Monday, 28 March 2016

Macro and Credit - The Pollyanna principle

"Skepticism: the mark and even the pose of the educated mind." - John Dewey, American philosopher
While watching with interest the much more positive tone in credit markets in recent weeks, with the rally in High grade credit erasing in effect the losses for the year after having spent virtually the entire year in negative territory, we reminded ourselves for our chosen title analogy of the Pollyana principle. The Pollyanna principle, also called the positivity bias is a tendency for people to remember pleasant items more accurately than unpleasant ones. Research in psychology indicates that our mind tend to focus on the optimistic at the subconscious level while, at the conscious level, it has a tendency to focus on the negative. Our subconscious bias towards the positive is described as the Pollyanna principle and the name derives from 1913 novel Pollyanna by Eleanor H Porter. This novel describes a girl who plays the "glad game" (like the sell-side pundits) trying to find something to be glad about in every situation (oil prices lower, Fed's cautious stance, the ECB's generosity, etc.). The issue with the Pollyanna principle, such as with unabated liquidity injections by central banks is that researchers Margaret Matlin and David Stang provided substantial evidence that the more people expose themselves to positive stimuli and avoid negative stimuli, the longer they take to recognize what is unpleasant or threatening than what is pleasant and safe, and they report that they encounter positive stimuli more frequently than they actually do. Of course, any similarities with today's financial markets would be as the saying goes totally fortuitous.

In this week's conversation, we would like to reiterate our focus on NIRP in Japan and in particular the Japanese yen and flows, given as we posited in our previous conversation "The Monkey and banana problem", when it comes to "risky assets" yen matters more and more.

  • Macro and Credit - Japanese investors' life under NIRP
  • Macro and Credit - In Europe, pricing is not the problem. Credit isn't growing.
  • Final chart: Front-running Mrs Watanabe and the ECB

  • Macro and Credit - Japanese investors' life under NIRP
While we pointed out in numerous conversations on our concerns on the Japanese yen in particular and Japanese flows from the Government Pension Investment Fund (GPIF) and his pension friends, we think, that from a global flow perspective and "risky assets" Japan matters and even more under Negative Interest Rate Policy (NIRP). 

More recently in our conversation "the Paradox of value", we indicated that courtesy of Bank of Japan's latest trick, US Investment Grade credit would benefit from increased allocation from Japanese large funds such as the sizable GPIF. Japanese investors are more likely to continue buying US Treasuries while as we have shown in our previous conversation NIRP has effectively "killed" the Japanese Money Market funds industry with all 11 Japanese asset managers closing their money market funds (MMF) and returning assets to investors,

Given the behavior of the Japanese long bonds discussed in our previous conversation, it is clear to us that the "carry" game played by "leveraged" players has gone into overdrive. This is particular clear to us in the USD/JPY basis and currency hedging costs as explained by Nomura in their report from the 22nd of March entitled "Key investor behaviour under negative policy rates":
"Impact of changes in USD/JPY basis and currency hedging costs
Currency basis swaps fell deeper into negative levels in reaction to the BOJ’s adoption of negative policy rates. This, coupled with a fall in JPY LIBOR since the BOJ rate cut, has raised basis swap costs for Japanese investors. As this coincided with a fall in UST yields, super-long JGBs looked more attractive than currency-hedged 10yr USTs at one point.

However, the current rise in UST yields and the drop in super-long JGB yields have made currency-hedged 10yr USTs look more attractive again. Investor stances should change depending on the relationship between super-long JGB and foreign bond yields after excluding the impact of currency-hedging costs.

As currency-hedged foreign bonds look less attractive than they did before (although they have become less expensive recently), investors may opt for markets with lower currency hedging costs (e.g., EUR over USD) and/or look to add risk exposure in their currency-hedged non-domestic credit investments, in our view.
- source Nomura

Indeed, not only have Japanese institutional increased their duration risk by buying longer-dated JGBs, they will as well most likely increase their credit risk exposure by raising aggressively their foreign investments we think. Therefore it is very likely that their interest in foreign corporate bonds will increase, in particular from the likes of lifers as indicated by Nomura in their report:
"Lifers may react to higher currency hedging costs by taking on foreign credit risk or increasing the weighting of unhedged foreign bonds
Lifers have continued to increase currency-hedged foreign bonds as an alternative to their yen bond investments, but currency-hedged foreign bonds do not look attractive as before due to higher currency hedging costs, particularly after the 29 January BOJ policy board meeting. Judging from cases in which currency hedging costs rose when the Fed was raising rates in 2004-2007, lifers could either take more credit risk overseas or increase the weighting of unhedged foreign bonds in their portfolios, in our view.

In February, lifers’ foreign bond investment was the highest level since April 2008 Currency-hedged foreign bonds look increasingly attractive now as super-long JGB yields fall. Lifers’ foreign bond investments reached JPY1,003.9bn in February, the highest level since April 2008 (no breakdown of whether they are hedged or unhedged, nor whether government and non-government bonds is available). We believe lifers’ demand for foreign bonds as an alternative investment to yen bonds, whose yields have fallen dramatically, may increase.
According to a Bloomberg report, one major lifer had no choice but to shift the focus of its bond investment to foreign bonds from yen bonds, and that it will raise the weighting of unhedged foreign bonds if the Fed continues with its rate hikes. Another insurer said it would increase the weighting of foreign bonds making up its investments as part of its effort to increase risk assets.

Its foreign bond investments are currently evenly divided between currency hedged and unhedged, but it is considering increasing hedged investments as JPY is currently strengthening.

Impact on pension funds
Corporate pensions have increased their weighting of foreign securities, investment trusts, cash and deposits and call loans under QQELooking at corporate pensions’ investment trends since the BOJ adopted QQE (April 2013), we find that they increased the weighting of foreign securities, investment trusts, cash and deposits and call loans while the weighting of JGBs in their portfolios has been almost unchanged or fell slightly.While they increased their weighting of risk assets such as foreign securities and investment trusts or alternative assets, they also seem to have increased the weighting cash (or cash equivalents).We believe the BOJ’s adoption of negative rates will make it more difficult for pension funds to hold cash and deposits and call loans, in our view. During the QE period from March 2001 and March 2006, the weighting of JGBs, cash and deposits, and call loans fell, while that of foreign securities and investment trusts rose. 

We will watch to see if they will further increase their investments in foreign securities and investment trusts." - source Nomura
We will as well track as well to see if indeed Japanese institutional investors do follow the Pollyanna principle and continue with their foreign investment binge (most likely).

As we pointed out in our previous conversation "The Monkey and banana problem", NIRP doesn't reduce the cost of capital. NIRP is a pure currency play:
"Whereas everyone has been focusing on the importance of the strength of US dollar in relation to corporate earnings and in similar fashion in Europe previously the focused had been on the strength of the Euro, we think, from a credit perspective, the focus should rather be on the Japanese yen going forward. Once again we take our cue from chapter 5 of Credit Crisis authored by Dr Jochen Felsenheimer and Philip Gisdakis:
"Many credit hedge funds not only implement leveraged investment strategies but also leveraged funding strategies, primarily using the JPY as a cheap funding source. A weaker JPY accompanied by tighter spreads is the best of all worlds for a yen funded credit hedge fund. However, these funds should be more linked to the JPY than the USD. One impact is obviously that the favorable growth outlook in Euroland triggers a strong EUR and tighter spreads of European companies (which benefit the most from the improving economic environment). However, the diverging fit between EUR spreads, the USD and the JPY, respectively, underpins the argument that technical factors as well as structural developments dominate fundamental trends at least in certain periods of the cycle. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
On the subject of "carry" play and leveraged funding strategies primarily using the JPY as a cheap funding source, it does look that NIRP is providing such an opportunity as highlighted by the astute Christopher Wood from CLSA in his Greed and Fear note from the 24th of March 2016:
"GREED & fear heard this week that it is now possible to earn about a 100bp spread by swapping dollars into yen to take advantage of negative JGB yields. This probably explains why foreign buying of JGBs is rising. Foreigners have bought a net Y3.6tn worth of Japanese bonds so far this year, after buying a net Y7.6tn in 2015. But it has to be wondered quite where such a process will end. GREED & fear has no idea. But the consequences will certainly not be positive. Meanwhile, GREED & fear is grateful to a London-based colleague for pointing out the remarkable fact that the price of the 20-year JGB has risen by 12% in yen terms and 19% in US dollar terms so far this year." - source CLSA
So, if one thinks about the Japanese yen "carry leveraged community play" and the Pollyanna principle, it seems to us that the more investors expose themselves to this kind of "dangerous basis play", the longer they take to recognize what is unpleasant or threatening it can become.

One thing for sure, there is a clear relationship between the USD/JPY 5 year basis spread and US credit spreads as displayed in the below chart from Nomura Japan Navigator no. 662 report from the 21st of March:

"While negative policy rates have created distortions in the JGB market, they have prompted a shift of investor funds into other assets more than the previous policy did. Recently, investors have looked to currency-hedged foreign bonds as alternatives to JGBs, particularly euro area government bonds, which have low hedging costs, and US credit, which can cover hedging costs. We believe these investor flows are likely pushing bond yields lower and credit spreads narrower overseas."
 -source Nomura

If negative rates do support activity, it primarily works through the exchange rate, adding to the portfolio substitution into risky asset via the previously mentioned yen carry play and the Pollyanna principle we think.

And when it comes to NIRP, it does not work by reducing financing costs materially, providing a ‘price of money’ stimulus. This brings us to our second point, namely that lowering the price of capital in Europe is not sufficient to trigger credit growth.

  • Macro and Credit - In Europe, pricing is not the problem. Credit isn't growing.
While many pundits have lauded Mario Draghi's latest efforts and effectively decided to play the "glad game", we think differently of the efficiency of the measures taken by "Le Chiffre". In no way the latest raft of measures is dealing with the bloated balance sheets of Italian banks plagued by rising and significant nonperforming loans (NPLs). Also, why many pundits have illustrated the success of the ECB supremo thanks to the fall in corporate lending prices. Credit is not growing enough to provide a sustainable growth exit path to the European project.

On this matter we read with interest Société Générale European Banks note from the 21st of March entitled "ECB - new hope, new danger":
"A dangerous step forwards
We are entering a new phase of ECB influence. The focus of support has switched from funding to underwriting. That is how the TLTRO2 should be read – Draghi is encouraging banks to move 40bps up the risk curve by subsidising this ‘first loss’. This starts to take ECB policy debate into the area where it can have the greatest impact: supporting front book and (more crucially) back book credit quality. It’s a step forwards, but the ECB could be opening up a dangerous new chapter of irrational lending.
The end of ever more negative rates
We believe that the most important step forward has been the realisation that we are realistically sitting at or near the ECB rate floor. This has quelled concerns that the ECB would just keep blindly pushing rates into unknowable sub-zero depths. The drag grows substantially the further we plunge and the longer we stay there. Ending this revenue risk is a positive. The ECB toolkit is focused elsewhere.
The start of the Draghi Donation
Everyone says that credit supply is abundant, and demand is the problem. We disagree – good quality borrowers can get credit, but supply is still weak to lower tiers of borrowers. SME credit rejection rates are still high in periphery Europe. Banks are still hesitant on writing new NPLs, and so seemingly strong credit supply is misleading. The TLTRO2 Draghi Donation of 40bps can help banks to move up the credit risk curve. We would be more positive if it was supported by co-ordinated efforts to clean up the existing NPL stock." - Société Générale.
Once again the ECB's ambition of restoring the credit transmission mechanism in Europe has been failing and will continue to fail because as we pointed out before, contrary to the Fed, it hasn't dealt with the "stocks" namely the NPLs still intoxicating many Southern European banks. While the ECB has provided cheap funding, to repeat ourselves, in no way the ECB has modified the credit profile of these ailing banking institutions. These assets have yet to be dealt with hence the risk of "japanification" given the time taken in dealing with these issues à la Japan. This is clearly illustrated in Société Générale's report:
"For all its sins, it is impossible to argue that the potent cocktail of negative rate policy and funding support brought no benefits. The ECB have been bent on improving the credit transmission mechanism, particularly in the European periphery. Over 2013, the European lending market clearly had a two-speed game: cheap funding for the corporate sector in the core, pricey funding in the periphery. This game was driven by the vast differences in funding availability and cost for banks.

Looking across Europe, it is clear that lower rates can help in a limited capacity. There are still categories of lending that look too expensive and are likely to strangle growth. SME lending in particular is more expensive the further south you travel.

Pricing is not the problem
The improvement in pricing masks an altogether deeper problem. Credit isn't growing. Regardless of the better pricing dynamic, it is somewhat meaningless if corporate credit demand remains too anemic to support sustained growth.
In terms of volumes, Europe still runs as a two-speed game. Household good, corporate bad. Core good, periphery bad.
When looking at the two charts below, keep in mind that the Draghi Donation kicks in at 2.5% lending growth for banks that are growing. On total eligible lending, that is equivalent to €150bn of new lending over the next two years. In reality, the requirement is lower, as some  banks are still shrinking. It does not make much of a dent in the c.€600bn of ‘lost’ corporate lending since 2009.

Looking at the detail, too many periphery banking markets are still in reverse. At the eurozone level, the trend is weak positive – with an overall recovery at 0.5pct YTD. This masks growth in Germany, France and the Netherlands, offset by more contraction in Spain and Italy. The three markets that have delevered the most remain in contraction:

The problem of the 'right' credit supply
The root of the growth problem is always put down to credit demand. The standard conclusion is that credit supply is vibrant, but the corporate sector just does not seem to need the money.
We believe this is the wrong conclusion. Credit supply is only fine for the highest quality credits. This is a subset of lending demand, and one that is already ably serviced by direct issuance. Indeed, with an extension of QE into IG corporate bonds, we believe this part of the corporate lending market will be even better supported.
Credit supply dries up when banks are asked to take on some credit risk. Particularly in the periphery, banks are groaning under the weight of soured loans. The incentive to avoid adding to this stock is more powerful than the need to grow.
While the data do show that bank lending prices are coming down, a more granular survey of actual SME opinions reveals a more difficult lending context. In the periphery, SMEs are still highly likely to find credit availability either non-existent or too expensive:
Rejection rates are high. For many SMEs, the demand for lending is there, but lending applications are either rejected (in whole or part) or offered at much less favourable terms and discouraged. As shown below, rejection rates are as high as 60% of applications in Greece and 30-35% in Spain and Italy. This compares to <15 blockquote="" core="" european="" in="" markets.="" the="">
The Draghi Donation – a credit risk subsidy
Funding has never been the issue for the European banking sector. Banks have been swimming in virtually free, virtually unlimited funding for months, and the impact on lending volumes has been stunted. The focus of the ECB has shifted from improving funding to finding ways to clear the backlog of credit quality issues and NPLs, particularly in the periphery.
Even with abundant funding, banks are hesitant on writing loans which will eventually sour, adding to the elevated stocks of NPLs.
This has been a much more consistent focus of ECB messaging in recent months. To quote Benoit Coeure:
“To reduce uncertainty, both policymakers and financial institutions need to play their part. They need to ensure that the financial system is fit for purpose and able to finance the recovery. And they need to do so today, not tomorrow.” ...“All the preconditions are now there to accelerate NPL resolution… The challenge now is to speed up the process of writing off and/or disposal. There are various policy measures that can facilitate this process.”
The 40bps is to subsidise credit risk, not funding
In this context, we view the 40bps ‘Draghi Donation’ as an incentive for banks to move up the risk curve, and extend lending to a broader group of corporate customers. The credit demand needs to follow, but banks at least need to be open to extending their new loan books outside the very top end of the credit risk spectrum.
We view the subsidy as 40bps of first loss underwriting by the ECB, rather than an attempt by the ECB to cut corporate lending pricing through the credit transmission mechanism." - source Société Générale
The issue at stake we have discussed on numerous occasions is that many of these Southern Europe banking institutions are capital constrained and cannot increase their lending capacity until the NPLs issues have been resolved!
Maximizing the funding via TLTRO2 in no way helps SME credit availability. The deleveraging has well is an on-going  exercise. What the new ECB funding does is slow down the deleveraging but in no way provides sufficient resolution to the "stock". NPLs are a"stock" variable but, Aggregate Demand (AD) and credit growth are ultimately "flow" variables. Until the ECB understands this simple concept, the "japanification" process will endure hence our "Unobtainium" analogy of last week:
"Unobtainium" situation. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day and now credit speculators are joining the party with both hand" - source Macronomics, March 2016
This means of course that thanks to the Bank of Japan and the ECB, we believe that the rally in credit has more room to go and that both central banks will again not be the benefactors of the "real economy".
One thing for sure, by applying the Pollyanna principle, we think that Investment Grade Credit will benefit strongly and that we will see large inflows into the asset class as per our final point and chart, for SMEs where not too sure...

  • Final chart: Front-running Mrs Watanabe and the ECB
As discussed in our conversation the "the Paradox of value", it looked like the US investment grade market was the only game in town but given the significant tightening of credit spreads in recent weeks, it also means that not only Mrs Watanabe will be playing it into overdrive, but over investors as well will be having a field day as per our final chart from Bank of America Merrill Lynch Credit Derivatives Strategist note from the 23rd of March entitled "How to trade credit in an ECB driven world":
"Front-running” the ECB
We have seen it in the past. When the ECB announces a government bond buying program, inflows accelerate into the asset class. With the help of the ECB, credit flows have broken free from a long period of outflows. Last week’s positive inflow into high grade and high-yield funds was the third consecutive and the biggest in 53 weeks.
We draw some parallels between the government bond buying program and corporate buying program. In March 2014 (more here), as inflation expectations started to deteriorate, market begun pricing the possibility that the ECB should have had to resort to more unconventional policies. In the following year or so government bond funds have seen significant inflows, with investors “front-running” the ECB government bond purchasing program.
In late February this year, investors’ expectations of an expansion of the QE program into corporate bonds instigated a strong rebound for credit spreads and a revival of the primary market. So far in three weeks, credit funds – high-grade and high-yield combined – have seen almost $5bn of inflows." - source Bank of America Merrill Lynch
Applying the Pollyanna principle to credit market inflows, one could indeed expect the yield compression to continue further. It looks we have moved back to early 2007 thanks again to the Fed's dovish stance and the ECB's additional generosity in conjunction with Bank of Japan enticing more duration and more credit risk... 
"Anyone who has begun to think, places some portion of the world in jeopardy." -  John Dewey, American philosopher
Stay tuned!

Saturday, 19 March 2016

Macro and Credit - Unobtainium

"Progress is impossible without change, and those who cannot change their minds cannot change anything." - George Bernard Shaw
Watching with interest the significant compression in credit spreads thanks to "Le Chiffre" aka Mario Draghi going "all in", which to some extent, is putting pressure on Haruhiko Kuroda and the Bank of Japan, to raise the stakes once more in this global game of liar's poker, given their respective ability in reaching their inflation targets and both their repeated failures, we reminded ourselves for our chosen title analogy of "Unobtainium", being any fictional, extremely rare, very costly, or impossible material, or (less commonly) device needed to fulfill a given design (inflation) for a given application (QE+NIRP). The word "Unobtainium" derives humorously from unobtainable (inflation) followed by the suffix -ium, the conventional designation for a chemical element. 

What we also find of interest in our chosen title is that there is a cryptocurrency named Unobtainium, which uses Bitcoin's source code with some modifications to the monetary policy. UNO aka Unobtainium is a SHA256 Proof of Work cryptocurrency unique for low inflation, scarcity, a fair launch and distribution. Just 250,000 Uno will ever be mined over 300 years. Unobtanium is merged mined with Bitcoin, resulting in a secure high-difficulty blockchain that is 3x faster than Bitcoin. Uno is rare not only in the number coins issued, but also in it's fair launch and distribution. Uno was not pre-mined. There is no POS inflation. On that matter we find it very amusing to read about the proto-currency known as RSCoin in recent column by Ambrose Evans-Pritchard on the 13th of March in the Telegraph in his article entitled "Central banks beat Bitcoin at own game with rival supercurrency" as a better alternative to Bitcoin and it's smaller rival "Unobtainium":
"The RSCoin is deemed more likely to gain to mass acceptance than Bitcoin since the ledger would remain exclusively in the hands of the central bank, with the 'trust' factor of state authority. It would have the incumbency benefits of an established currency behind it....RSCoin may be irresistible for central banks. Dr Danezis said it is allows them to turn the money tap on and off with calibrated precision, and lets them track the sort of counterparty liabilities that nearly blew up the financial system during the Lehman crisis. "There would be instant visibility. They could react very quickly in an emergency, " he said.
Ultimately it could achieve some of the objectives of 'narrowing banking' proposed by Adam Smith, or the Chicago Plan put forward by US economists in the 1930s - but never enacted - to transfer control of money creation from private banks to the state. Arguably, this would make the financial system safer and less prone to boom-bust cycles." - source The Telegraph, Ambrose Evans Pritchard, 13th of March 2016
We find it particularly hilarious that RSCoin is deemed more likely to "mass acceptance" thanks to the 'trust factor of state authority'. To paraphrase Hayek's 1988 book, one could argue that RSCoin will not likely be more successful than Bitcoin because having the "trust factor" of the central bank would be a "fatal conceit", but we ramble again...

On a side note, before we move on our weekly musing, we find as well very entertaining that China and its Popular Bank of China (PBOC) are thinking about the implementation of a "Tobin tax" given one of our latest musing was the "reverse Tobin tax". This was reported by Bloomberg on the 15th of March in their article "China Tobin Tax Riles Analysts as Citi Warns of Foreign Exodus":
"China’s central bank has drafted rules for a tax on foreign-exchange transactions, a plan that still needs central government approval, people with knowledge of the matter said on Tuesday. The initial rate may be kept at zero to allow authorities time to refine the rules and to deter speculators by letting them know that there is a system in place, said the people, who asked not to be identified as the discussions are private. 
The People’s Bank of China has been fighting to drive out traders who take advantage of the difference in the yuan’s rates at home and abroad. The PBOC drove the currency’s offshore borrowing costs to records in January, increasing short-selling costs, and instructed banks on the mainland to restrict sending yuan overseas. 
Among the biggest Tobin tax concerns cited by analysts is that the levy would sap market liquidity. One gauge of the ease of trading the yuan -- the currency’s bid-ask spread against the dollar -- was about 0.05 percent on average in March, versus 0.01 percent for the dollar-yen rate, according to data compiled by Bloomberg Intelligence." - source Bloomberg
As a reminder from our conversation, the Tobin tax suggested by Nobel Memorial Prize in Economic Sciences Laureate economist James Tobin was originally defined as a tax on all spot conversions of one currency into another. This tax intended to put a penalty on short-term financial round-trip excursions from the speculative crowd and was suggested in 1972, shortly after the fall of the Bretton Woods system which ended on August 15 of 1971. Also we would like to point out, that this additional precautionary measure from the PBOC, does seem to us overstretched as we indicated in our "The disappearance of MS München" conversation, the fate of the attack of the Yuan and in effect the attack of the HKD peg can be analyzed through the lens of the Nash Equilibrium Concept:
"It seems to us that speculators, so far has not been able to  gather together or at least one of them, did not believe enough in the success of the attack. It all depends on the willingness of the speculators rather than the fundamentals." - source Macronomics, 1st March 2016.
For us, this announcement from the PBOC is posturing and ambitions to deter further speculation and prevent speculators to gather together, ensuring in effect that renewed attacks will be postponed and inflict sufficient damage to the "short crowd". It seems to us that, shorting the yuan is indeed a very costly "Unobtainium" for now. End of our side note.

In this week's conversation, we would like to look at inflation expectations and what it means in terms of allocation and credit given the significant tightening move seen in recent weeks.

  • Macro and Credit - Is inflation really rearing its ugly head?
  • Macro and Credit  - The bond yield curves are now fully inelastic
  • Final chart: Demography is destiny

  • Macro and Credit - Is inflation really rearing its ugly head?
Back in October 2015 in our conversation "Sympathetic detonation", we posited that US TIPS were of great interest from a diversification perspective given the US TIPS market is the one for which, on a historical basis, the correlation with other asset classes is least extreme. We argued at the time:
"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
We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", and of course it has worked again like a charm in 2016:
"If the policy compass is spinning and there’s no way to predict how central banks will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of central banks, the option-value of both gold and bonds goes up."
Given it seems that US inflation expectations jumped after a renewed dovish Fed, one could argue that the compass in the US has somewhat stopped spinning hence the move in US breakevens and TIPS, in conjunction with the continuous support for Gold Miners (yes we are still long...). 

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?

What we also find of interest is that some have argued that with inflation supposedly "rearing its ugly head", US Treasuries are vulnerable in this situation. No doubt the dovish stance of the Fed is going to wreak havoc on the short end of the curve, but we do think the very long dated part of the curve (30 years) still offer some good carry and roll-down in a growing NIRP world (yes we are still long, very long US duration as well, if you'd like to ask). 

But when it comes to "inflation" and "Unobtainium", we still think as per our conversation "Perpetual Motion" from July 2014 that real wage growth is indeed the "Unobtainium" piece of the puzzle the Fed has so far been struggling to "mine":
"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, July 2014
A very interesting 2015 paper by the Bank of Israel ( (Sussman, N and O Zohar 2015, “Oil prices, inflation expectations, and monetary policy”, Bank of Israel DP092015.) indicates that since the Great Financial Crisis (GFC) of 2008, a 10% change in oil prices moves 5Y5Y expected inflation by nearly 0.1% in the US and 0.05% in the Euro area. Therefore, given the recent significant surge in oil prices towards the $40 mark, we do not think it is such a surprise to see a rise in inflation expectations in that context. This latest rise in inflation expectations could after all be transitory as well as the sudden rise in oil prices, particularly in the light of the tight relationship between the US dollar and oil prices. We think that the latest dovish stance of the Fed all has to do with their concerns relating to the "velocity" of the US dollar and the "unintended consequences" a too rapid rise of the "Greenback" could have on Emerging Markets (EM).

When it comes to the assessing the transitory nature of the rise in inflation expectations, we read with interest Bank of America Merrill Lynch's take from their Liquid Insight note from the 18th of March entitled "Yellen: The lady doth protest too much" where they disagree with the impact of the change in oil prices moves on inflation expectations we mentioned above:
"Key takeaways
• The Fed's dovish commentary on inflation is getting stale very fast.
• The evidence for a pick-up in wage and core price inflation is not just a couple data points, but is broad based.
• Markets are only beginning to come to terms with the reality of a steady upward move in inflation.

Our core disagreement with the Fed 
Once every year or two a significant gap develops between our thinking relative to the Fed. For example, early last year, we were struck by the Fed’s apparent complacency about the strong dollar. Fed officials seemed to dismiss the dollar, arguing that the US is a relatively closed economy and a strong dollar could be viewed as a vote of confidence in US growth rather than as a shock to US growth. That view seemed increasingly out of touch given both the size of the dollar move and the fact it continued to strengthen in the face of very weak US data. The Fed did not capitulate until March when they acknowledged the weaker outlook and moved out the expected timing of the first hike.
Today, a similar sized gap in thinking has emerged; this time around the outlook for core inflation. Despite stronger data, the FOMC continues to question whether core inflation is really picking up. “Inflation is expected to remain low in the near term …but to rise to 2% over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.” Asked about the pick-up in core inflation during the press conference, Chair Yellen vaguely talked of volatile components. The forecasts were similarly dovish: even though year-over-year core has already jumped from 1.3 to 1.7% YoY, the median forecaster continued to look for 1.6% inflation this year and the median forecast for next year actually dropped from 1.9% to 1.8%.
Here we take a closer look at the gap between the FOMC and our own thinking. We think the Fed’s views are stale in several respects. We also argue that the FOMC is more willing to allow inflation to overshoot the 2% target than they are suggesting. Looking ahead, we think this meeting outcome will be the high point for Fed dovishness this year and we reiterate our long-standing call for hikes in June and December. 
It was a new day yesterday 
A key Fed concern is that weakness in oil prices will pass through to the core over time. However, most studies find very weak or nonexistent pass through. The worst of the oil price drop now appears behind us: prices seem to be finding a floor, with Brent up about 40% from its 20 January low. As base effects fall out of the data, headline inflation should continue to converge to the core (Chart of the day above).
The Fed is concerned that the strong dollar will continue to drive import prices lower as the lags play out. Presumably they are also concerned that if they are too hawkish the dollar could surge again. In our view, the period of rapid dollar appreciation is fading into history (Chart 1).

As a result, consumer import price deflation has already slowed sharply. For much of last year, consumer import prices were falling at 1.3% YoY, but the rate of decline has now dropped to just 0.2%. In our view, this is a major factor in the recent pickup in core goods price inflation. 
Yellen and company seem skeptical about any pick in wage growth: “in the aggregate data, one doesn't yet see any convincing evidence of a pickup in wage growth. It's mainly isolated to certain sectors and occupations.” She also pointed to the pickup in the participation rate as a hopeful sign. In our view, the evidence of a pickup in wages is compelling. The growth in average hourly earnings in the last 12 months is higher than the prior 12 months for seven out of 10 major industries. Overall compensation growth has accelerated relative to a year ago for all the major compensation gauges except the employment cost index. A lot of second-tier measures, such as surveys from the Fed, have also picked up modestly. 
At her press conference Chair Yellen was asked why she was skeptical about the recent inflation numbers. She said, “I see some of that as having to do with unusually high inflation readings in categories that tend to be quite volatile without very much significance for inflation over time.” We agree that there are a few special factors in the numbers, but not enough to cancel out the inflation signal. The Fed has developed “trimmed mean” measures of core inflation that strip out all volatile items rather than somewhat arbitrarily eliminating all food and energy items (Chart 2).

The trimmed CPI measure is still up at a solid 2.5% annual pace in the last two months and on a year-over-year basis has been accelerating since May 2015. A similar story applies for the trimmed PCE: it is rising at a 2% annual pace in the last two months and has been drifting higher since last January. In our view, these are trends, not noise. 
The one dovish aspect of the Fed view we agree with is the risk of inflation expectations unhinging to the downside. Measuring inflation expectations is difficult. Survey measures have an upward bias and market-based measures can be heavily distorted by technical factors. Nonetheless, after six years of weakness in wage and price inflation it would be surprising if inflation expectations for real people had not fallen. We believe confidence in the Fed’s inflation-creating ability surely is under pressure and is already impacting wage and price setting. Despite this headwind, however, wage and price inflation is already starting to pick-up. This suggests the economy is already at full capacity.
Living in the past 
This brings us to our final point. Chair Yellen has been adamant that the Fed has not changed its inflation target: it is still 2% and it is still symmetric; they are just as concerned about above-target inflation as below-target inflation. We are skeptical. In our view, there is a very strong economic case for “really risking” overshooting the target. Recall that the reason the Fed’s target is 2% rather than zero is that the Fed wants to minimize the risk of deflation and avoid hitting the zero lower bound for the funds rate when fighting recessions. Recent experience argues strongly for a higher inflation target:
• the Fed and other central banks have been stuck at zero for many years,
• inflation has been chronically low
• inflation expectations have fallen below the Fed’s target
• and the equilibrium real rate has probably dropped.
With the benefit of 20-20 hindsight we think the Fed would have adopted a higher target: say 3%, instead of 2%. The problem is that resetting the goal would require a very complicated debate at the Fed, raise concerns about a slippery slope (if 3%, why not 4%?) and would likely subject the Fed to even bigger political attacks. In our view, the politically correct answer is to keep the target, but err on the side of overshooting and then wait for the inevitable recession to knock inflation back down to target.
The bottom-line of all of this, in our view, is ongoing upside risks to inflation breakevens as the markets recognize the Fed can create inflation after all." - source Bank of America Merrill Lynch
It seems to us that Bank of America Merrill Lynch is focusing on the content, like any good behavioral psychologist we prefer to focus on the process. If indeed, the Fed has recently preferred a slowdown in the "velocity" of the surge in the US dollar for obvious external EM concerns, hence its dovish tone, what has also been a concern has been the overall global tightening of financial conditions. What is also of interest is that the surging dollar in recent years and falling US treasury yields have happened in conjunction with falling commodity prices and particularly a sharp drop in energy prices. This has therefore reinforced the possibility of coordinate actions from central banks which could have happened given the US dollar has dropped as much as 3 percent since the G-20 meeting held in Shanghai which ended on February 27. Whereas the Fed's latest dovish tone aims at somewhat lessen the impact of a rapidly surging US dollar, clearly to us the ECB's ambition of purchasing corporate bonds, is a clear demonstration of its willingness in suppressing a surge in credit spreads and a flattening of the credit curves which would in effect trigger a rise in the cost of capital and funding for banks and other players, and trigger a renewed credit crunch in Europe in the process. Not only has the US dollar fallen relative to other currencies, but in Europe credit spreads have fallen very rapidly to much lower levels thanks to the ECB "credit put".

When it comes to wage inflation, which would entice us to validate the "recovery" mantra, we believe wage inflation remains "Unobtainium", an impossible material as posited by Zero Hedge in their article from the 18th of March entitled "Feeling Underpaid? This Is What Wage Inflation Around The World Looks Like" which is pointing to the similar Deutsche Bank report we read with interest "Inflation Sensation - a global inflation monitor" from the 16th of March. If US inflation is indeed rearing its ugly head, then the jury is still out there when it comes to monitoring wage inflation in the US:
"Wage developments are striking across the G10. While there are tentative signs of producer and consumer price disinflation bottoming in some countries, wage growth remains particularly weak. This may be because wages are a backward looking indicator of inflation pressure, but it may also be a sign of second-round effects influencing price-setting behaviour." - source Deutsche Bank
What seems so evident to us is that Central banks such as the ECB are pouring oil on the fire as they have trying to push long-term rates down after having succeeded in pushing short term rates to zero. 

In Europe, it is clear that the ECB's policy is having no lasting effect on prices and inflation. It is because the ECB can create all the money it wants, but it cannot command it to flow "uphill", in wages, hence the "Unobtainium" situation. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day and now credit speculators are joining the party with both hands:
 - graph source Deutsche Bank
As we pointed out in our recent conversation "The Monkey and banana problem":
"Lower rates then end up raising, rather than lowering the demand for bonds as the saving rate goes up. This negative feedback-loop, doesn't stop the frenzy for bonds and the "over-allocation process. On the contrary, as the "yield frenzy" gather pace thanks to NIRP. This push yields lower and bond prices even higher" - source Macronomics, February 2016
The results of the "Unobtainium" process is that money flows into Wall Street and less so into Main Street as a result. The latest decision by the ECB is putting the demand for credit products into "overdrive" while in no way the most recent TLTRO is altering the credit profile of ailing Italian banks and their balance sheets bloated by Nonperforming loans (NPLs). "Liquidity" via funding at zero cost doesn't resolve "Solvency". But, yes, the rally in credit has legs for the time being.

The "Unobtainium" process followed by our generous gamblers have not only enticed even more speculation downhill, in the government bond markets but now in the credit markets where we still favor quality and in particular US Investment Grade (for carry purposes...). All of this brings us to our next point, namely that bond yield curves behavior have changed dramatically.

  • Macro and Credit  - The bond yield curves are now fully inelastic
Whereas the rise in US inflation is raising some concerns relative to the US yield curve, we do not have such a sanguine approach for the long end of the curve particularly because, we agree with Louis Capital Markets latest points made in their most recent cross asset note from the 16th of March entitled "How does it end?":
"Last week there was also a huge move on long term Japanese rates. The 10 year Government bond yield appears now to be well anchored in negative territory. How is this possible? In what world do we live? 
Below, we show the average 10-year bond yield for developed countries and it stands at an all-time low, below 1%. We live in a world in which the public sector has never been so indebted. However, it can borrow money at a rate that has never been so low.

Economic textbooks are filled with details of the term structure of interest rates and the message of the bond yield curve. Below right we show that these academic books should be used now for lighting fires because the historical relationships have fully broken down. Since 2009, we have faced a long lasting capitulation towards the idea that one day long term bond yields will recover their pre-crisis levels. Thus, while the slope of the bond yield curve was negatively correlated to short term rates, it is now fully inelastic: short term rates have been stuck to 0% since 2009 and long term bond yields have moved from 3% to 1%.
The fact that long term bond yields confirm that even in the long term the situation will never normalise poses two questions. Firstly, do bond markets fundamentally misunderstand the economic situation or are they correct in their expectations? The problem is that central banks, who decide the level of short term rates, have remained unclear about what will be the next “normal situation”? The case of Sweden, one of the first countries having experienced deeply negative rates, is worth mentioning. We show below the dynamic of the core CPI, of wages, of Employment and we add the main refinancing rate into the mix as well. The  first chart below shows absolute data and the second one, it is a z-score (in standard deviations around the mean).
Sweden: Key Economic Data  

We see that in Sweden, the employment situation has normalised, the core inflation rate has normalised, the wage dynamic is a bit weak but interest rates have never been so low in economic history. Why has the Swedish central bank decided on such a policy? Or to put it in another way, what is required to put rates back above 0%?
The Fed will meet in two days. We believe Fed Board members remain very uncomfortable with the current situation. We will not repeat what we have said for many months now, that slacks in the economy no longer exist and that inflation is back to trend. The problem is not the US economy, the problem is the US$ leverage in the emerging world and the declining EM currencies. The question for Fed members is clearly subjective. Should they grant more time to EM countries to make their adjustments or should they reload their monetary policy tool because the US economic cycle is reaching maturity? These are two different questions and up to now, Fed members have refused to choose, leaning however a little towards the first solution.
Our stance remains the same, because we are bullish on the US economy, we do not understand how 5y×5y forward USD rates can trade below 3%." - source Louis Capital Markets
Apparently, the Fed has chosen to throw a lifeline to EM countries and to give them more respite by tampering their "normalization" process, but as far as our "inflation expectations are concerned and in relation to "Unobtainium", when it comes to the US we remain "data dependent" and it remains to be seen if the US has indeed reached "escape velocity" when it comes to "wage inflation". We do not share the same optimism as LCM on that matter and believe the rise in "inflation expectations" to be for the time being a temporary phenomenon. Yet, if indeed the slope of the bond yield curve which was negatively correlated to short term rates, is now fully inelastic from a strategy perspective, we believe being long US TIPS (given their embedded deflation floor), long gold miners and long US long bonds still represent a relatively attractive "allocation". What is as well interesting is that the short-end of the US yield curve is prone to more volatility in similar fashion than long-dated Japanese and German government bonds have become as well significantly volatile thanks to NIRP. 

The volatility of of the US yield curve is clearly in the front-end of the curve as indicated by Bank of America Merrill Lynch in their Situation Room note from the 16th of March entitled "Marking the Fed toward the market":
"Marking the Fed toward the market 
The main story at the conclusion to the March FOMC meeting was that, by lowering the dot plot to two rate hikes this year, the Fed chose to mark their view on the near term path for the Fed funds toward market expectations. In other words, the Fed acknowledged, what the market has suspected for a long time, that it will be difficult for the Fed to hike rates in an environment of global weakness and deflationary pressures. Hence the big bull steepening move in the Treasury curve with 2-year yields 10.9bps lower while 30-year yields were comparatively little changed (-2.0bps)
As a result the likelihood of a hawkish monetary policy mistake derailing the US economy declined significantly and VIX dropped 11.0% as stocks rose 0.6%. Less economic uncertainty in turn is positive for credit spreads, while the decline in interest rates is negative. However, with longer term interest rates holding up well the net effect is positive and supportive of our bullish outlook for HG credit as well as the Treasury curve steepening move supports our view that the 5s/10s spread curve flattens. Sector wise today's Fed moves are more positive for industrials than banks, although relative valuations and last weeks's ECB moves mitigate that." - source Bank of America Merrill Lynch
Whereas the rally in the US Investment Grade has been significant, the ECB's latest "generosity" package has lead to a rush towards credit spread products, enticing investors to renew the "beta" game in the process, namely reaching for yield and credit risk in the process. If indeed the short end of the European government bond market has become irresponsive thanks to NIRP and has plunged most of European short term bonds into negative territory, the consequences of yield curves becoming "inelastic" is pushing punters towards the only "less perceived risky"decent game in town namely investment grade credit. This is validated by the flows seen in Europe as shown in Bank of America Merrill Lynch chart below from their Follow the Flow note from the 18th of March entitled "Front-running” the ECB…":
"…as investors rush to buy corporate bonds 
We have seen it in the past. When the ECB announced the government bond buying program, inflows accelerated into the asset class. With the help of the ECB, credit flows broke free from a long period of outflows. Last week’s positive inflow into high-grade and high-yield funds was the third consecutive and the biggest in 53 weeks.
This considerable shift in momentum was mainly thanks to a decisive shift in high grade. The asset class recorded its first inflow in ten weeks and the biggest for more than a year. High yield funds enjoyed another - the fourth in a row - week of inflows.
Elsewhere in fixed income, government bond funds recorded another outflow during the previous week.
Money market fund flows were also in the negative territory, recording a fourth consecutive outflow – the longest streak since March ‘15.
To the contrary outflows continued from equity funds. The asset class has suffered outflows for the last six weeks, which now sum up to $15bn. This is the longest period of outflows seen in equities since October ’14." - source Bank of America Merrill Lynch
The outflows from equity funds do not surprise us. This what we pointed out in our recent conversation "The Monkey and banana problem":
"The sell-off this year has set up the stage for an operant conditioning chamber (also known as the Skinner box): When the central bank monkey correctly performs the "central bank put" behavior, the chamber mechanism delivers positive investment returns to the community and a buying behavior. In some cases of the Skinner box investment experience, the mechanism delivers a punishment for an incorrect or missing responses (central bankers). Due to the lack of appropriate response or incorrect response (Bank of Japan with NIRP) from central bankers in 2016, the investor monkey community has been delivered a punishment in the form of a violent sell-off, leaving the investor monkey community less inclined in going again for the "equity banana" for fear of another "electric shock" hence the reach for bonds." - source Macronomics, February 2016
No doubt that the "European investor monkey community" is fearful of another "electric shock", so for now they'd rather play the "reach for bonds", ditching equities in the process. The beauty of the Skinner box...or from "Unobtainium" (Main Street) to "Obtainium" (Wall Street), but, we are ranting again...

This leads to our final point and final chart, that no matter how hard central bankers try to generate "Unobtainium", demography matters, end of the day, no matter how big your "printing press" is.

  • Final chart: Demography is destiny
As we have pointed out, like many others before us, when it comes to the trajectory of bond yields and inflation expectations, demography matters. This is the point we made in our February 2015 conversation "The Pigou effect" relating to our long term deflationary stance. 
You probably better understand now much better our long standing deflationary stance and lack of "appetite" for European banks stocks (we are more credit guys anyway...). It's the demography stupid! Beside's that we have pointed out in our conversation "Stimulant psychosis:
Both the master Pigou and the student Keynes have inadvertently grant unprecedented capital gains to rentiers in the form of exorbitant bond price!
"Rentiers seek and prefer deflation - European QE to benefit US Investment Grade credit investors. Rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions, even at the expense of economic growth, capital accumulation and high levels of employment."
The problems facing Europe and Japan are driven by a demographic cycle not a financial cycle. This once again illustrated in our final chart and table from Bank of America Merrill Lynch from their latest Securitization Weekly note from the 18th of March:
"Demography is destiny 
The big picture
We borrow this week’s title from Dr. Joseph Coughlin of the MIT AgeLab, who was a featured speaker at this week’s BofAML Residential Mortgage and Housing Finance Conference. For financial markets, the key demographic reality is that populations across the globe are aging, some more rapidly than others. BofAML Chief Investment Strategist Michael Hartnett noted this in the recent piece, BofAML’s Transforming World Atlas: Investment themes illustrated by maps.Table 1 shows, by country, the percentage of populations that are 65 years old or over, as of 2015 and projected for 2050.

Japan is seen as the world’s leader in age, both now (26%) and in 2050 (37%). Europe (Germany, Italy, Spain) is not too far behind. The US, currently at 15%, is next, although countries such as China and Brazil will age more rapidly over the next 35 years and overtake the US in terms of the percentage of people above 65 years old. Not surprisingly, as populations age, productivity and consumption patterns change, with deflation conceivably an associated phenomenon. The bond market experiences of Japan and Germany relative to the younger US are perhaps illustrative. Chart 1 shows the history of 30yr bond yields in Japan, Germany, and the United States over the past 15 years. Japan has led the way lower while Germany has followed suit and narrowed the gap to JGB yields. US yields have moved lower but not to the same degree.
The question arises: will the US inevitably follow and see 30yr bond yields head below 1%? So far, US yields have proven to be somewhat more resilient than in Japan and Germany, and the different demographic outlook (less aging) argues for less downward pressure on yields than in Europe and Asia. Nonetheless, we should note that one of our conference presenters, Scott Minerd of Guggenheim Partners, made the case for a 1% 10yr treasury yield at some point in the not too distant future; currently, we are simply at the middle of the downward trend channel in rates of the past 30 years (Chart 2).

At a minimum, the aging of the global population suggests it is not unreasonable to think this is at least reasonably likely outcome at some point in the future. " - source Bank of America Merrill Lynch.
No offense to Bank of America Merrill Lynch but the title they used has not been authored by Dr. Joseph Coughlin of the MIT AgeLab but by August Comte, a French sociologist (1798-1857).

You probably understand by now, our inclination towards long dated US Treasuries. End of the day, if central banks cannot generate "Unobtainium" in the form of "renewed" inflations, what is not to like in the "carry play" offered in the long part of the US Treasury curve? We wonder.
"Low interest rates are usually attributed to low inflation, weak economic growth and super easy monetary policy. But there's another deep-seated factor that doesn't get much attention: demographics." - Greg Ip, Canadian journalist
Stay tuned!

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