Friday, 22 March 2019

Macro and Credit - Inflationism

"For the merchant, even honesty is a financial speculation." - Charles Baudelaire
Watching with interest the Fed's additional dovishness with the continuation in the rally in high beta and in particular credit, marking the return of "goldilocks at least for this asset class, when it came to selecting our title analogy, given the potential stagflationary outcome thanks to the Fed being S&P500 dependent, we decided to go for "Inflationism". "Inflationism" is a heterodox economic, fiscal, or monetary policy, that predicts that a substantial level of inflation is harmless, desirable or even advantageous. Similarly, inflationist economists advocate for an inflationist policy. The contemporary Post-Keynesian monetary economic school of Neo-Chartalism, advocates government deficit spending to yield full employment, is attacked as inflationist, with critics arguing that such deficit spending inevitably leads to hyperinflation. Neo-Chartalists reject this charge, such as in the title of the Neo-Chartalist organization the Center for Full Employment and Price Stability. Also, a related argument is by Chartalists, who argue that nations who issue debt denominated in their own fiat currency need never default, because they can print money to pay off the debt similar to what we are hearing these days from the MMT supporters. Chartalists note, however, that printing money without matching it with taxation (to recover money and prevent the money supply from growing) can result in inflation if pursued beyond the point of full employment, and Chartalists generally do not argue for inflation. It also worth noting that Keynes described the inflation and economic stagnation gripping Europe in his book The Economic Consequences of the Peace. Keynes wrote:

"Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some." [...]
"Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose." 

Keynes explicitly pointed out the relationship between governments printing money and inflation:
"The inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent Governments, unable, or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance." 
The direct result of inflation is a transfer of wealth from creditors to debtors – the creditors receive less in real terms than they would have before, while the debtors pay less, assuming that the debts would in fact have been repaid, and not defaulted on. Formally, this is a de facto debt restructuring, with reduction of the real value of principle, and may benefit creditors if it results in the debts being serviced (paid in part), rather than defaulted on. In a context of "Japanification", the carry trade is back on and credit markets will definitely benefit from the global dovishness from central bankers. In  that context, we would tend to agree with our former esteemed colleague David Goldman's recent post in Asia Times from the 20th of March entitled "Fearing slower growth, Fed says no rate hikes this year":
"Markets expected forbearance from the Federal Reserve, but the US central bank Wednesday leaned further towards monetary ease than the optimists expected. The Fed envisions no change in interest rates until sometime in 2020, and not at all if the economy weakens further. It won’t reduce the $4 trillion securities portfolio it built up through so-called quantitative easing.
This is a market that rewards cowardice – holdings of stable income-earning assets like credit and real estate – more than it rewards bravery. I continue to believe that carry will be king in 2019 as the Fed keeps interest rates low." - source David Goldman, Asia Times
This is clearly a market favoring "coupon clipping" we think but we ramble again.

In this week's conversation, we would like to look at the growing "stagflation" risks, which have been on this very blog a scenario we highlighted could happen.

  • Macro and Credit -  The return of the "yield" hogs in the Chinese year of the pig
  • Final charts - Oh my God they killed Macro volatility again!

  • Macro and Credit -  The return of the "yield" hogs in the Chinese year of the pig
In our previous conversation we highlighted the fact that "Deleveraging" and Deflation were good for credit markets. As expected, the additional dovish tone from the Fed is leading towards a reach for yield across credit. We also indicated that as long as interest rates volatility was remaining muted, it would be hard to be negative on credit markets. Given last Tuesday, Merrill Lynch's Move index, which tracks implied volatility on one-month Treasury bill options fell to a reading of 43.68, the lowest since the index’s inception in 1988, no surprise to see a continuation of the rally in high beta credit.

Rentiers seek and prefer deflation and fixed income investors continue to benefit from central bankers accommodative stance in that context. This definitely doesn't put us into the perma bear camp but more into the "realistic" camp we think hence our "japanification" stance.

Looking at the latest data coming out of Europe in general and Germany in particular, with Eurozone Manufacturing PMI coming at 47.6 vs 49.5 expected and previously at 49.3, no wonder the 10 year German bund is going again negative. As well, France Services PMI fell to 48.7 from 50.2 and expectations of 50.6 and Manufacturing PMI declined to 49.8 from 51.5 clearly pointing towards recession for the Eurozone.

Global dovishness has indeed favored the return of the "yield" hogs as indicated by Bank of America Merrill Lynch in their Follow The Flow note from the 22nd of March entitled "Bond mania":
"Dovish central banks and uncertainty favour quality
The epic U-turn in central banks’ stance, the round of fresh stimulus from the ECB and most recently the announced end of quantitative tightening from the Fed, have spurred a global search for yields that mainly benefited fixed income securities.
As flows pour into fixed income funds in 2019, outflows from equity funds have gathered pace, spurred by a macro picture that keeps deteriorating in Europe as shown by the below-45 print in German manufacturing PMI.

Over the past week…
High grade funds recorded an inflow for the third week in a row, with the pace of inflows ticking up. High yield funds enjoyed their fourth consecutive week of inflow. Looking into the domicile breakdown, Global-focused funds gathered half of the flows, with the other half evenly shared between US- and European-focused funds.
Government bond funds saw inflows following two weeks of outflows.
Money Market funds recorded an outflow last week, reversing a two-week streak of inflows.
All in all, Fixed Income enjoyed strong weekly inflows, the second largest print since 2004 and the best 12-week streak since 2017.
European equity funds continued to record a weekly outflow for the sixth consecutive week, whilst the pace of outflows remains strong relative to historical standards.
Global EM debt funds recorded four straight weeks of inflows. Commodity funds saw an inflow last week, the tenth over the last twelve weeks.
On the duration front, long-term IG funds were the laggards as short- and mid-term IG funds recorded inflows." - source Bank of America Merrill Lynch
Back in March 2016 in our conversation "The Pollyanna principle" when it comes to "japanification" and the attractiveness of credit markets in a central banking dovishness context we wrote the following:
"The issue at stake we have discussed on numerous occasions is that many of these Southern Europe banking institutions are capital constrained and cannot increase their lending capacity until the NPLs issues have been resolved!
Maximizing the funding via TLTRO2 in no way helps SME credit availability. The deleveraging has well is an on-going  exercise. What the new ECB funding does is slow down the deleveraging but in no way provides sufficient resolution to the "stock". NPLs are a"stock" variable but, Aggregate Demand (AD) and credit growth are ultimately "flow" variables. Until the ECB understands this simple concept, the "japanification" process will endure hence our "Unobtainium" analogy of last week:
"Unobtainium" situation. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day and now credit speculators are joining the party with both hand" - source Macronomics, March 2016
This means of course that thanks to the Bank of Japan and the ECB, we believe that the rally in credit has more room to go and that both central banks will again not be the benefactors of the "real economy".
One thing for sure, by applying the Pollyanna principle, we think that Investment Grade Credit will benefit strongly and that we will see large inflows into the asset class as per our final point and chart, for SMEs where not too sure..." - source Macronomics, March 2016.
If "Japanification" is still the trade "du jour" then, obviously, credit markets will benefit from it as we posited in our previous conversation. The new TLTRO might not do wonders for the European economy given many banks are still "capital" constrained due to still large legacy assets sitting on their balance sheets in the form of nonperforming loans, but, from a credit investors point of view, they will continue to enjoy the "bond" party rest assured.

This is what we suggested in our previous conversation:
"An allocation to credit rather than equities for these weaker players would seem prone to less "repricing" risk should buybacks dwindle and some dividends start to be cut in some instances." - Macronomics, March 2019
Clearly global growth deceleration is favoring the "D" word for "Deflation", therefore the D trade is back on and US long bonds are enjoying the bond party as well, not only the German bund. Gold miners and gold as well are benefiting as well again from the growing negative yielding "Bondzilla" the NIRP monster.

We have also recently advocated our readers to go for quality (Investment Grade) rather than quantity high yield given rising dispersion. We continue to view rising dispersion as a sign of cracks in credit markets and not as a sign of overall strength.

On that note we read with interest Bank of America Merrill Lynch's take from their High Yield Strategy note from the 15th of March entitled "Eliminate the Impossible":
"The last on our list of recent positive developments is some improvement in pricing of illiquid HY cap structures (Figure 1).

As a reminder, we noted in February that most of the rally to that point had been concentrated in large, liquid, higher-quality cap structures, i.e., relatively easy investments. Bonds in the opposite corner of the market remained largely bidless. This may have started to change in the last couple of weeks, as we are beginning to see some early signs of positive price momentum in that corner of the market. It remains modest so far, offsetting about one-third of the extent of the initial decline, but it nonetheless represents important progress.
Shifting gears to the other side of this equation, other factors that underpinned our recent defensive positioning remained largely unchanged or have even deteriorated further.
Key among them is the degree of dispersion in the overall HY market and in CCCs that refuses to show any signs of improvement. To the contrary, its current readings are below year-end as well as both month-ends since then. The dispersion index measures the proportion of all bonds that are trading close to the index level (+/-100bps for overall HY and +/-400bps for CCCs). The rationale behind this measure is that dispersion tends to be low at times of high investor confidence and risk appetite and drops significantly as credit conditions tighten as buyers remain cognizant of risks and differentiate strongly between relatively stronger and weaker names (Figure 2).

About one-third of all CCCs continue to trade at distressed levels, whereas for most of last year that proportion stood at 20% or below. This outcome suggest that investors remain cautious in reaching for credit risk among the names that otherwise would have the highest upside from here if a low-default scenario were to play out in coming months.
Note that reopening in the CCC new issue market has done little so far to alleviate concerns surrounding these two real-time indicators (dispersion and distress). Perhaps, the newly minted CCCs are yet again viewed as carrying relatively stronger credit profiles compared to the rest of that space, although any comps here are particularly challenging given the highly idiosyncratic nature of this segment. In addition, the B3/below segment in leveraged loans also experienced a sharp slowdown around yearend and has only recovered modestly since then. The latest-3mo pace of activity here is running at less than one-fifth of its peak levels reached in the middle of last year.
Lastly, Moody’s has reported 17 global HY defaults in the first two months of 2019, of which 12 were among US issuers. These counts are the highest over the past year and compare to an average of 2.7 default events per month in the second half of 2018." - source Bank of America Merrill Lynch
Obviously their defensive position has been vindicated by the most recent weakness we have seen in the high beta space, with equities as well in the first line of the volatility hence our more positive stance on credit relative to equities as per our previous conversation for those who follow us regularly.

When it comes to the support for credit markets, namely "Bondzilla" the NIRP monster which we indicated on numerous occasions has been "made in Japan".

Back in July 2016 in our conversation "Eternal Sunshine of the Spotless Mind" we indicated that "Bondzilla" the NIRP monster was more and more made in Japan due to the important allocations to foreign bonds from the Government Pension Investment Fund (GPIF) as well as other Lifers in conjunction with Mrs Watanabe through Uridashi and Toshin funds (Double Deckers) being an important carry player. In the global reach for "yield" and in terms of "dollar" allocation, Japanese investors have been very significant hence the importance of monitoring the flows from an allocation perspective. On this very subject we read another Bank of America Merrill Lynch's take in their Situation Room note from the 14th of March entitled "Japan 101":
"Japan 101
It is hard to imagine any country more transparent with investment flows than Japan. Hence, we know from the Japan Ministry of Finance’s weekly Data on securities investment abroad for medium and long term bonds as of March 8th that purchases are off to the strongest start to the year (¥5.76tr ) since 2012 (where the number was only slightly higher). This translates into $52bn of buying YtD, a dramatic change from sales of $6bn and $33bn during the same periods in 2018 and 2017 (Figure 1), respectively, and one of the key reasons the US corporate bond markets has been so strong this year, in our view.

Going forward, we can expect Japanese selling in a narrow window around fiscal year-end (March 31), where they tend to repatriate money (Figure 2).

It is also a straightforward assumption that Japanese purchases of foreign bonds accelerate in the new fiscal year starting April 1st, as seasonally about 75% of buying tends to take place in fiscal 1H, 25% in 2H.
EUR bonds and JGBs for life
Of course, this Ministry of Finance data covers all foreign bonds – not just US corporate ones. Luckily, Japanese lifers update on their investment plans twice a year – our most recent update is in the section “JGBs for life” in here: Situation Room 24 October 2018, which contained detailed plans for 2H of the Japanese Fiscal year (runs April 1-March 31). Clearly, heading into the first part of 4Q18 USD hedging costs had increased so much that they planned to shift hedged buying away from USD, into EUR – likely in a mix of European core corporate and sovereign bonds. Also, with rising rates and 30-Situation Room | 14 March 2019 3 year JGB yields already at 90bps+, they were getting ready to shift back into local government bonds as well. Of course, they planned to continue investing on a currency unhedged basis in the US.
Who let the doves out?
However, we suspect these plans had changed dramatically to favor much more US corporate bonds on a hedged basis by early this year as 1) market expectations for Fed rate hikes collapsed dovishly from about three over the following year heading into 4Q18 to none and 2) local 30-year JGB alternatives had plummeted as well to the 60bps range - far from the 100bps needed. Of course, they likely remained sizable buyers of EUR bonds, but probably less than originally planned.
While it is helpful that dollar hedging costs have come down somewhat over the past several months, as Libor-OIS tightened materially, that is not the main driver of increasing Japanese buying of US corporate bonds. We see this as US corporate yields have declined by roughly the same amount as dollar hedging costs (Figure 3), leaving yields after hedging relatively unchanged.

Instead, the main driver is the Fed’s dovish capitulation. The most common dollar hedging strategy for foreign investors involves a maturity mismatch with the underlying assets, as they roll short term – such as 3-month – forward fx rates. The cost of such strategy is driven by the difference between short term interbank rates, which in turn is driven mainly to relative monetary policy rates.
In early 4Q18 the Fed was the only major central bank hiking rates (3x priced in in 12months), as the BOJ and ECB were on hold. Foreign investors buying US corporate bonds rationally expected to be rolling into prohibitively expensive dollar hedges in 2019, leaving expected future yields after hedging costs on par with 90bps for 30-year JGBs (Figure 4).

Hence, US corporate bonds looked unattractive to Japanese investors. However, that all changed as markets priced out future rate hikes, and Japanese investors could thus have confidence dollar hedging costs would not increase. By the beginning of this year, Japanese investors could expect to keep, for example, 1.8% for dollar hedged 10-year BBB rated US corporate bonds, which compared very favorably to just 0.7% for 30-year JGBs.
Here to stay
We expect healthy Japanese and other foreign buying of US corporate bonds – which this year was always a key ingredient in our bullish call on spreads - to continue to help drive tightening for quite some time. Right now, the global corporate bond market – and USD is the biggest and most liquid chunk of that – is basically the only option for foreign investors. This changes when 1) valuations become unattractive – which will likely take a long time (Figure 4), 2) the market starts pricing in Fed rate hikes – which is not any time soon, or 3) US recession risk becomes too high – which should be years away, in our view." - source Bank of America Merrill Lynch
Not only Japanese Lifers have a strong appetite for US credit, but retail investors such as Mrs Watanabe, in the popular Toshin funds, which are foreign currency denominated and as well as Uridashi bonds (Double Deckers), the US dollar has been a growing allocation currency wise in recent years so watch also that space.

For Japanese investors increasing purchases in foreign credit markets has been an option. Like in 2004-2006 Fed rate hiking cycle, Japanese investors had the option of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During that last cycle they lowered the ratio of currency hedged investments to take on more credit risk.

This is confirmed by Nomura's Japan Navigator note number 815 from the 18th of March entitled "ECB and BOJ's policy impasse and risk of JPY appreciation":
"Lifers opt for credit rather than anticipating weak JPY
In an interview with Bloomberg last week, a major life insurer stated that it was offsetting the impact of currency hedging costs by selling FX call options (partly giving up the advantages of weak JPY), and by taking credit risk, generating returns of about 1% even after fully hedging. This former approach resembles that taken by two other major lifers interviewed recently (see page 7 of the 5 March Navigator), but this lifer seems to be more concerned about the minimal room JPY has to weaken than worried about the risk of stronger JPY. Regarding the latter, credit spreads are not only wider overall in the US than in Japan, but the yield curve is steepening (Figure 5), and as a result, lengthening  maturities have a greater effect in improving yields.

For this reason, if investors buy A rated US corporate bonds with maturities near 20yrs, they can bring in yields of about 1% even if they convert it to JPY using currency swaps with the same maturity. That said, we do not expect lifers to take risks on such long-term credit without a US economic downturn combined with a sense that the Fed will not turn hawkish again." - source Nomura
In relation to our "gold" outlook, while we won't bother going into much the details of Alfred Herbert Gibson's 1923 theory of the negative correlation between gold prices and real interest rates. We believe that the real interest rate is the most important macro factor for gold prices.  Obviously the more our NIRP monster grows, the more inflows gold funds will get given Gibson 's paradox. That simple.

Returning to credit, we have been advocating going higher the quality spectrum and use the recent rally to reduce highly illiquid high beta exposure such as leveraged loans. US Leveraged Loan Funds have seen 17 Weeks of outflows totaling $21.8 billion. Regardless of the performance, it is indicative, we think of risk reduction due to illiquidity factor coming into play. When it comes to US High Yield, though everyone has been talking about the BBB monster in Investment Grade sitting on the edge of the downgrade cliff, discussions surrounding High Yield has been more muted. On that specificity, we have read with great interest Morgan Stanley's take from their Corporate and Credit Derivative Research note from the 22nd of March entitled "A High Yield Hedge":
"Trends in the high yield market over the past few years, in particular, have been somewhat different from what we have seen elsewhere. For example, when thinking about the excesses in credit, many (us included) talk about BBBs in IG, which have seen enormous growth in this cycle, or the leverage loan market, where credit quality has arguably deteriorated for years (higher leverage levels, weaker covenants, weaker structures, etc.). But the high yield market is often left out of the discussion. After all, high yield went through a mini default cycle in 2016, centered on Energy, and since then, issuance has steadily declined, leading to no growth in par outstanding, very different from the trends noted above. Some investors assume that as a result, high yield is more insulated from the fundamental risks present in other pockets of credit markets. In fact, for much of 2018 (at least for the first three quarters), we regularly heard the view that the resilience of HY (relative to the weakness in IG, for example) was a testament to healthier fundamentals in the former.
Through the third quarter of last year, we published several notes (see: US Corporate Credit Strategy Brief: I Can't Believe It's Not Beta, 25 Apr 2018) on why we thought HY was so resilient at the time (i.e., low supply and very strong earnings growth, among other factors), but more importantly, why we also believed HY was very much not immune from the broader macro challenges to come. Fundamentally, we agree, it is hard to point to specific metrics that seem as glaring in HY as in other credit markets, especially since 2016. For example, post the Energy recovery, leverage now looks weaker in IG than in HY (beta-adjusted), while both the growth in and deterioration in ratings quality of the IG and loan markets has also been much more extreme than that of HY over the same time period. However, in our view, this certainly does not mean high yield is out of the woods.

First, speaking to the growth (or lack thereof) in HY par outstanding since 2016, and what that may imply, we think some often forget that this has been a very long ten-year cycle. The HY market, in fact, has grown substantially (+112% since the end of 2008, based on the index we track), just all that growth took place in the first six years.

Leveraged finance markets have been consistently growing the entire time (other than a small blip lower in 2016), and that is what matters most, in our view, as these markets will always be closely tied together, especially in a credit cycle.
Yes, the driver of the growth in leveraged finance markets has shifted over the course of this cycle, as we show in Exhibit 6, with HY the main contributor early on and loans over the past few years, but we don't see this change in trend as overly surprising or abnormal.

As we point out in Exhibit 7, the story was similar in 2006/07 when the growth in HY par outstanding was minimal in the last two years before the financial crisis, while loans were growing at an exponential rate.
Second, while easily-tracked fundamental metrics like leverage don’t look as extreme in high yield, we think other harder-to-track, more qualitative measures are more problematic. For example, when digging into the quality of the companies in various markets, we would argue high yield is more exposed to sectors with longer-term operational challenges (as we originally discussed in Cross-Asset Dispatches: Why We Prefer Equities Over Credit, 3 Nov 2017). In investment grade credit, 30% of the index is made up of Financials, a sector where balance sheets are very strong, thanks in part to a decade of financial regulation. The large cap equity indices are skewed towards fast growing technology companies. High yield, in our view, is more heavily exposed towards “old economy” business and Energy. Many of these companies also have high leverage, but they have survived because of such cheap money for so many years. We are guessing some of them will have trouble through another recession, especially if credit conditions tighten for a prolonged period of time.
Third, because some of the fundamental challenges are more widely discussed in other markets, they are likely also a bit more "in the price." A good example is that the BB/BBB spread basis is at cycle tights, in part because, on the surface, long-term problems seem more material in low-quality IG than in HY. However, while we have been very vocal around the issues with BBBs, we would actually buy BBBs over BBs, simply because we think the potential challenges in high yield in a credit cycle are less appreciated than the risks elsewhere (like in BBBs).
Finally, for those who still believe HY will be relatively resilient through a credit cycle due to better fundamental trends, let’s look at recent evidence. For example, we have had two growth scares in this cycle, in 2011 and in 2016, and in both cases HY traded to ~850bp, very close to prior recession wides (i.e., the levels where HY peaked in 1990 and in 2002).

Some still argue while that may be true, 2016 in particular, was unique due to the collapse in oil prices, which is a much lower risk in the future. In our view, any hope that HY would be more resilient in the next growth scare (or outright recession) should have been thrown out the window after witnessing the price action in 4Q18. After all, once the weakness in 2018 became about growth/earnings growth rolling over, the resilience of HY ended. At that point, spreads widened by almost 250bp, and HY underperformed the leveraged loan market, despite seemingly weaker fundamental metrics in the latter.

We think it is clear that high yield is and will remain highly sensitive to changing growth expectations as well as to changes in credit conditions.
Going forward, our view has been clear – we think the weakness in 4Q was not just a temporary valuation adjustment in a broader bull market, or about one-off headwinds like trade. We believe credit is in a bear market and the credit cycle is slowly turning. Defaults should remain low in 2019, but we think default expectations may rise this year, and actual defaults could start trending higher the year after. We believe this is a good time to position for this view, especially in places where it is clearly not priced, like short-dated HY CDX." - source Morgan Stanley
Now if indeed High Yield is highly sensitive to changing growth expectations and if as we posited last week CFOs in the Investment Grade space decide to reduce CAPEX, buybacks and dividends to address leverage concerns from investors, then it will be more "credit" friendly and less so for "high beta" related equities from these issuers. In a "japanification" context, we therefore think that playing quality and duration is less prone to burst of volatility and will be more rewarding for "yield hogs" cowards than the high beta punters out there.

With a return of ultra dovishness from our generous gamblers aka our dear central bankers, given the new record low in rates volatility as per the Move Index cited earlier on in our long conversation, as per our final charts below it seems to us that macro volatility has been somewhat "killed" again...

  • Final charts - Oh my God they killed Macro volatility again!
Back in November 2012, in our conversation "Why have Global Macro Hedge Funds underperformed", we argued that when volatility across all asset classes crashes, global macro strategies tend to suffer on both an absolute and relative basis. Our final charts come from HSBC Asia Chart of the Week from the 22nd of March entitled "The demise of macro vol" and highlights the fall in the volatility of activity data to record lows:
"Glued to your trading screens these last few years, you may well believe the world economy was roiled by one shock after another. Well, not quite. Financial markets have spiked and plunged, but underlying economic activity, at least across Asia, has been remarkably steady. In fact, it’s been ‘flat as a pancake’ to borrow a phrase from HSBC’s chief fixed income strategist Steven Major (see Fixed Income Asset Allocation, 12 March). Ah, ‘China’, you might say: the economy’s growth numbers have indeed been extraordinarily stable in recent years. But that’s actually been the case in virtually all Asian economies. The volatility of activity data has fallen across the board to record lows, well below the mid-2000s, when, if you recall, economists were celebrating the demise of macro volatility amid the ‘Great Moderation’. It’s hard to pinpoint the exact reasons for this – highly supportive, and swiftly reactive, monetary policy is probably one, as are structural factors like the growing share of services in output and much shallower inventory cycles in manufacturing. The fall in growth volatility, unsurprisingly, has been accompanied by a drop in inflation volatility. All this, ultimately, stokes leverage as borrowers and lenders become increasingly desensitized to risk…careful what you wish for.
"I may as well tell you that if you are going about the place thinking things pretty, you will never make a modern poet. Be poignant, man, be poignant." P.G. Wodehouse
Our fist chart is simple enough: it compares the standard deviation of GDP growth in the 2000s (2002 to 2007, to be exact) and 2010s (2012 to 2018).

Note that in virtually all cases, growth volatility has declined markedly. The exceptions are Sri Lanka, Thailand, Taiwan, and Vietnam. In the first two, this is easily explained by local political uncertainty and environmental disruptions. In the latter two, the increase in volatility has been slight or from a comparatively low level. Note also that China is often singled out as having rather stable GDP growth numbers, but the drop in volatility has been nearly uniform.
The decline in growth volatility, unsurprisingly, has been accompanied by a fall in the volatility of inflation. Our second chart replicates the first, this time showing the standard deviation of headline inflation for different economies. Again, the picture is broadly similar: in most markets, volatility has fallen. This time, the exceptions are Australia, India, Japan, New Zealand, and Singapore, with most increases being marginal (India is a stand-out, but may reflect computational issues). ‘Wait’, you might object, the decline in headline inflation volatility may simply reflect more stable global energy and food prices…perhaps, but core inflation is showing pretty much the same trend.
This fall in macroeconomic volatility is generally something that policymakers and investors alike desire. From this perspective, the past few years were quite positive, even if GDP growth itself fell short of expectations in many parts of the world, including in Asia. Financial markets, of course, have at times been highly volatile, but, overall, risk assets have performed quite well, which may in part be attributable to the ‘demise in macro vol’.
The trouble is, the longer a period of low volatility endures, the more desensitized everyone becomes to risk: if things are fundamentally stable, and memories of deep recessions are starting to fade, the appetite to leverage up grows and investors are increasingly tempted to buy ‘on the dip’.
But take a look at our last chart. This shows the volatility of GDP growth in emerging Asia over time. Note that this has been extraordinarily low in recent years (blue circle).

However, periods of low volatility often precede a spike: for example, vol plunged in the mid-1990s before the Asian Financial Crisis and also trended lower in the mid-2000s before the Global Financial Crisis (red circles).
Better stay nimble…" - source HSBC
 So while some central banks have decided that in order to acquire the resources they required, have printed notes for the balance to paraphrase Keynes, their inflationism policies, all of this, ultimately, stokes leverage as borrowers and lenders become increasingly desensitized to risk…careful what you wish for indeed...

"Speculation is only a word covering the making of money out of the manipulation of prices, instead of supplying goods and services." -  Henry Ford
Stay tuned !

Wednesday, 13 March 2019

Macro and Credit - The Queen of Spades

"Luck is believing you're lucky." - Tennessee Williams

While enjoying a much needed short break from blogging, hence our uncommon silence, we still managed to follow the macro news such as February’s anemic 20,000 new jobs creation in the United States from the latest nonfarm payroll report (when 180 K was expected). With global negative yielding bonds increasing by $509Billion in the last three-day trading to $7.437 trillion, given the global weaker tone in the growth outlook, no wonder the D word for "deflation" fears has staged a comeback. Given the recent dovish tone taken by our "Generous Gambler" Mario Draghi we also like to call "Le Chiffre", and that we do have "Sympathy for the Devil" because as we said on numerous occasions, "The greatest trick European central bankers ever pulled was to convince the world that default risk didn't exist", so, when it came to selecting our title analogy, we decided to go for both a great literature reference and another card game reference. "The Queen of Spades" is a short story by Alexander Pushkin about human avarice and was written in the autumn of 1833 and was first published in 1834. The story was also the basis of an opera by Pyotr Ilyich Tchaikovsky in 1890. It tells the story of Hermann, an ethnic German, who is an officer of the engineers in the Imperial Russian Army. He constantly watches the other officers gamble, but never plays himself. One night, Tomsky tells a story about his grandmother, an elderly countess. Many years ago, in France, she lost a fortune at the card game of faro, and then won it back with the secret of the three winning cards, which she learned from the notorious Count of St. Germain. Hermann becomes obsessed with obtaining the secret:
"The countess (who is now 87 years old) has a young ward, Lizavyeta Ivanovna. Hermann sends love letters to Lizavyeta, and persuades her to let him into the house. There Hermann accosts the countess, demanding the secret. She first tells him that story was a joke, but Hermann refuses to believe her. He repeats his demands, but she does not speak. He draws a pistol and threatens her, and the old lady dies of fright. Hermann then flees to the apartment of Lizavyeta in the same building. There he confesses to have killed the countess by fright with his pistol. He defends himself by saying that the pistol was not loaded. He escapes from the house with the aid of Lizavyeta, who is disgusted to learn that his professions of love were a mask for greed. 
Hermann attends the funeral of the countess, and is terrified to see the countess open her eyes in the coffin and look at him. Later that night, the ghost of the countess appears. The ghost names the secret three cards (three, seven, ace), tells him he must play just once each night and then orders him to marry Lizavyeta. Hermann takes his entire savings to Chekalinsky's salon, where wealthy men gamble at faro for high stakes. On the first night, he bets it all on the three and wins. On the second night, he wins on the seven. On the third night, he bets on the ace — but when cards are shown, he finds he has bet on the Queen of Spades, rather than the ace, and loses everything. When the Queen appears to wink at him, he is astonished by her remarkable resemblance to the old countess, and flees in terror. In a short conclusion, Pushkin writes that Lizavyeta marries the son of the Countess' former steward, a state official who makes a good salary. Hermann, however, goes mad and is committed to an asylum. He is installed in Room 17 at the Obuhov hospital; he answers no questions, but merely mutters with unusual rapidity: "Three, seven, ace! Three, seven, queen!" " - source Wikipedia
The card game of faro also plays an important role in Pushkin's story. The game is played by having a player bet on a winning card. The dealer then begins turning over cards, burning the first (known as 'soda') to his left. The second card is placed face up to his right; this is the first winning card. The third card is placed face up in the left pile, as a losing card. The dealer continues turning over cards, alternating piles until the bet has been won or lost. A reading of The Queen of Spades holds that the story reveals the Russian stereotype of the German, one who is cold and calculating person bent on accumulating wealth (Germans increasing savings at the expense of consumption, which depresses economic activity), one might wonder if indeed the "uber" mercantile policies followed by Germany versus the rest of the world in general and its European peers in particular such as France and Italy will eventually spell its downfall, but we ramble again. After all Pushkin’s Queen of Spades is an "eternal" tale of gambling and avarice, such as the current financial markets we see in front of our very own eyes.

In this week's conversation, we would like to look at the additional dovishness coming from the ECB which we think in Europe will continue to reward more actively the financial sector credit markets over equities. 

  • Macro and Credit -  Betting on the ace in European Rent-seeking credit markets
  • Final charts - ECB rates on Japanese path

  • Macro and Credit -  Betting on the ace in European Rent-seeking credit markets
Given our "Generous Gambler" aka Mario Draghi known as Le Chiffre fired his "Chekhov's gun" and unleashed QE in Europe, the consequences have been fairly simple. We have long been declaring that in that case credit would outperform equities when it comes to financials which is what we posited in January 2015 in our conversation "Stimulant psychosis":
"Rentiers seek and prefer deflation - European QE to benefit credit investors:
"In similar fashion to what we wrote about Japan in general and credit versus equities in particular in our April 2012 conversation "Deleveraging - Bad for equities but good for credit assets":
"Financial credit may be the next big opportunity
The build-up of corporate leverage in the 2000s was confined to financials which, unlike other corporates, had escaped unscarred from the 2001 experience. However, this changed in 2008. Judging by the experience of G3 (US, EU, Japan) non-financial corporates, there should be significant deleveraging in banks going forward. Indeed, regulatory pressures are also pushing in that direction. All else being equal, this should be bullish for financial credit." - source Nomura
Given the performance of European financial credit over equities, we are not surprised. On this very blog we have been advocating favoring exposure to credit markets when it comes to financials in Europe because of the "Japanification" process facing Europe. The recent dovish tone from "Le Chiffre" still at the head of the ECB is a reminder. The new TLTRO will continue to favor rent-seeking investors but probably less strongly than during the last decade following the Great Financial Crisis (GFC).

On that note we read with interest Bank of America Merrill Lynch The European Credit Strategist note from the 8th of March entitled "A decade of hubris":
"A decade of hubris
A decade ago, on March 12th 2009, European credit markets were on their knees, and companies faced extinction. But of course, the Armageddon never came, and years of exceptional monetary support from global central banks instead ignited a decade of significant returns across credit. Secular “winners” in the post-GFC era have been LT2 banks (102% cumulative total returns), transport (71% total returns), media (67%) and tech (66%). The “losers” on the other hand, have been healthcare (60%), energy (58%), autos (51%), and senior banks (48%). Secular contrarians would buy the “losers” as a catch-up trade. In fact, senior banks should reap the benefits of yesterday’s TLTRO announcement from Mr Draghi.
10yrs ago, on March 12th 2009, European credit markets were on their knees. High-grade spreads had peaked at 403bp (high-yield at 2147bp in mid-Dec ’08) and companies faced extinction…with spreads implying default rates of 7% for high-grade and 40% for high-yield. Years of exceptional monetary support from global central banks instead ignited a decade of phenomenal returns across the corporate bond market (chart 1).
Secular “winners” in the post-GFC era have been LT2 banks (102% cumulative total returns), transport (71% total returns), media (67% total returns) and tech (66% total returns).
The “losers” on the other hand, have been healthcare (60%), energy (58%) given oil price ructions, autos (51%) given trade tensions, and senior banks (48%) partly given the emergence of TLAC.
Secular contrarians would buy the “losers” going forward, as a catch-up play. In fact, senior banks should reap the benefits of yesterday’s TLTRO announcement from Mr Draghi – as historically has been the case (see our “who wins” under a TLTRO analysis)." - source Bank of America Merrill Lynch
From a Macro and Credit perspective, as posited by our Friend Paul Buigues in his 2013 post "Long-Term Corporate Credit Returns":
"Even for a rolling investor (whose returns are also driven by mark-to-market spread moves), initial spreads explain nearly half of 5yr forward returns." - Paul Buigues, 2013
As concluded as well in this previous 2013 by our friend Paul:
"Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates.
As a consequence, spreads themselves are a very good indicator of long-term forward returns, for both static and rolling investors."  - Paul Buigues, 2013
Do not focus solely on the current low default rates when assessing forward credit risk. Trying to estimate realistic future default rates matter particularly when there are more and more signs showing that the cycle is slowly but surely turning in both CRE and consumer credit. Fed hiking cycles and tighter bank lending standards have historically been preconditions for recessions. By tracking the quarterly Senior Loan Officers Surveys (SLOOs) published by the Fed you can have a good view into credit conditions. As we told you recently, next publication of the SLOOs will be essential in assessing credit conditions. Please also note that jobless claims are one of the best indicators of a regime shift, because they generally start to rise about a year before the economy enters a recession. 

But if "D" is for "Deflation", then again, looking at the growing concerns from credit investors about US companies' leverage, the biggest risk, for equities is a slowdown in buybacks and a cut in CAPEX spending and dividends for some companies to address leverage issues put forward by many investors. This would make credit more favorable than equities from an allocation perspective due to "Japanification" concerns.

Some might be expecting the Queen of Spades and a return to "goldilocks" when it comes to credit markets, yet we think you shouldn't expect a continuation of such a strong rally in high beta we have seen so far this year given the macro backdrop regardless of the strong dovishness playing out.

On the subject of "complacency" in the current market set up, we read with interest Bank of America Merrill Lynch's take from their High Yield Strategy note from the 8th of March entitled "Complacency Breeds Opportunity":
"Rebound loses momentum as unresolved risks resurface
Risk assets continued to struggle this week, as there appeared to be few takers interested in holding, let alone adding risk at current levels. For the HY market, the invisible wall demarcating poor value appeared to be somewhere around 400bps on the OAS scale, as the asset class has been oscillating around these levels for three weeks now, unable to meaningfully break through this barrier. The liquid benchmarks have been going nowhere for even longer, with HYG currently trading half a point away from its closing levels on Jan 30th, the day of the Fed meeting that marked the policy pivot. So what stands in the way of better risk appetite here? We think two key factors: high asset prices and unresolved risks. We have written extensively in recent weeks about high prices/tight spreads being the most important hurdle that would make it difficult for HY to continue to show outsized performance. Simply put, strong bids for HY usually don’t come at three-handle spreads.
The second set of factors describing the risk backdrop has improved materially since Q4, and it unquestionably helped market sentiment earlier this year. The list was in fact unusually long in late 2018 – ranging from trade talks falling apart to the US government shutdown to European economies slowing to the Fed potentially making a policy mistake to oil prices falling sharply to large IG issuers losing investor confidence to EPS growth slowing to financial conditions tightening. Given the length of this list and the potential severity of some of these issues, it is little surprise that even a modest pullback in those concerns created a powerful backdrop for improving risk appetite.
But that is all history; now is the time to reassess these risks and get a better sense – with the benefit of hindsight and all the new information we have learned since then – what we got wrong back in Q4 and how much room there is for new mistakes at this point.
We think some of these risks have, in fact, been largely addressed. For example, the US government has been reopened and we think the latest experience has taught both sides of the political spectrum not to go there again, reducing the probability of a repeat occurrence. The chance of a serious Fed policy mistake – never high to begin with, in our opinion – has been reduced to effectively zero. Oil prices are no longer falling; and while we do not claim to possess a particular skill to forecast this volatile commodity, we find sufficient comfort in a simplistic thinking that it has less room to go lower from $55 than it had from $75.
The rest of risks on our list have also subsided, but we would stop short of calling them addressed. For example, all signs continue to point toward some sort of a trade agreement to be signed between the US and China in coming weeks, which should have a limited market impact at this point given that it has been well telegraphed. We remain doubtful that this event resolves most residual concerns about trade, however. Europe appears to be next on the “to-do” list for trade talks, with auto imports likely presented as a threat to US national security, as our economists describe here.
Assuming European negotiations end with some form of an agreement, an eventual outcome we have little doubt in, the larger question remains whether we can expect trade flows to return to their pre-2018 levels on the other side of all this. We have doubts that an average corporate executive committee planning the location of strategic supply chain elements for coming years is comfortable assuming most trade frictions will be resolved by then. A rational decision here should err on the side of caution by postponing/reducing cross-border investments.
On the other side of all this, the US trade deficit increased to $620bn in 2018, up 25% since the Trump administration made its reduction a key focus. It is hard to describe this outcome as a surprise if one takes into account the expected likely response functions on the other side of each trade channel. What were the chances of foreign consumers becoming more interested in US products in this environment? Not far from zero. Could the nominal signing agreements with China and/or Europe change this attitude in foreseeable future? Unlikely.
The slowdown in Europe is another risk that rose in Q4 but was subsequently swept under the rug of a tactical market rebound. The ECB has reminded us of that risk earlier on Thursday, by slashing its growth estimates, postponing its intentions to begin normalizing rates later this year, and reintroducing new measures of policy support (TLTROs). None of this should be particularly surprising, as Barnaby Martin, our European credit strategist, has been discussing these expectations for weeks now (for full details of his latest views on EU credit, see here). One of the key arguments he makes is still not fully appreciated by consensus, in our opinion: even if Presidents Trump and Xi sign a trade deal, and China agrees to buy more of US goods – a widely expected outcome – shouldn’t this also imply they will have to buy less elsewhere? And if so, isn’t Europe poorly positioned along this particular geopolitical scale? We think the consensus view of trade disruption as a non-risk is still failing to connect these important dots.
The risk of IG issuers losing investor confidence has receded as well, with several key names in the BBB space announcing strong measures in response to the market wakeup call they received in Q4. Their intentions are ranging from suspension of share buybacks to dividend cuts to asset sales, with proceeds promised to be directed toward debt reduction. This change of heart potentially represents great news for bondholders in each particular cap structure in question. What the market may be overlooking here is the aggregate impact of all these measures, i.e., if all large BBBs decide to delever simultaneously, what would that mean for their aggregate capex spending, earnings growth, and M&A appetite?
Our estimates suggest that gross share buybacks may have been responsible for up to a half of cumulative EPS growth of many of these issuers over the past five years. Such a contribution must be smaller going forward, assuming BBB issuers maintain their deleveraging discipline. So EPS growth – currently standing at +12% yoy for all S&P 1,500 issuers (large + small caps) – is poised to come under pressure going forward from at least three sides: tax reform comps turning into a headwind, fewer share buybacks, and slower global macro.
The last risk on the list from Q4 – tightening in financial conditions – has naturally improved since year-end; however, it remains elevated by the standards of last year when HY spreads were pushing into low-300s. As we discussed last week, cracks remain visible, particularly in the CCC space, where one-third of all names still trade at distressed levels and the extent of dispersion (proximity to average index levels) has actually increased since year-end. Wider dispersion implies less reliable risk appetite, as the rebound so far has only increased the gap between potential winners and losers.
Taking all of the above arguments into account, we think that while various risks culminated in late 2018 and have been addressed or reduced in recent weeks, some of them still remain in place. The most important among them are disruptions to trade  flows coupled with deleveraging among the largest IG names and tax reform coming out of yoy comps, all leading to negative earnings impacts. We think many investors remained complacent about these interconnected risks, and – until most recently – were willing to hold risk despite high asset prices. This behavior may have started to change over the past couple of weeks, but it remains largely in place.
Complacency on the part of other investors creates opportunity for those who share our view of the world. We think these issues are likely to resurface in coming weeks and months, and when they do, more appropriate pricing of risks should reestablish itself. We think this potential path is inconsistent with HY spreads going deeply into the three handles, and as such we continue to advocate an underweight position with an eye toward more significant levels of risk reduction if spreads were to grind tighter. Importantly, we think HY is likely to generate meaningful negative excess returns at some point in coming weeks and months from current levels, although we find it impractical to try to pinpoint the exact turning point.
Our default rate indicator continues to produce 5.25% issuer and 4.25% par estimates over the next 12 months. We realize this is an out-of-consensus view, and as such we continue to constantly question our confidence level around it. It remains firm so far, with all the improvement in risk appetite earlier in the year captured by model inputs. 
Importantly, we advise our readers to think about this model estimate more in terms of its directional view and the order of magnitude, rather than a simple point on a scale. The critical argument here is not whether the par number happens to be 4.25% or 3.75%, but rather that the lows in defaults for this credit cycle are most likely behind us, a legacy of 2018, and that future credit losses are likely to be meaningfully higher.
The risk taking mentality in leveraged credit must therefore undergo a significant change, particularly at current tight spread levels. We recommend continued up-inquality positioning coupled with increased cash balances at these levels. We will be looking to redeploy this capital at more attractive levels in the future." - source Bank of America Merrill Lynch
We agree with Bank of America Merrill Lynch that going forward, fewer share buybacks, and slower global macro will weigh more on equities than credit and given the recent direction taken by US Treasury notes, long dated Investment Grade credit should benefit as well from the most recent move. 

As we stated before if it's D for "Deflation" and "Deleveraging", then it's good for credit markets in a "Japanese" fashion. So all in all yield "hogs" will benefit more in this Chinese year of the pig relative to equities we think. Dovish tone by central banks equals reach for yield again across credit, that simple.

When it comes to the validation in playing defense recent fund flows points towards a reach for quality (Investment Grade) over quantity (High Yield) as indicated by Bank of America Merrill Lynch in their Situation Room note from the 7th of March entitled "Monetary stimulus vs. global weakness":
"Outflow from risk
Inflows to US high grade mutual funds and ETFs remained strong at $4.68bn this past week ending on March 6, compared with a $5.01bn inflow a week earlier. On the flip side, outflows from risker asset classes such as high yield accelerated to $0.93bn this past week from $0.09bn one week earlier. This as flows also turned negative for loans and equities to $0.13bn and $5.83bn of outflows, respectively, following $0.05bn and $6.00bn of inflows a week ago. Hence inflows to all fixed income declined to $2.74bn this week from $5.72bn in the prior week (Figure 3).

The inflow to high grade funds increased to $4.24bn from $3.54bn one week ago, while the inflow to high grade ETFs declined to $0.44bn from $1.47bn (Figure 4).

On the other hand, the maturity breakdown of high grade inflows remained about evenly split between short-term (to +$2.55bn from +$2.70bn) and ex. short-term (to +$2.13bn from +$2.31bn). Flows improved for global EM bonds and money market funds to $1.61bn and $30.43bn, respectively, from $1.06bn and $3.29bn the prior week. Government bonds experienced $1.95bn in outflows following $0.75bn in outflows the prior week. Munis and mortgages both reported smaller inflows to $0.76bn and $0.23bn, respectively, from $1.24bn and $0.58bn one week ago." source Bank of America Merrill Lynch
We do watch with great attention fund flows when it comes to gauging risk appetite as our readers already know by now given fund flows have a tendency to follow total returns.

Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. For instance we were not surprised to read from Nomura Quants Insight report from the 13th of March entitled "How sustainable is this algo-supported goldilocks market?" that Risk Parity Funds have slightly increased their exposure to Investment Grade bonds:
"Nomura’s estimates that a raising portfolio leverage ratio by risk parity investors should have some effect on DM rates markets. When risk parity funds increase their leverage ratio to reach their target portfolio volatility level (usually set at ~10%), their activities tend to create buying pressure on a wide range of asset classes.
As a result, the market environment is similar to a "Goldilocks" state on its surface. However, we note that the portfolio exposure of a typical trend-following program like CTAs or risk parity funds continue to skew towards the long-side of DM bonds, which also means that DM bond markets gradually become vulnerable to unexpected increases in interest rate volatility." - source Nomura

As long as interest rates volatility remains muted, it's hard to be negative on credit markets. Also the slowdown in global growth in conjunction with weaker macro data overall have led to even more dovishness which has been highly supportive of the strong "high beta" rally seen. Yet, we do think that in a context where investors are starting to put pressure on leveraged players, an allocation to credit rather than equities for these weaker players would seem prone to less "repricing" risk should buybacks dwindle and some dividends start to be cut in some instances. Again, in this late cycle we are seeing rising dispersion. It doesn't mean there are no opportunities, it means you need to ensure you get smarter with your issuer selection process. 

When it comes to the different paths taken by Europe and the United States, given the ongoing woes for the ailing European financial sectors as per our final points below we still believe in the "Japanification" process of Europe and continue to be much more supportive for financial credit over financial equities. That simple, no need to point to us book value or any additional snake oil salesman tricks when it comes to European banks stock prices, we are simply not buying any of it.

  • Final charts - ECB rates on Japanese path
Back in August 2016, in our conversation "The Law of the Maximum", we indicated that the outcome for Europe would be different than in the United States:
"Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. The change in credit growth is a flow variable and so is domestic and global demand!
The big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.
As we have argued before QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think." - source Macronomics, September 2015" 

What is very clear to us is that the Fed and the ECB have been following different path, which obviously have led to different "growth" outcomes in recent years. The lack of "credit impulse" in Italy for instance, leading to lack of economic growth is entirely due to the capital constraints put on already stretched balance sheets of Southern European banks which had no choice but to collapse their loan books, in effect, the credit crunch in Europe was a self-inflicting wound." - source Macronomics August 2016
Our final charts come from Bank of America Merrill Lynch The European Credit Strategist from the 26th of February "Is it Japan all over again?" and shows clearly the "Japanification" at play in Europe:
"After a mega January for returns, February, by contrast, has felt more pedestrian. That said, high-grade spreads have still been able to grind 10bp tighter on the month (high yield 25bp) as the earnings season has driven the customary drop-off in supply. We remain of the view that March will be a tougher time for spreads given seasonally high issuance, coupled with the weaker firepower that investors now seem to have.
While spreads have tightened this year, the European manufacturing data has remained glum (albeit, with services the bright spot). Our favoured indicator – PMI manufacturing new orders – slipped further into recessionary territory last week. At 46.2, it is now far below the levels reached during the China growth scare in ’15, and now not far from the lows seen during the 2011 Eurozone periphery crisis.
The upshot of this is that spreads continue to look very dislocated from the reality of the economic data, in our view (see appendix chart). And while the Eurozone momentum should improve in the following quarters – buoyed by China stimulus, Germany/France fiscal loosening, and domestic wage growth – it seems to us that credit markets have already priced much of this in, if not more. The risk is that a protracted war of words on trade between Trump and the EU results in a shallower Eurozone recovery than the base case…leaving Euro credit spreads looking priced for perfection.
Is it Japan all over again?
The dovish pivot by central banks has undoubtedly made the rally this year. Even ECB members have sounded more concerned about the growth and inflation outlook, despite bringing QE to an end only 8 weeks ago. Accordingly, interest rate vol in Europe has fallen to a record low (now sub 40) and is yet again driving a conspicuous reach for yield across credit markets. After all, Draghi dovishness has almost always been a precursor to tighter credit spreads, since July 2012.
See you in 2033!
In our latest credit survey, we noted plenty of references to “Europe is Japan…” given how quickly the ECB appears to have altered its tune. While such a debate is clearly more complex, the comments, we think, are nonetheless prescient…as 20yrs ago to the month (Feb 12th ‘99) the BoJ first cut interest rates to zero. And with the exception of a few years in between, Japanese interest rates have barely moved since.
While history is never meant to repeat itself, it does seem to be coming close. Chart 1 shows that the progression of Japanese and ECB interest rates has been eerily similar when overlapping the two time series to match the point of zero interest rates (ECB deposit rates fell to zero in July ’12).
A crude extrapolation of chart 1 implies that ECB deposit rates will still be broadly at today’s levels in 2033!
History says…a policy error
Note, as well, that a crude extrapolation of chart 1 suggests that the ECB will raise interest rates towards the end of this year, in line with the current view of our Eurozone economics team (albeit they have frequently noted the risks to no hike given the recent data weakness.
Back in July ‘06, the BoJ raised rates by 25bp after 5 successive quarters of positive growth. The feeling was that Japan had moved away from the spectre of deflation (the BoJ statement at the time said: “Japan’s economy continues to expand moderately, with domestic and external demand and also the corporate and household sectors well in balance”). But this turned out to be premature. Post the Global Financial Crisis, the BoJ cut interest rates from 0.5% back down to 0.1% (and subsequently cut them to -10bp in late Jan ’16).
Eerie similarities
But it hasn’t just been interest rates that seem to be mimicking each other across Japan and the Eurozone. In fact, we find eerie similarities in many other areas. For instance:
• Chart 2, shows the progression (months) in headline inflation rates for Japan and the Eurozone.
Again, we overlap them at the point at which interest rates for both countries first hit zero (“Month=0”, in the chart). The correlation of Japanese and Eurozone inflation since then has been 52%.
• Likewise, chart 3 shows the progression of 10yr government bond yields for Japan and the Eurozone. The correlation between the two (from “M=0”) has been a eerily impressive 76%.

• And chart 4 shows the progression of Japanese and Euro high-grade credit spreads. Here, the correlation has been 50%. Note that Japanese high-grade spreads are roughly the same today as they were in February ’99.
But conspicuously high correlations alone don’t do justice to the debate of Europe is heading to Japanification, in our view. The story of Japan is one of huge debt growth and fiscal spending as governments have attempted to banish deflation demons. But an ageing population has been Japan’s Achilles heel for many years. Chart 5 shows that during the ’81-’91, and the post-GFC economic expansions, Japan has witnessed both low inflation rates and high growth in the percentage of the 65-year old plus population." - source Bank of America Merrill Lynch.
In their interesting note Bank of America Merrill Lynch indicates that the best performing sector, after 6m of a new TLTRO were senior financials (20% spread tightening) and likely reflected two themes: first, that with liquidity support the default risk and deposit flight issues for the banking sector are minimized. Second, given that TLTROs have usually been cost-effective funding for banks, the expectation of senior supply falls.

Finally, we still think that the more repressed the volatility by our central bankers, the more instability is brewing so in relation to our title analogy, on the first QE , investors bet it all on the three cards and won the "high beta" game. On the second large QE by the ECB, investors won on financials credit. on the third time, which is right now, investors risk betting on the ace - but when cards will be shown, they might find out that they had bet on the Queen of Spades, rather than the ace, and loses everything, but we ramble again...

"Diligence is the mother of good luck." - Benjamin Franklin
Stay tuned!
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