Macro and Credit - Inflationism

"For the merchant, even honesty is a financial speculation." - Charles Baudelaire

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

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

Keynes explicitly pointed out the relationship between governments printing money and inflation:

"The inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent Governments, unable, or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance." 

The direct result of inflation is a transfer of wealth from creditors to debtors – the creditors receive less in real terms than they would have before, while the debtors pay less, assuming that the debts would in fact have been repaid, and not defaulted on. Formally, this is a de facto debt restructuring, with reduction of the real value of principle, and may benefit creditors if it results in the debts being serviced (paid in part), rather than defaulted on. In a context of "Japanification", the carry trade is back on and credit markets will definitely benefit from the global dovishness from central bankers. In  that context, we would tend to agree with our former esteemed colleague David Goldman's recent post in Asia Times from the 20th of March entitled "Fearing slower growth, Fed says no rate hikes this year":

"Markets expected forbearance from the Federal Reserve, but the US central bank Wednesday leaned further towards monetary ease than the optimists expected. The Fed envisions no change in interest rates until sometime in 2020, and not at all if the economy weakens further. It won’t reduce the $4 trillion securities portfolio it built up through so-called quantitative easing.

This is a market that rewards cowardice – holdings of stable income-earning assets like credit and real estate – more than it rewards bravery. I continue to believe that carry will be king in 2019 as the Fed keeps interest rates low." - source David Goldman, Asia Times

This is clearly a market favoring "coupon clipping" we think but we ramble again.

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

Synopsis:

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

• Macro and Credit -  The return of the "yield" hogs in the Chinese year of the pig

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

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

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

Global dovishness has indeed favored the return of the "yield" hogs as indicated by Bank of America Merrill Lynch in their Follow The Flow note from the 22nd of March entitled "Bond mania":

"Dovish central banks and uncertainty favour quality

The epic U-turn in central banks’ stance, the round of fresh stimulus from the ECB and most recently the announced end of quantitative tightening from the Fed, have spurred a global search for yields that mainly benefited fixed income securities.
As flows pour into fixed income funds in 2019, outflows from equity funds have gathered pace, spurred by a macro picture that keeps deteriorating in Europe as shown by the below-45 print in German manufacturing PMI.

Over the past week…

High grade funds recorded an inflow for the third week in a row, with the pace of inflows ticking up. High yield funds enjoyed their fourth consecutive week of inflow. Looking into the domicile breakdown, Global-focused funds gathered half of the flows, with the other half evenly shared between US- and European-focused funds.
Government bond funds saw inflows following two weeks of outflows.
Money Market funds recorded an outflow last week, reversing a two-week streak of inflows.
All in all, Fixed Income enjoyed strong weekly inflows, the second largest print since 2004 and the best 12-week streak since 2017.
European equity funds continued to record a weekly outflow for the sixth consecutive week, whilst the pace of outflows remains strong relative to historical standards.
Global EM debt funds recorded four straight weeks of inflows. Commodity funds saw an inflow last week, the tenth over the last twelve weeks.
On the duration front, long-term IG funds were the laggards as short- and mid-term IG funds recorded inflows." - source Bank of America Merrill Lynch

Back in March 2016 in our conversation "The Pollyanna principle" when it comes to "japanification" and the attractiveness of credit markets in a central banking dovishness context we wrote the following:

"The issue at stake we have discussed on numerous occasions is that many of these Southern Europe banking institutions are capital constrained and cannot increase their lending capacity until the NPLs issues have been resolved!
Maximizing the funding via TLTRO2 in no way helps SME credit availability. The deleveraging has well is an on-going  exercise. What the new ECB funding does is slow down the deleveraging but in no way provides sufficient resolution to the "stock". NPLs are a"stock" variable but, Aggregate Demand (AD) and credit growth are ultimately "flow" variables. Until the ECB understands this simple concept, the "japanification" process will endure hence our "Unobtainium" analogy of last week:

"Unobtainium" situation. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day and now credit speculators are joining the party with both hand" - source Macronomics, March 2016

This means of course that thanks to the Bank of Japan and the ECB, we believe that the rally in credit has more room to go and that both central banks will again not be the benefactors of the "real economy".
One thing for sure, by applying the Pollyanna principle, we think that Investment Grade Credit will benefit strongly and that we will see large inflows into the asset class as per our final point and chart, for SMEs where not too sure..." - source Macronomics, March 2016.

If "Japanification" is still the trade "du jour" then, obviously, credit markets will benefit from it as we posited in our previous conversation. The new TLTRO might not do wonders for the European economy given many banks are still "capital" constrained due to still large legacy assets sitting on their balance sheets in the form of nonperforming loans, but, from a credit investors point of view, they will continue to enjoy the "bond" party rest assured.

This is what we suggested in our previous conversation:

"An allocation to credit rather than equities for these weaker players would seem prone to less "repricing" risk should buybacks dwindle and some dividends start to be cut in some instances." - Macronomics, March 2019

Clearly global growth deceleration is favoring the "D" word for "Deflation", therefore the D trade is back on and US long bonds are enjoying the bond party as well, not only the German bund. Gold miners and gold as well are benefiting as well again from the growing negative yielding "Bondzilla" the NIRP monster.

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

On that note we read with interest Bank of America Merrill Lynch's take from their High Yield Strategy note from the 15th of March entitled "Eliminate the Impossible":

"The last on our list of recent positive developments is some improvement in pricing of illiquid HY cap structures (Figure 1).

As a reminder, we noted in February that most of the rally to that point had been concentrated in large, liquid, higher-quality cap structures, i.e., relatively easy investments. Bonds in the opposite corner of the market remained largely bidless. This may have started to change in the last couple of weeks, as we are beginning to see some early signs of positive price momentum in that corner of the market. It remains modest so far, offsetting about one-third of the extent of the initial decline, but it nonetheless represents important progress.

Shifting gears to the other side of this equation, other factors that underpinned our recent defensive positioning remained largely unchanged or have even deteriorated further.

Key among them is the degree of dispersion in the overall HY market and in CCCs that refuses to show any signs of improvement. To the contrary, its current readings are below year-end as well as both month-ends since then. The dispersion index measures the proportion of all bonds that are trading close to the index level (+/-100bps for overall HY and +/-400bps for CCCs). The rationale behind this measure is that dispersion tends to be low at times of high investor confidence and risk appetite and drops significantly as credit conditions tighten as buyers remain cognizant of risks and differentiate strongly between relatively stronger and weaker names (Figure 2).

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

Obviously their defensive position has been vindicated by the most recent weakness we have seen in the high beta space, with equities as well in the first line of the volatility hence our more positive stance on credit relative to equities as per our previous conversation for those who follow us regularly.

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

Back in July 2016 in our conversation "Eternal Sunshine of the Spotless Mind" we indicated that "Bondzilla" the NIRP monster was more and more made in Japan due to the important allocations to foreign bonds from the Government Pension Investment Fund (GPIF) as well as other Lifers in conjunction with Mrs Watanabe through Uridashi and Toshin funds (Double Deckers) being an important carry player. In the global reach for "yield" and in terms of "dollar" allocation, Japanese investors have been very significant hence the importance of monitoring the flows from an allocation perspective. On this very subject we read another Bank of America Merrill Lynch's take in their Situation Room note from the 14th of March entitled "Japan 101":

"Japan 101

It is hard to imagine any country more transparent with investment flows than Japan. Hence, we know from the Japan Ministry of Finance’s weekly Data on securities investment abroad for medium and long term bonds as of March 8th that purchases are off to the strongest start to the year (¥5.76tr ) since 2012 (where the number was only slightly higher). This translates into $52bn of buying YtD, a dramatic change from sales of $6bn and $33bn during the same periods in 2018 and 2017 (Figure 1), respectively, and one of the key reasons the US corporate bond markets has been so strong this year, in our view.

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

It is also a straightforward assumption that Japanese purchases of foreign bonds accelerate in the new fiscal year starting April 1st, as seasonally about 75% of buying tends to take place in fiscal 1H, 25% in 2H.

EUR bonds and JGBs for life

Of course, this Ministry of Finance data covers all foreign bonds – not just US corporate ones. Luckily, Japanese lifers update on their investment plans twice a year – our most recent update is in the section “JGBs for life” in here: Situation Room 24 October 2018, which contained detailed plans for 2H of the Japanese Fiscal year (runs April 1-March 31). Clearly, heading into the first part of 4Q18 USD hedging costs had increased so much that they planned to shift hedged buying away from USD, into EUR – likely in a mix of European core corporate and sovereign bonds. Also, with rising rates and 30-Situation Room | 14 March 2019 3 year JGB yields already at 90bps+, they were getting ready to shift back into local government bonds as well. Of course, they planned to continue investing on a currency unhedged basis in the US.

Who let the doves out?

However, we suspect these plans had changed dramatically to favor much more US corporate bonds on a hedged basis by early this year as 1) market expectations for Fed rate hikes collapsed dovishly from about three over the following year heading into 4Q18 to none and 2) local 30-year JGB alternatives had plummeted as well to the 60bps range - far from the 100bps needed. Of course, they likely remained sizable buyers of EUR bonds, but probably less than originally planned.

While it is helpful that dollar hedging costs have come down somewhat over the past several months, as Libor-OIS tightened materially, that is not the main driver of increasing Japanese buying of US corporate bonds. We see this as US corporate yields have declined by roughly the same amount as dollar hedging costs (Figure 3), leaving yields after hedging relatively unchanged.

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

Hence, US corporate bonds looked unattractive to Japanese investors. However, that all changed as markets priced out future rate hikes, and Japanese investors could thus have confidence dollar hedging costs would not increase. By the beginning of this year, Japanese investors could expect to keep, for example, 1.8% for dollar hedged 10-year BBB rated US corporate bonds, which compared very favorably to just 0.7% for 30-year JGBs.

Here to stay

We expect healthy Japanese and other foreign buying of US corporate bonds – which this year was always a key ingredient in our bullish call on spreads - to continue to help drive tightening for quite some time. Right now, the global corporate bond market – and USD is the biggest and most liquid chunk of that – is basically the only option for foreign investors. This changes when 1) valuations become unattractive – which will likely take a long time (Figure 4), 2) the market starts pricing in Fed rate hikes – which is not any time soon, or 3) US recession risk becomes too high – which should be years away, in our view." - source Bank of America Merrill Lynch

Not only Japanese Lifers have a strong appetite for US credit, but retail investors such as Mrs Watanabe, in the popular Toshin funds, which are foreign currency denominated and as well as Uridashi bonds (Double Deckers), the US dollar has been a growing allocation currency wise in recent years so watch also that space.

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

This is confirmed by Nomura's Japan Navigator note number 815 from the 18th of March entitled "ECB and BOJ's policy impasse and risk of JPY appreciation":

"Lifers opt for credit rather than anticipating weak JPY

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

For this reason, if investors buy A rated US corporate bonds with maturities near 20yrs, they can bring in yields of about 1% even if they convert it to JPY using currency swaps with the same maturity. That said, we do not expect lifers to take risks on such long-term credit without a US economic downturn combined with a sense that the Fed will not turn hawkish again." - source Nomura

In relation to our "gold" outlook, while we won't bother going into much the details of Alfred Herbert Gibson's 1923 theory of the negative correlation between gold prices and real interest rates. We believe that the real interest rate is the most important macro factor for gold prices.  Obviously the more our NIRP monster grows, the more inflows gold funds will get given Gibson 's paradox. That simple.

Returning to credit, we have been advocating going higher the quality spectrum and use the recent rally to reduce highly illiquid high beta exposure such as leveraged loans. US Leveraged Loan Funds have seen 17 Weeks of outflows totaling $21.8 billion. Regardless of the performance, it is indicative, we think of risk reduction due to illiquidity factor coming into play. When it comes to US High Yield, though everyone has been talking about the BBB monster in Investment Grade sitting on the edge of the downgrade cliff, discussions surrounding High Yield has been more muted. On that specificity, we have read with great interest Morgan Stanley's take from their Corporate and Credit Derivative Research note from the 22nd of March entitled "A High Yield Hedge":

"Trends in the high yield market over the past few years, in particular, have been somewhat different from what we have seen elsewhere. For example, when thinking about the excesses in credit, many (us included) talk about BBBs in IG, which have seen enormous growth in this cycle, or the leverage loan market, where credit quality has arguably deteriorated for years (higher leverage levels, weaker covenants, weaker structures, etc.). But the high yield market is often left out of the discussion. After all, high yield went through a mini default cycle in 2016, centered on Energy, and since then, issuance has steadily declined, leading to no growth in par outstanding, very different from the trends noted above. Some investors assume that as a result, high yield is more insulated from the fundamental risks present in other pockets of credit markets. In fact, for much of 2018 (at least for the first three quarters), we regularly heard the view that the resilience of HY (relative to the weakness in IG, for example) was a testament to healthier fundamentals in the former.

Through the third quarter of last year, we published several notes (see: US Corporate Credit Strategy Brief: I Can't Believe It's Not Beta, 25 Apr 2018) on why we thought HY was so resilient at the time (i.e., low supply and very strong earnings growth, among other factors), but more importantly, why we also believed HY was very much not immune from the broader macro challenges to come. Fundamentally, we agree, it is hard to point to specific metrics that seem as glaring in HY as in other credit markets, especially since 2016. For example, post the Energy recovery, leverage now looks weaker in IG than in HY (beta-adjusted), while both the growth in and deterioration in ratings quality of the IG and loan markets has also been much more extreme than that of HY over the same time period. However, in our view, this certainly does not mean high yield is out of the woods.

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

Leveraged finance markets have been consistently growing the entire time (other than a small blip lower in 2016), and that is what matters most, in our view, as these markets will always be closely tied together, especially in a credit cycle.

Yes, the driver of the growth in leveraged finance markets has shifted over the course of this cycle, as we show in Exhibit 6, with HY the main contributor early on and loans over the past few years, but we don't see this change in trend as overly surprising or abnormal.

As we point out in Exhibit 7, the story was similar in 2006/07 when the growth in HY par outstanding was minimal in the last two years before the financial crisis, while loans were growing at an exponential rate.

Second, while easily-tracked fundamental metrics like leverage don’t look as extreme in high yield, we think other harder-to-track, more qualitative measures are more problematic. For example, when digging into the quality of the companies in various markets, we would argue high yield is more exposed to sectors with longer-term operational challenges (as we originally discussed in Cross-Asset Dispatches: Why We Prefer Equities Over Credit, 3 Nov 2017). In investment grade credit, 30% of the index is made up of Financials, a sector where balance sheets are very strong, thanks in part to a decade of financial regulation. The large cap equity indices are skewed towards fast growing technology companies. High yield, in our view, is more heavily exposed towards “old economy” business and Energy. Many of these companies also have high leverage, but they have survived because of such cheap money for so many years. We are guessing some of them will have trouble through another recession, especially if credit conditions tighten for a prolonged period of time.

Third, because some of the fundamental challenges are more widely discussed in other markets, they are likely also a bit more "in the price." A good example is that the BB/BBB spread basis is at cycle tights, in part because, on the surface, long-term problems seem more material in low-quality IG than in HY. However, while we have been very vocal around the issues with BBBs, we would actually buy BBBs over BBs, simply because we think the potential challenges in high yield in a credit cycle are less appreciated than the risks elsewhere (like in BBBs).

Finally, for those who still believe HY will be relatively resilient through a credit cycle due to better fundamental trends, let’s look at recent evidence. For example, we have had two growth scares in this cycle, in 2011 and in 2016, and in both cases HY traded to ~850bp, very close to prior recession wides (i.e., the levels where HY peaked in 1990 and in 2002).

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

We think it is clear that high yield is and will remain highly sensitive to changing growth expectations as well as to changes in credit conditions.

Going forward, our view has been clear – we think the weakness in 4Q was not just a temporary valuation adjustment in a broader bull market, or about one-off headwinds like trade. We believe credit is in a bear market and the credit cycle is slowly turning. Defaults should remain low in 2019, but we think default expectations may rise this year, and actual defaults could start trending higher the year after. We believe this is a good time to position for this view, especially in places where it is clearly not priced, like short-dated HY CDX." - source Morgan Stanley

Now if indeed High Yield is highly sensitive to changing growth expectations and if as we posited last week CFOs in the Investment Grade space decide to reduce CAPEX, buybacks and dividends to address leverage concerns from investors, then it will be more "credit" friendly and less so for "high beta" related equities from these issuers. In a "japanification" context, we therefore think that playing quality and duration is less prone to burst of volatility and will be more rewarding for "yield hogs" cowards than the high beta punters out there.

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

• Final charts - Oh my God they killed Macro volatility again!

Back in November 2012, in our conversation "Why have Global Macro Hedge Funds underperformed", we argued that when volatility across all asset classes crashes, global macro strategies tend to suffer on both an absolute and relative basis. Our final charts come from HSBC Asia Chart of the Week from the 22nd of March entitled "The demise of macro vol" and highlights the fall in the volatility of activity data to record lows:

"Glued to your trading screens these last few years, you may well believe the world economy was roiled by one shock after another. Well, not quite. Financial markets have spiked and plunged, but underlying economic activity, at least across Asia, has been remarkably steady. In fact, it’s been ‘flat as a pancake’ to borrow a phrase from HSBC’s chief fixed income strategist Steven Major (see Fixed Income Asset Allocation, 12 March). Ah, ‘China’, you might say: the economy’s growth numbers have indeed been extraordinarily stable in recent years. But that’s actually been the case in virtually all Asian economies. The volatility of activity data has fallen across the board to record lows, well below the mid-2000s, when, if you recall, economists were celebrating the demise of macro volatility amid the ‘Great Moderation’. It’s hard to pinpoint the exact reasons for this – highly supportive, and swiftly reactive, monetary policy is probably one, as are structural factors like the growing share of services in output and much shallower inventory cycles in manufacturing. The fall in growth volatility, unsurprisingly, has been accompanied by a drop in inflation volatility. All this, ultimately, stokes leverage as borrowers and lenders become increasingly desensitized to risk…careful what you wish for.

"I may as well tell you that if you are going about the place thinking things pretty, you will never make a modern poet. Be poignant, man, be poignant." P.G. Wodehouse

Our fist chart is simple enough: it compares the standard deviation of GDP growth in the 2000s (2002 to 2007, to be exact) and 2010s (2012 to 2018).

Note that in virtually all cases, growth volatility has declined markedly. The exceptions are Sri Lanka, Thailand, Taiwan, and Vietnam. In the first two, this is easily explained by local political uncertainty and environmental disruptions. In the latter two, the increase in volatility has been slight or from a comparatively low level. Note also that China is often singled out as having rather stable GDP growth numbers, but the drop in volatility has been nearly uniform.

The decline in growth volatility, unsurprisingly, has been accompanied by a fall in the volatility of inflation. Our second chart replicates the first, this time showing the standard deviation of headline inflation for different economies. Again, the picture is broadly similar: in most markets, volatility has fallen. This time, the exceptions are Australia, India, Japan, New Zealand, and Singapore, with most increases being marginal (India is a stand-out, but may reflect computational issues). ‘Wait’, you might object, the decline in headline inflation volatility may simply reflect more stable global energy and food prices…perhaps, but core inflation is showing pretty much the same trend.

This fall in macroeconomic volatility is generally something that policymakers and investors alike desire. From this perspective, the past few years were quite positive, even if GDP growth itself fell short of expectations in many parts of the world, including in Asia. Financial markets, of course, have at times been highly volatile, but, overall, risk assets have performed quite well, which may in part be attributable to the ‘demise in macro vol’.

The trouble is, the longer a period of low volatility endures, the more desensitized everyone becomes to risk: if things are fundamentally stable, and memories of deep recessions are starting to fade, the appetite to leverage up grows and investors are increasingly tempted to buy ‘on the dip’.

But take a look at our last chart. This shows the volatility of GDP growth in emerging Asia over time. Note that this has been extraordinarily low in recent years (blue circle).

However, periods of low volatility often precede a spike: for example, vol plunged in the mid-1990s before the Asian Financial Crisis and also trended lower in the mid-2000s before the Global Financial Crisis (red circles).

Better stay nimble…" - source HSBC

 So while some central banks have decided that in order to acquire the resources they required, have printed notes for the balance to paraphrase Keynes, their inflationism policies, all of this, ultimately, stokes leverage as borrowers and lenders become increasingly desensitized to risk…careful what you wish for indeed...

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

Stay tuned !

Macro and Credit - The Armstrong limit

"Men go abroad to wonder at the heights of mountains, at the huge waves of the sea, at the long courses of the rivers, at the vast compass of the ocean, at the circular motions of the stars, and they pass by themselves without wondering." - Saint Augustine

Watching with interest the Japanese Nikkei index touching its highest level in 27 years at 24,245.76 points, with US stock indices having rallied strongly against the rest of the world during this year, and closing towards new highs, when it came to selecting our title analogy we decided to go for another aeronautic analogy "The Armstrong limit". The Armstrong limit also called the Armstrong's line is a measure of altitude above which atmospheric pressure is sufficiently low that water boils at the normal temperature of the human body. Humans cannot survive above the Armstrong limit in an unpressurized environment. Above earth, this begins at 18-19 km (59,000-62,000 feet) above sea level. The term is named after United States Air Force General Harry George Armstrong who was the first to recognize this phenomenon. Commercial jetliners are required to maintain cabin pressurization at a cabin altitude of not greater than 2400 m (8,000 feet). The Armstrong limit describes the altitude associated with an objective, precisely defined natural phenomenon: the vapor pressure of body-temperature water.  Back in August in our conversation the "Dissymmetry of lift", we discussed our Quantitative Tightening (QT) amounted to reducing global liquidity and tightening global financial conditions overall as well as less airflow to maintain growth (we are already seeing signs in Europe).  When it comes to airflow and liquidity relating to equity indices we touched in this subject in two previous conversations: "The Coffin corner" in April 2013, the other being "The Vortex Ring" in May 2014. When it comes to our analogy and our reference to the Nikkei and US equity indices we remember clearly that the Nikkei hit its all-time high on 29 December 1989, during the peak of the Japanese asset price bubble, when it reached an intra-day high of 38,957.44, before closing at 38,915.87, having grown six fold during the decade. Sure the S&P 500 has grown six fold during the decade since the collapse of Lehman Brothers but it's within 1% of its all time high. One question investors are starting to ask themselves is what is the "Armstrong limit" for US equities? Bank of America Merrill Lynch in their recent The Flow Show note from the 27th of September entitled "Jay stalking" have two very interesting charts when it comes to equity allocation from Global Wealth and Investment Management (GWIM) into equities and cash allocation levels:

- source Bank of America Merrill Lynch

One might indeed wonder what level is the "Armstrong limit" before boiling point we think...

In this week's conversation, we would like to look at once again at the US consumer which seems to be increasingly relying on his credit card as well as other signs that warrants monitoring at this stage in the cycle.

Synopsis:

• Macro and Credit -  What's the Armstrong limit for the US consumer's confidence?
• Final charts - The "profit" illusion

• Macro and Credit -  What's the Armstrong limit for the US consumer's confidence?

In continuation to our last conversation, we think it is essential for the US growth outlook and forward earnings to continue to focus on the state of the US consumer. After all, the first on the line in any case of trade war escalation is the US consumer who gets the price increase passed onto by corporations facing a surge in costs. With the US consumer confidence index climbing to 138.4 in September from 134.7 in August, the highest since September 2000 we are wondering if it is the absolute Armstrong limit.

On this question we read with interest Wells Fargo's take from their US Consumer Confidence note from the 25th of September:

"In the past 51 years, only 11 times has confidence been higher than it is today. Said differently, roughly 98% of the time confidence is lower than it is now. That’s good news for the consumer, but for how long?

Remember the Sock Puppet Commercials?

The last time consumer confidence was as high as it is today was in the year 2000. A number of financial and economic indicators from that era are similar to where they are today. The stock market was soaring to all-time record highs, the unemployment rate was below 4% and the economy was in its 10th year of uninterrupted expansion. Then, as now, there were few people seeing an end in sight.

While we still think the current expansion has room to run, we would be remiss not to make note of just how rare a thing it is to see confidence at these lofty levels. Only in 11 individual months since 1967 have we seen confidence higher than it is today. Nine of those months were in the year 2000. The other two were in 1999. This is the thin air of the high peaks.

The euphoria is not limited to the consumer sector. The ISM manufacturing index is at its highest level since 2004 and the NFIB Small Business Optimism Index, an indicator of small business confidence, is at its highest level on records that date back to 1974. The fact that these measures are at record highs does not preclude them from going higher, but one characteristic that they all share is a tendency to peak before a slowdown.

No Time Like the Present

There is an interesting dynamic going on between consumers’ assessment of the present situation, compared to expectations for the future. As seen in the middle chart, the present situation measure is running well ahead; in the prior cycle there was a similar divergence late in the cycle.

Some Things That Are Different From 2000

The below chart plots consumer confidence alongside both retail sales (ex-autos) and real income growth on a per-capita basis. Here we see something that Fed policymakers have been wringing their hands over throughout this cycle, which is: if the labor market is so hot, how come income growth is so tepid?

That slower income growth tempers our enthusiasm for the ability of consumer spending to sustain growth indefinitely. We will get the latest read on this when the personal income and spending numbers hit the wire on Friday of this week.

I Don’t Know Why I Go to Extremes

For now, the surge in retail sales cannot be denied and we would be foolish to bet against the consumer with such a solid backdrop for consumer confidence. The official write-up that accompanied the release stated that “Consumers’ assessment of current conditions remains extremely favorable, bolstered by a strong economy.” We would not disagree, but what takes the shine off the apple for us is that extremes, by definition, imply “reaching a high, or the highest degree.” If this is the extreme, there is nowhere to go but down." - source Wells Fargo

With US Personal Income rising 0.3% in August, slightly less than expected (0.4%) last Friday, then indeed slower income growth should indeed temper slightly your enthusiasm we think.

As a reminder from last week's conversation, and as per the below Macrobond chart, the University of Michigan Consumer Confidence turning points tend to coincide with significant S&P 500 12 months return. It is worth remembering this from an Armstrong limit perspective:

- graph source Macrobond (click to enlarge)

Also, keep that in mind when looking at the significant rise of the S&P 500, because we think that we are in the melt-up "euphoria" phase and have yet to touch the "Armstrong limit":

- graph source Macrobond (click to enlarge)

Or you could also ask yourself as well what is the "Armstrong limit" when it comes to the S&P 500 Profit Margins in this long in the tooth credit cycle:

- graph source Macrobond (click to enlarge)

You could as well ask yourselves when will we reach "peak" M&A, which is also a sign you generally see in late credit cycles:

- graph source Macrobond (click to enlarge)

In last week's conversation, "White Tiger" we indicated that although everyone is focusing on the flattening of the yield curve, from an inflationary expectations perspective we worry a lot for asset prices about a spike in oil prices if we do get geopolitical flares up in November between the United States and Iran:

"The issue of course for the stretched US consumer would be if Core PCE inflation continues to pick up slightly faster than core CPI if healthcare service price inflation accelerates while rent inflation gradually slows. This upside risk to healthcare prices and expected further labor market tightening, one could expect core PCE inflation to rise further, not to mention the issue with gas prices at the pump should oil prices continue as well to trend up. Remember that the acceleration of inflation is a dangerous match when it comes to lighting up/bursting asset bubbles." - source Macronomics, September 2018

So for us, from an Armstrong limit perspective, we are closely watching the evolution of oil prices:

- graph source Macrobond

An inflation spike is very much on our radar. Oil has extended its gains after the longest quarterly rally in a decade thanks to a slowdown in American drilling as well as supply concerns. The U.S. and Saudi Arabia have discussed market stability yet it seems there are some questions relating to spare capacity with traders highlighting a potential surge towards $100 a barrel at some point. 

From an Armstrong limit perspective relating to the state of the US consumer, oil prices matter because not only retail has been sustained by the rise in credit card use but housing is seeing headwinds already thanks to rising mortgage rates. The issue at hand is the size of energy costs for the US consumer relative to his consumer spending. On that subject we read with interest Wells Fargo's take from their note from the 28th of September entitled "What Good is a Bigger Paycheck if it All Goes to Gas Money?":

"Wages and salaries posted the largest monthly increase since January, but increasingly higher gas prices and other energy costs are commanding a larger share of consumer spending.

Income Gets Boost from Wages

Personal income increased 0.3% in August, which was a bit shy of the 0.4% that had been expected by the consensus.

More than two thirds of the increase was due to the fact wages and salaries notched a solid 0.5% gain. That was the best monthly increase since January and the latest indication that the hot job market is at last translating into meaningful improvement in wages.

Personal interest income, which comprises less than a tenth of overall income, was down for the second straight month and was in fact the only category of personal income that declined during the period.

Energy Costs Taking up Larger Share of Consumer Spending

Despite the slightly softer print on the income side, spending did not disappoint with the 0.3% pick-up in outlays, matching the consensus expectation. The fact that wages and salaries drove much of the increase explains why the saving rate was able to remain unchanged at 6.6%.

Consumer durable goods outlays slipped 0.1%, but every other major category of spending was either flat or positive to varying degrees. Echoing one of the themes from the August retail sales report in which gas stations reported faster sales than other types of stores, the biggest category gainer in terms of price was energy goods and services, up 1.9% on the month. This category includes spending on gasoline but also includes energy goods delivered to the home through utilities like electricity and natural gas. The takeaway is that higher energy prices in August might have been holding back spending in other categories. Excluding food and energy, spending was flat in August.

Inflation Dynamics

People are not suddenly buying a lot more gasoline. Prices, of course, are largely to blame. The energy prices category within the price indices has seen double-digit percentage gains in each of the past four months. Mercifully for consumers, prices for durable goods have also been lower in each of those past four months, ameliorating the impact of higher energy prices. The headline measure for the personal consumption expenditures deflator, the Fed’s preferred inflation gauge, slowed slightly to 2.2% from 2.3% on a year-over-year basis in July.

Existing tariffs on a variety of imports totaled roughly $100 billion in August; with this week’s additional tariffs on $200 billion going into effect, the price effects for consumers might become more tangible. The nation’s largest retailer this week warned that it might be forced to charge higher prices.
In its statement earlier this week, the Federal Reserve noted that “inflation on a 12-month basis is expected to move up in coming months” before eventually stabilizing near the Fed’s 2% target rate." - source Wells Fargo

Tariffs and rising gas prices do not bode well for the euphoric US consumer we think in the near future. Sure US equities, consumer confidence and even US High Yield have had a very good run in 2018 (CCCs have outperformed higher quality by a wide margin: +5.6% of excess returns) in comparison to the rest of the world, so it's highly likely that the "risk-on" euphoric mood will continue given financial conditions are still fairly accommodative (as per the most recent Fed SLOOs), but we think that 2019 could start becoming much more challenging as QT accelerates and depending on the Fed's hiking path as we are officially out of negative real rates for now.

In continuation to our “macro” long conversation “The Money illusion”, where we concluded that liquidity is a coward and where we repeated what we indicated back in June 2015 from our conversation "The Third Punic War", bear markets for US equities generally coincide with a significant tick up in core inflation, given the amount of buybacks since with the issuance of debt in many instances in our final charts below, we are wondering if there could be as well a "profit illusion" when it comes to the US markets.

• Final charts - The "profit" illusion

Sure, liquidity is a coward and as many have pointed out, with dwindling inventories on banks balance sheet and the very significant rise in corporate debt issuance in credit markets, one can indeed ask if "liquidity" is an illusion. On the question of the "profit illusion" our final charts come from our esteemed former colleague David P. Goldman who now writes in Asia Times and ask if buybacks are creating the illusion of profit in his article from the 28th of September entitled "Something strange is happening with US corporate profits":

"Are companies creating the illusion of higher profits through stock buybacks? 

It was reported earlier this week that S&P 500 companies bought back a record US$189 billion of their own shares in the first quarter of this year. The buybacks make results look better than they really are, as The Wall Street Journal reported.

The charts below show that raw, unadjusted US corporate profits actually FELL year on year, and corporates are creating the illusion of higher profits by buying back shares.

This is the rawest, simplest measure of profits, before tax and inventory/capital consumption adjustments, which are model driven. This is basically what corporations report on their income tax, and it doesn’t look terribly strong.

Are profits rising or falling? 

- source Asia Times - David P. Goldman

One could contend that the boiling frog which is a fable describing a frog being slowly boiled alive, could be related to the Armstrong Limit looking at the altitude reached by equities and some valuation metrics. As a reminder, the premise of the fable is that if a frog is put suddenly into boiling water, it will jump out, but if the frog is put in tepid water which is then brought to a boil slowly, it will not perceive the danger and will be cooked to death. The story is often used as a metaphor for our inability or unwillingness to react to or be aware of sinister threats that arise gradually rather than suddenly such as the markets we are seeing one could argue. Though some would add that "thermoregulation" by changing location is a fundamentally necessary survival strategy for frogs and other ectotherms, rendering the legend a "myth". From an Armstrong Limit perspective, we certainly hope that some investors have their "g-suits" on given the lofty levels reached in some instances. Also we do not know yet what is the Fed's own "Armstrong limit" in their current hiking path but we ramble again...

"There can be no rise in the value of labour without a fall of profits." -  David Ricardo

Stay tuned !

Macro and Credit - The Golden Rule

"After World War II, there were a lot of pension funds in Europe that were fully funded, but they were pressured to hold a lot of government debt. There was a lot of inflation, and the value of all those assets fell. Those pension funds couldn't honor their promises to the people." -  Edward C. Prescott, American economist and Nobel Prize in Economics.

Looking at the technical "relief rally" in all things "beta" including US High Yield thanks to the tone down in the geopolitical narrative but with the pickup of the trade war rhetoric between the United States and China, when it came to selecting our title post analogy, we reminded ourselves of the "Golden Rule". The Golden Rule (which can be considered a law of reciprocity in various religions) is the principle of treating others as one would wish to be treated. It is a maxim found in most religions and cultures:

• One should treat others as one would like others to treat oneself (positive or directive form).
• One should not treat others in ways that one would not like to be treated (negative or prohibitive form).
• What you wish upon others, you wish upon yourself (empathic or responsive form).

The concept occurs in some form or another in nearly every religion and ethical tradition and is often considered as the central tenet of "Christian ethics".  It can also be explained from the perspectives of psychology, philosophy, sociology, human evolution, and of course economics hence our reference in relation to growing trade tensions. 

In this week's conversation, we would like to look again at where we are within the credit cycles, given as we pointed out in recent musings cracks have started to show in some parts and everyone is asking oneself when the downturn is given the relentless flattening of the US yield curve.

Synopsis:

• Macro and Credit - Have we reached the end of the credit cycle yet?
• Final charts -  The return of Macro to the forefront thanks to higher interest rates

• Macro and Credit - Have we reached the end of the credit cycle yet?

We have been discussing at length like many various pundits about the credit cycle and the fact that it was slowly but surely turning thanks to the Fed's change of narrative. We even posited that the Fed is the credit cycle in one of our musings. Back in October in our conversation "Who's Afraid of the Big Bad Wolf?", we indicated that for a "bear market" to materialize, you would indeed need a return of the Big Bad Wolf aka "inflation". With the continuing surge in oil prices in conjunction with commodities prices, we also pointed out as well in this prior conversation that credit cycles die because too much debt has been raised and therefore it remains to be seen if rising "inflation expectations" could indeed be the match that lights the ignite the explosion of the credit bubble hence the importance of gauging where we stand in this credit cycle. The increasing trade war narrative has proven in the first quarter to be "bullish" gold as we anticipated thanks to the "Golden Rule" being put forward between the United States and China. Following years of financial repression the house of straw of the short-vol pigs was blown off by the explosion of volatility following the Fed's decision to put a lower strike on its "put" for asset prices, which had been a deliberate part of their move in recent years. We have become increasingly wary of the situation of the US consumer hence us adopting more scrutiny on the rising price at the gas pump with an already strained US consumer balance sheet thanks to rising rents and healthcare and slowly rising wages with dwindling savings and rising usage of credit cards to maintain the lifestyle. 

So, one might rightly ask oneself, when does it all end given that as per the below recent Bloomberg chart, displaying US Economic Surprise indexes for both hard data and soft data trending lower:

- source Bloomberg

Many wonder if this time it will be different with the continuing flattening of the US yield curve. On this subject we read with interest Bank of America Merrill Lynch's Securitized Products Strategy Weekly note from the 20th of April,. First here is the summary of their findings:

"This time is different: late cycle mortgage lending, higher rates, and a flatter curve

This week’s yield curve flattening, to a post-crisis low of 43 bps on the 2yr-10yr spread, is raising concerns that the current cycle is coming to an end and recession is now on the not too distant horizon. It’s more than 9 years since the stock market low of March 2009, so it is clearly late in the cycle. However, we continue to believe that this cycle has at least a couple of more years before it ends and credit spreads, along with securitized products spreads (see “Bullish for Q2” for corporate-securitized products correlation discussion), widen materially.

In fact, although the path for spreads will be bumpier than what was seen in 2017, we think there is potential for spreads to tighten further in Q2 and beyond. As discussed last week, we think the 10yr breakeven inflation rate is likely to head higher in Q2, moving above 2.20% or even 2.30%, as oil experiences upward seasonal pressure. Given correlations, we see this as good news for securitized products spreads. (This week’s jump to an intraday high of 2.19% on the breakeven rate suggested that 2.20%-2.30% is not a particularly aggressive target.)

We acknowledge the tightness of spreads, but we caution against being too early to position for major spread widening in the near future. Although we see tightening potential for spreads, due to the tightness of spreads, we maintain our neutral view for securitized products.

We compare this cycle to the last cycle on two fronts:

First, and more broadly, we consider metrics such as the 2yr-10yr spread, the BofAML Global Financial Stress Indicator and the BofAML Liquidity Stress Indicator: all three indicators suggest little imminent stress. We see the current period as similar to May 2005. As a reminder, that was 2 years before credit spreads began to widen and over 3 years before full blown crisis and recession. Given the slow pace of monetary policy tightening in this cycle, we think the risk is that this cycle takes longer to end than the last one did when at a comparable point on the metrics just mentioned.

Second, and more specific to mortgages, we compare today’s mortgage lending environment to what was seen in the pre-crisis period and in the aftermath of the massive 2003 refi wave. The changes are dramatic. Non-bank lenders’ market presence is on the rise while banks are retreating; another refi wave has ended but primary secondary spreads are generous relative to 2005; most importantly, there is little to no evidence of a meaningful shift to the risky mortgage lending practices that precipitated the 2008 crisis. At a minimum, this cycle has a notable absence of the primary driver of what caused the crisis in the last cycle. If there is a trigger event for another broader downturn, it will have to come from a sector other than mortgages and housing. Perhaps it will be the corporate sector or the government sector but we would not dismiss the economic robustness derived from an exceptionally healthy mortgage market. Again, we think the risk is that years of healthy and disciplined mortgage lending prolongs this economic cycle."  -source Bank of America Merrill Lynch

We would have to agree, if indeed there is a trigger event for another broader downturn, then indeed, this time it will be different in the sense that it won't be coming from the housing sector and the mortgage markets. Many like ourselves are pointing out towards the excess leverage building up in the corporate sector thanks to a credit binge tied up to ZIRP and NIRP policies and credit markets. If US High Yield can be seen as being relatively expensive then European High Yield is a base case definition of what "expensive" can be defined as. We are closely monitoring fund flows given as of late there has been some rotation from credit funds towards government bonds funds as described by Bank of America Merrill Lynch in their Follow the Flow note from the 20th of April entitled "Trade wars flows":

"Rising geopolitical risk is pushing more money into govies

Over the past couple of months government bond funds in Europe have recorded sizable inflows. We think trade wars and rising geopolitical risk has been translated into deflationary pressures that feed primarily into a bid for “risk free” assets. IG fund flows in Europe have been slower to improve because of the trade uncertainties. However, inflows into Euro only IG funds over the last week were nonetheless positive.

Over the past week…

High grade fund flows were negative over last week after two weeks of inflows. While the breakdown by currency shows a marginally positive number for the eurofocussed funds, the dollar ones have driven the overall trend. Monthly data also were negative for a second month, March figures show.

High yield funds continued to record outflows (23rd consecutive week), and similarly the monthly data also displayed a fifth consecutive month of outflows. Looking into the domicile breakdown, US and Globally-focussed funds have recorded outflows, while the European-focussed funds flow was slightly positive. Note that this was the first week of inflows into euro-focused funds after 13 weeks of outflows.

Government bond funds recorded their 14th consecutive week of inflows just as the monthly data were rolling on to the fifth consecutive month of positive flows. All in all,
Fixed Income funds flows were on negative territory last week. Monthly data reveal that just like February, March was also characterised by outflows.

European equity funds continued to record outflows for a sixth consecutive week; driving the year-to-date cumulative flows below zero. The trend also transpired on the March number, which was the most negative since August ‘16." - source Bank of America Merrill Lynch

While it has been difficult to "Make Duration Great Again" given the recent rise in the 10 year yield in US Treasury Notes, from a contrarian perspective and given the significant short positioning in the long end, there will come a point when fundamentals might reverse the confidence in this overstretched positioning which would entail significant short covering. We are not there yet. 

Returning on Bank of America Merrill Lynch note on the relationship between a flattening yield curve and credit spreads, here is what they had to say on the subject:

"Yield curve flattening and credit spreads

The 2yr-10yr spread narrowed to a post-crisis low of 43 bps this week, raising concerns that the current cycle is coming to an end and recession is on the not too distant horizon. We see the recent flattening of the yield curve as consistent with expectations laid out in our 2018 Year Ahead outlook, published in November 2017. We expect the 2yr-10yr spread to reach zero and turn negative in the first half of 2019, and recession and material credit spread widening to occur 12-18 months later, in other words, mid to late 2020. Given the slow pace of monetary policy tightening in this cycle, we think the risk is that the process takes longer than we expect.

Chart 1 and Exhibit 1 provide some perspective on this view.

Chart 1 shows that today’s 2yr-10yr spread level of roughly 45 bps was observed in May 2005. We also see that today’s asset swap spread of roughly 300 bps on the ICE BofAML High Yield Index (H0A0) is comparable to the index spread in May 2005. (We use this high yield index for our securitized products discussion just because it allows us to make the longer term comparison.) The takeaway from this chart is that it took approximately two years for the curve to first fully flatten and then re-steepen. Similarly, it took approximately two years before credit spreads finished tightening, reaching a tight of 185 bps (over 100 bps tighter than the May 2005 level!), and began cyclical widening.

This is the primary basis for our view that material spread widening in the current cycle won’t occur until at least approximately mid-2020. In other words, we place a heavy weight on the yield curve as an indicator of where we are in the credit cycle. The first significant event that we would need to see for us to become more cautious on spreads is to have the curve fully flatten or invert. But even then, the 2005-2007 experience tells us that it could take over a year after flattening or inversion occurs before spreads materially widen.

Exhibit 1 shows a view of yield curve movements relative to the Fed Funds rate, along with rough projections. The primary observation for this cycle relative to the last cycle is that the Fed is tightening at about half the rate of the last cycle. Given this, we think the risk for this cycle is that the flattening and re-steepening/spread widening process takes longer than the last cycle.

Yield curve flattening and financial and liquidity stress indicators

Chart 2 and Chart 3 provide an additional view of today’s world relative to 2005, using the BofAML Global Financial Stress IndicatorTM and the BofAML Liquidity Stress IndicatorTM.

Both Global Financial Stress and Liquidity Stress are negative (indicating below average risk), have been trending lower since early 2016, and are currently comparable to the levels of May 2005. Both indicators moved up substantially only when the yield curve re-steepened in late 2007. Our takeaway here is that the low levels on the Stress Indicators are confirming our view that a 2yr-10yr spread of roughly 50 bps is  not necessarily indicating imminent stress. In other words, there is still ample monetary policy accommodation.

Mortgage lending in this cycle: low risk lending and the rise of non-bank lenders

While broad macro developments are currently similar to 2005, the mortgage market, arguably the trigger of the 2008 recession and crisis, is very different. In particular, mortgage market risk is far lower today than it was 13 years ago. To at least partly understand pre-crisis developments in mortgage lending, it’s useful to recall the role played by the massive 2003 refinancing wave.

Chart 4 shows the MBA refinancing index along with the primary-secondary spread back to 2000.

In some respects, the great refi wave of 2003 was the genesis of the mortgage crisis that followed. Lending capacity rapidly expanded to respond to the opportunity presented in 2003: refinancing volumes were unprecedented and margins, as measured by the primary-secondary spread (30yr mortgage rate-FNMA MBS current coupon yield) that peaked at 60 bps, were relatively attractive. When mortgage rates moved higher in 2004, refinancing volumes – and margins – collapsed. With massive capacity and minimal volume/margin in higher quality lending, the industry turned to higher margin, riskier lending as the alternative; we’ll come back to that in a moment.

But first, fast forward to 2018 in Chart 4 After years of low interest rates in the post crisis period, most that could refinance have refinanced: the MBA refi index is now at the lowest levels of the millennium. Chart 5 shows that purchase lending activity is on the rise, although it is still well below the levels of the pre-crisis era.

Going back to the primary-secondary spread in Chart 4, although it’s declined in recent years, we see a still relatively high margin on this low volume lending activity: currently about 75 bps, well above the levels of the pre-crisis period. The margin suggests no need to stretch on lending standards, but the volumes suggest that bankers have to work hard to get their share of the pie.

Next, consider some of the changes that have taken place or are underway.

Chart 6 and Chart 7 show the composition of lending in 2005 and 2017, respectively.

In 2005, 54% of production was ARMs, 36% was “expanded credit,” and 43% was government/conventional. In 2017, the composition shifted to 12% ARMs, 2% “expanded credit,” and 80% government/conventional lending. Clearly, the post-crisis regulatory changes and financial penalties associated with pre-crisis lending practices have changed lending behavior to higher credit quality.

Table 1 shows a lending and servicing snapshot for 2017, including YOY changes. Bank lenders experienced above average declines in lending volumes in 2017 while a number of the top 10 non-bank lenders actually experienced growth in originations.

On servicing, the shift away from the banks to the non-banks is even more pronounced. Bank servicing portfolios declined in aggregate while non-banks experienced double digit or even higher growth rates. Banks are conceding market share.

Overall, while the post-crisis refinancing lending opportunity has passed, and non-bank lenders are increasing their presence in the market, lending standards remain strong. The Urban Institute aggregate measure of the risk of loans closed shows that although credit risk has been rising in recent years, especially in the GSE segment, it remains well below pre-crisis levels (Chart 8).

If there is a trigger for the next crisis or even mild recession, we do not see it coming from the mortgage market. Similar to the indications from the Global Financial Stress and Liquidity Stress Indicators, there are no indications of current stress potential coming from the mortgage market." - source Bank of America Merrill Lynch

We would like to make a couple of remarks on the above. The shift to non-bank eg the "Shadow banking" has been significant. Banks have been less active in that space. Banks under higher regulatory pressure and oversight have reduced their activity and focused mainly on the higher quality segment of the mortgage market.  Also following the housing bust, US Homeownership Rates have come down significantly from a peak of 68% meaning US households could less afford buying a new home and have resorted to renting. Both Healthcare and rents now take a large chunk of the average American household income on a monthly basis. So, overall mortgage activity has become more muted for large banks. As always, there is risk you see and what you don't see to paraphrase Bastiat. It works as well for the US Mortgage market as indicated by the Brookings Institute in their article from the 8th of March entitled "The mortgage market risk no one’s talking about, plus a proposal to redesign the system":

"Nonbank mortgage originators and servicers—i.e.  independent  mortgage companies that are not subsidiaries of a bank or a bank holding company—are  subject to far greater liquidity risks  but  are  less  regulated than bank-lenders and servicers.  As of 2016, non-bank financial institutions originated close to  50 percent of  all  mortgages  and 75 percent of  mortgages with explicit government backing.

...
The research also  suggests that mortgages originated by nonbanks are of lower credit quality than those originated by banks, making nonbank lenders more vulnerable to  delinquencies triggered by a fall in house prices through  the  higher costs of servicing delinquent loans.  A  larger fraction  of  nonbank originations are insured by the Federal Housing Administration (FHA) or Department of Veterans Affairs (VA), which tend to be more likely to default than other types. Among  mortgages  in  Ginnie  Mae  pools, the data  indicate that mortgages originated  by nonbanks are twice as likely as bank-originated mortgages to be two  or  more  months  delinquent."  -source Brookings

Basically, as a reference to Nassim Taleb's latest book, banks have less skin in the game today in the mortgage market than they used to. So if housing is less the issue than in the prior cycle, then what is and what should we watch for when it comes to assessing the state of the credit cycles? 

On this matter we read with interest UBS Global Macro Note  "Credit Perspectives - Caution or Carry?" from the 19th of April in particular relating to the more advanced stage in the US of the credit cycle:

"Q: Where are we in the US credit cycle?

The US credit cycle is later-stage, but unlikely to end in 2018. Later-stage credit indicators are present. Corporate leverage is very high, covenant protections are very loose, lower-income consumer balance sheets are weak, and NYSE margin debt is elevated. But the market trades off changes in conditions, not levels. To this point, we do not see an inflection to suggest the credit cycle is turning. Our latest credit-recession model pegs the probability of a downturn at 5% through Q4'18. Corporate EBITDA growth is running at 5-8% Y/Y, enough to keep leverage and interest coverage from deteriorating. Lending standards and defaults are only tightening and rising, respectively, in select pockets, and the scale of tightening is not enough to engineer broad stress. Last, but not least, a quick shot to growth from significant fiscal stimulus in 2018 should keep the cycle supported.

Q: How will demand for US corporate credit evolve?

We expect overall US credit demand to slow, with an up-in-quality bias developing and continued demand for floating-rate product (leveraged loans, IG floaters). Rising USD funding costs are reducing the appeal of US credit to European and Asian investors. These funding costs are now 2.5% for Japanese investors and 2.8% for European investors (3 month FX swaps). With 3 more Fed hikes in 2018, these hedging costs will climb to 3-3.25% by year-end. We do not expect supportive unhedged foreign flows to materialize due to significant US policy uncertainty, higher capital charges on unhedged positions (especially Solvency II), and regulatory pressure (Taiwan). US IG is better positioned than US HY, as current yields of 3.8% should attract some additional domestic insurer and pension interest. Modestly rising credit risk in HY may also divert some flows back into IG. But US HY outflows are likely to continue, given Fed hikes, tight spreads, below average earnings growth, and declining equity valuations of HY-rated companies.

Q: How will Fed hikes impact the US credit cycle?

4 Fed hikes in 2018 will age the credit cycle and create pockets of volatility. The increase in LIBOR is resetting interest rates higher on $3.2tn of US business loans (1/3 of the total stock) and is reducing the appeal of US fixed-income to non-US investors. Higher interest rates are filtering through to US consumer loans; they are raising funding costs for non-bank lenders who utilize floating-rate bank credit to facilitate lower-quality auto and mortgage lending. But in the context of still strong US growth, the cycle has a buffer. Floating-rate leveraged loan issuers have interest coverage ratios still above 3x (EBITDA/Interest expense) and can withstand 3 additional Fed hikes in 2018. A strong job market will keep consumer delinquencies contained to the subprime space. And rising LIBOR is currently a benefit to large US banks, which can still access cheap funding via retail deposits, while receiving a higher interest rate on their loan portfolios.

We prefer US IG over US HY on a total and excess return basis. US HY spreads of 323bps are expensive vs. our blended model estimate of 429bps, while IG spreads are more aligned (105bps current vs. our blended model estimate of 116bps). We have a slight preference for BBB credit, given higher carry, and also that a declining non-US bid will hurt A-rated demand, while domestic demand could support BBBs. In US HY, we maintain our preference for B-rated credit. CCC's are vulnerable given declining equity valuations, while BB HY will struggle with higher duration fears. We prefer US leveraged loans over US high-yield given our call for 6 Fed hikes by 2019, and much stronger demand for loans and CLOs from US and non-US investors alike. By tenor, we prefer 5- 10yr IG, acknowledging slightly better valuations in the short-end than before. We still believe it is too early to position in 1-5yr IG credit, given lower carry, additional Fed hikes and negative repatriation technicals around large buyback/M&A announcements. We are also cautious on 10+ US IG credit, particularly in higher quality names, given very flat curves relative to expectations.

We understand the levels of conditions are weak, but the changes are critical to capturing inflection points. US earnings momentum, lending standards (C&I, consumer), and consumer defaults will be on our radar. The Fed and BOJ will be important. A Fed more tolerant on inflation will boost our view on risky credit; a change in the BOJ's yield target would be a negative for US credit. The resolution of the ATT/TWX antitrust case will also set the tone for future M&A supply.

A cyclical recovery won't be enough to tighten spreads. For US IG, spreads near current levels (105bps) are justified largely by "soft data", in particular strong ISMs. With a fading foreign bid, increasing duration fears and more M&A activity on the horizon, we think IG spreads will widen to 115bps in the near-term. The one positive is that US IG has already cheapened YTD, which will attract domestic investor interest and reduce material downside.

US HY now screens expensive, as spreads at 323bps are inconsistent with both structural credit risks and increased equity volatility. In addition, we believe significant outflows YTD have whittled down cash balances for fund managers. Aggregate fundamentals remain stable, but tenuous at lower ratings, with leverage elevated and interest coverage weak. We expect HY spreads to shift wider to 400bps.

The credit cycle isn't turning yet. Our credit-based recession gauge highlights a 5% chance of recession through Q4'18, far from the 40-50% that signals a red flag. Earnings growth, lending standards, and bank NPL trends are "good enough" to sustain the cycle. However, interest coverage will likely become less favourable as 3 more Fed hikes in '18 and '19 will flow through to $3tn in floating-rate business debt.

Fixed-rate US HY coupons are stable as firms are not yet refinancing into higher rates. For floating rate leveraged-loans, coupon payments have been range bound, as re-pricings and tighter spreads have offset higher LIBOR. But we expect higher interest payments for loan issuers later in 2018, as the Fed hikes 3 more times, and spreads can't tighten as much to offset higher LIBOR.

Despite rising interest costs, floating-rate US loans have resilient enough interest coverage to sustain 3 more Fed hikes in 2018. This dynamic, plus growing demand for floating-rate credit, underlies our preference for US Loans over US HY. 3 additional Fed hikes in 2019 will prove more problematic. This will push loan coverage ratios to low levels (inferior to 3x) for B-rated firms and pressure free cash flow. Earnings growth will need to rise to reduce this future risk.

US leveraged loan supply hit $500bn in 2017, over 50% for M&A and LBOs, and reported 1st lien leverage is 3.9x – the highest on record. EBITDA add-backs averaged 20-21% in 2017, and are averaging 26% for large PE sponsor deals YTD – suggesting leverage is underreported and rising. A conservative view would push average 1st lien leverage closer to 5x on M&A deals.

The non-US bid into US IG credit will slow in 2018. Non-US investors are paying 2.5% (Japan) & 2.8% (Europe) to hedge their US fixed-income allocations. We do not believe foreign investors will remove FX hedges, given broad uncertainty on the trajectory of the US dollar. As the Fed keeps hiking, these costs will rise further and US IG will become less attractive than long-duration sovereign alternatives and even EU IG credit by year-end.

Slower demand is one part of the equation, but we still expect IG supply to be robust in 2018 (+2.5% Y/Y). The M&A pipeline is large, and we expect more issuance could hit the market, conditional on favourable antitrust outcomes which have lowered closing rates. High multiples and still low rates suggest firms will finance with debt. Offshore repatriation may reduce issuance on the margin, but most IG firms do not have significant cash, either overseas or on balance sheets, to utilize.

The savings from corporate tax reform will only modestly delever capital structures, even assuming firms utilize 25% of their tax windfall to pay down debt. More importantly, credit spreads have already priced this; spreads per unit of net leverage are at all-time tights. Bottom-line, earnings growth needs to be much stronger to de-lever capital structures.

HY spreads have remained very resilient. Despite significant outflows in Q1, HY spreads were effectively unchanged. We believe Dec'17 coupon reinvestments and low issuance YTD (-22%) had replenished cash buffers. But given the outflows of Q1'18, cash buffers are low once again. We expect HY spreads to widen more aggressively if volatility picks up anew." - source UBS

As we pointed out recently, rising dispersion means that at the current stage of the credit cycle in the US, credit investors are becoming more discerning in their issuer process selection, meaning overall that active credit manager should continue to outperform as the credit cycle is gradually turning on the back of the Fed continuing its hiking trajectory. Sure, "beta" has rallied hard recently, but, one should think about gradually adopting a more defensive stance by starting to reduce high beta exposure towards safer places. While we pointed out in our conversation "Fandango" that some positioning appears to be stretched such as short the long end of the US yield curve, we don't think yet with have reached the "trigger point" making us bold enough to dip our investing toes into the long end of the US yield curve particularly as we are getting closer to the 3% level on the 10y Treasury yield. We are certainly watching any signs that would point out that the recent weaknesses seen in hard and soft US data has been temporary or not. 

While the "Golden Rule" is being vindicated by the Trump administration for the growing use of trade war measures, boosting gold price in the process, 2018 seems to be marking the return of "Macro" as a strategy following the unfortunate demise of many Hedge Fund players after years of financial repression thanks to lack of cross-asset volatility. As per our last charts below, Global Macro is making a come back thanks to rising volatility and dispersion across asset classes it seems.

• Final charts -  The return of Macro to the forefront thanks to higher interest rates

The final removal of the lid on volatility which has prevailed thanks to the strong central banking narrative has been fading and marked earlier on this year by the explosion of the short-vol pig house of straw that built up during many years. Our final charts come from Bank of America Merrill Lynch from their Global Liquid Markets Weekly note entitled "The gold big bang theory" from the 16th of April 2018 with one of the charts displaying the spike in vix which can be linked to the rising rate environment:

"Tighter Fed policy is helping lift OIS and LIBOR

We first argued in September 2017 (see Mind the unwind) that risk assets could suffer as a Fed balance sheet compression added on top of an already steady pace of US interest rate hikes. Six months later, the effects of tighter US monetary policy are starting to become visible in a number of markets and returns across major asset classes are negative for the year. The Fed has already been hiking rates at a steady pace for 9 quarters now (Chart 1).

Looking forward, with a tight labor market backdrop and rising commodity prices, our economics team believes that the Fed will likely complete three more hikes this year. In addition, we believe that Fed balance sheet tapering (see Missing the BEAT) has been an important contributor to the rapid widening in the 3m LIBOR-OIS spread (Chart 2).

In turn, higher interest rates are pushing up vol...

Just like ultra loose monetary policy was a balm for asset markets, this combination of rising rates and balance sheet tightening could well be having the opposite effect on bond and equity markets. As we have previously explained, rising interest rates tend to put upward pressure on macro volatility (Table 1).

This effect is often lagged but quite persistent, and macro volatility has been on the rise for some time now. In our view (see Forward vol looks cheap to carry as long as you believe markets are late cycle), the spike in the VIX can be partly traced to the rising interest rate environment (Chart 3).

But higher interest rates are not the only source of uncertainty at the moment for global markets.

...as US fiscal policy is entering a slippery slopeIn fact, just as monetary policy has tightened, the US Federal budget deficit is poised to balloon (Table 2) over the coming 24 months.

Our economists have previously argued (see Fiscal injection: round 2), that the US Federal government could face the worst cyclically adjusted fiscal deficit as a 5.1% of GDP in 2019 because of the continuous fiscal stimulus: tax reform, increase in budget caps, and greater infrastructure spending. Less bond demand from the Fed and a tightening interest rate path is meeting looser fiscal policy. And as the Fed stops reinvesting its bond proceeds, the market will have to absorb more US Treasuries (Chart 4).

Recent tax changes have also reduced the demand for dollar commercial paper from US corporates abroad.

Inflation is trending higher helped by oil prices

Of course, the tighter monetary policy path in the US and the normalization of interest rates is informed by the rising inflation pressures across the economy. On the one hand, the decline in the unemployment rate will likely support a steady increase in core inflation (Chart 5).

On the other hand, rising oil prices are already feeding into an increase in headline inflation (Chart 6).

Because we now expect Brent crude oil prices to hit $80/bbl over the coming months (see The ruble drop is bullish for oil) and US job growth is poised to remain steady, the Fed will likely continue to tighten policy.

Naturally, cross-asset info ratios have fallen

Tighter money policy will continue to impact macro volatility. With volatility on the rise, info ratios across major asset classes could well continue to roll over (Chart 7) in the coming months.

In our view, equities and bonds are unlikely to see the stellar rolling Sharpe ratios of the past few years as the Fed continues to drain liquidity. Moreover, we would argue that a tighter US monetary policy outlook is already acting as a drag on asset values. Year to date, cash returns of 0.4% compare favorably to S&P returns of -1.2%, Eurostoxx returns of -2.0%, or 10 year treasury returns of -2.1% (Chart 8).

So is the Fed ready to switch course? Not yet

True, leading indicators such as PMIs remain in positive territory across all major economies and inflation is on the rise. So the Fed is unlikely to change Yellen’s preset course for now under the new leadership of Powell. Yet, as money supply around the world continues to roll over on the back of tighter policy, asset returns could struggle (Chart 9).

The market is perhaps right to expect the Fed to hike interest rates roughly as scheduled (Exhibit 1).

 

But we still believe that escaping zero interest rate policy (ZIRP) will not result in a smooth path for asset markets." - source Bank of America Merrill Lynch

Back in November 2012, in our conversation "Why have Global Macro Hedge Funds underperformed?" we posited that when volatility across all asset classes crashes, global macro strategies tend to suffer on both an absolute and relative basis. If indeed we are moving from a cooperative world to a noncooperative world based on the Golden Rule in conjunction with a return of volatility then one should be wise to dust up the Global Macro playbook we think... 

"Monetary policy causes booms and busts." - Edward C. Prescott, American economist and Nobel Prize in Economics.

Stay tuned !