept updating a chart showing that the USSR was poised to catch up with the US in terms of GDP due to the latter's higher growth rate (the convergence date was always 40 years later).

This anecdote does not only illustrate that even the most brilliant minds are subject to the "extrapolation bias", but also that planned economies can create the illusion of high growth rates for a very long time until reality bites..."

"The whole world is run on bluff." - Marcus Garvey, Jamaican publisher

Stay tuned!

Thursday, 11 December 2014

Credit - The QE MacGuffin

"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up." - F. Scott Fitzgerald

In continuation to our conversation "Chekhov's gun",  and with the on-going hope for our "Generous Gambler" aka Mario Draghi to unleash QE in Europe, given the growing German dissent from Bundesbank's Jens Weidmann and German Finance Minister Wolfgang Schaeuble as well as some other members of the ECB council, we reminded ourselves for our chosen title of yet another cinematographic analogy, the MacGuffin. The MacGuffin technique is common in films, especially thrillers: 
"Usually the MacGuffin is the central focus of the film in the first act, and thereafter declines in importance. It may re-appear at the climax of the story, but sometimes is actually forgotten by the end of the story. Multiple MacGuffins are sometimes derisively identified as plot coupons." - source Wikipedia
In similar fashion our "Generous Gambler" has very aptly used this technique with the previous OMT and now with QE. Great film director Alfred Hitchcock explained the term "MacGuffin" in a 1939 lecture at Columbia University:
"It might be a Scottish name, taken from a story about two men on a train. One man says, "What's that package up there in the baggage rack?" And the other answers, "Oh, that's a MacGuffin". The first one asks, "What's a MacGuffin?" "Well," the other man says, "it's an apparatus for trapping lions in the Scottish Highlands." The first man says, "But there are no lions in the Scottish Highlands," and the other one answers, "Well then, that's no MacGuffin!" So you see that a MacGuffin is actually nothing at all." - Alfred Hitchcock
It seems to us that the much vaunted OMT was in fact a MacGuffin, namely, nothing at all. The OMT MacGuffin was a successful ECB apparatus for snaring bond investors into buying peripheral debt. Benoît Cœuré, described it: 
"OMTs are an insurance device against redenomination risk, in the sense of reducing the probability attached to worst-case scenarios. As for any insurance mechanism, OMTs face a trade-off between insurance and incentives, but their specific design was effective in aligning ex-ante incentives with ex-post efficiency." 
So despite never being used, the OMT instrument was evaluated to have been a successful instrument, in true MacGuffin fashion.

For filmmaker and drama writing theorist Yves Lavandier, in the strictly Hitchcockian sense, a MacGuffin is a secret that motivates the villains. In our investment world the villains are yield scoundrels and central bankers as we have argued in our conversation "The last refuge of a 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""
In Europe, the carry players, namely peripheral banks, benefited from the LTROs as well as the MacGuffin OMT to continue to invest massively in their respective domestic bond market.  As a reminder the German Constitutional Court expressed doubts about the legality of OMT under German and EU law. The European Court of Justice heard the case in October 2014, but has not yet issued its ruling.

For us, in the end, the discussions surrounding QE in Europe are indeed akin to a MacGuffin given the definition of Princeton's Wordnet defines a MacGuffin as simply "a plot element that catches the viewers' attention or drives the plot of a work of fiction".

In this week's conversation we would like to share again our concerns in relation to a particular type of rogue wave (currency crisis) we discussed in November 2011, the three sisters, that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:
"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: Wave number 1 - Financial crisis Wave number 2 - Sovereign crisis Wave number 3 - Currency crisis In relation to our previous post, the Peregrine soliton, being an analytic solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), it is "an attractive hypothesis to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace" - source Wikipedia." - Macronomics - 15th of November 2011
We would like also like to discuss in this conversation the never ending struggle between inflationary forces and deflationary forces, given it looks to us that deflation is indeed appearing to have the upper hand we think.

Wave number 3 - Currency crisis:
We voiced our concerns in June 2013 on the risk of a rapid surging US dollar would cause with the Tapering stance of the Fed on Emerging Markets in our conversation "Singin' in the Rain":
"Why are we feeling rather nervous?
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?
It is a possibility we fathom." - Macronomics - June 2013
At the time we stated that we were in an early stage of a dollar surge, in fact the global total returns YTD for the US dollar is 10.8%.

The situation we are seeing today with major depreciation in EM currencies is eerily similar to the situation of 1998, with both China and Japan at the center of the turmoil. On China specifically we will go into more details next week with a guest post from our friends at Rcube Global Asset Management.

In relation to the expected continued dollar surge in 2015 we read with interest Societe Generale FX Outlook H1 2015 entitled "Life Below Zero":
"Lots of USD upside, but Fed will want to rein rally inA year ago in “The reluctant dollar” we predicted that the US dollar would win by elimination in 2014. On a spot basis, the dollar has been the world’s best year-to-date performing currency (okay, we left the Sudanese Dinar aside). The Fed’s broad trade-weighted US dollar index is up some 7% year-to-date and our equal-weight USD/G10 and USD/EM indices are up by more than 10% each (Graph 1).
 Not bad. Our in-house economic views overwhelmingly support further dollar strength in 2015. There is plenty of room to the upside (Graph 2).
 We are confident about the view, but occasionally lose sleep on: 1) the fact that it is consensual, and we don’t like sitting with the crowd; and 2) fears that the raging currency war may have a bigger impact on the Fed’s reaction function than our economists think."
Central banks in the driving seat.
Graph 3 shows the year-to-date (YTD) change in 1y2y G10 rates relative to 1y2y USD, and the YTD spot currency move.

If the correlation does not appear to be as strong as it has often been in the past, this is to an extent because at the zero lower bound (ZLB), monetary policy isn’t just about the price of money, but also its quantity.
Typically the JPY undershoot is a function of the BoJ printing more money – don’t fight that trend, particularly when that policy looks increasingly impotent. The NOK has undershot too, thanks to the falling oil price. The SEK has done even worse, on fear the Riksbank would do more than just cut rates. AUD, NZD and GBP have been resilient (above the regression line) and might have some catch-up to do on the downside."            - source Societe Generale
Of course what we find of interest is that under the ZLB, many pundits have expected a recovery. When one looks at the commodity complex breaking down in conjunction with a weakening global growth picture which can be ascertained by a weakening Baltic Dry Index. No wonder yields in the government bond space are making new lows and that our very long US duration exposure we have set up early January (in particular via ETF ZROZ) has paid us handsomely and will continue to do so we think.

The Baltic Dry Index, indicative of a weakening growth outlook as of late - graph source Bloomberg:

The demise of the commodity complex in conjunction with weaker industrial production in Europe as well as a clear degradation in the shipping outlook are all elements highlighting the deflationary forces at play we have been so vocal about in our numerous conversations around the "japanification" process.

There has been no doubt a growing divergence between fundamentals from the real economy with asset prices levels courtesy of central banks meddling. While our central banks deities so far have benefited from the benefit of the doubt on the promise for some of more generosity in the form of a QE MacGuffin in Europe, we would have to agree with Societe General's take from their FX outlook on central banks meddling:
"It’s broken, and they don’t know how to fix itIt is remarkable that after so many years of super easy monetary policy, the global economy still feels wobbly. On the positive side the US continues to recover and the lower oil price will provide a boost to global growth in H1 2015. Yet the growth multipliers seem to be much weaker still than they have been historically, highlighting a lack of confidence, be it because of post-crisis hysteresis, the demographic shock, the excessive levels of non-financial debt, etc.‘Secular stagnation’ is the buzz word. The theory encompasses two ideas: 1) potential growth has dropped; 2) there is a global excess of supply, or a chronic lack of demand. If true, the implications are clear. First, excess supply creates global disinflation forces. Second, to fight lowflation and to help demand meet supply at full employment, central banks may need to run exceptionally easy monetary policy ‘forever’. In other words, real short-term rates need to remain very low, if not negative.
Life below zero. At the ZLB, central banks do what they know: they print money. But such policy seems to follow a law of diminishing marginal returns. It has worked well for the US, because the Fed had a first-mover advantage, and the support from pro-growth fiscal policy and a swift clean-up of the household and bank balance sheet. The BoJ and ECB aren’t as lucky. Let’s consider three transmission channels: 1) The portfolio channel. By pushing yields lower, central banks force investors into riskier assets, boosting their prices. But trees don’t grow to the sky. And the wealth effect on spending is constrained by high private and public debt. 2) The latter also gravely impairs the lending channel. And with yields already so low, it’s questionable what sovereign QE can now achieve. 3) The FX channel. This is where the currency war starts, as central banks try to weaken their currency to boost exports and import inflation. It however is a zero-sum game that won’t boost world growth.-The battle to win market shares highlights a fierce competitive environment, which tends to depress global inflation. Adding insult to injury, oversupply in commodities, especially oil and agriculture, currently add to the deflationary pressure. That leads central banks to get ever bolder, when instead they’d need to be more creative (e.g. a bolder ABS plan from the ECB would be far more effective than covered and government bond purchases) and get proper support from governments (fiscal policy, structural reforms).
Looking for a 2015 surprise. The BoJ has just sped up the race to the bottom. It may just help spread out the currency war. Consider Asia ex-Japan FX. It has been resilient relative to CEEMA and Latam (Graph 7), with the Chinese yuan (CNY) an anchor. But is has started to weaken in H2 2014, with the KRW, MYR and SGD weakening some 5-7% vs USD. For a long time China was happy to see CNY strengthen vs USD, as long as the latter was falling vs other currencies. 
But the trade-weighted CNY is now soaring, along with that of the USD (Graph 8). 
The CNY REER is up 27% over five years. It is increasingly difficult for China to afford such strengthening, given the local economic slowdown and deflationary pressure (PPI around -2% for almost three years)." - source Societe Generale
Of course, what Societe Generale is highlighting is what we discussed this year in April, namely "The Shrinking pie mentality":

"When the economic pie is frozen or even shrinking, in this competitive devaluation world of ours, it is arguably understandable that a "Winner-take-all" mentality sets in. Shrinking economic growth resulting from the financial crisis means that, from a demographic point of view in Europe with a shrinking working age population, low birth rates and a growing population of older people, it means to us that Europe does indeed face a critical choice: meet their unfunded pension liabilities and go bust, or cut drastically in entitlements in order to compete with emerging countries that don't have these large "legacy" costs associated with aging developed countries." - source Macromics, April 2014
When it comes to currency wars and currency crisis, we do expect China to seek a weaker yuan in order to deflate its epic credit bubble as we pointed out as well in our April 2014 conversation:
"In similar fashion, the US would thrive on a strong revaluation of the yuan, which would no doubt precipitate China into chaos and trigger a full explosion of the credit bubble in China, putting an end to the "controlled demolition" approach from the Chinese authorities. A continued devaluation of the yuan, would of course be highly supportive of the Chinese attempt in gently deflating its credit fuelled bubble, whereas it would export a strong deflationary wave to the rest of the world, putting no doubt a spanner in the QE works of the Fed, the Bank of Japan and soon to be ECB."
 As we posited before, if it is time for a pullback, get some greenbacks, at least that's what Dr Copper,  the metal with the economics Ph.D, is telling us as of late.

When it comes to dollar global liquidity, we agree with Societe Generale's take from their FX outlook, watch the US current account:
"It will soon be the ECB’s turn to embrace ‘proper’ (i.e., sovereign) QE. But the chances of ECB bond-buying doing much for bank lending or for demand are very remote. Bond yields will fall – but only a bit, given how low they are already. Equities will rise but, likewise, only slightly.
The main effect of QE will be to weaken the euro, but a big enough fall to really boost exports is hard to imagine yet. And the effect on inflation expectations is likely to be quite limited. So the danger, as ever, is that we see QE but don’t see much economic benefit. So, we’ll see more QE. And so on. So both the ECB and the BOJ response to low US rates is very different from what we saw in the last US recovery. Meanwhile, the big driver of dollar weakness pre-2008 – capital outflows to higher-yielding currencies and assets – is substantially weakened by the fact that these are now correcting from excessive valuations. And finally, the US current account deficit, which was almost 6% of GDP in 2006, is now 2.25% and falling even as the US economy outperforms.
 The US current a/c deficit is melting thanks to the shale oil revolution
All of this is enough to make us believe that we are at the start of a period of further dollar strength, even if real US interest rates will rise modestly, not dramatically. The dollar’s rally could be much bigger if asset markets suffer a major loss of confidence or if those trying to revive inflation expectations through currency weakness take that policy to its logical conclusion and engineer a downward spiral. Imagine a world with USD/JPY back in real terms at 1982’s level – USD/JPY 140 at today’s rate. What would that do for the rest of Asia, including perhaps for China? Imagine what happens if ECB QE has absolutely no impact and the ECB finds itself, in a year’s time, with inflation still at or below zero? Furthermore, if a falling euro or yen drives inflation expectations up and therefore real rates down (which is one of the major benefits of it), while a stronger dollar anchors US inflation expectations and supports real rates, then currency trends could tend to become self-sustaining until they overshoot – and that happens when US real rates become a drag on activity, which would probably take a big currency move.
All of which is to say that a very strong dollar is not inconceivable, even if it’s more likely that there is a 5-10% gain. In other words USD/JPY 120-130, EUR/USD 1.10-1.20, GBP/USD 1.1.40-1.50." - source Societe Generale
When it comes to oil and the velocity of the fall, we would like to re-iterate what we said in April 2013 in our conversation "The Awful Truth":

"In numerous conversations, we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced. The decline in the oil price to a nine-month low may prove to be another sign of deflationary pressure and present itself as a big headwind. Why is so?
Whereas oil demand in the US is independent from oil prices and completely inelastic, it is nevertheless  a very important weight in GDP (imports) for many countries. Monetary inflows and outflows are highly dependent on oil prices. Oil producing countries can either end up a crisis or trigger one.
Since 2000 the relationship between oil prices and the US dollar has strengthened dramatically.  As we highlighted in our conversation in May 2012 - "Risk-Off Correlations - When Opposites attract": Commodities and stocks have become far more closely intertwined as resources have taken on a greater role with China's economic expansion and increasing consumption in Emerging Markets."

A structural slowdown in economic activity like we are seeing is accentuating the fall in oil prices we think. Declining profitability and misdirected investments into unproductive assets and infrastructure projects have been triggered by years of Zero Interest Rate Policy (ZIRP) in Developed Markets (DM). This is having negative consequences in Emerging Markets given oil demand growth has been exclusively supported by strong EM growth. Lower GDP growth trend is therefore pushing for lower oil prices. 

We concluded our April 2013 as follows:
"Is Copper finally is telling us something about the real world, which equity markets are not currently focused on in true Zemblanity fashion, Zemblanity being "The inexorable discovery of what we don't want to know"? We wonder...
And, what if the trigger will be in Asia like in 1997 (as suggested by Albert Edwards recently) and not Europe after all? We wonder as well..."
Moving on to the subject of deflation having the upper hand, we think Bank of America Merrill Lynch's graph of 5-year 5-year forward breakevens (%) from their Liquid Insight note from the 9th of December 2014 entitled "Anchors Away", indicates the strength of the deflationary forces at play:
"Breaking bad
In recent years inflation hawks have been warning that aggressive monetary policy could cause inflation expectations to become “unanchored”. After all, stable expectations are not a birthright, but must be earned with a demonstrated track record of success. Unfortunately, there is building evidence that inflation expectations have already become unanchored; however, the unanchoring is to the downside.
The most obvious evidence is the plunge in 5-year 5-year forward breakevens in the Euro Area and the US (Chart of the Day). Euro Area breakevens are now even lower than during the 2008 crisis. US breakevens have not quite plumbed those depths, but are about 50bp or 70bp lower than normal. Both ECB and Fed officials have downplayed the drop. For example, in a speech on December 1, New York Fed President William Dudley argued that “despite some softness in market-based measures of inflation compensation, inflation expectations still seem well-anchored and this should also work to pull inflation gradually higher.”
We disagree and see four reasons to take this drop seriously. First, some survey measures of inflation expectations already shows signs of eroding. For example, in the Consumer Sentiment survey normally inflation expectations for five years ahead bounce around 3%, but now they have dipped to 2.6%. This is the lowest since the 2008-09 crisis." - source Bank of America Merrill Lynch.
We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed":
"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

But what has been clear with the demise of the commodity complex during the summer has been as well validated by the capitulation in inflation hedges trade as shown recently by Bank of America Merrill Lynch in their Flow Show note from the 4th of December entitled "Chasing Winners, Selling Inflation":
"Selling inflation hedges: redemptions from TIPS ($0.7bn – largest in 14 months), EM equities ($2.8bn - largest in 8 weeks), bank loans & precious metals"
- source Bank of America Merrill Lynch
When it comes to deflationary environment and defaults, we will re-iterate what we have argued in  July 2012 in our conversation of Jul 2012 entitled "Hooke's law":
"Moving on to the "unintended consequences" of this low yield environment will have to corporate balance sheets, to some extent, it tends to explain, why defaults tend to spike in a low rate deflationary environment such as today. The fall in interest rates increases bond prices companies have on their balance sheets, exactly like inflation (superior to what an increase of 2% to 3% of productivity and progress) destroys the veracity of a balance sheet for non-financial assets. The conjunction of low interest rates with higher taxations will undoubtedly damage companies, particularly in Europe, and in a country like France, for instance, where public expenditure as a % of GDP is much higher (57%) than in Germany (45%)." - Macronomics July 2012
High inflationary environments allow corporations to inflate away their nominal debt as their assets (and revenues) grow with inflation, leading to lower default rates but, Low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike.

The end of a low volatility period tends to a strong and sudden crash in prices, that is what you can fathom from Bayesian learning which leads to strong rise in asset prices courtesy of central banks generosity.

In credit markets, liquidity can fast become a problem and losses can be sudden and acute as witnessed this summer with the Phones4U debacle witnessed in the UK High Yield space as displayed by Societe Generale from their High Yield and Crossover Compass in December:
"Fixed income credit investment is as much about avoiding the losers as spotting the winners, and the growth in the number of discrete borrowers accessing the European High Yield market makes this task harder by the day. Juicy though the credit spread may have appeared at the time, investors in the Sterling bonds of Phones 4U must rue the day that they took exposure to the UK mobile phone retailer. Now in administration, even modest exposure will have impacted portfolio returns given how far and fast the senior and PIK notes fell when Vodafone and EE announced in quick succession that they were terminating their distribution agreements with the high street retailer.

Since the early September sell off of Phones4U bonds, the retail sector has come under continual pressure as investors take a second look at their holdings and consider just how robust some of these businesses are in the context of a continuing weak economic environment across Europe. Poor trading results can rapidly snowball into a rout as a “shoot first, ask questions later” approach by investors runs head long into poor secondary market liquidity." - source Societe Generale
Credit has always been a leading indicator. Recently widening spread as clearly indicated by our good friends Rcube Global Asset Management. in their note "US Equity / Credit Divergence: A Warning",  have been indeed signaling a sign of caution. We would add that the European High Yield market is as well showing some divergence as well as displayed by Bank of America Merrill Lynch's graph from their Thundering Word note of the 4th of December entitled "I'm a Commodity...Get Me Out of Here":
- source Bank of America Merrill Lynch

QE in Europe appears to be the central focus in true MacGuffin fashion but, rest assured that the widening in credit spreads and the deterioration of the economic outlook regardless of how the fall in oil prices is being presented in positive fashion by many pundits, deserve, we think much more attention.

On a final note, we leave you with a chart for Bank of America Merrill Lynch latest Thundering Word note entitled  "I'm a Commodity...Get Me Out of Here" displaying the stock price of ailing Italian oldest banking giant Banca Monte Dei Paschi di Siena:
- source Bank of America Merrill Lynch

We still believe in what we argued in our conversation "Pascal's Wagerabout the ultimate fate of Banca Monte Dei Paschi di Siena bondholders and shareholders alike:
"We believe that the path will be very painful for both shareholders and bondholders of MPS and that not only subordinated bondholders but seniors as well will face the music in the case of MPS, making MPS the precedent for future bail-in processes in the European banking landscape."

"The hardest tumble a man can make is to fall over his own bluff." - Ambrose Bierce, American journalist
Stay tuned!

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