Macro and Credit - Potemkin village

"Now I believe I can hear the philosophers protesting that it can only be misery to live in folly, illusion, deception and ignorance, but it isn't -it's human." - Desiderius Erasmus

Looking at the CoCo Bond slaughter surrounding the €1 takeover of ailing Spanish banking giant Banco Popular by another giant Santander, while thinking about the much vaunted narrative surrounding a Spanish "recovery", we reminded for our title analogy of Potemkin village. While markets are still racing ahead, on renewed optimism and reduced wall of worries, with credit still in tightening mode, thanks to significant fund inflows, we are already seeing some cracks in the narrative, particular in consumer credit in the US decelerating, which we think warrant close monitoring. On the subject of our title analogy, a Potemkin village is any construction (literal or figurative) built solely to deceive others into thinking that a situation is better than reality (Spain and other subjects come to mind). The term comes from stories of a fake portable village built to impress Empress Catherine II during her journey to Crimea in 1787. In similar fashion the story surrounding the appeal of AT1 bonds aka CoCo bonds and the recovery of some part of the European banking sector is akin to a Potemkin village, with a narrative solely built to deceive others into thinking that the situation is better than reality. On numerous occasions we have voiced our distaste for European banks equities. In this on-going "Japanification" process, we would rather continue to play the credit part, but, we continue to have a profound aversion for CoCo bonds, being short gamma that is and its poor risk/reward "beta" proposal.

In this week's conversation, we would like to look what we think of the second part of 2017 and why we are switching, probably early to "defense" and asking ourselves how long before the cycle turns.

Synopsis:

• Macro and Credit - Credit cycle turning, dude are we there yet?
• Final chart - US Consumer Credit taking a break.

• Macro and Credit - Credit cycle turning, dude are we there yet?

While we have been wise in early 2017 to fade the US long dollar crowd while remaining short term Keynesian and bullish equities and all things credit in the first part of the year, supported by strong fund flows thanks to NIRP still plaguing a significant part of the Fixed Income world, the deflation of the "Trumpflation" narrative could indeed put a spanner into the most recent performances of the various beta trades, one being High Yield. For the much vaunted "reflation" trade to continue to play out we think, you would need higher inflation expectations and higher and steeper yield curve. In both last two instances, no matter how the Potemkin narrative is playing out for some pundits, appearences, unfortunately can be deceptive, particularly when you cannot hide a flattening yield curve. 

With European High Yield yielding a paltry 2.59%, we can always go tighter à la 2007, but, credit wise, the risk-reward appears to us less and less appealing with US 10 year Treasuries yielding 2.21%. The Iboxx HY Corporates cash index dropped to just 2.89%, setting a new record low in the process, which is of course supported by the hunt for yield and significant inflows. While it doesn't mean you need to rush for the bunker and don a kevlar helmet as of yet, it does seems to us that there are already cracks showing up in the narrative such as weakening loan demand and decelerating consumer credit that already warrant close monitoring in this long extended credit cycle.

What appears to us fairly clearly is that, as the Trumpflation narrative is fading, so is the beta narrative. The outperformance in beta at least in credit has been very significant in the first half of 2017 and as well during the second part of 2016. Yet as we posited above, it looks to us increasingly that the second part of 2017 could become more complicated for a continuation in all things beta and we would rather reach for quality at this stage in credit. On the subject of beta in credit, we read with interest Bank of America Merrill Lynch's take on the subject in their Credit Strategy note from the 9th of June entitled "Beta losing its shine":

"Beta is losing its shine
A year ago ECB bought its first corporate bond, as part of the CSPP program. Lots have changed since then. ECB now holds more than €90bn of corporate bonds; an eighth of the eligible bonds universe. The beta trade has been in vogue since.

There is a clear correlation between macro and the performance of different beta trades (HY vs IG, XO vs Main, subs vs seniors, fins vs non-fins). So for the beta trade to continue outperforming we need higher inflation expectations and higher and steeper rates. With inflation expectations lowering in the past months we see risks that the beta trade has less favourable risk-reward profile. The dovish ECB yesterday further supports our view that in relative terms beta will underperform from here.

A key factor that has supported the relative outperformance of high beta over low beta pockets of the market was the rates cycle. Higher inflation expectations and higher and steeper rates were pivotal to see the beta trade performing. With inflation expectations lowering in the past months we see increasing risks that the beta trade has less favourable risk-reward profile. To be clear, we are not saying that high beta parts of the market will stop tightening, just that their relative outperformance will significantly reduce.

We think that the beta trade is linked to the growth outlook and inflation expectations. The stronger the economic data and the subsequent improvement in inflation expectations, the stronger the outperformance of high-spread / high-beta assets vs low-spread/ low-beta ones. As the chart above shows, there is a clear correlation between macroeconomic metrics (5y5y inflation swaps for instance) and the performance of different beta trades (HY vs IG, XO vs Main, subs vs seniors, fins vs non-fins) on a spread ratio basis. 

Till this backdrop improves again, we will favour reducing risk on corporate hybrids, high-yield bonds and senior financials CDS (vs senior bonds, high-grade credit and iTraxx Main, respectively), beta pockets that have performed significantly in the past months." - source Bank of America Merrill Lynch

We do agree with the above and in fact our tool DecisionScreen is telling us the same when it comes to its signal switching to slightly negative for US High Yield:

The current signal is at -0.25. The aggregated rule is made up of the following trading rules: BB Financial Conditions Index US (3M Z-Score), US Budget Balance (Level), G10 Economic Surprise (5Y Z-Score) and US GOV 10 year yield (1Y Z-Score). The trading rule statistics from 1986-09-03 to 2017-06-07 delivered a Sharpe Ratio of 2.13 with an annual volatility of 2.40%.

From a low volatility perspective, should we see in coming weeks a renewed bout of volatility, given the strong inflows in fund flows in conjunctions of the return of Bondzilla the NIRP monster made in Japan returning to play with Japanese Lifers and their friends deploying their cash, as pointed out in Bank of America Merrill Lynch, credit outperformed stocks in Europe last month and could continue to prove more resilient in case of some weaknesses in the equities space:

"The beta trade is also a function of investors’ perception about the pace of QE. As credit investors were expecting the ECB to start tapering purchases across the sovereign and the credit program proportionally (more in our Credit Investor Survey from April), they looked to add more beta, riding the reach for yield trade. However, credit investors realised, over the past month, that the ECB is more than happy to up the CSPP program when supply comes and thus provide stronger support for “eligible” assets. Additionally “eligible” assets look cheap vs “non-eligible” assets and thus we think that there is room for a catch up trade, as the ECB is on full-on mode buying “eligible” credit instruments.

We will be looking for two signals for us to become more constructive on beta-assets: (i) a pick-up on inflation expectations and (ii) a slower pace of the CSPP. Till then we expect the relative pace of tightening of high beta pockets like corporate hybrids, high yield bonds and senior financials CDS (vs seniors, high-grade and iTraxx Main, respectively) to slowdown." - source Bank of America Merrill Lynch

Whereas we remain more defensive on High Yield at the moment, tactically speaking, Investment Grade in both Europe and the US should be more resilient in the case of renewed pressure on equities and high beta credit, hence our appetite to reach for quality rather than yield currently. Wednesday will set up the tone for both inflation expectations and the Fed's hiking path as we will get the most recent reading on Core CPI in the US. Yet the deceleration in credit growth seen as of late is a cause for concern and it will be interesting to see the Fed's take on the subject. With the recent weakness seen in US breakevens pointing towards a deflation in the "Trumpflation" narrative, we read with interest Bank of America Merrill Lynch's take in their Credit Market Strategist note from the 9th of June entitled "Deflation and rate hike":

"Deflation and rate hike

Since 1957 there have been 722 overlapping two-month periods. As core CPI prices almost always go up (Figure 1), in only six of these, or less than 1%, have we seen core CPI deflation – but that includes the most recent March-April period this year (Figure 2).

On Wednesday we get the most recent (May) reading on core CPI as well as the Fed’s rate decision. With the Fed widely expected to hike, and normally not inclined to surprise investors, a rate hike is the baseline. But the inflation data has to be concerning, especially as long term inflation expectations have now completely retraced their post-election increase (Figure 3).

Moreover, as we have consistently pointed out this year, other data is week and suggest everybody is in wait-and-see-mode, including C&I and consumer lending data (see: Situation Room: In wait and see mode 07 February 2017). So the Fed has to be very careful in crafting the statement message and press conference. While the biggest near term risk for spreads remains a correction in equities we remain bullish on HG credit spreads." -source Bank of America Merrill Lynch

As well, if indeed there is a return of the "Japanification" narrative and a continuation in soft data, not only it makes sense to reach for Investment Grade credit but it makes also sense to go for MDGA (Make Duration Great Again). As we stated flow wise, Investment Grade is not losing steam as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 9th of June entitled "Buy what they (ECB) buy":

"Highest inflow into IG in 44 weeks

Tapering? What tapering? CSPP buying numbers have been moving higher in the past month, while PSPP absorbed most of the tapering pressure. IG credit emerges as the winner, as investors are piling on the same ECB trade that worked when CSPP was announced. The “buy what they buy” is hence making the IG market highly resilient. Another reason why inflows have been strong lately, especially for the mid- and long term funds, has been the slowdown and reversal of the trend seen in the previous months of higher and steeper yield curves. As our analysis has shown, the level and trajectory in the rates market is a very strong predictor of flows in credit market.

Over the past week…

High grade funds recorded another week of inflows; the 20th in a row. The latest inflow has been the highest in 44 weeks and the second-highest since EPFR data started. High yield fund flows remained in positive territory for a seventh week. Inflows to European-domiciled HY funds were coming from European and global-focused funds, while US-focused funds recorded outflows. Government bond fund flows were marginally positive last week, recording the first inflow in five weeks. Money market funds recorded their second consecutive weekly inflow. Overall, Fixed Income funds recorded their 12th consecutive weekly inflow and the highest in 45 weeks, thanks to a strong credit inflow.

European equity fund flows were positive for the 11th week in a row. The asset class has seen a positive trend despite the volatility in the size of inflows." - source Bank of America Merrill Lynch

The latest dovish comments from the ECB's supremo Mario Draghi is providing additional support for the fun uphill, the bond market that is. The carry trade in Europe is still the trade du jour thanks to the central bank and its purchases. But, behind the deceitful narrative, we remain very wary of oil prices and its deflationary weigh on "inflation expectations" and the potential for additional sell-off they could trigger in financial assets thanks to some Sovereign funds and oil producing countries under pressure from continuing lower oil receipts. 

Behind the Potemkin village of higher equity prices and tighter credits lies the on-going fight to the death between OPEC countries in general and Saudi Arabia in particular with US shale producers. The strategy of trying to drive US shale producers towards bankruptcy has spectacularly backfired thanks to innovation in 2016. On this subject Bank of America Merrill Lynch again highlighted in their 2016 Breakeven Analysis published on the 9th of June in their report entitled "The Incredible Shrinking US Breakevens" the relentless fall in breakeven prices which spell bad news in the light of recent OPEC cuts trying to offset the stiff competition. 

"2016 Breakeven Prices declined 9%…1-yr B.E. & $43/boe

In 2016, North American investment grade oil & natural gas producers continued to sharply reduce their cost structures with the mean aggregate breakeven (B.E.) price declining 9% to $54.22 per equivalent barrel of oil (/boe). However, when we adjust our methodology to look at B.E.s using reserve replacement costs (RRC) from just 2016, we find that B.E.s are much lower than that with a mean cost of $42.64 per boe with 11 of 17 companies having B.E. cost structures under $50/boe.

In short, this clearly explains why with oil prices trading around $46 per barrel WTI, the U.S. rig count continues to rise. Companies are making attractive (in some cases VERY attractive) returns in the current price environment. With capital still relatively cheap, our analysis suggests that crude prices would need to decline back to $40/bbl to change this behavior.

2016 Breakeven Prices declined 9% over 2015

Operating costs decline but lower realizations offset some of the benefit After the sharp 16% decline in the industry breakeven price among North American investment grade (IG) issuers in 2015, the aggregate breakeven price for the industry declined to $54.22 per barrel of equivalent production, down another 9% from 2015. Total costs for the seventeen companies in our annual breakeven report declined by 11% in 2016, relatively lower than the 15% reduction in unit costs we have calculated last year. Producers continued to cut costs in the first half of the last year and consequently cut production as commodity prices softened. While these cost savings are significant, we believe that it will be difficult to continue to cut costs beyond a point. Added to that, average price realizations relative to the West Texas Intermediate and Henry Hub averages for the year modestly declined to 57% from 58% in the previous year.
As commodity prices declined further, producers adopted different strategies to optimize costs like rationalizing production expense, reducing employee counts, recontracting service terms, asset sales, etc. Our annual review of unit costs and resulting breakeven calculation showed this declining trend clearly with 14 of the 17 companies achieving breakeven cost reductions.

The decrease in revenue due to lower realizations and production cuts more than offset declining costs and as a result, average margins per boe fell 10% y-o-y to a loss of $6.25/boe. In particular, the gassy names saw margins erode or if they did rise, the improvement was at a much slower pace than oil producers." - source Bank of America Merrill Lynch

On a side note, the velocity in the surge of 5 year forward breakeven inflation is what killed Gold post the US elections. In the case for TIPS and Gold, the cost of insurance for the velocity in the change in inflation expectations matters. Both gold and TIPS function as a hedge against unexpected inflation. But returning to the relationship between commodities and rising real rates we also agree with Bank of America Merrill Lynch's take from their Global Liquid Markets note from the 12th of June entitled "Oil is the Fed's canary":

"Commodities perform poorly on rising real rates...

Yet our rates strategists argue that opposite seems to be happening. For starters, as a number of Trump administration initiatives such as tax and health care have stalled, economic growth expectations have fallen. Also, gasoline prices are already down year on year as OPEC production cuts have failed to remove the oil inventory overhang, acting as a drag on inflation (Chart 5).

Moreover, a fast and furious recovery in US shale oil production YTD suggests we are witnessing yet another technology-induced deflationary episode. With expectations already stretched, a less accommodative Fed that accidentally creates a higher real rate environment could further exacerbate the recent drop in commodity prices. We have previously found that rising real rates are associated with negative commodity beta returns, and falling real rates are associated with positive commodity returns (Chart 6).

Moreover, changes in commodity prices can mechanically cause big swings in realized inflation, but can also drive expected inflation near term, exacerbating the Fed's problem.

...so another sell-off may signal a policy mistake

Real rates have a causal impact on commodity prices due to a variety of transmission channels (Chart 7).

Demand for consumed commodities like oil and base metals tends to fall when real rates rise all else equal, as it makes consumption of energy intensive goods harder to finance. Higher real rates also tend to be associated with a stronger USD, which can hurt consumption of energy intensive goods in EM countries. True, periods of high nominal yields have been associated with higher commodity returns during the past 20 years, as economic expansions tend to be characterized by both strong commodity demand and high nominal interest rates. However, periods of ultralow nominal interest rates have been linked to very poor commodity performance since the Global Recession (Chart 8), as commodities need healthy global nominal GDP growth to move higher.

So far, the commodity markets have assumed oil prices are lower because of a supply glut. However, if the Fed hike next week triggers another leg down in commodity prices, the focus may turn on demand conditions. Should the Fed be sleepwalking into a policy mistake next week, commodities may provide some warning signs." - source Bank of America Merrill Lynch

And that's the main issue with the Potemkin village of the GDP recovery story being sold out by many pundits, namely that in reality Global nominal GDP growth is not healthy, yet the Fed is continuing in its hiking path and tells us it is data dependent. 

So to answer the question relating to the credit cycle turning, yes it is slowly but surely turning but, we are not there yet. A burst in inflation and a significant rise in inflation would force the hand of the central banks, and this we think could be the real catalyst for a nasty bear market in various asset classes as discussed recently. We are also data dependent and watching very closely the trend in consumer credit as per our final chart.

• Final chart - US Consumer Credit taking a break.

Back in our conversation "Orchidelirium" at the end of last month we asked ourselves if the US consumer was "maxed out".  We noticed at the time that consumer loan demand, a finding consistent with the weaker spending in Q1 had been cooling. This is a significant indicator to monitor in the coming months we think and our final chart comes from Wells Fargo Economics Group note from the 7th of June and shows that consumer credit was below expectations in April and shows that year-over-year percent change in consumer credit needs to be monitored closely: 

"Consumer Credit Growth Decelerates

• Consumer credit rose by just $8.2 billion in April, the slowest pace since mid-2011. Both nonrevolving and revolving credit growth were soft in the month.

• Revolving and nonrevolving credit growth have continued to move in lockstep on a year-ago basis. This convergence makes sense as student and auto lending cool, while revolving credit plays catch up after an unusually slow recovery." - source Wells Fargo

While it might be premature to pull the curtain on the Potemkin village, if indeed we break the 5% level for nonrevolving credit and continue to see a deteriorating trend in the coming months, then it will be a cause for concern. For credit markets at the moment, it's pretty much "carry on", though we are clearly tactically more cautious with High Yield and high beta in general.

"Everything's fine today, that is our illusion." - Voltaire

Stay tuned!

Macro and Credit - Confusion

"When a man's knowledge is not in order, the more of it he has the greater will be his confusion." - Herbert Spencer, English philosopher

Looking at the reversal of our previous thoughts relating to the potential for yen weakening and Nikkei surging in the process given our expectations for new tricks from the Bank of Japan, while disappointed on our recent call, we did not trigger and added on going long Nikkei hedged this time around given the on-going "Confusion" in both macro data and weaker flows at least in gold miners for the time being, we decided that for our chosen title analogy, given our fondness for the music from the 80s and in particular for New Order that our title should reflect our state of mind as well as August 1983 maverick single from the British group. On a side note, we have made a previous reference to New Order's music in our July 2015 conversation entitled "Blue Monday".

While Emerging debt seems to be flow wise the new darling of investors (or "yield hogs"), and when it comes to US High Yield disregarding "safety" for "yield", as pointed recently by BlackRock's recent chart of the week, it seems for them that double-digit returns going forward will be a thing of the past it seems:

- source BlackRock

Given the upcoming European Banking Association "stress tests", we would like to look this week to re-iterate our preference for credit instruments rather than equities when it comes to European banks. We will as well look at Japan again given the details of the fiscal stimulus so far have disappointed the "central banking addicted" investor crowd and the much anticipated decisions coming from the Bank of Japan as well as the FOMC hence the on-going "Confusion".

Synopsis:

• Macro and Credit - European banks - So you wanna play "beta"? Stick to senior credit
• Macro and Credit  - Japan looking for a "helicopter stall"
• Final charts: Europe, "Mind the Gap" - Dividend yield is high relative to Earnings yield

• Macro and Credit - European banks - So you wanna play "beta"? Stick to senior credit

As we pointed out on numerous occasions, when it comes to the attractive "valuations" levels pointed out by some "confused" pundits, when it comes to assessing this "value play", we have long been recommending you stick to "credit". In fact, that's exactly we pointed out in our November conversation "Fluctuat nec mergitur":

"In this "beta" chasing game, some pundits would point out to the attractive "valuations" level of European banks. We continue to dislike the sector as the deleveraging and low profitability of the sector makes us prefer to play it through credit instruments à la "Japan".
Equities wise, we believe the banking sector will continue to underperform "high beta financial credit", regardless of the bullish and overweight stance of Société Générale's Equities team

No matter how our "equities friends" want to "spin it", we are not "buying it" and we will stick to "credit" when it comes to banking exposure in this "japanification" on-going process. There is much more "deleveraging" to go in Europe, in 2016" - source Macronomics, November 2015

And of course no "Confusion" there, we were right from the onset of 2016 on this very subject. To further make our point clearer, we read with interest Deutsche Bank's European Banks Capital Structure note from the 27th of July:

"Unlike the sell-off early in the year, the market has generally differentiated quite well between bank credit and equity. The former has been supported by historically high capital ratios and strong liquidity buffers, whereas the latter has suffered from downward earnings pressures.

This is clearly illustrated by Figure 28 and Figure 29.

While the Stoxx Europe Banks equity index is down 27% YTD, the iBoxx EUR Banks Senior index spread is now at 108bp, exactly where it was at the end of 2015. Moreover, while equities are down 13.4% since the Brexit vote, senior credit is 5bp tighter.

Even at the bottom of the debt capital structure, Additional Tier 1 (AT1) securities have done remarkably well relative to equities when compared to their performance in the market sell-off in February. This is shown in Figure 30 and Figure 31.

In total return terms, EUR AT1s are down 2.6% YTD whereas the total return on equities over that period is -24.5%. Since the Brexit vote, it has been 0.1% and -11.8%, respectively.

In February, however, concerns that some banks might miss an AT1-coupon payment led to an abrupt sell-off in those instruments, partly due to the (self-fulfilling) fear that such an event might spark massive volatility across the AT1 market. This was compounded by a lack of clarity about when the so-called Maximum Distributable Amount (MDA) restrictions kick in, preventing banks from paying discretionary coupons among others. As we explained in our report at the height of the sell-off, AT1s are contingently junior to equity both in payouts and capital, which increases their sensitivity to market moves once a certain stress level has been reached. A missed AT1 coupon is lost forever whereas dividends are retained for the benefit of shareholders (in fact just like the unpaid coupon).

Since then, the European Commission has cited precisely this argument as a reason to introduce more transparency and less rigidity into the application of the MDA rules by splitting the so-called Pillar 2 SREP capital buffer into a disclosed formal requirement and a guidance component where the breach of the latter should not constitute an MDA trigger (the “guidance” part would sit at the top of the capital stack rather than below the Combined Buffer, making the latter less likely to be breached and thus trigger MDA restrictions). This was confirmed in early June by the ECB stating that it will refine its SREP methodology in this fashion. This has reduced ambiguity and lowered AT1 coupon risks, bringing down volatility of these instruments as highlighted in Figure 30 and Figure 31.

AT1s need new buyers and we think that the relative resilience of this asset class this time around could bode well for future demand for the product. This is in contrast to February when the P&L damage to many accounts resulted in some key investors withdrawing from this market."  - source Deutsche Bank.

Where we disagree with Deutsche Bank entirely is that regardless of the future demand for AT1s, from a risk/reward perspective, we will re-iterate that we think that CoCos offer very poor value, no "Confusion" there from our perspective. Any serious trader out there will always tell you that you never ever want to be "short gamma". This is exactly what we pointed out in our February conversation "The disappearance of MS München" dealing with risk, VaR and much more:

"It is still time for you to play "defense", although we did warn you well advance of the direction markets would be taking at the end of 2015 and why we bought our "put-call parity" protection (long US long bonds / long gold-gold miners), given that if there is huge volatility in the policy responses of central banks, the option-value of both gold and bonds position would go up (it did...). Although some like it "beta" or more appropriately being "short gamma" such as the "value" proposal embedded in Contingent Convertibles aka CoCos (now making the headlines), we prefer to be "long gamma" but we ramble again..." - source Macronomics, February 2016

When you buy CoCos, you are effectively the "insurer", bear that in mind. Banks are benefiting from your generosity given you are providing the "crash protection" insurance and to do so they entice investors by offering higher coupons. There is no free lunch there...

Credit wise, we have been advising for a while to play the "quality" game rather than the "beta" game for investors willing to get "carried away and play the lower capital structure part of European banks credit. It comes to us as no surprise from reading Deutsche Bank's note that indeed senior unsecured bonds have had the best performance across the bank capital structure:

"Figure 32 and Figure 33 summarise relative spread performance across the bank debt capital structure. 

Compared to a year ago, bank EUR bond benchmark spreads are wider at all levels of seniority but their changes differ meaningfully:

• Covered bonds: 9bp wider (at 54bp now)

• Senior unsecured bonds: 1bp wider (at 108bp)

• Tier 2 bonds: 47bp wider (at 244bp)

• AT1 bonds: 292bp wider (at 870bp)

While this compares unfavourably with corporate non-financial senior bonds (16bp tighter at 94bp), senior unsecured bonds have had the best performance across the bank capital structure (including equity as shown before). Banks have been able to obtain term funding at relatively stable levels but their capital instruments have sold off meaningfully in spread terms due to broader concerns about compressed profitability and also potential solvency in weaker parts of the banking system.

On the one hand, regulation has brought explicit bail-in risk to bank creditors. On the other, regulatory policy over the last few years has ensured that banks have effectively been run for creditors. We have seen continued build-up of capital, de-risking of balance sheets and strengthening of liquidity profiles, all of that being bank credit positive. While we have shown that some banks are under obvious asset quality and capital pressures, major European banks have maintained reasonably strong credit profiles and this is why their credit has been relatively insulated from the equity turmoil." - source Deutsche Bank

Of course, this should not come as a surprise in the on-going "Japanification" process of the credit markets with the ECB as of late joining the bond buying spree. There is no "Confusion" there for this process to happen because it has all to do with central banks meddling with risk premiums and asset prices. They are indeed the first culprits in asset prices manipulation. This was as well clearly illustrated in Deutsche Bank's report:

"Investors have a behavioural bias towards absolute return targets. Even as ever lower rates and quantitative easing inflate asset prices and expected future market returns necessarily fall, they are reluctant to fully adjust their targets to the new reality. They reach for yield, moving down the risk spectrum to hit their return targets in a low-yielding world.
They take on more duration and credit risk, squeezing risk premia on the way. In the case of some term premia, for instance, these can turn negative as hold to- maturity considerations are overshadowed by a hope for a short-term capital gain or at least avoidance of the negative carry of shorter-duration instruments. (Locally, there seems to be particular aversion to negative yields although the initial resistance has been broken even in corporate bonds) Many investors, such as insurers and pension funds, also seek yield in less liquid and/or structured products, the latter often with greater tail risks.
Reaching for yield is an inherent part of the portfolio substitution channel that transmits QE to the financial conditions in the wider economy. As direct central bank purchases of sovereign and corporate bonds removed some downside risk, at least for now, they naturally contributed to a further drop in required risk premia. Investors then reach for yield in riskier asset classes.
There is nothing wrong with the willingness to accept lower risk premia. However, reaching for yield has limits and there is a risk of a yield over-reach.
To an extent, central banks trade off monetary and credit easing for potentially less financial stability down the road. At some point, however distant, reversal of the reach-for-yield phenomenon (repricing of risk premia) might be quite abrupt and lead to a sharp tightening of financial conditions, with macroeconomic and financial-stability consequences. But that is a worry for another day.
The financial sector has been a collateral victim of this environment. As maturity transformers, banks are notable earners of term premia, liquidity premia and credit risk premia. Consequently, their diminishment has been a drag on bank profitability. Given the difficulty in passing negative rates on to depositors, the competitive nature of the (in parts overbanked) industry and soft demand for credit, European banks seem to have been unable to reprice loans to preserve their margins. Also, eurozone banks increasingly compete with markets in which the ECB has been buying non-bank corporate bonds, driving spreads down relative to banks’ own cost of market funding despite bank bonds’ better ratings. The 3-6-3 banking rule most certainly does not apply here. Given the state of the economy, demand for credit and potential capital constraints, the required increase in loan volumes to compensate for tighter margins seems unlikely to be reached soon.
Low rates and QE have also had benefits for banks, such as lifting the value of sovereign holdings and improving asset quality relative to the counterfactual (of no such policies). Also, the ECB’s TLTROs or BoE’s Funding for Lending have been designed to provide funding cost benefits to banks, which should be positive for earnings if not fully competed away. Overall, however, the extraordinary rate environment has been deeply damaging to the prospects for bank profitability and it might potentially be structural if the “secular stagnation” hypothesis turns out to be correct.

Figure 5 summarises the dramatic shift in the rate environment over the years, spelling rather dire prospects for the European economy.

Banking in low-growth, low-inflation and flat-curve environment is simply a challenge. Globally, flattening curves and rates falling towards or below zero at ever longer maturities have been a vote of ever lower confidence in the adequacy of current policies to restore inflation and growth.
While one could have a long metaphysical discussion about whether 30-year bond yields near or below zero reflect true economic risks or duration overreach, their levels are not driven purely by QE purchases. Swiss 30-year government bonds have a negative yield even if the SNB is not buying. Clearly, peripheral sovereign credit has been a great beneficiary of ECB QE.

We review these market phenomena because they matter for the bank lending business as well, in addition to some of these bonds sitting directly in banks’ liquidity portfolios. In the corporate space, reaching for yield has been equally relentless. As we calculated recently, 3 over a third of AAs and As and nearly a quarter of BBBs, by amount outstanding, among non-financial corporate EUR bonds traded with negative ask yields.
Most recently, we have seen the first non-financial corporate (AA-rated Deutsche Bahn) issue a zero-coupon EUR bond with a yield of -0.006%. “Income” is disappearing from “fixed income”. These developments have pushed many bond investors down the credit quality spectrum but with BB yield at 3.06%, “high yield” is becoming a bit of a misnomer too, at least relative to its history.

All this weighs heavily on banks’ credit intermediation business. With interest rates on loans to households and firms on a multi-year downward trajectory, helped also by the ECB’s TLTROs, lending margins have been falling. Margins in our selected eurozone countries are mostly at 50-70% of their 2010 levels, with many worrying that the downward trend has more to go. Note that this
refers to new business only. There will be a further lagged response on the full loan book’s net interest margins (NIM) as it gets gradually repriced, eroding net interest income more.
In a negative-rate world with limited hopes for a change any time soon, NIM pressure is here to stay. Indeed, the collateral damage to bank stability and ultimately to economic growth from the negative-interest-rate policy has increasingly been seen as an impediment to more aggressive rate cuts by the ECB. At the same time, it has to be accepted that in a negative-rate world with much higher capital ratios than before the crisis, returns on bank equity below 10% might well be a fair compensation to shareholders. Current profitability measures cannot be compared to the “old days” of high interest rates and thin equity cushions.
To get on a higher earnings path, banks also have to continue to adjust their business models and cut costs. In banking systems with clear inefficiencies and overcapacity, especially as more European corporations raise funds via markets rather than banks, consolidation among smaller players and downsizing by some larger players may need to accelerate. There is a common interest in Europe in having a stable and adequately profitable banking system that promotes sustainable growth. That also requires overcoming some legacy challenges in pockets of potential instability." - source Deutsche Bank

Death by a thousand rates cuts and cost cutting, thanks to the stupidity of NIRP which is slowly but surely weighting on bank profitability and destroying NIM. At least from a credit investing perspective you have the ECB as your "buyer of last resort", avoiding in effect default risk to materialize for the time being but, just postponing the end result we think.

On a side note, we might be sounding yet again like a broken record but, for instance loan growth in Italy is constrained because Italian banks are "capital impaired" (to say it in a politically correct way...). Forget "bail-in" because if you do crush the retail crowd you can rest assured that Renzi's days will be over and that the whole European project would unravel with Italy threatening to leave the European project with a new majority such as the Five Star Movement. Even the leader of the populist movement is acutely aware of the risk "bail-in" would have on Italian savers.

The only way, we think is for the ECB to monetize NPLs to restore the credit transmission mechanism, because without growth, there is no reduction in both NPLs and budget deficits, that simple.
We also made a more in depth analysis of the Italian NPLs problem back in April in our conversation "Shrugging Atlas":

"Either you remove the NPLs from the bloated Italian Banks' balance sheets and the ECB monetizes the lot, or they don't. Anything in between is an exercise of dubious intellectual utility." - source Macronomics, April 2016

Also, back in our February conversation "The disappearance of MS München" we joked in around these new NPLs CDOs being the new "Big Short":

"If you want to make it big, here is what we suggest à la "Big Short," given last week we mentioned that Italian NPLs have now been bundled up into a new variety of CDOs and that the Italian state guarantees the senior debt of such operations and thinks it is unlikely ever to have to honor the guarantee (as equity and subordinated debt tranches will take the first hit from any shortfall to the price the SPV paid for the loans), maybe you want to find someone stupid enough to sell you protection on the senior tranche of these "new CDOs." - source Macronomics, February 2016

Reading through Deutsche Bank report, indeed, the Atlas plan was doomed from inception:

"With the aforementioned gap between market and book valuation of NPLs, disposals have been slow as banks are reluctant to book losses given their capital positions. In February, to facilitate disposals, the government introduced a scheme of state guarantees (GACS) of IG-rated senior tranches of NPL ABS at a cost linked to a basket of equally-rated Italian corporate CDS. While this introduced a handy hedging service, from the very start it stood little chance of solving the actual problem. To comply with EU State-Aid rules, these guarantees had to be offered at “market prices”. If that is the case, then by definition no amount of tranching and hedging can overcome the fact that if the securitisation vehicles acquire NPLs above their market values, investors in the junior tranches are unlikely to see the expected returns meet their targets. In reality, the scheme does offer guarantees that might not be readily available in the market otherwise and their pricing may be seen as marginally attractive. It just is not a silver bullet and can only be part of a bigger solution.

With no private buyers forthcoming, it has been increasingly clear that a comprehensive solution will require government involvement. The government coordinated the set-up of the €4.25bn Atlante fund by mostly private investors, which has been available for backstop recapitalisations (up to 70%) and NPL purchases (at least 30%). Its size, however, has been inadequate for the size of the NPL problem in Italy and at this point some €1.75bn remains available after recapitalising Banca Popolare di Vicenza (€1.5bn) and Veneto Banca (€1bn). It does not look like Atlante could dispose of those equity stakes soon, at acceptable prices, to free up resources for further purchases.
There have been reports that efforts are under way to set up Atlante 2 (to be called Giasone) with additional €2-3bn, particularly aimed at addressing NPL concerns around the largest troubled bank Monte Paschi. Even if such efforts succeed, however, the size of these private funds would be insufficient for a comprehensive solution." - source Deutsche Bank

Of course, these solutions are as we said earlier, an exercise of dubious intellectual utility. We might even suggest Italian banking authorities name Atlante Fund "iteration n" simply Danaus or Danaids (also Danaides or Danaïdes) because in Greek mythology the Danaids were condemned to spend eternity carrying water in a sieve or perforated device. In the classical tradition, they come to represent the futility of a repetitive task that can never be completed such as setting up private funds to resolve Italian NPLs.

Nonetheless, the ECB's credit buying spree is still supportive of credit versus equities when it comes to the European banking sector as a whole.

Moving on to our next "Confusion" point, we believe Japan, once more will have to play catch up to the tune of the ECB and stealth devaluation from China in order to revive "animal spirits", namely its stock market through yet another round of "unconventional" measures.

• Macro and Credit  - Japan looking for a "helicopter stall"

With Friday’s Bank of Japan meeting, every pundit is expecting "shock and awe" once more to induce yet another weakening bout of the yen as well as a rally in the Nikkei. In our last missive we indicated that re-initiating a short position on the Japanese yen could be of interest. While initially our timing was poor and faced an initial set back, we still believe Bank of Japan will again come to the rescue of its massive ETF equity exposure on its own local index.

What we find of interest in the discussions surrounding "helicopter money" and Japan is the analogy that can be made with Mario Draghi much discussed "bumblebee" reference in his 2012 speech that led to his "whatever it takes moment":

"And the first thing that came to mind was something that people said many years ago and then stopped saying it: The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does. So the euro was a bumblebee that flew very well for several years. And now – and I think people ask “how come?” – probably there was something in the atmosphere, in the air, that made the bumblebee fly. Now something must have changed in the air, and we know what after the financial crisis. The bumblebee would have to graduate to a real bee. And that’s what it’s doing."- Speech by Mario Draghi, President of the European Central Bank at the Global Investment Conference in London, 26 July 2012.

The issue with bumblebee according to 20th century folklore, the laws of aerodynamic prove that they should be incapable of flying:

"The calculations that purported to show that bumblebees cannot fly are based upon a simplified linear treatment of oscillating aerofoils. The method assumes small amplitude oscillations without flow separation. This ignores the effect of dynamic stall (an airflow separation inducing a large vortex above the wing), which briefly produces several times the lift of the aerofoil in regular flight. More sophisticated aerodynamic analysis shows the bumblebee can fly because its wings encounter dynamic stall in every oscillation cycle" - source wikipedia

 When it comes to "helicopter money" and vortex stall and Japan, we touched on this very subject in our May 2014 conversation "The Vortex Ring":

"In a "helicopter stall" or vortex ring state, the helicopter descends into its own downwash. Under such conditions, the helicopter can fall at an extremely high rate (deflationary bust).
For such structural failure or crash to occur you need the following three factors to be present as indicated by Helen Krasner in her article entitled "Vortex Ring: The 'Helicopter Stall'":

"To get into vortex ring, three factors must all be present:

• There must be little or no airspeed.

• There must be a rate of descent.

• There must be power applied.

Note that all three of these must be going on at the same time." - source Macronomics, May 2014

We also argued at the time:

"It is not only the Fed and its central bankers which have a tendency to overshoot, likewise, Governor Haruhiko Kuroda in Japan has failed to convince he had done enough to spur 2% inflation and that his policies will be enough to pull Japan out of 15 years of deflation, risking in effect another Vortex Ring state for the Japanese markets." - source Macronomics, May 2014

Given the relative dismal results induced by QQE on the Japanese results, we expect more of the same from Japan as posited by our friend Michael Lebowitz from 720 Global in his latest missive called Kyōki (Insanity):

"Eventually, due to the mountain of money going directly in to the economy, inflation will emerge. However, the greater likelihood is not that inflation emerges, but that it actually explodes resulting in a complete annihilation of the currency and the Japanese economy. In hypothetical terms as described here, the outcome would be devastating. Unlike prior methods of QE which can be halted and even reversed, helicopter money demands ever increasing amounts to achieve the desired growth and inflation. Once started, it will be very difficult to stop as economic activity would stumble." - source Michael Lebowitz, 720 Global

This is exactly what will eventually happen to the Japanese "bumblebee", under a Vortex ring state thanks to "helicopter money" a country can fall at an extremely high rate (deflationary bust).

We totally agree with our friend Michael Lebowitz about the dangers of "perpetual bonds", or bonds with no maturity date as well with is astute reference to the French money printing exercise ultimately leading to economic ruin and a leading factor fueling the French revolution. All of this is described by French economist Florin Aftalion in his 1987 book entitled "The French Revolution - An Economic Interpretation"

This is what we discussed in May 2016 in our conversation "When Doves Cry" when it comes to "assignat" and "helicopter money" leading to a Vortex ring state (helicopter crash...or deflationary bust leading to "hyperinflation"):

"At the time of the French Revolution, Pierre Samuel du Pont de Nemours observed that by issuing "assignats", the French nation was not really paying its debts:

"In forcing your creditors to exchange an interest-bearing proof of debt for another which bears no interest, you will have borrowed, as M. Mirabeau has said, at sword-point". 

The issue with the assignats was that in no way it was capable of facilitating the sale of public lands, that ones does not buy with a currency, which is merely an instrument for the settlement of a transaction, but with accumulated capital." -  source Macronomics, May 2016

"In forcing your creditors to exchange an interest-bearing proof of debt for another which bears no interest, you will have borrowed, as M. Mirabeau has said, at sword-point".

As we pointed out at the time and in relation to the ECB:

"To paraphrase du Pont de Nemours, in forcing credit investors to exchange an interest-bearing proof of debt for another which bears no interest (recent issues in the European Investment Grade land are zero coupons...), you will have borrowed at the sword point of the ECB." - source Macronomics, May 2016

In similar fashion, the Japanese idea of "perpetual bond" is very close to the dreadful "assignat" and its dire consequences are well documented in Florin Aftalion's seminal book:

Source: Le marché des changes de Paris à la fin du XVIIIe siècle (1778-1800) -1937 

We also commented at the time in our May 2016 conversation:

"Of course as well as in Japan, doves have been crying given that they much vaunted currency depreciation scheme has been put in reverse as of late. But given the mounting evidence of a global slowdown, one would expect the Bank of Japan to return to the QQE game during the second part of this year. Now that the ECB is directly in competition of the likes of Mrs Watanabe, Japanese insurance companies, the GPIF and their pension funds, one would expect that the "fun" uphill, namely bond speculation, continues to run unabated, for the real economy, we are not too sure..." - source Macronomics, May 2016

But returning to "helicopter money", Japan and its much anticipated 28 trillion yen ($265 billion) fiscal package announced by Prime Minister Shinzo Abe, we have yet to see how the Bank of Japan is going to make good on Abe's promises. When it comes to Ben Bernanke idea of perpetual bond, this has been tried before in the form of the "assignat". If Japan issue a perpetual bond, to paraphrase du Pont de Nemours, Japan will have borrowed more!

On the issue of "perpetual bonds" we read with interest Nomura's Richard Koo's take in his latest note from the 26th of July entitled "Cost-benefit analysis of helicopter money":

"Four versions of helicopter money (3): government scrip and perpetual zero-coupon bonds

A third version of helicopter money involves government money printing or the replacement of the JGBs held by the BOJ with perpetual zero-coupon bonds.

The people proposing these policies hope that fiscal stimulus financed by government scrip or perpetual zero-coupon bonds, which are not viewed as government liabilities, will elicit spending from people who are currently saving because of concerns about the size of the fiscal deficit and the likelihood of future tax increases.

Economists refer to this reluctance to spend because of worries about future tax hikes as the Ricardian equivalence. If true, it implies that consumption will increase each time the government raises taxes since higher taxes mean lower deficit in the future. The fact that this phenomenon has never once been observed in the real world suggests it is nothing more than an empty theory.

Moreover, there are serious issues that must be confronted once the economy picks up and the liquidity supplied by the monetary authorities via government scrip or zero-coupon perpetuals must be drained from the system. Perpetual zero-coupon bonds are essentially worthless, which means the BOJ cannot sell them—no one in the private sector would be stupid enough to buy them.

That means the only way to mop up the excess reserves created via the issue of perpetual zero-coupon bonds is for the BOJ to ask the MOF to issue equivalent amounts of coupon-bearing bonds.

The same would be true when trying to mop up reserves created by government scrip. Once this scrip starts circulating, it becomes part of the monetary base, and draining it from the system will require the government to absorb it by issuing bonds. And in the case of both perpetuals and government scrip, the government that issued the bonds cannot spend the proceeds. If the government spends them, the liquidity that had been mopped up will flow back into the economy again.

Those recommending the issuance of government scrip or perpetual zero-coupon bonds say that one advantage of this approach is that it does not lead to an expansion of government liabilities (upon issuance). However, they will become massive government liabilities when the economy eventually recovers and they must be mopped up.

Helicopter money proponents silent on issue of mopping up reserves

In other words, the biggest issue with helicopter money—as with quantitative easing—is the question of how to drain these funds from the system. It becomes clear just how problematic both policies are when the difficulty of draining reserves is taken into account.

Yet in all the discussion about helicopter money and quantitative easing in Japan and elsewhere, almost no one has touched on the massive costs involved in mopping up the excess reserves created under these policies. Everyone emphasizes the benefits of these policies when introduced while ignoring that those benefits are small indeed when we examine the costs and benefits over the policy’s lifetime.

As one example of this bias, Waseda University professor Masazumi Wakatabe argued in a Nikkei column titled “Easy Economics” that helicopter money is preferable to quantitative easing inasmuch as it enables the government to undertake fiscal stimulus without increasing its liabilities.

I suspect that the helicopter money envisioned by Mr. Wakatabe involves the issuance of government scrip or direct central bank underwriting of perpetual zero-coupon bonds. However, he makes no mention whatsoever of how the liquidity created via these methods will be drained from the system once private-sector demand for loans recovers.

Helicopter money offers no benefits whatsoever over policy’s lifetime

As described above, the only way to mop up liquidity that has been created using these methods is for the government to issue bonds and not spend the proceeds. I think this would be more difficult from both a legal and practical perspective than winding down quantitative easing, which in itself is no easy task.

Moreover, the amount of government debt that must ultimately be acquired by the private sector is no different from a case in which the government had issued bonds to fund fiscal stimulus from the outset.

In short, whether fiscal stimulus is funded with government scrip and zero-coupon bonds or with the ordinary issue of government debt, the size of the government’s liabilities will be the same in the end. Helicopter money offers no benefits whatsoever when viewed over the lifetime of the policy, including the eventual need to mop up liquidity." - source Nomura

In similar fashion to "assignat" perpetual bonds are essentially worthless and there is indeed a heightened risk that Japan will face significant consequences to the value of its currency and eventually trigger a Vortex ring state (helicopter crash...or deflationary bust leading to "hyperinflation"), hence our long term very short view on the Japanese yen (our target might even scare you...).

Of course these are longer term risks that will eventually play out, closer to home and short term wise, there is growing dividend risk in Europe going forward.

• Final charts: Europe, "Mind the Gap" - Dividend yield is high relative to Earnings yield

 While European banks are slowly but surely dying thanks to NIRP and with Japan increasingly looking for its "helicopter stall", no "Confusion" there, in Europe what we think is of interest for our final chart is the growing gap between European Dividend Yield (DY) versus European Earnings Yield (EY). As indicated in the below graphs from Deutsche Bank Equity strategy note entitled "A new hope?" from the 25th of July , we agree with them that, going forward, given the level attained by the European payout ratio (55%), there is growing dividend risk going forward so "Mind the Gap":

"The European dividend yield (DY) is at a 20-year high relative to the corporate bond yield, suggesting equities have yet to catch up with the recent performance of corporate bonds. However, unlike the DY, the relative European earnings yield (EY) remains firmly within its four-year range, suggesting equities are not clearly cheap relative to corporate bonds. The real issue here is that the DY is high relative to the EY, which means that the payout ratio is elevated, pointing to downside risks for dividends." - source Deutsche Bank

As far as we are concerned, "hope" is never a good strategy. We cannot resist but to chuckle again and remember a comment we read in the past from a credit desk:

"Equities = Hope, Credit = Reality, unfortunately, Reality follows Hope until the Hope dies, then Reality settles in."

So, yes indeed, mind the gap between DY versus EY, watch Japan and fade the sell-side pundits telling you that European banks are "cheap" from a valuation perspective (that's what many told you at the beginning of the year...). Like we posited before, the problems facing Europe and Japan are driven by a demographic not the financial cycle.

 As we concluded our April conversation "Shrugging Atlas":

"The very difficult situation that lies with "easy policy", there is an easy way in, but no easy way out. So as goes the the kite string theory, you can control a kite by pulling its string, but not pushing it. Once you reach the ZLB and implement NIRP on top of QE, it seems to us monetary policies become ineffective." - source Macronomics, April 2016

The game is moving towards capital preservation we think...

"Confusion of goals and perfection of means seems, in my opinion, to characterize our age." - Albert Einstein

Stay tuned! 

Credit - The Molotov Cocktail

"Incendiary capitalism is carrying its out evil works more dangerously than ever, and is doing so in the increasingly dangerous neighborhood of the powder kegs that are the great European military powers." - Karl Liebknecht, German politician, 1871-1919.

Looking at the dismal US GDP print for the 1st quarter at -2.9%r while enjoying the latest yield compression in US yields, thanks to our contrarian take since January 2014, and seeing the increasing trouble brewing in the Middle-East, with German businesses unsupportive of the sanctions against Russia according to Michael Harms, chairman of the Russian-German Trade Chamber, in conjunction with the complacency and lack of liquidity in the credit space, we reminded ourselves of the Molotov-Ribbentrop pact prior to the Second World War and the aforementioned explosive "Molotov Cocktail" created by the Finns during the Winter War which was highly effective against Russian tanks. 

When it comes to Germany's relationship with Russia, this relationship is very important for German companies as we highlighted in in our July 2012 conversation "The Game of The Century":

The European Union’s seven former communist members outside the common currency will have an average budget shortfall of 2.6 percent of gross domestic product and an average debt load of 44.7 percent of GDP this year, the European Commission estimates. That compares with 3.2 percent and 91.8 percent for the euro region according to Bloomberg. No wonder Germany, frustrated in the West, is increasingly looking more and more to the East:

"Russia is important for German companies. In 2011, there was a 30 per cent increase in trade between Germany and Russia, with a total volume of 75 billion euros. German economic representatives have been talking about the huge potential of the Russian economy for many years, and it is seen as advantageous that Russia is nearly as important for trade as Poland. In 2011, Russia ranked 12th in German exports behind Poland (10th) and before the Czech Republic (13th)."
"Russia is Germany’s biggest supplier of gas and oil, providing around 40 per cent of its gas and 34 per cent of its oil supply in 2011. With the government’s decision to stop producing nuclear energy by 2022, German demand for gas will increase in the short and medium term." - Source An Alienated Partnership - Vestnik Kazkaza - 7th of July 2012.
As we indicated in our conversation "Eastern promises" on the 9th of June:
"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed."

In relation to the German and Russian relationship, credit wise, it will be interesting to look at the outcome for the planned €5.1 billion sale of RWE Dea, the Oil and Gas business unit of Germany's utility giant RWE to a Russian group. Again, the "devil" is indeed in the "details" and like any good behavioral psychologist would tell you (and what we have kept doing) are as follows:

Try to watch the process, rather than focusing on the content given RWE (BBB+) is burdened by €31.5 billion of debt and posted a net loss of €2.8 billion in 2013. We would be very surprise to see Merkel blocking such a transaction given the deleveraging needs of its giant utility company RWE. It is just posturing, we think.

One of the reasons behind our chosen title is due to the increasing risks posed by the growing tensions in the Middle-East which could lead to another spike in oil prices, which would be of course highly damageable for growth in general and consumption in particular. The other being Financial Contingent Capital notes also called CoCos which we will discuss in this week's conversation as we think that as the quote above goes, they are akin to incendiary capitalism or most likely a "Credit Molotov Cocktail", but we ramble again.

When it comes to Middle-Eastern trouble brewing, oil prices are indeed the "Molotov Cocktail" for triggering recessions. As past history has shown, what matters is the velocity of the increase in the oil prices, given that a price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years. As displayed in the below chart, no need to press the "panic" button yet, but it is worth closely paying attention to oil prices going forward with the evolution of the geopolitical situation:

These spot crude oil and oil product inflation-adjusted values are derived using Bloomberg's proprietary data. Each index is calculated by dividing a spot  ticker by the U.S. Urban consumer price index.

What has been as well of interest has been the growing relationship between oil and gold in conjunction with inflation expectations with the continuation of the Fed's grand monetary experience as displayed below in this Bloomberg graph:

"Prior to 2000, Brent had little observed relationship to gold, a financial asset traditionally viewed as a hedge against inflation. While Brent prices have been heavily influenced by geopolitics and security challenges, the relationship between Brent and gold has become more pronounced in recent years, with Brent possibly emerging as the liquid complement to the hard asset. This may also have provided an inflation hedge as monetary accommodation has driven commodity prices." - source Bloomberg

The famous "great accommodation" play can indeed be seen in the close relationship between brent prices and money supply as displayed by Bloomberg:

"Accommodative monetary policy has helped support crude oil pices in recent years. A likely tapering of that policy and other stimulus measures may have a humbling effect on broader commodity markets. Stagnating money supply growth provides a challenge for higher oil prices without an improving global economy and demand. The BI study examines the relationship between the price of Brent and money supply. Lower gasoline prices are a likely result of lower Brent." - source Bloomberg

In our conversation "St Elmo's fire" (yet another incendiary reference), we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 had been announced - source Bloomberg:

Of course Oil has a stronger relationship with currencies markets rather than with 10 year US Treasuries as displayed in the below Bloomberg graph:

"Currencies, equity markets and other commodities may suggest stronger predictive relationships to crude, yet measuring a broader universe of factors may uncover other variables with less clear correlations. Disqualifying certain variables may be as important to investors as identifying those with greater predictive qualities, given that it allows for closer observation of those data that influence the direction of the subject being scrutinized." - source Bloomberg

Moving on to the subject of the Credit Molotov Cocktail and its incendiary capacity of the capitalist system, we reminded ourselves of the wise words of Dr Jochen Felsenheimer from asset management XAIA which we quoted back in September 2011 in our conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!":

"in the current system, capital market performance takes on immense importance in a system of fiat money, i.e. efficient allocation of said money. The great danger of a flippant approach to the provision of fiat money is that the financial markets are able to decouple from the real economy. And that is just what happened in the past few years. Following the crises of the past ten years, excessive liquidity was pumped into the system in order to cushion the real economic consequences. Only a fraction of this made it to the real economy, as a large part seeped away in the banking system and thus in the capital market. This is why the financial market is growing so quickly while the real economy is only showing moderate growth." - Dr Jochen Felsenheimer

Of course this is exactly what has happened and which can be ascertained by the meteoric rise in risky asset prices overall which can be illustrated by the significant correlation between the US, High Yield and equities (S&P 500). US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG  - source Bloomberg:

Another illustration of the effect of our "Deus Deceptors" central bankers can be seen in the compression in yields of European 10 year bonds which have, for some made new record lows - graph source Bloomberg:

From our September 2011 conversation we also reminded ourselves this quote from Dr Jochen Felsenheimer's letter:

"In terms of global competing systems, we can view countries like companies. The difference is that they only refinance through debt. Even if this refinancing option does not appear unattractive in view of the low interest rate, even cheap money has to be paid back sometimes. And that is exactly what is becoming increasingly unlikely." - Dr Jochen Felsenheimer

Of course this "Credit Molotov Cocktail" induced by central bank easy money has indeed not made its way to the "Real Economy", rest assured the TLTRO will not either given than no sanctions have been debated surrounding the unappropriated use of the latest round of the ECB's generosity for banks not providing cheap funding to the "Real Economy", end of the day the message is clear, keep on deleveraging with our support and "carry on" (in both sense) supporting European government bond yields. End of the day the new TLTRO amounts once more to "Money for Nothing", given all that easiness can be assessed in the lack of transmission to Businesses as effectively real rates have risen as illustrated by Bloomberg:

"Mario Draghi’s newest stimulus package aims to do something previous measures haven’t achieved-- push ultra-low interest rates through to the economy.
The CHART OF THE DAY shows the real cost of borrowing for companies, or bank interest rates adjusted for inflation, rose in most euro-area nations in the 12 months through April, the most recent period for which data is available. While the European Central Bank president cut the benchmark rate by half a percentage point over that period, the effect was largely wiped out by stagnant or falling prices and lenders’ reluctance to pass on the reductions.
Draghi announced policies on June 5 including a negative deposit rate and conditional loans to banks to bolster credit and steer the currency bloc away from deflation. Consumer prices rose 0.5 percent last month, down from 1.2 percent in April 2013 and below the ECB’s goal of just under 2 percent.
“Real rates need to ease further, or the ECB might be forced to do more,” said Frederik Ducrozet, an economist at Credit Agricole CIB in Paris. “While a short period of low inflation might be supportive of households’ purchasing power, higher real rates for longer would impair the recovery.”
Higher financing costs hurt companies’ willingness to invest, curbing output and employment and in turn weighing on consumer prices. Spanish companies paid an average of 1.2 percentage points more in real terms to borrow money in April compared with a year earlier as the cost of bank loans held steady and inflation slowed. A drop in nominal rates in Italy was overwhelmed by a slump in inflation.
Estonia, the Netherlands and Slovakia were the worst hit. Only Portugal, with the biggest decrease in nominal bank rates, and Germany recorded a decline in real borrowing costs. Data wasn’t available for Greece, Malta and Luxembourg. Latvia wasn’t included as it wasn’t part of the euro area in 2013." - source Bloomberg

Euro Consumer Credit? Still trending down falling 3.9% to fresh lows in May - graph source Bloomberg:

Euro Corporate Loans? Same story, an extended decline in May - graph source Bloomberg:

We reminded ourselves of the wise words as well of our good credit friend in 2012:

When somebody has too much debt and cannot reimburse it, how do you bail him out? Obviously by restructuring his debts, which imply losses for his creditors.

But when one lends him more money in order for him to pay back what he owes, he is not bailing him out but rather pushing him in a bigger hole! The game until now has been to "print" more money and to add more debt on the shoulders on the indebted ones, to gain some time in the hope that growth will resume and reduce de facto the weight of the existing debt burden and the additional new debt issued to support the initial debt troubles.

This is a big misunderstanding of debt dynamics and its effects on the economy. When debt becomes too big, which it is now the case in many parts of Europe, the servicing drains all the available cash flows and reduces the growth potential."

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. We hate sounding like a broken record but: no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits and debt levels.

In relation to the subject of Contingent Capital notes also called CoCos, banks have issued more than €30 billion worth of these additional tier-1 instruments in order to build buffers to meet the new Basel rule for total-capital ratios. As indicated by Bloomberg recently CoCos, like European government bonds, are indeed underestimating risk to coupons and par value:

"In many cases these bonds are trading significantly above par. Instruments issued in 2010 to 2012 paid coupons of 6% to 8% and currently offer yields to maturity of 4% (at Credit Suisse) to 6%. The Bank of England suggests investors may be underestimating the likelihood of additional tier 1 instruments, known as CoCos (contingent convertibles), being converted into equity or written down in the event that a bank's capital ratio falls below a pre-defined level. A Bank of England report notes two risks which may not be adequately reflected in current CoCo prices: a lack of disclosure linked to certain elements of capital requirements, and guidelines dictating when a coupon may be cancelled."- source Bloomberg.

Again we reminded ourselves the wise words of Dr Jochen Felsenheimer we quoted in a previous conversation relating to banks, government and mis-pricing of risk:

"Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. Particularly those in currency unions with explicit - or at least implicit guarantees. It is just such structures that let government increase their debt at the cost of the community. For example, in order to finance very moderate tax rates for their citizens so as to increase the chance of their own re-election (see Italy). Or to finance low rates of tax for companies and at the same time boost their domestic banking system (see Ireland). Or to raise social security benefits and support infrastructure projects which are intended to benefit the domestic economy (see Greece). Or to boost the property market (Spain and the USA). This results in some people postulating a direct relationship between failure of the market and failure of democracy."

A good illustration of the "japonification" process and the "Credit Molotov Cocktail" and its incendiary capacity in inflicting ultimately significant losses to investors (who are more than ever dipping their toes in untested markets and reaching for yield outside their comfort/risk zone) can be seen in the significant outperformance of the CoCos asset class as related by John Glover in Bloomberg on the 23rd of June in his article "CoCos in Best Debt Returns Win Regulators Plaudits":

"The riskiest debt from European banks is outperforming a gauge of 964 securities from Spain’s Abengoa SA to U.K.’s William Hill Plc, according to Bank of America Merrill Lynch indexes. The new-style contingent capital notes, or CoCos, issued to meet stiffer capital rules, returned 9.12 percent, compared with average gains of 5.86 percent for the broader high-yield bond index of companies in the region." - source Bloomberg.

From the same article, it is clear to us that banks and government are playing the same game when it comes to debt issuance and the duplicity of regulators for banks in issuing more debt rather than true sound capital in the form of more equity

"As long as governments agree to treat AT1s as debt rather than equity, interest payments out of pretax earnings make them cheaper to issue than stock." - source Bloomberg.

We discussed that very subject of equity buffers in our conversation "Dumb buffers" back in March 2013:

"The beauty for the issuer is that the CoCo automatically boosts its Core Tier 1 capital ratio in times of stress rather than being forced into a dilutive right issue during difficult market conditions. Owning a CoCo, according to a recent BNP Paribas note is very similar to selling a Down-and-In put option on the issuing bank’s shares with a knock-in barrier linked to a balance sheet capital ratio as opposed to stock price level.

The issuing bank is effectively buying skew and convexity (crash protection) from the investor, who is exposing himself to losses in stress scenarios. 

It is not a free lunch although a coupon in the region of 7% to 8% is outright appealing in this low rate / low yield environment." - source Macronomics

We were therefore not surprised to see an outperformance of this "Credit Molotov Cocktails". The compression in spreads for some of these issues since issuance as illustrated by Bloomberg:

"Benchmark spreads on Barclays and UBS CoCo bonds have narrowed since issuance, with some more than 300 bps tighter, implying few concerns among investors about credit risk. CoCo's pose risks to bondholders through write-downs if a certain trigger event occurs, often a minimum capital level defined by the regulator. Regulatory discretion to impose losses before a trigger level is reached has been cited as an additional risk, prompting Standard & Poor's to consider cutting credit ratings on the bonds." - source Bloomberg

By issuing more and more CoCos with the complacency and support from regulators given that under European Union rules, banks can count additional Tier 1 debt equivalent to 1.5 percent of assets weighted by risk when calculating certain ratios, banks are indeed issuing more "Molotov Cocktails" rather than building true equity buffers we think.

On a final note we would like to point out that without a significant depreciation of the euro which is not going to happen unless the nuclear QE option is triggered to the tune of at least €1 trillion, there is no such thing as a credit-less recovery in Europe as discussed in our conversation "In the doldrums":

"If credit growth does not return, economic recovery may prove to be difficult in the absence of sizeable real exchange rate depreciation." - Zsolt Darvas - Bruegel Policy Contribution.

"So for us, unless our  "Generous Gambler" aka Mario Draghi goes for the nuclear option, Quantitative Easing that is, and enters fully currency war to depreciate the value of the Euro, there won't be any such thing as a "credit-less" recovery in Europe and we remind ourselves from last week conversation that in the end Germany could defect and refuse QE, the only option left on the table for our poker player at the ECB:

"The crux lies in the movement needed from "implicit" to "explicit" guarantees which would entail a significant increase in German's contingent liabilities. The delaying tactics so far played by Germany seems to validate our stance towards the potential defection of Germany at some point validating in effect the Nash equilibrium concept. We do not see it happening. The German Constitution is more than an "explicit guarantee" it is the "hardest explicit guarantee" between Germany and its citizens. It is hard coded. We have a hard time envisaging that this sacred principle could be broken for the sake of Europe."

"Incendiary capitalism is carrying its out evil works more dangerously than ever, and is doing so in the increasingly dangerous neighborhood of the powder kegs that are the great European banks." - Macronomics.

Stay tuned!