Credit - Tokyo Drift

"As the blessings of health and fortune have a beginning, so they must also find an end. Everything rises but to fall, and increases but to decay." - Sallust, Roman historian

Watching with interest the continuation of the deflationary trend of peripheral yields in conjunction with the brewing turmoil in France given the recent dissolution of the latest government, we decided this week to use a relatively simple analogy, using the 2006 third opus of the "Fast and Furious" movie saga entitled "Tokyo Drift" as our title given the on-going "Japanification" process of Europe.

In fact, this "Japanification" process aka "Tokyo Drift" reminded us of our conversation from March 2012 entitled "St Elmo's fire" where we indicated the following:

"If Europe is moving towards a Japanese decade, there might be at least some solace for Spanish Golf players given that according to Bloomberg there has been a high correlation between Golf Membership fees and Tokyo land prices - source Bloomberg:"

The continuation of the European "adjustment" in similar fashion bodes well for European golfers but we ramble again...

Peripheral yields have been subdued even without the OMT being triggered. In similar fashion, the Euro has weakened without even QE being launched.

In this week's conversation, we will review the acceleration of the deflationary trend we are seeing and what to expect: QE or no QE?

Another sign of the "Tokyo Drift" in the European financial world can be seen in the Eonia which, as indicated by Morgan Stanley in their ECB Tender Tracker note from the 20th of August has been drifting towards Depo:

"Eonia fixing at new lows: Eonia has been fixing at record lows for the past two weeks, with spot Eonia currently being at 0.005% and 1y forward 1y Eonia at 0.042%."

"The next event the market will be watching out for is the first TLTRO take-up on September 18. At the press conference of the August ECB meeting, President Draghi quoted a lower range of the total take-up at the TLTRO from banks’ survey, i.e., €450-850 billion, compared to the ceiling of €1 trillion announced in June. While Draghi may have lowered the ECB’s expectation of the overall take-up at the TLTRO, our bank analysts’ estimates are at the lower end of the range – a total take-up of just €350-650 billion." - source Morgan Stanley

In fact 1 year 1 year Eonia has been trading down to -1.5 bps as of late.

When it comes to the "inflationary" trends in Europe, the deceleration of inflation has been intensified by the volatility in energy/food prices as indicated by Bank of America Merrill Lynch in their note from the 22nd of August entitled "Tracking deflation: more worries":

"HICP fell to 0.4% yoy in July, while it had been expected to be unchanged at 0.5% yoy. Looking at its components, the changes were driven by energy dropping aggressively from 0.1% yoy to -1% yoy. Alcohol and tobacco receded from -0.2% to -0.3% yoy, non-energy industrial goods were stable, while services grew 1.3% yoy, unchanged from June (Chart 6)." - source Bank of America Merrill Lynch

Another significant indicator of the deterioration of inflation expectations in Europe can be seen in spot inflation break-evens in the same report, showing the various maturities falling in concert:

"Spot inflation break-evens have resumed their fall and are now at levels close to 0.5% on a one- and two-year horizon. Five-year break-evens are also falling and stand at around 0.99%.

Forward inflation break-evens computed from swaps also started to fall again and, for the first time, the 5Y5Y forward has crossed the 2% line. - source Bank of America Merrill Lynch

Looking as well at the recent weakness of Euro versus the US dollar, it is for us the continuation of our "Generous Gambler" aka Mario Draghi being very apt in applying some of General Sun-Tzu's greatest concepts following his July 2012 OMT bluff:

“The supreme art of war is to subdue the enemy without fighting.” ― Sun Tzu, The Art of War

To that effect, Mario Draghi has once more played a very smart hand in lowering the Euro without even firing his QE bazooka. We agree with Morgan Stanley's comment from their latest FX Pulse note from the 21st of August that lowering the value of the euro was indeed an obvious monetary policy goal:

"No EUR Value

Meanwhile, the ECB’s policy tools to revive the ailing economy have become a constraint. Lowering the value of the EUR has become an obvious monetary policy goal, explaining why a declining EUR is now taken as a bullish sign by European asset markets. The weakening exchange rate is now an indicator of the success of the ECB’s easing approach. This interpretation makes sense as declining sovereign spreads failed to reduce peripheral private sector funding costs, as shown in Exhibit 3, and implicitly failed to raise private sector credit supply. 

Nowadays, low sovereign bond yields will help reduce the foreign value of the EUR. This is best illustrated by Exhibit 4 showing volatility-adjusted yield differentials no longer support peripheral bond markets."

- source Morgan Stanley

Indeed, declining peripheral yields have not transferred to peripheral private sector funding due to "crowding out" which we discussed a year ago in our conversation "Fears for Tears":

One of main reason of the relative calm in the European government bond market has been the "crowding out" of the private sector.

"Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments

It is fairly simple, in effect while the deleveraging runs unabated for European banks, most European banks have been playing the carry trade and in effect boosting their sovereign holdings by 30% since 2011 to record"

We also commented at the time:

"Yes, we all know that Mario Draghi's OMT "nuclear deterrent" has yet to be tested. But what we are concerned about is, as we indicated in our conversation "Cloud Nine", is the lack of credit growth in peripheral countries which are most likely to be exacerbated by the upcoming AQR 

As a reminder: AQR = Asset Quality Review, planned for 1st Quarter 2014 as a prelude to the ECB becoming the Single Supervisor for large euro area banks in 2H 2014. The AQR's intent is to review banks challenged loan portfolios and the need for capital increase.

"Until the AQR is completed and capital shortfalls identified and remedied, you cannot expect a significant pick up in lending." 

So QE or no QE?

Not yet.

We have to agree with Bank of America Merrill Lynch's take from the 19th of August entitled "Rates market still not priced for ECB QE as displayed in their Chart of the Day - 5y5y Euro inflation swap rate - breaking below the 2% level last Friday:

"Inflation swaps point to rising risk of no QE

Last but not least, the past two weeks saw a clear break in the relationship between forward nominal rates and breakevens, with a sharp fall in inflation forwards. While the rally in nominal forwards over the past few months used to be reflected in lower real rates, the last two weeks saw it translate into a drop in inflation forwards. The 5y5y inflation swap rate, closely monitored by the ECB as an indicator of long-term inflation expectations, has crossed the 2% on Friday, for the first time since October 2011 (Chart of the day). The drop in inflation forwards is even more noteworthy given that the end of July/start of August often sees firmness in breakevens because of July index events and the absence of supply." - source Bank of America Merrill Lynch

We also agree with Bank of America Merrill Lynch's comment on the heightened risk of "disappointment":

"Weak GDP but tighter spreads may seem consistent with QE…

Last week, the release of weaker-than-expected 2Q GDP for the Eurozone was still accompanied by a tightening in peripheral spreads. Many interpreted this as the market pricing in increased likelihood of QE. We would disagree with that view. While the weak data places more pressure on the ECB to act, we find the moves in peripheral spreads and other rates products inconsistent with the rates market discounting greater chance of QE. Unfortunately, there is no straight way to measure the probability that the market assigns to ECB QE, and even surveys have indicated a very large range of expectations, depending on investor class (Chart 5).

- source Bank of America Merrill Lynch

From a contrarian stance and from a risk reversal point of view, there is indeed a potential for a correction of the consensus long US dollar trade we think. Particularly when everyone is long gamma on EUR/USD as indicated by Bank of America Merrill Lynch in their note "Trading a new USD vol regime" from the 25th of August:

"There was significant demand for EUR/USD gamma over the last week as the pair weakened below 1.32. In the short term there is a strong likelihood of a rebound in the pair following the completion of a triangle breakout (Closing our tactical €/$ short). With short EUR/USD positioning at stretched levels, this rebound is likely to be volatile." - source Bank of America Merrill Lynch

But, then again, one of the real reasons behind the weakness in the Euro as of late has indeed been equity outflows as pointed out by Bank of America Merrill Lynch in their Liquid Cross Border Flows entitled "USD marching higher" from the 25th of August:

"Equity outflows drive EUR lower

Real money selling has been the main driver of EUR weakness in recent weeks, also reflected by outflows from Eurozone equities (Chart 5). 

The CFTC data shows EUR shorts near a two-year high and our quant and technical analysis warn of a short-term pause in EUR weakness. However, as long as the ECB avoids more aggressive easing, equity outflows could weaken the Euro in the medium term." - source Bank of America Merrill Lynch

Should the rebound in European equities accelerate, this could as well play for a rebound in the euro in the near term we think.

In similar fashion, the strong move of the US dollar versus the Japanese Yen appears to us slightly overdone and we might see as well some pull-back from a "contrarian" point of view but technicals, indeed appear less favorable for now when it comes to the yen trade.

From a credit perspective, we continue to believe in the safety of Investment Grade versus the risk of renewed volatility in the High Yield space. Our stance is as well confirmed by recent flows as described by Bank of America Merrill Lynch in their HY flows note entitled "Back to positive" from the 22nd of August:

"Safety over yield

European investors have poured more funds into high-grade and government bond focused funds over the last couple of months. On the other hand, investors have cut risk on more high-beta and growth related asset classes, like equities and high-yield credit. We present this dichotomy of trends in chart 2, by using the cumulative 4 week average flows per pair."

"Credit flows (week ending 20th August)

HG: +$2.0bn (+0.3%) over the last week, ETF: +$183mn w-o-w

HY: +$734mn (+0.3%) over the last week, ETF: -$94mn w-o-w

Loans: -$96mn (-1.1%) over the last week

High-yield flows are back in positive territory after 5 weeks and a total of $13.4bn of non-stop outflows. High-grade inflows remained upbeat, with another $2bn (almost) inflow for another week. High-grade fund flows have been a strong 7.1% of AUM, the strongest since 2010. On the ETFs side, flows continued to decouple, as high grade ETF funds continued to see inflows, while high-yield suffered another outflow over the last week."

- source Bank of America Merrill Lynch

Flows continue to validates Nomura's take on the golden age for credit we discussed back in 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets" which we mentioned again in our last conversation. We like being long duration in European investment grade credit.

On a final note, as far as the Tokyo Drift is concerned and Japan in particular, the continuation of the increase in bank lending in Japan warrants close monitoring we think when it comes to assess Japan's never ending fight against the "deflation beast" - graph source Bloomberg:

"Harmony makes small things grow, lack of it makes great things decay." - Sallust, Roman historian

Stay tuned!

Credit - Deus Deceptor

"The senses deceive from time to time, and it is prudent never to trust wholly those who have deceived us even once." - Rene Descartes, French philosopher

Watching with interest the EONIA index posting new lows (1.5 bps) in the European space, spelling "death by a thousand rate cuts" for European money markets funds, meaning so far that they are only managing to survive by taking increasing interest rate exposure through Euribors, we decided to use another reference to central bankers' deception tricks in our chosen title this time around namely Deus Deceptor being a "deceptive god". 

Evolution of the Eonia index - graph source Bloomberg:

We had already used a reference to a great text from French poet Charles Baudelaire "Generous Gambler" aka Mario Draghi, but, this week we decided to refer to French philosopher René Descartes given he was accused of blasphemy by Protestants in 1643 and 1647 as he was positing an omnipotent God of malevolent intent (could we use this as an analogy to the central bankers of today?). 

The evil demon, sometimes referred to as the evil genius is a concept in Cartesian philosophy:

"In his 1641 Meditations on First Philosophy, René Descartes hypothesized the existence of an evil demon, a personification who is "as clever and deceitful as he is powerful, who has directed his entire effort to misleading me."" - source Wikipedia

Most Cartesian scholars opine that the evil demon is also "omnipotent" (hence the blasphemy as god is only considered as being "omnipotent"), and thus capable of altering mathematics and the fundamentals of logic. In Cartesian philosophy, sensation and the perception of reality are thought to be the source of untruth and illusions, with the only reliable truths to be had in the existence of a metaphysical mind. 

In similar fashion we already touched on the "Omnipotence Paradox" back in November 2012:

"1. A deity is able to do absolutely anything, even the logically impossible, i.e., pure agency.
2. A deity is able to do anything that it chooses to do.
3. A deity is able to do anything that is in accord with its own nature (thus, for instance, if it is a logical consequence of a deity's nature that what it speaks is truth, then it is not able to lie).
4. Hold that it is part of a deity's nature to be consistent and that it would be inconsistent for said deity to go against its own laws unless there was a reason to do so.
5. A deity is able to do anything that corresponds with its omniscience and therefore with its worldplan." - source Wikipedia.

But in terms of blasphemy and the "evil" intent of the central bankers both Descartes and the Cartesian scholars were wrong for the simple reason that central bankers are not omnipotent. Although, our "Deus Deceptors" of the central banking world, have indeed managed to altering mathematics (probability of default risk for the time being) and the fundamentals of logic, no doubt about that. 

"The gazing populace receives greedily, without examination, whatever soothes superstition and promotes wonder". - David Hume

Back in 2012 in our conversation we also argued:

"The "unintended consequences" of the zero rate boundaries being tackled by our "omnipotent" central banks "deities" is that capital is no longer being deployed but destroyed (buy-backs being a good indicator of the lack of investment perspectives)."

In this week's conversation we will look at the development in the credit space, which is a continuation of the "japonification" process with continued spread compression as the "yield frenzy" goes on as we move towards the close of the 1st semester of 2014 as well as some perspectives for the second semester 2014. 

Our take on Credit:

Credit, no doubt has had yet another great run in the first half of 2014, which comes to us as no surprise given the performance of credit in a deleveraging environment as it happened before in Japan.

In similar fashion to what we wrote about Japan in general and credit versus equities in particular in our April 2012 conversation "Deleveraging - Bad for equities but good for credit assets":
"Financial credit may be the next big opportunity

The build-up of corporate leverage in the 2000s was confined to financials which, unlike other corporates, had escaped unscarred from the 2001 experience. However, this changed in 2008. Judging by the experience of G3 (US, EU, Japan) non-financial corporates, there should be significant deleveraging in banks going forward. Indeed, regulatory pressures are also pushing in that direction. All else being equal, this should be bullish for financial credit." - source Nomura

The "japonification" process in the government bond space continues to support the bid for credit, with the caveat that for the investment grade class, there is no more interest rate buffer meaning investors are "obliged" to take risks outside their comfort zone (in untested areas such as CoCos - contingent convertibles financials bonds).

"Japonification" illustrated with German 2 year yields versus Japan coming close to negative again - graph source Bloomberg:

The strong convergence between the CDX index in the US representative of Investment Grade credit risk and its European counterpart the Itraxx Main Europe 5 year CDS index - graph source Bloomberg:

And the same picture since 2006 - graph source Bloomberg:

Could we go back to negative territory in terms of spread difference between Europe Investment Grade risk and the US like we did previously? We certainly can and will, given that back in January we expected more M&A and LBOs to materialise in 2014 as we move towards a later stage in the cycle we expect the US  to releverage at a faster pace.

Credit is far less volatile than equities, some leverage is sensible. Even leveraged credit can be less risky than unleveraged equities.

When it comes to High Yield and volatility, the spread compression has followed the compression in Eurostoxx Implied volatility as displayed in the below Bloomberg graph:

Of course there is more compression to come in both as ample central bank liquidity thanks to our "Deus Deceptors" who have managed to suppressed volatility and led to yield starvation meaning investors are reaching out for yield by taking additional risks down the credit quality spectrum.

But, when it comes to US High Yield, as far as we are concerned, it is "priced to perfection" and we cannot see the risk justifying the rewards anymore as displayed in the below Bloomberg graph illustrating the average High Yield Spread to Treasuries (Option Adjusted Spread - OAS):

Credit wise we agree with Société Générale weekly credit strategy note from the 20th of June when it comes to additional performance from the credit space and prefer European High Yield therefore to US High Yield which appears to us somewhat "richer" in terms of valuation.

"Credit fundamentals should remain strong (corporates are now in much more solid shape than pre-2008), and technicals supportive. That means that credit stands to gain further particularly HY, even if most market participants feel the asset class (IG and HY) is too rich. After all, it’s the bund’s fault as spreads remain much wider than pre-crisis (in IG, less so in HY). High yield names, corporate hybrids and AT1/Cocos stand to be the outperformers. After all, finding investments that yield over 5% are becoming increasingly rare, not even the recent issues by Greece or Cyprus (out this week) paid that. The great credit run is far from over, but even if the pace has slowed down, we expect the rally to continue with further compression between high and low beta names and sectors." -source Société Générale

Our take on US treasuries:

From a tail risk perspective and as a hedge with decent carry, we are staying long duration, a position we have taken on the ETF ZROZ - PIMCO 25+ Year Zero Coupon US Treasury Index Exchange-Traded Fund, a position we entered around 90 in terms of price level early in 2014 - graph source Bloomberg:

The contrarian 10% trade which we discussed in January.

Those who listened to us have done well so far in 2014 given we hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed":

"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

We do indeed learn a lot from our "Deus Deceptors and their magic tricks... 

While every sell-side and most buy-side strategists and their dogs expect US 10 year yields to end 2014 at a level of around 3.25%, we are more incline to be contrarian on that matter for now until the facts change, before we change our facts to paraphrase Keynes. So we disagree with the consensus and agree at least with Nomura's take on UST as posited in their latest Japan Navigator from the 23rd of June:

"UST rates remain low but for different reasons

Many investors see low UST rates as reflecting economic weakness

We held a seminar primarily for equity investors in Tokyo this week. In a questionnaire given to seminar participants, we asked about the main factors to which they attribute the decline in UST rates since January. We also gave the same questionnaire to bond investors on our website. The results are shown in Figure 3.

More bond investors chose the second answer, which suggests that they consider low UST rates as being caused by structural reasons. Although fewer stock investors chose the second answer, over a half of respondents chose either the first or second answers in both groups. To the extent that these answers refer to slowing growth and/or slowing inflation, they are consistent with a weak stock market. In contrast, the third and fourth answers imply that yields are kept unjustifiably low relative to economic and inflation outlooks. They look consistent with a strong stock market.

We believe UST rates have been kept low for different reasons after mid-April

UST rates have remained low since January, but for different reasons before and after mid-April, in our opinion. Considering that the S&P 500 trended below end-2013 levels until mid-April, we believe UST rates were kept down largely by factors [1] and/or [2] until then. However, as stock prices continued to set new highs subsequently, we believe rates remained low more because of factors [3] and [4].

Considering that the strong bond and stock trend was more pronounced following the ECB announcement of a rate cut and the possibility of additional easing, and that the UST yield curve priced in a rate hike that was later than Fed guidance and lower neutral policy rates, factor [4] may have had a greater impact, in our view. As the ECB and BOJ continue to supply long-term funds at low rates, carry flows from the euro area and Japan into the UK, US and Oceania are likely to have a more material impact on these markets, in our view." - source Nomura

Welcome to a "Macro World"...

Our take on EUR/USD:

In terms of our take on the Euro currency's strength, in our conversation in early January 2014 entitled "Third time's a charm" we argued the following:

"As we move into 2014, our chosen title reflects the third time strategists put forward the case for a weaker euro. So could indeed 2014 see finally the much anticipated weaker euro forecasted by so many pundits?

In terms of our prognosis in both 2012 and 2013, we did not believe in a weakening of the Euro versus the dollar and we reiterated our stance in numerous occasions such as in our conversation from April 2013 "Big in Japan":

"In terms of the EUR/USD, we still think in the second quarter that it should remain in the 1.30 region versus the US dollar, which were our views for the 1st quarter. As we posited in January 2012, when most strategists were bearish on the EUR/USD, the Fed swap lines in conjunction with the FOMC decisions at the time did put a floor to the euro and are delaying a painful adjustment in Europe. The latest decision by Japan will as well prolong the European agony. In the process the European recession can only be prolonged and the European economy will continue to suffer (unemployment rate now at 12%)."

We also added:

"Unless Mario Draghi unleashes in Europe QE to fight off the growing deflationary risks we have been tracking and warning about, we do not see a weakening of the Euro in 2014."

Arguably in recent months, thanks to the US Fed tapering, the 1 year/1 year forwards for the US dollar and the Euro have increasingly diverged as displayed in the below Bloomberg chart:

This seems to indicate that the market clearly anticipates at some point some "nuclear" action from the ECB and also indicative of the tapering effect on the US dollar versus the Euro we think.

For us the divergence is as well an illustration of the difference in the inflation outlook between the US and Europe as shown in the below Bloomberg graph:

While many pundits point out to the interest rate differential which should lead therefore going forward to a lower euro. We disagree and expect Euro to strengthen during the second part of 2014 towards 1.40 (we therefore share the same views as Steen Jakobsen Chief Economist & CIO, Saxo Bank A/S). A very interesting explanation on why the Euro appears to be the new "widow maker" (in similar fashion to the short JGB trade) comes from Paul Donovan, senior economist at UBS as reported in the Jakarta Post:

"A key part of the explanation for the Euro’s defiance of divergent monetary policy lies in a revolution that has taken place in the world economy. Put simply, globalization has collapsed dramatically since 2007, and that collapse in globalization has profound implications for financial markets. 

The collapse in globalization is nothing to do with global trade. Global exports (as a share of the world economy) are at a higher level than they were in 2007 — here there has been a complete recovery. Instead the collapse has taken place in the realm of global capital flows. Global capital flows (again as a share of the world economy) are running at roughly a third of their pre-crisis peak, and around half the levels seen in the decade before the global financial crisis. 

The collapse of global capital flows has been brought about by several factors coming together. Investors, in particular banks, are more regulated than before the crisis. With that regulation has come about a bias to investment in domestic markets — in some cases as an unintended consequence of regulation, in some cases as a direct policy objective. In addition the more political nature of several developed financial markets has acted as a deterrent to international investors, who are likely to have less understanding of politics in remote markets. 

When capital flows were abundant, an economy with a current account deficit did not have too many problems finding the capital inflows necessary to finance the current account position. Only a tiny proportion of the huge amount of capital sloshing around the world had to be diverted to provide the funding. Now, with capital flows reduced to a thin trickle, a current account deficit country has to work a lot harder to attract the capital that they need. Crudely put, it is three times more difficult to finance a current-account deficit, now that capital flows are one third their pre-crisis levels. 

This helps to explain the Euro. The Euro area is a current account surplus area. The United States is a current-account deficit area. The interest rate differential argues for a weaker Euro. The current account position argues for a stronger Euro. These two forces battle it out in the foreign exchange markets, and the result is less Euro weakness than many had expected. 

This new model for foreign exchange has implications that reach far beyond the errors of Euro/dollar forecasting. Reduced capital flows means reduced capital inflows into Asian markets — something that has already slowed the pace of foreign exchange reserve accumulation. Reduced capital flow may mean a less efficient global allocation of capital resources. Global capital flows have been hidden from the headlines, but the collapse of globalization may turn out to be one of the most important economic changes of the past decade." - source Paul Donovan, senior economist UBS - the Jakarta Post.

Given that Europe's current-account balance, a broad measure of an economy's international financial position, increased in adjusted terms to a surplus of 21.5 billion euros ($29.26 billion) in April, after an upwardly revised surplus of EUR19.6 billion in March, we expect the Euro to trade higher in the coming months, not lower. (The balance reflected a EUR16.9 billion surplus for goods and a EUR10 billion surplus for services).

Also, for the 12-month period that ended in April 2014, the cumulated surplus was 2.6% of the euro zone's gross domestic product, higher than the 1.9% in the 12 months ended April 2013, so regardless of the interest rate differential put forward, we have a hard time believing in a weaker euro for now, unless of course the European "Deus Deceptor" in chief Mario Draghi unleashes a €1 trillion QE but we do not see that happening anytime soon.

Our take on Japan:

Moving on to our take on Japan, given it has been seriously lagging in terms of equities performance since the beginning of the year being down -5.66%, the Nikkei has indeed rallied significantly in one month (+9.67%) while the Japanese yen have been lagging and holding in a tight range pattern around 102. What has been interesting as of late has been the disconnect between the Nikkei index and the JPY/USD as indicated in the below graph where we have been monitoring the USD/JPY exchange rate, the Nikkei index and the credit risk Itraxx Japan CDS spread (inverted) - source Bloomberg:

Credit spreads have led the significant rally seen in equities and the depreciation of the Japanese yen by the Bank of Japan has further supported the rally in both asset classes in 2013. A typical central bank's intervention, the "reflation trade" lifting risky assets, reducing perceived credit risk and suppressing volatility. As a result of aggressive quantitative easing, we think credit risk itself could even go lower due to the wealth effect on company assets and greater ease procuring large amounts of funds via debt financing. 

But, when it comes to Japan, there is hope, we think as displayed in the below growth showing somewhat an increase in bank lending - graph source Bloomberg:

The boost in the money supply has drastically reduced the yen effective exchange rate while bank lending has been gradually climbing.

What so far has been hindering the Japanese reflation story has been Mrs Watanabe's household savings even though the dollar-yen rate has been seriously impacted by the Bank of Japan's aggressive monetary stance as displayed in the below Bloomberg graph:

Of course the depreciation story has led as well Japanese CPI higher in conjunction with higher durable goods prices and furniture and utensils prices - graph source Bloomberg:

So all in all, we plan to re-enter the Nikkei play currency hedged in Euro again very shortly as we believe Japan is poised for a rebound. We plan to go long Nikkei but in Euros via a quanto ETF in that respect.

The story for  the remainder of 2014 in Europe is still France:

This is what we argued in January 2013 and this is still what we are arguing now. While French politicians are benefiting from low rates on French debt issuance courtesy of on-going Japanese support, but, on the economic data front France is increasingly showing signs of growing stress. 

France should be seen as the new barometer for Euro Risk. With Industrial Production at -2%, the French government is seriously in denial when it comes to growth assumptions: 1% in 2014 (down from 1.2%) and 2% in 2015 is way over optimistic we think. 

A sobering fact, services in the French economy represent around 80% of the GDP versus 76% for the rest of the European union. the latest read at 48.2 for Services PMI is indicating contraction (the lowest level reached in February 2009  was at 40.2).

French industrial production (white line), French GDP (orange line) and French Services PMI (blue line, data available since 2006 only) tell the story on its own, we think - source Bloomberg:

An industrial production at -3.3% equals zero growth.

If the Services PMI contracts, it doesn't bode well for France's unemployment levels. Services represent the number one employment sector in France (34% of total employment in 2010 according to INSEE).

Normally "entrepreneurial economy" can’t do that well as long when they are entrepreneurs in the picture but in the special case of France, given French civil servants have done their best to "kill" the entrepreneurs in France with great success, the economy will continue to linger.

A tight credit channel, high inventory levels vs. order books, depressed consumer sentiment and a forced fiscal tightening create a dangerous economic environment for an already weak economy.

On a final note we leave you with Bank of America Merrill Lynch's latest graph from the Thundering Word from the 19th of June displaying the infatuation with "yield" (it reminds us of our Dark Crystal reference from our March 2013 conversation "The Yield Skeksis"):

"Men still have to be governed by deception." - Georg C. Lichtenberg, German scientist

Stay tuned!

Markets update - Credit - Modicum of relief

mod·i·cum (m d -k m). n. pl. mod·i·cums or mod·i·ca (-k ). A small, moderate, or token amount. - The American Heritage, Dictionary of the English Language.

"Thus, the questions we should ask here are what makes the current economic upswing different from the past two recoveries, and whether such differences are sufficient for the economy to reach the sustained growth path."
Toshihiko Fukui - 29th Governor of the Bank of Japan from March 20, 2003 to March 19, 2008.

Given everyone is awaiting the results for the Greek PSI, Collective Action Clauses and CDS trigger, we thought using "Modicum of relief" as a title was, somewhat, an appropriate title in relation to the most recent LTRO program and continued rally in the equity space (Euro Stoxx 50 index reaching a seven-month high) as well as the significant tightening in peripheral bond spreads. While in our previous conversation "Schedule Chicken" we touched on the importance of tracking deposits levels in conjunction with lending surveys, this time around we would like to focus our attention on systemic risk diagnosis. Domestic deposits are essential in defining the default path in a credit cycle (it was the case for Argentina...). But before we jump into more in depth analysis of the latter, it is time for our usual credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:

Following the second round of the LTRO, there has been a raft of new issues in the primary market: 1.1 billion GBP and 1.85 billion euros worth of investment-grade corporate bonds with an average maturity of 4.5 years for euro-denominated investment grade corporate bonds.
The iTraxx SOVx Western Europe Index of sovereign credit-default swaps (15 governments) remains elevated, even after the second round of LTRO. The big beneficiaries of the second round of support remains the financial sector given Itraxx Financial Senior 5 year CDS index  (representing Senior risk level for European banks and financial institutions) is approaching once again the 200 bps level while Itraxx Financial Subordinate 5 year CDS index is marginally tighter, one week on, at around 343 bps (20 bps tighter than last week).

The spread between the Itraxx Financial 5 year CDS index versus the SOVx Western Europe is still indicating the divergence of support courtesy of LTRO 2 and at a record level (138 bps) impacted by the still widening trend of Greek CDS and elevated levels of peripheral CDS sovereign spreads - source Bloomberg:

"Flight to quality" picture, Germany 10 year Government bond yields remain well below 2% yield and falling 5 year CDS spread for Germany, confirming our previous call, namely that demand for precautionary assets remains elevated and the widening for the 10 year German benchmark bond remain somewhat capped - Source Bloomberg:

The current European bond picture with Italy and Spain 10 year government yields accelerating their fall in yields, courtesy of the LTRO 2 effect this time around - source Bloomberg:

While yields are falling, support for peripheral debt is coming from peripheral banks which are in effect encouraged by the LTRO in purchasing their domestic debt, other European banks are not participating to the party.

As indicated by Lucy Meakin in her Bloomberg article - Banks Miss Best of Bond Gains as Fear Trumps Greed: Euro Credit, major European banks are missing out on the big rally in peripheral bonds:
"Italian securities have handed investors a return of 11 percent this year, the most among 26 bond indexes tracked by Bloomberg and EFFAS as of March 1. Ireland’s debt has returned 9.9 percent, Belgium’s 3.8 percent and Spain’s 3 percent, the indexes show. Germany’s bonds, the European benchmark, have gained 0.2 percent, beating only Greece among their euro zone peers. Italian two-year note yields fell below 2 percent for the first time since October 2010 yesterday.
RBS cut its holdings of Italian, Irish, Portuguese, Spanish and Greek government debt by 90 percent in 2011 while boosting those of German bunds, according to a Feb. 23 investor presentation."

We keep saying this:
"It is all about capital preservation rather than a hunt for yield".

From the same Bloomberg article:
"As the credit ratings of countries such as Ireland, Portugal and Greece have been cut, those nation's bonds have also become too risky to remain in many developed-market government indexes, reducing the number of institutions willing to buy the securities. Standard & Poor's downgraded nine euro- area countries, including Italy and Spain, on Jan. 13."

Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS level finally moving above Italy - source Bloomberg:

Back in our conversation "Lather, rinse, repeat", we indicated our contrarian stance on Spain versus Italy:
"Given the ongoing deleveraging, in the light of the recent Sovereign CDS convergence between Italy and Spain, we might be viewed as contrarian but looking at the ongoing deleveraging process and the sectorial composition of debt as a percentage of GDP, Spain appears to us as being in a less favorable position particularly in the lights of its housing hangover"

We think Spain Sovereign CDS will drift wider, indicating increasing default risk perception given:
-Italy's shrinking budget deficit to -3.9% in 2011 from -4.6% in 2010,
-Spanish unemployment level expected to reach 24.3% in 2012,
-Spanish Prime Minister Mariano Rajoy has decided to side step the 4.4% deficit target for 2012, for 5.8%:
“I didn’t communicate the deficit target to the heads of state, nor do I have to. This is a sovereign decision taken by Spain.”
Yet another political surprise in true "Greek referendum" style. We think you can reasonably expect more similar "political surprises" with upcoming elections and the European "Schedule Chicken". We all know by now how frantic politicians become when it is election time (Spanish local elections in March).
It will be interesting to see if the European Commission will strictly pursue sanctions under its recent enhanced powers granted in 2011.

The liquidity picture, as per our four charts, ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

ECB Says Overnight Deposits Surge to Record on 3-Year Loans - Jana Randow -source Bloomberg:
"Financial institutions parked 776.9 billion euros ($1.03 trillion) with the Frankfurt-based ECB. That’s the most since the euro was founded in 1999 and up from 475.2 billion euros a day earlier. Banks get 0.25 percent on the deposits."
The jury is still out there to decide whether the new raft of 36 months lending via LTRO 2 will avoid a credit crunch, and we will be closely monitoring the ECB's lending surveys as well as deposits movements in the European banking system.

“The banks that have borrowed liquidity from the ECB are not the same as those that are using the deposit facility of the ECB,” - Mario Draghi
We think the "modicum of relief" of LTRO 2 will be relatively neutral to risky assets compared to LTRO 1. Nomura's recent take on the 36 months LTRO, was the following:
"Market impact is likely to be relatively neutral
Market participants expecting "risk-on" may be mildly disappointed, with some in the market looking for €1trn+ take-down from the operation for the rally to continue. The market is in a more neutral state now than it was in December, with positioning seemingly light in most segments, which should lead to a more muted reaction to this operation than we have seen since the last 36-month operation.
In general, we would expect investors across instruments and curves to remain segregated. The bid to periphery front-end is likely to continue from domestic institutions, though the strength of the rally since December in Italian and Spanish front-ends may leave limited upside potential without an altering of the credit profile of these countries.
We think Bunds are likely to remain tied to the more acute risks in the euro area, such as the developments in Greece, Irish referendum and the French elections. France is likely to be a low beta against difficulties in Italy and Spain, though political risks may provide uncertainty as we approach the early-May elections.
Euribor should continue its downward trend in the short term given the additional liquidity, with Eonia little changed unless the ECB adjusts the deposit which we think is unlikely."

Our good credit friend and we confabulated around the latest round of liquidity injections by the ECB:
"In order to keep the big picture in mind, the global economy now faces higher commodity prices, austerity budgets in Europe, and households decreasing disposable income. The “cocktail” could prove toxic for risky assets, as well as for sovereign bonds. Earnings and credit metrics will be affected by various factors, and budgets targets may not be met, endangering the recovery in the sovereign bond market.
Remember: credit dynamic is based on Growth! No growth or weak growth can lead to defaults and asset deflation."

Moving on to this week subject of systemic risk diagnosis, wholesale bank deposits flights and tracking the loan-to-deposit ratio of banks can be used as a simple gauge of risk profile. It is as well a good indicator of banks 'capacity in supporting lending in their respective economy. Maintaining lending and credit flows is paramount to avoid a credit crunch which would essentially impair GDP growth in the process (as per our "car" analogy used in our previous conversation).

Hungary has been our pet subject in various conversations ("Hungarian dances"). The reason behind our choice is that it appears to us as very good case study for systemic risk diagnosis from a macroeconomic point view (after all our blog is called Macronomics).
Hungary Banks’ Credit Capacity Drops to 2008 Level - Edith Balazs, Bloomberg:
"Hungarian banks’ lending capacity fell in the fourth quarter to a level last seen in September 2008, when the financial crisis engulfed the country, because of tighter and more expensive funding, the central bank said.
“The deterioration in lending capacity was last reported by such a proportion of banks upon the outbreak of the September 2008 crisis,” the Magyar Nemzeti Bank said in a survey published today in Budapest. The drop in lending capacity is driven by shrinking external funding and rising foreign-currency funding costs, it said.
Hungary’s banking industry turned unprofitable for the first time in 13 years in 2011 because of losses from foreign-currency mortgage repayments, rising bad loan provisions and a special industry tax. Regional competition for external funding is becoming more difficult for the Hungarian banks, the central bank said."

From the same Bloomberg article:
"A net 70 percent of banks involved in the survey expect funding conditions to worsen in the first half of 2012, according to the study. Banks plan to further tighten credit criteria for corporate loans in the first half of 2012, it said.
Commercial banks posted a combined loss of 92.6 billion forint ($428 million) last year, the financial supervisory authority, or Pszaf, said on Feb. 23. OTP Bank Nyrt., the country’s largest lender, competes with Italy’s Intesa Sanpaolo SpA and UniCredit SpA, Austria’s Erste Group Bank AG and Raiffeisen Bank International AG, and Germany’s BayernLB."

Looking at Erste Bank Hungary's latest results, it is not a surprise to see how impaired its lending capacity is given its:
-loan-to-deposit ratio of 192%, the highest in the sector.
-the proportion of non-performing loans in the bank's portfolio rose to 20.5% in 2011 from 11.7% in 2010 (The rate in the retail portfolio increased to 16.3% from 11.4%, while the rate in the corporate portfolio climbed to 29% from 12.5%) according to Bloomberg.

A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse). A solvency crisis can still happen when the loans banks have made turn sour, which implies more capital injections to avoid default (hence the flurry of subordinated bond tenders we have seen). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios.

As a follow up to our previous conversation, the race is on in Europe to improve the loan-to-deposit ratio for peripheral banks given wholesale funding is more challenging, yet improved nevertheless by the two rounds of LTRO. For instance, Lloyds banking group is still a recovery story when it comes to its loan-to-deposit ratio, compared to rock solid Standard Chartered with its 76.4 loan-to-deposit ratio and 11.8 Core Tier 1 capital. Lloyds banking group loan-to-deposit ratio for 2011 was 135%, versus 154% in 2010 and 169% in 2009. Part of the ongoing deleveraging process for banks is supported by the liquidity support and central bank sources (Lloyds took 11.4 billion pounds from LTRO 2).

In relation to systemic risk, credit risk conditions can significantly and persistently be decoupled from macro-financial fundamentals as indicated by Bernd Schwaab, Siem Jan Koopman and André Lucas in their December 2011 paper "Systemic risk diagnostics: coincident indicators and early warning signals":
"We demonstrate that a decoupling of credit risk conditions from macro financial fundamentals has preceded financial and macroeconomic distress in the past with non-negligible lead time (about four quarters).

We mentioned Argentina at the start of our conversation, prior to Argentina defaulting in 2002, as indicated by CreditSights in their 31st of July 2001 paper "Defining the Default Path", they are some interesting similarities to the current Greek and Hungarian situation:
"Should trade finance dry up, the associated reduction in economic activity could be devastating for a country trying to emerge from a deep recession. The second key issue is the behavior of depositors, who have pulled a little over 6 billion US dollars out of the banks this month and are, if press reports are accurate, sending it abroad or stuffing it into the mattresses.
Given Argentina's long history of confiscating wealth (the last time was under ex-president Menem in 1989), the most puzzling aspect of the crisis so far is the relative complacency of the public. This is starting to be tested. The term structure of deposits doesn't bode particularly well, especially as the government has tried to force the banks out longer on the curve than is ideal given deposit withdrawals. We estimate that almost 2/3 of deposits are eligible to be withdrawn in the next 30-60 days and we would be surprised if those deposits that extend in the system were put in time deposits. In addition to the obvious potential of a run on the banks, the lack of liquidity in the system has forced the central banks to provide unprecedented level of repos to the system and also relax reserve requirements. The problem is that this is very unclear whether that additional liquidity is funding anything but capital flight at this point."

Any similarity to actual countries, is purely coincidental...

On a final note, we leave you with Bloomberg Chart of the day, indicating that the induced "LTRO Alkaloid" is at odds with bunds and gold:

"The CHART OF THE DAY compares the Euro Stoxx 50 Index with 10-year German borrowing costs and an inverted gold price. Government bonds and gold are perceived as safe assets in times of financial-market downturns. The equities gauge has gained 9.2 percent this year while gold has climbed 14 percent. Bund yields are little changed since the ECB’s first tender on Dec. 21."

“We cannot have equities at these levels if the European economy needs a further 530 billion euros. People are taking on risk only because the ECB is happy to provide liquidity to banks that are in a dire situation.” - Alberto Espelosin, Ibercaja Gestion.

"There are things known and there are things unknown, and in between are the doors of perception."
Aldous Huxley

Stay tuned!