Macro and Credit - Shrugging Atlas

"Atlas was permitted the opinion that he was at liberty, if he wished, to drop the Earth and creep away; but this opinion was all that he was permitted." -  Franz Kafka

Watching with the interest Italy's new Bank Rescue Fund meeting with investor's understandable skepticism, given the dismal €5bn equity buffer against €360bn of nonperforming loans (NPLs) which amounts to a miserable "equity tranche" CDO like attachment point of 2%, we thought for this week's title analogy, we would used a tongue in cheek veiled reference to 1957 Ayn Rand novel "Atlas Shrugged", where she dealt with the failures of governmental coercion. In similar fashion, the Italian governmental coercion in setting up a new Bank Rescue Fund will fail, given that the issue of circularity cannot be broken: the Italian economy stagnates, NPLs rise, Italian banks need injection of capital and cannot lend to SMEs due to bloated balance sheets. No matter how low interest rates on corporate loans have fallen and has been much vaunted by the ECB and many pundits as a "great success", lack of "Aggregate Demand" (AD) and loans flowing to SMEs thanks to insufficient demand, this will not, rest assured, resolve the on-going woes, which have been much increased by the recent implementation of Negative Interest Rate Policy (NIRP), of the Italian banking sector. Either you remove the NPLs from the bloated Italian Banks' balance sheets and the ECB monetizes the lot, or they don't. Anything in between is an exercice of dubious intellectual utility, hence our chosen title. Also as per our analogy, we wonder if, at some point, in similar fashion to Ayn Rand's book, investors will not go on "strike" when it comes to helping out the Italian banking sector as a whole.

In this week's conversation we would like to first focus on Italian banking woes, then look at Japan's results of three years of QQE and look as well at credit transmission to the real economy via credit creation and why central banks are failing.

Synopsis:

• Macro and Credit - Shrugging the Italian Atlas
• Macro and Credit  - Japan and the kite string theory
• Macro and Credit  - Central banks and credit transmission - a case of "broken arrow"
• Final chart: Italy - Credit demand/supply imbalance continues to widen

• Macro and Credit - Shrugging the Italian Atlas

While the priority for the fund is reportedly to assist in the upcoming bank recaps, we found it amusing that the fund may purchase NPLs from the banks close to their book value. We see it as yet another exercise of "buying time" rather than solving the issues at hand. In terms of fixing the Italian banking system (the need to recapitalize banks rapidly and early on), European politicians have not taken on board, the lessons from Japan or the US in the 1930s. The extend and pretend game of hiding losses has been of course been supported by LTROs and by now the increased ECB QE. Normally, in the face of continuing weak nominal economic growth, banks must move from forbearance to foreclosure within their loan books and thus "crystallize" the loan losses. It seems to us that buying NPLs closer to the book value is "very generous" indeed, and clearly indicative of how bad the capitalization issue is for some of the weaker players. On that subject, to illustrate further the horrible issue of circularity and European banking woes, we think the failing of Banca Monte dei Paschi (BMPS) is indicative of the severity of the problem given that NPLs amount now to €48bn against €29.5bn at the end of 2012. Furthermore, given the lack of "credit" flowing to SMEs, we don't think the current Italian exercise is going to resolve anything, hence us "Shrugging Atlas", particularly for BMPS given its very high exposure to corporate SMEs as indicated by Deutsche Bank in their article from the 30th of March entitled "Basel's model removals and fixes proposals will increase RWAs":

- source Deutsche Bank.

So no matter how some pundits are "spinning it" about the fall in interest rates levels for corporate loans in Europe in general and in the periphery in particular, with credit not flowing towards SMEs in Italy, we don't see, given BMPS extensive exposure, how we will get a happy ending with "Atlas" alone.

The extent of the €360bn Italian problem was as well displayed back in February in a Deutsche Bank report entitled "State guarantee on NPL securitization: not enough, but it helps":

"In simple terms, the only way to transfer more than Euro 200bn total system NPLs (Figure 3) to NPL vehicles with no loss for the banks would be to pay those NPLs more than 40% of their nominal value (as they are covered for less than 60% of their nominal value). For the Italian banks we cover (excluding BPM), the sale would not lead to a RWA release, as they work with internal models7; for most of the banks we do not cover, the loss would be partially offset by a reduction of RWA, limiting the CET1 ratio decline." - source Deutsche Bank

Of course, some would point out that by transferring these NPLs close to their "book value" (if they are booked appropriately) this is mitigating the impact for the Italian banks and reducing potential losses.

The most important issue at stake rather than Atlas on its own is the time it takes in Italy to foreclose. This was as well described clearly in Deutsche Bank report:

"Bankruptcy reform: a recap 

In July 2015, the Italian government passed a law decree containing measures to shorten bankruptcy procedures and aid collateral recovery. The Bank of Italy estimated that the bankruptcy length could decline from six to three years and the enforcement length from four to three years, barring organizational constraints. 

Indeed, in a report published last year, we showed that the Italian foreclosure time of almost five years is well above the European average (Figure 6), and we calculated (Figure 7) that, for every year reduction in the foreclosure time, the gap between the book value of banks’ NPLs and the market price reduces by c.5ppt. 

So, on average, for every one year of reduction in the foreclosure timing, the value recognized by the NPL buyers increases by 5ppt, everything else being equal. This means that an efficient bankruptcy reform (for example, moving the Italian average foreclosure timing from the current level to the European average) would significantly improve NPL price.
The implementation of the 2015 new bankruptcy law will take 12-18 more months, but the press reported that the MEF is working on additional and more incisive adjustments to that law to make it more effective.

In order to support the NPL sales, measure to speed up collateral repossession and to support the real estate market would be useful, in our view. For example, any form of financing for investors willing to purchase a real estate asset in auctions would allow for the acceleration of foreclosure. Incentives for banks granting these loans could be introduced in the prudential rules on risk weighting. At the moment, if a bank grants a mortgage to the buyer of a real estate asset in the market (for example, at a price of 100) or to the buyer of a real estate asset in an auction (at a discount of 40% versus the market price, i.e., at 60 in our example), the risk weight is the same; however, the underlying risks of the two purchases are different, as in the second case the purchase happens below market price." - source Deutsche Bank

So until, we see a clear implementation of the 2015 new bankruptcy law, we think you are better off "Shrugging Atlas" because, when it comes to "restructuring", the faster you restructure is always the better.

For further illustrative purposes, here is how NPL securitization works as displayed by Deutsche Bank in their quoted report:

"How does an NPL securitization work? 

NPL securitization is a process by which cash-generating assets (e.g., loans or NPLs) are converted into securities sold to investors. The assets are transferred to a special purpose vehicle (SPV) that issues the securities. The securities are paid from the cash flow on the assets rather than from the originator (e.g., NPL owner).

The bank that transfers NPL to an SPV can effectively deconsolidate it from its balance sheet only if there is a real transfer of risks to other investors, i.e., if equity/junior debt is sold to other investors.

The advantages of an NPL securitization for the selling bank could be: 1) balance sheet strengthening, via the exchange of low-quality assets with cash; 2) transfer of the credit risk of the NPLs to a third party; 3) potentially lower funding costs; and 4) savings in the corporate center (as all the back-office and servicing of the NPL is done by the SPV).

The investor returns are normally based on the NPL recoveries, in the form of payments from some of the defaulted borrowers, or sale of the collateral. In particular, the return of for equity/junior notes holders also depends on the cost of funding of the vehicle (i.e., the coupon to be paid to the senior notes).
The rating of the liabilities of the SPV is based on the quality of the underlying NPLs, but also on the servicer or liquidity provider rating and credit." - source Deutsche Bank

The  "Atlas" fund should only invest in the junior tranches of NPL securitization, while senior tranches might be more easily sold to the other institutional investors. "Atlas" can also invest in real estate assets. Back in our February conversation "The disappearance of MS München" we joked in around these new NPLs CDOs being the new "Big Short":

"If you want to make it big, here is what we suggest à la "Big Short," given last week we mentioned that Italian NPLs have now been bundled up into a new variety of CDOs and that the Italian state guarantees the senior debt of such operations and thinks it is unlikely ever to have to honor the guarantee (as equity and subordinated debt tranches will take the first hit from any shortfall to the price the SPV paid for the loans), maybe you want to find someone stupid enough to sell you protection on the senior tranche of these "new CDOs." - source Macronomics, February 2016

Looking at the details highlighted in Deutsche Bank report from the 12th of April entitled "A new bank rescue fund", it looks to us that indeed, it could potentially be a candidate:

"No sledgehammer, but a positive step in a broader strategy 

The fund is unlikely to wipe out market concerns about the Italian banking system given (i) the fund’s limited size and (ii) that resources come largely from within the banking system.
Although the size of the fund is small relative to the total size of NPLs, it is nonetheless a positive step within a broader strategy to strengthen the stability of the Italian banking system:

• The fund should stimulate the NPL market by investing in junior tranches of securitized NPLs. This should complement the GACS scheme which provides a guarantee to senior NPL tranches after 50% of the junior tranches are sold.
• A key element holding back the NPL market in Italy is the abnormally long average foreclosure time (Figure 2). 

The government is expected to issue a decree simplifying the bankruptcy procedures and speeding up the recovery of collateral as early as next week as mentioned by the Prime Minister.
A key question is whether the Atlante fund could be considered state aid. We are not legal experts but we think that it should not be considered state aid. The fund will be privately funded by Italian banks and insurance companies, although CDP will have a minority stake. It appears that the EC will not ask to preliminary approve the creation of the fund, but it will closely monitor it. 

Size relative to current capital rising 

The size of the fund should be enough to support the three ongoing capital raising exercises by four medium-size Italian banks for a total of up to Euro 3.75bn. This creates an important backstop as failed capital increases could heighten market concerns about the stability of the Italian banking system. But how much will be left to intervene in the NPL market?

• One of the capital raising exercises follows a merger between two banks. These two banks could in extreme circumstances forsake the merger rather than “consume” the resources of the funds. In other words, priority could be given to financial stability considerations. So we could assume that in a conservative scenario the fund would have left only Euro 2bn to invest in the NPL market (assuming a total fund size of Euro 5bn and no leverage). That said, some small banks could find themselves in the need of support from the fund.
• In an optimistic scenario the existence of the above fund could increase confidence in all capital raising exercises without actually having to intervene. In this case the fund could invest Euro 5bn in the NPL market (assuming no leverage).

The size of the fund may not be large enough to dispel market doubts about Monte dei Paschi di Siena (MPS). The issue here continues to be the elevated proportion of NPLs. But the second purpose of the fund is to help the NPL market, which indirectly could also help MPS." - source Deutsche Bank

Of course, we do not buy the "optimistic" scenario and the Atlas exercise amounts to us as yet another way of buying some time, and as always "hope" is never a great strategy which is exactly Deutsche Bank's conclusion from their note:

"Ultimately the prospects for the Italian banking sector and those of the economy are intrinsically related. GDP recovery remains mediocre and fragile, but it should continue this and next year. Maintaining confidence in the banking system is essential." - source Deutsche Bank

We cannot resist but to chuckle again and remember a comment we read in the past from a credit desk:

"Equities = Hope, Credit = Reality, unfortunately, Reality follows Hope until the Hope dies, then Reality settles in."

So, we are sorry, but when it comes to "Atlas", we are shrugging and when it comes to "hope" being a strategy and buying time being another, this brings us to our second point, namely the situation of Japan and the kite string theory.

• Macro and Credit  - Japan and the kite string theory

Looking at the recent evolution in both the Japanese yen and the Nikkei index, one has to wonder where the magic of the Bank of Japan (BOJ) and Haruhiko Kuroda has gone. Three years have gone since the BOJ implemented QQE. During these three years their target was never reached. Back in March 2013 in our conversation "the rise of the Kagemusha", we hinted that the BOJ would fail in its attempts, in similar fashion the Takeda clan failed in hiding the death of their leader. If indeed the "Kagemusha" was a term used to denote a political decoy, QQE will be probably be used to denote a "monetary decoy". On the subject of the anniversary of the QQE, we read with interest Bank of America Merrill Lynch's take in their note from the 6th of April entitled "Looking back at three years of QQE":

"Japan: Looking back at three years of QQE 

The reflationary policies of the past three years, kicked off by the BoJ's adoption of quantitative and qualitative easing (QQE) in April 2013, aimed to achieve a 2% inflation target within about two years by expanding the monetary base. Without any clear reason why increases in the monetary base should boost the inflation rate, this could be seen as a social experiment to see whether inflation could be boosted endogenously by working on market expectations. Monetary policy has traditionally played the role of constantly adjusting the water level within a container while keeping an eye on the not-necessarily fixed size of that container, but the BoJ's QQE seemed to be an experiment to see whether turning the water spigots to full on would cause the container to increase in size. After three years of water flowing in, the monetary base has risen substantially, but growth in the money stock has been limited and the inflation rate has been flat recently.

The main reason prices have not risen is the deflationary mindset that has taken hold since the collapse of the bubble, and this is consistent with the logic of using an expansion of QQE to foment inflation expectations in the market in order to exit deflation. We do not rule out the possibility that an exit from deflation can be achieved by further strengthening the current set of policies. It would be hard to argue that such an approach has been successful so far, however. Although the timeline for the target was initially set at two years and the policy implemented was bold enough to be termed a bazooka, the target has yet to be achieved three years down the road, and it may be meaningful to discuss factors causing this.

Asset prices are rising, but consumer prices are not 

The quantitative and qualitative easing (QQE) policy unveiled by the BoJ on 4 April 2013 was called a bazooka. In many respects, it was a grand social experiment to see if market expectations could be affected, and an exit from deflation engineered, by expanding the monetary base. The expectation was that growth in the monetary base would increase bank lending, expand the money stock, and spark an increase in consumer prices. The BoJ's quantitative expansion did steadily increase the monetary base, but bank lending, while in a rising trend, did not increase as much as expected. The credit multiplier considered to be relatively stable has been anything but, and there has only been limited growth in the money stock, which is the amount of funds circulating in the real economy (Chart of the day).

Consequently, although asset prices have risen, the rise in consumer prices has been tepid.
Plotting JGBs futures prices on the horizontal axis and the Nikkei 225 Average on the vertical axis, it is evident the relationship between the two was much different prior to QQE than it has been under QQE (Chart 1).  

Normally, there is a negative relationship between the two: when the price of JGBs, often considered a “safe” asset, rises (falls), the price of stocks, a risk asset, falls (rises). That relationship held until 2013, but broke down after the implementation of QQE, and since then JGB prices and stock prices have risen at the same time. Because of quantitative expansion, the yen weakened in financial markets, and the price of both JGBs and stocks rose in yen-denominated terms. There seemed to be a shift away from a risk on/off relationship and toward a policy on/off relationship. This relationship also seems to have weakened since the start of 2016, however. 

Turning to consumer prices, after QQE was implemented the consequent weakening of the yen along with opportunistic price increases in conjunction with the consumption tax hike in April 2014 led to solid growth in the core CPI, the inflation measure excluding fresh food used by the BoJ, but inflation subsequently dropped back to around 0%. Although the drop in oil prices made things difficult for the BoJ, the YoY change in the core CPI had dropped well below the BoJ's target of 2% (Chart 2).

The CPI excluding energy prices has been hovering around 1% recently, but it remains to be seen what sort of impact will be felt by the peaking out of the upward price effects from yen depreciation and by wage increases. Meanwhile, the fact wage growth has not kept up with increases in the price of daily necessities is having a dampening effect on consumption. Accordingly, further price increases may have negative impacts on consumption, further complicating the problem.
Either way, regardless of the amount of funds supplied by the BoJ, there does not seem to be sufficient demand to accommodate that supply now. It may take more time to gauge better whether a further supply of funds will raise demand or if instead there will be no impact regardless of the amount of funds supplied in the absence of demand, but it is unknown how much longer this experiment can be continued." - source Bank of America Merrill Lynch

It seems more and more evident that, the experiment overtaken by the BOJ in the last three years has failed to move upwards inflation thanks to any significant wage increases. The Japanese government cannot afford to allow rates to rise, and yet by keeping rates so low it increases distortions in the economy through the "mispricing" of risk. This is clearly evident by the inversion in correlation between bond prices and the Nikkei index!

Furthermore, the size of the BOJ's buying spree in the Japanese market has led to the market becoming not only unstable but as well as totally broken and volatile. Basically what was supposed to be riskless in the Japanese Government Bond (JGB) has become the most risky and volatilie investment of all thanks to the BOJ as indicated in Bank of America Merrill Lynch's note:

"Liquidity in the JGB market has been declining over the years (Chart 5) because of the BoJ's large amount of JGB purchases, and every time the BoJ makes a move it causes market volatility to increase sharply (Chart 6).

The combination of declining yields and rising volatility has greatly reduced risk-adjusted expected returns recently. A further rise in JGB volatility would likely lower the risk tolerance of financial institutions. This in turn would probably make them more hesitant to invest in risk assets. Normally, JGBs are expected to function as a “safe” asset and investments are selected by comparing their excess returns and risks relative to a benchmark provided by safe assets, but when safe assets are no longer safe, it makes it difficult to take on more risk. The longer the BoJ's JGB purchases drag on, the more market liquidity declines and the greater the risk of an increase in volatility." - source Bank of America Merrill Lynch

Exactly, thanks to "overmedication", the JGB market is now totally disrupted and broken and safe assets are no longer "safe", making it more and more difficult to generate "stability" thanks to central banking meddling. In the end, Atlas might as well go on "strike" and the BOJ will become the market on its own.

Of course the issue is that once you have entered the QE, it becomes a trap as indicated in Bank of America Merrill Lynch's note:

"Although raising the policy rate makes it possible to cool an overheated economy and inflation, the reverse is not always true, and the response appears to be asymmetric (known as the kite string theory, we can control a kite by pulling its string, but not pushing). The formation of the bubble in the late 1980s was exceptional. The BoJ started expressing concern over rising asset prices around 1986 and began leaning toward gradually hiking interest rates, but it lost its opportunity because of Black Monday in the US, and the bubble wound up getting larger. On the other hand, in August 2000, because long-term rates were stable and the economy was recovering somewhat, the BoJ decided to abandon the zero interest rate policy (ZIRP) that it had instituted in 1999, but this proved to be the worst possible time to do so, and the subsequent crash of the IT bubble helped to strengthen the deflationary trend. It is still battling deflation even today. Even if prices and the economy were to recover under the current monetary policy accommodation, it would probably be very difficult to time the exit from that policy. The same can be said of interest rate hikes in the US now. " - source Bank of America Merrill Lynch

The QE trap was highlighted by Richard Koo we quoted in our conversation "the Vasa ship" from February:

"Negative interest rates an act of desperation driven by failure of past accommodation

In my view, however, the adoption of negative interest rates is an act of desperation born out of despair over the inability of quantitative easing and inflation targeting to produce the desired results. That monetary policy has come this far is a clear indication that both ECB President Mario Draghi and BOJ Governor Haruhiko Kuroda have fundamentally misunderstood the ongoing recession.
To begin with, despite the all-out efforts of central banks in Japan, the US, the UK and Europe, neither quantitative easing nor inflation targeting were able to achieve their initial objectives.
The BOJ has now pushed back the date when it expects to achieve its inflation target from “around the second half of fiscal 2016” to “around the first half of fiscal 2017,” which would be fully four years into the Kuroda/Iwata era.

Failure of monetary easing symbolizes crisis in macroeconomics

This failure clearly demonstrates that the Japanese economy envisioned by Mr. Kuroda and Mr. Iwata at the time of their appointments when they pledged to step down if they failed to achieve 2% inflation in two years was very different from the reality. In short, their models were wrong.
The same mistake has been made repeatedly in the US, the UK and Europe. In each case the monetary authorities undertook extreme quantitative easing measures in an attempt to achieve inflation targets, yet price growth continues to run far below the target levels.

In view of the fact that some of the most talented, well-educated economists in these countries are working for these central banks, it is hard not to conclude that this global policy failure is less a reflection on the abilities of Mr. Kuroda and Mr. Draghi than a signal of a crisis in the discipline of macroeconomics itself." - Nomura, Richard Koo

The NIRP act from Japan as posited by Richard Koo, seems more akin to an act of "desperation" than a well thought plan. The BOJ has painted itself in a corner. In similar fashion the Fed is in a difficult situation but, less so given more favorable "demography". Like we posited before, the problems facing Europe and Japan are driven by a demographic not financial cycle.

Furthermore, Richard Koo, in his most recent note from the 29th of March entitled "Cycle of conflict between authorities and markets seen continuing for now ",  clearly highlights the "QE trap":

"The QE “trap” 

Figure 1 brings together everything discussed up to this point in a simple graph, which illustrates the behavior of long-term interest rates in two scenarios: one where the central bank has engaged in quantitative easing (red line) and one where it has not (thin blue line).

When a central bank does not engage in QE after a bubble bursts, long-term interest rates initially fall sharply but then begin to climb gradually in line with the pace of recovery in the economy and private-sector loan demand (the thin blue line in Figure 1). The central bank will also continue raising short-term rates at a pace it deems appropriate given the extent of recovery in the economy and private-sector loan demand.
However, a central bank that has implemented QE faces a very different set of circumstances. While the economic recovery is likely to come sooner than in the economy where there was no QE, the market starts to gird for trouble once rate hikes and a mop-up of excess liquidity appear increasingly likely. That marks the start of the sort of volatility currently being witnessed in US markets. This sort of back-and-forth conflict between the markets and the authorities—what I have dubbed the QE “trap”—will persist until monetary policy has been normalized.
In the US, it should be noted, the QE trap manifested itself in the forex market—in the form of dollar appreciation—instead of in the Treasury market. Soon after the Fed began discussing a normalization of monetary policy in September 2014, the BOJ eased policy again and the ECB began indicating it would follow with its own version of QE. These developments prompted an inflow of global capital into the Treasury market with its higher yields. That prevented the sharp rise in long-term US rates I initially expected and thereby rescued the country’s real estate sector. However, the dollar’s surge against other major currencies struck a heavy blow to US manufacturers." - source Nomura, Richard Koo

That is the very difficult situation that lies with "easy policy", there is an easy way in, but no easy way out. So as goes the the kite string theory, you can control a kite by pulling its string, but not pushing it. Once you reach the ZLB and implement NIRP on top of QE, it seems to us monetary policies become ineffective.

This brings us to our third point, namely that when it comes to Central banks and credit transmission we have a case of "broken arrow".

• Macro and Credit  - Central banks and credit transmission - a case of "broken arrow"

As we have argued back in November 2014 in our conversation "Chekhov's gun", QE on its own is ineffective, hence the recent discussions growing around "helicopter money":

"Our take on QE in Europe can be summarized as follows: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

We might sound like a broken record, but it seems to us that central banks do not understand clearly the difference between stock and flows. Aggregate Demand (AD) as well as "credit growth" are flow variables, NPLs are stock issues. That simple.

On that particular point, we read with interest Morgan Stanley's take from their report entitled "Transmission Matters - Musings on Money Multipliers and Credit Creation" published on the 8th of March:

"Despite aggressive monetary policy easing, the ability of central banks to boost bank lending and hence economic growth has been limited. Here we analyse why and discuss the process of credit creation in detail.
Market perception of the effectiveness of monetary policy measures seems to be oscillating between believing that central banks are omnipotent to them becoming impotent. Note that in itself this market skepticism could undermine the effectiveness of monetary policy.
Increasingly, central bank watchers seem to question whether monetary policy measures can effectively boost credit creation. As a result, monetary aggregates seem to be coming back into fashion, having been discarded in favour of interest rates as the only driver of policy transmission over the last decades.

While central banks still have ammunition left, repeated easing initiatives seem to have a diminishing effect on financial markets, portfolio reallocation, and economic sentiment. Central banks’ ability to boost bank lending also crucially depends on financial regulation, fiscal policy and structural reforms.

Liquidity trap means that it is mostly excess reserves that are rising 

Why did this happen? Effectively, the commercial banks found themselves in a liquidity trap, wherein they became happier to hold ever larger deposits with their own Central Bank rather than wanting to use such reserves to expand their assets. Central Banks can, and indeed do, enforce an aggregate increase in the total of reserve deposits available to commercial banks, but it is up to the individual commercial bank to decide whether to use its own, now much larger, reserve deposits to purchase other (normally higher-yielding) assets.

The Collapse of the Money Multiplier

As shown in Exhibit 6, there has been no relationship between the rate of increase in the monetary base and in broad money since 2008.

QE has led to a massive expansion in the monetary base; this consists of currency outstanding and the reserve deposits of the commercial banks held at the Central Bank. The cash usage of the general public is demand determined; the Central Bank and the commercial banks provide on demand, e.g. from ATMs, whatever the public wants. Apart from a panicky blip in 2008 Q4, such cash usage has generally risen quite slowly and steadily, unlike in the USA in 1929-33 when there was a massive shift out of bank deposits into cash, to protect against the risk of bank failure.

So the bulk of the massive increase in monetary base ended up in commercial bank reserve holdings at the Central Bank. Since such reserves (R) had been kept low prior to 2008, this represented an even larger percentage increase in R than in M0, as Exhibits 8-11 show: 

Macro-models often neglect money, focus on interest rates 

But no matter. In the macroeconomic models currently in vogue, the monetary aggregates do not appear, do not seem to play any role. Instead, the variable that enters, prominently, in such models is the interest rate. So Central Banks seem to have put on a brave face given their inability to restore the expansion of broad money and bank loans, and some indeed claimed, ex post facto, that they had never expected this particular transmission channel to work anyhow. Others, such as the ECB, stress the impact of their policies on bank lending rates and credit flows. Instead, the important requirement was to lower both nominal and real interest rates, in the latter case by preventing deflationary expectations from taking hold. If the monetary aggregate channel was gummed up, the portfolio balance channel could still work, as well as the effect of a lowering of interest rates on the intertemporal balance of expenditures; in other words, the lower the interest rate, the greater the incentive to shift expenditures (both consumption and investment), from tomorrow to today. " - source Morgan Stanley

In terms of "Shruggin Atlas", whatever the ECB is trying to justify it has achieved, we are not buying it for the simple reason that they do not seem to understand that no matter how much liquidity they provide, the stock remains on banks bloated balance (NPLs) and there is no "flow" to the real economy, namely SMEs no matter how low the interest rates on new corporate loans fall.

Furthermore at the ZLB (Zero lower bound), monetary policy remains ineffective, even with NIRP, which we argued recently was only a "currency play". On the ineffectiveness of NIRP we agree with Morgan Stanley's take from the same note:

"Boost to growth from negative interest rates negligible ... 

On the other hand, there is no sign that this move towards negative official rates has done anything to stimulate their domestic economies, apart from the exchange rate effect. Nor do we think that schemes to change currency usage to allow even more negative official rates would be, in present circumstances, much more 

... due to incomplete transmission via the banking system 

The reason for this scepticism is that the transmission mechanism for interest rate effects runs again largely through the commercial banks. The vast majority of us cannot borrow, or lend, at anything close to the official risk-less interest rate. Instead, we borrow from banks, and hold our liquid financial assets primarily in bank deposits, or in some cases in money market mutual funds. So much, perhaps most, of the force of changes in official rates occurs when, and if, interest rates on deposits and on bank lending change in line with official rates, or in other words when bank spreads vis a vis official rates remain constant. 

Commercial banks face a ZLB even if central banks don't 

But as official rates fall towards, and beyond, zero this is not happening, and should not have been expected to happen. The reputation of commercial banks (and MMFs) has depended on them being ‘safe’, which is widely interpreted as not declining in nominal value, not ‘breaking the buck’. There is some margin for increasing fees on handling deposits, strongly limited by commercial pressures, but, as a generality, commercial banks (and MMFs) face an even stronger ZLB than do Central Banks.

It is not just the direct effect of the negative rate on their (marginal) reserves that matters; it is the wider effect of the reduction of interest rates on their assets, relative to the rate that they will feel forced to continue offering on their (retail) deposits that matters. As was set out in our previous note, February 17, ‘Negative rates a “dangerous experiment” with diminishing positive impact’, the effect of this policy on banks’ net interest margins and incomes is increasingly hostile (see Banks/Economics/FX/Rates Strategy: Negative rates a "dangerous experiment" with diminishing positive impact? (17 Feb 2016). The impact on commercial banks of negative rates on their deposits at the Central Bank and their holdings of public sector debt, is to reduce their interest income and profitability yet further. If this happens, their reaction could be to widen spreads between deposit and lending

Negative interest rates could backfire 

Commercial banks, and MMFs, have a reputation to defend. They will not, perhaps cannot, pass on increasingly negative official interest rates to their retail customers on a one-for-one basis, unless the government takes full responsibility for the exercise. And until that happens, the application of such negative official rates may well continue to be counter-productive. If a government should state publicly that the purpose of its policy is to enforce a continued decrease in the nominal value of all your liquid assets, it may have a sharp and beneficial effect on expenditures; spend now because you will not have that much to spend next year. But would that be a political vote winner?

Monetary policy transmission interrupted 

Have proponents of negative interest rates thought through its political implications? Unless the government takes the heat off the banks by taking responsibility for negative deposit rates, it will not work economically. But if they should take the heat off the banks by taking direct responsibility for declining nominal values, it will probably not work politically. The basic problem, both with monetary expansion and negative interest rates, is that the primary transmission channel is via the commercial banks, and that channel has, for a variety of reasons, become constricted." - source Morgan Stanley

Given as we have highlighted above, Italian banks for example are "capital constrained", due to "bloated balance sheet" with rising NPLs, therefore the primary transmission to the "real economy" namely SMEs is "broken". What Japan has told us is that you need to deal rapidly with the "stocks" of NPLs to rebuild the primary transmission, namely the "flows".

So far, it seems to us that the ECB is failing because it is enticing the money "uphill" namely into "bond speculation" where all "the fun is", not downhill, to the real economy as indicated by Morgan Stanley:

"Bring back the monetary pillar of the ECB policy strategy ...

The ECB used to apply a two-pillar approach, with the second pillar based on growth of the monetary aggregates, not just on M0. Whatever became of this second pillar? Can any Central Bank really expect to achieve significant real expansion if its commercial banking system, broad monetary growth and bank lending remain mired in a difficult slough? Moreover, the problem is getting worse because the prior expansionary success of Central Banks rested partly on a generalised belief that they did have the power to lift us out of despond. But confidence in that power is ebbing, and that just makes it that much harder for them.

… and track whether the money goes to productive investment, not real estateA somewhat deeper problem is that banks have, by and large, almost ceased to be a conduit for channelling household savings towards business. The bulk of their business now involves channelling household savings into real estate projects; they have become akin to ‘real-estate hedge funds’. The nexus between bank credit expansion, housing booms and busts and the financial cycle has become a major source of dynamic instability in our economies. Yet, partly because of an erroneous diagnosis of the causes of the GFC, blaming it largely on the dangers of exotic derivatives and investment bankers, little has yet been done to break this nexus and to mitigate the underlying dynamic instability. 

Bottom line: Central Bank policies have bought time, but the limits to their powers are becoming more evident. Probably the main economies of the world will muddle through. But if not, where would we go next? This largely would depend on other policy areas, notably fiscal policy, structural reforms and bank regulation. " - source Morgan Stanley

No matter what, while everyone believes the ECB is "Atlas", the latest raft of measures do not solve the underlying problems, particularly in Italy as per our final chart.

• Final chart: Italy - Credit demand/supply imbalance continues to widen

To further illustrate and to conclude our long conversation we would like to point out towards Barclays chart from their report entitled "Italian ‘bad bank’ scheme - No pain, no gain, but still hope" from the 29th of February which shows that the credit demand/supply imbalance remains unresolved:

- source Barclays

The only gains are in the bond market, and so far it seems to us that the ECB's strategy in re-igniting "credit growth" remains "hope". Until the ECB decisively deals with the "stocks" (NPLs), "flows"  (credit growth) will remain "muted". That's a given.

"It is useless to tell one not to reason but to believe - you might as well tell a man not to wake but sleep." -  Lord Byron

Stay tuned!

Credit - Paradise Lost

"When a wise man points at the moon the imbecile examines the finger." - Confucius

Looking at the "tax bomb" falling from the "Panama Papers" and awaiting for the radioactive "fallout", we could not resist but use for our title analogy "Paradise Lost" being an epic poem in blank verse written by 17th century English poet John Milton (1608-1674). The poem deals with the biblical story of the "Fall of Man" and the temptation of Adam and Eve by the fallen angel Satan and their expulsion from the Garden of Eden. What we find of interest is that previously we already referred to the "devilish nature" of central bankers such as Mario Draghi portrayed as "The Generous Gambler" back in 2011, which was no doubt to us, a similar reference to the Devil as the one used in John Milton's masterpiece. We re-iterated our reference to the "fallen angel" which probably inspired this great text from Charles Baudelaire in our September 2014 post entitled "Sympathy for the Devil", a reference this time around to the 1968 Rolling Stones title. What we find of interest, given the very impressive rally in credit, which will no doubt continue at least in Investment Grade thanks to Japanese flows, is Milton's criticism of idolatry which is deeply embedded, not only in his poem but, as well in today's financial markets with investors on-going worship of central bankers. In the opinion of Milton, any object, human or non-human, that receives special attention befitting of God, is considered idolatrous, central bankers are no exception. In similar fashion we already touched on the "Omnipotence Paradox" back in November 2012:

"1. A deity is able to do absolutely anything, even the logically impossible, i.e., pure agency.
2. A deity is able to do anything that it chooses to do.
3. 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).
4. Hold that it is part of a deity's nature to be consistent and that it would be inconsistent for said deity to go against its own laws unless there was a reason to do so.
5. A deity is able to do anything that corresponds with its omniscience and therefore with its world plan." - source Wikipedia.

The idolatry and evilness of central bankers have been a recurring them we have used on numerous occasions, particularly in our June 2014 post "Deus Deceptor":

"In terms of blasphemy and the "evil" intent of the central bankers both Descartes and the Cartesian scholars were wrong for the simple reason that central bankers are not omnipotent. Although, our "Deus Deceptors" of the central banking world, have indeed managed to altering mathematics (probability of default risk for the time being) and the fundamentals of logic, no doubt about that." - source Macronomics, June 2014

We also added a quote at the time when it comes to the idolatry in central bankers:

"The greatest trick central bankers ever pulled was to convince the world that default risk didn't exist" - Macronomics.

 Looking at deflationary pressure rising with Eurozone PPI falling 4.2% in February, being the largest YoY drop in producer prices since 2009, one might wonder if indeed "Paradise" will not be lost in 2016? In our February 2016 conversation "Common knowledge" we also added:

"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...

When it comes to "Common knowledge" and growth outlook, it seems we always follow the same trajectory:We start with an overall 3% consensus for US growth and US 10 year yield end of the year targets of between 2.50% to 3%, then after a couple of months, it gets revised down to 1.50% / 2% and US yields get revised accordingly towards the same objective." - Macronomics, February 2016

Given the Atlanta Fed latest GDPNow model forecast for real GDP growth in Q1 2016 is 0.7%, it seems that once more we follow clearly the same usual pattern.

As a reminder, when it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:

"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."

We hope, at some point, this will become "Common knowledge" and that some sell-side pundits will stop defying this simple yet compelling "Wicksellian" logic.

So in this week's conversation, we would like to focus on "credit" and ask ourselves if indeed given the significant rise in the number of fallen angels (number of at-risk companies) to 22% of firms with Moody’s second-highest junk grade according to Bloomberg, if "Paradise" is "Lost".

Synopsis:

• Credit - Investment Grade? Paradise isn't lost
• Credit - US High Yield? Paradise is lost
• Final chart: Paradise Lost? A record number in "fallen angels"

• Credit - Investment Grade? Paradise isn't lost

In our recent conversations, we stressed that Japanese flows did matter, particularly when it comes to credit flows. Whereas inflows in recent week have been significant, particularly in US High Yield (+$13.3bn over the past 5 weeks), given the rising number of "fallen angels", we would rather continue from an allocation perspective to focus on "quality" than chasing High Yield. When it comes to "Paradise", we do think that, in particularly in US High Yield, "Paradise" is "Lost" particularly when one focuses on the deterioration in "credit metrics". We will look at this specifically in our second bullet point.

As we pointed out in early March in our conversation "The Paradox of value", the US investment grade market was no doubt the only game in town when one looks at the performance of the asset class relative to US High Yield. This was highlighted in Bank of America Merrill Lynch Monthly HG Review from the 1st of April entitled "End of the rollercoaster ride":

"March ’16: End of the rollercoaster ride

If you just returned from your sabbatical you would be forgiven to think that not much happened while you were out, as stocks returned +1.35% in 1Q, HY +3.25% while HG was the best performing major asset class at +3.92%. In fact all the asset classes we track in this report had positive returns in 1Q including Treasuries (+3.35%). Of course these quarterly numbers mask the big volatility during the quarter that saw equities reverse a correction and high grade credit spreads retrace a 27% spread widening. Thus March was a great month for most asset classes with equities up 6.78%, and leading the performance table, followed by HY (+4.42%) and HG (2.71%) while Treasuries returned +0.14%.

There were multiple reasons for the big turnaround in the markets after the lows on February 11th, including reassurance by the governor of the PBOC that China wants to see a more stable exchange rate, talks between OPEC and non-OPEC members putting a floor under oil prices and a sharp rebound in US economic data alleviating recession concerns. Then later followed global central bank action (BOJ, ECB, Fed).
HG credit spreads tightened 35bps in March for a big excess return of 253bps. For 1Q credit spreads tightened 3bps with excess returns of 18bps.

Sector wise excess return performance in March was led by Metals & Mining (+584bps), Oil &; Gas (+575bps) and Pipelines (+557bps) on the rebound in oil and commodity prices, while the worst performing sectors included REITs (+103bps), Banks/Brokers (+141bps) and Industrial Products (+146bps). For 1Q the best performing sectors were Metals & Mining (+714bps), Pipelines (+178bps) and Media-Cable (+177bps) and while at the other end of the performance spectrum we find Multi-line Insurance (-311bps), Life Insurance (- 200bps) and REITs (-85bps)." - source Bank of America Merrill Lynch

What we also find of interest is the performances in the 1st quarter of US TIPS from a diversification perspective:

- table source - Bank of America Merrill Lynch

In fact, we recommended (a little bit early) looking at US TIPS back in October 2015 in our conversation "Sympathetic detonation" from a great diversification perspective:

"Given secular stagnation, and "Japanification" of the economy (which has long been our scenario, Europe wise), indeed US TIPS are more "compelling" than UK linkers and still are less positively correlated to nominal bonds for a very simple reason: their embedded "deflation floor" - source Macronomics, October 2015

In March again in our conversation "Unobtainium" we commented that we continue to like US TIPS:

"We continue to like US TIPS particularly if pundits started claiming inflation in the US is rearing its ugly head, particularly for the specific deflation floor embedded in US TIPS. It works both ways, so what's not to like about them in the current "reflationary" environment?" - Macronomics, 19th of March 2016

As we move into the second Quarter, not only does Investment Grade appear enticing, but, from an allocation perspective US TIPS still remain particularly attractive. But, moving back to Investment Grade, we do believe that "Paradise" is not "Lost" and if indeed as we pointed out, Mrs Watanabe, Japan's GPIF and its pension friends are looking for yield abroad in a more aggressive fashion then indeed adding duration with less credit risk than High Yield makes sense as pointed out by Bank of America Merrill Lynch in their report:

"Early for excess returns, late for total returns

With the biggest three month reversal of high grade credit spread widening behind us (27% spread widening and complete reversal over a three month period), and a more benign rates outlook, we provide updated return forecasts for the remainder of the year.

Our year-end spread target of 150bps (compared with 170bps currently), and outlook for a much flatter spread curve, imply excess returns of about + 400bps this year – which is mostly ahead of us as YtD excess returns are just +18bps (Figure 8). 

In terms of total returns, due to the big decline in interest rates we are already about two thirds through the roughly +6% we now expect for 2016. For 2016 we identified 30-year corporate bonds as a sector that should generate equity-like returns (see: 2016 US High Grade Outlook) – now following a return of about +7% YtD, we expect another roughly +3% by year-end (Figure 9).

Rest of the year

In Figure 11 below we summarize the returns for the remainder of 2016 implied by our full-year forecast. We look for total and excess returns of 2.13% and 364bps, respectively, for the remainder of 2016.

Hence, we look to realize about a third of the total return during the remaining three quarters of the year as well as almost our entire excess return forecast for the year. Just like for the full year, we look for spread curves to flatten and the back-end to outperform both on the total and excess return basis."  - source Bank of America Merrill Lynch

But then again, you might rightly ask why our obsession with Japanese flows and why looking at taking on long duration exposure?

With Bank of Japan implementing NIRP, we believe that when it comes to Investment Grade "Paradise" is not "Lost" and you should be inclined being overweight duration and quality wise going for Investment Grade corporate credit. This is clearly illustrated by Bank of America Merrill Lynch Liquid Insight note from the 4th of April entitled "The Japanese flow playbook":

Land of the rising global bond buyers

A favorite flow theme recently has been Japanese buying of foreign bonds: Japanese investors have bought around $75bn in foreign bonds over the last six weeks, their strongest stretch in three years.

While we have recommended US investors consider JGBs to monetize the cross currency basis (see Getting sheet smart), looking at it from the other angle requires us to consider a few more variables. This is because Japanese investors appear more willing to take FX and duration risk while US investors going the other way are usually purely interested in monetizing the basis. Japanese investors essentially can consider four options: (1) buy bonds currency unhedged; (2) finance it through repo; (3) FX and duration hedge completely through the cross currency basis swap market; or (4) employ a rolling FX forward hedge." - source Bank of America Merrill Lynch

Now if many bond investors are in the "purgatory" or "hell" of "negative yielding" government bonds in both Japan and Europe, they can take solace in the fact that Japanese investors got their back thanks to NIRP. Increasing flows, meaning effectively that Paradise is US Investment Grade Credit particularly in the long end of the curve. 

Some would then ask us about our views on European Investment Grade. 

Given US investment-grade corporate credit yields currently stands at 3.95% (almost their highest point since the 2013 taper tantrum) versus European investment-grade credit currently yielding around 1.4%, we believe European Investment Grade to be less enticing than European High Yield from a relative value perspective (less leverage in European High Yield than in the US). Whereas the ECB is in effect providing a technical "bid" to the asset class, from a convexity risk perspective, we believe European Investment Grade to be clearly less enticing than US Investment Grade credit. This is clearly illustrated by the recent A1/AA rated Sanofi new issue which saw €7bn of demand for a combined €1.8bn deal. The 3 year tranche was priced at midswaps +17bps, offering a paltry yield of 0.05% and a coupon of zero. While some might be desperate, we'd rather pass on this kind of offering. After all, 5 year swap rates are still marginally positive at around 0.015%. Then again with the ECB being the new buyer on the "credit block", the convexity risk doesn't make European Investment Grade of high quality particularly attractive to say the least. When it comes to "japanification" and the attractiveness of Investment Grade corporate credit, we read with interest Société Générale Multi Asset Snapshot from the 4th of April entitled "It's time to overweight corporate credit":

"US corporate credit undervalued and under-owned

The recent bout of market volatility has pushed valuations across the $7 trillion global corporate credit markets up to even more attractive levels. This is clearly reflected in the following market moves:

• US investment-grade corporate credit yields currently stand at 3.95%, almost their highest since the 2013 taper tantrum; this is still more than double the benchmark 10-year Treasury yield.
• US high-yield credit yields exceeded 9% for the first time since the 2011 European credit crisis in February, and have since fallen to 7.7%.
• US high-yield spreads more than doubled to a multi-year high of 775bp on 11 February from 315bp in May 2014, and now stand at around 600bp.
• US high-yield credit funds have seen net outflows of $64bn since May 2014, equivalent to nearly a fifth of total AUM

The increase in US high-yield credit spreads now reflects a substantial rise in defaults (see chart below). Moody’s forecasts the US speculative default rate to reach 5.4% by the end of 2016 compared with 3.6% in February.

US corporate credit stands to significantly benefit from any improvement in market sentiment throughout the rest of the year. The extent of the weakness we have seen, driven by the persistently low oil prices and exacerbated by the scale of fund redemptions, leaves US corporate credit, especially high yield, with significantly improved risk-reward for 2016." -source Société Générale.

Whereas we agree with Société Générale's take on the relative attractiveness of US Investment Grade corporate credit, while the dovish stance of the Fed has generated significant inflows into US High Yield in conjunction with a significant compression in High Yield spreads, we'd rather stick to our quality and duration call than chasing this rally. This leads us to our second point, namely is "Paradise Lost" in High Yield?

• Credit - US High Yield? Paradise is lost

Whereas Société Générale in their report has put a positive spin on the appealing levels of US High Yield we must confess that we do not share their enthusiasm and, that the recent record inflows in short order in the asset class could be short lived. We have in numerous conversations pointed out the clear deterioration of elemental credit metrics in the asset class and we'd rather be safe with Investment Grade than sorry with US High Yield. On that matter we would side with Bank of America Merrill Lynch's take from their Fixed Income Digest note from the 1st of April entitled "Don't go with the flows":

"Flow to low quality might not last

The main forces that we believe will drive the bond market are: modest economic growth and a slight rise in inflation. We continue to favor high quality: investment grade corporates, munis, TIPS and fixed-to-floating rate preferreds.

We believe that modest economic growth and slightly higher inflation will be the main driver of bond market returns for the rest of the year. That leads us to continue favor high quality: investment grade corporates, munis, Treasury Inflation Protection Securities (TIPS) and fixed-to-floating preferreds.Those sectors are doing well so far this year, as Table 1 shows.

But non-US bonds and US high yield (HY), which are mostly low quality, are also doing well. Based on the BofA Merrill Lynch Global Bond Indexes, HY corporates have enjoyed a 3.2% YTD return.

Strong performance of low quality might not continue 

We doubt that low quality will continue its strong run. More than half of the better than 9% returns on both non-US developed country sovereign debt and local currency emerging market (EM) debt has come from the weakening in the US dollar. We expect the dollar to strengthen in the second half of the year as the Fed resumes raising rates.We are also turned off by the average yield of 0.39% on developed country sovereign debt. In the EM world, we favor corporate debt, most of which is denominated in dollars.

We believe that US HY will perform well over the longer term, but we have doubts about the staying power of the recent rally. The jump in oil prices from mid-January through March has been key driver of the HY market, but the rally has extended to non-energy names. Michael Contopoulos, high yield strategist, notes earnings for non-commodity companies have been weak, and they might face challenges in generating the cash flow needed to service their debt obligations. Defaults have been rising and we expect them to rise further.

What we like and why

The case for TIPS is simply that even the modest rise in inflation that we expect for the rest of the year exceeds what is priced into the market. We expect consumer price inflation to rise from its present pace of 1.0% to 2.0% at the end of the year. The breakeven inflation rate for TIPS versus nominal Treasuries is 1.65%.
We also suggest investment grade corporates as an alternative to nominal Treasuries. They are high quality and offer better yields than Treasuries. The average yield on the BofA ML index is 3.2%, a spread of about 170 basis points over Treasuries.
Among preferreds, we still see better value in $1000 pars than $25 pars, but the advantage narrowed somewhat in March when $1000 pars outperformed. We also still favor fixed-to-floaters, although the paucity of new issuance in that sector, and our subdued outlook for bond yields, argues for holding fixed-rate preferreds as well.
The appeal of munis remains their tax free income. For investors in the 25% federal tax bracket and higher the yield on AAA rated munis exceeds the after-tax yield on 10-year Treasuries. In-state munis also stack up well against similarly-rated corporate bonds for those in higher federal tax brackets and those who face high state income tax rates." - source Bank of America Merrill Lynch

While we have pointed out on numerous occasions, that while defaults and leverage matter for High Yield, clearly earnings matter even more and looking at the weaker tone in EBITDA, US High Yield defaults rates have only one way to go but higher. On the subject of US High Yield we would tend to conclude that the latest rally might be short lived and that indeed when it comes to the asset class, we think it is "Paradise Lost". We would have to agree once more with Bank of America Merrill Lynch's High Yield research team with their take from their High Yield Strategy note from the 1st of April entitled "Spring is here, but a fall is coming":

"Spring is here, but a fall is coming

We’re afraid not. Contrary to a true ‘risk rally’, it is the higher quality names that have tightened the most. In fact, when looking at the tightest 50% of non-commodity names we see that they have tightened over 25% from February 11 levels compared to widest 50% names tightening just 16.9%. And with the US HY default rate increasing by 105bps during this time period – a pace we have never seen outside of a recessionary period – we expect this reluctant rally to ultimately fade should retail pull out. Even ex- Commodities, the default rate has risen 48bps since January and is threatening to breach the 2%-handle for the 1st time since 2013 (tab 2.01). Given more than half of our HY sectors have negative year-over-year EBITDA (section 6), a closing of the capital markets (more on that below), and ex-Commodity downgrades outpacing upgrades by a factor of 2 to 1, we expect defaults outside of Energy to continue gaining momentum and for spreads to eventually be forced wider by the mounting credit losses. 

Issuance doldrums

With $34.67bn priced, Q1 2016 saw a 3rd consecutive quarter of less than 3% in new supply relative to the amount of all high yield paper outstanding. The only other time span in which we have seen an extended issuance drought of this magnitude was Q3 2008 to Q3 2009, a period not fondly remembered by high yield investors. And although issuance has increased in each of the last four months and volumes were boosted by a $5.2bn offering from Western Digital, the most recent month still saw the 5th lowest March issuance relative to outstanding supply on record, and the smallest amount since 2009. Even more concerning is the lack of triple-C issuance, where for the 3rd consecutive quarter less than 15% of all HY supply was triple-C rated.

We remain concerned that these risky companies will be unable to obtain funding in the context of poor earnings, forcing them to potentially default on future principal and/or interest payments." - source Bank of America Merrill Lynch.

When it comes to US High Yield forecast, Bank of America Merrill Lynch at the end of March 2016 was expecting 850 bps in spread which would equate to a total return at year end of -3.63%. 

In similar fashion to Bank of America Merrill Lynch, UBS in their Global Credit Strategy note from the 31st of March entitled "Does this credit rally still have legs?" concur with them, in the sense that they do not believe either the recent rally in US High Yield can last contrary to the beliefs of Société Générale mentioned above:

"Structurally, the HY rally is not sound

However, the reasons behind the recent credit rally give us room for pause, particularly in high-yield. Rising oil prices have created a technical bid for the market, which is not sustainable without further increases in oil. On the former, one can see clearly in Figure 7 how high-yield flows have moved in lockstep with oil prices since they began falling in mid-2014, while high-grade demand has remained resilient. US high-yield remains largely a bet on oil prices, while high-grade has more staying power due to new inflows from abroad.

In addition, high yield spread tightening has occurred with anemic primary market issuance. Hence, the main theme is rising oil prices + new fund inflows + limited supply = higher prices. However, this is not solving fundamental credit risk and re-financing issues that will creep up on this market over the next several years7. Figures 8 & 9 below detail weekly high-grade and high-yield spreads vs. weekly issuance respectively. The dotted line is the average weekly issuance one would expect based on seasonal factors from our interactive issuance model and total AUM outstanding.

One can see how high-grade spreads have continued to tighten despite above-average weekly supply hitting the markets, which is a positive signal for US IG that robust demand exists for new paper. In contrast, HY issuance has remained tepid; it has been below average in almost every week of 2016. The recent $5.6bn Western Digital deal may change that fact for this week, but one week does not make a trend. Current primary market conditions are not healthy for high-yield.

The bid for yield vs. credit risk

There is a clear divide taking shape in credit. The bid for yield is lifting high-grade, 

while credit risk is thwarting high-yield. How will we know if the bid for yield or credit risk will win this tug of war? In the short-run, it is impossible to abstract away our discussion from oil prices. Oil prices will continue to drive near-term inflows and outflows from the asset class. But away from oil, we will be watching several key data points. The bid for yield theme will gain credence if high-yield issuance picks up in coming months, particularly for those lower quality issuers rated B & CCC. On the flip side, if lending conditions continue to deteriorate from banks (such as the Q1 Fed Senior Loan Officer Survey released in May), and non-banks (such as the monthly CMI Index of Trade Credit, whose March survey should be released March 31st) and corporate earnings continue to fall through 1H ‘16, we fear that credit risk will begin to encroach on B and possibly even BB-rated firms as the year progresses." - source UBS

 This does indicates that when it comes to US High Yield, if lending conditions continue to falter then this will clearly signal "Paradise Lost" for US Yield no matter how some pundits would like to spin it.
What is another concern about the lateness in the credit cycle is the significant rise in the number of "fallen angels" (issuers migrating from Investment Grade to High Yield).

• Final chart: Paradise Lost? A record number in "fallen angels"

Whereas the latest news around oil prices and the correlation with US High Yield in particular points to caution in the aforementioned rally we would not be chasing, what is another indicator you need to track apart from the Senior Loan Officer Survey and issuance, is the velocity in the rise of "fallen angels". To that effect, we would like to point out to JP Morgan Default Monitor note from the 31st of March relating to High Yield and Leveraged Loan Research for our final chart:

"In March, there were three Global fallen angels affecting $8.2bn, which followed February’s 30 fallen angels totaling $115.8bn, a record month both in terms of number of issuers and amount of volume affected. And there was only one rising star totaling $600mn in March, which followed one rising star for $260mn in February, the year’s first upgrade to investment-grade. Year to date, Global fallen angel volume totals $140.4bn, compared with $143.1bn during all of last year and a record high of $150.2bn in 2009. Excluding International bonds, US fallen angels YTD total 26 companies (20 Energy) and $107.9bn in bonds ($85.2bn Energy, 79% of the total, $15.3bn Metals/Mining, 14%). For reference, there was $45.5bn of US fallen angel volume for all of 2015, which was a high since 2009’s record $141bn. In terms of EM fallen angels, there have been 10 YTD totaling $27.3bn, which compares to last year’s $90.4bn of EM fallen angels." - source JP Morgan

In Milton's poem, the evil army loses against God and the Devil's reign in Hell starts with his band of loyal followers, composed of "fallen angels", which is described to be a "third of heaven", but that's another story...

"Go to Heaven for the climate, Hell for the company." -  Mark Twain

Stay tuned!