Macro and Credit - Narrative paradigm

"The first step towards philosophy is incredulity." - Denis Diderot, French philosopher

Watching with interest hard data becoming softer with the latest weak US CPI (-0.3%) and disappointing retail sales falling by 0.2% (0.1% fall expected), when it came to choosing our title analogy we reminded ourselves of the Narrative paradigm, a theory proposed by 20th century scholar Walter Fisher. It stipulates that all meaningful communication is a form of storytelling or reporting of events. It promotes the belief that humans are story tellers and listeners and are more persuaded by a good story than by good argument. Because of this, human beings experience and comprehend life and financial markets as a series of ongoing narratives, each with its own conflicts, characters, beginning, middle, and end. In his theory Walter Fisher believed that all forms of communication that appears to our reason are best viewed as stories shaped by history, culture, and character. The ways in which financial pundits and the Fed have been selling us the "Trumpflation" and "recovery" story justifying the hikes in interest rates have more to do with telling a credible story than it does in producing evidence or constructing a logical argument we would argue, hence our chosen title. These pundits, like the Fed are essentially storytellers and each individual chooses the ones that match his or her values and beliefs. Obviously, the test of the narrative rationality is based on the probability, coherence, and fidelity of the stories that underpin the immediate investment decisions to be made. Unfortunately, these "Jedi tricks" do not function well with us. We must confess that we never bought the strong dollar narrative story that everyone piled into. As of late, the latest raft of hard US macro data has pushed us to revisit a US long duration exposure. It seems to us that US GDP for Q1 2017 is going to be most likely more disappointing than Q1 2016, therefore we have gone with the narrative rationality of MDGA (Make Duration Great Again) from a tactical perspective but we ramble again...

In this week's conversation we would like to look at 

Synopsis:

• Macro and Credit - Foreign bonds allocation - Are the Japanese back in town?
• Final charts - Credit, the only easy day was yesterday...

• Macro and Credit - Foreign bonds allocation - Are the Japanese back in town?

At the end of March in our conversation "Outflow boundary", we argued that it was important to focus on what our Japanese friends such as GPIF, Lifers and Mrs Watanabe were doing in terms of foreign bonds allocations.  At the time we also added:

"The weakness seen since the beginning of the year has reduced the cost of dollar funding, and with US policy in turmoil in conjunction with prospects for slower US growth than anticipated, there is a chance to "make duration great again" we think in the current "Outflow boundary" environment" - source Macronomics, March 2017

We also note that our tactical bullish US long bonds allocation since our recent post was validated:

"Now, if US long bonds yields such as 30 years continue receding, then indeed our contrarian stance of once again dipping our toes in long duration exposure (ETF ZROZ - TLT) and adding to Investment Grade credit with higher duration as well could be tactically enticing. We are watching closely the 3% level on the 30 year." - source Macronomics, March 2017

With the 30 year US bonds now at a yield of 2.89% supported mostly by geopolitical woes in conjunction with recent weaknesses in hard data such as CPI and retail sales. As we pointed out in our recent musings including our most recent one, we were eagerly anticipating a return of the Japanese investment crowd in US Treasuries and US credit thanks to an improving cross-currency basis. We also highlighted last week that European domiciled accounts had been front-running the Japanese investment crowd, which has now entered its new fiscal year. The big question one might ask in the current "Narrative paradigm" is as follows: are the Japanese back in town when it comes to their foreign bonds purchases?

One clear trend seen in recent years has been Bank of Japan's QE programme between December 2012 and June 2016 which has enticed large inflows into the US bond markets as displayed in Nomura FX Insights note from the 10th of April entitled "Where has the ECB QE Money gone":

- source Nomura

Is this time going to be different? We wonder. There is currently a clear avoidance in terms of allocation by the Japanese investment crowd for French Government bonds given the looming French elections. There is as well prevailing uncertainties from the new US administration when it comes to fiscal policies. What appears to be the case is that the current level of uncertainties is clearly slowing the return of the Japanese crowd this time around.

Also, the recent bout or "risk-off" with USD/JPY trading through the significant 110 level is somewhat probably dampening the velocity in the return of this specific investment crowd. On this subject we read with interest Bank of America Merrill Lynch Liquid Insight note from the 13th of April entitled "New fiscal year, new flow":

"New fiscal year, new flow

Japan entered the new fiscal year this month. Last week, we argued JPY strength may be overdone and that the USD/JPY’s medium-term uptrend has not ended despite a near-term possibility of further technical sell off through 110 where we stop out (Is JPY strength justified? 105 first or 117? 07 April 2017). In our view, global risk events may not fully explain the extent of JPY strength, and flow dynamics could have been behind the JPY strength. With new data from the balance of payment statistics, we argue the demand/supply balance of USD/JPY should be improving especially after an eventful April.

Japanese money in the new fiscal year

We have seen a notable slowdown in foreign securities purchases by Japanese investors since the US election in November (Chart of the day).

The slowdown probably reflects position unwinding among bank accounts and a wait-and-see stance among the Japanese real money community amid a volatile Treasury market in the final months of the Japanese fiscal year (Chart 1-Chart 2).

Banks could continue to unwind Treasuries, but it would involve little FX impact as they usually fund these investments in the USD, unlike real money accounts we discuss below.

Lifers – more USD buying

There is a seasonality of increased foreign bond purchases by insurance accounts during the early part of Japanese fiscal year. This year, we observe (1) rising yields in the JGB’s super long sector, but still at a relatively low level; (2) lower FX hedge cost; and (3) higher US yields, and (4) a lower USD/JPY (Chart 4).

True, it is unlikely they would be very aggressive in unhedged foreign bond investments as investors would balance across JGBs, hedged foreign bonds, and unhedged foreign bonds. For now, the USD/JPY at 110 may not attract strong demand, but we believe the USD demand will increase in the next few months once we go through April full of risk events or if we get renewed optimism for the US tax reform.

Trust accounts – market stabilizer

Trust accounts continued to sell rising assets and buy falling assets last quarter as the GPIF portfolio has presumably been close to its target for some time (Chart 5).

Going forward, a traditional risk-off market, as we currently observe, would likely be met by selling of domestic bonds (and potentially foreign bonds) and buying of domestic and foreign equities by pension funds. Reflation trade would be met by selling of foreign and domestic equities and buying of foreign bonds (and potentially domestic bonds) by pension funds.

Exporters’ hedging

Another source of the earlier USD/JPY weakness may have to do with Japanese exporters’ hedging activity into the fiscal year-end. Japan’s trade balance has been rising in light of stable oil prices and rising real exports (Chart 7).

There is a possibility the final months of the fiscal year generated additional USD selling.

As FY17 starts, we think corporate hedging should be more orderly, unlike last year. According to the BoJ’s tankan survey, large manufacturers had assumed an average USD/JPY rate of 117.5 heading into FY16, while the year actually opened at 112s, which led to a severe USD selling pressure last April, in our view (Revisiting the dollar’s 100 yen scenario 07 April 2016). This year, corporates assume an average USD/JPY rate of 108.4 (Chart 8).

Though this may suggest some near-term pressure, the assumption itself seems conservative, in our view. While the improving trade balance may support the JPY over the medium-term at margin, we believe corporate USD selling will be spread out and less intense this year." - source Bank of America Merrill Lynch

Whereas the Narrative paradigm has been so far seen in renewed optimism for US tax reform, the latest raft of hard data makes us wonder how many weeks before we seen again "Bondzilla" the Japanese NIRP monster's appetite return. Our current stance, given the weaker tone in both geopolitical rising tensions in conjunction with a much softer tone in hard data, has pushed us, was we indicated earlier on in our conversation to play the duration game again, in effect front-running the Japanese investment crowd before they are back in town, yet this time around in 2017 with a delay we think. On that point we agree with Bank of America Merrill Lynch's conclusions:

"Flow in the new fiscal year will likely put widening pressure on JPYUSD basis but the magnitude will be less this time

As highlighted above (and here), lifers are expected to start investing in foreign bond markets after the French election, but in the early part of the Japanese fiscal year. Lifers’ outward flow usually pushes JPYUSD basis wider as they try to hedge FX risk. This will likely be no different this time, but we expect the widening pressure will be less and it would be difficult to see JPYUSD basis go wider to last year’s level. At the current level of USDJPY, lifers will be more open to keep their foreign bonds unhedged and some of the contributing factors to the tightening of USDJPY basis since the start of the year are structural." - source Bank of America Merrill Lynch

No doubt the Lifers will come into play in terms of their foreign bonds allocations, and this will also have some impact in the already volatile USDJPY currency pair. What is of interest of course, when it comes to the "Narrative paradigm" is that there are already early signs of the Japanese investment crowd dipping their toes back into foreign bonds as indicated by UBS in the Global Rates Strategy note from the 10th of April entitled "What Japanese Investors Are Buying":

"French bonds overtake US Treasuries as main force behind Japanese selling Japanese investors' post-US presidential election trend of considerable net selling of overseas bonds continues. Weekly flow data underscores how Japanese investors sold ~¥5.4 trillion of foreign bonds from the time of the election to the end of Mar-17.
Today's more granular data release of which individual sovereign bond markets were bought and sold in Feb-17 highlights that French bonds have overtaken US Treasuries as the main force behind the overall selling pressure. This suggests that political risks as of February overshadowed the increasingly attractive currency-hedged pick-up over JGBs offered by French bonds. Separately, we note that the last week of Mar-17 saw the largest net purchases of overseas bonds in six months. However, as this follows the typical pattern around Japan fiscal year-end (.Figure 4), we would caution interpreting this as a sign of a sustainable rebound in Japanese demand for overseas bonds.

 - source UBS

While, yes it might be seen as too early to embrace yet the "Narrative paradigm", in the light of the recent weakness in both the US dollar and hard macro data, we would rather be a little bit early and start tactically adding at least on the long end of US Treasuries, rather than wait for additional signs from the Japanese investor crowd. Some says fortune favors the brave, we would posit that in most occasions it favors the bold contrarian but we ramble again here.

Finally, for our final charts below, as we posited in previous conversations, when it comes to the situation in credit and in particular in 2017, we would rather go for US credit, given it seems to us that Euro High Yield is "priced to perfection" and when it comes to US High Yield we closely follow what oil prices are doing and much less sanguine than we were back at the end of 2015. Yes, the credit cycle seems to be turning, but, it is slowly turning.

• Final charts - Credit, the only easy day was yesterday...

Whereas the second part of 2016 saw a very significant rally in general for US High Yield and in particular for the US energy sector, the rally so far this year has been significant as well, making us wonder if there is any "juice" left given the performance so far. Yet something we would agree with Barclays from their Global Strategy Chart book from the 10th of April is that when it comes to credit we would favor US Investment Grade over Euro Investment Grade. On top of that agreement we also think that, when it comes to credit overall, the only easy day was yesterday:

"Credit was strong in 2016n but easy gains likely behind us" - source Barclays

As we pointed out, foreign demand remains key to not only US credit but as well for US Treasuries, so overall, let's see if indeed the Japanese Investment crowd and Bondzilla the NIRP monster find again their appetite while the "Narrative paradigm" surrounding the "Trumpflation" story fades away.

"Skepticism is a virtue in history as well as in philosophy." -  Napoleon Bonaparte

Stay tuned!

Macro and Credit - Outflow boundary

"It was one of those March days when the sun shines hot and the wind blows cold: when it is summer in the light, and winter in the shade." -  Charles Dickens

Watching with interest the inflows pouring into short term Investment Grade credit funds, somewhat validating, the defensive posture we have been discussing as of late, we reminded ourselves for our title analogy of the concept of "Outflow boundary". An "Outflow boundary" also known as a gust front, is a storm-scale or mesoscale boundary separating thunderstorm-cooled air (outflow) from the surrounding air, similar in effect to a cold front. While outflows boundaries can persist for 24 hours or more after a thunderstorm, with passage marked by a wind shift and usually a drop in temperature and a related pressure jump, in similar fashion outflows in funds can persist for a specific amount of time. Also "Outflow boundaries" do create low-level wind shear which can be hazardous during aircraft takeoffs and landings, so if you are indeed piloting in similar "market conditions", you need to be extra cautious, and probably embrace somewhat a contrarian stance, at least from a long duration perspective we think.

In this week's conversation we would like to look at the oil fueled decompression in credit, and why we are turning more positive when it comes to going long US duration, which will be supported flow wise by a return of the Japanese crowd thanks to better cross-currency basis.

Synopsis:

• Macro and Credit - Front-running our Japanese friends?
• Final chart - Beware of "credit" repatriation

• Macro and Credit - Front-running our Japanese friends?

While we have long argued that in recent years you had to focus on what our Japanese friends such as GPIF, Lifers and Mrs Watanabe were doing in terms of allocations, given we are moving towards the end of the Japanese fiscal year, we are wondering if we are close to the "Outflow boundary" as many of them have shun foreign bonds lately. Could this time be different? 

It was only a matter of time before the weakness in oil translated into a weakness in credit, hence the fund outflows we have discussing about in our recent musing and our argument relating to High Yield being "priced to perfection" hence our recommendation to seek refuge in US Investment Grade. This outperformance of Investment Grade credit in conjunction with the weakness in oil has been clearly described by DataGrapple in their recent blog posting from the 24th of March entitled "Oil-Fueled Decompression":

"After a few months a stability, oil experienced a tumultuous month of March. Over the last four weeks, it has slid more than 10% amid supply woes. Russia’s policy makers are leaning on the cautious side. They said they were using below consensus estimates - $50/barrel on average in 2017, falling to $40/barrel at the end of 2017 and then staying near that level during the 2 following years – to establish growth forecasts in an economy still driven by oil to a large extent, adding to the market nervousness in doing so. That certainly goes a long way in explaining the underperformance of the energy heavy CDX HY compared to its investment grade benchmark equivalent, CDX IG. Since the 24th February, CDX IG series 27 – series 28 did not exist at the time – has tightened by 3bps to 60bps, while CDX HY series 27 has widened by 7bps to 327bps. Using a standard beta and thus assuming 1bp of CDX IG is equivalent to 5bps of CDX HY, it means HY has underperformed IG by almost 1 percentage point in cash price over the last 4 weeks." - source DataGrapple

In terms of oil and US High Yield with a correlation of 0.72, it makes sense from a Total Return perspective to see a relationship, particularly given the significant weight of the Energy sector in US High Yield indices:

- source MacroCharts

Of course flow wise, recent weeks saw a defensive rotation on the back of the weakness in oil prices as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 24th of March entitled "Rising risk of outflows out of short-term funds":

"Forsaking duration vs reaching for yield

Despite the significant risk-on we have seen across risky assets in the past weeks, inflows continue to pile into short-term IG funds. Total returns are turning negative over the past weeks (chart 1), and this increases the risk of outflows hitting IG funds in Europe. 2y bund yields have re-priced significantly higher since late February. The flattening of the yield curve is not supportive either. EM debt funds continue to attract interest as dollar slips lower.

Over the past week…

High grade funds flows remain on the positive side for the ninth week in a row. Even though flows are still strong, the pace is weakening lately. High yield funds flow remained negative for a second week, however the outflow was less more than halved w-o-w. Looking into the domicile breakdown, as charts 13 and 14 show, the largest part of the outflow came from euro-focused and US-focused HY funds. The globally focused funds were almost flat last week.

Government bond funds flows remained on negative territory for the fourth consecutive week, recording over $3.5bn of outflows over that period. Money market funds weekly flows remained positive for a third week, but the inflow was marginal. Overall, fixed income funds flows flipped back to positive territory after a brief week of outflows. European equity funds flows were negative for a second week, with outflows picking up w-o-w. However these outflows are significantly smaller than what we have experienced in 2016.

Global EM debt fund flows continued on a positive trend for an 8th week. The latest inflow was the highest in 34 week as dollar continued to weaken. Commodities funds recorded their second week of inflows.
On the duration front, strong inflows continued in short-term IG funds for the 14th week in a row recording the biggest inflow in this part of the curve since July ‘14. Mid-term funds posted a second outflow in a row, the largest outflow in four weeks. Flows in long-term funds remained slightly positive for a second week." - source Bank of America Merrill Lynch

When it comes to oil woes and High Yield weakness, it remains to be seen if indeed we are going through an "Outflow boundary". As pointed out by Deutsche Bank's US Credit Strategy Sector Themes from the 24th of March, High Yield's weakness apart from outflows, seems to be continuing and worth monitoring given its correlation with equities (more on this below):

"HY weakness persists, despite slower issuance, stable oil

The HY bond market has repriced noticeably this month, having seen its spread widening from the lows of 368bps reached on March 2 to 423bp today. It started with weakness in the higher-quality segments of the index, before extending itself down the quality spectrum. At the end, CCCs have lost 2.6% in excess return, compared to 1.4% in BBs in March, while maintaining about a 2pt lead for the year.

A record-setting streak of eight-day outflows from ETFs earlier this month claimed 7.2% of their AUM, compared to 6.7% in withdrawals in the immediate aftermath of the Third Ave fund failure in Dec 2015. Eventually the outflows extended to broader fund space, claiming a couple of $1bn+ days of heavy withdrawals, which continue to this day.
Issuance has slowed down noticeably in recent days, after breaking some records leading to the Fed meeting. This suggests it only had a limited contribution to HY weakness at that point in time. Similarly, HY temporary bounce a week ago was happening in the background of WTI trading close to its recent lows, also supporting our view that oil had only a limited impact on spread widening. We think it is mostly about repricing longer-term rates and growth expectations. IG spreads remained broadly unchanged March, oscillating around 120bp.

The global yield environment is shifting fast

The yield on Bloomberg’s Global Agg index has jumped by 20bps between late February and the Fed’s meeting, reaching 1.75% at its peak before giving back a few basis points since then. To put things into perspective, these 20bps represent 2/3rds of its increase between the US election and year-end. We think this datapoint is a key aspect of what drove HY weakness in recent weeks, as the reach for yield trade can only survive in the environment of lack of global yield opportunities, and every basis point of increase in that benchmark’s yield equals $4.6 of incremental income produced in a year. In an average month, global HY market produces $12bn of income, and in the middle of last year this number stood for a quarter of total income produced by the Global Agg. At any point in time between Brexit vote last June and US election in November, investors were willingly accepting lower yields on their EU IG holdings than they can currently get in the German 10yr bund." - source Deutsche Bank

As we pointed out recently, the performance for High Yield since the "Trumpflation"trade has been impressive to say the least. This is also pointed out by Deutsche Bank's report:

"HY vs IG

HY spreads have tightened dramatically post the US election, setting a low print of 368bp in early March, or almost 150bp below their level on Nov 8. In the meantime, IG spreads have only tightened by 20 bps to 118bps. The 1:7.5x relationship between IG and HY we experienced over the past few months breaks the historical norm of around 1:3.5x between these two asset classes.

A tight relationship that exists between these two asset classes has been pushed to the limit in early March, as Figure 2 demonstrates.

This resulted in the error term (actual vs estimated HY spread based on regression vs IG) of -75bps, matching its cyclical tights.

Going forward, we expect this tight relationship (85% r-squared) to reassert itself, resulting in relative excess return underperformance in HY. While the normal historical spread beta between IG and HY spreads is 1:3.5x, the excess return beta is only 1:1.5x (a function of shorter HY effective duration). As such, we use this 1.5x beta as the weighting for the IG leg of this positioning recommendation. One easy way to execute on this trade would by using ETFs: LQDH is a rates-hedged version of LQD, and HYGH is an equivalent in HY. We recommend shorting $1 of HYGH vs going long $1.5 of LQDH.
HY CDX is trading much closer to IG CDX based on a similar regression analysis, implying little potential value in replicating this trade there. Also, an extension of this recommendation to total returns is challenging, given our expectations for higher rates. IG is more likely to underperform HY in total return terms in that scenario." - source Deutsche Bank

We agree with the above, namely that the weakness in US High Yield is likely to persist further. and, this represents as well some headwind for our equities friends out there. Why is so, just a simple correlation close to 1:

- source MacroChart

In case you are asking, it just shows you that High Yield, isn't that much of an "alternative" asset class, as put forward by some pundits. So really please tell us where your potential for diversification is? Because,  when it comes to High Yield, we do not see it hence our "Outflow boundary"analogy.

But, the big question, as we await the allocation decision from our Japanese friends, if there will be enticed again by foreign bonds like they have in recent years. The weakness seen since the beginning of the year has reduced the cost of dollar funding, and with US policy in turmoil in conjunction with prospects for slower US growth than anticipated, there is a chance to "make duration great again" we think in the current "Outflow boundary" environment. This is as well put forward by Bank of America Merrill Lynch in their Credit Market Strategist note from the 24th of March entitled "Hedging costs in the driver seat":

"Hedging costs in the driver seat

We feel increasingly confident about our bullish outlook for high grade credit spreads, as well as our 10s/30s spread curve flattener. But our 5s/10s flattener is challenged. Volatility from policy risks aside the technicals of the high grade corporate bond market are about to improve. This is because of sharp further declines in the cost of dollar funding for foreign investors (Figure 1), as US policy gridlock dampens the outlook for accelerating economic growth.

Recently this has been particularly pronounced for Japanese investors – perhaps due to liquidation of foreign assets toward the end of their fiscal year (March 31st, Figure 2).

This, along with the shift higher in US interest rates and continued decline in interest rate risk (Figure 3), come conveniently just ahead of the new Japanese fiscal year where their foreign bond buying steps up significantly.

Higher inflows …

That also means continued strong inflows to high grade bond funds and ETFs, as we have argued these are presently driven by foreign investors. This is because we are seeing record inflows in a time with poor bond price performance, which contrasts with the typical historical pattern where bond fund inflows are driven by retail investors chasing performance (Figure 4).

Furthermore the acceleration in inflows began at the time dollar funding costs declined early this year, and further accelerated after the Chinese New Year.

… but in the curve

While our bullish outlook for credit spreads welcomes the decline in the cost of dollar funding, as inflows accelerate, our 5s/10s spread curve flattener does not. This is because of the high degree of yield sensitivity of foreign demand, which means that the cost of dollar funding is a prime determinant of how far out the steep maturity curve they must reach. Hence the declining cost of dollar funding this year is allowing many foreign investors to reach their yield bogeys at shorter maturities in the US corporate bond market this year compared to the last part of last year. This is why the dealer-to affiliate volumes show a large increase in 3-7 year foreign buying this year, which is the key reason for the steepening bias in 5s/10s spread curves (Figure 5).

However, as foreign inflows accelerate we expect the cost of dollar funding to rebound and again send foreign investors out the curve, generating flatter 5s/10s curves." - source Bank of America Merrill Lynch

Obviously the big question coming up is relative to Japanese foreign bond buying. Is this time different? Are we going to see them return in drove to US Investment Grade?

On this very subject we read with interest Nomura's take from their Japan Navigator note number 713 entitled "Buying lower-rated credit instruments or adding currency-market exposure?":

"On supply and demand, we believe domestic investors are unlikely to aggressively add duration in determining their FY17 portfolios, either in yen or (currency-hedged) foreign bonds, in light of substantial losses that they incurred in these markets in FY16.

For these investors, increasing purchases in foreign credit markets may be an option. Assuming this, the recent narrowing of USD/JPY basis may look positive for their flows into these markets, but this is also a result of the narrowing difference between credit spreads in the US and Japan (Figure 2), which makes their aggressive (currency-hedged) buying of US corporates unlikely, particularly as the Fed hike will likely prompt a widening of the difference between short-term rates in the US and Japan (Figure 3).

This leaves Japanese investors options of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During the previous 2004-06 Fed rate hiking cycle, life insurers lowered the ratio of currency hedged investments (Figure 4).

Currency hedging costs and Japanese foreign bond investment

More investors appear to be converting USD to JPY USD basis has been tightening, not only to JPY but also to all key currencies, meaning the tightening of USD/JPY basis is not specific to JPY (Figure 5).

We also note that USD/JPY has tightened more in short-term tenors (Figure 6), which we attribute to a reversal of the sharp widening into end-2016.

USD funding tightened on MMF reforms in the US and concerns over Fed hikes. We believe the widening trend has been reversed as the market has recognized there is greater USD supply than expected. In addition, the recovery in EM currencies likely lowered the need for USD (Figure 7).

Coupled with the recent tightening of supply and demand in short and intermediate tenors of the JGB market (Figure 8), these factors suggest to us a wider range of investors are converting USD into JPY for yen bond purchases.

Basis swaps appear to provide global investors one of the few opportunities to earn low-risk returns now that central bank tightening has reduced the range of such options. This explains why USD/JPY basis has not widened to the extent we saw in late 2016, even as the Fed continued to lay the foundation for a March hike. Investors looking to buy currency-hedged foreign bonds may well take this opportunity.

Cheaper USD may not lead to an increase in Japanese investor flows into foreign bonds

That said, Japanese investor flows into foreign bonds are unlikely to pick up just because of cheaper USD funding, as the recent tightening of USD basis – particularly in long tenors – reflects the narrowing difference between credit spreads in the US and Japan (Figure 2). Specifically, the difference between the spreads of A-rated corporates in the US and Japan has narrowed to levels that no longer cover USD-hedging costs.

In addition, we believe the recent narrowing of USD/JPY basis likely reflects a decline in Japanese investors’ appetite for foreign bond investments, as the difference between short-term rates in the US and Japan is widening while the Fed is increasingly likely to hike more aggressively than was initially expected." - source Nomura

If indeed the Fed decides to have a more aggressive tightening stance, as we posited in our last conversation when it comes to our Swiss Wall analogy and path outcomes, then indeed Nomura could be right. But, as we stated in our last conversation, the dovish tone of the Fed might be linked to the recent weakness related to Commercial and Industrial lending (C&I). This is worth monitoring from a "credit impulse" perspective.

In relation to Nomura's take on the recovery in EM currencies lowering the need for USD, we will closely be watching oil prices and its relation with Asian currencies in particular. There is a significant correlation over time. Where oil goes, Asian currencies follow:

- source MacroCharts

Now, if US long bonds yields such as 30 years continue receding, then indeed our contrarian stance of once again dipping our toes in long duration exposure (ETF ZROZ - TLT) and adding to Investment Grade credit with higher duration as well could be tactically enticing. We are watching closely the 3% level on the 30 year.

One thing that appears clear to us is that in recent years, USD corporate credit in recent years has been supported by a large contingent of foreign investors. It remains to be seen how long the ECB and the Bank of Japan (BOJ) will remain accommodative when the Fed is about to take a way the punch bowl as per our final chart below.

• Final chart - Beware of "credit" repatriation

While we do think renewed signs of volatility could impact High Yield, we agree with most sell-side pundits that a move towards "quality" could be warranted and therefore US Investment Grade could provide some buffer. Our final chart comes from Wells Fargo Global Corporate Credit Outlook for Q2 2017 published on the 24th of March and entitled "Hope is not a strategy". This final chart displays Non-US Demand for US Credit and clearly highlights the risk of "repatriation", if there is a trend reversal for US credit demand from foreign investors:

"If the ECB and others start to follow the Fed's lead and move away from their extraordinarily easy monetary policies and front-end yields start to move toward a positive rate, then global flows could shift dramatically. We estimate that about 40% of the $8.5 trillion USD corporate credit market is held by non-U.S. investors with about 30% held in Europe and 10% held in Asia. For these investors, price sensitivity is determined by creditworthiness, interest rate movements and foreign exchange movements. If interest rates start to rise and the USD weakens, then non-U.S. investors would experience material mark-to-market losses and may start to repatriate their funds. Admittedly, this is more likely a risk for the second half of this year, but given the dramatic inflows into USD credit from overseas investors over the past several years, a reversal of the trend could be quite jarring to the market." - source Wells Fargo

For now the "Outflow boundary" seems to hold (low level wind), for the second part of the year, we do remain relatively cautious, yet, tactically we think adding duration is starting to become enticing on a risk of renewed turbulences and volatility in the short term.

"Political language... is designed to make lies sound truthful and murder respectable, and to give an appearance of solidity to pure wind." - George Orwell

Stay tuned!

Macro and Credit - The Swiss Wall

"When things are steep, remember to stay level-headed." - Horace

Looking at the consequences of a finally Dovish Fed leading to a significant rise in gold and gold miners, with a continuation of the rally in risky assets, given we have been vacationing in the French Alps, it reminded us, this time around for our title analogy about a steep and difficult piste in the Portes du Soleil ski area, on the border between France and Switzerland called Le Pas de Chavanette, also called the Swiss Wall. 

This particular slope is classified in the Swiss/French difficulty rating as orange, which means that it is rated as too difficult to fit in the standard classification of green (very easy), blue (easy), red (intermediate) and black (difficult). It has a length of 1 kilometre and a vertical drop of 331 metres, starting at 2,151 metres above sea level. In similar fashion, if indeed the Atlanta Fed's Q1 US GDP estimate is estimated at 0.9% and the Fed continues with its "normalization" process, while there are some early signs of credit slowing, then in similar fashion to those who have experienced skiing on the much dreaded Swiss Wall (like ourselves) will know that this particular "slope" or normalization process, can quickly become hazardous, to say the least. The scary Swiss Wall starts in a narrow pass on the mountain top with an inclination of 40 degrees. The initial 50 metres have to be skied or boarded by everyone taking Le Pas de Chavanette. Especially without fresh snow, the slope gets icy quickly, turning the area between moguls into ice sheets. Not making a turn in these situations means that you miss the next mogul, and pick up too much speed to make the next one after that, starting off a tumble that ends a couple of hundred metres down the slope, while hitting a few dozen icy bumps in the course. By having kept interest rates, too low for too long, and given the Fed's propensity of being often behind the curve (or the slope), means, when it comes to our chosen analogy that markets could potentially tumble, hence the defensive outflows seen as of late from High Yield where the punters (or skiers) are aware of the difficulties that lie ahead of them. In similar fashion, on the Swiss Wall, after the initial very steep stretch, the choice can be made, up until the rocky passage in the direct path, to escape to the less steep left hand side of the slope, where a stumble is less dangerous. The direct path down Le Pas de Chavanette, to the right hand side and down the rocky passage, should only be taken by very experienced skiers and riders who know how to handle moguls, as it is effectively a continuation of the first 50 metres. As the slope eases out, it is easier to negotiate the moguls and make a single run down to the end, although the inclination and bumps still call for significant dexterity and physical strength. It remains to be seen, which path the Fed will decided to take and how experienced skiers they are when it comes to take the very slippery slope of the interest rate normalization process. In similar fashion to skiers venturing on the Swiss Wall, wearing protective gear like a helmet and a back protector is highly recommended. Same things goes in these "inflated" markets we think.

In this week's conversation we would like to look at how global financial risks can be driving spreads, in conjunction with near term political risks.

Synopsis:

• Macro and Credit - Taking the Investment Grade path where a stumble is less dangerous
• Final chart - USD likely to weaken given current position in historical tightening cycle

• Macro and Credit - Taking the Investment Grade path where a stumble is less dangerous

While there has been a continuation in the performance of risky assets and in particular equities on the back of the Fed's rate hike and a somewhat more dovish tone, in terms of outflows, there has been a continuation of a defensive stance building up in credit, leading to a rotation from High Yield towards Investment Grade. We do remain short term "Keynesian" when it comes to credit and in particular Investment Grade, yet we are cautious on a longer time frame due to the leverage accumulated thanks to cheap credit which funded buybacks on a grand scale, weakening in the process corporates' balance sheets. In similar fashion to skiers on the Swiss Wall, as of late investors have chosen to take the less steep left hand side of the slope, where a stumble is less dangerous. This can be seen in fund flows as reported by Bank of America Merrill Lynch from their Follow the Flow note from the 17th of March 2017 entitled "Quality yield inflows as political risks near":

"Cautious flows 

Heading to the Dutch elections, investors preferred to look for quality yield. Inflows into high grade bonds strengthened considerably, while outflows hit HY funds particularly hard. Equity funds suffered light outflows, as equity investors wanted to be light heading to the Dutch elections. However, we feel that post the strong risk-on moves yesterday, part of these flows should reverse back to high yield and equity portfolios. 

Over the past week… 

High grade funds continued on the same positive trend of late for the eighth week in a row; and recorded an inflow as strong as the one a week ago. Monthly data reveal that February flows were the strongest in 6 months. High yield funds flow dipped into negative territory; making last week’s outflow the largest in 32 weeks. Looking into the domicile breakdown, among the European HY domiciled funds the ones that focus on US and European HY were the ones that recorded the vast majority of the outflows, while outflows from globally-focused funds were marginal. HY monthly flows remained positive for a third month in a row. 

Government bond funds flows remained on negative territory for another week, recording a sizable outflow, the largest in 12 weeks. Money market funds weekly flows remained positive for a second week. Overall, fixed income funds flows flipped back to negative after 11 weeks of inflows. However February data reveal that FI funds recorded the strongest inflow in six months. European equity funds flows flipped back to negative territory, recording relatively mild weekly outflows. Monthly flows remained relatively muted in February for a third month in a row for the asset class.

Global EM debt fund flows continued on a positive trend for a 7th week. The asset class has seen ~$14bn of inflows YTD. Commodities funds flows flipped back to positive. On the duration front, strong inflows continued in short-term IG funds for the 13th week in a row. Mid-term funds posted a small outflow, while flows in long-term funds flipped to a marginal positive figure after three weeks of notable outflows. " - source Bank of America Merrill Lynch

There has been definitely a scare in The Swiss Wall of investing when it comes to High Yield as reported by Bank of America Merrill Lynch in their High Yield Flow Report entitled "The outflows continue":

"Largest outflows from HY since Ukraine; 3rd largest ever 

US HY recorded a $4.06bn (-1.7%) net outflow last week, the largest since August 2014 and 3rd largest of all time. This brought the YTD total back into negative territory at - $3.3bn (-0.9%) through Wednesday. Whereas last week’s $2.8bn in redemptions were driven mostly by HY ETFs, open-ended funds bore the brunt of this session’s outflows with a $3.1bn (-1.6%) net loss. Similar to the aggregate high yield figure, this was the largest outflow from open-ended funds since the Ukrainian plane crash in the summer of 2014.

Although there has not been one cataclysmic event to cause the recent burst of outflows, they have likely been driven by a combination of higher rates, renewed fears over another dip in oil prices, and a fatigued rally that pointed towards a reluctance to continue investing in high yield. These withdrawals have pulled down returns in March, which currently stand at -1.4% through the 15th. Non-US HY also recorded a sizeable outflow totaling -$1.64bn (-0.6%) last week, their first period of net redemptions since November." - source Bank of America Merrill Lynch

If indeed investors (or skiers) have been on the cautious side prior to the FOMC rate hike decision, hence their rotation towards a more defensive position, we are awaiting to see if the Japanese investors crowd such as the gigantic GPIF and Lifers will come back to play with their foreign bonds allocations as they should be enticed by higher yielding US investment grade once more. What we also find of interest relating to our analogy is that investors and skiers alike, given the Fed's dovish tone, are encouraged by some sell-side pundits to take the right hand side and down the rocky passage of the Swiss Wall of investing namely in "equities". So far this year as indicated by Bank of America Merrill Lynch in their Fixed Income Weekly Strategy note from the 17th of March, this strategy has been vindicated:

 - source Bank of America Merill Lynch

Yet, from a valuation perspective and given current US valuation levels reached, from a skiing perspective and thanks to the Fed's dovish tone as of late, we would therefore rather go for EM equities if we had to make this choice down the slope of the Swiss Wall of investing. The bullish "skiing" stance down the Swiss Wall of investing is as well put forward by Bank of America Merrill Lynch in their Relative Value Strategist note from the 13th of March entitled "In the realm of diminishing returns":

"Don’t be a hero 

Despite the wobble in risk assets over the last week, credit indices are close to their post-crisis tights. And after the strong jobs report, we think the near-term path of spreads is likely to lead them further towards these lows, post-FOMC and the March CDX roll. That said, in our view credit as an asset class is now past its prime; at these valuations, we believe we are entering a realm of diminishing returns. In fact, as our analysis shows, returns in either direction aren’t likely to be large enough to warrant significant, outsized positions. In our view, if there ever was a time to step back, clip coupon, accumulate small gains and focus more on avoiding blow-ups, it is now. 

Great or not, the rotation is here 

If you’re bullish, we think the risk-return payoff in equities is far more compelling than in credit. In particular, we like being long S&P 500 vs. short in a HY cash index product (hedged for rates). Over the last 7y, in excess return terms, corporate bonds have failed to consistently generate returns that would overcome the losses during bad times. The upside vs. downside payoff looks far better in equities and CDX than in corporate bonds. Going forward, if the economy remains on this trajectory, the equity market is likely to continue outperforming credit. The prospect of higher rates is more favourable to equities, while in HY, negative convexity will likely cap any significant capital appreciation here on. On the downside, certain tax policy proposals which aren’t being priced in, namely borderadjustment tax and the elimination of interest-rate deductibility, are likely to have a significant negative impact on both equities and credit if implemented. Within credit, we think high yield companies are more susceptible than HG names and a short in HY cash is likely to provide a good offset to a SPX long from a policy risk perspective. 

Upside, downside, and in between 

For those looking for a credit long, medium/long term, we think CDX HY is a good candidate. While this may seem non-intuitive at first glance, we think technical issues with the index will continue to mean that it is often less volatile than either IG or its cash counterpart. Over the last 7y it has provided better risk-adjusted returns than either. For those bearish credit in the near-term (3-6m), we think it best to wait to set CDX shorts (IG or HY), at wider levels, just as the sell-off begins to gain momentum. Historically, shorts at current levels haven’t had a significant pay-off over 3m, despite wider spreads. Finally, we reiterate our preference for positive basis positions i.e. long CDX or synthetics over cash indices/bonds." - source Bank of America Merrill Lynch

We do agree with Bank of America Merrill Lynch, that, for bolder skiers, going for the synthetic option for playing High Yield makes sense first because of the liquidity factor provided by the index, second because of the lower duration factor compared to cash.

Of course, like any difficult slope, it can always get trickier on the ever changing Swiss Wall of investing. The rally can continue thanks to a dovish tone from the Fed which would be supportive of EM asset classes and put pressure on the crowded long US dollar positions. When it comes to credit, we do agree with Bank of America Merrill Lynch's take, that we are getting closer to the lower bounds of credit spread, even with the technical support of lower supply in the primary markets:

"In the realm of diminishing returns 

Credit spreads, unlike stock prices, have a lower bound (notwithstanding the recent spurt of negative spread bonds in Europe). We’re aware that we trot this statement out every now and then, as credit benchmarks approach previous tights, but it is a point worth bearing- the payoff in credit becomes more asymmetrical at tighter spread levels. Despite the wobble in risk assets over the last week, credit indices are close to their post-crisis tights, reached in June of 2014. And after the strong jobs report for February, the near-term path of spreads is likely to lead them further towards these lows. Over the coming weeks, we think there is potential for spread compression, post-FOMC and also into the March CDX roll. 

In last week’s HY Wire, we noted the similarities between now and the first half of 2014. Of course, back then geopolitics and oil prices poured cold water on the rally by the third quarter and that set the stage for high volatility and poor returns for the next two years. For this year too we think the second half has the potential to turn sour as disappointment with legislative progress in Congress starts weighing on the market. As we wrote last month, it seems as if all the good has already been priced in, with little to account for the bad. That said, it is difficult to pinpoint what will eventually make the market turn and more importantly, when. There’s also the possibility, that the underlying strength in the economy and confidence keeps risk assets buoyed for much longer. 

In our view what is perhaps more certain, is that credit is now past its prime; at these valuations, we think we are entering a realm of diminishing returns. In fact, as our analysis shows, returns in either direction aren’t likely to be large enough to warrant significant, outsized positions. This is well reflected in our HY returns forecast for the year – around 6% - and even better in our year ahead title – ‘Don’t be a hero’. If there ever was a time to step back, clip coupon, accumulate small gains and focus more on avoiding blow-ups, we think it is now. 

• If you’re bullish, we think the risk-return payoff in equities is far more compelling than in credit – consider long S&P 500 vs. short in HY cash.
• For those looking for a credit long, medium/long term, we think CDX HY is a good candidate. While this may seem non-intuitive at first glance, we think technical issues with the index will continue to mean that it is often less volatile than either IG or its cash counterpart. Over the last 7y it has provided better risk-adjusted returns than either.
• For those bearish credit in the near-term (3-6m), we think it best to wait to set CDX shorts (IG or HY), at wider levels, just as the sell-off begins to gain momentum. Historically, shorts at current levels haven’t had a significant pay-off over 3m, despite wider spreads.
• Finally, we reiterate our preference for positive basis positions i.e. long CDX or synthetics over cash indices/bonds." - source Bank of America Merrill Lynch

In our Swiss Wall of investing, when there is plenty of snow, the path downhill is easier on both side of the slope. But, as conditions changes and when the snow melts away at the end of the season, leading to some icy parts forming, not only it gets trickier even for the experienced skier like ourselves, but you need to chose your path more wisely according to the weather conditions. At this stage of the credit cycle, it becomes easier we think to stumble, no matter how experienced you think you are. What we have learned from both our investing experience and skiing the Swiss Wall is the need to stay humble and avoid being overconfident. From one day to the next, the Swiss Wall is never the same slope, this is why it makes it very challenging at this stage of the credit cycle. Even if Emerging Markets (EM) looks currently more enticing from an allocation perspective compared to Developed Markets (DM), as put forward by Bank of America Merrill Lynch in their EM Corporate Weekly note from the 14th of March 2017 entitled "Beware of fat tails", "Global financial risk" is the most important short term driver of spreads (icy patches):

"Global financial risk most important ST driver of spreads 

Ahead of the upcoming risk events (FOMC, Dutch & French Elections), we analyze past short-term drivers of EM credit spreads. Using a simple econometric model, we find that changes in UST yields, commodity prices, and global financial stress are able to explain more than half of the variation in credit spreads. Changes in BofAML’s Global Financial Stress Index (GFSI) are the most important driver (a one standard deviation increase in the GFSI is associated with +6 bps wider EMCB OAS). The second most important factor is changes in UST yields, followed by commodities. Our analysis also finds that these three factors can only explain 84 bps of spread tightening for our EMCB index since July 1st, compared to an actual tightening of 111 bps. This residual can likely be explained by technical factors which we do not explicitly include in our model. 

In Focus: quantifying the drivers behind spreads 

EM corporates are facing two different currents: on the one hand, technicals remain strong and credit fundamentals are improving on the back of higher commodities and GDP growth. On the other hand, valuations look expensive and a rise in external risks could lead to a re-pricing of credit spreads. In an attempt to quantify the historical impact of external factors on spreads, we run a simple multivariate linear regression model. We gathered weekly data from Jan 2012-Mar 2017 for our EM corporate indices as well as several external factors. Our baseline specification is the following:

Where UST5Y is the weekly bp change in 5Y UST yields, Commodities is the weekly percentage change in the S&P GSCI index, and GFSI is the weekly unit change in BofAML’s Global Financial Stress Index which is a measure of global cross-asset risk. 

Global financial risk biggest driver of spreads 

Results from our model suggest that BofAML’s GFSI index has the biggest impact on spreads: a three standard deviation weekly increase in the GFSI index is associated with spreads widening by 18 bps. EM HY is more correlated with changes in the GFSI than EM IG: a 3SD increase is associated with +36 bps of widening for EM HY vs. +12 bps for EM IG. LatAm is more correlated with the GFSI than other regions (Chart 3) with an est. spread widening of 25 bps given a 3SD move compared to +11 bps for Asia.

By sector Basic Materials and Real Estate are most correlated with the GFSI while Capital Goods are the least (Chart 4).

The last time the GFSI index rose by 3SD was February 12th 2016 (China and commodity selloff). Note that the GFSI has a correlation of 0.67 with the VIX. The latter did not show as much explanatory power in our regressions, which is why we prefer the GFSI. It is also a broader measure of risk appetite. 

Higher commodities associated with tighter spreads 

As expected, a 10% (4 SD) increase in commodity prices is associated with spreads tightening by 10 bps, holding other factors constant. EM HY is more sensitive to changes in commodities than EM IG, while LatAm is more sensitive than other regions given the larger share of commodity issuers (47%). On a sector basis, Energy, Basic Materials, and Transportation are most negatively correlated with commodity prices. 

EM HY has most negative correlation with UST yields 

In contrast to the positive correlation between the GFSI and spreads, changes in UST yields are negatively correlated with changes in spreads. A 50 bps (4.7 SD) weekly increase in 5Y UST yields is associated with OAS spreads tightening by 16 bps (beta of - 0.33), holding other factors constant (Chart 3). This implies that average yields would rise by 34 bps if 5Y UST yields rise by 50 bps. We also tested to see whether is a difference in the estimated beta depending on whether UST yields are rising or falling, but didn’t find any statistical significance. EM HY has a more negative beta than EM IG (-0.6 vs. -0.3) while Asia has the least negative beta across the regions (-0.2 vs. -0.4 for LatAm and EEMEA). On a sector basis, energy and consumer goods have the most negative beta, meaning spreads stand to tighten the most in a rising UST environment. 

Spreads have tightened more than predicted since July 

This regression also allows us to check whether the 111 bps tightening in EMCB spreads since July 1st 2016 is justified based on the actual changes in UST yields, commodity prices, and global financial stress. We find that the 103 bps increase in UST yields can explain 30 bps of the tightening in spreads, the 5% rise in commodities can explain 8 bps of tighter spreads, and lower financial stress can explain 46 bps of spread tightening. In total, our model calculates that EM spreads should have tightened by 84 bps since July 1st, implying that spreads overshot by 27 bps. However, the three variables in our model explain only 53% of the total variation in spreads, so it is possible that other factors which we don’t account for, such as technical factors or EM specific news account for the remaining spread tightening. High frequency data on technical factors are difficult to come across but we will explore this topic in future research." - source Bank of America Merrill Lynch

Now, if you remember our February 2016 conversation "The disappearance of MS München", we quoted Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis, when it comes to assessing warning signals that could weight on spreads:

"Depending on the type of crisis, there are different warning signals, such as significant current account imbalances (foreign debt crisis), inefficient currency pegs (currency crisis), excessive lending behavior (banking crisis), and a combination of excessive risk taking and asset price inflation (systemic financial crisis). A financial crisis is costly, as they are fiscal costs to restructure the financial system. There is also a tremendous loss from asset devaluation, and there can be a misallocation of resources, which in the end, depresses growth. A banking crisis is considered to be very costly compared with, for example, a currency crisis.We classify a credit crisis as something between a banking crisis and a systematic financial crisis. A credit crisis affects the banking system or arises in the financial system; the huge importance of credit risk for the functioning of the financial system as a whole bears also a systematic component. The trigger event is often an exogenous shock, while the pre-credit crisis situation is characterized by excessive lending, excessive leverage, excessive risk taking, and lax lending standards. Such crises emerge in periods of very high expectations on economic development, which in turns boosts loan demand and leverage in the system. When an exogenous shock hits the market, it triggers an immediate repricing of the whole spectrum of credit-risky assets, increasing the funding costs of borrowers while causing an immense drop in the asset value of credit portfolios." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis - Macronomics, February 2016

In world where positive correlations have been rising as discussed in last year's conversation and where global economies are much more intertwined, we have noticed in recent years much larger standard deviation moves, which have had significant large impacts on a very short period of time in various asset classes. In fact what is of interest from the quoted EM report from Bank of America Merrill Lynch comes from the volatility of spreads and kurtosis:

- source Bank of America Merrill Lynch

In similar fashion to the Swiss Wall of investing, as we move towards the end of the credit cycle, kurtosis is showing up, meaning that bursts of volatility can be faster and shorter in terms of time frame as we saw in the first part of last year with the Energy sector and spreads blowing out initially, and outperforming in the second part of the year. We continue to be very wary of the second part of 2017 which could play out as the reverse of 2016, namely we could move from "good performance" to "bad performance". The rally so far this year for many asset classes has been significant.

One thing appears clear to us is that the dovish tone of the Fed might indeed be linked to the recent weakness we mentioned last week in Commercial & Industrial (C&I) lending:

"Given C&I loans are strongly related to what the "real" economy does, this warrants we think close monitoring in the coming months, to assess if it is only a short blip or if there is indeed something more sinister going on (slowing credit growth)." - source Macronomics, March 2017 

This "dovish" respite most likely explains the rebound in the Euro versus the crowded long US dollar and is providing an additional boost for EM asset classes in the process. Yet, we think the trend in C&I lending is worth following very closely. This is as well highlighted by Bank of America Merrill Lynch Credit Market Strategist note from the 17th of March entitled "HG sector outlook: long beta, leverage and inflows":

"Soft data is hard, hard data soft 

The Fed’s patience makes sense as hard economic data outside the labor market has been relatively soft. As we have highlighted (see: Situation Room: In wait and see mode 07 February 2017), loan demand has been soft recently – C&I lending for example has been flat since October while consumer loans on bank balance sheets have risen just 4% (Figure 36, Figure 37).

Clearly everybody is in wait and see mode pending details of actual fiscal policy expansion from the new administration – including especially tax reform. Until they deliver – and that is not a small task – it would be counterintuitive to see a marked hawkish shift at the Fed. In the meantime we remain bullish on high grade credit spreads." - source Bank of America Merrill Lynch.

We agree with the above, namely that before taking the more difficult path of the the Swiss Wall of investing with its normalization process, the Fed is clearly awaiting for more clarity from the new US administration. On a side note, we were quite surprised by the strong rally in gold/gold miners following the FOMC as we were expecting a more hawkish tone from the Fed on the back of ADP/NFP data releases.

From our continued contrarian position and Swiss Wall of investing perspective, we believe that the US dollar is likely to weaken further, contrary to the herd mentality, which has been taking a different path on this slope and a significant long position on the "greenback" as per our final chart below.

• Final chart - USD likely to weaken given current position in historical tightening cycle

While the trade war rethoric seems to be still in play following the most recent G20 meeting, we still believe as per our early 2017 conversations that the path on the Swiss Wall of investing is lower, not higher in the current environment. This is as well highlighted in our final chart from Barclays note Thoughts for the Week Ahead entitled "The Fed says carry on":

"We expect further near-term USD weakness, concentrated primarily against high-yielding currencies. History suggests that this point in the Fed’s tightening cycle is typically followed by further near-term USD weakness, stable equity prices and lower 10y UST yields (Figure 1). 

Although low-yielding G10 and EM currencies will likely struggle to materially strengthen further against the USD, the drop in cross-asset volatility (Figure 2) will likely support high yielders, particularly the ones with positive idiosyncratic stories (RUB, INR, IDR and BRL), in our view.

Additional USD consolidation is also likely, amid still elevated long USD and short UST positioning, according to CFTC data (Figure 3). 

- source Barclays

One could argue that, if everyone is thinking the same, no one is really thinking, because, if indeed the Fed's recent caution on the Swill Wall of investing appears to be warranted in the light of the recent Atlanta Fed 1st quarter GDP projection and slowing credit growth, there is indeed a possibility for our "bold skiers" to "tumble" if one takes into account their current stretched positioning but, we ramble again...

"Tis one thing to be tempted, another thing to fall." - William Shakespeare

Stay tuned!