Macro and Credit - Rota Fortunae

"The less we deserve good fortune, the more we hope for it." -  Lucius Annaeus Seneca

Watching with interest the strong rebound in Nonfarm payrolls, beating expectations to the tune of 271K and somewhat confirming the rates lift-off for December according to most pundits, we decided to keep up with the philosophical analogies for this week's title and elected Rota Fortunae. The Rota Fortunae also called the Wheel of Fortune belongs to the goddess Fortuna, who spins it at random, changing the positions of those on the wheel - some suffer great misfortune, others gain windfalls. The Rota Fortunae was widely used as an allegory in medieval literature and art medieval writers who preferred to concentrate on the tragic aspect, dwelling on downfall of the mighty - serving to remind people of the temporality of earthly things. In similar fashion to the "Rota Fortunae", there is a Latin phrase "Arx tarpeia Capitoli proxima" (“the Tarpeian Rock is close to the Capitol”) which we have previously used, while discussing the different courses taken by the Fed under Ben Bernanke and the ECB under Trichet's guidance in 2011. In similar fashion to 2011, there is again another growing divergence between the Fed and the ECB when it comes to monetary policies, EUR/USD cross-currency (XCCY) basis swaps aside. Some have interpreted the Latin phrase to mean that “one's fall from grace can come swiftly”. Indeed, if ones look at the on-going demise of the entire commodity complex triggering as well convolutions in Emerging Markets, the Rota Fortunae has inflicted great misfortune. And talking about "Fortune", positive correlations and large standard deviations move are still on the menu if one looks at the 22% drop in Rolls Royce share prices, showing indeed the growing instability in an "overmedicated" market but we ramble again.

In this week's conversation, we will look at monetary divergence being back in play à la 2011 (Bernanke vs Trichet) whereas this time around it is the Fed being "Hawkish" and the ECB being "Dovish".

Synopsis:

• Policy divergence back in play when it comes to credit: A tale of Two Central Banks
• What to expect from Le Chiffre (aka Mario Draghi) in December 
• Final chart - Emerging Markets bank lending conditions the tightest in 4 years

• Policy divergence back in play when it comes to credit: A tale of Two Central Banks

Whereas every pundits is trying to "second-guess" the intentions of Le Chiffre aka Mario Draghi in December it seems to us very interesting to look at the growing divergence between the Fed and the ECB in terms of monetary policy from a default cycle perspective (hence our more constructive approach on European High Yield versus US High Yield).

As in recent weeks we have been discussing our rising concerns when it comes to the lateness in the credit cycle in the US, the European credit market appears to us more favorable thanks to a divergence in leverage, but more importantly thanks to the divergence in monetary policies as once more central banks are in the driving seat and are calling the "spin" on the "Rota Fortunae".

From our credit perspective, there is indeed a growing divergence in the default cycle between Europe and the US given that Europe and in particular its Banking sector is an on-going story of deleveraging, whereas the US has been, credit wise, releveraging, at least from the corporate side. On the subject of default cycle divergence, we read with interest Bank of America Merrill Lynch's take from their Credit Derivatives Strategist note from the 6th of November entitled "Europe vs. US – trading different default cycles":

"Cycles, cycles, cycles

Markets are warming up to the possibility that the ECB could announce another depo cut in its next meeting. Meanwhile, it seems more likely than not that the Fed will embark on its first hiking cycle in over ten years in December. If both these events come to pass as expected, it will be the first time since May 1994 that the US had a rate hike while Europe had a rate cut. Just as Europe seems to be some years behind in its economic and monetary policy cycles, the credit cycle too is likely to play out with a lag relative to the US. In this environment, we expect CDX.HY to continue underperforming the Itraxx Crossover CDS 5 year index.

The fundamental story

In the US, leverage is rising and investor risk appetite is waning. We expect the default cycle to turn and the default rate to tick up to the mid-to-high single digits next year. It is difficult to be constructive on US HY in this environment. On the other hand, HY leverage in Europe is actually declining, thanks to QE. Note that double-B leverage is down to 2x from 2.9x in Q3’14. 

Just as Europe seems to be some years behind in its economic and monetary policy cycles, the credit cycle too is likely to play out with a lag relative to the US. In the US, after a five year credit binge, earnings for high-yield issuers has more or less stalled, leverage is rising and investor risk appetite is waning. It is difficult to be constructive on US HY market in this environment. We expect the default cycle to turn and the default rate to tick up to the mid-to-high single digits next year.

On the other hand, even as US HY corporates have been steadily releveraging over the last five years, leverage in Europe is actually declining, thanks to the ECB QE. With the ECB potentially extending/expanding QE and lending interest rate costs declining to multi year lows, the default outlook for European high-yield market next year appears to be quite benign

Default cycles have been broadly parallel, between the European and the US high-yield markets historically. There have been almost identical peaks and troughs since 2000.

However, more recently the cycle has turned decisively in the US, while Europe has managed to ‘decouple’ (chart above). This pattern – of lower defaults in Europe - is likely to continue for the next couple of years, not unlike the late 90s, which is a time-period we refer to quite often, in order to draw parallels to today’s conditions." - source Bank of America Merrill Lynch.

As we posited in our conversation "Blue Monday": default and leverage do matter, but looking at defaults on their one and assess their predictive matters like most "tourist" credit investors do, is pointless:

What is of course of interest is that looking at the current default rate doesn't tell you much about the direction of High Yield, as aptly explained by our good friends at Rcube Global Asset Management, entitled "Long-Term Corporate Credit Returns"  in their very interesting previous note:

"Credit investors have a very weak predictive power on future default rates. Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates. " - source Rcube

All in all, looking at default rates on their own is akin to looking at the rear view mirror for too long while driving on the narrow credit road.

We rehammered our point in our "Le Chiffre" conversation when it comes to using defaults as a proxy for the direction of credit:

"So while Société Générale is right in pointing out the "low default rate" in Europe, it is we think "oversimplistic", leverage matters more and so does earnings when it comes to High Yield. Looking at default rates is like looking at the rear view mirror. It tells you what has happened, not what is going to happen and maybe indeed looking at the iTraxx CDS credit indices is a cleaner way to look at the pure credit risk, given the greater liquidity in these synthetic contracts versus cash. We like mostly as an early indicator, the ability of our "CCC credit canary" to tap the primary market when it comes to using an early warning indicator in rising default risk and exhaustion in the credit cycle.
As we posited in our September conversation "The overconfidence effect", when it comes to credit spreads and default risks and leverage, end of the day, earnings matter!" - source Macronomics, October 2015 

So yes, defaults and leverage matters, but as we posited back in October, end of the day earnings matter even more!

On that subject, we note with interest that High Grade earnings in the US declined further in the 3rd quarter which is yet another point confirming the divergence in the "credit cycle" between the US and Europe. Bank of America Merrill Lynch in their Situation Room note from the 10th of November entitled "High grade earnings decline further in 3Q" just confirmed our negative stance when it comes to assessing the "credit cycle" and the growing divergence between monetary policies in the US and in Europe:

"High grade earnings decline further in 3Q.

The 3Q earnings season is winding down. With the last busy week of the season behind us the pace of reporting now slows down considerably. By today 533 out of 601 (89%) US public high grade issuers have reported. Based on these results (and estimates for those that have not yet reported) earnings and revenues declined 2.9% and 5.0% YoY in 3Q, respectively. The actual earnings beat the bottom-up consensus expectations at the start of the season of a 4.5% decline, while sales disappointed, coming in below the expectations of a 3.0% deceleration vs. 3Q-14. Also, 3Q results were weaker relative to 2Q, when the YoY changes in earnings and revenues were -1.8% and - 4.1%, respectively. However, excluding the more global issuers (deriving more than 50% of revenues from abroad) and the volatile Energy and Finance sectors, the 3Q earnings growth at +9% was the same as in 2Q.
The large moves in oil prices and the dollar continue to exert downward pressure on earnings. First, excluding the Energy sector earnings grew 4.2% in 3Q. Second, companies deriving less than half of revenues from abroad (ex. Energy and Finance) – and hence less impacted by the dollar and the related global weakness – had earnings and revenue growth of 9% and 4%. In contrast the more global issuers – those deriving more than half of revenues from outside the US – reported a 2% and 4% declines in 3Q earnings and revenues. The impact of the weaker dollar on high grade credit is limited, however, by the fact that the global companies tend to have lower leverage.

- source Bank of America Merrill Lynch.

No surprise to see more domestic companies withstanding more easily the divergence between monetary policies and getting a more favorable outcome from the spin of the "Rota Fortunae"!

While last week in our conversation "Ship of Fools", we re-iterated the use of central banks’ credit surveys given that credit availability is the most predictive variable for default rates, if one looks at Europe, the most recent lending survey points indeed towards a "growing" divergence in defaults outcome between Europe and the US. This was as well confirmed in Barclays European and US Credit Focus note from the 6th of November 2016 default outlook:

"Europe: 

We forecast a 1.75-2.75% issuer-weighted default rate for HY bonds in 2016 (1.5- 2.5% par-weighted) – still near historical lows, but slightly higher than the current default rate. While loose monetary policy should keep defaults lower, the reduction in primary liquidity for highly leveraged securities could spell trouble for issuers that need to tap the high yield market.

In leveraged loans, we forecast a 1.5-2.5% issuer-weighted default rate in 2016 versus 1.5% seen over the past 12 months. While benign funding conditions, limited refinancing pressure and improving fundamentals point to the default rate staying close to the post-crisis lows, we see risks to the upside from a potential spike in volatility and deterioration in funding conditions, should the global macro outlook continue to weaken.

The duality of markets: updating our default model
We apply both a top-down macro model and a bottom-up fundamental analysis to produce our forecast. Our default model uses two key factors to forecast the default rate, and when we backdate these factors by 12 months we have observed a remarkable correlation with default rates (R-Squared of 77%). Specifically our model uses:
• The percentage of the Barclays Pan European High Yield Index (excl. Financials) that the market currently views as at risk of default: we define this as bonds trading with a cash price below 70. As we calculate both a par-weighted and issuer-weighted default rate, we calculate the percentage of par outstanding and issuers for the respective models (Shown in Figures 2).
• The ECB’s bank lending survey, which reflects the net percentage of respondents reporting tighter lending conditions. This quarterly series comes from the ECB and is highly correlated with defaults 12 months forward, as it proxies the openness of primary markets (Figure 3).

It is worth mentioning that historically we have used Moody’s default rates to perform our analysis. However, in September 2015 Moody’s revised its default rate calculation, which materially increased the number of financials in the default universe. As our analysis is focused on the default rates for corporates, we use Moody’s default rates from its August 2015 report for our forecast, so the universe is consistent with past analysis.

It is worth mentioning that historically we have used Moody’s default rates to perform our analysis. However, in September 2015 Moody’s revised its default rate calculation, which materially increased the number of financials in the default universe. As our analysis is focused on the default rates for corporates, we use Moody’s default rates from its August 2015 report for our forecast, so the universe is consistent with past analysis.

When constructing our model, other macro factors such as charge-off rates, GDP growth, Treasury curves and V2X were also considered; however none of these factors adds much value when the ECB bank lending survey series is included. For posterity, we also looked back at what our model forecasted for this year’s trailing 12m default rate at this point last year. Indeed, the model forecasted a 1.39% default rate for the period ending 31 August 2015, compared to Moody’s reported 1.37% default rate. This year, while our forecast still indicates a historically low default rate of 2.02%, this is in fact a slight increase from the current modelled rate of 1.82%.
Interestingly, the two factors we use for our model indicate divergent paths for default rates. For six consecutive quarters, lenders have reported easier lending standards for bank lending – the longest period since 2004-05 when lenders reported easier standards for seven consecutive quarters (Figure 3). With Monetary policy set to remain accommodating to lenders, it would not be surprising if this became the longest continuous stretch of easier lending in the history of the ECB. When modelled on this factor alone, predicted default rates for the upcoming year are slightly lower than current levels – at 1.23% (Figure 4).

US:
We forecast a substantial increase in the default rate in 2016. Combining an econometric model of the default environment with a bottom-up review of credits in the high yield market, we arrive at an issuer-weighted default rate of 5.0-5.5% in 2016, up from the current 2.5% rate; we believe the par-weighted rate will rise from 2.5% to 4.5-5%. The bulk of the y/y increase will come from defaults in the energy and metals & mining sectors as the commodities credit cycle nears its end; we do not believe the end of the commodity cycle will lead to the end of the business cycle.

Defaults have ticked up slightly in recent months, but remain well below historical averages. As of the end of September, the trailing 12-month issuer-weighted default rate for the US speculative grade universe tracked by Moody’s was 2.54%, versus a long-run average of approximately 4.5%. The par-weighted default rate is nearly identical, registering 2.47% in the 12 months ending September 30, according to Moody’s, compared with a long-run average of closer to 5.0% (Figure 1). 

The speculative grade default rate masks some divergence in bonds and loans, with the former group registering 3.4% in the LTM period ending in September, and the latter nearly 2% lower at 1.6%.

Econometric Model of Defaults

As a reminder, our top-down default rate forecasting model relies on a two-factor regression1 of the 12-month forward default rate on the following variables:
• C&I lending standards: The net percentage of senior loan officers reporting plans to tighten lending standards for commercial and industrial (C&I) loans. This quarterly series comes from the Federal Reserve and is highly correlated with defaults 12 months
forward, as it proxies well for the openness of primary markets.
• Distress rate: The percentage of bonds in the Barclays U.S. High Yield Index trading with a spread of 1,000bp or higher. Besides capturing the market’s expectations of impending defaults, this factor also relates well to the likelihood of distressed exchanges, which Moody’s accounts for in its default rate.

Our econometric model has been very good at forecasting the default rate over a 12-month horizon (Figure 4), and predicts a 4.8% default rate.  

The uptick from current levels is due to increases in both independent variables in the regression. The most recent senior loan officer opinion survey (SLOOS) points to a potential reversal in the long trend of loosening underwriting standards. As shown in Figure 5, this diffusion index indicated modest net tightening (+7.4%) of underwriting standards among survey participants, following a nearly unbroken trend of net loosening (22 out of the prior 23 quarters).

The distress rate has also continued to rise since last year, and stands at 14.4%, largely due to the aforementioned distress in commodities sectors (Figure 6).

While both factors in our model point to higher defaults, approximately four fifths of the increase in our default rate forecast comes from the change in the SLOOS index. We continue to monitor underwriting standards closely because we have found this factor to be most correlated with default rates in the past. While we do not expect bank underwriting standards to weaken too much in the current regulatory environment, we believe the near-record $2.6trn in excess reserves of depository institutions held at the Fed should make significant tightening in standards less likely." - source Barclays

Whereas, of course we agree with Barclays' more favorable approach to European credit mostly thanks to the predictive nature of central banks' lending surveys, we do not share their optimism when it comes to pointing out the excess reserves in the US financial sector as a "mitigating" factor in 2016.

One might conclude that from a relative value perspective and in terms of "Rota Fortunae", investors would be better off being long European High Yield / Short US High Yield. European investors could favor as well US Investment Grade in the US, playing a continuation in the rise in the US dollar and also being less exposed to financial repression in Europe with negative yields rising in the European Government space (2 year German Schatz firmly in negative territory). The continuation of the "Dovish" tone of the ECB makes somewhat European High grade less appealing, but then again, the leverage in Europe is much lower. It seems you cannot have it both ways these days thanks to "diverging" monetary policies causing the "Rotae Fortunae" to spin in different directions.

Given the lateness in the credit cycle, which is much more advanced in the US, the fact as we pointed out that in the recent rally our "CCC Credit Canary" has underperformed in the High Yield bucket, does indicate to us that all is not well in the High Yield market to paraphrase yet again Shakespeare. Another clear illustration of the "CCC Credit Canary" playing out as well in Europe was also pointed out by Barclays in their 2016 defaults note:

"Stressed by default

Looking back over the past 12 months and looking ahead to next year, the default rate for European High Yield has been and will likely continue to be low. However, a cursory look at returns and spreads for the riskiest credit shows us that it is not merely the rate of default that impacts these bonds. A few high profile or unexpected blowups (Phones4U, New World Resources) drove a dramatic underperformance in CCC credit during the second half of 2014, while in 2015 insulation from larger macro risks (China, commodities), as well as the absence of any notable defaults have helped the impressive total returns for these bonds (Figure 11). 

Thus, the nature of defaults when they do occur, and how well prepared the market is for these events, can impact the high yield market much more than the pure default rate.
Further, spreads for these issuers have remained wide compared to last year, only recently moving inside levels seen after Phones4U defaulted (Figure 12).

The current reduction of secondary market liquidity increases mark-to-market risk for investors in lower-rated bonds even when default is not a true concern. Looking ahead, while continued monetary easing by the ECB should keep defaults muted, any increase in volatility will affect highly-leveraged issuers even more acutely than in the past." - source Barclays

Whether it is Phone4U bonds, Abengoa SA bonds (see our conversation "The Battle of Berezina"), Rolls Royce equities, Volkswagen and other recent stories, they all point out to the "overmedication" provided by central banks leading to significant large standard deviation moves described in our August conversation "Positive correlations and large Standard Deviation moves".

2015 is indeed a story of "sucker punches", in equities, credit FX (SNB move on CHF, China's summer surprise on Yuan devaluation), etc.

On a side note and given our credit inclinations, before we move on to our second point, please not the Russell Index is more positively correlated to Credit in the U.S (CDX IG in particular). should you feel an urge to look at a nice 2016 "short" trade if indeed we are in the late stage of the credit cycle in the US.

• What to expect from Le Chiffre (aka Mario Draghi) in December 

In our recent conversation on Le Chiffre aka Mario Draghi we indicated that in the movie Casino Royale, Bond knew he could beat Le Chiffre as he was confident that he would catch his tell and get an insight into his game and strategy (bluffs included). Given the growing divergence in monetary policies à la 2011 between the Fed and the ECB, we think it is important to remind us of the law of diminishing returns of QEs once more from our previous  "Bond" related conversation:

"In similar fashion to Liebig's law of the minimum, the law of diminishing return means that at some point, adding increasingly more fertilizer (liquidity via QE) improves the yield by less per unit of fertilizer (QE), and excessive quantities can even reduce the yield (check out 2 year Italian and Spanish government yields...)." - source Macronomics, October 2015

But, given that Le Chiffre is truly a poker prodigy, one should not underestimate is "bluffing" abilities and card tricks for December:

"If we were to conclude that our medium-term price stability objective is at risk, we would act by using all the instruments available within our mandate to ensure that an appropriate degree of monetary accommodation is maintained." - Mario Draghi

This is brings us to the current divergence between the Fed and the ECB as explained by Bank of America Merrill Lynch in their Ethanomics note from the 6th of November entitled Fedexodus which also explains how Le Chiffre has been honing his skills since disappointing markets on the 8th of December 2011 when everyone was expecting him to unleash a big "bazooka":

"The prospective policy divergence between the Fed and other central banks is modest by historic standards. For example, the Fed and ECB balance sheets are similar in size and the roughly 100 bp divergence in policy rates over the next year is not high by historic standards (Chart 3). 

Moreover, we disagree with the idea that policy easing by the ECB and other foreign central banks hurts the US economy. Unless the dollar reacts much more than normal, foreign central bank easing is a net positive for the US.

In the eventLet’s dig a little deeper and explain why a dovish ECB is good for the US. As we wrote last week, in standard model simulations a dovish European Central Bank hurts the US via a stronger dollar, but helps the US on net by stimulating other asset markets. In particular, ECB easing has two positive spillovers to the US. First, by stimulating European asset markets it boosts aggregate demand in Europe, boosting imports. Second, the rally in European asset markets stimulates US asset market, boosting US aggregate demand. On the other hand, the consensus view essentially assumes away all of these positive channels, leaving just the negative currency effect. Which story is correct?

Here we look at the empirical evidence using an “event study” approach. In particular, we look at the market response to seven major ECB announcements during the Draghi era (From November 2011 to present). If markets are efficient they should respond to policy makers when they signal policy changes, rather than wait for the actual policy to be implemented. If there is no other major news out on the day of the announcement, this gives a relatively clean test of how the markets read the ECB.

In our view, daily moves in the dollar and the European and US equity markets together give a good gauge of how news is digested.
• If dovish ECB moves are interpreted as a “currency war” that benefits Europe at the expense of the US, then the dollar should strengthen, European equities should rally and US equities should sell off. This is a negative sum game.
• If the dovish move is seen as a stimulus to global financial conditions then the dollar should rise slightly and both the European and US equity markets should rally. A rising tide of liquidity raises all ships.
• Finally, the markets could read the ECB action as inadequate and see the announcement as signal of economic weakness in Europe. In this case, European and US equities should fall and the Euro should weaken.

The results are compelling (Chart 4).

In none of the episodes was ECB policy viewed through the lens of a currency war. In all cases, the US and European equity markets rose or fell together. In six instances both equity markets celebrated the easing as a positive sign of more liquidity. On these days an average gain of 1.9% in the STOXX 600 index triggered a 1.4% gain in the S&P 500. In one episode, both equity markets were disappointed by the news. 

According to the Reuters, on December 8, 2011 the markets were expecting a big “bazooka” liquidity announcement and they were disappointed by both the small size of the new program and the downbeat commentary out of Draghi that day. Apparently, Draghi has learned his lesson and has been very good at delivering positive surprises to the markets ever since.

The market response is similar for smaller ECB announcements. On their website the ECB lists 11 other key event days. In 9 out of 11 days the European and US equity market moved in the same direction. There is no correlation between the dollar and US equities on these days: on 5 days they moved together, in 5 days they moved in opposite direction and on one day the dollar did not move.
Is the more recent period different? Actually, the strongest examples come from this year. Both dovish announcements in January and October have triggered a stronger dollar, yet in each case the US equity market has followed the lead of European equities, rallying 1.5% and 1.7% respectively on the day. Maybe the ECB is not the Fed’s enemy?" - source Bank of America Merrill Lynch

While we agree with Bank of America Merrill Lynch's take on Mario Draghi's being quick on the steep learning curve of central banking, we think their argument that stimulating European assets is boosting Aggregate Demand (AD) is dubious at best. In our conversation "Le Chiffre" we quoted Richard Koo on the impact of QE on the real economy:

"Central bank-supplied liquidity has nowhere to go without real economy borrowing." - Richard Koo

On the impact of QEs on the "real economy", it is a subject we already discussed at length in our November 2014 "Chekhov's gun":

"In relation to Europe, the decrease in imports and lower GDP means consumer have indeed less money to spend. We cannot see how QE in Europe on its own can offset the deflationary forces at play" - source Macronomics, November 2014

A clear indication of the "lack of borrowing" which could stimulate AD can be seen in the below Bank of America Merrill Lynch's graph from their Euro Area Economic Viewpoint from the 11th of November entitled "ECB after US payroll: it’s still about QE":

- source Bank of America Merrill Lynch

So what will Le Chiffre do in December? While some pundits argue that he might cut further the depo cut, we would have to agree with Bank of America Merrill Lynch Gilles Moec's take on the subject from the same note quoted above, namely that cutting further the depo cut would have unintended consequences given the on-going "Japanification" process in Europe and many Peripheral banks being still capital impaired from their NPL bloated balance sheet. It is still a story of deleveraging in Europe à la Japan:

"The ambiguous economics of a depo cut
For a large part of our client base - especially those located in the US where the Fed actually PAYS banks to keep excess reserves - the debate on the depo cut in Europe is probably quite arcane. Here is a somewhat pedestrian guide to this issue.
Let's start with a simplified version of a bank balance sheet. On the asset side, banks hold loans, bonds, foreign assets and claims on the central bank (their balance on their account at the CB, which usually exceeds their reserve requirements). On the liability side, they have to service capital, debt and borrowing from the central bank (what they took against collateral in CB refinancing). Quite simply, banks make money if the average return on assets exceeds the cost of their liabilities, or funding costs.
What usually happens if the interest rate the CB pays on the banks' reserves falls? Not much. It is normally accompanied by a drop in the interest rate paid by banks on its borrowing from the central bank, and banks can also take further steps to ensure that the drop in the average return on assets is matched by a drop in their overall cost of funding by taking down the rate they serve on their customers' deposits (they control that, not the IR on their debt).
Things do not work the same way when cutting the depo rate deeply in negative territory. Indeed, unless the CB also cut the refinancing rate, the "transformation margin", i.e. the difference between the rate of return on assets and the cost of funding, shrinks. Banks can try to mitigate this by taking further down the rate they pay on their customers' deposits, but there are downward rigidities when savers' remuneration is already close to zero.
Incidentally, this has wide-ranging distributional consequences. While large banks can offset the cost over a large and internationally diversified balance sheet (they may hold CB cash out of the jurisdictions where the deposit rate is negative) smaller banks struggle. This is reason why deep depo cuts are often "fudged" (i.e. apply only to a small fraction of deposits).
But the hope of the proponents of the depo cut is that banks will try to offset the deterioration in their transformation margin by re-allocating their assets towards those with a higher return (loans to the domestic private sector, or foreign assets). This would be positive from a macro point of view, boosting lending and/or depreciating the currency.
The problem with this is that all banks will do the same and compete for credit demand by taking their lending interest rates down. This will be a profitable operation for banks only if the increase in volume supersedes the drop in margins. QE initially worked through this channel: by reducing the interest rates on government bonds, it incentivised banks to re-allocate towards loans by reducing the lending rate. Still, at the time the average level of those retail rates was very high, and massive pent-up demand for loans could be tapped. Banks could re-allocate, and still find a more than decent margin on an expanding volume. And don't forget that contrary to reserves held at the CB and government bonds, enjoying a zero risk weight, loans entail a significant capital cost, so that one cannot easily compare the "facial" relative returns.
Interestingly, after a swift drop, margins have re-increased lately throughout the Euro area (Chart 2).

This may indicate that banks are less convinced that the interest rate on loans cover the risk that they are taking (NPLs remain high in large swathes of the region, especially after taking into account the capital charge).
If they are not convinced it makes any economic sense, banks are not forced to reallocate across assets. They can simply shrink their balance sheet. The easiest way to do this would be to redeem early the long term funding they took from the ECB through the TLTROs. This would defeat the ECB's purpose in offering lightly conditional cheap money to banks in exchange for more loan origination.
At the beginning of the year excess reserves in the Euro area stood at c.EUR200bn. It has now tripled to reach nearly EUR 600bn and will continue to rise in line with QE (to purchase bonds from banks the ECB credits their cash accounts). By September 2016 we could reach EUR1.2trn, and in our baseline this would continue as QE would be extended. A further cut in the deposit rate by 50 bps (towards Swiss levels) would thus cost banks c. EUR6bn per year. This would be equivalent to 0.25% of banks' capital and reserves (in the ECB definition). This is not entirely insignificant… Of course the ECB could mitigate the adverse effects on banks by lowering the entirety of the interest rate corridor. Taking the refi rate in negative territory as well, but while such move would probably be very powerful to lower the exchange rate, this would be a very controversial decision for the ECB from a political point of view.
In sum, operating via the deposit rate to try to force banks to lend more seems to us a very convoluted and not bullet-proof approach. Sometimes, simple is good. Rather than reducing the average rate of return on banks' assets, cutting the average cost of banks funding further could make more sense. This could be done for instance by extending by another year the TLTROs, or extend QE which will reduce the cost of debt issuance for banks for longer, by taking the long term risk-free reference interest rate (government bonds) down." - source Bank of America Merrill Lynch

Given the need for some weaker banking players to continue to strengthen their balance sheet , we could not agree more, a deposit cut would be a too costly decision. We would like to think that  we have caught Le Chiffre's physical tell (A tell in poker is a change in a player's behavior or demeanor that is claimed by some to give clues to that player's assessment of their hand) and that indeed, he will go towards the "easing" path of QE for longer while extending TLTROs. This will push further European government short terms yields into negative territory and will continue to represent a "Goldilocks" boon for European credit investors à  la Japan. Credit will therefore continue to perform at least until the end of the year. For 2016's Rota Fortuna and misfortunes, it's another story...particularly for EM corporates but we ramble again!

• Final chart - Emerging Markets bank lending conditions the tightest in 4 years

Will 2016 bring some suffer great misfortunes? We have highlighted the global tightening financial conditions (except Europe where overall financial conditions appear to be so far more "accommodative hence our positive relative value stance on European High Yield). Our final graph comes from Société Générale's Fixed Income Weekly note from the 5th of November entitled "Fade that sell-off" and displays EM bank lending conditions which are clearly indicative of upcoming deteriorating credit metrics and consequent headwinds for some:

"We see the EM rally as corrective and probably short lived. This is a position clean-up following the PBOC rate cut and signs (hopes?) of stabilisation in China. We have met a number of investors over the past two weeks, especially in Europe and Asia, expressing positive thoughts about recent Chinese data, e.g. rising home and land prices. This seems to have supported short covering. However we see the EM problems as structural, with the debt leverage accumulated over the past five years likely to prove a durable drag on growth. A recent IIF survey shows that EM bank lending conditions are the tightest they’ve been in nearly four years (Graph 4). Our credit and equity strategists and analysts focus on downside risks in a new cross-asset note: “What if EMs slow further?” Our fear in particular remains that 2016 may see a rise in EM bad loans, leading to a widening in EM hard currency corporate bond spreads and keeping the whole EM complex under stress. The sharp rise in leverage over the past five years is now starting to cause trouble, as fresh announcements from Standard Chartered suggest."

- source Société Générale

Whereas the 2015 Rota Fortunae has brought some great windfalls for some (European High Yield investors), some suffered great misfortune (EM), we think that, in 2016, EM is indeed set for additional pain and that indeed, the short covering rally in EM should be faded, unless of course the Fed decides to change its mind in the course of 2016 but that's another story...

"It seems to never occur to fools that merit and good fortune are closely united." - Johann Wolfgang von Goethe

Stay tuned!