Macro and Credit - Hypertonic surroundings

"The advancement and diffusion of knowledge is the only guardian of true liberty." - James Madison

Watching with interest the numerous convolutions in Emerging Markets, with Gold taking the proverbial sucker punches thanks to the bloody rampage of "Mack the Knife" (King Dollar + positive real US interest rates), when it came to selecting our title analogy, we decided to return to a biology one, namely "Hypertonic surroundings" given our global macro reverse osmosis theory we discussed in our conversation "Osmotic pressure" back in August 2013 seems to be playing out for the weakest EM "cells" out there:

"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013

 This is the theory we put forward in terms of biology analogy at the time:

"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - Macronomics, August 2013.

We also added in our July 2015 conversation the following: 

"More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike." - Source Macronomics July 2015.

A good illustration of our "reverse osmosis" and "hypertonic surrounding in our macro theory playing out in true Mack the Knife fashion has been the pain in EM most recently with the usual suspects such as Turkey and Argentina being first in the line of the murderous rampage of "King Dollar". 

Nota bene: Hypertonic

"Hypertonic refers to a greater concentration. In biology, a hypertonic solution is one with a higher concentration of solutes on the outside of the cell. When a cell is immersed into a hypertonic solution, the tendency is for water to flow out of the cell in order to balance the concentration of the solutes." - source Wikipedia

What we are seeing in true "biological" fashion is indeed tendency for capital outflows to flow out of an Emerging Market country in order to balance the concentration not of solutes, but in terms of "real interest rates" (US vs rest of the world). Animal cells lack rigid cell walls. When they are exposed to hypertonic environments, water rushes out of the cell, and the cell shrinks. The resulting cells are dehydrated and lose most or all physiological functions while in the shriveled state. If cells are returned to isotonic or hypotonic environments, water reenters the cell and normal functioning may be restored. Cells without cell walls (capital controls) can burst when in a hypertonic condition. Too few solutes (US dollars) and the environment will become the hypertonic solution. There goes our reverse osmosis global macro analogy for you.

In this week's conversation, we would like to look at the main reasons for the start of the "unwind" of the carry trade and the pain inflicted to EM macro tourists, namely that Mack the Knife is a consequence of financial conditions tightening for many leveraged global players. 

Synopsis:

• Macro and Credit - The Fed is tightening its financial conditions tourniquet 
• Final charts - So you want to be bearish? Oil-price spikes have preceded most recessions

• Macro and Credit - The Fed is tightening its financial conditions tourniquet 

While every pundits around the financial sphere are pointing the rise of the US dollar as the main reason for the ongoing bloodbath in the EM space, we think that the rise in the greenback is a manifestation, not the main cause of Mack the Knife's rampage. The reality as pointed out by David P. Goldman in Asia Times on the 16th of August is that financial conditions are getting tighter as per his article entitled "It’s all about financial conditions":

"The collapse of the copper price by 20% from its June peak evidently is not an economic phenomenon driven by demand. Rather, it is an expression of risk aversion.

The world has gotten riskier during the past few months, for two primary reasons:

1. There is a low-level trade war between the US and China underway that could turn into a high-level trade war; and
2. The Italian elections put a bunch of unpredictable firebrands in charge of an economy with US$2.3 trillion in foreign debt and a dodgy banking system.

Heightened risk translates into a greater desire to hold cash balances (and that means a higher dollar, because most people pay bills in dollars and therefore hold cash balances in dollars). To get higher cash balances, market participants sell things like raw materials.

Turkey is utterly irrelevant to this shift towards risk aversion. The Turks may make the mistake of thinking that they matter but no-one else should encourage them. Turkey’s whole stock market is worth about US$30 billion at current prices, roughly the market capitalization of Monster Beverage Co. The big issues are European disintegration and Italian dyspepsia, and the US-China trade war." - source David P. Goldman - Asia Times

Because of fears of dollar scarcity, thanks to QT and the Fed turning off gradually the monetary spigot, the commodities rout has been about raising dollar cash/playing defense as indicated by David P. Goldman. As well there are the usual "known unknowns" everyone and their dog have been talking about, namely the risk of trade war escalation and of course the potential brewing internal rift between the European Commission and Italy. It's going to be interesting to say the least to see how Le Chiffre at the helm of the ECB aka Mario Draghi is going to deal with the Italians and their budget which will no doubt necessitate some helping hand in buying their bond issuance. This is what we wrote in our October 2015 Le Chiffre conversation:

"While in the movie Le Chiffre pretty much made a game out of it with nothing on his cards in the first game, in similar fashion Mario Draghi made a game out of it with his "OMT" and "Whatever it takes" July 2012 moment. In the movie it made Bond surmise that Le Chiffre was in desperation to get the money and resorted to bluffing (It was exactly our thought at the time). Le Chiffre and Mario Draghi share the same trait, both are poker prodigies hence our title analogy." - Macronomics, October 2015

 But, hey whatever it takes...as we wrote as well in the same conversation:

"While Le Chiffre has been a prodigious  Poker player when it comes to "bluffing" his way out of the "bond vigilantes" in Europe setting their sights on weaker European government bonds, when it comes to both "credit growth" and "inflation expectations", we think Le Chiffre has indeed been "overplaying" it." - Macronomics, October 2015

So while the US dollar is indeed on everyone's mind when it comes to EM woes and the Turkish side show, still the big European elephant in the room remains Italy. The current Fed normalization process is making Le Chiffre's balancing work even more complicated we think if he intends to remain a "forced" marginal buyer of Italian BTPs with of course Merkel's German consent.

But, moving back to our recurring themes in recent conversations, we discussed rising dispersion and large standard deviation moves. This late cycle phenomenon is attributable we think to liquidity being withdrawn thanks to QT and global financial conditions being tightened. As we saw earlier one the short-vol pigs house of straw blown away, obviously the next levered candidate were the macro-tourist pigs house of sticks such as Turkey and Argentina. 

In our March 2017 conversation entitled "The Endless Summer" we concluded our missive at the time asking ourselves how many hikes it would take before the Fed finally breaks something. As well we commented the following in our February missive "Buckling":

"The difficulty for the Fed in the current environment is the velocity of both the rates rise and inflation, because if indeed the Fed hike rates too quickly then it will trigger some other avalanches down the capital structure (short-vol complex being the equity tranche or first loss piece of the capital structure we think). If inflation and growth rise well above trend, then obviously the Fed will be under tremendous pressure to accelerate its normalization process. It is a very difficult balancing act." - Macronomics, February 2018

The Fed is still relentless on its hiking path, particularly in the light of US CPI coming at 2.9% year-over-year, unchanged from June; the fastest pace in more than six years. As we repeated in numerous conversations, for a bear market to materialize you would need a significant pick-up in inflation for your "buckling" to occur and to lead to a significant repricing of risky asset prices such as equities and US High Yield. In recent conversation "Bracket creep", which describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation, we indicated that with declining productivity and quality with wages pressure building up, this could mean companies, in order to maintain their profit margins would need to increase their prices. To repeat ourselves "Protectionism", in our view, is inherently inflationary in nature. At some point there might be a confrontation between the Trump administration and the Fed we think.

A clear sign of financials conditions tightening we think has been the unwind of the EM carry trade to the benefit of our friend "Mack the Knife" aka the US dollar. This is clearly indicated by Bank of America Merrill Lynch in their Liquid Insight note from the 16th of August entitled USD in the FX carry driver's seat:

• "USD has been a top yielder in G10; a fundamentally-strong USD with asset status supports FX carry and further dollar gains
• USD on the asset side and SEK on the funding side has upended correlations; FX carry beta risk is low and investors own vol
• After the momentum surge in February-April, FX carry looks poised for another leg higher; will AUD & NZD stand in the way?

The shifting dynamics of FX carry

The US dollar resides firmly on the asset side of the FX carry spectrum, currently occupying the top yield rank (Chart of the day).

Its presence atop the yield ranking is historically atypical and a reflection of a robust US economic cycle and a steadily hiking Fed, attributes that have supported USD higher since 1Q18. USD asset status alongside SEK liability status (displacing JPY) has also sharply shifted historical FX carry correlations, resulting in long carry positions now having very low traditional “beta” (risk-on/risk-off) exposure as well as long exposure to implied volatility. FX carry investors now actually get paid to own tail risk in a robust economic cycle, which has traditionally supported carry returns. These are important shifts that enhance the attractiveness of both FX carry as an investment approach in an uncertain world as well as support the USD as principal currency beneficiary. After a strong surge in momentum through mid-April, event analysis suggests FX carry is poised to make another run higher in the weeks ahead. Of key importance will be whether recent sharp depreciation in AUD and NZD – the two other asset currencies aside from USD – moderates.

FX carry revisited

Traditional FX carry strategies involve going long currencies offering the highest yields, funded in currencies offering the lowest yields. The number of currencies on respective asset and funding sides can vary but often is symmetrically three (particularly in G10). For the sake of simplicity, our analysis uses Bloomberg’s G10 FX carry index, which uses a simple top three/bottom three construction and, in our view, is representative of the approach used by many FX carry-themed investors.

The general historical pattern of FX carry positions should be unsurprising to those familiar with the strategy. On average, since 2000, the highest ranking carry currencies have been NZD, AUD and NOK, in that order. The lowest ranking carry currencies have been CHF, DKK and JPY. Historically, USD, EUR, GBP and CAD have been positioned somewhere in the middle.

The carry spectrum today: What’s wrong with this picture?

Chart 1 shows the current FX carry spectrum based on implied three-month yield. A simple top three/bottom three FX carry strategy would currently be long USD (2.32% yield ), NZD (2.31%) and AUD (2.19%), funded in CHF (-0.80%), DKK (-0.59%) and SEK (-0.49%).

The position of USD on the asset side of G10 FX carry clearly represents a major departure from the past (Chart 2).

Moreover, its position at number one represents a full five rank positions above the historical average (about number 6). This is by far the greatest discrepancy with respect to current FX yield rank vs historical average across G10.

Additional anomalies worth highlighting are SEK, currently squarely on the funding side and two positions below its historical average; and JPY, now approaching middle-of-the pack status and two positions above its historical average (no longer a funder). Nonstandard monetary policy measures and forward guidance put in place by the ECB are responsible for low European yields, in particular that of SEK. Indeed, the Riksbank responded with aggressive measures of its own aimed at preventing unwanted exchange-rate appreciation, the practical result being relegation of SEK to the FX funding bin. Negative funding yields have clearly enhanced the spread of high yielders.

Factors affecting carry performance

FX carry has traditionally been a risk-on and implicitly short volatility strategy, essentially a reflection of relative yield providing compensation for relative perceived risk (Chart 3).

High yield also provides an incentive to fund external deficit currencies, often on the asset side of an FX carry strategy historically. Conversely, low (currently  negatively) yielding funding currencies usually exhibit safe-haven status, often due to external surpluses and correspondingly high international investment positions (IIPs). FX carry investors earn a positive return in one of two ways: (1) exchange rates remain stable or decline by less than the yield spread between the asset and funding currencies; or (2) asset currencies increase in value relative to funding currencies, hence producing capital appreciation additive to the positive carry differential. The latter scenario is the ideal one for carry seekers. FX carry investors lose money (ie, experience negative total return) when depreciation in asset currencies vs funding currencies exceeds the positive carry earned. Losses have been severe at times, as was the case during the Global Financial Crisis (GFC), when financial markets convulsed and global growth dove into recession.

Investors are likely aware that FX (forward) markets are priced such that the expected rate of depreciation in high yielding currencies relative to low yielding ones equals the positive carry earned (interest rate parity), meaning long carry investors implicitly think the FX market is incorrectly priced (generally too ‘pessimistic’). This is a key reason why FX carry traditionally suffers when risk tolerance takes a dive. With global risk appetite heavily influenced by global growth (Chart 4), FX carry performs well in periods of cyclical strength.

This makes tepid performance of the strategy all the more perplexing, particularly considering strength of the US cycle, particularly this year.

Carry momentum to re-assert

FX carry experienced a surge in momentum back in mid-April. After a protracted four month consolidation period, history suggests another leg higher in the weeks ahead. Back on 13 April, the 50-day information ratio of FX carry returns rose above 4.0, a two standard deviation event indicative of a significantly high level of carry momentum (Chart 5).

Readings of this magnitude have only happened 19 times since 2000. Of those 19 instances, 17 were higher after 100 trading days for an average total return of about 3% (vs currently only about 1% after day 87) (Chart 6).

Within this sample, 26 November 2012, stands out as having strikingly similar price action to today. This instance is 70% correlated over the last 60 trading days and 80% correlated over the last 20 trading days and suggests an impending 4% surge higher in the FX carry index to peak levels over the next few weeks. 

Carry caveat: will the antipodeans cease plummeting?

We believe USD will contribute to another leg higher in FX carry for fundamental reasons (strong cyclical position, monetary policy divergence). Our confidence in AUD and NZD – the other two currencies currently on the asset side of the strategy – is lower. Recent sharp slides in the antipodeans have been amplified by elevated global trade war, China and EM-related uncertainty. At a minimum, the pace of depreciation needs to moderate. So far, our LCBF flow data, which show four-week flows recently crossing into negative territory, for now do not support potential cessation of selling pressure. That said, speculative positioning as measured by CFTC and other data sources is very short AUD and NZD, potentially helping to contain a continued downside slide.

Note that in the recent February-April FX carry upswing, AUD and NZD trended moderately lower. But because of sharp USD strength and SEK weakness the strategy produced strong positive returns anyway. Resumption of AUD and NZD strength against SEK would clearly bode well for the FX carry strategy looking forward.

On a relative basis, our views are constructive AUD vs NZD (Greater AU and NZ divergence 15 Aug 2018). Of the three currencies currently included on the asset side of FX carry, NZD is clearly the weak fundamental link" - source Bank of America Merrill Lynch

There you go, if the USD is on a rampage, not only do we have rising dispersion among asset classes such as credit and equities but, now there is indeed a "hypertonic surrounding" situation when it comes to the swelling US dollar carry. This of course is the manifestation rest assured of QT hence the reason for the commodities bloodbath with many players busy raising their USD cash levels for protective measure.

While in our previous conversation we indicated we remained short term "Keynesian" and starting to become "Austrian" from a medium perspective, there is no doubt in our mind that there are clouds lining up on the horizon that warrants close attention. For instance from a "flow" perspective the latest Follow The Flow note from Bank of America Merrill Lynch from the 17th of August is aptly entitled "Nowhere to hide":

"Outflows from IG, HY, govies, EM and equities

It seems that investors have nowhere to hide. Almost all the asset classes we follow recorded outflows last week. We saw outflows from IG, HY, Govies and EM debt. Same in equities and even in money market funds. Higher risk assets volatility, EM FX sell offs, trade wars and Italian political risks have instigated a risk off trend in flows across risk assets. Will risk aversion abate any time soon? Should the aforementioned risks not disappear, we struggle to see a structural shift in flows back to Europe especially amid dollar strength and global interest rate differentials.

Over the past week…

High grade funds flows dipped further into negative territory. Further euro weakness (vs. the dollar) has pushed more outflows out of euro funds over the past week. High yield funds were hit again by outflows, erasing the inflows we have seen over the previous two weeks. Looking into the domicile breakdown, Global and European-focused funds have recorded outflows while US-focused funds recorded inflows.

Government bond funds recorded a strong outflow over the past week; almost reversing the inflow we saw a week ago. All in all, Fixed Income funds recorded a sizable outflow; the largest in eight weeks and the first after three consecutive weeks of inflows.

European equity funds recorded outflows for the 23rd consecutive week. $55bn has left the asset class over that period.

Global EM debt funds recorded another outflow last week, amid a rapidly weakening
trend in EM FX land. Commodity funds recorded a small inflow.

On the duration front, there were outflows across all parts of the curve. It feels that outflows were more sizable on the back-end of the curve." - source Bank of America Merrill Lynch

No wonder, the winner take all mentality is taking its toll flow wise and the US powering ahead in true "Dissymmetry of lift" fashion. But good news might indeed be history as we move towards the fall. While we recently wondered about MDGA (Making Duration Great Again) from an exposure point of view, we think that it is the time to reduce some risk and starting playing defense we think. On that specific point we read with interest Bank of America Merrill Lynch's take in their Securitization Weekly Overview from the 17th of August entitled "Risk off stew: QT, rate hikes, refi's dead, declining breakevens, expensive housing":

"Risk off stew: QT, rate hikes, refi’s dead, declining breakevens, expensive housing

Risk off signals are escalating. In our view, the only positive note this week was the trade war news that China will send a delegation to the US to try to resolve differences. We’re doubtful that a meaningful “fix” to a situation that has been brewing at least since China’s entry into the WTO in 2001 will be reached, but we’ll see. The Shanghai Composite closed the week at 2669, the lowest level in over two years, so market skepticism about trade war resolution appears intact. Meanwhile, the list of negatives for markets, away from trade, is getting longer, creating a risk off stew in our opinion.

QT has been accelerating: the Fed’s balance sheet is now down by $219 billion in 2018 and the 4-week rolling change of $64 billion is by far the largest decline in a 4-week period since the unwind started. 10 years after the crisis led to dramatic expansion of the Fed’s balance sheet, the unwind is picking up steam; we look for another $175-$200 billion by YE 2018. On top of that, another rate hike in September seems fairly certain, consistent with our Economist’s views. Jackson Hole or the upcoming Fed minutes seem unlikely to offer any meaningful change from the Fed’s somewhat autopilot policy tightening plans. But these events will be worth watching, as a dovish shift could alter the risk off conditions.

Another negative is recent declines in the 10-year breakeven inflation rate, which has dropped down to 2.08%. While the breakeven rate has stabilized above 2.0% in 2018, the Fed’s continued policy tightening may well challenge that stability. BofAML technical strategist Paul Ciana is now highlighting that the 10y breakeven rate is at risk of a bearish breakdown to 1.91%-1.98% in the months ahead. Based on our breakeven inflation valuation framework for securitized products, this would be consistent with our view that spread widening risk now dominates for the sector. In mortgages and housing, things are not great either. The MBA Refinancing index dropped to an 18-year low this week. Long gone are the days that increased refinancing activity provided a savings stimulus to the household sector. Instead, declining refinancing activity is consistent with policy tightening from the Fed. Meanwhile, the latest UMich consumer sentiment reading reported “home buying conditions were viewed less favorably in early August than any time since August 2006.” This is consistent with the recent sharp drop in the MBA purchase index and is even more negative than the affordability index, which is back to 2008 levels, would suggest; given the changes in mortgage credit availability since the pre-crisis era, affordability is probably more constrained than the nominal time series suggests.

As we noted in “Soft housing data piling up: prepare for risk-off,” the mortgage/housing market could use a 10Y rally back to the 2.25%-2.50% range over the near term. If the trade war and Fed remain on their recent, market-unfriendly paths, the chances seem increasingly good that a sharp risk off rally in bonds is coming, as is more pronounced spread widening in securitized products. We’ll watch for change in the coming weeks, but, in our view, now is the time to become more defensive. We doubt either the Fed or China will meaningfully change course without more pronounced market turmoil as motivation. Most likely, spread widening in securitized products has only just begun."  - source Bank of America Merrill Lynch

From a contrarian perspective, two things stand out, not only the consensus short US Treasury Notes is stretched but if indeed we are starting to see a fall in breakevens, there could be a potential for a rebound in gold which has been relentlessly impacted by the surge of "Mack The Knife" though one could argue that given the momentum in USD FX carry, it might be still difficult to time your entry. 

In their notes Bank of America Merrill Lynch highlights the different factors pleading for a more cautious stance in the weeks ahead of us:

"This week, we survey a number of factors that argue in favor of a more pronounced risk off phase for markets in the period ahead. We began warning of this phase back on July 27 in “Soft housing data piling up: prepare for risk-off.” This week provided a hint of what we think is in store for markets in the next 2-3 months. In our view, spread widening risk in securitized products now dominates. We think defensive positioning is warranted.

Two factors could change this: a sudden change in tone from China on the trade war and the Fed on tightening policy. We think more downside in markets is likely need to create such changes, but we will watch in the weeks ahead, particularly in the upcoming Fed minutes and Jackson Hole, for signs of a shift.

Factor 1: the trade war

The simple trade war gauge we have been watching is the Shanghai Composite index. While it is heading lower, we see risk that weakness in China spills over and increases global recession risk, which will be reflected in wider credit spreads. Chart 1 shows the index closing this week at the lowest level since 2016, down 25% since the January high.

Chart 2 shows the index inverted against the IG corporate index spread. Our point with this chart is that at least some of the trade-related weakness in China is spilling over to the US.

As we write, there is a report of a possible high-level US-China trade summit in the months ahead. While this is positive news, it is a long way from resolving a host of issues that date back at least to 2001, when China entered the WTO. More downside pain in markets may be necessary to lead to true resolution.

Factor 2: the Fed balance sheet and rate hikes

It’s almost 10 years since the financial crisis led the Fed on a path of significant balance sheet expansion. 2018 has seen the start to the unwind (Chart 3): down $219 billion YTD in 2018, with the last 4 weeks seeing a drop of $63 billion.

The unwind is accelerating, as the balance sheet should see another $175-$200 billion decline by YE 2018. On top of this, the Fed maintains ambitious rate hike plans relative to the market (Chart 4).

The upcoming minutes release and Jackson Hole meeting provide opportunities for the Fed to offer new views on policy. Our rates and economics colleagues Mark Cabana and Joe Song suggest the Fed will provide “updated guidance on the longer-run operating framework, which will have implications for a potential end date to the balance sheet unwind.” See “The week in fedspeak,” 17 August 2018. Whether this will be enough to signal a meaningful shift in tightening plans remains to be seen. For now, as with trade, we’re skeptical.

Factor 3: breakeven inflation rates are declining once again

The combination of trade war and tightening policy has reversed the rise in the 10yr breakeven inflation rate (Chart 5).

We’ve seen this movie before in the past few years (2015 and 2016-2017): inflation expectations move higher and then roll over. This year has seen more stability above the important 2% threshold, which is why we have retreated from frequent discussion of our breakeven inflation valuation framework for securitized products.

Now, as the breakeven rate has dropped to its 200d moving average, BofAML technical strategist Paul Ciana is highlighting that the 10y breakeven rate is at risk of a bearish breakdown to 1.91%-1.98% in the months ahead. Our valuation framework suggests this is consistent with spread widening risk for securitized products.

Essentially, it appears as if the market has reached a critical, potential break point on factors 1 and 2 above, the trade war and Fed tightening. If there is no capitulation by either the Chinese or the Fed, the chances are good that breakevens will indeed head meaningfully lower, undoing the work that has been done to stabilize inflation expectations above 2%.

Factor 4: mortgages and housing – refi’s are dead and housing is expensive

This week saw the MBA refinancing index drop to the lowest level since 2000 (Chart 6), nearly 18 years ago.

Gone are the days when an increasing refinancing incentive created a savings stimulus for household. Instead, the Fed’s policy tightening is showing one additional sign of stimulus withdrawal, in the form of declining refinancings. Higher rates have mattered.

Similarly, the MBA purchase index has rolled over sharply in recent weeks (Chart 7), as high home prices and high mortgage rates have hurt affordability.

Confirming this, the latest University of Michigan consumer sentiment reading reported “home buying conditions were viewed less favorably in early August than any time since August 2006.”

The sentiment is interesting, as affordability is currently at 2008 levels, which were actually better than 2006 levels. Chart 8 shows affordability along with the MBA’s mortgage credit availability index.

2006 was the lowest level of affordability in the history of the index. But it was also the year of maximum credit availability that acted as an “offset” to low affordability.

While we see potential for some loosening of mortgage credit, we see little chance of a return to pre-crisis levels of availability. The best solution to low affordability is lower rates. As we noted in “Soft housing data piling up: prepare for risk-off,” the mortgage/housing market could use a 10Y rally back to the 2.25%-2.50% range over the near term. Given the risk off stew that is brewing,  a risk off move in markets may give the mortgage and housing market what it needs." - source Bank of America Merrill Lynch

Sure housing would indeed get a respite from lower yield no doubt. It's all about Wall Street versus Main Street. Given the amount of known unknowns in these "hypertonic surroundings" we would rather take a more cautious tone and raise cash levels in dollar terms within our allocation tool box, given cash in the US thanks to the rise of the front-end is appealing again.

Finally, as per our final charts below, what could really trigger a more recessionary and bear market outlook to the current scenario would be rapid rise in oil prices with an escalation with Iran we think. As we pointed out earlier one, for a bear market to materialize you would need a significant pick-up in inflation and oil could be the match that triggers the lot. 

• Final charts - So you want to be bearish? Oil-price spikes have preceded most recessions

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.  It is worth closely paying attention to oil prices going forward with the evolution of the geopolitical situation with Iran. Our final charts come from Bank of America Merrill Lynch Global Economic Weekly note from the 17th of August entitled "the law of large numbers". The first chart displays the surge of the US dollar since tariffs were imposed in March and the second chart displays the risk posed by oil shocks in post-war recessions:

"Since the steel and aluminum tariffs were imposed on March 1, the dollar has strengthened against many currencies (Chart 1).

Iran: oil slick?

Oil sanctions against Iran pose an almost equal risk to global growth. Recall that oil shocks have played a role in most post-war recessions (Chart 2). Given the steady shrinkage in Venezuelan supply, the large gyrations in Libyan supply, and the fact that OPEC and US fracking supply is already high, a cut-off in Iranian oil could have a major impact on prices. Iran currently exports about 2.3mn barrels of crude oil per day (b/d). Francisco Blanch and team estimate that a reduction of 1mn b/d in Iranian supply would increase Brent prices by about $17/barrel. This means that if the Trump administration pursues its stated goal of cutting Iranian oil exports to zero, Brent could rise above $100/barrel. This would be a major headwind to global growth, especially since dollar strength is pushing the non-dollar price of oil up even faster.

The Iran story is not just about global oil supply. It has created yet another split between the US and many of its allies. The sanctions could also worsen US relations with major importers of Iranian oil, including China and India, which together have purchased nearly 60% of Iranian crude oil exports this year. Although the sanctions have been imposed unilaterally by the US, they would apply to any shipping or insurance company that deals with Iranian oil. This gives the US the power to effect substantial cuts in Iranian exports globally, should it choose to do so.

A final striking aspect of the sanctions is their timing. Full sanctions on Iranian oil go into effect on November 5, just one day before the US midterm elections. In our view, this is a sign that the Trump Administration views getting tough with Iran as a winning political issue. The timing argues against a common view that the Trump Administration will moderate its policies—and reduce the risks to the markets and the economy—in the run-up to the election." - source Bank of America Merrill Lynch

We do live indeed in interesting "hypertonic surroundings" times, with of course many known unknowns to keep us entertained for the weeks ahead. What's always more worrying is the unknown unknowns but that's another story and we ramble again...

"Knowledge is not simply another commodity. On the contrary. Knowledge is never used up. It increases by diffusion and grows by dispersion." - Daniel J. Boorstin, American historian

 Stay tuned!