"When dealing with people, remember you are not dealing with creatures of logic, but creatures of emotion." - Dale Carnegie, American writer
This might be a good way to think about CBs and their presumed or real abilities"
"The idea of common knowledge is often introduced by some variant of the following puzzle:
On an island, there are k people who have blue eyes, and the rest of the people have green eyes. At the start of the puzzle, no one on the island ever knows their own eye color. By rule, if a person on the island ever discovers they have blue eyes, that person must leave the island at dawn; anyone not making such a discovery always sleeps until after dawn. On the island, each person knows every other person's eye color, there are no reflective surfaces, and there is no discussion of eye color.
At some point, an outsider comes to the island, calls together all the people on the island, and makes the following public announcement: "At least one of you has blue eyes". The outsider, furthermore, is known by all to be truthful, and all know that all know this, and so on: it is common knowledge that he is truthful, and thus it becomes common knowledge that there is at least one islander who has blue eyes. The problem: assuming all persons on the island are completely logical and that this too is common knowledge, what is the eventual outcome?
The answer is that, on the kth midnight after the announcement, all the blue-eyed people will leave the island." - source Wikipedia: Game of Common Knowledge
"Emerging market economies may be facing tighter liquidity conditions as cross-border lending to emerging economies, especially China, shrank in the third quarter of 2015 and U.S. dollar borrowing by non-bank companies in those economies was flat for the first time since 2009, according to the Bank for International Settlements (BIS).The BIS, furthermore, is known by all to be truthful, and all know that all know this, and so on: it is common knowledge that it is truthful, and thus it becomes common knowledge that there is at least one "islander" who has a credit crisis on his hands.
BIS General Manager Jaime Caruana said global liquidity – a term that captures the ease of financing in global financial markets – shows that the stock of U.S. dollar-denominated debt of non-bank borrowers outside the U.S. was unchanged at $9.8 trillion from June to September and dollar borrowing by non-banks in emerging economies also was steady at $3.3 trillion.
An even clearer sign that global liquidity conditions for emerging markets may have peaked comes from a decline in cross-border lending to China, Brazil, India, Russia and South Africa. In the third quarter of last year lending shrank by $38 billion to $824 billion from the second quarter, Caruana said in a speech at the London School of Economics (LSE)." - source Reuters, Emerging markets may be facing tighter liquidity – BIS, 5th of February 2016"
So dear readers, the problem is as follows, assuming all the central bankers on the island are completely logical and that this too is common knowledge, what is the eventual outcome?
For us it is very simple, a liquidity crisis always leads to a financial crisis.
And this, dear readers is unfortunately "Common knowledge" and will nonetheless be the outcome because knowing that everyone knows does make a difference. When the BIS public announcement (a fact already known to all) becomes common knowledge, the central bankers having a credit crisis on their hands on their island eventually deduce their status but we ramble again...
On a side note we touched on central bankers and their "deity" status "Omnipotence Paradox" back in November 2012:
"A deity is able to do anything that is in accord with its own nature (thus, for instance, if it is a logical consequence of a deity's nature that what it speaks is truth, then it is not able to lie)."Therefore the concept of "Common knowledge" is central in game theory.
If a deity status is only attained if it is not able to lie (SNB, BOJ, ECB, FED...) then central bankers are not omnipotent except the BIS...
"The "unintended consequences" of the zero rate boundaries being tackled by our "omnipotent" central banks "deities" is that capital is no longer being deployed but destroyed (buy-backs being a good indicator of the lack of investment perspectives)."And in October 2014 in our conversation "Pascal's Wager" we argued:
"Pascal's wager was devised by 17th century French philosopher, mathematician and physicist Blaise Pascal (1623-1662). It posits that humans all bet with their lives either that God exists or not. In the investment world, we think investors are betting with their "life savings" that central bankers are either gods or not.
Pascal's Wager is of great importance and was groundbreaking at the time because it charted new territory in probability theory, making the first use of decision theory.
Pascal's Wager in the form of a decision matrix:
The only "rational" explanation coming from the impressive surge in stock prices courtesy of QEs and monetary base expansion has been to choose (B), belief that indeed, our central bankers are "Gods"." - source Macronomics, October 2014.
In this week's conversation, we will again look at the debilitation of the credit markets and what it entails according to the BIS "deity" and the central bankers islanders and the implications for "risk assets".
- Instability risk and large standard deviation moves - Rising positive correlations are a cause for great concern and so is the denial on the state of US growth
- Credit - the liquidity canary, willingness to lend and the credit cycle
- Final chart - The Bank of Japan is a Black Hole for JGBs
- Instability risk and large standard deviation moves - Rising positive correlations are a cause for great concern and so is the denial on state of US growth
"Cushing's syndrome" aka central banking "overmedication" leads to a rise in "positive correlations. There is a growing systemic risk posed by rising "positive correlations.
Since the GFC (Great Financial Crisis), as indicated by the IMF in their latest Financial Stability report, correlations have been getting more positive which, is a cause for concern:
- source IMF, April 2015
This "overmedication" thanks to central banks meddling with interest rates level is leading to what we are seeing in terms of volatility and "positive correlations", where the only "safe haven" left it seems, is cash given than in the latest market turmoil, bond prices and equities are all moving in concert.
Regardless of their "overstated" godly status, central bankers are still at the mercy of macro factors and credit (hence the title of our blog). The correlation between macro variables (eg, bund yields, FX and oil) and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market." - source Macronomics, August 2015.
This rising instability risk we discussed previously can be once more ascertained by the rise in correlations across asset classes such as Chinese equities and selected asset classes as well as with oil prices, which are all well above averages as shown in the below charts from IIF:
- source IIFWe told you at the end of 2015, that, 2016 would be a year of high "risk reversal" opportunities. The large move experienced as of late such as the one seen this week in the US dollar are clearly an indication of the brewing instability in financial markets (not that you haven't been warned on numerous occasions on this very blog). These "sucker punches" should not come as a surprise. The herd mentality has made various exposures crowded trades, with very poor risk reward after all, as pointed out by our Rcube friends in their November guest post "US Equity / Credit Divergence: A Warning":
"Everyone is expecting higher equities due to lower yields and depressed food and energy prices. But when everyone is thinking alike, no one is really thinking…."As contrarian investors we don’t like sitting with the crowd. The fact that a long dollar was too consensual, was to us a serious "red flag". Also, our fears that the raging currency war would clearly escalate (thank you Bank of Japan) shows that it has had a bigger impact on the Fed’s reaction function than people were thinking.
Under the zero lower bound (ZLB), monetary policy isn’t just about the price of money, but also its quantity. This is what we pointed out in December 2014 in our conversation "The QE MacGuffin":
"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." - source Macronomics, December 2014While in early 2015, we tactically booked our profits on our long duration exposure, as we have told you end of 2015, following the December FOMC we not only re-entered our tactical long duration exposure, but, we also added started adding on our "Gold Miners" exposure.
"If the policy compass is spinning and there’s no way to predict how central banks 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 central banks, the option-value of both gold and bonds goes up."
Long dated US government bonds from a carry and roll-down perspective continue to be enticing at current levels compared to the "unattractiveness" of the mighty German 10 year bund indicating a clear "japanification" process in Europe. By the way if you are a "credit investor, you sure want to be "duration" hedged in Europe and probably less so in the US...
Also, what we find of "instability" as of late and in response to the "bullish recovery" crowd we would like to point out towards the evident fragility of the "Consumer Discretionary" complex. Because if you want to talk about the "quality" of jobs created in the US and their consumer discretionary potential here is a chart we have built our from the Bureau of Labor Statistics (BLS) that tells it all, depicting the Employment Status by educational attainment:
- source Macronomics / BLSAnd if you think this doesn't represent a "headwind" for consumer discretionary, we could as well point out from a "Common knowledge" perspective, the situation relation Food Stamps:
- source Macronomics / Bloomberg.The American economy is doing so well that it can subsidies for free 45 million of Americans (14.24% of the population)...
In this context, the price action aka "sucker punchers on two bellwether "Consumer Discretionary" stocks namely Royal Caribbean on the 4th of February and Ralph Lauren are clearly indicative of the global mood in the consumer discretionary sector we think (it is not only in dwindling Rolex sales in Hong Kong):
"Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data." So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you."
- Credit - the liquidity canary, willingness to lend and the credit cycle
When it comes to forecasting the default trajectory and in particular when one wants to assess the vulnerability of High Yield, we have pointed out that willingness to lend is paramount when it comes to the state of the credit cycle. On that particular subject we read with interest Bank of America Merrill Lynch's Securitization Weekly note from the 5th of February:
"Willingness to lend and the credit cycle
This week’s Senior Loan Officer Survey Report from the Fed for January (Chart 13) showed that lenders have gotten the message from capital markets: C&I and CRE credit is tightening on a net basis (8.2% and 5.6% of respondents, respectively).
It is noteworthy to us that the most closely related sectors, CLOs and CMBS, are those that are facing risk retention deadlines at the end of this year. As a reminder, the primary purpose of risk retention rules is to ensure that originators of loans are on the hook for the risk of the loans they originate. It may be too early to make the connection between the willingness to lend data and risk retention deadlines, but it seems fair to say that as the deadline draws closer, lenders are likely to further tighten lending standards, as they will own the risk. It is also noteworthy that the one sector exempt from risk retention rules, GSE mortgages, shows a fairly large number of respondents (-14.3%) that are loosening credit. We can see that this trend will be observed by investors in the risk transfer space and likely cause them to demand additional spread compensation for credit risk going forward. Credit card lending has not quite tightened yet (-1.9%), but it is getting close. GSE mortgages are the clear outlier on this chart.
We also layer on top of Chart 13 the high yield loan default cycle. Not surprisingly, tightening C&I and CRE credit has either coincided with (early 2000s) or led (2008-2009) a loan default cycle. The amount of tightening observed to date has been fairly minimal compared to the prior cycles. Nonetheless, if Liquidity Stress and credit market spreads continue in the direction they have been heading (higher), then more credit tightening and a more pronounced default cycle seem likely in the not too distant future.
Much should be revealed on this front over the next 1-2 months. Will some policy “fix” to liquidity stress be delivered, or will there be a disorderly move higher in liquidity stress? We shall see." - source Bank of America Merrill LynchAs we pointed out in our introduction, liquidity crisis always lead to financial crisis, and yes, dear readers, credit always lead equities. When it comes to assessing "liquidity" risk, which we highlighted in our previous conversation, we think the situation is clearly pointing out to some deterioration. This is as well highlighted again in Bank of America Merrill Lynch we quoted as well in our previous conversation. We are indeed on the same page and share "Common knowledge":
"Liquidity stress: the canary in the coalmine
Last week (“Things are bad, at risk of getting worse”), we discussed the BofAML Global Financial Stress Index (GFSI, Chart 1), noting that it is currently near the elevated levels of 2007-2008, right before the Great Financial Crisis (GFC).
The message was that the GFSI signals some fragility for the financial system, which puts the system at risk of destabilizing quickly, perhaps due to policy error or some other shock. For securitized products credit sectors such as CMBS and CLOs, we think this means downside risks are still too high to look to take advantage of the spread widening that has occurred in recent weeks and months.
This week, we take a look at a sub-index of the GFSI, the Liquidity Stress index (Chart 2, IRISILIQ
on Bloomberg), and consider the trends in liquidity stress and securitized products credit spreads over the past two years. We highlight in Chart 2 some of the key events that have occurred around the time liquidity stress has been rising: beginning of the taper by the Fed in early 2014, the Swiss and Chinese currency revaluations and Fed rate hike in 2015, and Japanese NIRP in 2016.
Chart 3 shows that, compared to the broader GFSI, liquidity stress has somewhat methodically and steadily risen over the past two years: while the GFSI has moved higher in fits and starts, liquidity stress has more persistently risen, only pausing its rise at times, before moving higher.
This persistence suggests to us that deteriorating liquidity is at the heart of and may be the primary driver of broader rising financial stress. If so, then continuation of the rising trend in liquidity stress may eventually lead to another spike in broader financial stress in the months ahead." - source Bank of America Merrill LynchCredit flows matters, because if indeed, the "credit tap" is about to be turned off, recovery and growth will be difficult particularly for China, in the absence of course of a sizeable real exchange rate depreciation. This would trigger a significant deflationary wave impulse for the rest of the world rest assured.
Also credit spreads are a more useful indicator of credit supply disruptions than credit quantities. The increase in spreads during the Great Financial Crisis (GFC) is symptomatic of unusual financial distress, and not just the reflection of the increased default risk faced by borrowers.
(See 2012 papers from Adrian, Colla and Shin, Gertler, Gilchrist and Zakrajsek quoted in a Bruegel Policy Contribution of February 2013, by author Zsolt Darvas in his note entitled "Can Europe Recover Without Credit?").
So watching what credit spreads are doing, given they are gently drifting wider à la 2007 is paramount we think. Much more important than being obnubilated by "oil prices".
When comes to assessing the state of the credit markets, we have to agree with DataGrapple's note from the 3rd of February entitled "It is still a bear grind":
"Credit indices have been weak throughout the session, and they were no different from all other risky assets today in that respect. The most striking feature of the move wider so far - over the last few days, but that is true since the beginning of the year - is that we have not seen any panic. Credit investors have not had their “coyote moment” yet, when they suddenly realise that they have gone over the edge and that they are hanging in the air. Some sessions have been brutal - iTraxx Main (ITXEB) widened by almost 6bps today and closed above 100bps at 104bps for the first time since 2013 -, but bases – the difference between the traded value of an index and the therotical value computed with the risk premia of its individual constituents - remain large across the board and it is still worth in excess of 50cts at the close on ITXEB. The latest DTCC statistics show that investors are still long risk on most indices. They are slowly bleeding in this steady bear grind." - source DataGrappleWhen one looks at the closing prices for European Itraxx 5 year CDS indices with Itraxx Europe Main S24 (Investment Grade proxy) closing 5bps wider on Friday at 110 bps and Itraxx Crossover S24 closing 20 bps wider on the day to around 423 bps you get the drift...
Moving back to our liquidity concerns, we would like to point out once more to Bank of America Merrill Lynch's take from their Securitization Weekly recent note:
"Liquidity stress: possible causes and “solutions”
The natural question that arises from Chart 1 is: why has liquidity stress risen so persistently since the beginning of 2014? No doubt, this is a complex question with no simple answers. Nonetheless, we think there are at least two plausible key drivers:
1. The post-crisis regulatory (Volcker) and capital (Basel) regime that has substantially raised trading restrictions and capital requirements for banks/dealers and, in so doing, reduced liquidity dealers can provide to markets.
2. Emerging market and high yield credit problems related to the collapse in oil prices, and commodities more broadly. With balance sheet scarce due to higher capital requirements, and capital charges high for poor credits, liquidity in stressed sectors perhaps naturally is the first to go.
The combination of these two factors has led to a somewhat vicious cycle and feedback loop, where poor liquidity is spreading, and liquidity problems appear to be turning into fundamental problems. Moreover, tightening of monetary policy by the Fed, first through tapering and now through tightening, may have been necessary from an economic perspective, but the tightening appears to be adding fuel to the fire of liquidity deterioration.
The next question that arises is: what can be done to stabilize liquidity, or even reverse the trend of liquidity deterioration? This is an even harder question to answer than the first one posed above on causality. Arguably, poor liquidity was part and parcel of the post-crisis design for the financial system: in a world of significantly higher capital requirements for dealers, nobody should really be surprised that balance sheet is scarce and liquidity is lower. This suggests there is no “fix” coming for cause #1 above; what we have now was in fact “the plan.” The only response to poor liquidity would be related to cause #2, the credit problems. We see two possible alternatives to watch for:
1. A coordinated global policy response. Here we are referring to what BofAML Chief Investment Strategist Michael Hartnett is calling the “Shanghai Accord,” a coordinated policy response from G20 Finance Ministers and Central Bankers at the February 26-27 Shanghai meeting.
2. Coordinated oil supply cuts from OPEC and Russia, which would help alleviate the downward pressure on oil, and the associated credit stress.
Barring developments on these fronts, further liquidity deterioration seems inevitable. If so, as the following discussion suggests, then securitized products credit spreads are likely to widen further. Moreover, the 10yr inflation breakeven rate is likely to head lower, creating downside risks for interest rates and upside risk for agency MBS prepayments.
Liquidity stress, credit spreads and inflation breakevens
Next, we take a look at the relationship between liquidity stress and credit spreads, as well as the 10yr inflation breakeven. Given that credit spreads feed into the construction of the Liquidity Stress index, correlation between the index and credit spreads should be expected. Nonetheless, it is useful to take a look at how spreads in various credit sectors have trended in the past two years, as liquidity has inexorably deteriorated.
We make the following observations:
• The HY CDX spread (Chart 5) seems to have tracked the deterioration in liquidity
over the past two years the most, starting in early 2014. The modest narrowing of the spread in early 2015 appears to have been the anomaly.
• CLO BBB spread (Chart 6) tightening in the first half of 2015 appears especially anomalous.
In retrospect, deteriorating liquidity was a good signal that CLO spreads were at risk of significant spread widening. We missed the signal. At this point, CLOs currently appear to be “very cheap” on a fundamental basis, but if liquidity broadly continues to deteriorate, through correlation, CLO spreads are likely to continue to widen.
• Like CLOs, BBB- CMBS (Chart 7) have played catch up on spread widening this year.
• Prime AAA auto ABS, often thought of as a highly liquid cash substitute, experienced disproportionate spread widening in 2015 (Chart 10), but has stabilized and even tightened over the past few months.
We think the sector should be relatively strong from a defensive perspective going forward, but will not be immune from further spread widening if liquidity stress escalates further. Similarly, BBB subprime auto ABS (Chart 11) seems likely to widen further.
• The correlation between liquidity stress and the 10yr breakeven inflation rate (Chart 12) is especially noteworthy, raising two important question: 1) is the collapsing breakeven rate just a reflection of deteriorating liquidity and, as the Fed suggests, not a particularly relevant indicator of future inflation (or more correctly, disinflation)? or 2) has the new regulatory/capital regime impaired liquidity so severely that it is heightening
disinflationary pressures, which the collapsing breakeven rate is correctly signaling?
We’ll see whether the Fed is right on this one. But for now, the market is largely saying that deteriorating liquidity is disinflationary and further liquidity deterioration would bias interest rates lower. This means higher convexity cost for agency MBS, which leads us to recommend adding prepayment protection in the sector." - source Bank of America Merrill Lynch
And what does higher convexity means?
As a reminder: In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger because to avoid paying negative rates, investors have either taken more duration risk or more credit risk!
The negative convexity of High Yield callable bonds for instance enhance the downside during a sell-off. Furthermore, over the last 3.5 years, when spreads were at or below the current level (442bp), HY has widened 56% of the time over the next three months.
"One key aspect of later stages in the cycle is unlikely to recur this time – liquidity. In the new regulatory environment dealers hold less than one percent of the corporate bond market. Previously dealer inventories grew to almost 5% of the market through the cycle. " - source Macronomics, Cushing's syndrome, May 2015.This we think is the current state of affairs in the credit space, which is akin to a 2007 environment. We've seen it before and we think it is playing out again, hence our heightened attention to the Securitized markets.
As well we keep an eye also in what is happening in the land of the "setting sun" aka Japan as per our final chart and bullet point.
- Final chart - The Bank of Japan is a Black Hole for JGBs
Finally when it comes to "liquidity", central bank meddling and common knowledge, what find of interest given Bank of Japan's latest jump in the NIRP bandwagon, is that when it comes to Japanese Government bonds aka JGBs, the Bank of Japan has become a Black Hole in JGBs, in effect Bank of Japan has vacuumed so many bonds that in effect it has become the market as displayed in our final graph we find in Bank of America Merrill Lynch Japan Rates Viewpoint note from the 2nd of February entitled "In BOJ-led JGB market, will target shift from quantity to real interest rates?":
"Chart 6 shows JGB transactions by major banks in the secondary market. Since the expansion of QQE, transactions have been running at a low level, now about ¥8.5trn monthly. Considering that monthly transactions were about ¥25trn before the expansion of QQE and before its introduction, transactions have declined sharply. This suggests that newly issued JGBs are absorbed by the BOJ without entering the secondary market.
Safe assets are usually considered to be those with high liquidity and low volatility, but a better description of the recent JGB market might be that it has simply lost activity. In the past, volatility has risen during low-liquidity phases in the JGB market, and we believe the current market needs monitoring because a slight move by investors could prompt a volatility increase. The introduction of negative interest rates has raised volatility, but for the time being yields will probably continue downward, albeit accompanied by higher volatility.
Sustainability of quantitative and qualitative easing with negative interest rates
The BOJ’s balance sheet has continued expanding, to the point where it reached about 76% of GDP at the end of 2015. This is a substantial figure compared to the about 25% accumulated by the FRB and ECB. In January 2015, when the Swiss National Bank (SNB) eliminated its ceiling on the Swiss franc’s exchange rate vs. the euro, its balance sheet was about 80% of GDP (it has expanded again recently, reaching about 90%). The meaning of a central bank’s balance sheet relative to GDP can be debated, and the assets held by the BOJ and SNB differ in kind, so a simple comparison is not possible. Nevertheless, the approach of the BOJ’s balance sheet to 80% of GDP is noteworthy. At the time, the SNB’s president described the situation as unsustainable. Even a central bank cannot go on expanding its balance sheet without limit.Yes indeed. Even a central bank cannot go on expanding its balance sheet forever, and that's "Common knowledge". The problem is one need to assume that all our central bankers "islanders" are completely logical and not totally insane...
Given that JGB supply-demand is tight and a shortage of sellers will gradually emerge, doubts are being raised about the BOJ’s ability to keep expanding its balance sheet at the current rate. The introduction of negative interest rates might shorten the viable period of the expansion. Also, the longer that balance sheet expansion continues, the more difficult that monetary policy normalization will become. As the BOJ’s purchasing operations go on, JGB yields are being lowered at ever-longer maturities. In other words, the longer that monetary easing continues, the more likely the JGB curve is to factor in monetary normalization as a very distant event. Therefore, when normalization comes, the probability of a strong reaction is rising." - source Bank of America Merrill Lynch
"Logic is like the sword - those who appeal to it, shall perish by it." - Samuel Butler, British writerStay tuned!