Wednesday, 16 November 2016

Macro and Credit - When Prophecy Fails

"Experience is the only prophecy of wise men. Alphonse de Lamartine," - French poet
Looking at the dislocation and violent bond market gyrations that followed our second "prescient" call (following our correct Brexit call) on Trump being elected in the US as indicated in our conversation "Empire Days" which by the way earned us two nice bottle of wines thanks to our friends being plagued by "Optimism bias", we decided to steer towards "behavioral psychology" for our chosen title analogy this time around by referencing the classic 1964 book of social psychologists Leon Festinger, Henry Riecken and Stanley Schachter where they deal with the psychological consequences of disconfirmed expectations. While we have already used "Cognitive dissonance" as a previous title, this book was very importance in the sense that it published the first cases of dissonance. The chief reason for us selecting the above title reside in the fact that not only did the US election was a case of disconfirmed expectations and of course "Optimism bias" but, the resulting wakening of "Bondzilla" the NIRP monster led to the reversing of Gibson paradox given the sudden rise in real yields that lead to not only a bloodbath in the bond space but also a vicious sell-off in both gold and gold miners, with silver not spared either. As a reminder about Gibson paradox from previous conversations: When real interest rates are below 2%, then you get bull market in gold, the reverse also works. There has never been an episode in history when Gibson's paradox failed to operate. Real interest rate is the most important macro factor for gold prices. Also the relationship between the gold price and TIPS (or “real”) yields is strong and consistent. Gold and TIPS both offer insurance against “unexpected” (big and discontinuous) jumps in inflation. The price of gold normally falls along with the price of TIPS (which means that TIPS yields rise). So to conclude, gold and gold miners are not the best hedge at the moment given the negative correlation with real rates and the aforementioned "sucker punch" delivered in a very short order. So while many noses have been bloodied in recent days following Trump's victory, our contrarian and behavioral posture tells us we think the market might be trading way ahead of itself given the uncertainties relating to what the policies which will be implemented by the new US administration. When it comes to disconfirmed expectations and its inflationary bias as of late, we are still awaiting to see additional pressures coming from wages before we embrace the recovery mantra. Nonetheless we have been gradually de-risking our early 2016 barbell position significantly (long US long bonds / long gold miners) in favor of cash in US dollar terms waiting for the time being for the dust to settle and the fury to abate before dipping back our toes.

In this week's conversation we would like to revisit our July 2015 theme of "Mack the Knife", also known as the Greenback in conjunction with US real interest rates swinging in positive territory hence the pressure on gold prices marking the return of the Gibson paradox which we mused about in our October 2013 conversation. Of course what is happening in the Emerging Markets space is of no surprise to us given we mused on Emerging Markets risks in our conversation "The Tourist trap" back in September 2013:
"Of course if Bernanke is serious about initiating his "tap dancing" following "twist", this might spell out the "last tango" for Emerging Markets, and as we posited in a previous conversation (Singin' in the Rain), we might get another "dollar" crisis on our hands:
"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: 
Wave number 1 - Financial crisis 
Wave number 2 - Sovereign crisis 
Wave number 3 - Currency crisis
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?"
Real interest rate and US dollar strength have indeed been the "out-of sight" jack-knife of our Mack the Knife's murder of gold prices. That simple.

  • Macro and Credit - Gold and Emerging Markets : The return of Mack the Knife
  • Final chart - People are trading on hope: Higher growth or higher inflation?

  • Macro and Credit - Gold and Emerging Markets : The return of Mack the Knife
For us, Mack the Knife = King Dollar + positive real US interest rates. 

When it comes to the acceleration of flows out of Emerging Markets and growing pressure on their respective currencies, it is, we think a clear illustration of our "macro theory" of reverse osmosis playing as we have argued in our conversation "Osmotic pressure" back in August 2013:
"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013
The mechanical resonance of bond volatility in the bond market in 2013 (which accelerated again in 2016 after the US elections in very short order) started once again the biological process of the buildup in the "Osmotic pressure" we discussed at the time:
"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - Macronomics, August 2013.
More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike.

A good illustration of our "reverse osmosis" and "hypertonic surrounding in our macro theory playing out in true Mack the Knife fashion has been China with the acceleration in capital outflows put forward by many pundits and displayed in the below chart from Bank of America Merrill Lynch from their Global Emerging Markets Weekly note from the 10th of November entitled "Should I stay or should I go":
"Asia: It’s complicated
We expect weaker Asian currencies vs USD. In addition to the higher US rates channel, Asia is very exposed to US trade protectionism and will rely on rate cuts, weaker currencies and domestic fiscal policies to offset those risks. We like short KRW and SGD vs USD, and we remain short CNH against a narrow CFET basket as outflows are expected to continue (Chart 2). A complicating feature will be the greater scrutiny on USDCNH and whether President elect Trump will come true on his election threat to charge 45% punitive tariffs on Chinese exports to the US." -source Bank of America Merrill Lynch
Nota bene: Hypertonic
"Hypertonic refers to a greater concentration. In biology, a hypertonic solution is one with a higher concentration of solutes on the outside of the cell. When a cell is immersed into a hypertonic solution, the tendency is for water to flow out of the cell in order to balance the concentration of the solutes." - source Wikipedia
As a reminder and what is playing out again is what we are seeing in true "biological" fashion is indeed tendency for capital outflows to flow out of an Emerging Market country in order to balance the concentration not of solutes, but in terms of "real interest rates" (US vs China). So, all in all, the likely Fed hike in December in conjunction with USD strength will once again result in additional capital outflows which are leading not surprisingly to textbook bigger CNY depreciation from China.

When CNY / USD depreciation expectations continue to rise or USD strengthens, you can expect once again more pressure on capital outflows if other macro factors remain relatively stable. Emerging Markets including China are in a hypertonic situation; therefore the tendency is for capital to flow out. In conjunction with capital outflows from exposed "macro tourists" playing the carry trade for too long, the recent price action in US High Yield (ETF JNK and outflows) and the convexity risk we warned about as well as the CCC bucket being the credit canary are all indicative of the murderous proficiency of "Mack the Knife" (King Dollar + positive real US interest rates) hence our propensity in this kind of situation to raise significantly cash levels in US dollar terms.

Our reverse osmosis process theory from a macro perspective can be ascertained by monitoring capital flows. On the subject of monitoring for the purpose of the exercise, we read with interest Nomura's latest Capital Flow Monitor from the 14th of November entitled "EM Pressure Index Update":

  • EM central banks (excluding China and the OPEC countries) continued to buy reserves in foreign currencies to the tune of $37.7bn in October vs. $12.0bn the prior month, led primarily by strong purchases from Hong Kong (around $25.3bn). This is the eighth consecutive month of net buying by these EM central banks. Of these 20 EM central banks, two sold reserves, nine bought, and nine did not intervene.
  • After adjusting for FX valuation and coupon payment effects, we estimate that China sold FX to the tune of $11.2bn in October, after having sold around $29.8bn in September.
  • EMFX pressure rose moderately: Our Global EM FX Pressure Index (excluding China and the OPEC countries) continues to deteriorate. The main contributors to the pick-up in pressure are the South Korea, Indonesia, Israel and Russia, in that order of significance. This was partly offset by lower FX pressure in the Philippines, Mexico (MXN appreciated significantly in October), and Brazil.
Global EM FX Pressure Index
The Global EM FX Pressure Index combines information on EM central bank reserve dynamics and EM FX price action.
EM FX price action is measured by the monthly percentage change in EM currencies against the USD. Reserve dynamics are measured by EM central bank intervention (in USDbn) scaled by the money base. EM central bank intervention is estimated to be based on changes in the level of FX reserves, adjusted for valuation effects. The two indicators are then summed up on a vol-adjusted basis to arrive at the final index value.
The methodology above is developed by the IMF
  • EMFI pressure rose in October: Our Global EM Fixed Income Pressure Index, which combines information on cross-border flows into EM local bonds and price action, indicates a significant increase in pressure. The absolute pressure level was high in October relative to history.
Global EM Fixed Income Pressure Index
The Global EM Fixed Income Pressure Index follows a similar methodology and combines information on cross-border flows into EM local currency bonds and EM local currency bond price action.
EM local currency bond price action is measured by the change in bond prices, computed based on the monthly change in 10yr sovereign yields and a 7yr duration assumption. Cross-border flows are acquired from various local sources; most of them are estimated based on changes in foreign holdings of local currency bonds. The two indicators are then summed up on a vol-adjusted basis to arrive at the final index value.
Estimates for the current month are made based on flow data from Mexico, India, Indonesia, Hungary, South Africa, and Turkey. A revision will be made (in the following month) once data from Colombia, Brazil, Malaysia, Korea, Russia, Poland, Israel, Thailand, and the Czech Republic are released.

Pressure on EM bonds rose in October
  • EMFI pressure rose: The index fell to -1.2% (a significant rise in pressure). As indicated in Figure 2, this level of pressure is low compared to historically.
  • Bond flow: EM local bond markets saw an estimated outflow of $4.3bn, compared with an inflow of $9.1bn of inflows in September and $2.0bn of inflows in August (based on a consistent sample of six countries that have reported for May: Mexico, India, Indonesia, Hungary, South Africa, and Turkey).
  • Price action: Of the 19 EM countries we track, two countries saw their sovereign yields fall, while 17 rose (Figure 9). Russia (+54bp) and Turkey (+33bp) saw their sovereign yields rise the most, while Brazil (-19bp) and India (-2bp) saw their yields fall the most. Yields in the advanced economies rose, with US 10yr yields up around 23bp, Japanese only up 4bp, and eurozone up an average of 35bp, led by Italian bonds.
- source Nomura

From our monitoring perspective and our interest in dwindling currency pegs with Egypt being the latest one to throw in the towel, given that we won the "best prediction" from Saxo Bank community in their Outrageous Predictions for 2016 with our call for a break in the HKD currency peg as per our September 2015 conversation and with the additional points made in our conversation "Cinderella's golden carriage", we might have had once again our timing wrong in 2016 as far as the HKD is concerned. But, when it comes to dwindling currency pegs and with our own prophecy failing so far to materialize in 2016 we would like to remind you the trend for currency pegs so far. When it comes to our 2016 "convex" macro musing around the HKD we also note that Asian pegged or quasi peg currencies could indeed be the next shoe to drop if Mack the Knife continues his run unabated:
-source Société Générale

Interesting thing happens during currency wars, currency pegs like cartels do not last eternally. These are indeed the "shadows of things that have been". We also note from Nomura's research piece that when it comes to intervention by country and capital flows, once again Hong Kong Monetary Authority (HKMA) had to step in significantly in October:
- source Nomura

What has been happening of course for Emerging Markets and yield hunters alike is that central bank's meddling with interest rates (ZIRP, QE, NIRP) drove traditional investors seeking mid-to-high single digit yields out of investment grade/ crossover credit into high yield, leveraged loans and emerging market debt to satisfy their yield appetite. The problem, however, is some of these "macro tourists" underappreciating exponential loss and mark-to-market functions for low quality high yield assets. As we have noted previously when the credit cycle will eventually turn in earnest (not yet the case according to the latest US Senior Loan Officer Survey showing some easing as of late) annual triple C default rates can surge from 5% to 30% while average triple C prices can fall into the $40 - $50 range as we have seen earlier on in 2016 for the energy sector. Yet, it seems given the significant returns delivered in the second part of the year to the High Yield sector, that some of these "macro dimwits" have not learned their lesson, given that not only they have increased their credit exposure, but, they have also extended their duration exposure at the same time! Hence the on-going bloodbath. As a reminder, in the current low yield environment, both duration and convexity are higher; therefore price movements lower for bonds are larger.

In August 2013 in our conversation "Alive and Kicking" we argued the following:
For us, there is no "Great Rotation" there are only "Great Correlations" and we have to confide that we agree with Martin Hutchinson's recent take on "Forced Correlations":
"The lack of a major banking crash and major job losses from the LTCM debacle, and the Fed's insistence on goosing the stock bubble yet further by reducing interest rates when LTCM collapsed, produced the moral hazard from which we are now suffering, and in the long run the correlations from which the more leveraged and better connected are currently profiting. 
However, the new correlations are - like LTCM's correlations in 1996-8 - entirely artificial and capable of reversing at any time. As we are seeing in the bond markets, where the Fed in spite of all its efforts is proving incapable of keeping interest rates to the level it wants, even the Fed does not have access to large enough printing presses to keep these correlations going once they start to turn negative. As with LTCM, the eventual reversal of the current correlations will within a few months cause gigantic losses and a major market crash. 
Only this time the loser will not be a single albeit bloated hedge fund but more or less the entire universe of investors, all of whom have become overextended in a market far above its fundamental value. With a crash so widespread, the losers will not be just too big to fail, they will be too big to bail out - an altogether more perilous state." - source Asia Times, Martin Hutchinson
It seems to us the central bank "deities" are in fact realizing the dangers of using too much "overmedication" in the sense that the Fed paved the way for "mis-allocation" and the rise in inflows into the credit space and Emerging Markets bond funds alike. Even the Fed's generosity cannot offset the rising risks of a broad exit in a disorderly fashion in bond funds given that the Fed's role is supposedly one of "financial stability". We will not delve again into our views relating to positive correlations and large standard deviation moves as we have already tackled the subject in February in our conversation "The disappearance of MS München" conversation. We commented at the time that the fate of the attack of the Yuan and in effect the attack of the HKD peg could be analyzed through the lens of the Nash Equilibrium Concept:
"The amount of currency reserves is obviously the crucial parameter to determine the outcome, as a low reserve leads to a speculative attack while a high reserve prevents attacks. However, the case of medium reserves, in which a concerted action of speculators is needed is the most interesting case. In this case, there are two equilibriums (based on the concept of the Nash equilibrium): independent from the fundamental environment, both outcomes are possible. If both speculators believe in the success of the attack, and consequently both attack the currency, the government has to abandon the currency peg. The speculative attack would be self-fulfillingIf at least one speculator does not believe in the success, the attack (if there is one) will not be successful. Again, this outcome is also self-fulfilling. Both outcomes are equivalent in the sense of our basic equilibrium assumption (Nash). It also means that the success of an attack depends not only on the currency reserves of the government, but also on the assumption what the other speculator is doing. This is interesting idea behind this concept: A speculative attack can happen independent from the fundamental situation. In this framework, any policy actions which refer to fundamentals are not the appropriate tool to avoid a crisis. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
It seems to us that speculators, so far has not been able to "hunt" together or at least one of them, did not believe enough in the success of the attack to break the HKD peg. It all depends on the willingness of the speculators rather than the fundamentals for a currency attack to succeed we think.

When it comes to the much feared Mack the Knife and Asia, Bank of America Merrill Lynch in their Global Emerging Markets Weekly note from the 10th of November entitled "Should I stay or should I go" looks further into the dominating risk from a rising US dollar:

"Does dollar strength dominate everything?
The sharp reversal higher in risk assets following the Republican clean sweep has raised the question of whether reflation optimism (driven by the end of gridlock and expectations of US fiscal stimulus) could support Asia FX over the coming months. We are skeptical, at least vs the USD. As we have argued, the biggest implication of a Republican clean sweep is a stronger USD and higher US rates– this should lead to higher USD/Asia, even if trade-weighted FX performance remains more sensitive to risk.
US tax cuts – this time is different for Asia
Historically, large US tax cuts have been followed by a widening of the US current account deficit driven by higher imports (Chart 9).
This supported Asia export growth and exchange rates, especially during the Bush tax cuts of 2004 (Chart 10).

However, this time could be different, partly because the US household spending has been shifting towards non-tradable services. More importantly though, Trump’s policy platform itself is geared towards reducing dependence upon foreign goods and services.
Trade policy risks
While the prospect of draconian trade restrictions is still uncertain under a Trump Presidency, some risk premium is likely to be factored into Asia FX. There will be particular focus on the trade policy stance towards China. China is currently far from meeting the existing US Treasury criteria for currency manipulation, primarily because it has not engaged in RMB weakening intervention. It will be important to watch if the US Treasury amends these criteria under the new Administration. Another issue would be China’s expectations to be granted market economy status on 11 December 2016, fifteen years after its WTO accession, and the negotiations around this. A key risk is if China chooses to weaken its currency more quickly ahead of these events and the new Administration taking office." - source Bank of America Merrill Lynch
In the current context, from an allocation perspective, we are neutral on gold and silver until we see more stabilization in the move in real rates. While many have been jumping on the "equity" bandwagon, if indeed there is further weakening of the yen relative to the USD then again, the Japanese Nikkei should benefit so what is not to like in going long Nikkei hedged in either USD or Euro? Also, the strengthening of the HKD, should benefit Chinese shoppers and Japan from a "retail" perspective. This is already a subject we discussed in our conversation"Cinderella's golden carriage" in December 2015 as  tourists amounts to more than 12% of  Hong-Kong to GDP:
"So, from an "allocation" perspective, if you want to play the "luxury" and "tourism" theme, then "overweight" the "golden carriage" in Japan, as Hong-Kong is more likely to turn into a "pumpkin"....but we ramble again." -source Macronomics, December 2015
As we stated before, if Asia is one the receiving end of further "Chinese" devaluation, then, for us, Hong-Kong is indeed in a "very weak position" to maintain both its peg and its competitivity. Something is going to give we think. While our "prophecy" failed in 2016, if the trend continues, who knows how long Hong Kong can hold the line.

When it comes to failing prophecies and high expectations, particularly of the inflationary type and the market trading ahead of itself our final chart below is highlighting once again the gap between equity investors (the eternal optimists) and fixed income investors (the eternal pessimists). 

  • Final chart - People are trading on hope: Higher growth or higher inflation?
While the Fixed Income crowd continues to be trounced by rising real rates and surging inflation expectations we do believe that the market is trading way ahead of itself and speculating already on what the new Trump administration will be able to deliver. The significant rise in interest rate volatility in conjunction with real rates means that not only fixed income in general and emerging markets in particular are getting slammed, but, it means once more that Gibson's paradox is at play at the moment hence our neutral stance for the time being and cautiousness. Our final chart from Deutsche Bank's Torsten Slok Chief International Economist and illustrates the different trajectories of volatility between rates markets and equities:
"Fixed income markets and equity markets are following completely different narratives after the election. Rates markets are focusing on higher inflation and what it means for rates across the curve, including the risk of the Fed falling behind the curve. Equity markets, on the other hand, are focusing on higher GDP growth, and equity markets don’t seem to worry about the risks of an overshoot of inflation and the Fed falling behind the curve. These different ways of looking at the election outcome have opened up a huge gap between rates volatility and equity volatility." - source Deutsche Bank
Indeed, mind the gap, because if volatility continues to surge in rates markets, we have a hard time believing it will not eventually spill-over to equities. We shall see if the inflationary prophecy materializes itself in the coming months. For the time being, like any good behavioral therapist, we'd rather focus on the process of a rising US dollar rather than on the prophetic content of the policies which will be followed by the new US administration.

"In the computer field, the moment of truth is a running program; all else is prophecy." -  Herbert Simon, American scientist
Stay tuned!

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