Tuesday, 15 December 2015

Macro and Credit - Charles' law

"There is no such thing as talent. There is pressure." - Alfred Adler, Austrian psychologist

Watching with interest the demise of some Distressed/High Yield funds thanks to "price action" and "low liquidity", with continuous pressure as well on some other asset classes in true "Risk-Off" fashion, we reminded ourselves for this week's title analogy of Charles' law, or the law of volumes. Charles' law simply states that a gas tends to expand when heat is applied to it. This law was published in 1802 by French chemist Joseph Louis Gay-Lussac, who credited Jacques Charles for all his work on the subject. Jacques Charles was a French scientist and inventor whose most notable work came during the late 18th century. Charles was presumably the first to discover that hydrogen could be used as a lifting agent in balloons. More recently, central bankers discovered that liquidity injections could be used as a lifting agent in "asset prices" ("Cantillon Effects"). In similar fashion, in our "macro" world, credit spreads "expand" (widen) when heat is applied to it. In physics, when the combustion starts, it is difficult to stop, same happens in credit and macro, when the credit cycle is turning, leading as well to "capital outflows" and surge in yields. When it comes to lifting agent, balloons, and combustion, we remember what happened to the LD129 Zeppelin Hindenburg on the 6th of May 1937 but, that's another story...

In this week's conversation, we would like to look at the continuous effect of positive correlations and large standard deviations move we discussed in August. Given the rise in volatility, we will also look at why we think "volatility" is the asset class to own as we move towards 2016 and the gradual erosion of central banks' credibility in 2016.

  • The opportunities in unprecedented turbulences
  • "Negative carry" - Central banks' credibility is effectively suffering from "time decay"
  • Final chart - CNY weakness is likely to de-anchor Asia ex-Japan (AxJ) currencies
  • The opportunities in unprecedented turbulences
As we posited back in August, rising positive correlations due to the intervention of our "generous gamblers" aka "omnipotent" central bankers have led to significant rising "instability" à la Minsky. We argued at the time:
"There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis." - source Macronomics, August 2014
And we concluded:
"Expect more violent moves going forward as a consequence. For us, there is no "Great Rotation" there are only "Great Correlations"..." - source Macronomics, August 2014
The 3rd of December was a good illustration of the "instability" due to rising "positive correlations" which inflicted havoc on "balanced fund". Below are two charts illustrating the large standard deviations move in Europe following the ECB - graph source Bloomberg:

German 10 year Bund:
- Graph source Bloomberg

To illustrate further our prognosis of "rising instability" à la Charles' law, we read with interest Bank of America Merrill Lynch's take in their Global Equity Derivatives Outlook for 2016 published on the 9th of December:
"As we highlighted in our 2015 outlook, the most distinguishing feature of markets today is not the general trend in volatility, but the unprecedented turbulence.
Rising fragility; moving deeper into uncharted waters
In 2016 we expect volatility to maintain its gradual upward trend, however, to continue to be punctuated with violent but short-lived shocks owing to poor liquidity, extreme positioning and a market still heavily manipulated by (and dependent on) the central bank put. Despite below-normal levels of volatility across asset classes, we are in uncharted waters in terms of a lack of stability: 
• Markets are setting records in terms of jumping from calm to stressed & back
• Our indicator of cross-asset market fragility is near its highs (Chart 1)
• CB liquidity is tightening, making markets more accident prone (Chart 7)
Asset managers are struggling, with the poorest hedge fund performance relative to the risk they are taking since 2008, despite overall market volatility being only 1/4th of 2008 levels. Their poor performance is better explained by the extreme levels of market fragility, which by our metric is at 80% of its 2008 highs (Chart 1 above).
Unfortunately, we don’t see conditions improving and only becoming more acute as liquidity continues to deteriorate, asset valuations become increasingly stretched, and the Fed navigates the unwind of the greatest policy experiment in history. " - source Bank of America Merrill Lynch
We don't see conditions improving either in 2016 and last Monday was once again an illustration of "Blue Monday" in the works we think. With liquidity deteriorating and hydrogen having been used by our "generous gamblers" as a lifting agent in  "asset balloons", there is indeed no surprises in seeing a significant rise in idiosyncratic risk leading to significant price movements. 2015 saw an increase in the number of "sucker punches" inflicted to the "cross-asset" crowd. By no means 2016 is going to be different.

When it comes to High Yield's jitters, we have long seen it building up as we carefully studied the credit cycle, it doesn't come to us as a surprise. As a reminder, this is what we have repeated in numerous conversations:
"The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield spaceIn the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..."
But, from a short term tactical "contrarian" perspective, we are seeing in US High Yield and Equity / Credit volatility some early signs of "capitulation" (volumes, implied volatilities for ETFs) which, would make for the "adventurous" punter some interesting entry point, to play a short term rally in the making.

Following Friday's move, we have noticed a multiple of "alarmist articles/headlines" from various pundits which have been late to the "party" on the matter of US credit. We believe it is a short term contrarian sign from our behavioral psychologist mantra, given we prefer to focus on the process rather than the content. For instance, we are seeing real signs of capitulation, via flows and implied volatilities on listed options on both principal liquid ETFs.

Volumes for iShare HYG:
- graph source Bloomberg

Implied Volatility 3 months HYG US:
- graph source Bloomberg

Spread volatility Russel / volatility HYG : 
It represents some good entry points for a tactical short term long/short strategy. The implied volatility on credit is trading on comparable levels with "mid-cap" equity volatility.  We believe it is an interesting "capital structure trade" that warrants attention, either from a "directional" perspective (selling straight "Put" options on HYG / buying straight "Put" options on RTY/SPX) or through a "pure" volatility strategy. 

In fact as we were typing this very post, we noticed a rebound on the aforementioned HYG. To paraphrase our November 2015 conversation "Ship of Fools", this time around on HYG we remain tactically short-term "Keynesian" bullish but, remain long term "Austrian" bearish given the lateness in the US credit cycle.

More and more in 2016, we believe there will be many opportunities in unprecedented turbulences movements we have seen so far in 2015. 2016 will be a year in which "tactical" global macro "convexity" trades such as the one highlighted above will be plentiful. Volatility will therefore be one of the core asset class to own, in various "cross-assets" (FX, rates, commodities, credit, etc.). On that point we agree with Bank of America Merrill Lynch's take from their latest Global Equity Derivatives Outlook:
"Successfully trading a less stable worldWhile many are struggling with this new market dynamic, we believe there are smart ways to combat it – and even profit – by monitoring cross-asset risk, and taking advantage of the inflection point in asset correlations. For example:• Gaps in cross-asset volatility can aid in differentiating between “local” and global risks, to determine when to fade the market or add a hedge• Shocks create entry points for cross-asset RV between leader and laggard assets which has been successful in generating alpha• Risks implied by derivatives, including correlation, often are unlikely to realize as stress unfolds, allowing for cheap directional trades• Cheaper hedges can be constructed by harvesting underpriced volatility through proxy puts overlaid on standard put spreads• Strategies that collect the volatility risk premium, for example through call overwriting, while dynamically managing these risks can add alpha" - source Bank of America Merrill Lynch
Although "volatility" is a "negative carry" proposal, the events of the 3rd of December on the German Bund following the ECB, which were close to a 7 standard deviation move, have shown how quickly your "carry" can be wiped out. But, as liquidity is being drained by the Fed and given the increasing signs of global financing conditions tightening, if the "trend" is your "friend", then we are bound to see a surge in volatility in 2016. This trend is pointed in the same report from Bank of America Merrill Lynch:
"A trend of rising vol as liquidity drains
Our Economics of Volatility1 framework has been anticipating the 2015 starting point to a turn in volatility for the last two years2. From here on we expect to see a rising trend in equity volatility levels, a trend that could last 1-2 years, transporting us from the low volatility regime of the last 3 years towards a sustained high volatility regime.
Our expectation for a turn in the volatility cycle follows from a clear turn higher in 5Yr real rates in 2013, and allows for a 2-year lag (Chart 6).  
High volatility regimes may resemble periods like 1998-2003 or 2008-2011, as two examples. Transition periods can also take various forms. Unlike the 1996-1998 transition period which was gradual and well behaved, the 2008-2009 transition was short and violent, as a suppressed and overdue re-pricing of risk finally manifested itself. It’s hard to predict the exact form the next transition will take. While our base case is for an orderly transition, we are wary of the possibility of unpleasant surprises resulting from an unwinding of the highly unusual monetary policy of the last 7 years.
Unwinding extreme easy monetary policy is a tightening
The monetary tightening cycle which started with the 2013 taper has continued its progress, reflected in rising 5yr real rates. This in turn has driven a significant tightening in global liquidity as capital flows from developed to emerging markets start to reverse, evidenced in a slowdown and reversal of FX reserve accumulation."
Tightening liquidity combined with fragility: equity markets are accident proneChart 7 (earlier in our post) shows a measure of global US$ liquidity derived from the momentum of the Fed’s balance sheet. Historically we see that tightening cycles have typically started at high liquidity levels. The current cycle in fact started in anticipation of the tapering of the open-ended QE3 program in 2013, with the impact evident in the sharp turn in the 5Yr TIPs rate (Chart 6), and the subsequent fall in US$ liquidity. Given how far liquidity has already dropped, it is going to be interesting to watch the impact of the more traditional part of the tightening cycle – actual rate hikes – which are expected to start imminently. Combined with our view of an increased likelihood of local shocks due to deteriorating trading liquidity, we may find the markets more accident prone in 2016 than they have been in some time. "- source Bank of America Merrill Lynch

This "reversal" of capital flows in Emerging Markets is exactly the manifestation of our "reverse osmosis" macro theory playing out we think. As a reminder from our August 2013 conversation "Osmotic pressure":
"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - source Macronomics
Of course as the Fed is on the "normalization" path as anticipated by market participants, stemming capital flows will continue to be increasingly difficult, particularly for the hard hit commodity players and as well China, trying to "deflate" its "hydrogen fueled "credit" balloon.

Whereas volatility is a "negative carry" proposal, so is central banks' credibility which is effectively suffering from "time decay" we think. 2015 has already shown the weak hand for some of the central banks "punters" such as the SNB and the PBOC losing its cool during the summer. "Le Chiffre", aka Mario Draghi, as well, our "poker prodigy" has shown some weakness in his "bluffing" abilities as of late. We wonder if 2016 will not see further "erosion" in their "ability" to steer markets. This brings us to our second point.

  • "Negative carry" - Central banks' credibility is effectively suffering from "time decay"
Whereas "volatility" is a "negative carry" proposal" as posited earlier one, as we move towards 2016, it remains clear to us that 2015 saw many players at the "poker" table fold earlier (such as the SNB). On the 3rd of December, our "Le Chiffre" bluffing abilities suffered as well at the "poker table." As we move towards 2016, we are wondering wether 2016 will see additional weaknesses from our powerful "omnipotent" central bankers. For sure, we think their abilities will be tested even further, given the high deflationary forces at play, particularly with the further weakening of the CNY/Yuan, which will represent yet an additional "headache" for our enduring "gamblers".

On that subject, once more, Bank of America Merrill Lynch's 2016 Global Equity Derivatives Outlook makes some very interesting remarks relating to the "weakening" of the global markets "Central banks Put":
"Power of CB put shows risk of its lossCentral banks have had a tremendous impact on financial markets in the last seven years, which is never more apparent than when looking at the world through the volatility lens. As shown in Chart 12, cross-asset volatility reached all-time lows in the summer of 2014, falling even below the 2007 pre-GFC bubble lows, crushed under the weight of unprecedented monetary policy (or in the ECB case, the promise of policy). This is remarkable considering the size of the risk “bubble” created pre-GFC.
The result is that risk is not fairly priced based on fundamentals but rather is better explained by investors not wanting to stand in front of central banks as they embark on QE. As Chart 13 shows, when decomposing the 41 factors of risk covering 5 asset classes from our GFSI index into regions, both Europe and Japan (the two regions still actively engaging in QE) are the two regions with the most depressed price of risk.
This is despite being the two developed regions with some of the greatest fundamental risk.
Unprecedented CB – market co-dependenceCentral banks have never been more sensitive to financial market conditions as they are today. This hyper-sensitive reaction function has placed huge downward pressure on volatility, and has accentuated local shock behavior as investors have become accustomed to CBs verbally supporting the market at very low levels of stress compared to the past.
In the last three instances when our GFSI critical stress signal has triggered, during the taper tantrum in June 2013, the Oct 2014 growth tantrum, and the Aug 2015 China tantrum, central banks have stepped in to verbally support the market (Chart 14). 
In each case central banks have reversed market stress, creating a string of three false signals, which is historically unusual. From 2000-2012, the GFSI’s critical stress signal triggered 15 times, 12 of which resulted in a further escalation of risk and a pull-back in global equities of at least 5%. This illustrates the extent to which central banks have essentially capped risk at levels where it historically was likely to spill over. 
This has self-reinforced a “buy-the-dip” mentality which, together with the fact that investors have generally been underweight US equities this year, has caused the S&P to record larger returns on days the market was rising than when it was falling. Combined with the fact the S&P fell more days than it rose YTD but the market overall was up makes this historically unusual, occurring only 5 other years since 1928.
Pulling the safety net away will be riskyArguably one of the reasons central banks have been so sensitive to market risk is that they are fearful of a negative wealth effect resulting from a financial market sell-off hurting the real-economy, given they have little monetary ammunition left. Keeping rates low to avoid the rising costs of record high debt burdens could also be a motive. 
The US Fed’s fear was made particularly clear by Yellen’s decision to not hike in September, citing the sell-off in equities and China weakness, at a time when the S&P
500 was only about 10% below all-time highs. 
However, the challenge will be to remove this safety net given how dependent the market has become. And once the Fed begins its hiking cycle, it may be implicitly less able to provide the support for fear of being seen as making a policy mistake. This reduced power of the CB put will only help increase market fragility.
Central bank’s risk manipulation well explains local tails
A good way to explain why we have seen local tail risks arise so frequently since central banks began to heavily manipulate asset prices is with the following analogy, illustrated in Exhibit 1.
Essentially central banks, by unfairly inflating asset prices have compressed risk like a spring to unfairly tight levels. Unfortunately, the market is aware the price of risk is not correct, but they can’t fight it, and everyone is forced to crowd into the same trade. By manipulating markets they have also reduced investors’ inherent conviction by rendering fundamentals less relevant.
This then creates a highly unstable (fragile) situation that breaks violently when a sufficient catalyst causes risk to rise – overly crowded positioning meets a market with little conviction.
Catalysts can range from a “valuation scare” similar to Oct-14 or Aug-15 to a prominent investor stating that assets (e.g. bunds) are not fairly priced and are the “short of the century”. 
The unwinds from these crowded positions are violent, but almost equally violent in some cases are the reversals, which are driven from investors crowding back in when they realize central banks are still there providing protection. 
From this vantage point, it becomes clear that the biggest visible risk to financial markets is a loss of confidence in this omnipotent CB put." - source Bank of America Merrill Lynch
Exactly, 2016, will be all about "risk-reversal" trades. Given the extreme positioning and crowded positions in some asset classes, we expect to see much more "risk-reversal" pain trades aka "sucker punches" being delivered in 2016. From a global "macro" convex positioning, there are already many cheap "convex" overcrowded consensus trades, such as "short gold", "short oil", to name a few. From an "opportunistic approach, there is potentially tremendous "upside" in taking the opposite view via the option markets on various asset classes we think. 

Indeed, the "omnipotent CB put", that's why "Theta" is always "negative". Same goes with central banks' credibility. Whereas up until now, to be fair, thanks to the "omnipotent CB put", options sellers experienced lots of small wins, while getting lulled into a false sense of success and "security", in 2016 they might eventually suddenly find their profits (and possibly worse) obliterated in one ugly move against them as we pointed out in our previous conversation when using our "Cinderella's golden carriage" analogy. 

What would most likely dent even further "central banks' credibility" in general and the Fed in particular is indeed the biggest "deflationary" threat coming from China with a continuous "stealth devaluation" of its currency. This would indeed send a very strong "deflationary" impulse to Developed Markets (DM) and represents a major headwind for our "generous gamblers" as per our final chart.

  • Final chart - CNY weakness is likely to de-anchor Asia ex-Japan (AxJ) currencies
We believe that a steady grind lower in Yuan/CNY will occur in 2016, this will put additional pressure on the rest of the world and won't be enough to counter "capital outflows" in China. This we think is a "big risk" for 2016 and amounts in effect to Charles' law playing out. On this subject, we would like to point out Société Générale's take from their Fixed Income Weekly note from the 10th of December entitled "EM deleveraging":
"CNY weakness is likely to de-anchor Asia ex-Japan (AxJ) currencies, creating a disinflationary shock in developed economies – bullish for bonds. ADXY is threatening to break YTD lows (Graph 3).  
Our Asian strategists warn that a currency war induced by CNY depreciation may take either a direct form, with policymakers trying to match CNY weakness, or an indirect one, with investors shorting Asian currencies as a proxy trade. If the depreciation in the CNY accelerates or volatility increases significantly, the risk is a destabilisation of the entire EM currency complex: an example of the butterfly effect we refer to in our 2016 FI Outlook.
When the PBoC fights excessive weakness to discourage capital outflows, it is a seller of bonds, especially Treasuries. However, the recent bout of CNY weakness has not seen any particular pressure on Treasury yields or USD swap spreads. If anything, the latter have recently recovered. That suggests lighter PBoC intervention, which might support the idea that it will be less proactive now that the IMF has given the green light on CNY inclusion to SDR." - source Société Générale
Finally, when it comes to Charles' law and our "reverse osmosis" macro theory and capital outflows from China, we would like to point out towards JP Morgan's chart below from their "China: Devaluation in 2016 - the why, the how and when it will occur" note from the 9th of December:
"Capital outflows will persist and will become an increasingly important driver of currency weakness. Capital outflows will persist for two reasons: firstly, growth headwinds are unlikely to dissipate, which, as chart 3 below highlights, should correlate well with further capital outflows.

The second factor will be continued corporate unwinding of dollar liabilities (we estimate another $400bn dollar liability needs to be deleveraged after recent rise of corporate hedging)" - source JP Morgan.
One thing for sure and as far as Charles' law is concern, in our "macro" driven world, trouble "expand" (widen) when heat is applied to it. Trouble will indeed expand to Asia, should the pressure on ADXY continues, rest assured.
"There are plenty of recommendations on how to get out of trouble cheaply and fast. Most of them come down to this: Deny your responsibility."- Lyndon B. Johnson, US President
Stay tuned!

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