Thursday, 12 October 2017

Macro and Credit - Anatomy of Criticism

"Criticism may not be agreeable, but it is necessary. It fulfils the same function as pain in the human body. It calls attention to an unhealthy state of things." - Winston Churchill

Watching with keen interest, the continuation of the beta rally in both equities and credit, while looking at the weakening of the US duration trade on renewed discussions on tax reforms in the US as well as most recent macro data, when it came to electing this week's title analogy, given the growing change of narrative coming from our central bankers, we reminded ourselves of Canadian literary critic Northrop Frye's work entitled "Anatomy of Critiscim" from 1957. In Frye's Anatomy of Criticism, he deals extensively with what he calls myths of Spring, Summer, Fall, and Winter:
  • Spring myths are comedies, that is, stories that lead from bad situations to happy endings. Shakespeare's Twelfth Night is such a story and QE 1 as well in addition to the suspension of mark to market accounting rules. and other supports provided by our "Generous gamblers" aka our central bankers.
  • Summer myths are similarly utopian fantasies such as Dante's Paradiso or Universal Basic Income, or incredible valuation levels for Aramco's upcoming IPO.
  • Fall myths are tragedies that lead from ideal situations to disaster. Compare Hamlet, Othello, and King Lear and the movie Legends of the Fall, or the referendum in Catalonia, or the ongoing face-off with North Korea.
  • Winter myths are dystopias; for example, George Orwell's 1984, Aldous Huxley's Brave New World, and Ayn Rand's novella Anthem and the rise of the robots, including the spying of individuals through social networks and other means.
In similar fashion, all human narratives have certain universal, deep structural elements in common. Same things goes with credit and business cycle, no exception there. Our credit criticism in various musings have illustrated a rising unhealthy state of things to paraphrase Churchill. As we pointed out as well more recently, the beta rally is still going strong towards 11 that is, in true Spinal Tap fashion. After all records have to be broken on the way up as well as on the way down. But, contrary to the perma-bear crowd, we still think this rally has some more steam to go, given current financial loose conditions we are seeing, hence the outperformance of the beta play such as the CCC High Yield credit bucket this year. Of course there is always the exogenous risk factors at play, which could indeed spark some repricing in the on-going rally. We had the BREXIT, the Trump rally and now we have the on-going political tussle in Spain which we have decided to coin "FRACASTONIA" but we ramble again...Anyway, from a financial markets point of view in the coming weeks is the rising change of narrative from central bankers. Like in Disney's movie Fantasia, it's looks to us that our sorcerer's apprentice is starting to think it's liquidity injection via his magic broom is getting a little bit out of control, and for this little guy, financial stability matters, and matters a lot.

Dear readers, we would like to apologize for the lack of posting recently, but we have been travelling hence our difficulties in putting our thoughts down in our usual weekly fashion. In this week's conversation, we would like to look at if in credit, carry is still the trade du jour, or put it simply, is it still "beta max". Also from a macro perspective, we will look again at inflation from an autocorrelation problem perspective.

  • Macro - Inflation has an autocorrelation problem.
  • Credit - Beta max? Don't get "carried" away.
  • Final chart - A structural weakness in the labor market
  • Macro - Inflation has an autocorrelation problem.
While we recently took many potshots at the Phillips Curve "cult members" and discussed also the change in markets fundamentals such as globalization and demographics which have to some extent weighted on the efficiency of the Fed's model, we would like to look at additional reasons why the Fed continues to deviate from its 2% inflation mandate and what it entails. On that subject we read with interest Wells Fargo's take from their note from the 3rd of October entitled "Is There an “Invisible Hand” Behind the 2 Percent Inflation Target Rate?":
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” - Mark Twain
Executive Summary 
The Federal Open Market Committee’s (FOMC) 2 percent inflation goal is often targeted by adjusting the FOMC’s monetary policy stance. The implicit assumption (or the invisible hand) behind the 2 percent inflation target is that the inflation rate is mean-reverting at the 2 percent rate. However, this assumption requires further inspection and raises questions regarding the possibility that the inflation rate would deviate from the target rate. Moreover, what is the behavior of above-/below-target inflation? Are these deviations temporary or permanent in nature? 
An inflation target plays a critical role in the FOMC’s monetary policy decision making process. Therefore, testing, instead of assuming, to determine if the PCE inflation rate is mean-reverting is crucial for decision-makers.
Our statistical analysis suggests that the PCE inflation rate may be mean-reverting, although the evidence is tenuous. So, can we assume inflation is mean-reverting, and what level of confidence do we have? A mean-reverting series, by definition, can fluctuate from its mean but eventually returns to some average value. The next challenge is to estimate the pace of adjustment. That is, how long does it take the inflation rate to return to the target rate after deviating from it? And does the PCE inflation series have a persistence/autocorrelation problem? 
Why is persistence/autocorrelation of the inflation rate a concern for decision-makers? Inflation persistence has crucial policy implications as a consistently below-/above-target inflation rate would suggest an accommodative/restrictive monetary policy for an extended period of time, all else constant. Therefore, a very slow pace of monetary policy normalization would be a possible result if below-target inflation persists for an extended period of time. 
To Anticipate the Results 
Our analysis indicates that inflation has an autocorrelation problem. Put differently, when the inflation rate deviates from the target rate, inflation takes a long period to get back to the 2 percent target rate. One major reason is that the current inflation rates are highly correlated with the past values (coefficients are very high, close to one). Therefore, the inflation rate would take a longer time to get back to the target rate than if autocorrelation were not present. For example, during the period from November 2008 to August 2017, the inflation rate was below the 2 percent target for 86 out of 106 months. 
Furthermore, persistently low inflation may not only affect interest rates but also other variables. One of them is the unemployment rate, as the Phillips curve suggests an inverse relationship between the unemployment rate and inflation. The recent debate about the Phillips curve status is reflective of the characteristic that the original Phillips curve does not allow for an autocorrelation problem. Persistently low inflation may also explain part of the slower wage growth in recent years. Low inflation rates may reduce business production and their ability to raise prices, and, thereby, may affect profit margins in a low-productivity economy. The wage-price spiral may have lost its speed as well.
Source: U.S. Department of Labor and Wells Fargo Securities 
The 2 Percent Inflation Target Rate: Is Inflation Mean-Reverting? 
Statistically, if a series is mean-reverting then that series will move around its mean (the FOMC is assuming the 2 percent is the mean) and deviations from the mean (higher/lower inflation periods) are temporary in nature. As a policy model, the FOMC’s 2 percent target assumes, implicitly, the inflation rate is mean reverting. 
We live in a constantly changing world and need to test, instead of assume, that the PCE inflation rate is mean-reverting. We apply a unit root test (ADF test) to find out if the inflation rate is mean-reverting.1 The PCE deflator (year-over-year percent change) is the preferred inflation measure of the FOMC, and, thereby, we utilize that series in our analysis, Figure 1.
For the 1984-2017 period, we find the inflation rate is mean-reverting and the mean is 2.3 percent. In the next step, we apply the state space approach to test the possibility of a structural break in the inflation rate series. If we find a structural break in the inflation rate and the break coefficient is positive (negative), then that indicates the inflation rate has shifted upward (downward) since the break date. We found two breaks—one positive and the other negative. Both breaks represent the price swings during of the 2008-2009 financial crisis. Therefore, the inflation path temporarily shifted and then returned to the long run average—a typical behavior of a mean reverting series.
Autocorrelation: When Slow and Steady May Not Be Enough to Win the Race 
If a series is mean-reverting, the fluctuations from the mean are temporary—but fluctuations still exist. Thus, while inflation rates may deviate from the mean, it is crucial to find out the pace of adjustment. How long does it take inflation to get back to the mean? PCE inflation persistently above or below the 2 percent target rate is not ideal for the FOMC. Both of these scenarios would ask for an extended period of a particular monetary policy stance. One way to test if the inflation rate series has a persistence problem is to test for an autocorrelation. The inflation data having an autocorrelation problem would indicate that the farther the inflation rate deviates from the target rate, the longer the inflation rate would take to return to the 2 percent target rate.
We estimate autocorrelation functions (ACFs), and the estimated correlation coefficients are nonzero, statistically, for first 12 lagging months, Figure 2. Furthermore, if the estimated coefficients are non-zero then that indicates the underlying series has the autocorrelation problem. We found that the PCE inflation series is autocorrelated, which indicates current inflation rates are highly correlated with its past values (coefficients are very high, close to one). Therefore, the inflation rate would take a longer time to get back to the target rate. During the period from November 2008 to August 2017, the inflation rate was below the 2 percent target for 86 out of 106 months.
This gives reason for the market’s expectation that the pace of monetary policy adjustment would be gradual as well. 
Why is the persistence/autocorrelation of the inflation rate noteworthy for monetary policy decision-makers? Inflation persistently below the target would indicate an accommodative monetary policy for an extended period of time, all else constant. Therefore, a very slow pace of the monetary policy normalization is a possible result of persistently lower inflation
Final Thoughts: The Invisible-hand may need a Boost 
The mean-reverting along with lack of autocorrelation/persistence assumptions may be the ‘invisible hand’ behind the 2 percent target rate. However, our findings of autocorrelation suggest the invisible hand may need a boost. Moreover, the autocorrelation/persistence problem has broader implications for decision makers, as persistently lower inflation may not only affect interest rates but also other variables. One of them is the unemployment rate, as the original Phillips curve does not anticipate an autocorrelation problem, Figure 3.

A persistently low inflation rate may also explain part of the slower wage growth in recent years. The persistently low inflation rate may reduce business production and their ability to raise prices and thereby may affect profit margins in a low-productivity era. The wage-price spiral may have lost its speed as well. Therefore, the invisible hand behind the inflation rate may need a boost." - source Wells Fargo
So on top of structural headwinds mentioned while criticizing the Phillips Curve model aka the Norwegian Blue parrot, inflation does suffer from an autocorrelation problem as well it seems. Furthermore, there has been rising discussions surrounding a potential return of inflation in recent weeks, not only on the blogosphere, but, as well from the sell-side. Concerns of the tightness in certain labor markets in Developed Markets (DM), make some sell-side pundits wonder if inflation could not make an unexpected return. Despite the low inflation conundrum discussed in various musings of ours, we do think that the change of the narrative from our central bankers is more a case of loose financial conditions than anything else. Regardless of the undershoot of the Fed's inflation mandate, we do think that Financial Stability matters more, when it comes to their rising discomfort with valuation levels reached in many asset classes. This is an important point put forward by Bank of America Merrill Lynch in their Liquid Insight notes from the 6th of October entitled "Jobs and FX":
"When central banks ignore low inflation 
Since the latest USD rally started in mid-August, the only currencies that have done even better than the USD are GBP and CAD. In all three cases, the respective central banks surprised markets with a hawkish turn, either hiking, as in the case of the BoC, or effectively announcing that a hike was on the way, as in the case of the Fed and the BoE. In all three cases, the real reason was not inflation concerns: UK inflation is above the BoE’s target, but mostly because of the sharp GBP drop since the Brexit referendum. Concerns that the labor market was getting too tight was the main reason, in our view, possibly leading to inflation pressure in the future. 
This suggests to us that many G10 central banks may either believe inflation is temporarily low, or that available inflation measures are missing something important. In Don’t fight the central banks when they want to do the right thing we argued that the Fed and most likely other central banks are also concerned about asset price bubbles and that they would take advantage of the “good times” to normalize policies, despite low inflation. It may not be their job to call a bubble, but it would also be irresponsible to allow bubbles to form. Leaning against the wind may be a good compliment to macro prudential measures, which have proved to have a mixed record anyway. 
Inflation could still surprise to the upside. The Phillips curve has lost its appeal, but the gap between labor markets and inflation is the widest it has been in recent decades (Chart 1). 
Some indicators suggest US inflation is not that low, with an index including a larger basket of goods suggesting US inflation is high and rising (Chart 2). 
Global monetary policies remain very loose in any case. A simple Taylor rule suggests that global monetary policies have never been looser than today in recent decades, with all G10 central banks having loose policies (Chart 3 and Chart 4).

Monetary policies have a long way to tighten before they become tight.
At the same time, while in recent years G10 central banks were involved in a form of a currency war, this has changed more recently. We believe Fed tightening—hikes and unwinding of its balance sheet—creates more room for other central banks to adjust their policies to a stance more consistent with their domestic conditions, without being concerned that their currencies may overshoot. 
Labor markets and FX valuations 
We are trying to assess possible inflation pressures by looking at the extent to which G10 labor markets are tight. Even if the Phillips curve is flat, or at least more flat than it used to be, recent central bank focus on labor market constraints suggests to us that the answer on which central banks are likely to move next may be in the labor market.
To do so, we do not have to know the natural rate of unemployment, which is difficult to estimate in practice. Instead, we look at the difference between the latest unemployment rate from the lowest level since 1980. It is reasonable to assume the smaller this gap, the tighter the labor market, and the more likely the central bank may want to tighten policies.
We then compare labor market tightness with valuation of G10 currencies. We also take a simple approach in FX valuation, by considering the z-scores of real effective exchange rates from their 20-year averages. Currencies that deviate the most from their historical average are likely to be the most misaligned. The results could provide insights on which G10 FX crosses could perform well in the medium term because of central bank policies, keeping everything else constant.
The Chart of the Day shows the results from this analysis, as follows:

  • GBP/CHF has the most upside potential. The UK labor market is the tightest in G10, with the unemployment rate at an all-time low. At the same time, GBP is the most undervalued G10 currency. On the other hand, unemployment remains historically high in Switzerland, while the CHF is overvalued. Of course, Brexit uncertainty is what is keeping GBP weak. Still, our results suggest GBP/CHF has the most potential to appreciate in G10 if the BoE starts a hiking cycle, or if the UK and the EU agree on a Brexit transition. EUR/GBP will also weaken in this case, as the Eurozone has the highest unemployment rate compared with its own history.
  • CHF/JPY could weaken. The cross is overvalued, while the labor market in Japan is tighter than in Switzerland. This is consistent with our bearish CHF outlook.
  • The Scandies could do well against the Antipodeans. SEK and NOK are historically cheaper and with tighter labor markets than AUD and NZD. Our results also support buying CAD against AUD and NZD.
  • The outlook for EUR/USD is mixed based on this analysis. Although the Eurozone has much higher unemployment than the US, EUR/USD is somewhat undervalued. This is consistent with our projections, expecting EUR/USD to weaken slightly more, to 1.15, by end-2017, but appreciate back to 1.19 in 2018.
  • Similarly, our analysis suggests balanced risks for USD/JPY, with the US labor market tighter than in Japan, but USD/JPY overvalued.
  • EUR/JPY on the other hand could weaken, as Japan’s labor market is tighter than in the Eurozone, while EUR/JPY is historically strong. However, this analysis does not take into account the ECB constraints, which are likely to force early QE tapering next year. If the BoJ remains committed to its loose monetary policies, EUR/JPY could even appreciate more—for these reasons, long EUR/JPY was one of our high conviction year-ahead trades for 2017. 
Bottom FX line 
Our analysis suggests possible surprises from central banks in G10 as they focus more on labor market conditions, despite low inflation, could support GBP against CHF and EUR, with the caveat of downside risks from Brexit negotiations. They could also support the Scandies, CAD and JPY against the Antipodeans, and could also be bearish for CHF/JPY. 
Although our results are mixed for the USD, as the US labor market is tight but the USD is not historically weak, we would argue the Fed will continue leading the normalization process, which should keep the USD supported. In any case, the USD is not far from its historical average, suggesting it could appreciate more in the short term. We expect Fed tightening to create more room for other central banks to follow, without being concerned that their currencies could overshoot. This suggests to us that the trigger to position for monetary policy divergence in G10 FX could be provided by the December Fed hike, particularly if markets move closer to the Fed’s dot plot for next year. Progress in US tax reform could have a similar impact, although with a much stronger USD
appreciation, in our view. " - source Bank of America Merrill Lynch
While we agree with Bank of America Merrill Lynch's view that the Fed and other central banks are also concerned about asset price bubbles, when it comes to USD strength, we have already seen a significant rally in a short period of time. A cause for concern we think, from an "Anatomy of Criticism" perspective lies in the growing trade war rhetoric between several countries. This would not be supportive of the USD dollar, on the contrary. While everyone is focusing on the US tax reform, we do think that it will be essential to monitor possible growing tensions in global trade in the months ahead.

When it comes to asset price bubbles, we also think that we continue to be on a trajectory of going to 11 that is, in true Spinal Tap fashion when it comes to valuation levels. We might have been overly defensive credit wise when it comes to the performance of the beta space and in particular the CCC High Yield bucket. It remains to be seen how long this game is going to continue. In the meantime flows remain supportive and the change in the narrative from our central bankers is yet to be perceived  as a meaningful threat by the investors crowd.

  • Credit - Beta max? Don't get "carried" away.
Whereas we continue to witness a significant mountain of negative yielding assets globally, the credit mouse trap has been set by our central bankers. For investors starved of safe yield, anecdotally we even have seen Investment Grade investors with no choice but to reach out for more duration and more credit risk. No wonder they have gone for higher quality high yield, causing the BBs rating bucket to return a very decent 6.8% YTD. At the same time, low volatility and minimal credit losses, have led CCCs  credit canary to reward handsomely credit investors with a YTD of 9.8% according to Bank of America Merrill Lynch. The current low interest rates volatility is providing a "goldilocks" environment for credit. Unless there are some meaningful exogenous factors that come into play, it seems to many that the game of "carry" appears to be "bulletproof". 

As we pointed out in recent musings, no doubt to us that we will go to 11, valuation wise in true Spinal Tap fashion. On the subject of valuation for credit we read with interest Deutsche Bank's Credit Strategy note from the 20th of September entitled "Is Carry Still King?":
"Valuations even more stretchedThe performance seen through the summer has only served to make credit appear to be even more expensive as we head towards Q4. Figure 2 (left) updates our often used analysis highlighting where current spreads rank relative to their own histories for a broad selection of credit indices. As we stand all but two of the analysed indices are at a spread level tighter than the median. For EUR HY, spreads are at levels where they have been tighter less than about 15% of the time through history. It is not quite so extreme for IG but non-financial BBBs across all currencies are around the cusp of the tightest quartile. Looking at the right hand chart, which is focused on the rank history for EUR non-financials, we can see that we reached even tighter spreads in early August. 

In Figure 3 we look at EUR IG and HY non-financial spread histories to get a sense of where current spreads sit relative to levels going all the way back before the financial crisis. As can be seen, the current HY/IG spread ratio is near a record low and we continue to see HY valuations as stretched at an absolute level as well as relative to IG. Nevertheless, we are also cognizant of the fact that at the current stage of the economic cycle stretched valuations can persist for a while. Overall, we think HY would be more vulnerable in a sell-off following its recent outperformance.

Spreads supported by positive economic momentum 
In general, there's no doubting that across the credit spectrum valuations appear expensive. However continued performance has been supported by the solid macro backdrop. In particular European macro data have generally been strong in recent weeks/months. In Figure 4 we show our economists' SIREN monitors looking at indices summarising both economic growth momentum and macro surprises.

(For more information on these monitors, please see the relevant section in DB Focus Europe, available at The SIREN Momentum index has been in a new, higher range in the last six months, consistent with close to 2.5% annualised GDP growth. At the same time the SIREN Surprise index has also improved since the middle of the year, edging back into positive territory.
In addition to the supportive macro data we have also continued to operate against a backdrop of low volatility which tends to keep spreads tight. Measures of market volatility remain at the lower end of ranges and as such we couldn't entirely rule out some further spread compression. Updating our simple spread model looking at where implied equity, rates and FX volatility suggest that while HY spreads are broadly in line with the volatility-implied levels, for IG an argument can be made that spreads could get even tighter. But at the very least the charts suggest that if we don't see a meaningful move higher in volatility then spreads are likely to remain close to the current relatively tight levels. 

Will technicals provide some headwinds? 
Obviously, central banks remain a key driver of asset prices and in EUR credit, the ECB CSPP remains a powerful force keeping spreads in check. While we do expect the ECB to announce a further trimming of the overall QE programme on 26 October, we expect them to err on the side of caution given the absence of inflationary pressures. The ECB's exit from the bond market is likely to take place over an extended period of time even if the economy evolves according to their forecasts. While we do expect the negative technicals of a QE taper to lead to moderate widening of spreads, as long as economic fundamentals continue to be strong we would not expect a meaningful sell-off in credit." - source Deutsche Bank
Indeed, central banks remain the key driver of asset prices, hence the importance to track the change in their narrative. Both the Fed and the ECB will probably reduce the alcohol content of the credit punch bowl at a very slow pace.

While we advise for caution, the continuation of the rally in all things beta seems to be pointing towards the development of a state of euphoria. As long as the narrative of our generous gamblers doesn't meaningfully change or some exogenous factors comes into play (Catalonia aka "Fracastonia", North Korea and more...) it seems we are surely going to move towards the 11 level. After all records are meant to be broken. In this high stake poker games, it seems the margin for error is smaller by the day, we would rather tone down the enthusiasm and continue building some defenses. One could opine that given the on-going goldilocks period for credit thanks to low interest rates volatility, one should continue to play the "beta max" game as posited by Société Générale in their Credit Strategy Weekly note from the 29th of September entitled "Only a shock can shake credit":
"Only a shock can shake credit 
Into the last stretch of what has been another good year: The last quarter of the year is upon us, and so far the performance has been fairly healthy across the various credit asset classes. After surpassing all major political tests, there remains one hurdle in the form of the ECB meeting in late October. The risk is that the central bank announces a rapid withdrawal of QE support that disrupts the markets. Even a slow withdrawal is likely to be enough to push sovereign risks higher and put pressure on credit spreads, even if we believe that CSPP will be the last programme to be altered. At best, the ECB will simply announce an extension, and in that case it’s plain sailing until the end of the year. But a tapering announcement is not improbable, and in that sense we prefer to reduce duration, as we expect the credit curves to steepen. 
High beta sectors remain the place to be: Tapering or no tapering announcement, the higher beta sectors (AT1 CoCos, sub insurance, Tier 2 bonds and corporate hybrids) remain the better investment alternatives on both sides of the Atlantic, in our view. If there is no tapering, the high beta sectors, names and bonds will outperform given the higher carry and tightening potential. But if tapering does come and we see yields on a rising trend, then these sectors are likely to be the more volatile, but the higher breakevens will provide a better cushion and ultimately a better performance than low beta, low yielding, high rated and long maturity bonds." - source Société Générale
Whereas macro data continues to be supportive, from an "Anatomy of Criticism" perspective, only a change in the narrative from our "Generous Gamblers" constitute the largest threat to the investors crowd. The herd mentality continues to be strong in playing the beta game. When it comes to US Investment Grade Credit as shown by Bank of America Merril Lynch in their Situation Room report from the 11th of October entitled "New post-crisis tights" we are going to 11 in a Spinal Tap fashion:
"On Tuesday our benchmark US high grade index reached the tightest level at 103bps since the financial crisis. This follows the previous spread market peak over three years ago, when spreads bottomed out at 106bps on June 24, 2014 (Figure 1).

Here we update our analysis on where spreads stand currently relative the prior market peak in 2014 (see Vs. post-crisis tights). One factor contributing to tighter spreads currently are the large downgrades to high yield in 2015, mostly among EM credits. With many wider issuers out of the high grade index, EM spreads are now 40bps tighter than in June 2014, while DM issuer spreads are actually 3pbs wider." - source Bank of America Merrill Lynch
Thanks to low rate volatility, the carry game enables all sort of beta plays. Unfortunately, it is getting late in the game and central bankers have started to lower the volume in the credit binge party. You have been warned.

Whereas the latest job report was a miss, for our final chart, there is more to the low inflation story and its coming in the US from structural issues preventing an acceleration in wages increases and it has to do with the labor market.

  • Final chart - A structural weakness in the labor market
We won't go through again all the arguments we have put forward for the Fed's broken Phillips Curve model, hopefully we have put that Norwegian Blue parrot to rest, no offense to the cult members out there. What is we think more interesting from a US macro perspective is that there is a structural weakness in the US labor market which, as pointed out by Wells Fargo in their report from the 6th of October entitled "Taking the Long View Over the Short Run Dip". The Beveridge curve shows that the mean duration of unemployment remains stubbornly high:
"Structural Problems Persist: Drag on GrowthFor any given unemployment rate (labor supply), the vacancy rate (job openings) remains wider than in the previous expansion (bottom graph), however the slack is gradually tightening. 

This Beveridge Curve signals a structural weakness in the labor market which is confirmed by several labor market survey indicators. Compared to a year ago, the unemployment rate for those without a high school education and with a high school diploma remains higher than the unemployment rate for those with some college. The mean duration of unemployment rate remains at 24.4 weeks which is higher than any level since 1982. Finally, the prime age labor force participation rate has risen over the last year but remains far below the level of participation since 1990." - source Wells Fargo
If inflation remains low, is also due to the fact that the prime age labor force participation rate hasn't been repaired and is still pretty much impaired. Fed minutes show concern that low inflation is not transitory. Whereas the Fed finds it mysterious that inflation is still so low, we don't. Maybe the Fed should start their own "Anatomy of Criticism" after all, but we ramble again...

"The true mystery of the world is the visible, not the invisible." -  Oscar Wilde

Stay tuned!

Monday, 25 September 2017

Macro and Credit - Rescission

"Perfection of planned layout is achieved only by institutions on the point of collapse." -  C. Northcote Parkinson, British Historian

Looking with interest at the decisions taken by the Fed at its FOMC meeting to start unwinding its bloated balance sheet, when it came to selecting our title analogy, we reacquainted ourselves with the term "Rescission" from contract law, (not to be confused with "Recession" yet). In contract law, "Rescission" has been defined as the unmaking of a contract between parties. "Rescission" is the unwinding of a transaction. This is done to bring the parties, as far as possible, back to the position in which they were before they entered into a contract (the status quo ante). One could opine that "Rescission" is typically viewed as "an extreme remedy" which is rarely granted, but in the case of the Fed, it was a unanimous decision to hold the federal funds rate between 1.00% and 1.25% and begin the process of shrinking its balance sheet by October hence our chosen analogy for this week's conversation.

Before we go into more details of this week's conversation, we would like to make a support appeal on behalf of our surfing friends in Saint Martin. They lost everything when hurricane Irma levelled their island. While we do have a tip jar on the blog page, for those of you who enjoy our free weekly musings, we would be extremely grateful if you could be helping out in providing financial support for the reconstruction of Saint Martin's surf club facilities given they really need a new boat. These facilities have been effectively wiped out. Jean-Sebastien Lavocat, a great windsurfer and surfer, is running the place. In 23 years of existences the surfing club of Saint Martin has generated numerous young surfing champions including current top French number three Maud Le Car. He really needs your support to continue to do so. You can make donations at the following address: Solidarity with Windy Reef. Please give them a hand. As well, the natural reserve area where the surf club is located, needs financial support. You can also donate on the following page: "Réserve Naturelle St-Martin Vs IRMA". After Irma please participate in the restoration of the last natural sites of the island of Saint Martin! Thanks again.

In this week's conversation, we would like to look at the Fed's low inflation mystery, in relation to the fall of productivity in the US, yet another nail in their Norwegian Blue parrot aka the Phillips Curve. Another wise wizard from the BIS, namely Claudio Borio has delivered another blow to the outdated model used by the central banking "cult members".

  • Macro - Low inflation mystery? The Fed is gone fishing.
  • Credit - Beware of rapid credit expansion
  • Final chart - "Broken" asset investment in Developed Markets

  • Macro - Low inflation mystery? The Fed is gone fishing.
Given the colloquial meaning of "Gone Fishing" relates to a checkout from reality, as well as being unaware of what's going on, Janet Yellen's latest comment on the low inflation mystery is another indication of their lack of understanding of why their Phillips Curve model is clearly past its due date we think. 

While in various recent musings we have been pounding this Norwegian Blue Parrot, which is still resting for the Phillips Curve "cult members", we couldn't resist to bring back this subject following the support coming from Claudio Borio, Head of the BIS Monetary and Economic Department in his most recent discussion on the low inflation issues entitled "Through the looking glass" published on the 22nd of September 2017.  
"Central banks must feel like they have stepped through a mirror, and who can blame them? They used to struggle to bring inflation down or keep it under control; now they toil to push it up. They used to fear wage increases; now they urge them on. They used to dread fiscal expansion; now they sometimes invoke it. Fighting inflation defined a generation of postwar central bankers; encouraging it could define the current one.
What is going on in this topsy-turvy world? Could it be that inflation is like a compass with a broken needle? That would be a dreadful prospect – central bankers’ worst nightmare. And what would be the broader implications for central banking?
In my presentation today, I would like to address these troubling questions. I will do so recognising that “in order to make progress, one must leave the door to the unknown ajar”, as Richard Feynman once said. We should not take for granted even our strongest-held beliefs. That, of course, means that I will be intentionally provocative.
I will make three key points – putting forward two hypotheses and drawing one implication.
First, we may be underestimating the influence that real factors have on inflation, even over long horizons. Put differently, Friedman’s famous saying that “inflation is always and everywhere a monetary phenomenon” requires nuancing (Friedman (1970)). Looking back, I will focus mainly on the role of globalisation; but, looking forward, technology could have an even larger impact.
Second, we may be underestimating the influence that monetary policy has on real (inflation-adjusted) interest rates over long horizons. This, in fact, is the mirror image of the previous statement: at the limit, if inflation were entirely unresponsive to monetary policy, changes in nominal rates, over which central banks have a strong influence, would translate one-to-one into changes in real rates. And it raises questions about the idea that central banks passively follow some natural real interest rate determined exclusively by real factors, embodied in the familiar statement that interest rates are historically low because the natural rate has fallen a lot. Here, I will provide some new empirical evidence to support my hypothesis.
Finally, if these hypotheses are correct, we may need to adjust monetary policy frameworks accordingly. As I shall explain, that would mean putting less weight on inflation and more weight on the longer-term real effects of monetary policy through its impact on financial stability (financial cycles). Incidentally, the stronger focus on financial stability would bring central banking closer to its origins (Goodhart (1988), Borio (2014a))." - source Claudio Borio, BIS
Of course, we would argue that, if indeed, one is to make progress, one should be ready to reassess the validity of its framework such as the sacrosanct Phillips Curve. We were pleasantly surprised to read in the excellent speech from one of the BIS maverick economists, that globalization was put forward as one of the reasons for the lack of responsiveness of the Phillips Curve framework, which for some is simply resting like a "Norwegian Blue parrot":
"The one I find particularly attractive is that the globalisation of product, capital and labour markets has played a significant role. Is it reasonable to believe that the inflation process should have remained immune to the entry into the global economy of the former Soviet bloc and China and to the opening-up of other emerging market economies? This added something like 1.6 billion people to the effective labour force, drastically shrinking the share of advanced economies, and cut that share by about half by 2015. Similarly, could it have remained immune to the technological advances that allowed the de-location of the production of goods and services across the world? Surely we should expect the behaviour of both labour and firms to have become much more sensitive to global conditions. We know that workers are not just competing with fellow workers in the same country but also with those abroad. We know that, for a given nominal exchange rate, the prices of two tradable goods that are close substitutes should track each other pretty closely. And we know that exchange rates have not been fully flexible, as the authorities have been far from indifferent to exchange rate movements. In other words, we should expect globalisation to have made markets much more contestable, eroding the “pricing” power of both labour and firms. If so, it is quite possible that all this has made the wage-price spirals of the past much less likely.
More specifically, one can think of two types of effect of globalisation on inflation. The first is symmetrical: assuming something akin to a global Phillips curve, one would expect domestic slack to be an insufficient measure of inflationary or disinflationary pressures; global slack would matter too. The second is asymmetrical: one would expect the entry of lower-cost producers and of cheaper labour into the global economy to have put persistent downward pressure on inflation, especially in advanced economies and at least until costs converge." - source Claudio Borio, BIS
As we pointed out earlier in September in our conversation "Ouroboros", these are the reasons why the Phillips Curve is broken we think:
"For us, there are three main reasons why the Phillips curve is a Norwegian Blue parrot, simply resting in a Monty Pythonesque way:

  1. Demographics: as population ages, there are more pressure on aggregate demand and total consumption. 
  2. Globalization: real wages have come under pressure thanks to offshoring of labor in different parts of the world, leading to good solid wages jobs in the industrial sector being replaced by low qualification low paying jobs in the service and hospitality sectors.
  3. Technology: As per Henderson's work and recent progress in technology, pressure on prices as been appearing thanks to the Experience curve. The fight between Amazon and the retail sector comes to mind we think about it. Technology has been holding down costs overall and facilitated rapid price competition in some sector (internet on retail).
This is why we think the Phillips curve is obsolete, for structural reasons." - source Macronomics, September 2017

Obviously our hypotheses have been given some much appreciated boost from none other than the wise and respected Claudio Borio from the BIS. We will not delve into more details of Claudio Borio's speech, but, in our opinion, it is a must read, particularly for the Phillips Curve "cult members". As Richard Feynman once said, and as pointed out by BIS Head of Monetary and Economic Department, in order to make progress, one must leave the door to the unknown ajar. Unfortunately, for many it seems, the door is closed. For them, the Phillips Curve is simply "resting".

The pace of wage inflation is influenced by productivity growth. In this environment of weak productivity growth, firms may be more hesitant to raise wages. Productivity growth has averaged 0.5 - 1.0% yoy over most of this recovery, which is a historically slow pace of growth. Without productivity growth, it becomes harder for companies to justify raising wages since the output per worker has failed to increase, that simple. We already discussed the issue of US productivity in June 2016 in our conversation "Optimism bias":
"In our book, "secular stagnation" is not only due to the burden of high global debt levels but, as well by the evident slowdown in productivity labor growth, which is clearly impacted by the "rise of the robots". This does not bode well for the stability of the "social fabric" and with rising populism in many parts of the world." - source Macronomics, June 2016
As we pointed out to Kevin Muir author of the Macro Tourist in our conversation "The Dead Parrot sketch", a business owner is a "deflationista" at heart because he fights day and night to compress his costs and find smart ways to do more and earn more with less in order to maximize his profits. Also it is worth mentioning French economist Jean Fourastié's work relating to real wages, real prices and in particular around productivity. In our last conversation we indicated that when it comes to the Phillips curve, the deflationary bias of capitalism and the Experience Curve should not be neglected in addition to the globalization factor:
"As we move towards the end of an economic expansion in the US, productivity has been falling, and jobs have been mostly created for lower skills workers, hence the lower wages conundrum weighting on inflation expectations." - source Macronomics, September 2017
When it comes to productivity issues, it seems to us that the Fed is unaware of what's going on, namely, that they've "gone fishing". On the issue of low productivity, we read with interest Bank of America Merrill Lynch's Economic Weekly note from the 22nd of September entitled "Productivity growth is a procrastinator":
  • "The US economy is currently in a low productivity regime, averaging just 0.6% growth since 2011.
  • The near-term outlook appears dim due to headwinds from unfavorable demographic factors and weak capital investment.
  • Broad adoption of new IT goods and services could generate better productivity growth. But a regime shift is likely a long-term story.
Productivity growth down in the dumps
Labor productivity growth has been abysmal. Since 2011, it has averaged less than 1% and the trend is pointing down, as it came in flat in 2016. As we wrote last week, low productivity growth is likely one of the factors holding down wage gains and one of the catalysts that led some FOMC participants to revise down their longer-run dot in the latest SEP projections. In this note, we break down productivity growth into its three major components—labor quality, capital deepening and multifactor productivity—and ponder the near-term outlook.
Not all hours are created equal
Labor quality measures the effect of shifts in the age, education, and gender composition of the workforce. One can imagine that total output will vary given a workforce with a certain set of education, skills, and experience. Contribution of labor quality to productivity growth has varied over time as the composition of the workforce has shifted (Chart 1).

Labor quality took a dip in the late 60s to the 70s as a surge of young inexperienced workers (Baby-Boomers) entered the job market, lowering the experience level of the overall workforce. But as those workers gained experience and entered their prime-working age (when they are likely to be the most productive), the labor quality of the workforce increased, leading to greater productivity gains. Additionally, we saw the skill level of the workforce rise as a greater share of workers obtained higher degrees, helping to usher in an era of high productivity growth.
Today, the forces affecting labor quality are mixed (Chart 2).

On one hand, the share of the prime-age workers is declining as Baby-Boomers begin to retire and the Bureau of Labor Statistics projects that the trend will remain flat over the next decade. On the other hand, a greater share of workers are obtaining college degrees or higher and the trend looks broadly positive. In the long run, a more-educated labor force should pay dividends for productivity growth. However, in the near term the “Silver-Tsunami” effect will likely be a bigger countervailing force, keeping the contribution of labor quality to productivity growth below levels experienced in the 90s and 2000s.
You got to spend money to make money
Capital deepening or capital intensity is the amount of capital investment in relation to labor input. More machinery or equipment should make a worker more efficient, which should translate to more output per hour. Prior to the Great Recession, capital deepening contributed on average 0.9pp to labor productivity growth. Moreover, we experienced a big surge in capital investment at the turn of the century as businesses invested more in information and communication technology during the IT revolution. Since then, the pace of capital investment has slowed. The Great Recession played a role in holding down business investment, but during the current recovery, the pace of net stock of capital investment growth has remained well below prior trends (Chart 3).

Recently, businesses have placed investments on hold, as they wait to see if Congress passes corporate tax reform. Moreover, in the industrial sector, capacity utilization remains well below pre-recession levels and overall capital formation is only modestly outpacing depreciation, lessening the need to invest heavily in new equipment and machinery. All told, given our expectations for nonresidential fixed investment to grow at a tepid pace over the next several years, we see little prospects of a strong pickup in capital deepening.
Multifactor productivity: the magic elixir for growth?
Multifactor productivity (MFP) measures the output per unit of capital and labor input. In essence, it measures the overall production efficiency of the economy. The driving force of MFP is hard to pinpoint. In fact, empirically MFP is usually estimated as the residual of the production function. But the right combination of labor and capital can lead to significant productivity growth similar to what we experienced during the IT boom.
Although productivity growth at the aggregate remains weak, certain sectors have benefited from adoption of new technologies (Table 1).

For example, the oil and gas industry experienced a surge in MFP growth due to new drilling methods such as “pad” drilling, which allows rig operators to drill groups of wells simultaneously. Additionally drillers have found further efficiencies by developing fracking methods, which reduce the amount sand and water needed to drill wells. The IT-producing and service industries such as “computer and electronic products” and “computer systems design and related services” industries continue to see productivity gains from faster processors and algorithms and the adoption of cloud computing technology. In the retail world, ecommerce has led to a surge in the share of retail activity at non-store retailers, while job growth has remained limited, boosting productivity growth in the sector. In fact, according to the BLS, labor productivity growth for non-store retailers has averaged 5.6% over the last five years, well above the aggregate pace.
Innovation in robotics and artificial intelligence, adoption of big data and machine learning analytics raise the prospects for productivity gains. However, broad diffusion of these technologies will likely take years if not decades, implying that the hoped for rebound is likely a long-term story. We could see some incremental increase in the meantime, but a full regime shift seems unlikely.
A word on mismeasurement
It’s possible that there are some mismeasurement issues in the data. The skeptics of low productivity growth usually argue that prices for IT products used to deflate nominal expenditures are too high given the quality improvements, implying more real output and greater productivity. The jury is still out, but the preponderance of evidence suggests that mismeasurement issues were around prior to the slowdown in productivity growth and there’s little evidence to suggest it has exacerbated. One area where we see potential measurement issues is profit shifting of US corporations abroad, distorting the way corporate income is reported, which leads to wider trade deficits than the official measure. According to Guvenen et. al., adjusting for this mismeasurement would add 0.1pp annually to productivity growth for 1994-2004 and 0.25pp for 2004-2008, mitigating some of the productivity slowdown.
Adding it all up
The prospects of returning to a high-productivity regime and seeing better potential growth in the near term seem limited. In fact, the risks are likely skewed to the downside to our already low estimate for potential growth of 1.7%. Demographic trends are unfavorable and businesses appear to be in a “wait and see” mode on capital spending. Multifactor productivity remains an unknown factor: the trend doesn’t look too promising, but broad diffusion of new IT products could lead to some modest productivity gains in the short run before seeing greater gains once potential is fully realized. Until then, we remain comfortable with our call for productivity growth to stay subdued and for growth to hover around 2% over the next several years." - source Bank of America Merrill Lynch
As we pointed out, productivity has been falling, and jobs have been mostly created for lower skills workers. On top of that, business owners have been more creative in keeping costs under control and not only due to "globalization". Overall, low inflation should not be a mystery for the Fed:

  • if they had read the work of French economist Jean Fourastié, 
  • if they had taken the globalization factor pointed out by Claudio Borio at the BIS 
  • if they had taken into account BCG's Experience curve impact (a company’s unit production costs fall by a predictable amount - typically 20 to 30 % in real terms - for each doubling of “experience,” or accumulated production volume). 

What we called recently in one of our musings the "Amazon factor" is effectively today' application of the Experience curve in the sense that it is the ability to produce existing products more cheaply and deliver them to an ever-wider audience (or what BCG calls "shaping demand with successive innovations").

That's about it for our "Macro" bullet point. For our credit point below, we would like to point out the brewing instability coming from rapid credit expansion, as it might be the case, that, from a Financial Stability perspective, at least the Fed is getting nervous on that front.

  • Credit - Beware of rapid credit expansion
As we pointed out in our previous conversation, the work of Claudio Borio from the BIS, has been very interesting when it comes to pointing out the risks for Financial Stability including rapid credit expansion. As a reminder, Claudio Borio and his colleague Philip Lowe wrote in 2002 a very interesting paper entitled “Asset prices, Financial and Monetary Stability: Exploring the Nexus”, BIS Working Papers, n. 114. In this paper the authors made some very important points that are worth reminding ourselves today:
"Widespread financial distress typically arises from the unwinding of financial imbalances that build up disguised by benign economic conditions […] Booms and busts in asset prices […] are just one of a richer set of symptoms […] Other common signs include rapid credit expansion, and, often, above-average capital accumulation" - source BIS 
A common sign of brewing instability has always been rapid credit expansion. The "controlled demolition" analogy we used in the past when discussing the threat of the Shadow Banking sector in the Chinese economy was a clear illustration that the Chinese authorities were clearly aware of the risks. So far they have managed to dampen the issues at hand. It is always critical to assess rapid credit expansion to gauge rising instability in our current credit world. On this subject we reminded ourselves of September 2016 paper by Matthew Baron and Wei Xiong, Quarterly Journal of Economics, entitled "Credit Expansion and Neglected Crash Risk":
"By analyzing 20 developed economies over 1920–2012, we find the following evidence of overoptimism and neglect of crash risk by bank equity investors during credit expansions: (i) bank credit expansion predicts increased bank equity crash risk, but despite the elevated crash risk, also predicts lower mean bank equity returns in subsequent one to three years; (ii) conditional on bank credit expansion of a country exceeding a 95th percentile threshold, the predicted excess return for the bank equity index in subsequent three years is -37.3%; and (iii) bank credit expansion is distinct from equity market sentiment captured by dividend yield and yet dividend yield and credit expansion interact with each other to make credit expansion a particularly strong predictor of lower bank equity returns when dividend yield is low." - source Matthew Baron and Wei Xiong, Quarterly Journal of Economics
As pointed out by the BIS work, rapid credit expansion can have severe consequences on the real economy. The recent Great Financial Crisis (GFC) was an illustration of out of control credit expansion in the housing markets with global dire consequences:
"The recent financial crisis in 2007–2008 has renewed economists’ interest in the causes and consequences of credit expansions. There is now substantial evidence showing that credit expansions can have severe consequences on the real economy as reflected by subsequent banking crises, housing market crashes, and economic recessions, (e.g., Borio and Lowe 2002, Mian and Sufi 2009, Schularick and Taylor 2012, and L´opez-Salido, Stein, and Zakrajˇsek 2016). However, the causes of credit expansion remain elusive. An influential yet controversial view put forth by Minsky (1977) and Kindleberger (1978) emphasizes overoptimism as an important driver of credit expansion. According to this view, prolonged periods of economic booms tend to breed optimism, which in turn leads to credit expansions that can eventually destabilize the financial system and the economy. The recent literature has proposed various mechanisms that can lead to such optimism" - source Matthew Baron and Wei Xiong, Quarterly Journal of Economics.
As we have discussed recently, in credit booms such as the ongoing one, credit quality is deteriorating, which is the case when it comes to US Investment Grade. The deterioration of credit quality forecasts not only lower future corporate bond returns but, will also have an impact on the recovery value. In their very interesting paper, Matthew Baron and Wei Xiong look if credit expansion predicts a significantly higher likelihood of bank equity crashes:
"We find that one to three years after bank credit expansions, despite the increased crash risk, the mean excess return of the bank equity index is significantly lower rather than higher. Specifically, a one standard deviation increase in credit expansion predicts an 11.4 percentage point decrease in subsequent three-year-ahead excess returns." - source Matthew Baron and Wei Xiong, Quarterly Journal of Economics.
Their analysis demonstrates the clear presence of overoptimism by bank shareholders during bank credit expansions, which of course not a surprise given this phenomenon is known as the optimism bias, and it is one of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics. You might already be wondering where we are going with this but, we think that right now, loose financial conditions are leading to rapid credit expansion which is probably a concern for the Fed relating to Financial Stability. On this subject we read with interest Société Générale Market Wrap-up note from the 19th of September entitled "What the macro number tell us about borrowing" which indicates that leverage is rising now in Europe as well:
"Market thoughts
In “Leverage is rising in Europe too,” we used two bottom-up data series of leverage, built from the companies in the iBoxx euro-denominated IG and high yield indices, to show how European companies were getting more risky. Do the macro figures back these conclusions up?
The Banque de France published its latest update on the financing of the corporate sector on 12 September. The year-on-year growth rate of loans to non-financials remains just under 5%, more or less unchanged from where it has been since mid-2015 (as Chart 1 shows).

The growth rate is broadly in line with the levels seen in mid-2011, ahead of the euro crisis, but less than half the peaks in 2001 (ahead of the 2002 bear market) or 2007/8 just before the US-led global financial crisis. The level of borrowing is not striking, but the composition is more noteworthy. While borrowing for short-term needs is now stable year-on-year, and borrowing to finance property investment has dipped, the borrowing for other forms of capital investment is running at 7% per annum, well above the 2011 peaks.
This suggests that companies are borrowing to invest, and explains some of the rise in balance sheet leverage noted in our earlier study.
Seen at a pan-European level, however, the trend looks far less significant. Chart 3 shows the growth in borrowing from the ECB for corporates and households (with the latter split into consumer credit and house purchases).

Corporate borrowing is not only growing less quickly than household borrowing, but the year-on-year growth rates have decelerated recently.
On balance, then, the macro data is rather less alarming than the bottom-up figures, which do show that leverage is rising. As we noted in our earlier study, however, this could be because of the increase in high yield borrowing and issuance in euro-denominated debt from issuers outside the eurozone. The bank lending figures themselves are more likely to be biased towards domestic borrowers." - source Sociéte Générale.
While on balance the macro data seems less alarming, there is no doubt that leverage is creeping up and that covenants are being loosened, even in Europe, which seems to indicate rapid credit expansion in some instances. No surprise some central banks including the Bank of England are wary about these developments. As shown in a recent article by the Wall Street Journal, leverage loans are coming back at a rapid pace, as indicated in their article from the 24th of September entitled "Leveraged Loans Are Back and on Pace to Top Pre-Financial Crisis Records":
"Lending to the most highly indebted companies in the U.S. and Europe is surging, a development that investors worry could pressure financial markets if the global economic expansion starts to fade.
Volume for these leveraged loans is up 53% this year in the U.S., putting it on pace to surpass the 2007 record of $534 billion, according to S&P Global Market Intelligence’s LCD unit.
In Europe, recent loans offer fewer investor safeguards than in the past. This year, 70% of the region’s new leveraged loans are known as covenant-lite, according to LCD, more than triple the number four years ago. Covenants are the terms in a loan’s contract that offer investor protections, such as provisions on borrowers’ ability to take on more debt or invest in projects.
Toys ‘R’ Us offered a reminder of the risks of piling on debt when the company filed for bankruptcy protection on Monday. The toy seller’s chief executive said in court papers that Toys ‘R’ Us had been hampered by its “significant leverage.” Its $5.3 billion in debt included a large number of leveraged loans and high-yield bonds" - source Wall Street Journal
Given in the US a third of loans to private-equity backed companies this year are leveraged six times or more, according to LCD’s calculations of companies’ debt to earnings before interest, tax, depreciation and amortization and despite 2013 guidelines from U.S. regulators, including the Fed, on loan underwriting stating that leverage of more than six times "raises concerns for most industries", you probably understand why the Fed is envisaging "Rescission" from its generosity, and draining some of the alcohol out of the credit punch bowl. In similar fashion, credit expansion and loose covenants have become more aggressive in Europe as indicated in the Financial Times on the 20th of September in their article "Aggressive term in Stada bond sale causes outcry":
"Analysts and investors are crying foul at an aggressive term in the bond sale backing the €4.3bn buyout of Stada, which they say creates a new way for the drugmaker’s private equity owners to strip cash out of the business.
The €825m high-yield bond deal is being sold alongside a €1.95bn syndication of leveraged loans, in order to finance Bain Capital and Cinven’s acquisition of German generic drugmaker Stada. The acquisition is the largest leveraged buyout of a European-listed company in four years." - source Financial Times
European companies are indeed getting more risky. This another indication of the lateness of the credit cycle, even in Europe, although one could argue that US is ahead of Europe when it comes to its rapid credit expansion phase as pointed out by JP Morgan in their note from the 20th of September entitled "Age isn't everything -  Gauging the DM business cycle":
"The US looks modestly more vulnerable
On balance, most indicators suggest that the DM as a whole is not close to its next recession, despite having returned to full employment. While this case can be made for the DM as a whole, the picture is more mixed for the US—the economy farthest advanced in its cycle. Our US team’s recession risk tracker places the risks of a recession in the next twelve months at a relatively low at a 1-in-4 chance. However, the risk profile rises sharply to a 3-in-4 chance at the two to three year horizon.
Two factors appear to differentiate the US from other DM economies. First, falling productivity growth and weak pricing power has led to a significant decline in corporate profit margins from the highs. Some of this margin compression owed to the hit to the energy sector in recent years. With oil prices having bounced from the severely depressed levels in early 2016, and also with productivity growth having recovered, US corporate margins are staging a bit of a recovery. Still, with labor markets continuing to tighten, the pressure will be for some compression in US corporate margins.
Second, there has been a large increase in nonfinancial corporate credit with debt/asset leverage at the 85th percentile of its nearly four decade average. It is important to recognize that our US recession probability model does not account for the fact that rising corporate leverage and falling margins have usually been accompanied by other late cycle pressures that push interest rates up. With US interest rates low and the Fed unlikely to tighten policy significantly over the next year, forces magnifying problems due to tight labor markets and lower corporate margins do not look likely to intensify soon. Still, US shocks generate powerful reverberations through the rest of the world, and it is important to track the factors generating US vulnerabilities alongside our assessment of DM risks in the aggregate." - source JP Morgan
One thing for sure, the Fed might be in "Rescission" mood when it comes to its balance sheet and the credit punch bowl, the US Yield curve is still not buying their "Jedi tricks" as it is getting flatter even after the latest FOMC. So overall credit is becoming stretched and productivity is remaining low in the US. Meanwhile business investment remains very low as well in this unusual "recovery" cycle as per our final chart below.

  • Final chart - "Broken" asset investment in Developed Markets
Although the Fed is lost in "inflation" translation, and with the ongoing low productivity seen so far in this cycle, there has been as well a notable imbalance such as the downward trend in business investment. Our final chart comes from JP Morgan report quoted above and displays the trend in Fixed asset investment in Developed Markets (DM):
"With regard to imbalances, there are few signs of an overstretched durables spending cycle. Even accounting for a downward trend, the level of outlays for business investment remains relatively low by historical standards (Figure 18).

Similarly, DM spending on housing and motor vehicles remains low relative to GDP or to population growth. At the same time, household balance sheets are quite healthy even if corporate balances are beginning to look somewhat stretched. 
It is difficult to be precise about the timing of recessions,which are inherently coordination failures among millions of economic actors. The historical record on slack underscores a wide range of outturns once full employment is reached, and there is sufficient evidence to suggest that the typical vulnerabilities associated with recessions are not currently present. However, as vulnerabilities rise, they can be amplified by unforeseen shocks, often coming from financial or commodity prices. It is worth noting that every US recession (except one) was preceded by a material increase in oil prices and every oil market disruption (except one) was followed by an economic recession (“Historical Oil Shocks,” J. Hamilton, 2011). The fact that oil prices have witnessed a spectacular supply-led collapse since 2014 and continue to struggle is encouraging in this regard. While the direction of causation is widely debated, it is arguably the interaction between the various vulnerabilities noted above, along with tightened economic conditions, with financial and commodity prices that becomes the catalyst for recession." - source JP Morgan
As we pointed out last week, for a bear market to materialize, you would need a buildup of inflationary pressure that would reignite the volatility in bonds via the MOVE index. We also pointed out in a previous conversation in similar fashion to JP Morgan that past history has shown that what matters is the velocity of the increase in the oil prices. A price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years. No need to press the "panic" button yet, but it is worth closely paying attention to oil prices going forward with the evolution of the geopolitical situation. The Fed might be in "Rescission" mode when it comes to its bloated balance sheet, the US Yield curve remains oblivious to its Jedi tricks and continues to flatten. This does indicate that "Rescission" could eventually lead to "Recession" in 2018, but that's another story...

"Expansion means complexity and complexity decay." - C. Northcote Parkinson, British historian.
Stay tuned !

Monday, 18 September 2017

Macro and Credit - The Two Who Stole The Moon

"Three things cannot be long hidden: the sun, the moon, and the truth." - Buddha

Watching with interest the continuation of the beta trade in conjunction with new record highs in US equities, we listened with great interest to the interview on Bloomberg of the always wise real Gandalf of central banking namely William White from the OECD. In this must see interview, the former great wizard of the BIS goes through the "end game" and the current state of affairs. Given recent discussions in the central banking world of helicopter money and also the growing discussions about universal basic income, while thinking about our title analogy, we reminded ourselves of the 1962 Polish children's film based on  Kornel Makuszyński's 1928 story "The Two Who Stole the Moon". The film stars the Kaczyński twins, two of the country's future political leaders of Poland incidentally. Despite having been known to Polish children for many generations, the film gained renewed fame in the 2000s because it starred two of the country's future leaders: Lech Kaczyński, who served as President of Poland from 2005 until his death in a 2010 plane crash, and his identical twin brother Jarosław Kaczyński, the Prime Minister of Poland from 2006 to 2007, Chief of Office of the President of Poland from 1990 to 1991, and current chairman of the Law and Justice party. The twins were thirteen at the time. The story of the film we are using as a title analogy is about two twins, Jacek and Placek who are two cruel, greedy and lazy boys whose main interest is eating, eating anything, including chalk and a sponge in school. One day they have the idea of stealing the moon; because, after all, it is made of gold:
"If we steal the moon, we would not have to work""But we do not work now, either...""But then we would not have to work at all".
After a few small adventures, they really manage to steal the moon. Immediately a gang of robbers notices the little thieves and captures them. The two regain their freedom, and one of the twins devises a plan to enter the "City of Gold". The plan works, but when the robbers try to collect the gold, they turn into gold themselves. The twins escape and then run home and promise to help their parents with their work as farmers. In similar fashion, our central bankers have been stealing the "printing press" and the idea of "helicopter money" or universal basic income is doom to fail given as posited by Adam Smith:
"Labour was the first price, the original purchase - money that was paid for all things. It was not by gold or by silver, but by labour, that all wealth of the world was originally purchased." - Adam Smith
No matter how our central bankers or bitcoin followers would like to play it, even after "stealing the moon", as the Polish children story goes, the twins ended up having to work with their parents as farmers, labour being the first price, the original purchase, but we ramble again...

In this week's conversation, we would like to look at the financial conditions versus the upcoming update of the Fed's dot plot.

  • Macro - Losing the dot plot
  • Credit - US Investment Grade - putting the brakes on leverage
  • Final chart - The only easy day was yesterday

  • Macro - Losing the dot plot
In our previous conversation "Aleatoricism", we discussed how immune the US yield curve has been to the Fed's "Jedi tricks" given the on-going flattening stance and the recession predictability of an inversion of the US yield curve. A very important point mentioned we think was that with a December hike, the threshold for a 69.2 percent chance of a recession during the next 17 months (average lead time) according to the study we quoted and made by Wells Fargo would be reached. Their framework has predicted all recessions since 1955 with an average lead time of 17 months, therefore one wants to be extra careful in 2018 for any signs of slowdown/recession. What is of interest and in continuation to our last conversation relating to the Fed's dot plot with the upcoming update is that the Taylor rule has fallen about 20 bp since the June update. Financials conditions matter particularly when looking at the Taylor rules used by the Fed. On this subject we read with interest Deutsche Bank's Fed Notes from the 13th of September entitled "Can loose financial conditions save the Fed's dots?":
"With an announcement to begin tapering balance sheet reinvestment viewed as nearly a done deal at next week’s FOMC meeting, focus will be on any signs of a shift in the Fed’s views about the expected policy rate path as represented by the “dots.” While the recent string of soft inflation prints argues for some downgrade to the dots, one key question is how much, if at all, loose financial conditions can counterbalance disappointing inflation and support the Fed’s rate hike expectations.
Taylor rules and financial conditions
Financial conditions have eased considerably in recent months. After bouncing around near zero just prior to the US election – a level indicating that financial conditions were broadly neutral for growth – our high-frequency financial conditions index (FCI) rose to its highest (i.e., most growth-supportive) level in several years in August (Figure 1).

Our FCI has declined slightly over the past month but continues to indicate that financial conditions are loose, signaling solid growth in the coming quarters.
As our FCI has risen, traditional Taylor rules, which do not account directly for financial conditions, have fallen sharply. In recent years, the predicted fed funds rate from a Taylor rule espoused by Chair Yellen in a March 2015 speech has implied a fed funds rate above the Fed’s actual policy rate. However, the recent decline in measures of the neutral fed funds rate, or r-star, and recent soft inflation, have led to a collapse in the prescribed fed funds rate towards the actual policy rate. Indeed, after peaking near 2% at end-2016, the fed funds rate implied by Yellen’s preferred rule has fallen to near 1.2%, just above the current effective fed funds rate (Figure 2).

And the predicted fed funds rate from this Taylor rule has fallen about 20bp since the Fed last updated their dots in June.
Does the easing in financial conditions alter this story? In previous work, we constructed an FCI-augmented policy rule to quantify how movements in financial conditions would affect fed funds rate prescriptions from traditional Taylor rules. In that work, we converted the level of our FCI into a fed funds rate equivalent at each point in time, and then incorporated this value into the Taylor rule that
Yellen mentioned.
According to this FCI-augmented Taylor rule, loose financial conditions in recent months have consistently added between 30 and 50bp to the typical Taylor rule prescriptions (Figure 3).

Nevertheless, the FCI-augmented Taylor rule has also fallen considerably. After peaking at around 2.25% in February 2017, with core PCE inflation near 1.9% and the Laubach-William’s measure of r-star around +0.1%, the FCI-augmented Taylor rule has fallen nearly 60bp to 1.69%. It has also fallen by about 5bp since the Fed last updated their rate expectations at the June FOMC meeting. In other words, loose financial conditions are only able to partially offset the decline in the fed funds rate predicted by traditional Taylor rules.
Do Fed officials care about financial conditions?
There is correctly some skepticism about how important financial conditions are for the Fed outlook. Some officials, such as NY Fed President Dudley, clearly put meaningful weight on financial conditions. But financial conditions are less of a focus for other Fed officials, and in fact, the traditional Fed view has been that financial conditions and financial stability considerations are typically better dealt with via supervision and regulation tools, not monetary policy.
In this context, it is important that the FCI-augmented rule can also be interpreted as capturing a forward-looking element to monetary policy expectations. Financial conditions provide an important signal about economic growth in the upcoming quarters (Figure 4).

In turn, FCIs provide information about future developments in the Fed’s dual mandate – full employment and 2% inflation. Fed officials that are less inclined to place significant weight on financial conditions may therefore still want to consider the impact of financial conditions on growth, the labor market, and inflation when setting their expectations for rate increases in the coming quarters. That is, current loose financial conditions can provide some support for a view that growth will remain solid, the labor market will continue to tighten, and inflation should rise from current low levels.
Financial conditions alone unlikely to save the dots
Recent soft inflation prints have been a critical driver of the decline in Taylor rule predictions for the fed funds rate. As such, a rebound in the inflation  trend in upcoming months would produce a meaningful increase in rule-based prescriptions. This Thursday’s US CPI print could also be critical for the September dots. A stronger print that is in line with our expectations and consensus, could give the Fed some confidence in their central narrative that inflation should rebound and return towards the Fed’s 2% objective after recent weakness.
We will detail our expectations for the dots more precisely in a September FOMC preview note later this week. But while loose financial conditions are likely to help keep rate hike expectations stable for some key Fed officials, like Dudley, the conclusion from our analysis here is that financial conditions alone are unlikely to be enough to save at least some Fed dots from falling." - source Deutsche Bank
US CPI came out at 0.4% month-on-month and 1.9% year-on-year, which was above expectations of 1.80%. It's too early to expect a rebound inflation towards the Fed's 2% target we think. On that point we disagree with Deutsche Bank. Deutsche Bank in their Japan Economics Weekly note from the 25th of August entitled "The decline in labor share touched a very important point relative to our Norwegian Blue parrot aka the Phillips Curve when it comes to wages and productivity relative to the end of an economic expansion:
"Financial markets think that a strong economy tightens the labor market, driving wages up, but people who are hired closer to the end of an economic expansion phase have lower productivity and are hence paid lower wages. Thus, the preconception that the rise in per-capita wages accelerates in an economic expansion is doubtful." - source Deutsche Bank
This is exactly what we have been saying when discussing recently the Phillips curve, the deflationary bias of capitalism and the Experience Curve. As we move towards the end of an economic expansion in the US, productivity has been falling, and jobs have been mostly created for lower skills workers, hence the lower wages conundrum weighting on inflation expectations.

Also, when it comes to including Financial Conditions in the Taylor rules, this is a subject we discussed in our conversation "An Extraordinary Dislocation" given we would prefer the Fed used a Wicksellian Differential:
"Before we start our usual Macro and Credit musing we would like as a reminder to discuss Wicksell Differential and the credit cycle (linked to the leverage cycle). Wicksell argued in his 1898 book Interest and Prices that the equilibrium of a credit economy could be ascertained by comparing the money rate of interest to the natural rate of interest.  This simply equates to comparing the cost of capital with the return on capital. In economies where the natural rate is higher than the money rate, credit growth will drive a positive disequilibrium in an economy. When the natural rate of interest is lower than the money rate which is the case today (rising Libor), the demand for credit dries up (our CCC credit canary are being shut out of credit markets) leading to a negative disequilibrium and capital destruction eventually. In a credit based global macro world like ours, the Wicksellian Differential provides a better alternative estimation of disequilibrium than the more standard Taylor Rule approach of our central bankers. At the Bank for International Settlements since 1987, Claudio Borio and his colleague Philip Lowe wrote in 2002 a very interesting paper entitled “Asset prices, Financial and Monetary Stability: Exploring the Nexus”, BIS Working Papers, n. 114. In this paper the authors made some very important points that are worth reminding ourselves today:
"Widespread financial distress typically arises from the unwinding of financial imbalances that build up disguised by benign economic conditions […] Booms and busts in asset prices […] are just one of a richer set of symptoms […] Other common signs include rapid credit expansion, and, often, above-average capital accumulation" - source BIS 
So when we hear Janet Yellen at the Fed saying the following:
  "Asset values aren’t out of line with historical norms." -Janet Yellen, 21st of September 2016
We reminded ourselves that Wicksell used just the housing sector to illustrate his theory. Excess lending dear Mrs Yellen, always lead to "overinvestment". Just because the Taylor Rule used by the Fed doesn't include asset prices, it doesn't mean in our book that asset values are not out of line of historical norms
Why is the Wicksellian Differential so important when it comes to asset allocation? Either profits increase due to an increase in the return of capital and/or a fall in the cost of capital (buybacks funded by a credit binge)." - source Macronomics, October 2016
Of course the Wicksellian Differential is an ex-post measure, so, it isn't that helpful for investors as a predictor (or the Fed but still better than a crude Taylor rule).

The leverage ratio and the rate of profit or changes in general price level or output per worker are much better factors to take into account for designing a predictive tool. We also pointed out in our previous conversation the importance of the Fed's quarterly Senior Loan Officer Opinion Surveys (SLOOs) in terms of credit impulse and credit availability guides for the US credit markets. As we pointed out last week, we do monitor as well the shape of the High Yield credit curve through its proxy the CDX High Yield CDS index. We also look at the ability of the CCC rated US High Yield segment's ability in tapping the credit markets as a sign of tightening financial conditions:

- source Bank of America Merrill Lynch

Overall the market is pretty much open still for the CCC rating bucket (the Energy sector and Healthcare being the most prominent sectors in the US), yet for the last 12 months, the trend of the market has been somewhat a tad tighter as per the above graph.

What is of interest to us is the importance of comparing the cost of capital with the return on capital from a Wicksellian Differential perspective hence the importance of tracking the evolution of the cost of capital as pointed out by Wells Fargo in their Interest Rate Weekly note from the 13th of September entitled "Evolution of the Cost of Capital Over the Business Cycle":
"Equity capital is one factor in financing economic growth and yet the cost of equity capital varies over the business cycle.
Top Line Growth: The Reward for Capital Investment
Nominal GDP growth provides a starting point to judge the top-line growth opportunities for business and thereby a measure of incentives to balance against the cost of capital.
As illustrated in the below graph, nominal GDP growth provides evidence of a linear downward trend over time.

This downward trend in growth signals that nominal GDP growth is not a mean-reverting series. This observation stands against the claim that somehow nominal growth and capital returns will come back to some average value over time.
The Price-Earnings Ratio: Another Non Mean Reverting Series
Commentators frequently argue that equity price-earnings ratios are either above or below some average value and that this difference indicates the equity market is under or overvalued. However, as illustrated by the below graph, an average value can be calculated for any time series, but that does not indicate that the behavior of that series will return to some average value. Mean-reverting behavior for a series cannot simply be assumed. 

In fact, the P/E ratio is not mean reverting. There have been significant shifts in the series in October 1987 (downward) and in October 1991 (upward) and then down again in July 2002. In fact, the P/E ratio is dependent on the behavior of several economic fundamentals such as expected nominal growth and interest rate polices as well as regulatory changes and exogenous shocks that alter the risk/reward calculus. The P/E ratio is not independent of the economic cycle and, instead, a product of the many forces of the economic cycle.
CAPE Ratio: Another Product of Economic Fundamentals
Cyclically adjusted price/earnings (CAPE) is another measure to judge the pattern of equity finance costs relative to a recent past (bottom graph). This series, as well as the P/E ratio itself, is subject to many exogenous forces that result in a pattern of behavior that reflects the influence of economic, political and regulatory forces.
The CAPE ratio is not mean-reverting, thus there is no single number that is the standard of value. Second, the CAPE ratio is subject to several shocks that shift the behavior of the series (Sep. 2001, Oct. 2008, Nov. 1998) such that the ability to judge the cost of equity finance relative to the recent past will have to adjust to the many structural shifts in the CAPE series.

Since the 1970s, the CAPE ratio does evidence peaks prior to a recession but the series also provides evidence of declines such that the CAPE ratio does not appear to provide a reliable leading indicator. Instead, the CAPE ratio itself is an endogenous part of the economic cycle and is a function of ongoing changes in economic activity as the business cycle matures." - source Wells Fargo
Of course there have been so many articles relating to lofty valuations in many various asset classes from the usual perma-bear crowd, which will be right in the end. But, what matters we think, is the potential change in the central banking narrative. For us, as we pointed out in various musings, for a bear market to materialize, you would need a buildup of inflationary pressure that would reignite the volatility in bonds via the MOVE index. This would create the necessary conditions for a change in the direction of markets. In our recent musings, we pointed out that in the on-going credit "Goldilocks" scenario, already expensive asset classes would become even more expensive, going to 11 that is, in true Spinal Tap fashion.

On another note, whereas the first part of the year saw a significant rally in Emerging Markets equities thanks to  US dollar woes and our correct January call, we are wondering if indeed the US dollar is not due for a bounce, should some tax reforms be passed by the US administration.

When it comes to credit and the lowering of quality we have witnessed in US Investment Grade, leverage in recent years has been going up thanks to buybacks and M&A. As of late there seems to be a pause at this stage, which is "credit friendly".

  • Credit - US Investment Grade - putting the brakes on leverage

The latest rafts of earnings report, in conjunction with the SLOOs we mention, have shown us that Financial Conditions are still loose. Richer equity valuations have somewhat dampened the appetite of CFOs in pursuing buybacks as well as M&A for the time being. When it comes to the current stability of credit spreads, this is a welcome respite given leverage is higher in the US than in Europe as indicated by Société Générale in their Market Wrap-up note from the 29th of August entitled "Where US leverage is rising the most":
"US balance-sheet leverage has risen
Chart 1 shows the change in US debt/equity. The weighted average is shown in blue; the median is shown in brown. Both have risen since around 2013, and while the weighted average is not quite back to 2002/3 levels, the median is within a whisker of these points.
How did we get here? Chart 2 shows the breakdown of the median leverage numbers by industry. Two sectors – Real Estate and Utilities – have seen only modest increases. Other sectors have risen more sharply, and the biggest rise has been in Mining & Energy, still the sector with the lowest overall leverage.

US income-sheet leverage has also risen 
Chart 3 shows the weighted average of US net debt/EBITDA;

Chart 4 shows the median level. Of the two, Chart 4 is more worrying.

The weighted average level of income-sheet leverage is nowhere near the 2001 peak (let alone the late-2008 peak) and has been declining since early 2016. The median figure keeps climbing and is now close to the 2002 peak.
Looking at net debt/EBITDA by sector confirms the concerns with the median figures. Chart 5 shows that leverage has dropped slightly in the Mining & Energy sector but continues to rise in the Consumer and Industrials sectors, while Telco leverage has been flat.

The Consumer and Industrial sectors are among the most cyclical in the index, so if the economy turns down and EBITDA starts to decline, we should expect these leverage ratios to jump much more sharply.
Income-statement leverage has also been rising in the Real Estate and Utilities sectors, which we show separately in Chart 6 to make both charts more legible. 
US cash-flow leverage is up as well
Finally, we turn to interest coverage, our cash-flow leverage indicator. Charts 6 and 7 show the weighted average and median levels of the indicator across the IG and HY universes.

Net interest coverage, which we plot in reverse to make these charts comparable to the preceding ones, has been falling, but this fall has stabilised on an average basis and is declining in median terms. This is comforting, but remember that interest coverage is probably going to be the last leverage indicator to flash warning signs.
It’s worth noting moreover that the worsening in interest cover since 2010 has largely been limited to two sectors – Mining and Real Estate. In addition, real estate interest coverage remains high in absolute terms:
Conclusion: reasons to worry about the cyclicals 
What should we conclude from these numbers? Balance-sheet leverage and income-sheet leverage are both near the top of their historical ranges, so both are giving warning signals. A drop in EBITDA and net income would lead to historical highs both in income and cash leverage. This, combined with relatively tight spreads, should make investors more defensive on the US credit market.
The sectors where we are most wary are first Mining & Energy and second the Consumer and Industrial sectors. The problems of the Mining & Energy sector are well known; by contrast the cyclical Consumer and Industrial sectors are probably more vulnerable than investors realise. Telecoms are also showing higher leverage and could be challenged if interest rates rise and refinancing conditions become more difficult. The most defensive sector is certainly Utilities, with Real Estate fairly defensive too in comparison to historical leverage levels." - source Société Générale
As we are slowly but surely moving towards the end of this long credit cycle, we do agree that it is time to start building up defenses and move up the quality ladder, yet there is no denying that we are currently seeing some respite not only through better SLOOs but also with CFOs tempering their appetite for increasing leverage in the US as indicated by Bank of America Merrill Lynch Situation Room note from the 13th of September entitled "Spending less on stocks":
"Spending less on stocks
With even the late reporters 2Q results in by now, data from US non-financial high grade issuer cash flow statements shows that companies have again reduced spending on both share buybacks and acquisitions during the quarter (Figure 1, Figure 2).

This spending has been trending down as a share of free cash flow as well (Figure 3).

The decline is notable because buying your own or other company equity is typically the biggest drivers of leverage for the high grade market (Figure 4).

The reason for the decline is likely a combination of richer equity valuations as well as better growth globally that allows companies to deliver EPS growth without resorting to financial engineering. Finally, robust supply volumes in the first half despite decelerating cash needs supports our view that issuance was front-loaded this year.
Aggregate data for our universe of high grade issuers shows expenditure on net share buybacks declining from $84bn in 4Q-16 to $73bn in 1Q and $64bn in 2Q. Similarly spending on acquisitions fell from $99bn in 4Q-16 to $72bn in 1Q and $62bn in 2Q." - source Bank of America Merrill Lynch.
Although this is a welcome respite, US Investment Grade spreads benefit from a bigger interest rate buffer than European Investment Grade spreads, so if and when the ECB decides to taper its purchases the impact will be different. But, given the cyclical exposure to US Investment Grade, slower growth would probably have a more meaningful impact in the US thanks to the leverage difference. We might not be heading for the bunker yet and don a kevlar helmet, but, we are keeping a close eye on 2018 for potential signs of exhaustion in the credit and business cycle.

  • Final chart - The only easy day was yesterday
Whereas Financial Conditions matter for Taylor rules as per our macro bullet point, it remains to be seen how accommodative the Fed is going to be at its next FOMC meeting, whether it will keep a somewhat dovish stance or adopt a more hawkish tone, relative to its worries about Financial Stability, meaning they would start indicating they are about to drain some alcohol out of the credit punch bowl they have been serving for so many years. After all, in our book the Fed is the "credit cycle". Our final chart comes from Bank of America Merrill Lynch and displays the National Financial Conditions Index from the Chicago Fed, as goes the saying, the only easy day was yesterday, for tomorrow, we are not too sure:
"The best high level metric that reflects these benign conditions is the Chicago Fed’s National Financial Conditions Index seen in Chart 3. It’s tightened ever-so-modestly in the past month, going from -0.88 to -0.85. But the long term perspective shows that we are still in record territory as far as easy financial conditions. A slightly lower level of - 0.898 was observed in June 2014, but we have to go all the way back to August 1993 to the all-time low of -1.0 – not very far from where we are today; it was six months later, in early 1994, that a dramatic and disruptive hiking cycle began, but those were different times. Financial conditions don’t really get much easier than they are today.
With that in mind, the question is whether the Fed is ready to shift the framework at next week’s meeting, and deliver a more hawkish message than markets expect. As one gauge of the market’s dovish view of the Fed, there is currently a 53% probability assigned to a December rate hike (up from about 20% a week ago, but still well below 100%), and there is still about a 75 bp spread between what the market thinks for YE 2018 versus the Fed’s last dot plot. As we noted last week, this disconnect seems to represent a source of near-term risk for securitized products spreads; it’s the #1 reason we think spreads are more likely to widen than tighten in September-October. With financial conditions as easy as they are, and with a 10yr breakeven inflation expectation of 1.85% (in other words, pretty close to 2.0%), the Fed seems to have a great opportunity to deliver a hawkish message. Obviously, though, hawkish has not really been the MO for the Yellen Fed, so it seems reasonable to assume a “balanced” outcome is most likely.
If the Fed is dovish next week, securitized products spreads will probably tighten, but modestly. If the Fed confirms the market view, and December hike probability is still at about 50% a week from now, spreads will likely remain range-bound. If the Fed is hawkish, and hike probabilities increase materially, we expect spread widening. We think there is some asymmetry around spread widening potential relative to tightening potential, so we retain our defensive posture for September-October. If it’s a dovish Fed next week, we’ll give up on the defensive posture. If it’s hawkish, and spreads begin to widen, we will eventually look to add on spread weakness. Longer term, for fundamental and technical reasons, we remain constructive on securitized products." - source Bank of America Merrill Lynch
The major big question we have these days is relative to the direction of the dollar. Will it continue to "break bad" or are we due for some important rebound which would have implications for the rally seen so far this year in Emerging Markets equities? We wonder but, we are not lazy enough to go and steal the moon just yet...

"Don't tell me the moon is shining; show me the glint of light on broken glass." -  Anton Chekhov

Stay tuned ! 
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