"Knowledge is marvelous, but wisdom is even better." - Kay Redfield Jamison, American psychologist
In this week's conversation we will be wondering whether or not we could be facing an inflexion point, namely that a correction in equities might start to weight on credit and in particular High Yield, currently "priced for perfection".
- Macro and Credit - 2017 - Credit leads equities, but could equities lead credit in 2017?
- Final charts - US Consumers yet to feel "Hypomaniac"
- Macro and Credit - 2017 - Credit leads equities, but could equities lead credit in 2017?
From our perspective when it comes to "Hypomania", greed and the potential for a sell-off or the start of a bear market, we reminded ourselves of our 2014 conversation "Equity bear markets tend to coincide with high global core inflation":
"High global core inflation as a risk-off signal
Individual country inflation series are noisy, but the average across G10 economies has been stable in the 1-2% range, and has exhibited clear cyclicality. Bear markets for US equities have usually coincided with high global core inflation. We believe inflation based carry will remain attractive until inflation increases globally and we would expect currencies to mean revert when this occurs.
High inflation leads to mean reversion for currencies
Given the strong correlation between FX carry trades and equities in recent years, the observation that recent equity bear markets have coincided with high global inflation suggests that inflation can be used as a carry filter. More generally, we would expect currencies to mean revert during periods of risk-off, which may or may not be negative for carry strategies. Our analysis suggests that a strategy of mean reversion towards 5 year averages would have performed well during the last two periods of high inflation. Is there a fundamental link that makes this robust?
Inflation matters when inflation is high
Central banks have historically been much more concerned with fighting inflation than deflation, so that high inflation is likely to result in greater attention being paid. Increased attention on fundamentals could drive currencies towards fair value. Behaviourally speaking, high inflation may tip the psychology of the market towards accepting the inevitability of some nominal currency depreciation. This shift in psychology might result in greater reluctance to buy expensive currencies." - source Bank of America Merrill Lynch / Macronomics, June 2014At the time we also mused around a phenomenon we saw in 2008 in relation to core inflation in the US:
"Interestingly, back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008:
Given January CPI rose 2.5% y-o-y, the strongest gain since early 2012 (core CPI up 2.3% y-o-y), and with Janet Yellen taking a more hawkish tone recently in the latest FOMC, one might be wondering if indeed the current "Hypomania" and global rising core CPI will not lead to some sort of "accident" in the not too distant future (like a rate hike in March...). Clearly the inflationary "build up" is putting stress on the QE infinity camp. We indicated in our recent conversations as well that the cozy relationship between central bankers and politicians was as well coming under renewed pressure (Germany). So overall, there is no doubt to us that we are seeing a dwindling support for central bankers. The QE backstop is slowly but surely fading on top of the buildup of inflationary pressures globally.
So of course, as anyone else we are watching inflationary pressure building up very closely. On this subject we read with interest Bank of America Merrill Lynch's take in their Credit Market Strategist note from the 10th of February entitled "The day of max inflation":
"The day of max inflation
WTI oil prices have more than doubled since reaching the low close of $26.21 a year ago on 2/11/2016 (Figure 1). This means that, if oil prices remain stable, headline inflation is peaking (at least locally) today. However, because economic data is reported on a delayed basis – and only monthly, not daily – we should continue to see oil prices driving up headline inflation numbers above core when reported for January (next week) and February.
As we pointed out as well in 2014, in our conversation "The Molotov Cocktail", past history has shown, what matters is the velocity of the increase in the oil prices, given that 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.
In this "Hypomania" environment we reminded ourselves of the wise words of Dr Jochen Felsenheimer from asset management XAIA which we quoted back in September 2011 in our conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!":
"in the current system, capital market performance takes on immense importance in a system of fiat money, i.e. efficient allocation of said money. The great danger of a flippant approach to the provision of fiat money is that the financial markets are able to decouple from the real economy. And that is just what happened in the past few years. Following the crises of the past ten years, excessive liquidity was pumped into the system in order to cushion the real economic consequences. Only a fraction of this made it to the real economy, as a large part seeped away in the banking system and thus in the capital market. This is why the financial market is growing so quickly while the real economy is only showing moderate growth." - Dr Jochen Felsenheimer
"In terms of global competing systems, we can view countries like companies. The difference is that they only refinance through debt. Even if this refinancing option does not appear unattractive in view of the low interest rate, even cheap money has to be paid back sometimes. And that is exactly what is becoming increasingly unlikely." - Dr Jochen FelsenheimerGiven the risk of a surge in trade wars with the new US administration, where it becomes interesting is that in our global competing systems, it seems we are moving away from "cooperation". This could of course have nasty consequences to say the least, for global trade, and would therefore continue to be bullish for gold (hence our late December positioning on gold miners as a reminder). As we pointed out on numerous occasions when discussing gold matters, has been the return of the Gibson paradox which we mused about in our October 2013 conversation:
"When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact." - MacronomicsReal interest rate is the most important macro factor for gold prices. US real rate has been the main driver for gold prices moves in recent years; while academic papers (Barsky, Summers, 1988) have given theoretical support. Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond rising fast since the US elections, gold prices went down rapidly as a consequence of the interest rate impact. You might be wondering what has led four our switch to our positive stance towards gold/gold miners at the end of December 2016, it all had to do with real rates as indicated by Bank of America Merrill Lynch in their Inflation Strategist note from the 14th of February entitled "Breakevens go overboard over border tax":
"Imports to CPI to breakevens: a perfect pass-through?
That a border tax has been interpreted as a stagflationary shock is apparent when one looks at the inflation market since the markets attention shifted to it post the Dec hike. Roughly about 11% of CPI is tied to imports using input-output tables. A 20% border tax would push 1y inflation up by 220bp immediately with a follow through impact of 40bp on 5y breakevens. It is no coincidence that since the December Fed hike, 5y breakevens went up 30bp, 5y real rates went down by 50bp and the DXY was weaker by 3% – a classic stagflationary shock priced in by the markets.
However, in our view it is too optimistic to expect the market to price in a perfect passthrough to breakevens without the any currency adjustment. Our analysis has shown that a border tax of 20% could be wiped out by a 25% likely rally in the dollar. Also, likely if a border tax were, implemented, it would be delayed and staggered over several years, making the impact on very front-end breakevens unclear. Ultimately, as highlighted in detail here and summarized in Chart 2, we see the border tax adjustment proposal largely playing out as a higher dollar and flat-lower breakeven trade.
Recent price action proves real rate a better short
To us, last week’s price action post the euphoria, proves exactly why real rates offer a better protected short than breakevens. While the upside may not all be captured in a rate selloff, any unwind of the Trump trade is far more likely to hurt breakevens than real rates. Consensus was expecting four hikes over the next two years even six months ago, when the odds were favoring a gridlocked Congress, a continued Yellen Fed and no fiscal stimulus. This suggests that the unwind of the post-election euphoria is likely to manifest as an unwind of the reflation trade as opposed to the unwind of the Fed hike trade, in our view. We maintain our short real rates recommendation across the curve."- source Bank of America Merrill LynchWe agree with the deflating Trumpflation trade, and we also agree with Bank of America Merrill Lynch's recommendation for "shorting" real rates. There is of course an explanation around this which was very clearly put forward by David Goldman in Asia Times on the 17th of February in his article "A mistery solved: Why real yields are falling despite higher growth":
"Economists often think of real yields as the “real interest rate,” or baseline rate of return, in a macroeconomic model. From this standpoint the low level of TIPS yields is a mystery: when economic growth is rising, the real interest rate should rise. The expected short-term interest rate has been rising as the Fed sets about normalizing rates, and the rising short-term rates affect real yields. The fall in TIPS yields in the face of Fed tightening and stronger growth presents a double challenge to the conventional wisdom.
The conventional way of looking at real yields ignores the way markets treat risk. Government debt (and particularly the government debt of the United States) is not just a gauge of economic activity, but a kind of insurance. If the world comes crashing down, you want to own safe assets. Investors hold Treasuries in their portfolios not just for the income, but as an insurance against disaster. And TIPS offer a double form of insurance: If economic crisis takes the form of a big rise in the inflation rate, TIPS investors will be paid a correspondingly higher amount of principal when their bond matures. That explains why TIPS yields sometimes are negative: investors will accept a negative rate of return at the present expected inflation rate in return for a hedge against an unexpected rise in the inflation rate.
The yield on TIPS has tracked the price of gold with a remarkable degree of precision during the past 10 years, as shown in the chart below. Gold tracks the 5-year TIPS yield with 85% accuracy. That’s because both gold and TIPS function as a hedge against unexpected inflation.
During the past year, for example, we observe that the relationship between gold and the 5-year TIPS yield has remained consistent, while the relationship between the expected short-term rate (as reflected in the price of federal funds futures for delivery a year ahead) has jumped around. There are lots of local relationships between federal funds futures and the TIPS yield, but the overall relationship is highly unstable." - source Asia Times - David Goldman
The rest of his article, is a must read we think. but if indeed there are rising inflation expectations, then it makes sense for real yields to continue to fall, which can be assimilated to the cost of the insurance for "unexpected outcomes" is rising. In the case for TIPS and Gold, the cost of insurance for the velocity in the change in inflation expectations is going up.
So moving back to how inflation can play out ultimately on credit spreads, it is most likely through a sell-off induced in equities which could be triggered by a "preemptive hike" by the Fed in March. On this subject we read with interest Bank of America Merrill Lynch Credit Market Strategist note from the 17th of February entitled "Equities not rates":
"Equities not rates
As highlighted by this week’s tightening of credit spreads amidst increasing rate hiking risks (Figure 1), higher interest rates and inflation are not the biggest near term risks to our bullish view on credit spreads.
With the continued rally in equities instead we are getting to the point where we are most concerned in the near term about scenarios that lead to a correction in stocks (Figure 2) – especially if interest rates decline materially in sympathy. Two leading candidate scenarios for this include US policy risk – including most prominently, but not limited to, disappointments around tax reform – and developments ahead of the French election.
Border adjustment tax
The key uncertainty in US tax reform is the border adjustment tax (BAT) from House Speaker Ryan’s blueprint. As we have argued, should the BAT – against our house view – be included, chances are that tax reform gets delayed significantly, as the scheme creates many losers that will push back (and winners – but losers tend to complain more than winners cheer), both domestically and internationally. As much of the recent rally in risk assets hinges on tax reform such delays could be troublesome. Perhaps we will know more on or before February 28th when President Trump addresses a joint session of congress.
To see this note that from an international trade perspective taxing imports, but exempting exports, is the equivalent of imposing an import tariff and giving out an export subsidy. There are three key effects of this. First it creates winners and losers domestically (see: Equity Strategy Focus Point: Death and tax reform 29) which again, as we have seen, translates into pushback against the plans. Second it creates losers and winners internationally as well. Potential losers and winners include countries that are net exporters to (Figure 3) and importers from (Figure 4) the US, respectively. Because the US is running a large trade deficit in goods and services ($490bn in 2016) of course there are more losers than winners abroad. That ensures significant pushback against the BAT abroad as well and the risk of trade war.
Third, the BAT issue is particularly sensitive as about two thirds of the US trade deficit is with just one country – China – which creates a particularly high risk of retaliation. In terms of possible responses, to mitigate the impact of a US border BAT for example China could choose to devalue the Renminbi against the dollar, which is very deflationary globally through commodities (Figure 5) and would bring back the memories of some of the biggest sell-offs in risk assets we have seen the past couple of years (Figure 6).
There are many reasons why the Trump administration might want to implement a BAT scheme, including that it creates significant revenue to help mitigate the impact of lowering the corporate tax rate. This is because the net effect of the border adjustments is effectively to tax the trade deficit by the new corporate tax rate – for example, a 20% tax on a $500bn trade deficit translates into $100bn in new tax revenue annually. Hence, taking out the BAT creates the need to find $100bn annually elsewhere, which may constrain the ability to lower tax rates." - source Bank of America Merrill LynchThe conjunction of all these factors in an environment where "Hypomania" has reigned supreme, makes us particularly more nervous as we move towards March and a potential rate hike on the back of a stronger than expected January CPI and retail sales data. We also note that from a flow perspective, there have been some significant inflows into High Grade funds and ETFs as put forward as well in Bank of America Merrill Lynch's note:
"Flows refocus on stocksInflows to US equity funds and ETFs reached $13.13bn this past week (ending on February 15th) – the highest weekly inflow in two months – compared to a $1.95bn inflow the week before and $8.81bn inflow for the week ending on February 1. The pickup in inflows is consistent with the recent stock market rally. At the same time inflows to bonds moderated to $5.06bn from a high $8.04bn inflow in the prior week, mostly due to lower inflows to high grade." - source Bank of America Merrill LynchWe don't think that "Hypomania" is warranted when the reliance in "opioids" is fading. On top of that, as we pointed out in our previous conversation, the latest Federal Reserve Senior Loan Officer Survey shows a weakening demand for credit overall, with Commercial Real Estate feeling the brunt.
- Final charts - US Consumers yet to feel "Hypomaniac"
"In wait and see mode
While most often the Federal Reserve Senior Loan Officer Survey is closely monitored for color on bank lending standards, the most striking aspect of Monday’s report was weak loan demand across the board (see: Situation Room: The French Connection 06 February 2017). Perhaps this is due partly to rising interest rates, which would make sense for mortgages. However, one would certainly expect that development to play a smaller role for consumer loans and business loans. Tuesday’s Fed Consumer Credit expansion of $14.6bn in December (Figure 9), the lowest since June, is consistent with the sizable contractions in credit card and auto loan demand reported in the Senior Loan Officer Survey (Figure 10).
For more timely data the Fed’s weekly H.8 data allows us to come up with good estimates for January 2017 bank loan growth. We estimate that in January US banks experienced only a 0.6% annualized increase in consumer lending, down from 5.3% in December and the lowest reading in two years (Figure 11).
Furthermore C&I lending remained weak in January at 0.9% (Figure 12).
While bank profitability stands to benefit from higher NIMs as interest rates go up, nothing yet suggests animal spirits – in fact US consumers and businesses appear presently stuck in wait-and-see mode." - source Bank of America Merrill LynchSo if indeed US consumers are closed to being "maxed out", then if the Fed is ready to pull the "hike trigger" in March, things could become interesting in "Hypomania" land we think. Can you spell "Policy Mistake"? Because we can...
Stay tuned!"Mistakes can be corrected by those who pay attention to facts but dogmatism will not be corrected by those who are wedded to a vision. " - Thomas Sowell, American economist