"If you spend a week at a casino you will very easily see that people have a certain way of behaving in a casino." - Mads Mikkelsen, Danish actor (who played Le Chiffre in the recent Casino Royale).
- QEs and the law of diminishing returns
- Europe's "Japanification" process is still supportive of European credit
- Final chart - Bonds have been the only game in town when it comes to "over-allocation"
- QEs and the law of diminishing returns
"Credit standards on loans to companies eased for the sixth consecutive quarter, the ECB’s Bank Lending Survey showed on Tuesday. Terms for mortgages tightened, with banks citing national regulation as the primary cause. A small majority of lenders reported an increase in profitability over the past six months as a result of the central bank’s quantitative-easing program, though a deterioration is seen over the next two quarters." - source Bloomberg
"Growth in loans to the private sector slipped to 0.6 percent in September on a year ago, lower than August’s 1 percent rate and nowhere close to the near double-digit numbers clocked before the global financial crisis. Loans to non-financial corporations grew just 0.1 percent in September from 0.4 percent the month before, the first monthly slowdown since June 2014.That data also are at odds with ECB’s Bank Lending Survey findings released last week, which showed banks reported increasing demand for business loans." - source Reuters
"ECB President Mario Draghi last week signaled more easing is coming in December, and that has already become the consensus among economists.
But more than six months of QE – 60 billion euros of bond purchases in each – and years of cheap long-term cash auctioned by the ECB has so far yielded lacklustre results despite the extraordinary amount of stimulus along with interest rates at or below zero.
More stimulus will not necessarily give banks the incentive to start lending to businesses.
Instead, European banks are lending a lot for house purchases, which does not suggest there will be a spurt broader consumer prices, which the ECB targets.Consensus forecasts for euro zone inflation at the end of 2015, 2016 and 2017 have either stayed constant or been downgraded in each Reuters poll since May, even as it slipped back below zero last month." - source Reuters
"If domestic demand is indeed a flow variable, the big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think.
In textbook macroeconomics, an increase in AD can be triggered by increased consumption. In the mind of our "Generous Gamblers" (aka central bankers) an increase in consumer wealth (higher house prices, higher value of shares, the famous "wealth effect") should lead to a rise in AD.
Alternatively an increase in AD can be triggered by increased investment, given lower interest rates have made borrowing for investment cheaper, but this has not led to increase capacity or CAPEX investments which would increase economic growth thanks to increasing demand. On the contrary, lower interest rates have led to buybacks financed by cheap debt and speculation on a grand scale.
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
"QE doesn’t boost bank lending: I have two problems and one question. The first problem is economic: I can’t see how further ECB ‘QE’ can really help boost economic activity and specifically, how it can help boost loan growth. The second problem is a market one: I have no idea how to judge how far German Bund yields can fall as growth loses momentum and investors project zero (or negative) rates further onto the future and settle for less and less yield in their portfolios. The question, which I shall attempt to answer, is what that means for the Euro. Whatever else it means, of course, it isn’t good news.
The chart shows (In my opinion) the key part of the ECB’s monthly money supply release: the growth of loans, adjusted for securitisations. This slowed to an annual rate of just 0.4% in September, from 0.8% and from a recent peak of 1.4% in July. That’s a severe loss of momentum. I plotted it against the annual rate of change in the ECB’s balance sheet, although I could have plotted it against almost any other measure of QE and got the same answer – QE does not appear to be doing anything to boost loan growth in Europe.
We don’t know (what would have happened to bank lending or economic activity if the ECB hadn’t embarked on its bond-buying programme but ‘QE’ has supported peripheral bond markets, narrowing spreads and preventing a crisis of confidence, and it seems have supported equity and increasingly, property markets across Europe. But it hasn’t supported lending. QE + the shift to negative interest rates meanwhile, have as a combination weakened the Euro, which has hopefully helped exports (though a 9% year-to-date fall against the dollar is only a 5 ½% fall on a trade weighted basis).
"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."
"Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…).
“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?" - source Macronomics, November 2014
"Central bank-supplied liquidity has nowhere to go without real economy borrowingAs I have repeatedly pointed out, the central bank can supply as much base money (liquidity) as it wants simply by purchasing assets held by private-sector banks.But a private-sector bank cannot give away that liquidity, it must lend it to someone in the real economy for that liquidity to leave the banking sector." - Nomura, Richard Koo
"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)." - source Société Générale, December 2014 - MacronomicsIndeed, in December we expect Le Chiffre to get even bolder.
When it comes to Le Chiffre and QE, we would have to agree with Société Générale's Forex Weekly note from the 22nd of October, "QE is losing is Mojo" and so is Le Chiffre:
"Dubious QE impactThere’s a belief in the foreign exchange market that ‘QE’ - bond-buying by central banks - can continue to weaken currencies and boost asset prices, pretty much ad infinitum. This argument feels more and more dubious to me. In particular, I am doubtful that increased conventional QE (bond-buying) by the ECB or the BOJ will weaken the yen or the euro significantly further from their recent lows. Indeed, I’m not sure how much of the weakness in either currency to date can really be attributed to QE in the first place. I think we have learnt enough from the experiment in glowing central banks’ balance sheets to understand more about how this works in practise. The Fed went first and, by buying bonds, forced a portfolio switch on US investors, out of Treasuries and into more exotic assets, first into mortgages, then corporate bonds and then on into domestic equities and foreign assets. Up went the S&P500 and down went the dollar as outflows to EM grew. US QE was turbocharged by intervention to limit the rise of the ruble, real and perhaps most of all the renminbi
As central bank reserves grew across EM, which created more demand for Treasuries, magnifying the effect. And it also spilled over, through diversification, into demand for euros, Australian dollars and even sterling. I wouldn’t want to argue that Fed QE didn’t undermine the dollar. But what about BOJ and ECB action? Well, these moves weren’t turbo-charged in the same way, yet the yen and euro weakened. I put that down in large part to the other policies undertaken by these ‘excess saving’ central banks. The BOJ started with FX intervention after Mr Abe’s election and the next big phase of yen weakness came about as a result of a deliberate asset allocation switch into equities, including foreign equities by the public sector pension fund. The ECB generated euro weakness not through QE but later, when QE was compounded with negative interest rates in 2015. Driving yields down, on its own, isn’t always enough to persuade investors in savings-rich, low inflation countries to move money overseas - just look at the Swiss.
If conventional QE wasn’t what weakened the euro and yen as much as combining QE with other more potent policy adjustments, it seems to me wrong to assume that another simple round of QE by the ECB or BOJ will have much impact on the euro or yen in the coming days/weeks. Maybe there’s still an effect on peripheral bonds spreads in Europe, and perhaps on equities in both Europe and Japan. Or maybe, as in the UK, the most visible effect now will be on the property market. But in FX, perhaps not so much.
If words from the ECB and QQE from the BOJ this month fail to weaken the euro and the yen meaningfully, there’s a risk of the FX market adding two and two together and making four - concluding that QE ‘doesn’t work in FX’ and challenging the idea of a stronger dollar. EUR/USD at 1.20 and USD/JPY under 115 are not at all inconceivable outcomes this autumn. All it takes is for US Treasury yields to remain anchored." - source Société Générale
- Europe's "Japanification" process is still supportive of European credit
"As volatility of credit is much lower than equities, investors could have taken a suitable amount of leverage on credit to convert this into high absolute returns" - source NomuraBut, while Le Chiffre is promising some additional "unconventional" card tricks in December, the law of diminishing return means that as we are getting late in the credit game in the US, we could indeed have a spillover effect on European High Yield, should the Fed proceed with some form of normalization in December as expected by the markets following the latest FOMC statement.
When it comes to European High Yield, we would have to agree with Société Générale's take from their Credit Market Wrap up of today:
"Additionally, whatever (in)action the central bank takes today, the markets are likely to react one way or another. However, hike or no hike, we believe that the reality in Europe will remain largely the same. That means low inflation, poor economic growth, high unemployment and the need for more structural reforms and ongoing QE. In that environment, don’t expect corporates to start reckless releveraging processes any time soon, and that means, as we mentioned already this week, low to non-existent defaults and supportive credit metrics in general. The end result is a constant pressure on spreads to head tighter as credit, particularly HY, remains a more attractive alternative to other fixed income asset classes." - source Société GénéraleOnce more, Central Banks are indeed in the "driving seat" given the non-existing strong economic growth prospects, which makes this "Japanification" process "Goldilocks" period for "credit investors". Even more so in Europe if indeed Le Chiffre in December goes far more "unconventional and extending the already finite bond buying list of some Corporate issuers further. This would of course provide an additional "boost" to European credit. This was a well highlighted by Société Générale in their Credit Market Wrap up from the 25th of October entitled "Where did the defaults go?":
"Highlights: Credit yields are heading lower again, a trend that looks unstoppable for the coming months, even though they are much more attractive than equivalent sovereign bond yields. Still the upside of credit is again increasingly limited and the downside is growing. The good news is that spreads remain very wide by historical standards and compensate amply for the risk of defaults which are simply not happening.
The ECB continues to prepare the ground for an increase in its QE program, most likely for the duration of it (extending it well beyond next September), but we suspect for the size and scope as well with the central bank gearing up to buy non-financial corporates next year. But even if the ECB confines its purchases to sovereign bonds, the ultra-low yield environment (not just sovereigns but corporates too) is set to remain in place for a very long time. And that means that funding conditions for both governments and corporates will remain extremely attractive for the time being.
And we can already see some of the benefits of the favourable funding conditions. Coupons in IG of 1% are no longer rare, and only corporate hybrids offer 3%+. In HY, coupons can vary substantially depending on the rating but the average of new issues this year stands at 5.08% or 5.4% since the end of the summer. And this low funding, added to the ongoing disciplined approach to spending, means that defaults globally seem to be a negligible worry. As we can see in the chart below, it’s been around four years already with very low levels of defaults despite a very difficult recession and a very slow economic recovery.
In Europe there were only two defaults in September, Privatbank and Savings Bank of Ukraine, both Ukrainian banks, which is not too surprising given the situation in the country, and to a certain extent this pushes the European default rate higher than it should be under normal circumstances. Still, spreads continue to price in a higher level of defaults to come.
The iBoxx Corporates index is currently around B+157bp, better than where it ended September but still very wide compared to the current level of defaults. The iTraxx indices are a cleaner way to look at the pure credit risk which is in the end a reflection of the risk of default, given the greater liquidity in the synthetic contracts but even these continue to show a very high level of implied default rates. Currently, the iTraxx Main implies a default rate of 1.15% in a year’s time for IG which is excessive as the actual default rate remains at 0.0% and IG defaults tend to be very rare. The X-Over implied a default rate of 4.86% which also looks high versus current and forecast default levels.
Moody’s forecasts a speculative default rate of 3.2% in 12 months’ time, the highest forecast in a long time but even this is lower than what the X-Over is pricing. Furthermore, Moody’s universe is very broad and includes very vulnerable names (the two Ukrainian banks for instance), while the X-Over is made up of the 75 strongest names in the HY universe, companies that have easier access to the capital markets. Additionally, we believe funding conditions for corporates will remain very attractive throughout the life of the ECB’s QE as sovereign yields remain ultra low (and are probably falling) with spreads tightening gently in the coming months. With the economy growing even at a slow pace, it is difficult to see a wave of defaults on the way." - source Société GénéraleWhat of course could but a "spanner" in the current "overconfidence" in Le Chiffre's ability in driving further "credit" into "overtime" for us are two factors, first one being a Fed December normalization process when liquidity will be very thin, second factor is that the EPS momentum continues to slump. As per our conclusion of last week's conversation, companies overall remain extremely sensitive to revised guidance and earnings outlook. This was clearly illustrated in an another interesting note from Société Générale from their Global Equity Market Arithmetic series from the 26th of October entitled "While equities celebrate central bank actions, EPS momentum continues to slump":
- Global equity markets continued their resurgence with the MSCI World up 1.4% last week, up over 10% from the recent lows. Interest rate cuts from the PBOC and dovish comments from the ECB pointed to a continuing downward trend in global interest rates.
- The ECB's words undoubtedly had the intended effect of weakening the euro and as such, in local currency terms, it was the eurozone equity markets that were the better performers last week with the MSCI Eurozone index up 4.6% and the DAX gaining 6.8%. The DAX has rebounded strongly from the correction, having bounced back 14%, but it is still 8.0% off this year's high. With the Eurozone and Chinese central banks having made their intentions clear, all eyes will no doubt shift to Japan.
- Away from the central banks, the US reporting is in full swing and there have been some impressive price moves, particularly in the large cap tech stocks, in response to positive earnings surprises. The message remains the same though, revenues are disappointing and despite some Herculean efforts to deliver EPS surprises, US earnings momentum is awful, with 70% of all revisions to 2016 numbers coming through as downgrades. Interestingly European and Japan EPS momentum is suffering the same fate, with the direction firmly negative. Only Emerging Markets and Pacific ex Japan are seeing a rebound from lows.
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!
Finally, for our final chart, we would like to point out that both the Fed and Le Chiffre have been great benefactors to bond speculators who continue to have a field day. Bonds have been the only game in town when it comes to "over-allocation".
- Final chart - Bonds have been the only game in town when it comes to "over-allocation"
But of course there is a caveat to the Fed and Le Chiffre "overplaying" it in this monumental poker game. On that specific matter we will simply quote again Antal Fekete from our July 2014 conversation entitled "Perpetual Motion":
While Le Chiffre is indeed in the process of trying to mesmerize us once more in December with his astute poker abilities, if bond investors continue to observe Le Chiffre, they will at some point find out his 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)."Moving back to the important notion of the difference between stocks and flows we do agree with Antal Fekete's take in May 2010 in his article "Hyperinflation or Hyperdeflation" being akin to a Black Hole and the possibility of capital being destroyed thanks to ZIRP (as it is mis-allocated towards speculative endeavors) hence the risk of pushing too far the "Perpetual Motion" experience":
"Obviously, you need a theory to explain what is happening other than the QTM. I have offered such a theory. I have called it the Black Hole of Zero Interest. When the Federal Reserve (the Fed) is pushing the rate of interest down to zero (insofar as it needs pushing), wholesale destruction of capital is taking place unobtrusively but none the less effectively. Deflation is the measure of wealth in the process of self-destruction -- wealth gone for good. The Fed is pouring oil on the fire as it is trying to push long-term rates down after it has succeeded in pushing short term rates to zero. It merely makes more wealth self-destruct, and it makes the pull of the Black Hole irresistible.But why is it that the inordinate money creation by the Fed is having no lasting effect on prices? It is because the Fed can create all the money it wants, but it cannot command it to flow uphill. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day. Their bets are on the house: if they lose, the losses will be picked up by the public purse. But why does the Fed under-write the losses of the bond speculators? What we see is a gigantic Ponzi scheme. The Treasury issues the bonds by the trillions, and promises huge risk-free profits to the bond speculators in order to induce them to buy. Most speculators believe that the Treasury is not bluffing and they buy. Some may believe that the Fed is falsecarding doubts and they sell. But every time they do they only see foregone profits. What we have here is a rare symbiotic relation between the government and the speculators." - Antal Fekete
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). This is what happens at the end!
Why? Because Le Chiffre used to place his left hand near his wounded eye at times during play. That was his physical tell. It ended up very badly for Le Chiffre but that's another story...
"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up." - F. Scott FitzgeraldStay tuned!