Macro and Credit - The Sokal affair

"Truth is ever to be found in simplicity, and not in the multiplicity and confusion of things." -  Isaac Newton

Looking at the recently released minutes of the Fed's latest FOMC and its dovish impact on the US dollar in conjunction with the new US administration war of words, not only validating our solitary contrarian stance so far against the US dollar bullish crowd but, as well rewarding us for our late December gold/gold miners positioning, made us reminder for our chosen title analogy the Sokal affair, 

Given our fondness in recent musings in anything relating to hoaxes, the Sokal affair, also called Sokal hoax, was a publishing hoax perpetrated by Alan Sokal, a physics professor at New York University and University College London. In 1996, he submitted an article to Social Text, an academic journal of postmodern cultural studies, to test the intellectual rigor and, specifically to investigate weather "a leading North American journal of cultural studies - whose editorial collective includes such luminaries as Fredric Jameson and Andrew Ross – [would] publish an article liberally salted with nonsense if (a) it sounded good and (b) it flattered the editors' ideological preconceptions". The article, "Transgressing the Boundaries: Towards a Transformative Hermeneutics of Quantum Gravity", was published in the Social Text spring/summer 1996 "Science Wars" issue. It proposed that quantum gravity is a social and linguistic construct. At that time, the journal did not practice academic peer review and it did not submit the article for outside expert review by a physicist.  On the day of its publication in May 1996, Sokal revealed in Lingua Franca that the article was a hoax, identifying it as "a pastiche of left-wing cant, fawning references, grandiose quotations, and outright nonsense ... structured around the silliest quotations [by postmodernist academics] he could find about mathematics and physics."

The hoax sparked a debate about the scholarly merit of "humanistic commentary" about the physical sciences; the influence of postmodern philosophy on social disciplines in general; academic ethics, including whether Sokal was wrong to deceive the editors and readers of Social Text; and whether Social Text had exercised appropriate intellectual rigor. In response to the heavy criticism received by the editors of Social Text, Sokal said that their response illustrated the problem he highlighted. Social Text, as an academic journal, published the article not because it was faithful, true, and accurate to its subject, but because an "Academic Authority" had written it and because of the appearance of the obscure writing:

"My goal isn't to defend science from the barbarian hordes of lit crit (we'll survive just fine, thank you), but to defend the Left from a trendy segment of itself. ... There are hundreds of important political and economic issues surrounding science and technology. Sociology of science, at its best, has done much to clarify these issues. But sloppy sociology, like sloppy science, is useless, or even counterproductive."

You are probably asking yourself once again, where we are going with this analogy of ours, but, it appears to us that the Fed, and other central bankers, are "making it up" as they go along. Given most of them are "Academic Authorities", so, when it comes to the Fed's FOMC latest statement we reminded ourselves of the "wise" words of former Fed supremo Alan Greenspan:

"I know you think you understand what you thought I said but I'm not sure you realize that what you heard is not what I meant"

In similar fashion, in relation to our central bankers and their hoaxes, sloppy economics beliefs based on sloppy "science" is useless, even counterproductive to paraphrase Sokal.  On that very subject we recommend you read John Mauldin's recent article "Post-Real Economics". 

As one of our loyal readers "kertch" commented in our recent musing "The Woozle effect" on Seeking Alpha, more and more "Academic Authorities" in central banks are indeed making claims that are entirely contrary to the basic principles of economics:

"Wozzle is a much more specific and descriptive term. It was revealed recently that the entire decades-long crusade against saturated fat was based on a Wozzle and has no basis in fact. I also now see economists make claims that are entirely contrary to the basic principles of economics. When will we see scientists make claims that are entirely contrary to the laws of physics? (Actually that has already begun - don't get me started!) It seems that the principles of logic and mathematics (statistics) that apply to basic research have become irrelevant relics of another time and social paradigm. Scientific method in our culture is badly in need of a Renaissance."

By now you probably understand where we are going with our Sokal affair analogy given that the same "Academic Authorities" which are at the helm of central banks are less and less challenged in their economic assertions by the Mainstream Media (MSM). Furthermore, on our recent musing "The Ultimatum game", same reader "kertch" made some very interesting points in relation to principles of economics and scientific rigor that is badly lacking in economics nowadays:

"I think once again economists have jumped to the same mistaken cause/effect conclusions with the idea of "Aging Nations Like Low Prices Over High Incomes" as they did with the Phillips Curve. They go on to link the phenomenon to a decreased demand for durable goods and property. I have seen no evidence of this in countries with an aging population. In fact the opposite appears to be the case. First, it is premature to conclude that demographics is the culprit. It is more likely that economic development drives demographic trends and the accumulation of capital assets, as every nation that has achieved a high level of economic development develops almost the exact same trends. Perhaps when economists stop seeing the economy as some rigid machine where moving a lever causes a knob to turn, and turning the knob causes said lever to move, they will start paying attention to cause and effect, and asymmetric, non-reversable functions. As I've said before, it's a field were logical and scientific rigor is sadly lacking."

Exactly, in similar fashion, one could argue that Thomas Piketty much vaunted book "Capital in the Twenty-First Century", lack logical and scientific rigor but we would be rambling again in that instance...

In this week's conversation, we will look again at what the rise of protectionism entails in terms of allocation and risk and why so far we think our solitary contrarian stance (short US dollar, long gold/gold miners, long volatility) and defensive stance has more to run.

Synopsis:

• Macro and Credit - Trump told you so folks
• Final charts - Deglobalize me

• Macro and Credit - Trump told you so folks

In recent musings we have delved into the "optimism bias" of the "consensus crowd" being long the US dollar, long oil, short volatility, short US Treasury notes to name a few. We have argued we were not "buying" it, hence us playing the "devil's advocate" or as some left wing pundits would argue the "Trump advocate". 

As reality settles in given "Mack the Knife" aka King Dollar + positive real US interest rates is year to date down 4% and our gold mining stance up around 16% (GDX) as we type, we think it is high time you reconsider the risk of trade war escalation and what it entails for a variety of asset classes.

On the rising risk posed by US protectionism we read with interest Bank of America Merrill Lynch's take from their Liquid Insight note from the 2nd of February entitled "Playing with fire - the FX implications of US trade protection":

"He told us so

What if Trump does what he has said on trade policies? The so-called Trump trades, and particularly the USD, have seen a correction this year, as President Trump’s rhetoric has shifted toward trade protection. Our baseline assumes the US will avoid such policies, but we also see risks and markets could get more concerned in any case. This is consistent with a volatile but still upward USD trend. However, it is worth discussing the possible market reaction to potential US trade protection and how to hedge. This is just a first look, as a lot would depend on policy details and the potential reaction of the rest of the world.

We recommend hedges that could do well even in our baseline scenario of no trade protection. We consider three main scenarios of de-globalization: higher US trade protection; a global trade war; and a major repatriation of flows. Our analysis suggests that JPY, USD, and NOK would benefit in most cases, particularly against AUD, CAD, MXN and KRW—USD/JPY would weaken. However, for investors who do not expect such extreme scenarios but would still like to hedge their long Trump trades, our analysis supports being long the USD against AUD and CAD in G10, and against KRW in EM.

Trade protection and the Trump trades

The so called Trump trades, and particularly the long USD trade, have seen a correction this year. This is to a large extent because President Trump has gone back to his tough pre-election rhetoric against free trade. In one of his numerous recent tweets on the subject, he warned that “car companies and others, if they want to do business in our country, have to start making things here again. WIN!” In his inaugural speech, he said "we will follow two simple rules: buy America and hire America," adding "protection will lead to great prosperity and strength." This week, Trump and members of his administration accused Germany and Japan of manipulating their currencies to keep them weak. Indeed, the market correction started after President Trump’s first press conference after the elections, on 11 January, where he used strong rhetoric against US companies that invest abroad and then export to the US. This contrasts with his speech after he won the November elections, when he focused on fiscal stimulus and other market-friendly policies.

Our view is that the market is still pricing a benign scenario, in which the new US administration delivers fiscal stimulus and deregulation, but does not go ahead with trade protection. The market remains long the USD, despite the recent adjustment. The VIX index is at historically low levels, despite its latest increase. Global equities remain at historical highs, even after its correction this week. EM FX has been somewhat volatile, but without a clear trend this year. If anything, our flows reflect some buying in EM FX.

This is consistent with our baseline as well, but we do see risks. We have been arguing that the balance between fiscal stimulus and trade protection in the first 100 days of the Trump administration will determine the outlook of the Trump trades and of the USD. We remain constructive on the USD, as we expect President Trump to deliver on fiscal policy and not turn to trade protection. However, even in this scenario, we do not expect a substantial further USD rally, as the USD is already strong and the US government would also push against an excessively strong USD. Moreover, we have been flagging high uncertainties, as we are increasingly concerned about the strong rhetoric against free trade and free FDI coming from the US. Our baseline expects a volatile USD path upward. USD bulls should be more tactical, in our view.

In this context, we discuss which of the G10 and major EM currencies could be at risk in a scenario where we are wrong and President Trump does what he has said on trade policy and increases protection. Of course, a lot would depend on the details and on how the rest of the world reacts in this case. This is a first and very basic approximation but one that can provide insights even for a scenario in which the US does not increase trade protection but markets get more concerned about such a risk.

“What-if” scenarios of trade protection

Global trade is already on a declining trend. Following an almost smooth upward trend in recent decades, the share of global trade to GDP is now below what it was 10 years ago (Chart 1). After a V-shaped move following the global crisis, it has been falling recently.

This is a concern, as empirical evidence suggests international trade and economic growth reinforce each other. A move toward trade protection in the US could lead to a further decline in global trade, making everyone worse off.

Focusing on US trade policies, trade protection would hurt Mexico and Canada the most. China and the Eurozone export more to the US (Chart 2).

However, as a share of their GDP, Mexico and Canada stand out (Chart 3).

We believe MXN already reflects Trump policy risks, but we have been arguing that CAD underestimates such risks.

If we consider a very adverse scenario, in which protectionist trade policies in the US potentially trigger a global trade war, KRW, MXN and CAD could be affected the most.
• Looking at openness to trade as defined by the share of total exports and imports to GDP, the countries most vulnerable to a potential pull-back of global trade include Hungary, Czech Republic, Switzerland, Korea, Poland, Sweden and the Euro zone (Chart 4).

However, most of the European trade is intra-regional and it is safe to assume that protection within Europe will not increase—the region could still suffer if global supply chains get significantly disrupted. Excluding Europe, Mexico and Canada also stand out.
• Looking at the FDI net inflows as a share to GDP, the countries that will be affected the most by a pull-back include Switzerland, the Euro zone, Hungary, Brazil, Australia, Canada and the Czech Republic (Chart 5).

• Combining these two measures, this analysis will suggest negative risks for CAD, MXN and KRW, particularly against USD and JPY (Chart 6).

HUF, CZK, CHF, PLN, and EUR could also be at risk if global protectionism affects European exporters—our CEE baseline is bullish, as these currencies are undervalued and will benefit from a hiking cycle.

Considering an even worse scenario, in which trade protection triggers a repatriation of flows, Norway, Switzerland and Japan would receive most of it as a share of their GDP (Chart 7).

These are the economies with the largest net international investment positions relative to GDP by far. We would therefore expect NOK, CHF and JPY to appreciate in such a scenario, particularly against NZD, AUD, MXN and TRY.

Bottom line

Putting everything together, our analysis suggests investors who would like to hedge a tail risk scenario of a move away from globalization and toward trade protection should be long JPY, USD, and NOK against AUD, CAD, MXN and KRW. USD/JPY would also weaken in this case.

As the scenarios we have considered are extreme and mostly tail risks, we would prefer to focus on hedges that can do well even if these risks do not materialize and the USD rally continues. In this context, we would be long the USD against AUD and CAD in G10 and against KRW in EM. We remain constructive in CEE and we would avoid shorting MXN, as it could do well in a free-trade scenario." - source Bank of America Merrill Lynch

Obviously our contrarian stance sits opposite to Bank of America Merrill Lynch's baseline scenario and the "optimism bias" of the long US dollar "herd mentality". In prolongation to what we posited in our last missive, we would tend to agree with their tail risk scenario, in the sense that the dislocation in volatility between EURJPY versus USDJPY has been at the cheapest levels relatively in past decade as indicated by Bank of America Merrill Lynch previously quoted FX Vol trader note entitled "USD vols are relatively overvalued". Regardless of the Fed's monthly FOMC "Sokal" hoax, we tend to focus on what is "cheap" from a "relative basis" perspective to what is "crowded" such as long US dollar from a positioning perspective. As we pointed out last week:

"If indeed the current account balance in the US deteriorates, then the US dollar should weaken as it generally happens in the late stage of a 10 year credit cycle, hence our contrarian stance versus the bullish US dollar crowd. The credit cycle is therefore deterministic we think" - source Macronomics, January 2017.

While at this juncture, FX wise we have recommended going against the dollar bullish consensus, in relation to the "Big Short" aka the short US Treasury speculative short positioning, we have yet to fall meaningfully enticed to the other side for the time being, at least until we see the Japanese GPIF, Lifers and others coming back to play in size, but obviously this is depending on some adjustment in the currency basis.

Moving on to "credit", as we pointed out in last week's final chart, it seems to us that currently High Yield is indeed "priced for perfection". As we indicated, we will be tracking very closely what credit spreads will do in the coming weeks. Yet, flows remain supportive for now and so does the shape of the CDX High Yield CDS index, a proxy for High Yield in the derivatives space. As pointed out by Bank of America Merrill Lynch in their Follow The Flow note from the 3rd of January entitled "So far so good...inflows across the board", investors have continued playing the "beta" game:

"YTD flows – inflows across the board

So far this year, amid a rising rates environment, investors have favoured higher yielding pockets of the fixed income world. Both EM debt and HY funds recorded strong inflows YTD. However, the ECB QE backdrop remains positive for IG and government bond funds; at least for now. Equities have started on the positive territory, but the pace is still slow (Chart 1).

Over the past week…

High grade funds continued on a positive trend for the second week in a row. However the flows trend remains below what we have seen before tapering fears emerged. High yield funds saw inflows for the ninth consecutive week, and the asset class has accumulated more than $4bn of inflows since the start of the year. However, looking into the domicile breakdown, as Chart 13 shows, the inflow last week came only from US domiciled and globally-focused funds, while the European-focused funds inflows were very marginal.

Government bond funds had their second week of outflows amid rising rates; albeit very small. Money market funds weekly flows were negative for the third week in a row, while the outflow trend is strengthening. Overall, fixed income funds recorded a strong week of inflows, the highest in 27 weeks and the sixth positive in a row.
European equity funds flows were positive for a second week showing signs of moderate strengthening. Last week’s inflow was the highest in 11 weeks. However note that this pace is much slower than the inflows strength seen during 2015.

Global EM debt fund flows flipped back to positive territory after a brief week of outflows. Last week’s inflow was also the strongest in four weeks. Dollar weakness has been beneficial for the sector. Commodities funds flow remained positive for a third week in a row, but the inflow pace has slowed down.

On the duration front, inflows continued in short-term IG funds for the seventh week in a row. However the pace of the inflows has slowed down notably over the past weeks. Mid-term funds’ large outflow couple of weeks ago was partially reversed recording the biggest inflow in 13 weeks. On the other hand, flows into long-term funds remained downbeat recording an outflow for a second week." - source Bank of America Merrill Lynch

It is no surprise to see, credit investors playing "defense" and rotating into shorter duration funds given that last year, during the second part they had increased both credit risk and duration risk as well. As we mentioned earlier, we are very wary about Japanese flows and appetite for foreign bonds which have been dwindling as of late following a record 2016 take up. Data from Japan’s Ministry of Finance confirmed this week that Japanese investors sold around ¥1.3 trillion ($11.54 billion) in foreign bonds between Jan. 21 and Jan. 28, taking net sales for the last 12 weeks to over ¥3.7 trillion, the largest amount since April 2014 according to the Wall Street Journal. This is as well confirmed by the latest Nomura JPY Flow Monitor note from the 2nd of February 2017:

"MOF international weekly capital flow data (22 - 28 Jan)

Japanese investors were net sellers of foreign bonds again last week for the second week in a row. The net selling accelerated to JPY1359bn ($11.9bn) from the previous week (JPY538bn), recording the biggest net selling since March 2016.

Uncertainty on the US policy stance remains high, while US yields have been rising again since mid- January, which has likely discouraged Japanese investors from increasing their foreign bond investment for now. Seasonally, foreign bond investment by insurance companies tends to slow in Q1 too, as the fiscal year-end approaches. January foreign portfolio investment by investor type data are scheduled next Wednesday, which will show the major contributors to the relatively large net selling of foreign bonds last week.

Japanese investors resumed their purchases of foreign equities for the first time in two weeks. They bought JPY125bn ($1.1bn) of foreign equities last week. This suggests the underlying Japanese appetite for foreign assets remains strong, although they had been large net sellers of foreign bonds over the past two weeks.

Foreign investors continued selling Japanese equities for the second week in a row (JPY144bn or $1.3bn), although the pace slowed from the previous week (JPY376bn). Their fixed income investment was mixed, purchasing long-term Japanese bonds (JPY446bn or $3.9bn) while selling short-term bonds (JPY586bn or $5.1bn)." - source Nomura

This could have serious implications should this trend continue. It represents not only a headwind for immediate further compression on US Treasuries yield, but, as well, it is adding pressure on the US dollar and could as well generate, contrary to what is expected by many, a rebound in the Euro in short order.
Furthermore, when rates move up, while it can be even more supportive for Euro High Yield, it represents a significant headwind for already expensive European Investment Grade thanks to the convexity factor credit wise. In conjunction with rising inflation, it is in short a bad recipe. This is clearly explained by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 1st of February entitled "When rates move up":

"Rising rates are supportive for high yield credit

Fixed income investors embrace higher yielding (with same quality/rating) instruments when rates decline. This has been the case over the past decade as flows into high grade funds were accelerating vs flows into govies. We find that there is a strong correlation between the rates trajectory vs. the flows differential between high-grade and government bond funds. We also find that flows tend to exhibit a “barbelling” trend, when rates advance, and vice-versa. Amid a rising rates backdrop, we see that the balance of flows in the fixed income market will likely favour high yield and govies more than flows into high grade funds.
High yield credit tends to beta-outperform its high grade counterpart in a rising rates environment. We prefer to be long European high yield via synthetics more than via cash bonds, post the recent underperformance of Crossover.

Rising peripheral risks are under-priced in credit

European credit spreads have always been well correlated to peripheral risks (chart 1). The recent move higher in BTPs vs Bunds has not been unprecedented; it has been experienced before the PSPP-era, but also briefly in late November 2016. The common ground in both cases was that credit spreads were a lot wider. Even compared to last November levels, credit spreads were ~10bp wider, when Italian 10y yields were at the wides vs Germany. We feel that the move in rates is under-priced in credit spreads at these levels. This is also taking place as Greek government bond yields are rising again over the past couple of days.

Rising rates and credit performance

The world economy is in sync mode. Global QE across the Fed, ECB, BoJ and BoE, have resulted in a well synchronised rebound in economic data. Surprise indicators are also pointing to the strongest rebound globally. The reflation trade is strong across Europe and US with rates moving higher. The global QE is reaching “peak strength” this quarter. However, the reflation knock on effect is ultimately negative for credit, according to our analysis. Credit spreads tend to react negatively in periods of rising inflation. Fund flows are also pointing to the downside, as higher rates hit high-grade fund flows more than flows into government bond funds and high-yield debt. Barbelling your portfolio in risk-terms can be the solution. High yield credit tends to beta-outperform its high grade counterpart.

Can a policy mistake be the driver of a trend shift?

Inflation is picking up; but unfortunately it is not the core inflation trajectory that is trending higher. Headline inflation is picking up over the past months on the back of higher commodity, and more importantly oil prices. As our economics team has been highlighting this is the “bad” inflation that is decoupling and surprising to the upside. Low and sticky nominal wage growth means that purchasing of consumers suffers again very soon; and populism continues to rise. 

The recent ECB meeting highlights the discrepancy between a very dovish message and a hawkish monetary policy (QE tapering from April), we think. Should headline inflation keep trending higher on the back of higher energy prices; we see higher risks of another policy mistake.

The credit market has historically been very well correlated to inflation trends.
• In chart 7, we find that the year-on-year changes in core inflation across Eurozone countries and the year-on-year changes in iTraxx Main non-fins 5y spreads are well synchronized. This has been the case especially in the period since the GFC were the central banks started unleashing their quantitative easing programmes.

• The same stands for headline inflation trends. However, should one look at the trend of headline inflation, there is a clear decoupling over the past year from that of credit spreads (chart 8).

 

It is notable that the credit market is still focusing on core rather than headline inflation. But at current levels, we fear that a policy mistake, like the one of the forthcoming April tapering decision, will ultimately be negatively received by credit investors.

Credit is mispricing the current headline inflation pick up

Chart 8 is depicting the decoupling between inflation and credit spreads trajectories.

To normalise these moves we employ a z-score analysis, presented in chart 9.

We find that the current “richness” of credit spreads trend vs. that of headline inflation is the highest it has been in almost a decade.

Looking back in times when this dislocation - between credit spreads and HICP - has been that strong, we find that the future credit market performance was not that positive. The previous peaks in “richness” have been in October-07, March-10 and March-11, as per chart 10. Remember that subsequently post reaching these peaks, credit spreads have always moved wider over the following months.

Downside risks on credit flows as rates move higher

The forthcoming “peak” of the QE positive backdrop is not our only source of concern. Fund flows into high-grade funds are negatively impacted amid a rising rates environment too. In our analysis we find that the higher the yield one can source from the government bond market - deemed as “risk free” - the lower the need to hunt for “quality yield” via the IG credit market.

We compare cumulative flows trends in high-grade and government bond funds vs. the level of “risk-free” rates. For the fund flows we use EPFR data as per our weekly Follow the Flow publication, and we use the 5y bunds generic yield to track the trends in the European rates market.

Historical evidence shows that:

• Fixed income investors embrace higher yielding (with same quality/rating) instruments when rates decline. This has been the case over the past decade according to our analysis (chart 11).

Note that there is a strong leading indication (6 months) of the rates trajectory vs. the flows differential between high-grade and government bond funds (in relative terms, % of AUM).

• There is a critical level in the rates market that prompts a shift into “quality yield” (i.e. high-grade credit) we think. This force kicks in when 5y bunds dip below the 1% handle (chart 12) it seems.

At the end of 2011, at the heights of the sovereign crisis, the lack of yield in the “risk-free” market (i.e. bunds) and the subsequent OMT moment, six months later, prompted a strong reach for “quality yield” and inflows accelerated into IG bond funds. We are still far from that level, but the trend is clear from here.

The solution to higher rates = barbell your portfolio

In 2016 we saw the lowest in yields and spreads. We doubt that we will see these levels again, especially post the recent strengthening of economic data across the globe. We expect that as rates will continue higher from here in the years to come (more in the latest Global Rates weekly) this will have a strong effect on flows across fixed income pockets. We think that flows  into govies and HY credit funds will fare better than flows into high-grade ones." - source Bank of America Merrill Lynch.

While both the Fed and the ECB might continue with their Sokal hoaxes, it appears to us that the recent shift from investors towards shorter duration is clearly a manifestation of a defensive stance, which could be further validated by the weakness in the support from overseas investors such as Japanese investors. Where we slightly disagree with Bank of America Merrill Lynch's take is that, if indeed there is some short term correction in equities, it is hard for us to expect that a move wider in European High Yield could be avoided thanks to its inherent strong correlation to stock movements. Though, from a convexity perspective, High Yield should be less immune than Investment Grade with rising sovereign yields, should equities remain stable in the coming weeks.

As a reminder from our August 2013 conversation "Alive and Kicking":

"Moving on to the subject of convexity and bonds, how does one go in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":

"CDS benefits from positive convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays

Convexity measures how duration changes as yields change. For a positively convex bond, the duration increases as the yield declines, and decreases as the yield rises. Positive convexity means that the price increase for a given decline in yields is greater than the price decrease for the same rise in yields. Non-callable bonds are positively-convex. Bonds with traditional call options, such as preferreds, and mortgage-backed securities, or some specific callable high yield notes are generally negatively convex. If you expect yields to rise, you should avoid bonds with long duration, such as those with longer maturities and lower coupons, and favor bonds that have shorter duration and higher yields. In periods were you can expect higher volatility in yields, you should avoid low or negative convexity bonds such as callable bonds in the High Yield space.

The downside protection offered by the CDS market as well as the better liquidity provided by the CDS market can indeed mitigate the damages.

Nota bene: Liquidity in the CDS market tends to be greatest at the 5 year point, making the 5 year single name CDS contract a more viable alternative than other CDS maturities.

Conclusion:

With positive convexity from using CDS, the sensitivity of the price to yield changes (i.e., duration) works in your favor whereas with negative convexity, duration works against you as the price of the bond is becoming more sensitive to yield changes. The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger... " - source Macronomics, August 2013

Therefore you now understand why Bank of America Merrill Lynch prefer to be long European high yield via synthetics more than via cash bonds, post the recent underperformance of Itraxx Crossover. We totally agree on this and it makes perfect sense.

Finally for our final chart, rising populism has gone hand in hand with protectionism (that 30s feeling we talked about...) hence renewed inflows into the "barbaric relic" aka gold which, we hinted, we had been adding since late December.

• Final charts - Deglobalize me

In numerous convcrsations we have mused around the rise of populism in conjunction with protectionism, which represents clearly a negative headwind for global trade and is therefore bullish gold. The rhetoric of the new US administration has gathered steam and there are already mounting pressure to that effect. Our final charts come from Bank of America Merrill Lynch from their European Credit Strategist note from the 2nd of February and entitled "Unwinding globalization". The first chart displays the eerie calm in the VIX index while gold inflows have been surging. The second chart shows the growing theme of protectionism in Developed Markets (DM):

"Unwinding Globalization

Protectionism has been the buzzword over the last few weeks, and much of the narrative has been emanating from the US. Since President Trump’s inauguration, executive orders have been signed to repeal free trade deals and to temporarily restrict certain forms of US immigration. Add to this the growing comments from the Republican administration around foreign countries’ weak currencies, and perhaps the post-Lehman vision of globalization has never felt more challenged. And as the rest of the world looks on, the risk of retaliatory protectionist rhetoric – or actions – grows.

While stocks and corporate bonds have rallied year-to-date, we see a very “incongruous” kind of calm in the markets at present. Note, that while equity volatility is still hovering around record lows, inflows into gold funds year-to-date in Europe have surged (chart 1).

In reality, the trends of protectionism – or “deglobalization” – have been bubbling for a while. Plenty of protectionist measures have in fact been put in place by countries around the world in the aftermath of the Global Financial Crisis – albeit ones not as dramatic as directly repealing free trade agreements. Rather than just tariffs and trade defense measures, governments appear to have become more imaginative in avoiding WTO disciplines. And over the last few years, more overt trade spats and protectionism have been seen (such as the EU’s and China’s issue over solar panels in 2013).

Chart 2 shows the countries that have implemented the most protectionist measures since 2005. Note that the US and the EU head the list. Moreover, the WTO’s trade monitor from June last year highlighted that for the 2015-2016 reporting period, trade restrictive measures had jumped to the highest monthly average on record.

Yet protectionism, in our view, is inherently inflationary in nature. As Chart 3 shows, just as globalization is being challenged by leaders, the world is more “connected” than ever at present.

Corporate supply chains have branched out across the globe over the last 10 years. And free movement of goods, services and labour have been an additional boon for corporate profit margins.

But if protectionism cuts back the tentacles of global supply chains – be it through higher tariffs, border checks or restricting worker migration – then corporates stand to be made less efficient via a rising cost base. Thus to preserve corporate margins, output prices will need to rise…" - source Bank of America Merrill Lynch

So, all in all, regardless of the Sokal monthly hoaxes from our central bankers, can you spell "stagflation"? Because we certainly can...

"Truth emerges more readily from error than from confusion." -  Francis Bacon

Stay tuned!

Macro and Credit - Two Generals' Problem

"It is impossible to suffer without making someone pay for it; every complaint already contains revenge." -  Friedrich Nietzsche

Watching with interest, the trade war narrative escalating thanks to the new US administration and reciprocal tweets between president elect Donald Trump and former Mexican president Vicente Fox relating to the Mexican wall to be erected, in true MMMA fashion (Macro Mixed Martial Arts) reminded us for our title analogy of the Two General's problem. The Two Generals Problem is a thought experiment meant to illustrate the pitfalls and design challenges of attempting to coordinate an action by communicating over an unreliable link. It applies to any type of two party communication where failures of communication are possible. The problem we chose as a title analogy highlights the importance of "Common knowledge", which we have used in the past as an analogy about potential outcomes for credit crisis. 

The Two General's problem is also known as the Two Generals Paradox, the Two Armies Problem or the Coordinated Attack Problem. We find of interest that it was the first computer communication problem to be proved to be unsolvable in the face of arbitrary communication failures, thus providing a base of realistic expectations for any distributed consistency protocols. In regards to realistic expectations, with the latest US GDP in Q4 rising only 1.9% and below the expected 2.2%, one could argue that given the heavier debt load which has been accumulated in recent years, some would be wise to review their growth expectations in the light of US growth being lower for longer but we ramble again. 

But, moving back to our analogy, the problem is as follows: Two armies, each led by a general, are preparing to attack a fortified city. The armies are encamped near the city, each in its own valley. A third valley separates the two hills, and the only way for the two generals to communicate is by sending messengers through the valley. Unfortunately, the valley is occupied by the city's defenders and there's a chance that any given messenger sent through the valley will be captured. While the two generals have agreed that they will attack, they haven't agreed upon a time for attack. It is required that the two generals have their armies attack the city at the same time in order to succeed, else the lone attacker army will die trying. They must thus communicate with each other to decide on a time to attack and to agree to attack at that time, and each general must know that the other general knows that they have agreed to the attack plan. Because acknowledgement of message receipt can be lost as easily as the original message, a potentially infinite series of messages are required to come to consensus. The thought experiment involves considering how they might go about coming to consensus. In its simplest form one general is known to be the leader, decides on the time of attack, and must communicate this time to the other general. The problem is to come up with algorithms that the generals can use, including sending messages and processing received messages, that can allow them to correctly conclude:

"Yes, we will both attack at the agreed-upon time."

Allowing that it is quite simple for the generals to come to an agreement on the time to attack (i.e. one successful message with a successful acknowledgement), the subtlety of the Two Generals' Problem is in the impossibility of designing algorithms for the generals to use to safely agree to the above statement. The first general may start by sending a message "Attack at 0900 on August 4." However, once dispatched, the first general has no idea whether or not the messenger got through. This uncertainty may lead the first general to hesitate to attack due to the risk of being the sole attacker. To be sure, the second general may send a confirmation back to the first:

"I received your message and will attack at 0900 on August 4." 

However, the messenger carrying the confirmation could face capture and the second general may hesitate, knowing that the first might hold back without the confirmation. Further confirmations may seem like a solution - let the first general send a second confirmation: 

"I received your confirmation of the planned attack at 0900 on August 4." 

However, this new messenger from the first general is liable to be captured too. Thus it quickly becomes evident that no matter how many rounds of confirmation are made, there is no way to guarantee the second requirement that each general be sure the other has agreed to the attack plan. Both generals will always be left wondering whether their last messenger got through. Since the protocol is deterministic, the general sending that last message will still decide to attack. We've now created a situation where the suggested protocol leads one general to attack and the other not to attack - contradicting the assumption that the protocol was a solution to the problem.

You are probably already asking yourself, where we are going with this analogy, but, it appears to us that the tweeting protocol of the new US president of the United States is not the solution to the trade problem of his country. On another note, while in our analogy and example a protocol is deterministic, regardless of the generals at the Fed, so is the credit cycle.

Synopsis:

• Macro and Credit - The credit cycle is deterministic
• Final chart -  High Yield priced to perfection is not a good sign

• Macro and Credit - The credit cycle is deterministic

While central bankers and in particular the Fed has been attempting in recent years to avoid pitfalls and failures to communicate appropriately their actions through a deterministic communication protocol, regardless of their numerous communication attempts, something still remains and it is the credit cycle. On numerous occasions we have looked back on how the "Global Credit Channel Clock" operates, as designed by our good friend Cyril Castelli from Rcube which we introduced in our conversation "The Night of the Yield Hunter":

- source Rcube

Although arguably, long government bonds appear to be a poor proposal at this very moment, particularly in Europe since the election of US president Donald Trump. There will come a point where US long bonds will get enticing again, particularly with such a consensus short base on the US 10 year Treasury Notes. What appears to us clearly "mis-priced" from our perspective is volatility. Risks are more and more asymmetric in 2017, therefore one should seek asymmetric payoffs in this context.

As shown by the latest US GDP in Q4 rising only 1.9%, if growth disappoints in Q1, as it did in 2016, the Fed has little ability to use a deterministic protocol, in a year where pundits are focusing more and more on inflation expectations. As we pointed out in our November conversation  "From Utopia to Dystopia and back":

"The second half rally saw credit investors piling on more duration and more credit risks, meaning more instability in credit markets at the time where "Dystopia" has been fading in financial markets. As we pointed out in our previous conversation, we think the market is trading ahead of itself when it comes to its expectations and utopian beliefs. Like any good behavioral therapist we tend to focus on the process rather than the content and look at credit fundamentals to assess the lateness of the credit cycle." - source Macronomics, November 2016

In a market where both US High Yield and European High Yield are "priced to perfection", we will be very wary about what credit spreads will be doing in the coming weeks. To repeat ourselves, there is no doubt to us that we are moving towards the last inning of the credit cycle. On that subject we read with interest Nomura's take from their Japan Navigator note number 702 from the 23rd of December:

"Sharp JGB market sell-off is the first sign of a credit crisis

From the perspective of a 10-year credit cycle,  financial markets have entered a third-year period that represents the last stage of expansion, and thus are approaching a credit crisis (Figure 3).

We would view a sharp JGB sell-off as the first sign of the credit crisis, and believe that the JGB market entered the bearish cycle in mid-2016.
In the current 10-year cycle, we believe a credit crisis will stem either from China’s property market or the US corporates market. Both of these markets have inflated to alarming levels. The Fed became aware of the risk of an asset inflation bubble in the corporates market in 2013, exiting QE3 and implementing two hikes. Despite these efforts, the market continues to inflate on investor flows from the Euro area, Japan and China, where central banks remain ultra-easy (Figure 4).

That said, government bond markets began to sell off in summer 2016, which we view as their pricing-in of the ECB’s and BoJ’s hawkish shift, suggesting the excess liquidity-driven rally has entered its final stage.

What will follow the US’ protectionism and isolationism

In our opinion, the Trump administration’s potential failure in its protectionist strategy is the biggest downside risk for bond yields in 2017. We believe the new administration is unlikely to seek a diminished equilibrium via a weaker USD and higher tariffs, as included in President-elect Trump’s campaign pledge, but instead use these measures as bargaining chips to win concessions from others in expanding domestic demand and opening markets – in short, it will likely seek an expanded equilibrium.

However, if the Trump government fails in its attempt, it could actually implement these bargaining chip measures, thus exporting deflation to other economies, in our view. We would also be concerned about a scenario of another Brexit as a result of isolationism gradually taking hold in the Euro area. If this materializes, we would expect substantial risk aversion, but we see little risk of any such scenario at this point.

We view China’s higher inflation as not only a downside risk in the bond market, but also a factor that could lead to a global credit crisis. If China’s CPI inflation rise above 3% (which we consider an optimal level) in 2017, we would expect fairly aggressive PBoC tightening, which could lead to the bursting of China’s property market bubble. In this materializes, we believe the last stage of the global credit cycle would be brought forward.

Medium-term scenario

• We believe the bearish cycle that started from the US presidential election (Trump risk-on rally) will end its first stage in December-February. In March-May, markets will likely test room for flattening as: 1) concerns over an increase in US fiscal spending under the Trump administration subside; 2) the US criticizes other countries’ weak currency policies; 3) the likelihood of three Fed hikes by end-2017 is questioned; and 4) investors begin their FY17 investments. We believe yields marked just before the 20-21 September BoJ meeting (20yr yields of 0.45%) will serve as a resistance point.

• We expect the Trump risk-on rally to enter its second stage before summer 2017 due to concerns over: 1) the US prompting other countries to increase fiscal spending; and 2) global higher inflation stemming from China. The BoJ could adopt an even more flexible approach to its quantitative target, or could abolish it in April-July 2017. As concerns over BoJ tightening increase, we believe 5yr, 10yr and 20yr yields could rise to positive levels, exceed 0.10% and rise to 0.80%." - source Nomura

In recent musings we pointed out that tightening financial conditions were already showing up in the US in Commercial Real Estate (CRE). This is a segment we will be particularly monitoring in conjunction with its synthetic CMBS proxy the CDS CMBX index and in particular series 6 which comprises the highest retail exposure with 37%.

Furthermore, if indeed we are moving towards somewhat a repeat of 2016, namely "risk-off" and a US Q1 GDP print at 1%, then obviously, it makes sense to put our contrarian boots on again we think. From a USD/JPY perspective, what has been driving the currency pair as of late has been the beloved "Mack the Knife" aka King Dollar + positive real US interest rates. On the subject of USD volatilities, we read with interest Bank of America Merrill Lynch's note from the 19th of January from their FX Vol Trader series entitled "USD vols are relatively overvalued":

"Enamoured by Trump

Since Trump was elected, markets have focused almost exclusively on the US. As an example, USDJPY has recently been driven almost entirely by US rates rather than the Japan story of easing and reform (Chart 1).

This has resulted in USD vols trading at a significant premium to non-USD pairs. In the case of EURJPY vs USDJPY vols, the former is now trading at the cheapest levels relative to the latter in the past decade (Chart 2).

While we see the possibility of the USD continuing to rally, we do see this dislocation in vols as an opportunity to fade the spread.

Vols mostly underperforming

Despite the recent USD correction, vols in general are underperforming on both a high and low frequency basis. Curve flatteners seem the optimal way to position for vol consolidation, given steep curves, while being hedged against event and headline risk of short-term volatility spikes." - source Bank of America Merrill Lynch

While the Japanese story has not been in the driving seat of the recent price action for the USD/JPY currency pair, we think it is important, not only to track as we have indicated the foreign investments from Japan's GPIF, Lifers and Mrs Watanabe to determine the outcome for government bond yields in the coming months, but, there are as well some implications from Japan's Current Account surplus as highlighted by Deutsche Bank in their recent Japan FX Insights note from the 13th of January entitled "Implications of Japan's C/A surplus":

"No need to regard Japan's C/A surplus as yen-bullish when US economy is expanding

Japan's current account (C/A) surplus has held at around an annualized ¥20trn. With recent yen weakness, there is a possibility of the trade balance and international tourism balance, compounded by a further rise in UST yields, contributing to an increase in the primary income surplus. However, we do not necessarily agree with the view that this will soon result in yen appreciation. C/A-related flows are a relatively small part of overall FX flow, so we do not expect this to be a dominant factor for the medium term JPY movements.
In the past, the USD/JPY has often tended to strengthen in phases when imbalance between the US-Japan C/A balances has expanded.

The US trade deficit has been prone to expand due to higher imports when US domestic demand outperforms major trading partners on the back of a booming economy. However, the robust US economy supported a rise in rates and asset prices, which energized fund inflows to the US and pushed up the USD.
Cyclically, it has been observed C/A cycle leading the USD/JPY by 1.5 years. Rather than supply-demand causal relationship, however, this can be explained by the cyclical phenomenon that the C/A balance changes with reflecting the economic cycle while the USD/JPY moves in line with the economic cycle with 1.5 years lag. So, we think the key focus should be the economic cycle.

We have maintained that the most important factor in the direction of the USD/JPY in this phase has been the strength of the US economy. The USD/JPY fell from above 120 toward 100 when the US economy slowed early in 2016, despite the BoJ using a negative rate policy to encourage the yen lower. In this process, no small number of market participants attributed the stronger yen to an expansion of Japan's C/A surplus.
However, the yen's weakening under the Trump market was not the result of the Japanese C/A balance falling into deficit. No critical turning point for USD/JPY can readily be grasped if the theory that "yen appreciation is due to a C/A surplus" (which may appear correct at first glance) is taken at face value. It is clear that the Trump market is the result of cyclical expectations of higher rates and a reacceleration of the US economy driven by aggressive fiscal measures.
Comprehensive forex supply/demand analysis incorporating factors such as trade balance, C/A balance, and investors' foreign securities investment trends is also often seen as a means of determining the yen exchange rate, but this is likely virtually useless in grasping market dynamism. This only reveals the degree of pressure that can gradually emerge when the market is in a lull. As seen in developments after Trump won the presidential election, market moves dramatically alter the composition of supply/demand." - source Deutsche Bank

So if indeed, the consensus for stronger growth is wrong again when it comes to the US 1st quarter GDP and we do get a repeat somewhat of 2016, then obviously, it seems to us that we could see a spike in FX volatility and somewhat renewed pressure on the USD/JPY currency pair and a potential strengthening of the Japanese yen versus the US dollar in short order. 

Although the consensus trade is still being long the US dollar, when looking at the credit cycle, we think we do sit an important fault line when it comes to real yields and inflation expectations. This could also have implications for the long USD crowd and our recent positive stance on gold miners. On that specific point we read Nomura's most recent Japan Navigator note number 705 from the 23rd of January:

"Inflation expectations continue to rise even without large stimulus spending

Next week, a 40yr JGB auction will be held, and trade and CPI data will be released. Expectations for the US substantially increasing fiscal spending under the Trump administration have apparently faded, and concerns over Fed hikes have fallen. Despite this, risk-on momentum remains in place and inflation expectations continue to rise
(Figure 1).

We attribute this to the strength of macro data in the US and China, and Treasury Secretary designate Steven Mnuchin’s comments aimed at easing concerns over a weak-USD policy under the Trump administration. Chair Yellen does not seem to be laying the foundation for a March hike but has been suggesting that the decision will be data dependent.
The UST market rallied on short covering, but stopped rising after regaining only one third of the ground lost since the US presidential election, which suggests investors expect the bearish cycle to continue. We believe risks in the UST market are skewed towards the downside until the January jobs data are released (early February) and Chair Yellen testifies before congress (mid-February).

In the yen rates market, while JGBis are slow to rise due to concerns over the 7 February supply, nominal JGB yields are likely to rise and the curve is likely to steepen on improved growth expectations and higher inflation expectations (Figure 1), in our view.

Super-long JGB rates are approaching levels just before the BOJ intervened with an increase in its purchases of super-long JGBs on 13 December (20yr rates of 0.65%). However, we believe investors may well not buy by assuming a support at this level, as the bank reduced its purchases of these bonds to previous levels only 10 business days after. We believe the BOJ is unlikely to target super-long JGBs at these levels, but intervened just because the curve steepened too sharply.

Assuming the short and intermediate tenors of the JGB market stabilizes and yields rise in a consistent manner, we believe the BOJ would intervene at yields higher than the market assumes (20yr rates of 0.8% or higher and 40yr rates of 1.0% or higher, seen before the excessive flattening in March 2016). 

Reasons why USD should strengthen under Trumponomics

Weak USD in the first stage of the credit cycle, strong USD in the last stage half
In this section, we look at the relationship between the credit cycle and US government policies.

In the early stage of the credit cycle, monetary policy tends to be accommodative and USD to weaken (Figure 2).

This is because inflation tends to head lower in that period due to a carry-over from the recession. In contrast, in the last stage of the credit cycle, Fed policy tends to be tightened and USD tends to strengthen.

However, we see little relationship between US fiscal policy and the credit cycle. A new administration’s stance on fiscal policy tends to be a reversal of its predecessor’s. In addition to political reasons (i.e., refuting the previous administration’s policy), the new government tends to face constraints in terms of the fiscal and current account balances.

The US may seek to increase fiscal spending, tighten monetary policy and strengthen USD under Trumponomics

Assessing Trumponomics in terms of the credit cycle, we note: 1) the new administration takes office in the last stage of the credit cycle; and 2) Former President Obama took fiscal austerity measures. The first point suggests USD would strengthen and the second point makes an increase in fiscal spending likely under the Trump administration.
However, the unemployment rate and other indicators show that the US economy is beginning to face supply-side constraints, and Fed policymakers and others say larger stimulus spending is unnecessary. Despite this, we believe the new administration will substantially increase fiscal spending as President Trump intends, at least in the first one to two years, because; 1) he won the election by calling for the need to stimulate growth, primarily via increased fiscal spending; 2) Republicans control the presidency and both houses; and 3) the fiscal and current account deficit look fairly small, leaving room for a further deterioration (Figure 3).

Reasons why USD remains supported even though the current account deficit increases

As the US currently faces supply-side constraints, an increase in demand brought about by tax cuts and infrastructure investments would likely translate into increased imports, and – contrary to President Trump’s intention – an increase in trade and current account deficits, which may weaken USD. 

However, USD historically begins to weaken several years after the current account balance begins to deteriorate (Figure 3).

This is because the current account balance tends to deteriorate in the last stage of the credit cycle, when tighter monetary policy, higher UST rates (i.e., relative to other government bond yields) and higher US domestic growth (relative to other economies) prompt higher investments into the US.
There is also a lag of about one year between the reversals in the movement of the UST-JGB yield differential and USD/JPY (Figure 4).

As the UST-JGB yield differential is still widening, we believe USD/JPY is unlikely to begin falling in the near term.

Judging by their comments, we believe President Trump and Treasury Secretary nominee Mnuchin will not look to improve US exporters’ competitiveness via macroeconomic policies (e.g., by guiding USD weaker, as seen in President Reagan’s second term and President Clinton’s first term). We believe the Trump administration is likely to use a weaker USD and higher tariffs merely as bargaining chips to win concessions from others. Instead, the new US administration will look to prompt its trading partners (governments, corporates) to increase investment into the US.
Higher investment into the US may lead to higher production in the US and an increase in US exports to others, but USD would likely remain supported while capital continues to flow into the US." - source Nomura

Interestingly, we agree with Nomura that, in the last stage of the credit cycle, Fed policy tends to be tightened and USD tends to strengthen. This overall has clearly had an impact on global financial conditions. But, if indeed the current account balance in the US deteriorates, then the US dollar should weaken as it generally happens in the late stage of a 10 year credit cycle, hence our contrarian stance versus the bullish US dollar crowd. The credit cycle is therefore deterministic we think.

So, overall, you might garner from the above our defensive stance and our "risk-off" feeling but, one thing that do makes us feel nervous is indeed the overall complacency in high yield where it seems as per our final chart, that the market is nearly priced to perfection.

• Final chart -  High Yield priced to perfection is not a good sign

Since the beginning of the year credit has continued to perform and in particular High Yield. As we indicated earlier on in our conversation, the second half rally of 2016 saw credit investors piling on more duration and more credit risks, meaning more instability in credit markets at the time where "Dystopia" has been fading in financial markets. Right now, we think that "Dystopia" has been replaced by "Euphoria" and the current levels reached by high yield, make us think that indeed, the risk/reward for the asset class appears to us particularly poor following a very good 2016. Our final chart comes from Société Générale's Credit Strategy Weekly note from the 20th of January and entitled "It's starting to get trickier". It displays how pricey High Yield relative to Investment Grade (IG):

"We're even more worried about High Yield

In the editorial of last week’s Credit Weekly, we argued that European high yield markets were too ebullient. Clearly, market participants disagree. This week in Europe, government bond yields rose to within a whisker of their December peaks (at 40bp on the Bund), equity markets corrected (slightly) lower, but European high yield spreads continued to tighten. While IG spreads in Europe were broadly unchanged, high yield spreads tightened another 5bp.

Note that the recent moves have brought the relationship between IG and HY markets in Europe to very rare levels. Chart 1 shows the spread ratio (HY/IG) and the spread differential (HY-IG) since the financial crisis. We have smoothed the data to reduce the impact of monthly rebalancing. Note that the spread ratio is closing in on the lowest levels since 2012, while the spread differential is at the lowest levels since the mid-2008 widening. High yield is very expensive indeed.

Beta, not supply, has driven the markets tighter this year. The risk here is that the mood may well sour. Indeed, we think it will, given the shakier tone in other markets and the political risks in evidence this week with Theresa May’s Brexit speech and ahead of the French leftwing primaries. We still recommend reducing risk in portfolios despite the rally seen in the year to date." - source Société Générale

While in recent years the "printing protocol" and "wealth effect" of various central banks has been seen as a solution to a global debt problem, it appears to us, in contradiction to their assumption, when it comes to GDP growth, the protocol they have used was clearly not the solution to the problem but we ramble again with our unsolvable Two Generals' Problem.

"An ignorance of means may minister to greatness, but an ignorance of aims make it impossible to be great at all." - Elizabeth Barrett Browning, English poet

Stay tuned !