"Skepticism: the mark and even the pose of the educated mind." - John Dewey, American philosopher
- Macro and Credit - Japanese investors' life under NIRP
- Macro and Credit - In Europe, pricing is not the problem. Credit isn't growing.
- Final chart: Front-running Mrs Watanabe and the ECB
- Macro and Credit - Japanese investors' life under NIRP
"Impact of changes in USD/JPY basis and currency hedging costs
Currency basis swaps fell deeper into negative levels in reaction to the BOJ’s adoption of negative policy rates. This, coupled with a fall in JPY LIBOR since the BOJ rate cut, has raised basis swap costs for Japanese investors. As this coincided with a fall in UST yields, super-long JGBs looked more attractive than currency-hedged 10yr USTs at one point.
However, the current rise in UST yields and the drop in super-long JGB yields have made currency-hedged 10yr USTs look more attractive again. Investor stances should change depending on the relationship between super-long JGB and foreign bond yields after excluding the impact of currency-hedging costs.
As currency-hedged foreign bonds look less attractive than they did before (although they have become less expensive recently), investors may opt for markets with lower currency hedging costs (e.g., EUR over USD) and/or look to add risk exposure in their currency-hedged non-domestic credit investments, in our view.
"Lifers may react to higher currency hedging costs by taking on foreign credit risk or increasing the weighting of unhedged foreign bonds
Lifers have continued to increase currency-hedged foreign bonds as an alternative to their yen bond investments, but currency-hedged foreign bonds do not look attractive as before due to higher currency hedging costs, particularly after the 29 January BOJ policy board meeting. Judging from cases in which currency hedging costs rose when the Fed was raising rates in 2004-2007, lifers could either take more credit risk overseas or increase the weighting of unhedged foreign bonds in their portfolios, in our view.
In February, lifers’ foreign bond investment was the highest level since April 2008 Currency-hedged foreign bonds look increasingly attractive now as super-long JGB yields fall. Lifers’ foreign bond investments reached JPY1,003.9bn in February, the highest level since April 2008 (no breakdown of whether they are hedged or unhedged, nor whether government and non-government bonds is available). We believe lifers’ demand for foreign bonds as an alternative investment to yen bonds, whose yields have fallen dramatically, may increase.
According to a Bloomberg report, one major lifer had no choice but to shift the focus of its bond investment to foreign bonds from yen bonds, and that it will raise the weighting of unhedged foreign bonds if the Fed continues with its rate hikes. Another insurer said it would increase the weighting of foreign bonds making up its investments as part of its effort to increase risk assets.
Its foreign bond investments are currently evenly divided between currency hedged and unhedged, but it is considering increasing hedged investments as JPY is currently strengthening.
Impact on pension funds
Corporate pensions have increased their weighting of foreign securities, investment trusts, cash and deposits and call loans under QQELooking at corporate pensions’ investment trends since the BOJ adopted QQE (April 2013), we find that they increased the weighting of foreign securities, investment trusts, cash and deposits and call loans while the weighting of JGBs in their portfolios has been almost unchanged or fell slightly.While they increased their weighting of risk assets such as foreign securities and investment trusts or alternative assets, they also seem to have increased the weighting cash (or cash equivalents).We believe the BOJ’s adoption of negative rates will make it more difficult for pension funds to hold cash and deposits and call loans, in our view. During the QE period from March 2001 and March 2006, the weighting of JGBs, cash and deposits, and call loans fell, while that of foreign securities and investment trusts rose.
We will watch to see if they will further increase their investments in foreign securities and investment trusts." - source Nomura
"Whereas everyone has been focusing on the importance of the strength of US dollar in relation to corporate earnings and in similar fashion in Europe previously the focused had been on the strength of the Euro, we think, from a credit perspective, the focus should rather be on the Japanese yen going forward. Once again we take our cue from chapter 5 of Credit Crisis authored by Dr Jochen Felsenheimer and Philip Gisdakis:
"Many credit hedge funds not only implement leveraged investment strategies but also leveraged funding strategies, primarily using the JPY as a cheap funding source. A weaker JPY accompanied by tighter spreads is the best of all worlds for a yen funded credit hedge fund. However, these funds should be more linked to the JPY than the USD. One impact is obviously that the favorable growth outlook in Euroland triggers a strong EUR and tighter spreads of European companies (which benefit the most from the improving economic environment). However, the diverging fit between EUR spreads, the USD and the JPY, respectively, underpins the argument that technical factors as well as structural developments dominate fundamental trends at least in certain periods of the cycle. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
"GREED & fear heard this week that it is now possible to earn about a 100bp spread by swapping dollars into yen to take advantage of negative JGB yields. This probably explains why foreign buying of JGBs is rising. Foreigners have bought a net Y3.6tn worth of Japanese bonds so far this year, after buying a net Y7.6tn in 2015. But it has to be wondered quite where such a process will end. GREED & fear has no idea. But the consequences will certainly not be positive. Meanwhile, GREED & fear is grateful to a London-based colleague for pointing out the remarkable fact that the price of the 20-year JGB has risen by 12% in yen terms and 19% in US dollar terms so far this year." - source CLSA
"While negative policy rates have created distortions in the JGB market, they have prompted a shift of investor funds into other assets more than the previous policy did. Recently, investors have looked to currency-hedged foreign bonds as alternatives to JGBs, particularly euro area government bonds, which have low hedging costs, and US credit, which can cover hedging costs. We believe these investor flows are likely pushing bond yields lower and credit spreads narrower overseas."
- Macro and Credit - In Europe, pricing is not the problem. Credit isn't growing.
"A dangerous step forwards
We are entering a new phase of ECB influence. The focus of support has switched from funding to underwriting. That is how the TLTRO2 should be read – Draghi is encouraging banks to move 40bps up the risk curve by subsidising this ‘first loss’. This starts to take ECB policy debate into the area where it can have the greatest impact: supporting front book and (more crucially) back book credit quality. It’s a step forwards, but the ECB could be opening up a dangerous new chapter of irrational lending.
The end of ever more negative rates
We believe that the most important step forward has been the realisation that we are realistically sitting at or near the ECB rate floor. This has quelled concerns that the ECB would just keep blindly pushing rates into unknowable sub-zero depths. The drag grows substantially the further we plunge and the longer we stay there. Ending this revenue risk is a positive. The ECB toolkit is focused elsewhere.
The start of the Draghi Donation
Everyone says that credit supply is abundant, and demand is the problem. We disagree – good quality borrowers can get credit, but supply is still weak to lower tiers of borrowers. SME credit rejection rates are still high in periphery Europe. Banks are still hesitant on writing new NPLs, and so seemingly strong credit supply is misleading. The TLTRO2 Draghi Donation of 40bps can help banks to move up the credit risk curve. We would be more positive if it was supported by co-ordinated efforts to clean up the existing NPL stock." - Société Générale.
"For all its sins, it is impossible to argue that the potent cocktail of negative rate policy and funding support brought no benefits. The ECB have been bent on improving the credit transmission mechanism, particularly in the European periphery. Over 2013, the European lending market clearly had a two-speed game: cheap funding for the corporate sector in the core, pricey funding in the periphery. This game was driven by the vast differences in funding availability and cost for banks.
Looking across Europe, it is clear that lower rates can help in a limited capacity. There are still categories of lending that look too expensive and are likely to strangle growth. SME lending in particular is more expensive the further south you travel.
Pricing is not the problem
The improvement in pricing masks an altogether deeper problem. Credit isn't growing. Regardless of the better pricing dynamic, it is somewhat meaningless if corporate credit demand remains too anemic to support sustained growth.
In terms of volumes, Europe still runs as a two-speed game. Household good, corporate bad. Core good, periphery bad.
When looking at the two charts below, keep in mind that the Draghi Donation kicks in at 2.5% lending growth for banks that are growing. On total eligible lending, that is equivalent to €150bn of new lending over the next two years. In reality, the requirement is lower, as some banks are still shrinking. It does not make much of a dent in the c.€600bn of ‘lost’ corporate lending since 2009.
Looking at the detail, too many periphery banking markets are still in reverse. At the eurozone level, the trend is weak positive – with an overall recovery at 0.5pct YTD. This masks growth in Germany, France and the Netherlands, offset by more contraction in Spain and Italy. The three markets that have delevered the most remain in contraction:
The problem of the 'right' credit supply
The root of the growth problem is always put down to credit demand. The standard conclusion is that credit supply is vibrant, but the corporate sector just does not seem to need the money.
We believe this is the wrong conclusion. Credit supply is only fine for the highest quality credits. This is a subset of lending demand, and one that is already ably serviced by direct issuance. Indeed, with an extension of QE into IG corporate bonds, we believe this part of the corporate lending market will be even better supported.
Credit supply dries up when banks are asked to take on some credit risk. Particularly in the periphery, banks are groaning under the weight of soured loans. The incentive to avoid adding to this stock is more powerful than the need to grow.
While the data do show that bank lending prices are coming down, a more granular survey of actual SME opinions reveals a more difficult lending context. In the periphery, SMEs are still highly likely to find credit availability either non-existent or too expensive:
Rejection rates are high. For many SMEs, the demand for lending is there, but lending applications are either rejected (in whole or part) or offered at much less favourable terms and discouraged. As shown below, rejection rates are as high as 60% of applications in Greece and 30-35% in Spain and Italy. This compares to <15 blockquote="" core="" european="" in="" markets.="" the="">15>
The Draghi Donation – a credit risk subsidyFunding has never been the issue for the European banking sector. Banks have been swimming in virtually free, virtually unlimited funding for months, and the impact on lending volumes has been stunted. The focus of the ECB has shifted from improving funding to finding ways to clear the backlog of credit quality issues and NPLs, particularly in the periphery.
Even with abundant funding, banks are hesitant on writing loans which will eventually sour, adding to the elevated stocks of NPLs.
This has been a much more consistent focus of ECB messaging in recent months. To quote Benoit Coeure:
“To reduce uncertainty, both policymakers and financial institutions need to play their part. They need to ensure that the financial system is fit for purpose and able to finance the recovery. And they need to do so today, not tomorrow.” ...“All the preconditions are now there to accelerate NPL resolution… The challenge now is to speed up the process of writing off and/or disposal. There are various policy measures that can facilitate this process.”The 40bps is to subsidise credit risk, not fundingIn this context, we view the 40bps ‘Draghi Donation’ as an incentive for banks to move up the risk curve, and extend lending to a broader group of corporate customers. The credit demand needs to follow, but banks at least need to be open to extending their new loan books outside the very top end of the credit risk spectrum.
We view the subsidy as 40bps of first loss underwriting by the ECB, rather than an attempt by the ECB to cut corporate lending pricing through the credit transmission mechanism." - source Société GénéraleThe issue at stake we have discussed on numerous occasions is that many of these Southern Europe banking institutions are capital constrained and cannot increase their lending capacity until the NPLs issues have been resolved!Maximizing the funding via TLTRO2 in no way helps SME credit availability. The deleveraging has well is an on-going exercise. What the new ECB funding does is slow down the deleveraging but in no way provides sufficient resolution to the "stock". NPLs are a"stock" variable but, Aggregate Demand (AD) and credit growth are ultimately "flow" variables. Until the ECB understands this simple concept, the "japanification" process will endure hence our "Unobtainium" analogy of last week:"Unobtainium" situation. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day and now credit speculators are joining the party with both hand" - source Macronomics, March 2016This means of course that thanks to the Bank of Japan and the ECB, we believe that the rally in credit has more room to go and that both central banks will again not be the benefactors of the "real economy".One thing for sure, by applying the Pollyanna principle, we think that Investment Grade Credit will benefit strongly and that we will see large inflows into the asset class as per our final point and chart, for SMEs where not too sure...
- Final chart: Front-running Mrs Watanabe and the ECBAs discussed in our conversation the "the Paradox of value", it looked like the US investment grade market was the only game in town but given the significant tightening of credit spreads in recent weeks, it also means that not only Mrs Watanabe will be playing it into overdrive, but over investors as well will be having a field day as per our final chart from Bank of America Merrill Lynch Credit Derivatives Strategist note from the 23rd of March entitled "How to trade credit in an ECB driven world":"Front-running” the ECBWe have seen it in the past. When the ECB announces a government bond buying program, inflows accelerate into the asset class. With the help of the ECB, credit flows have broken free from a long period of outflows. Last week’s positive inflow into high grade and high-yield funds was the third consecutive and the biggest in 53 weeks.We draw some parallels between the government bond buying program and corporate buying program. In March 2014 (more here), as inflation expectations started to deteriorate, market begun pricing the possibility that the ECB should have had to resort to more unconventional policies. In the following year or so government bond funds have seen significant inflows, with investors “front-running” the ECB government bond purchasing program.
In late February this year, investors’ expectations of an expansion of the QE program into corporate bonds instigated a strong rebound for credit spreads and a revival of the primary market. So far in three weeks, credit funds – high-grade and high-yield combined – have seen almost $5bn of inflows." - source Bank of America Merrill LynchApplying the Pollyanna principle to credit market inflows, one could indeed expect the yield compression to continue further. It looks we have moved back to early 2007 thanks again to the Fed's dovish stance and the ECB's additional generosity in conjunction with Bank of Japan enticing more duration and more credit risk..."Anyone who has begun to think, places some portion of the world in jeopardy." - John Dewey, American philosopherStay tuned!