Credit - The tourist trap

"Employ your time in improving yourself by other men's writings, so that you shall gain easily what others have labored hard for." - Socrates

Looking at the continuous outflows from Emerging Markets funds and in continuation of our recent title analogies relating to the "reverse osmosis" thesis, we thought this time around we would use a simpler analogy in our title reference namely the colloquial "tourist trap". As per the definition of a "tourist trap", a tourist trap is an establishment, or group of establishments, that has been created or re-purposed with the aim of "attracting tourists" and their money.

Our favorite "magician central banker in chief", namely Ben Bernanke, has indeed engineered the "best" of tourist trap when it comes to Emerging Markets. 

In our case, Ben's "tourist trap" involved ZIRP, low volatility and high carry trades in Emerging Markets currencies which, for many years, had the favors of Japanese retail investors in the form of the "double-deckers" (the famous Uridashi funds which particularly favored the Brazilian real). 

Of course if Bernanke is serious about initiating his "tap dancing" following "twist", this might spell out the "last tango" for Emerging Markets, and as we posited in a previous conversation (Singin' in the Rain), we might get another "dollar" crisis on our hands:
"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:

"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely:

 Wave number 1 - Financial crisis

 Wave number 2 - Sovereign crisis

 Wave number 3 - Currency crisis

If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?"

"Wave number 3", namely a Currency crisis is still in its infancy and is highly dependent on the "tapering" stance of the US Fed although, as per its members, the fate of Emerging Markets, is not really their "primary" concern...
"An appropriate next step toward normalizing monetary policy could be to reduce the pace of purchases from $85 billion to something around $70 billion per month." - Kansas City Federal Reserve Bank President Esther George - 6th of September 2013.

So in this week's conversation, and in continuation to our "reverse osmosis" analysis from previous weeks, we will look at the evolution of the "tourist trap" as well as the "Great Rotation" story as far as flows are concerned and the potential evolution in the markets (our own "Forward Guidance" so to speak), which warrants caution we think in this "statistically" bearish month of September ("Over the long haul, September has been the weakest of the 12 calendar months" - Doug Short).

A good illustration of our chosen theme of "tourist trap" can be seen in the slide of India's rupee which saw its dollar denominated external debt swell in recent years courtesy of "hot money" thanks to the "generosity" of our "magician-in-chief" aka Ben Bernanke:

- graph source Thomson Reuters Datastream / Fathom Consulting / Macronomics.

Also, when it comes to India's external debt and as illustrated recently by Bloomberg Chart of the Day, the rise of its external debt burden does complicate the situation for India in defending its currency. We could in fact call it the rupee "tourist trap" we think:

"India’s record foreign debt threatens to undermine the government’s plan to halt the rupee’s biggest slide in more than 20 years by reining in the budget and current-account deficits.
The CHART OF THE DAY shows the rupee weakened to an all-time low this year even as the combined deficits shrank. Previously the currency rose when the shortfalls narrowed and fell when they widened. The rupee dropped 8.1 percent last month to as weak as 68.845 per dollar. The lower panel tracks external debts owed by Indian governments and companies, which swelled to $390 billion as of March 31.
“Until the start of the current sell-off, the rupee had stuck pretty closely within the confines of its combined current-account and budget deficits,” said Philip Wee, a senior currency economist in Singapore at DBS Group Holdings Ltd. “By that measure, the rupee should be between 50 and 60 to the dollar, not 65 and 70.” 
India’s offshore liabilities rose to 21.2 percent of gross domestic product in the year ended March 31, according to official estimates, the highest since 2001. The rupee has plummeted 18 percent since then, the steepest drop among 24 emerging-market currencies tracked by Bloomberg. This has made refinancing the debt more expensive as global borrowing costs climb because investors expect the U.S. to pare stimulus thisyear, curtailing flows to emerging-market assets.
Finance Minister Palaniappan Chidambaram told the lower house of parliament on Aug. 27 that India’s twin deficits are responsible for the rupee’s fall, and that external debt was manageable.
He announced plans on Aug. 12 to reduce the current-account shortfall to within 3.7 percent of GDP this fiscal year from a record 4.8 percent in the prior period. The government us seeking to contain the budget shortfall to 4.8 percent of GDP from 4.9 percent." - source Bloomberg.

All the investors that piled in "high beta trade", namely our "tourist trap", in the form of Asian High Yield, Emerging Debt Bonds and Equities as well as Emerging Currencies are being hit hard. They thought they were "smart investors", playing "alpha", when it was a pure beta play courtesy of repressed volatility thanks to central bank meddling due to negative real US interest rates.

And, when volatility is not repressed due to "tapering", this is what you get as illustrated by Merrill Lynch MOVE index rising back towards its record high of 118 bps:

We recently added JP Morgan Emerging Markets Currencies Volatility Index to our graph to display the on-going effect US Treasury volatility has on Emerging Market currencies.

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market currencies. The index is based on three-month at-the-money forward options, weighted by market turnover.

With US real interest rates moving into positive territory, it is therefore not really a surprise to read that Asian dollar denominated bonds have dropped below par for the first time since 2011 as reported by David Yong in Bloomberg in his article from the 2nd of September 2013 entitled "Asian Bonds Tumble Below Par in Capital Flight":
"Asia dollar-denominated bonds have dropped below par for the first time since 2011 as investors pull money out of the region amid concerns that growth is slowing and as currencies from the rupee to rupiah plunge.
Average prices of company debentures in the region fell to 98.61 cents on the dollar on Aug. 22, the least since October 2011, Bank of America Merrill Lynch indexes show. Dollar bonds globally have held above 100 cents since September 2009. Both investment- and non-investment-grade debt in Asia were below par on Aug. 22. The last time that happened was in September 2008, when Lehman Brothers Holdings Inc. collapsed.
Investor sentiment toward Asia is shifting as economic growth in China slows and currencies in India and Indonesia -- the two countries with the biggest external funding needs in the region -- plunge. About $44 billion has been pulled from emerging-market stock and bond funds globally since the end of May, data provider EPFR Global said on Aug. 23." - source Bloomberg

Investors are indeed trying to escape the "tourist trap" while some others are seeing their "tourist clients" finding their debt "less appealing" as witnessed in the recent auction failures for Russia, India and Taiwan, as discussed by Alex Nicholson and Lyubov Pronina in Bloomberg on the 4th of September in their article entitled "Russia joins India to Taiwan as Emerging Debt Sales Miss Targets":
"Russia failed to raise as much money as planned at a government bond auction, joining nations from India to Taiwan in missing borrowing targets as investors keep away from emerging-market assets.
The Finance Ministry in Moscow sold 6.07 billion rubles ($182 million) of its so-called OFZ notes due May 2016 after offering 13.6 billion rubles, according to a statement on its website. Russia canceled an auction last week as only one bidder took part. The ministry issued today’s bonds at a 6.5 percent average yield, the top of its proposed range.
Developing nations are trimming auctions as the prospect of the U.S. paring financial stimulus measures and tensions over Syria curb investor appetite for riskier assets. India’s central bank said it cut the size a debt auction this week to 100 billion rupees ($1.5 billion) from 150 billion rupees. Indonesia scaled back an Islamic debt offering for the first time since July, while Taiwan’s note sale yesterday fell short of the government’s goal for the first time since 2011." - source Bloomberg.

When it comes to the famous "Great Rotation" story from bonds to equities put forward since the beginning of the year, the only "Great Rotation" story as far as equities are concerned appears to be from Emerging Markets to Developed Markets as displayed by the cumulated weekly flows into Developed Markets and Emerging Markets from Nomura's recent Global Equity Fund Flow report from the 6th of September:

- source Nomura.

Of course some would argue that this "Great Rotation" story from bonds to equities, as far as flows are concerned, has been playing out in earnest in 2013 as displayed in Nomura's recent report:

- source Nomura.

So far, so right...but, if one looks at the inflows into bonds versus equities since 2010, then the "Great Rotation" story does seem much ado about nothing as displayed once more in Nomura's recent chart:

- source Nomura.

In fact, what seems to be happening, when it comes to "Great Rotation" for equities is a rotation out of equities except for European equities according to Nomura:
"Equity and bond funds both suffered outflows last week with USD 11bn redemptions from equity funds and a small net outflow of USD 0.8bn from bond funds according to EPFR. Money market funds also saw net sales totalling USD 7.5bn last week. Both developed market and emerging market equity funds suffered net selling and European funds once again outperformed, being the only region that we track to have received net inflows last week. Our global composite flows based equity sentiment indicator has oscillated fairly tightly around 1 standard deviation over the most recent eight weeks and last week dropped marginally to 0.97 standard deviations, a reading that we would consider as bullish but just below extended levels.
-US fund investors sold USD 5bn from equity funds last week. Over the past three weeks they have withdrawn a total net USD 15bn from equity funds, reversing only a fraction of the net USD 141bn invested into equity funds in the 33 weeks of the year to 14 August, according to the Lipper weekly reported dataset. Our US flows based indicator continued to moderate last week and now reads 0.7 standard deviations, signalling moderately bullish sentiment in our view.
-European equity funds bucked the global selling trend as they attracted an additional USD 0.8bn of net inflows last week. This is the 10th consecutive week of net inflows into European equity funds, a major reversal from the persistent selling seen in recent years. However, last week's inflow showed a moderation in the magnitude of money flowing recently into European equity funds. Consequently, our European flows based equity sentiment indicator was unchanged over the week at 2.24 standard deviations but remains close to the historical bullish extremes of sentiment measured over the past nine years.
-Emerging market equity investors continued selling equity funds last week with an additional net USD 2.8bn outflow from GEM equity funds. Although last week's outflow was the most significant since the end of June, our GEM sentiment indicator rose to -1.4 standard deviation but still reflects very depressed sentiment towards EM equities. Furthermore, investors continued to exit from the dedicated regional EM equity funds with net outflows of USD 1.1bn from Asia ex Japan funds, USD 0.1bn from LatAm funds and the highest weekly outflow (USD 0.5bn) from emerging EMEA funds in almost two years." - source Nomura.

"Great Rotation" or "Great Escape" you decide, given Bank of America Merrill Lynch also indicated on a note from the 5th of September entitled "EM Pain trade is up" the following:
Big weekly equity redemptions of $11.4bn. Past 3 weeks equity outflow of $29bn largest in 2 years (Chart 1). 

Investors reduced exposure in run-up to payroll. Big $6.1bn redemptions from EM stock & bond funds. Massive $60bn outflows from EM equity & bond funds over past 3 months = capitulation. Note EM equities outperformed after similar redemptions Jul'04, Aug'06 and Sep'08 (Chart 2).

Tactical bounce in EM equities continues unless a big payroll print (>250K) causes gap higher in treasury yields (>3%).
Inflows to Treasury funds this week despite historic sell-off. Follows 8 weeks of redemptions. Suggests onset of smart short-covering in recent days. Blowout payroll required for clean immediate break of 2%, 3%, 4% levels by 5, 10, 30-year Treasury respectively. No jobs blowout...look for reversals in recent sell-offs in bonds and EM." - source Bank of America Merrill Lynch.

Yes, the bounce in Emerging Markets has indeed occurred in the past after similar redemptions, but we disagree with Bank of America Merrill Lynch. We have not seen the bottom yet, and that the rebound could probably materialize at a later stage, maybe in 2014.

Why so?

Because of tightening financial conditions, particular in China following a massive credit growth, which will impact bank lending behavior in a negative way. China is increasing the clampdown on credit and on industrial overcapacity. Given banks are always a leverage play on economic growth, despite record profits at China's largest banks, stock valuations are not benefiting from this surge given the significant rise in nonperforming loans as displayed in the below Bloomberg graph:

"The CHART OF THE DAY shows that while combined net income of Industrial & Commercial Bank of China Ltd., China Construction Bank Corp., Agricultural Bank of China Ltd. and Bank of China Ltd. for the three months to June 30 was 72 percent higher than three years ago, their price-to-estimated earnings ratios have fallen since then. The lower panel shows total nonperforming loans in the nation started increasing in September 2011.
Default risk is rising in the world’s second-largest economy, which economists forecast will grow this year at the slowest pace in 23 years. The government has been clamping down on excess capacity in industries including steel and cement as it tries to transition to a more sustainable economic growth model based on consumption rather than export-driven production." - source Bloomberg.

The delicate rebalancing act for the Chinese economy is in fact being put at risk by the aggressive "tapering" stance at the Fed as indicated by Chinese Vice Finance Minister Zhu Guangyao comments at the G20 as reported by Bloomberg:
"The U.S. should be mindful of a possible “very significant spillover effect,” said Zhu, who called for greater coordination between nations and added that there’s no need for a rescue plan for developing countries."

He also added:
“Some emerging-market economies are facing difficulties,” Zhu said. “Capital is flowing out of these countries and their currencies are under pressure of depreciation, and the major direct cause of such a phenomenon is the Fed’s announcement that it may exit its unconventional monetary policy. However, on the other hand, there are some structural problems with these emerging market economies as well.” - source Bloomberg, "China Asks U.S. to Cap QE Exit Risk as Indonesia Warns of Impact"

Therefore the impact of a tightening credit channel in China means more pain for the current account of countries exporting to China (including Germany), given that in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off.

The tightening credit channel in China and the clampdown on overcapacity will of course hurt Germany.

These were our concluding remarks in our recent conversation "Fears for Tears":
"The CHART OF THE DAY shows that Germany’s factory output as gauged by a manufacturing purchasing-managers’ index has mirrored Chinese bank-lending growth since a credit boom that began in 2008"

No surprise therefore to see German industrial production falling more than expected in July after surging in June, adding to signs that growth in Europe’s biggest economy is moderating:
-Output, adjusted for seasonal swings, fell 1.7 percent from June, when it jumped a revised 2 percent, the Economy Ministry in Berlin said on the 6th of September when economists were only expecting a decline of 0.5%.
-German exports, adjusted for working days and seasonal changes, fell 1.1 percent in July from the prior month, the Federal Statistics Office in Wiesbaden. Economists predicted an increase of 0.7 percent in a Bloomberg News survey.

On the impact of current account for countries exporting to China, we agree with our friends at Rcube Global Macro Asset Management:
"Current account of countries exporting to China are turning negative (and will remain so as long as China tighten its flow of credit). FX reserves’ pace of accumulation reverse and with them a host of asset prices that have been tightly correlated with it over the last decade: domestic real estate and equity prices, private consumption, commodity prices etc…"

- source Rcube Global Macro Asset Management

So, due to our Pareto efficient economic allocation, the weakness in Emerging Market equities, which have been simply the victims of currency wars and "Abenomics" mostly, (see our post "Have Emerging Equities been the victims of currency wars?"), will continue further, because the "reverse osmosis" occurring in Emerging Markets as displayed by "funds allocation" is positively correlated to US real rates moving into positive territory, or put it simply, when the risk doesn't match the reward anymore. 

The velocity in the "allocation" is entirely due of course to the speed of rising yields in developed countries as displayed in the chart below from Thomson Reuters Datastream / Fathom Consulting displaying by how many basis points 10 year yields have risen since the 30th of April:

- graph source Thomson Reuters Datastream / Fathom Consulting:

On a side note, those who piled into Apple 30 years, part of their $17 billion bond auctioned on the 30th of April are probably still licking their wounds given these bonds are currently trading around 83 in cash price...But, don't despair, you might get a "second chance" with Verizon which plans a record $25 billion debt offering as it gathers financing to buy Vodafone’s stake in their Verizon Wireless joint venture...

Moving on to our own "Forward Guidance", as we enter the statistically dangerous month of September, some additional signs in the markets, apart from "tapering" noise, Syrian issues, European political jitters in Italy and Emerging Markets tantrums, can be seen in the currency market according to our Rcube friends, in particular in the AUDCHF currency pair:

"The world’s economic momentum is slowing not accelerating, as evidenced by the AUDCHF:

The AUDCHF is a much better leading indicator of global growth than PMIs:

The Australian dollar is a commodity currency, with a high sensitivity to cyclical commodities, and hence to world growth. On the contrary, the CHF is a defensive, safe haven currency; it tends to appreciate when investors become risk averse.

As a result, the AUDCHF usually weakens when global growth economic momentum slows down and/or when financial stress kicks in. When the two happen at the same time (1998, 2001, 2008, 2011) the move is all the more violent. 

Today, the AUD is weakening because of the EM slowdown, but more recently the CHF has strengthened on its own, probably on the back of rising risk aversion due to the FED tapering anxieties (EURCHF peaked on May 22nd)." - source Rcube Global Macro Asset Management

And if you think that the "reverse osmosis" plaguing Emerging Markets has touched a bottom, think again because as our Rcube friends put it, regardless of the incoming chatter surrounding the "debt ceiling" debate, budget balances do matter, but the US budget balance, when it comes to Emerging Markets, it matters A LOT:
"Additionally, the US budget balance is improving faster than at any time in history. In the past this has been associated with a tighter liquidity environment (fewer dollars in circulation) which was particularly negative for emerging markets. As shown in the chart below, when the budget balance improves (deviation from 2yr trend goes up), emerging markets underperform DM equities, and inversely. Given the current expectation for the budget deficit to shrink further (‐2% of GDP in 2015 vs. ‐4.6% today), the relationship will remain negative for EM equities in the foreseeable future."

Another evidence that deflation might be a bigger threat than inflation is the fall of breakeven rates. In that sense, the negative correlation between equities and inflation expectations could be a complacency sign. Japan has won the currency war, it is now exporting deflation through lower export prices, and it is forcing others to do so as well. But because Europe is in a current account surplus and the US is moving towards the neutral zone, the currency war will be much less effective. This is also why inflation expectations are currently falling fast.

This would be worrying enough on its own. The problem is that Europe is deleveraging at the same time. Its credit channel remains weak. As a result, unemployment keeps rising." 
- source Rcube Global Macro Asset Management

On a final note, we would like to provide you with another "out of the box" interesting indicator we follow namely Sotheby's stock price versus World PMIs since 2007 - graph source Bloomberg:

The performance of Sotheby’s, the world’s biggest publicly traded auction house is indeed a good leading indicator and has led many global market crises by three-to-six months.

The recent stellar performance of the art market in general and Sotheby's in particular can also be partly explained by the flood of global liquidity provided by our "omnipotent" central banker at the Fed. Art markets and economic growth tend to be positively correlated we think.

And, when it comes to providing "liquidity" and market backstop, rest assured that Sotheby's has been as involved as any central bank, given it has started again into auction guarantees totaling $166.4 million in a move aimed at winning more consignments. But, more recently the New York-based auction house said last night it’s reducing its exposure by “irrevocable bids” of $23.5 million, which are from undisclosed third-party guarantors. It may further reduce risk by additional “irrevocable bids” before auctions in the fourth quarter, it said in the filing with the U.S. Securities and Exchange Commission as reported by Bloomberg.

Looks like even auction houses are preparing for "tapering"...
Oh well...

So move along, no risk of financial crisis:
“The probability of it happening again in our lifetime is as close to zero as I could imagine"

“The way these firms are managed, the amount of capital that they have, the amount of liquidity that they have, the changes in their business mix -- it’s dramatic.”

“The largest financial institutions in the U.S. are as healthy now as they have ever been,”

“There’s a difference between incompetence or mismanagement or poor judgment or excessive risk taking from actually breaking the law,”

“There’s nothing I’ve seen that would suggest that any of the major participants in the financial crisis should be in jail for their actions.”
- Morgan Stanley Chief Executive Officer James Gorman, on the Charlie Rose show.

Stay tuned!

Credit - Misstra Know-it-all

"The only thing we have to fear is fear itself." - Franklin D. Roosevelt 

While we ventured back last week towards biology analogies in our chosen title, we have chosen again to venture towards our beloved musical analogies in this week chosen title. This time around we decided to pick probably our favorite song from Stevie Wonder, namely 1974 hit "He is Misstra Know-it all", from his "Innervision" album masterpiece. 

Why our chosen title?

The song "He is Misstra Know-it-all" is essentially a long description of a know-it-all confidence trickster character (in our case our "omnipotent" central banker at the Fed) who is a "man with a plan", who has a slick answer to all his critics and who has "a counterfeit dollar in his hand."

Looking at the continuing "funk" in Emerging Markets, courtesy of many years of lax ZIRP monetary policies by the Fed, we were, like many pundits, taken aback by the latest comment coming from the Fed during their latest Jackson Hole meeting in particular coming from the president of Atlanta Fed Dennis Lockhart on Bloomberg TV:

“You have to remember that we are a legal creature of Congress and that we only have a mandate to concern ourselves with the interest of the United States” 

“Other countries simply have to take that as a reality and adjust to us if that’s something important for their economies.”

Although Chinese Sheng Laiyun, a spokesman for the National Bureau of Statistics, said in a press briefing in Beijing reported by Bloomberg the following:

“Given that U.S. monetary policy has a huge influence on emerging markets and the global economy, we hope that U.S. monetary policy authorities, whether exiting or scaling down stimulus, will not only consider the U.S.’s own economic needs but also think about economic circumstances in emerging markets,”

Don't bet on that, given James Bullard president of the Saint Louis Fed comments as reported by Bloomberg:

“We’re not going to make policy based on emerging-market volatility alone"

"If you tell him he's livin' fast 

He will say what do you know 

If you had my kind of cash 

You'd have more than one place to go oh" 

Lyrics from "He is Misstra Know-it all", Stevie Wonder, 1974.

By suppressing interest rates through ZIRP, the Fed has allowed risks to be "mis-priced" leading to global aggressive "mis-allocation" of capital in the search for returns. As displayed in the below graph from Nomura's recent paper from the 30th of August entitled "EM performance, renewed outflows, chicken & egg", inflows in Emerging Markets have been significant since 2010, as US real rates stayed in negative territory. 

"Our local bond market analysis using country-specific data from official sources shows much less outflows, suggesting to us that the first round of outflows by retail investors in July was possibly met by institutional investors buying EM. Note that some bond markets (in this most recent sell-off) with high weights in EM local bond indices have started to lose liquidity quite significantly (Indonesia and Turkey are the key examples) and asset swaps in markets with good liquidity turned negative. Bad liquidity markets saw asset swaps widen considerably (making swap paying less of a hedge) and start to trade like credit products. This phenomenon, if it continues, could result in a lot of proxy hedging through FX, FX vol, buying CDS and, at a more serious stage, selling what investors could unwind. Clearly, we are not there, but the performance deterioration is probably a good reason to pause and think about liquidity more than usual before entering fresh trades (as being too liquid now would be a concern for that market which could be subject to "proxy hedging")." - source Nomura

Of course given volatility is on the rise and that VaR (Value at risk) has risen sharply from a risk management perspective, re-calibrating risk exposure could indeed accentuate the on-going pressure of reducing exposure to Emerging Markets, triggering to that affect additional outflows in difficult illiquid markets to make matters worse.

The volatility in the fixed income space has remained elevated as displayed by the recent evolution of the Merrill Lynch's MOVE index rising from early May from 48 bps  towards the 100 bps level, whereas the VIX, the measure of volatility for equities is reacting as well. We have also added JP Morgan Emerging Markets Currencies Volatility Index - graph source Bloomberg:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market currencies. The index is based on three-month at-the-money forward options, weighted by market turnover.

So in this week's conversation, and in continuation to our "reverse osmosis" analysis from last week, we will look at"positive correlations" and outflows courtesy of central banks meddling as we enter the "decisive" month of September as far as risky assets are concerned. 

As we argued in  our conversation "Alive and Kicking":

"For us, there is no "Great Rotation" there are only "Great Correlations""

A perfect example of the illustration of positive correlations and the meddling of our "Misstra Know-it-all" with financial prices, has been, no doubt, in the commodity space.

The Fed tried to increase jobs by lowering interest rates, weakening the dollar in the process, boosting exports but exporting inflation on a global scale, particularly in the commodities space, leading to political instability in the process with QE 2. The effect QE 2 has had on the commodity sphere has been well described in a Bank of Japan research paper entitled "What Has Caused the Surge in Global Commodity Prices and Strengthened Cross-Market Linkage?", published in 2011.

Like we said about "positive correlations", "Misstra Know-it'all" has indeed played a quick hand, lifting stock prices, playing on the wealth effect game and exporting "hot money" flows in Emerging Markets.

We have been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:

In our "Pareto Efficiency" conversation back in September 2012 we indicated:

"QE2 saw a surge of the SPX (Standard and Poor's 500) as well as a surge in oil prices as well as significant surge in US Treasuries yield, which surge by 100 bps from 2.50% to 3.50%. 2011 saw a significant correlation with SPX, Oil and US treasury yields falling significantly during the "risk-off" period triggered by liquidity. This time around, one can expect during the on-going "risk-on" period to see as well rising US Treasury yields in conjunction with surging SPX and oil prices."

This of course exactly the same movie...

When it comes to "Misstra Know-it-all" and positive correlations in the commodity space, we have read with interest Barclays note from the 30th of August 2013 entitled "Untangling commodity correlations":

"Commodity markets continue to chart a path of independence, reflecting a breakdown in recent patterns with lowered commodity/equity correlations, a downtrend in cross commodity correlations, as well as changed relationships between the US dollar and oil prices.

The reputation of commodities as a portfolio diversifier, lacking a consistent correlation with equities based on historical trends has been undermined following the 2008 recession, with commodity/equity correlations moving and staying in highly positive territory from September 2008 onwards. However, of late, commodity markets have been reflecting a breakdown in recent patterns with lowered commodity/equity correlations, a downtrend in cross commodity correlations, as well as changed relationships between the US dollar and oil prices. The recent sell-off in equity markets, particularly in emerging markets, has not been replicated in commodities. Instead, commodity prices have been rather stable in the current market environment where sentiment is being dominated by expectations regarding the start of QE tapering and negative newsflow from emerging markets. Not only have commodities been stable, they are actually among the strongest performing assets this quarter and gaining, in contrast to the losses in equity markets. The positive correlation between commodities and equities has continued to trend lower and has recently fallen into negative territory (see Figure 1). 

While it may be premature to say that the long period of positive commodity correlations with equities is now over, the latest move is part of a consistent trend of diminishing positive correlations in place since late last year, suggesting that commodities can still provide investors with diversification.

After an extended period of trading as a derivative of risk-on, risk-off sentiment through much of 2011 and all of 2012, commodity markets have also been less shackled by macro drivers this year. While the flow of economic data, liquidity and monetary policy continue to affect commodity prices, they have ceased to be the dominant driver, which is in stark contrast to the way commodities traded in line with the European debt crisis."  - source Barclays

What has changed as well is the relationship of Oil and the US dollar as indicated in the same note:

"Typically, a stronger US dollar has implied weaker dollar denominated commodity prices and vice versa but recent performances reflect a more mixed outcome. Broadly the commodities complex has followed that logic but a notable absence has been WTI crude oil where the recent rally has gone hand in hand with a stronger dollar, leading to a stark rise in the positive correlation between these two variables. At 58%, that positive correlation between WTI crude oil prices and the US$ trade weighted index has spiked sharply higher (see Figure 3). 

However, in other commodity markets like base and precious metals, the dollar has continued its negative correlation." - source Barclays

Not so fast...

We do believe that increasing tensions in the Middle-East make it very likely to see an additional rise in WTI Oil prices, which could "roil" the "nascent" US recovery and gold is likely to rebound further from a positioning point of view (we will look at positioning further on).

Dollar index versus Gold - graph source Bloomberg:

Looking at the ongoing predicament in emerging markets, in similar fashion to our May 2012 conversation "Risk-Off Correlations - When Opposites attract", the Greenback remains a powerful magnet as far as capital flows are concerned.

Last week, we indicated:

"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. By put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up." - David Goldman's article about Gold and Treasuries and bonds in general written in August 2011 (the former global head of fixed income research for Bank of America)

So far we have bought the put leg of the put-call parity strategy and we are indeed thinking of adding the call leg shortly."

As we stated above, for us, there is no "Great Rotation" but "Great Correlations".

Also as we have argued in "Pareto Efficiency":

"Given that in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off, investors are facing indeed an increasingly strong dilemma, due to the growing number of US retirees and a falling yield environment"

"The Baby Boomers Generation is that huge post-war cohort born between 1946 and 1964. The first wave of baby boomers turned 65 in 2011. It is estimated that during the next 20 years, roughly 74 million "boomers" will retire in the United States. That is an average of more than 10,000 new retirees a day!

The rest of the world also had their own "baby booms". The United Kingdom, France, Denmark, The Netherlands, and Australia are just some of the other countries considered to have had Baby booms starting around 1946." - source Keenan Overseas Investors.

As far as consumers and The Wealth effect are concerned QE wise, as indicated by Keenan Overseas Investors:

"- Many US and European property markets have significant unsold inventories.

- New generation of young adults in the US weighed down by student debt.

- Consumer demand reduced when people consider themselves poorer.

If interest rates increase, all of these problems get worse!"

Exactly! And if you are expecting that Baby Boomers will not influence US Treasuries and we have escaped the deflationary environment, you are wrong as displayed by Bloomberg's Chart of the Day from the 25th of August:

"Baby Boomers’ influence on U.S. Treasuries will help hold yields down as people born in the initial decades after World War II shift to fixed-income assets to prepare for retirement, mirroring a pattern in Japan.

The CHART OF THE DAY shows Treasury yields have gradually declined as the proportion of U.S. citizens over 65 years climbed. The age group will swell to 20 percent of the population by 2030 from 14 percent now, according to the U.S. Census Bureau. The chart tracks a similar trend in Japan, where 24 percent are over 65 years, the world’s highest ratio of seniors, up from 19 percent a decade ago.

“As Japan’s population aged, that suppressed bond yields,” said Larry McDonald, the chief equity, credit and policy strategist at Newedge USA LLC in New York. About 4,100 Americans are turning 65 every day, quadruple the number in 2003, he told Bloomberg Radio’s “The Hays Advantage” earlier this month. “Those people are more likely to own bonds,” he said. Baby boomers are considered people born from 1946 to 1964.

Demand from retirees hasn’t been enough to offset a bond market rout this year. Treasuries have tumbled on speculation the Federal Reserve will taper an $85 billion monthly debt-buying program designed to stimulate the economy amid signs output and jobs are growing. Government securities have fallen 3.9 percent through Aug. 22, based on the Bloomberg U.S. Treasury Bond Index.

Japan’s 10-year bonds yielded 0.765 percent at the end of last week, the lowest of 27 developed markets Bloomberg tracks. The nation’s central bank has its own debt-buying program, worth about 7 trillion yen ($71 billion) of securities a month.

Investors are snapping up Japanese bonds even though the nation’s debt is equivalent to more than double its gross domestic product, McDonald said. The ratio is the highest in the world, data compiled by Bloomberg show. The U.S. debt is equivalent to 74 percent of GDP." - source Bloomberg

In continuation to Baby Boomers' impact on yields and the effect of demography, this is what we said on the subject in June this year in our conversation "Lucas critique":

"What are "inflationistas" of the world and "tapering believers" fail to take into account in their analysis is the importance of demography we think in true Lucas critique fashion. Therefore we agree with Andrew Cates as reported by Simon Kennedy and Shamin Aman in their Bloomberg article from the 7th of June entitled "Aging Nations Like Low Prices Over High Income":

"The older a country’s population, the lower its inflation rate, posing a challenge for central banks in the world’s industrial nations, according to a UBS AG report.

Singapore-based economist Andrew Cates of the Swiss bank’s global macro team plotted average inflation levels over the last five years against changes in the dependency ratio, which compares the very old and very young to the working-age population.

The resulting chart showed nations that have aged in recent years typically faced very low inflation and, in the case of Japan, deflation. By contrast, those that have been getting younger, such as India, Turkey and Brazil, have relatively strong price pressures.

“Since ageing demographics will now start to feature more prominently in the outlook for many major developed and developing countries this is clearly of some significance for how inflation might evolve,” said Cates in a May 30 report.

The finding clashes with the view of economics textbooks, according to Cates, which tend to say a slowdown in population growth should put upward pressure on wages -- and therefore inflation -- as labor supply shrinks. Still, this ignores how demographics influence demand for durable goods and property, Cates said.

He cited a Federal Reserve Bank of St. Louis study that says because the young initially don’t have many assets, wages are their main source of income. The young are therefore comfortable with relatively high wages and the resulting inflation.

By contrast, because older generations work less and prefer higher rates of returns on their savings, they are averse to inflation eating away at their assets.

“Whichever group predominates in any economy will therefore have more ability to control policy and more ability to control economic outcomes,” said Cates." - source Bloomberg

When it comes to Baby Boomers, additional lyrics from Stevie Wonder's song point towards the direction yields will take. It might be time to put on the additional leg of the put-call parity (long gold / long US Treasuries):

"Any place 

He will play 

His only concern is how much you'll pay 

He's Misstra Know-It-All"

Lyrics from "He is Misstra Know-it all", Stevie Wonder, 1974.

We have long argued that the fight over deflation is still going on as illustrated by the evolution of container prices in the shipping industry. 

We have on numerous occasions discussed shipping as being not only a leading credit indicator (with the collapse in European structured finance) but as well a leading economic growth indicator (on that subject please refer to "The link between consumer spending, housing, credit and shipping"), our "Bear Case" is still playing out (as mentioned in our conversation "The Dunning-Krueger effect"), excess capacity and a weak global economy with a China slowdown will drive rates down even with price increases, pressuring margins - graph source Bloomberg:

"The Drewry Hong Kong-Los Angeles container rate benchmark fell 5.2% to $1,836 in the week ended Aug. 28, dropping 14.1% after carriers implemented a $400 peak season surcharge the last week in July. Rates are at the lowest levels since June. Even with five increases in 2013, rates are 17.1% lower ytd and 26.5% lower yoy, as slack capacity continues to pressure pricing." - source Bloomberg

These five increases in 2013 have followed eight rate increases in 2012, totalling $3,650. It is still a question of excess capacity in a weak global economy. Of course high unemployment (12.1% in the Eurozone) will continue to weight on the economic "recovery" in general and shipping in particular.

Moving on to outflows and positioning, particularly in relation to "reverse osmosis" for Emerging Markets, the latest report from Deutsche Bank from the 30th of August entitled "Positioning Amidst Rising Risks" indicated the following:

"As the market once again faces a number of risks going into September (Syria, EM, taper, etc), we assess how investors are positioned for those risks across asset classes. Oil positioning is already at peak levels while EM bond and equity outflows have surpassed 2008-09 levels suggesting Syria and EM risks are being priced in. Down from a peak long in May, rates positioning on the other hand has remained stubbornly near neutral despite the rise in yields. With bond outflows just 20% of the way through the 1994 scenario, bonds and EM bonds in particular are likely to remain under pressure from outflows. Finally, aggregate equity positioning is overweight. This in large part reflects sector positioning for higher rates but the cyclical tilt makes equities susceptible to disappointing growth." - source Deutsche Bank

From the same report and in relation to Emerging Markets:

"EM outflows surpass 2008 levels but positioning not yet underweight.

Outflows of over $20b from both EM bond and equity funds have already exceeded 2008-09 outflows; but not as a % of AUM. 

We note that world bond fund outflows were 20% of AUM in 1994 suggesting EM outflows could have further to run. EM equity and bond outflows of 3% and 7% of AUM, respectively, have likely drained cash balances. Accordingly, GEM equity fund beta is well above average levels, suggesting exposures could be cut further. EM equity vol skew is also well below average despite the rising risks." - source Deutsche Bank

As far as Gold is concerned, we are confident Gold, being one of the legs in our put-call parity strategy, has further to run as indicated by Deutsche Bank when it comes to positioning:

- source Deutsche Bank

But moving back to our "reverse osmosis" thesis, it has been recently validated by looking at outflows taking place in the Emerging Markets space. The rising tapering signs could no doubt spell additional trouble and outflows for the asset class as also indicated by Barclays in their Emerging Market Flows Snapshot from the 26th of August:

"• EPFR data shows that since 22 May, cumulative outflows from EM bonds topped USD23bn and almost fully reversing the USD30bn of inflows between mid-2012 and May. The scale and positive correlation between consecutive outflows suggests a self-reinforcing wave of stop-loss selling of EM bonds. 

After the initial selloff in May-June, EM FX performed well in July (with the obvious exceptions of TRY, BRL, IND, IDR) amid a slight fall of US long-term real interest rates. But even in that period, EPFR data indicated continued outflows. The acceleration of outflows in last two weeks (particularly last week) was triggered by a spike in US real interest rates, which overtook the rise in nominal yields (Figure 1B).

• This time around though, rising real rates in the US have hurt flows into both EM and US equities. This might be a sign that further increases in US real rates could negatively affect developed market equities generally. Since 22 May, US real rates (10y) have jumped 150bp. Given that US debt is on the order of 267% of GDP, (sovereign debt + private debt excluding financial institution debt), the rise in yields implies a higher real cost of debt servicing equal to 4% of GDP. There is a growing risk to the cyclical recovery from an overshoot of real rates, in our view. Thus additional guidance from the Fed, about future rates, is probably needed. Such guidance would have positive implications for EM especially where real rates are high (BRL) or where positioning is light and the country has access to an FCL (eg, Mexico)." - source Barclays

And like Ian Keenan said:

"If interest rates increase, all of these problems get worse!"

When it comes to "Forward Guidance" by "Misstra Know-it-all" we keep reminding to ourselves the lyrics of Stevie Wonder's song:

"When you say that he's living wrong 

He'll tell you he knows he's livin' right 

And you'd be a stronger man 

if you took Misstra Know-It- All's advice oh oh "

Emerging-market stocks have lost more than $1 trillion since May, according to data compiled by Bloomberg. The MSCI Emerging Markets Index has fallen about 12 percent this year, compared with a 13 percent gain in the MSCI gauge of shares in advanced countries. When one looks at the relative performance of the S&P 500 versus MSCI Emerging, one can easily see EM equities have been clearly lagging. Emerging markets (MXEF) continue to underperform developed markets  - source Bloomberg:

On a final note for illustrative purposes, we have been plotting the growing divergence between the S&P 500 and trailing PE since January 2012 - graph source Bloomberg:

As we argued in our "Fears for Tears" conversation, the rally has been as well sustained by multiple expansions and very significant stock buy-backs:

- source Deutsche Bank

We share our concerns with Bloomberg as indicated by Inyoung Hwang and Alexis Xydias in their article from the 26th of August entitled "Multiples Growing Fastest Since Dot-Com Bubble as Rally Ages":

"Price gains of stocks in the Standard & Poor’s 500 Index are outpacing profits by the fastest rate in 14 years as the bull market extends beyond the average length of rallies since Harry S. Truman was president.

The benchmark gauge for U.S. equities has risen 14 percent relative to income over the past 12 months to 16 times earnings, according to data compiled by Bloomberg. Valuations last climbed this fast in the final year of the 1990s technology bubble, just before the index began a 49 percent tumble. The rally that started in March 2009 has now outlasted the average gain since 1946, the data show.

Bears say the failure of earnings to keep up with prices signals the bull market is in its last stages, as companies from Caterpillar Inc. and Danaher Corp. forecast slower profit growth and the Federal Reserve prepares to reduce stimulus. Optimists point to expanding multiples as proof individual investors are growing confident enough in the economy to return to stocks.

History shows the final phases of rallies have provided some of the biggest gains. “Markets have been running away,” Robert Royle, who helps oversee $21 billion as manager of the North American Trust at Smith & Williamson Investment Management LLP in London, said by telephone on Aug. 20. “Everyone is hoping for a second-half recovery in fundamentals,” he said. “I am just not sure what will drive the recovery.” - source Bloomberg.

From the same article:

"The last time gains in stocks outpaced profit expansion by this much was in 1999, when equity valuations surged 19 percent in a year to 30 times reported profit, according to data compiled by Bloomberg. That bull market ended the following year, with the S&P 500 tumbling 49 percent from March 2000 through October 2002 as the dot-com bubble burst.

In 1987, prices rose so fast, valuations increased 43 percent through August, about twice the pace of the year before. That month marked the peak in a five-year rally, followed by a 34 percent loss through December 1987.

U.S. equities have been whipsawed since May, when Fed Chairman Ben S. Bernanke first indicated that the central bank may start to reduce its quantitative easing bond buying this year. The S&P 500 fell 5.8 percent from a high on May 21 through June 24 and rallied 8.7 percent through Aug. 2, before declining 2.7 percent.

Corporate earnings need to accelerate to justify the surge in equities as the central bank begins to scale back its unprecedented monetary stimulus, according to Joost van Leenders of BNP Paribas Investment Partners in Amsterdam." - source Bloomberg

So "Misstra Know-it-all" might indeed try to makes us fall with some "Forward Guidance", but given not many companies are giving their own "Forward Guidance" and that those who are a giving negative outlooks, and "Misstra Know-it-all" being the confidence trickster character we know, we wonder if he will stay true to his current "tapering" stance...

Oh well...

"If he shakes 

On a bet 

He's the kind of dude that won't pay his debt 

He's Misstra Know-It-All" 

"If we had less of him 

Don't you know we'd have a better land 

He's Misstra Know-It-All" 

Lyrics from "He is Misstra Know-it all", Stevie Wonder, 1974.

Stay tuned!

Credit - Osmotic pressure

"We want a story that starts out with an earthquake and works its way up to a climax." - Samuel Goldwyn 

Looking at the continued sell-off in Emerging Markets currencies with the Indian Rupee touching a record low level of 65.56 before bouncing back by 2.1%, on Friday the biggest move since June 2012 and the Brazilian Real which continued its slide before bouncing back as well 3.7% to 2.3488 following a 60 billion US dollar central bank pledge, made us venture towards our distant memories, in similar fashion like our previous posts made us revisit our musical souvenirs from the 80's.

Emerging Currencies "tapering" in true MMA fashion since Bernanke started mentioning "tapering" its QE programme, graph source Thomson Reuters Datastream / Fathom Consulting / Macronomics:

So why "Osmotic pressure" as our chosen title you might rightly ask?

This time around, our chosen title is directly linked to capital flows we are seeing, with the outflows from Emerging Markets towards Developed Markets. 

As the Osmosis definition goes:

"When an animal cell is placed in a hypotonic surrounding (or higher water concentration), the water molecules will move into the cell causing the cell to swell. If osmosis continues and becomes excessive the cell will eventually burst. In a plant cell, excessive osmosis is prevented due to the osmotic pressure exerted by the cell wall thereby stabilizing the cell. In fact, osmotic pressure is the main cause of support in plants. However, if a plant cell is placed in a hypertonic surrounding, the cell wall cannot prevent the cell from losing water. It results in cell shrinking (or cell becoming flaccid)." - source Biology Online.

Nota bene: Hypertonic

"Hypertonic refers to a greater concentration. In biology, a hypertonic solution is one with a higher concentration of solutes on the outside of the cell. When a cell is immersed into a hypertonic solution, the tendency is for water to flow out of the cell in order to balance the concentration of the solutes." - source Wikipedia

So the reasoning behind our chosen title is linked to our past "biology" classes of course, given since 2009, the effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility.

We did send a warning in June in our conversation "The Daisy Cutter":

"If you think rising yields are only putting global trade at risk, think as well how it will ripple through in various sectors and countries." - source Macronomics 

This is what we envisaged in our conversation "Singin' in the Rain" as well:

"If the dollar goes even more in short supply courtesy of Bernanke's "Tap dancing" with his "Singin' in the Rain", could it mean we will have wave number 3 namely a currency crisis on our hands? We wonder..."

The mechanical resonance of bond volatility in the bond market started the biological process of the buildup in the "Osmotic pressure" we think and bond volatility has yet to recede. 

The volatility in the fixed income space has remained elevated as displayed by the recent evolution of the Merrill Lynch's MOVE index rising from early May from 48 bps  towards the 100 bps level again, whereas the VIX, the measure of volatility for equities is finally reacting - graph source Bloomberg:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

Of course, what we have been tracking with interest is the ratio between the ML MOVE index and the VIX which remains elevated from an historical point of view if we look back since October 2000 - graph source Bloomberg:

With VIX picking up, no wonder the ratio between the MOVE index and VIX has fallen from last week 7.06 level towards 6.10 as the contagion in the equities space is finally picking up. Hence, last week our "Fears for Tears" concerns for our equities friend as the "tapering" noise increases as we move towards September.

As a reminder, we started pondering about the potential end of the goldilocks period of "low rates volatility / stable carry trade environment in June:

"As pointed out by Bank of America Merrill Lynch's note stable carry thrives in low rates volatility environment, the recent spike in US bonds volatility has had some devastating effect in high yielding assets:

"Carry trades love low risk-free interest rates, but they love low interest rate volatility even more. This is why over the past three years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving their risk premiums to abnormally low levels."

So what we are witnessing right now is indeed "reverse osmosis" in Emerging Markets, and the osmotic pressure which has been building up is no doubt leading to an "hypertonic solution" when it comes to capital outflows in Emerging Markets.

Let us explain:

In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment.

So in this week's conversation, as we moved towards the "interesting" month of September we will revisit some of our thoughts from our conversation "Singin' in the Rain" and look at the risk and opportunities lying ahead.

As a reminder from our June conversation:

"We got seriously wrong-footed by the market's reaction to the "tapering QE" scenario and we still think at some point the Fed will maybe redirect its buying towards MBS, given that rising rates could seriously dent any hope of a "housing recovery" should the move continue at a rapid pace like it has this week."

The "housing recovery is indeed at risk - graph source Thomson Reuters Datastream / Fathom Consulting:

As indicated by Prashant Gopal on the 22nd of August in Bloomberg in his article "U.S. Mortgage Rates Jump to Two-Year High With 30-Year at 4.58%": 

"The average rate for a 30-year fixed mortgage rose to 4.58 percent this week from 4.4 percent, Freddie Mac said in a statement today. The average 15-year rate climbed to 3.6 percent from 3.44 percent, the McLean, Virginia-based mortgage-finance company said. Both were the highest since July 2011.

Homebuyers are rushing to take advantage of historically low borrowing costs before they increase any more. Existing-home sales in July jumped 6.5 percent to the second-highest level in six years, the National Association of Realtors reported yesterday. Those transactions largely reflect closings of contracts signed a month or two earlier, when mortgage rates were just beginning to edge up." - source Bloomberg

From the same article:

"The Mortgage Bankers Association’s index of applications to lower monthly payments fell 7.7 percent in the week ended Aug. 16, the 10th straight decline. A measure of purchases rose 1.2 percent, the trade group said yesterday.

The 30-year fixed mortgage rate is well below its average of about 6.3 percent for the past 20 years, according to data compiled by Bloomberg. The 20-year average for a 15-year loan is about 5.83 percent." - source Bloomberg

Yes but, there is indeed a "convexity issue at play" given the US average Maturity of Fixed Rate Mortgages has been steadily increasing in the last decades - graph source Thomson Reuters Datastream / Fathom Consulting:

 And as our very wise credit friend former head of credit research said on the subject of convexity in June in our conversation "Singin' in the Rain":

"Convexity is a bigger issue in all the pensions + fixed income funds. That's one reason mortgages have been whacked. the Fed will basically have to do a ECB - stop buying USTs and start buying RMBS. But pensions (or Fannie / Freddie) do not hedge MBS with USTs - they do it with LIBOR"

At the time we argued:

"The Fed is likely to step in and actually increase QE to try and hold rates down, because mortgage rates have spiked substantially over the last month from a low of around 3.5% to around 4.3%, we have to agree with our friend that a "new dance" routine from the Fed might be coming." 

Central Banks Assets - graph source Thomson Reuters Datastream / Fathom Consulting:

Why the Fed might indeed increase QE? 

Point number 1:

Because the Fed is facing a raft of sellers and the economy is not as strong as it seems.

For instance, China’s holdings in May were $1.297 trillion, less than the $1.316 trillion reported by the Treasury last month. China’s stake dropped by $21.5 billion in June, or 1.7 percent according to Bloomberg as per Treasury Department data released on the 14th of August. On top of that US Commercial Banks as well have been selling as indicated by Bloomberg Chart of the Day from the 19th of August - graph source Bloomberg:

"U.S. commercial banks are dumping Treasuries at the fastest pace in a decade and boosting loans, helping make the debt securities the world’s worst performers as the economy gains momentum.

The CHART OF THE DAY shows banks’ holdings of U.S. Treasury and agency debt tumbled $34.7 billion to $1.81 trillion in July, the biggest monthly decline in 10 years, according to the Federal Reserve. The level dropped to $1.79 trillion in the first week of August, Fed data showed on Aug. 16. Also tracked are 30-year bond yields climbing to a two-year high. The lower panel records commercial and industrial loans as they surged to $1.57 trillion, the highest since 2008.

Bank sales of Treasuries accelerated after Federal Reserve Chairman Ben S. Bernanke said on June 19 policy makers may reduce the bond-buying program they use to support the economy. Concern the Fed will trim its $85 billion a month of Treasury and mortgage purchases helped send notes and bonds due in a decade or longer down 11 percent in the past 12 months. It was the biggest loss of 174 debt indexes tracked by Bloomberg and the European Federation of Financial Analysts Societies." - source Bloomberg.

Point number 2:

Our "omnipotent" magicians are desperately trying to "bend" the velocity curve and anchor higher inflation expectations. On that note we read with interest Professor Rogoff comments in Bloomberg article by Aki Ito and Michelle Jamrisko on the 12th of August - "Rogoff Saying This Time Different Calls for Reflation":

"Rogoff is espousing aggressive monetary stimulus, even at the cost of moderate price increases. At a time of weak global inflation, higher prices may even help the U.S. economy by lowering real interest rates and reducing debt burdens, he said.

“In more normal times, you’re looking for the central banker to be an anchor against high inflation expectations and to assure investors that inflation will stay low and stable to keep interest rates down,” Rogoff, co-author with Carmen Reinhart of the 2009 book “This Time Is Different: Eight Centuries of Financial Folly,” said in an interview. Now “we’re in this situation where many of the central banks of the world need to convince the public of their tolerance for inflation, not their intolerance.”

G-7 Inflation

Central banks across the developed world are struggling with inflation that’s too low. Consumer price increases in all but one of the Group of Seven economies are currently running under 2 percent, which has become the standard goal in recent years for monetary authorities. Two years ago, deflationary Japan was the only country struggling with below-target inflation."  - source Bloomberg.

The only issue is once the "Inflation Genie" is Out of the Bottle" as warned by Fed's Bullard in 2012, it is hard to get it back under control:

“There’s some risk that you lock in this policy for too long a period,” he stated.  ”Once inflation gets out of control, it takes a long, long time to fix it”

While the recent jump in interest rates, has created an "hypertonic surrounding" in the reverse osmosis plaguing Emerging Markets, it has had some positive effect somewhat for the insurance sector as well as the Auto Industry given that it has provided some relief in terms of "reserve adequacy" for insurers and a relief on "reinvestment rates" to plug the growing gap in pensions liabilities hindering the allocation of capital for the Car industry giants.

As a reminder from our conversation "Cloud Nine": 

"If we look at GM and FORD which went into chapter 11 due to the massive burden built due to UAW's size of "unfunded liabilities", they are still suffering from some of the largest pension obligations among US corporations. Both said this week they see a significant improvement in their pension plans liabilities because of rising interest rates used to calculate the future cost of payments. When interest rates rise, the cost of these "promissory notes" fall, which alleviates therefore these pension shortfalls. So, over the long term (we know Keynes said in the long run we are all dead...), it will enable these companies to "reallocate" more spending on their core business and less on retirees. Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2."

But, of course, what matters is indeed the "velocity" of the movement, and the intensity. So far we have avoided a major sell-off in credit. 

As indicated by Megan Hickey and Zachary Tracer in their Bloomberg article from the 1st of August commenting on US insurer's Metlife's results entitled "Metlife Says $10.9 billion of Bond Gain Erased, More Than Crisis", what matters is the pace of the rise in interest rates:

"MetLife Inc., the largest U.S. life insurer, saw $10.9 billion in bond gains wiped out in the three months ended June 30 as interest rates rose, exceeding the decline in any quarter of the financial crisis.

Net unrealized gains narrowed to $20.9 billion on the portfolio of available-for-sale fixed-maturity securities, from $31.8 billion three months earlier. The tumble helped cut MetLife’s bond holdings about 4.8 percent to $356.5 billion." - source Bloomberg

They also added the following comments from a Fitch Ratings analyst:

"Losses tied to deterioration in the creditworthiness of issuers are more worrisome than the more recent fluctuations related to interest rate movements, said Douglas Meyer, an analyst at Fitch Ratings. He said higher rates can help increase investment income at insurers and improve profitability on some products.

“The jump in interest rates, the way we look at it, it has a positive impact on the industry,” he said. “This will provide relief in terms of reserve adequacy, it will provide relief on reinvestment rates.”

An extreme spike in rates of more than 5 percentage points could hurt insurers, he said. Clients might redeem products that offered lower yields, forcing insurers to sell securities at a loss to meet withdrawal demands, he said." - source Bloomberg.

We quoted our fellow blogger and friend Martin Sibileau back in June in "Singin' in the Rain" on the risk ahead for credit:

"If Ben triggers a sell off in credit with the insinuation of tapering, the dealers on the other side, making the bid for the investors, will be forced to do the rate hedge their investors did not do, because they must be interest rate neutral! That means selling US Tsys for an average of 85% and 50% of positions in HY and IG respectively! In other words, the potential sell-off tomorrow may trigger a surprising self-feeding convexity. How are precious metals to react in such scenario?" - Martin Sibileau

And as we discussed above, "macro" osmosis has led to "positive correlations". When it comes for risks ahead, we share CITI's Matt King views from his European Credit Weekly, namely that after a pleasant summer for credit, it might be time indeed to continue to reduce exposure to neutral:

"Dominoes

One of my favourite games as a child was always dominoes. No, not the rather tedious business of laying tiles end to end and trying to match up their spots.

Rather, the much more thrilling challenge of creating long and winding lines before knocking them over, and being amazed at the far-reaching devastation which could be caused with a single flick of the finger.

European credit feels at present to us like the last asset in a similarly long chain – seemingly remote from the problem of higher UST yields, almost immune to date to the outflows starting to occur elsewhere, and yet nevertheless with an intricate linkage to other assets which belies its apparent distance.

Ironically, our best guess has been and remains that the domino run will not quite get started in the first place – or, at a minimum, that some benign and omnipotent central banker will reach in to remove a domino or two and stop any run before it reaches us. Our house forecasts show the UST backup abating, show credit spreads remaining tight, and the EM sell-off remaining contained to mid-2014.

Moreover, it is striking just how well spreads have generally performed in the face of the backup in UST yields to date. EM hard currency mutual funds, for example, have lost nearly one-third of the last three years’ cumulative inflows (Figure 2), against which the backup in EM spreads, while notable, is hardly cataclysmic. 

The outflows from credit funds have been tiny by comparison, and in Europe have been almost negligible. Unless outflows pick up very significantly, there is every reason to think € spreads remain resilient." 

Besides, in many respects the risks as we head into September seem rather obvious. Tapering has been extremely well flagged. The Fed minutes suggest it will happen this year, but did not seem overly attached to our view of a September start.

German elections have been talked about a great deal, but seem ever less likely to bring about a significant change in the political landscape. Conscious corporate releveraging seems largely confined to the US. Supply is likely to pick up significantly, but is likely to have been widely anticipated. Above all, we have little sense of any build-up in complacent longs during the summer in the way we earlier feared, as is vouched for by the lack of outperformance of most high-beta names.

And yet despite all this, we still recommend reducing any remaining longs in € credit to neutral." - source CITI

CITI's Matt King also added:

"When playing dominoes, it usually takes a few goes before the run really gets started (unless, of course, you didn’t mean for it to start, in which case there’s no stopping it). Our best guess is likewise that, despite the somewhat precarious lineup, not a great deal happens over the next few weeks, and that spreads trade more or less sideways.

But that’s a bit like leaving the room and hoping that when you come back later you’ll still find all the dominoes standing just as you left them. As those with younger brothers will know, you ought to be okay – but at this point we just don’t think you’re being paid for it." - source CITI

The issue for us is that from a "macro" perspective, if the reverse "osmosis" has truly started and with "positive correlations" still in place, there is indeed not only heightened risk from the continuation of the sell-off in Emerging Markets which could affect Developed Markets in the process, but, exogenous factors with political tensions and agendas could indeed roil further risky asset classes.

The $3.9 trillion of cash that flowed into emerging markets over the past four years has started to reverse, indicative of the "Osmotic Pressure" and "reverse osmosis" process taking place.

As we posited back in June for Emerging Markets:

"Why are we feeling rather nervous?

If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?" - source Macronomics, June 2013, "Singin' in the Rain"

Moving back to our friend Martin Sibileau's June question on "precious metals":

"In other words, the potential sell-off tomorrow may trigger a surprising self-feeding convexity. How are precious metals to react in such scenario?"

At the time we argued that precious metal had further to fall and they did.

But, as we move towards September and what has already started is a bounce back. In similar fashion to what we confided in our January conversation "If at first you don't succeed...", we have once again put in practice the effect of our magicians ("omnipotent" central bankers practicing their "secret illusions") by starting being long gold miners via ETF GDX and some selected miners as well.

The S&P 500, the US 10 year breakeven, please note we have added Gold into our previous Chart,  graph source Bloomberg:

Once again we have broken our Magician's Oath:

"As a magician I promise never to reveal the secret of any illusion to a non-magician, unless that one swears to uphold the Magician's Oath in turn. I promise never to perform any illusion for any non-magician without first practicing the effect until I can perform it well enough to maintain the illusion of magic."

What is the rationale behind our call? We once again come back to our June conversation "Singin' in the Rain" where we quoted David Goldman's article about Gold and Treasuries and bonds in general which he wrote in August 2011 (the former global head of fixed income research for Bank of America):

"Why should gold and Treasury bonds go up together? Gold is an inflation signal and bonds are a deflation hedge. At first glance it seems very strange for both of them to rise together. Why should this be happening?

 The answer is simple: bonds are an option on the short-term interest rate, and gold is a perpetual put option on the dollar. Both rise with volatility.

 It’s like the old joke about the thermos bottle: “How does it know if it’s hot or cold?” If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. By put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

Our thermos bottle is lately behaving accordingly because the YTD movements in 5 year forward breakeven rates is falling again, which is indicative of the strength of the deflationary forces at play - source Bloomberg:

The 5 year forward breakeven was at 2.56% on the 21st of August but it has been breaking lower as per the most recent reading - graph source Thomson Reuters Datastream / Fathom Consulting:

QE and the US Dollar - graph source Thomson Reuters Datastream / Fathom Consulting:

Dollar index versus Gold - graph source Bloomberg:

So far we have bought the put leg of the put-call parity strategy and we are indeed thinking of adding the call leg shortly. That's all for magic tricks. We enjoy your company, dear readers, but we should not be breaking our Magician Oath too often as you haven't sworn to uphold the Magician's Oath in turn yet...

On a final note, in true Pareto efficient economic allocation, while some pundits wager about simultaneous developments having contributed to the weakness in Emerging Market equities, for us Emerging Markets have been simply the victims of currency wars ("Have Emerging Equities been the victims of currency wars?"), "Abenomics", and of course "reverse osmosis" courtesy of positive real interest rates in the US. It is therefore not a surprise to see that the biggest beneficiary of "reflationary"policies have indeed been the Japanese as displayed in Bloomberg's Chart of the Day from the 22nd of August displaying the Earnings Per Share for 6 regions:

"Prime Minister Shinzo Abe’s policies to lower the yen and end deflation are already paying off for corporate earnings, with Japanese companies’ profits outpacing the rest of the world.

The CHART OF THE DAY shows earnings per share in six regions tracked by Bloomberg rebased to 100 at the end of June 2011. Profits for the Topix climbed the most, rising 32 percent as companies in Japan’s equity benchmark recovered from the March 2011 earthquake that damaged large parts of the country’s north east. The lower panel of the chart shows the yen’s decline against nine other world currencies.

“Japan has been through a full earnings cycle over the past two years,” said Mert Genc, a London-based strategist at Citigroup Inc., which composed the graph. “First, largely as a result of the earthquake, earnings halved. But then they doubled again, with the latest boost coming from weakness in the yen and improving economic performance.”

Japanese exports jumped by the most since 2010 in July, showing the economy has benefited from the yen’s 22 percent slide against the dollar since the end of 2011. Earnings in the U.S. have climbed 16 percent since June 2011 as the Federal Reserve’s bond-purchasing program helped to stimulate growth. Profits in the U.K., the euro area, emerging markets and Australia have declined in the same period.

Analysts estimate earnings in the Topix will grow 11 percent in 2014, according to Bloomberg data, in line with the average for the other regions in the chart of the day." - source Bloomberg.

The MSCI Emerging Markets Index has declined 12 percent this year, compared with a 12 percent gain for the MSCI World Index of companies in advanced economies.

"Remember, the storm is a good opportunity for the pine and the cypress to show their strength and their stability." - Ho Chi Minh 

Stay tuned!