Macro and Credit - Road to Nowhere

"The person attempting to travel two roads at once will get nowhere." -  Xun Zi, Chinese Philosopher

Looking at the Japanese PMI coming at 47.7, and Japan recording its seventh straight month of falling exports in April down 10.1% on-year with Haruhiko Kuroda, Bank of Japan's governor declaring at a two-day Group of Seven (G-7) meeting in Sendai:

"I think, yes, we have enough ammunition," Kuroda said, when asked whether the BOJ had sufficient monetary policy options, or "ammunition," left to achieve the target. "If necessary, we can further ease our monetary conditions in three dimensions. Quantitative, qualitative and interest rates." - Haruhiko Kuroda, Bank of Japan's governor

We had Japan in mind when we selected our title analogy for this week's musing "Road to Nowhere", the 1985 rock song written by David Byrne from the Talking Heads album "Little Creatures". What is of "humoristic" interest is that David Byrne indicated the following about his song:

"I wanted to write a song that presented a resigned, even joyful look at doom," - David Byrne

Clearly when one looks at the recent raft of dismal data from the Japanese behemoth, one can relates to our chosen title and analogy we think. Haruhiko Kuroda, also added when asked about what remained in Bank of Japan's "tool box" the following:

"I think, yes, we have enough ammunition," (when asked whether the BOJ had sufficient monetary policy options, or "ammunition," left to achieve the 2% inflation target). "If necessary, we can further ease our monetary conditions in three dimensions. Quantitative, qualitative and interest rates." Haruhiko Kuroda, Bank of Japan's governor

As far as we are concerned, we think Japan is indeed on a "Road to Nowhere". In this week's conversation we will look at Japan's "achievements" after 3 years of "Quantitative and Qualitative Easing (QQE), and what the lackluster Nonfarm payroll number means to us as well as the growing complacency in the on-going risk-on rally which we thinks warrants not only caution, but probably "hedging" as well.

Synopsis:

• Macro and Credit - Looking back a the "Three arrows"
• Macro and Credit  - Is the Fed on a "Road to Nowhere"?
• Final chart: Now is the right time to "hedge"

• Macro and Credit - Looking back at "The Three arrows"

As a reminder, the massive experience that started on the 4th of April 2013 by the Bank of Japan ambitioned to achieve a 2% inflation rate within 2 years by expanding drastically the monetary base.
In our April conversation "Shrugging Atlas" we already touched on the impact of three years of QQE and the impact of the deflationary mindset that has taken hold in Japan. We argued at the time:

"It seems more and more evident that, the experiment overtaken by the BOJ in the last three years has failed to move upwards inflation thanks to any significant wage increases. The Japanese government cannot afford to allow rates to rise, and yet by keeping rates so low it increases distortions in the economy through the "mispricing" of risk. This is clearly evident by the inversion in correlation between bond prices and the Nikkei index!
Furthermore, the size of the BOJ's buying spree in the Japanese market has led to the market becoming not only unstable but as well as totally broken and volatile. Basically what was supposed to be riskless in the Japanese Government Bond (JGB) has become the most risky and volatile investment of all thanks to the BOJ" - source Macronomics, April 2016

We also argued that the headwinds facing Japan and as well Europe in our April conversation stem from "demography", rendering the problems more "structurally" acute. When it comes to Japan and its central bank and credit transmission we have a case of "broken arrow". Europe seems to be as well facing very similar difficulties we think.

When it comes to assessing the effectiveness of the "Three arrows", we read with interest Nomura's take on the subject in their Japan Economic Weekly note from the 20th of May entitled "Taking a fresh look at the three arrows":

"Summary: 1) Reconstructing the "three arrows"

When the second Abe administration was formed in December 2012, it announced what it called "the three arrows." Since last year, the government has been talking about "three new arrows," policies aimed at achieving its goal of the "dynamic engagement of all citizens." While the label may have changed, the government is presumably still committed to what it has called "growth strategies," structural reforms aimed at supporting economic growth.

Summary: 2) Shortcomings of existing economic policies

While the government has in the past claimed that deflation would soon be overcome, it cannot be said to have achieved this or to have boosted economic growth. We see two shortcomings in its policies. First, it has failed to sufficiently counter dwindling expectations of economic growth, with the result that the first and second arrows of traditional monetary and fiscal policy have not had the expected impact. Such policies seek to bring forward demand at the expense of the future. With demographics depressing growth expectations, policies that seek to bring forward future demand can make households and companies even more reluctant to spend. Second, in terms of the third arrow of growth strategies, the government may not have properly considered whether to bias its policies in favor of either labor or capital or, how in what order to do so.

Summary: 3) Some distinctive features of the Japanese economy now

The government's focus, which during the early stages of its strategies for growth was on capital (specifically on increasing corporate earnings power by means of structural reforms such as corporate governance), has since gradually shifted to trying to boost the labor participation rate (eg, by means of the government's Plan to Realize the Dynamic Engagement of All Citizens) and improving the share of labor. As a result of implementing policies biased towards capital and, especially, improving shareholders' rights, Japanese companies have probably become more focused on efficiency, productivity, and profitability than ever. The result is a state of affairs where wage growth and the labor share have failed to increase and a virtuous cycle of rising employment, incomes, and consumption has failed to develop.

Summary: 4) Challenges

It would seem fairly clear what kinds of policies are needed in order to increase Japan's economic growth. What the government needs to do next is to increase the number of companies that succeed in improving their earnings power, thereby increasing both employment and the labor share, rather than encourage such companies to use those earnings to increase the labor share." - source Nomura

When it comes to Japanese efficiency and productivity, no doubt that Japanese companies have become more "lean" and more profitable than ever. The issue of course is that at the Zero Lower Bound (ZLB) and since the 29th of January, below the ZLB with Negative Interest Rate Policy (NIRP), no matter how the Bank of Japan would like to "spin" it, the available tools at the disposal of the Governor appears to be limited. This is clearly explained in Nomura's interesting note:

"To put it rather bluntly, traditional fiscal and monetary policies seek to boost the real economy and stir inflation by bringing forward demand at the expense of the future. Monetary policy basically works by artificially reducing the future value of a currency, whether by means of positive or negative policy interest rates or by means of interest rates or the quantity of money, in order to encourage companies and households to spend more. Fiscal policy, on the other hand, does not exactly bring forward future demand but achieves a similar effect by using (increased) future government revenue as collateral to fund current spending.
The Nikkei and other news media reported on 14 May that Mr Abe is probably going to announce that the planned increase in the consumption tax is going to be postponed for a second time. Bolstering current demand by postponing a tax increase is also a kind of fiscal policy as it tries to encourage current spending by using future government revenue as collateral.
However, policies that try by one means or another to bring forward future spending in order to boost current economic growth assume that people will expect the economy to grow. However, if people are convinced that the economy is going to shrink, traditional economic policies may have the unintended consequence of making people even more reluctant to spend. We cannot rule out the possibility that the demographic headwinds facing the Japanese economy in the form of a declining and aging population may have led many Japanese households and companies to assume that the Japanese economy will inevitably shrink. This may explain why traditional fiscal and monetary policies have not had the expected impact." - source Nomura

While the Japanese government has been successful in boosting the labor participation rate thanks to more women joining the labor market, the improved corporate margins of Japanese companies have not lead to either wage growth, incomes and consumption despite the repeated calls from the government. The big winners once again have been the shareholders through increased returns in the form of higher dividends. In similar fashion to the Fed and the ECB, the money has been flowing "uphill", rather than "downhill" to the real economy due to the lack of "wage growth". This is clearly illustrated in rising on the Return Of Invested Capital (ROIC) as displayed in Nomura's note:

"ROIC, far from declining, has been rising despite a substantial decline in interest rates in general suggests to us that companies have increasingly been focusing their capex on projects with better returns than in the past. In other words, that companies have been increasing their capex and stepping up depreciation of their existing plant and equipment without raising more capital suggests to us that they have managed to both increase their capex and improve their margins without expanding their balance sheets.
At the same time, we note a marked tendency for the profits generated by this efficient capex to accumulate as retained earnings and to be paid out as shareholder returns in the form of dividends, etc without impairing ROE." - source Nomura

If indeed Japan fails to encourage "wage growth" in what seems to be a "tighter labor" market, given the demographic headwinds the country faces, we think Japan might indeed be on the "Road to Nowhere". The challenges facing Japan in revisiting its "three arrows" are clearly underlined in Nomura's note:

"Challenges

Assuming the above analysis is correct, it would seem fairly clear what kinds of policies are needed in order to increase Japan's economic growth. The main challenge is how to raise growth expectations, and the solution probably lies in the existing policy mix.
Two of the existing growth strategies that have proved relatively successful are probably (1) the corporate governance reforms aimed at increasing corporate earnings power and (2) the resulting increase in capex. If that is indeed the case, the next step that needs to be taken is presumably to implement a strategy for increasing the number of companies that succeed in increasing their earnings power.
The labor and employment policies the government has begun to push strongly should focus on those aimed at further improving corporate earnings power as well as on increasing employment and the labor share by increasing the number of Japanese and foreign companies that develop their earnings power, rather than focus on policies aimed at increasing labor participation or the labor share that target existing Japanese companies.
With a widening income gap becoming a social problem on a global scale and politics heading in a direction that reflects that trend, coming up with such policies will be no easy matter. However, in view of Japan's position as the most disadvantaged country in terms of the impact of its demographics on growth expectations, the need for such policies is all the greater." - source Nomura

We could not agree more, unless the Japanese government "tries harder" in stimulating "wage growth", no matter how nice it is for Japan to reach "full-employment", the "deflationary" forces the country faces thanks to its very weak demographic prospects could become rapidly "insurmountable".

Either you focus on labor or on capital, end of the day, Japan has to decide whether it wants to favor "wall street" or "main street".

When it comes to the effect NIRP has had on Japanese Life insurers, we have discussed on numerous conversations the impact it has had on their foreign allocations and in particular bonds. This was as well clearly displayed in Nomura FX Insights note from the 26th of May entitled "JPY: Lifers' hedge ratio inched up":

"As monthly flow data have been showing, the nine major lifers accumulated foreign exposures aggressively during H2 FY2015 (Figure 2). 

Total foreign exposures held by the nine lifers increased to JPY42.9trn ($391bn) from JPY40.2trn six months ago. After considering the FX valuation impact, we estimate they have increased foreign exposures by JPY4.9trn ($44bn) during H2 FY2015, the highest pace at least since FY2002, which is consistent with the historically biggest foreign bond investment by lifers in February and March, after the introduction of negative rates by the BOJ (see “Temporary pause in portfolio outflows”, 12 May 2016).

Unhedged foreign exposures stood at JPY18.8trn ($171bn), largely unchanged from JPY18.7trn in September 2015. As we expected, most of the recent foreign bond investment by lifers has been on an FX-hedged basis. At the same time, they kept unhedged exposures almost constant despite JPY appreciation in Q1, which suggests lifers were likely small dip buyers of USD/JPY, to keep FX exposures.

US assets remained preferred

A large part of the foreign investment during H2 FY2015 was in USD-denominated assets as expected. The nine major lifers’ exposures in USD assets increased to JPY26.9trn ($245bn) from JPY24.6trn. The USD share in total foreign assets increased to 62.7% in March from 61.3% in September 2015, recording the highest share since September 2002. The FX hedge ratio for USD assets increased to 55.7% from 51.6% during the same period (Figure 3).

As a result, unhedged exposures in USD assets stayed at JPY11.9trn ($108bn), largely unchanged from September last year (Figure 4).

Lifers’ preference for US assets remained strong, but they still prefer FX hedged investment for now.

Fed policy and political risk to be important for lifers’ hedging stance

Major lifers’ FY2015 financial results confirmed their strong appetite for foreign bond investment, without increasing FX risks for now. The results also showed stronger preference for US assets over other foreign assets. As JGB yields remain low, UST investment could give lifers slightly higher yields than JGB investment even after FX hedging (see “Lifers’ shift into foreign bonds continues”, 20 May 2016). The major lifers’ investment plans for FY2016 showed a strong appetite for foreign bond investment this fiscal year, but their investment should be largely FX hedged for the time being (see “JPY: The shift into foreign assets by lifers should continue”, 27 April 2016).
At the same time, the likelihood of a Fed rate hike by July is clearly rising now, which will increase hedging costs further. Lifers’ risk appetite could also improve after the UK referendum on Brexit. Thus, lifers may consider taking more FX risks in H2 this year." - source Nomura

Of course the latest "sucker punch" delivered to the US dollar versus the Japanese yen thanks to the clearly weak Nonfarm payroll data could somewhat tamper the hedging appetite of the Lifers and trigger some additional volatility on the currency pair.

Whereas Japan has stronger demographic headwinds, the latest miss in the United States coming from the labor market pushes us to ask ourselves on our second point if indeed the Fed is not as well on a "Road to Nowhere" when it comes to its willingness in hiking further during this summer.

• Macro and Credit  - Is the Fed on a "Road to Nowhere"?

Looking at the miserable May employment report published on Friday, one might rightly ask itself if indeed the Fed is not on the "Road to Nowhere". With only 38,000 jobs created in nonfarm payroll growth and a -59,000 of net revisions, given employment is a lagging indicator on the state of the economy and that we have long argued that the US economy was weaker than expected, it seems to us particularly clear that our long US duration stance will continue to be rewarding. 

While our stance relating gold miners had been vindicated in recent weeks, another surge in gold was clearly expected with this type of miserable NFP. We agreed with Martin Sibileau's view when he posted in his blog A View from the Trenches, on April 4th, 2011 "Gold, the Fed, Ron Paul and Napoléon Bonaparte" at the time he made the following comment:

"The Fed is not stimulating anything. The Fed is only massively monetizing the US fiscal deficit. Therefore, a lower unemployment rate is actually worse, because a lower unemployment rate implies higher wages, sooner rather than later. And if wages rise, people will have more purchasing power to afford the increasingly higher commodity prices. The higher wages will validate the higher prices of food and oil. In the process, the supply of money, ceteris paribus, will decrease. If the US fiscal deficit continues unabated (our key assumption here), the Fed will be forced to engage again in quantitative easing. For this reason, we think that the unemployment rate announced on Friday was actually bullish of gold."

In our previous conversation "Through the Looking-Glass", we argued that the Fed was in a bind given the late state of the credit cycle and tightening lending standards. What is of course of interest as well from the previous comments of our friend Martin Sibileau quoted above is that contrary to the key assumption, because the US fiscal deficit has fallen, the Fed had to start "tapering as displayed in the below chart from TradingEconomics:

- source TradingEconomics.com

What is of interest today is that with this kind of employment report, the job of Janet Yellen at the Fed has become even more complicated. On that note we read with interest Bank of America Merrill Lynch's take from their US Economic Watch note from the 3rd of June entitled "Payroll pain for the Fed":

"As expected, average hourly earnings grew 0.2% mom and 2.5% yoy, the latter pace holding steady from April. The modest acceleration in wage growth from last year reflects the tightening in the labor market, although there is still a debate as to whether we have reached full employment. Indeed, the broader measure of the unemployment rate, the U6 figure, held at 9.7%.

What does this mean for the Fed?

There was no saving grace in this disappointing report, and the recent sluggishness in the labor market warrants increased Fed cautiousness. We think a June hike is off the table (and the markets agree, pricing in less than a 5% chance of hike after the number this morning). While a hike in July is still a possibility, we are increasingly comfortable with our September call. There is simply not enough time leading up to those summer FOMC meetings to see the growth and labor data rebound convincingly, and inflation continue to accelerate—all necessary conditions for another increase in rates. After today’s report, Fed Chair Yellen’s speech on Monday will be even more important." - source Bank of America Merrill Lynch

As a reminder if a lower unemployment rate implies higher wages, sooner rather than later, then indeed Janet Yellen's hiking job is difficult. So far wage acceleration doesn't seem to be that material from the latest readings. A real tightening scare from the Fed would only happen if there is concrete evidence of an acceleration in wage pressure. On the other hand, deteriorating market conditions, meaning falling share prices and rising credit spreads à la Q1, would most likely lead the Fed to some renewed easing we think.

What is more and more apparently clear is that too much conflicting communication snippets from Fed members are leaving market pundits puzzled and are indeed eroding more and more the Fed's credibility. This was bound to happen and was clearly illustrated by Nomura's economist Richard Koo, quoted in our November 2014 conversation "Chekhov's gun":

"Since the Greenspan era, however, transparency has gradually come to be viewed as a desirable characteristic in the conduct of monetary policy. This trend gathered momentum under the leadership of Mr. Bernanke, who had been making a case for greater transparency in monetary policy since his days in academia. During his tenure at the Fed, this view was reflected in the shortening of the time required for FOMC minutes to be released, the holding of press conferences by the Fed chair, and the release of interest rate forecasts by FOMC members."- source Richard Koo, Nomura Research Institute

This outcome of "eroding credibility" has been highlighted in our musings and has also been put forward by Bank of America Merrill Lynch in their Ethanomics note from the 3rd of June 2016 entitled  "The Fed's risk management":

"Dazed and confused

It is fair to say that many clients are a bit confused and frustrated with Fed communication. The Fed seems to be constantly changing its focus from one meeting to the next. They seem to regularly promise hikes, only to back off at the last second. Fed statements often seem stale, reflecting where the economy and markets were a couple months ago, rather than current conditions. They say their 2% inflation target is not a ceiling, and yet they only plan to bring inflation back to 2%. They argue that the risks to the outlook are very asymmetric—with rates near zero they have limited anti-recession ammunition—and yet their inflation target is symmetric. This is policy transparency?

Here we pierce the cacophony and offer a simple guidebook to understanding the Fed. The core lesson here is simple: until the Fed is able to achieve significant separation from the zero lower bound for interest rates they will remain highly risk averse. This means they will:
• focus on the latest risk factor rather than their baseline,
• pause at relatively small signs of trouble,
• be very slow to “turn off” risk warnings,
• take a very high risk of overshooting their inflation target,
• and take very little risk of an economically meaningful hawkish “policy mistake.” 

Attention deficit disorder

A common complaint from clients is that the Fed seems to be constantly shifting its focus. One day it is the labor market, and then it is GDP, then inflation, then global developments and then financial conditions. No wonder markets are confused about just what “data” the Fed are “dependent” on.
Contrary to popular belief, the Fed is not constantly changing its mind. Instead, their shifting focus is a sign of very high risk aversion. With the Fed and many other central banks facing chronically low inflation, a weak recovery and near-zero rates they are much more sensitive to downside risks to growth than to upside risks to inflation. As a result, their focus tends to shift to whatever is causing downside risks at the moment.
The labor market has been out of the Fed spotlight for a long time because it is the healthiest part of the economy. By contrast, there have been a number of troubling dead spots for GDP growth and there have been repeated periods of elevated global economic and financial risks.
We expect the Fed to remain highly risk aversion until they have created significant separation from the zero lower bound. Get used to it: as risks rotate, so will the Fed’s focus.

Markets are fast, the Fed is slow

Despite a rebound in the markets in late February and March, Fed officials remained super dovish until after the April 26-27 FOMC meeting. Some investors wondered “what more are they looking for to become more optimistic” and “if this improvement is not enough, will they ever hike?” Recall that even in normal times, there is a good deal of inertia in Fed decision making as they have a very strong aversion to flip flopping. This is one reason why the lagged funds rate is often included in econometric models of the Fed reaction function. Moreover, in our view, each shock is making the Fed a bit more risk averse, making them a bit slower to give the “all clear sign.”. Yellen’s next major speech is on June 6th and we expect her to offer a much less stale view, given months of better markets and no sign that the risk-off trade damaged the economy. There are two lessons here: (1) what the Fed is looking for is more time to decide, and (2) their caution means slow hikes, not no hikes.

The inflation target: do the right thing

Another confusing part of the Fed’s message is the way they describe their inflation target. On the one hand, they swear 2% is “not a ceiling” and they want to average 2% over time. On the other hand, they only want to raise inflation to 2% in the next few nyears, taking an equal risk of overshooting and undershooting. As we noted here, inflation tends to be low early in business cycles and then rise late in the cycle. Hence achieving average inflation of 2% requires overshooting in the second half of economic recoveries. As we also note, this has nothing to do with making up for past low inflation, but is a requirement if the Fed is going to avoid repeatedly undershooting its target in the future.

They also have an inconsistent message on the risks around policy. On the one hand, they underscore that their targets are “symmetric”; on the other hand, they argue that with interest rates near zero the risks to the economy are asymmetric to the downside.
If the risks are asymmetric, why would they have a symmetric target? Moreover, the zero lower bound constraint is one of many things arguing for asymmetry:
• Inflation expectations have clearly slipped below their 2% target, restoring
expectations requires proving that they can achieve average inflation of 2%.
• The increased volatility of the business cycle means the Fed needs to have a higher
nominal funds rate at the end of an expansion to have sufficient ammunition to
fight the next recession.
• The drop in the equilibrium real funds rate lowers the equilibrium nominal funds
rate, giving the Fed less anti-recession ammunition, not more.
• The risks of deflation have risen relative to when the Fed first set its target.
• With other central banks stuck at zero, the Fed may be alone to fight the next
recession.

We see only two offsetting arguments. First, overshooting could trigger political backlash. The Fed can deal with this by quietly overshooting and assuring that the overshoot will be limited. Second, a slow exit adds to bubble risks. However, even with its slow exit the Fed has already taken some of the froth out of high yield bonds and commercial real estate lending.1 Ultimately, we expect the Fed to do the right thing and acquiesce to a moderate overshooting of their inflation target. Hence we expect them to act like they have a de facto target of 2.5% over the next several years.

It is hard to fall down when you are crawling

For much of the economic recovery, the bond market consistently priced in rate hikes that never materialized, but the last two years the roles have reversed with the market pricing in less hikes than the Fed is forecasting. Thus a common refrain is that the Fed is “making a policy mistake.” They are going to hike too quickly, damaging the recovery and may be forced to reverse course.
We are skeptical. A corollary of this high risk aversion is that the Fed is unlikely to make a “hawkish” policy mistake. The Fed is moving at a snail’s pace and pauses at every sign of downside risks. Indeed, they have delayed every planned tightening. Moreover, the economy has done fine despite the “taper tantrum,” the “surging dollar” and repeated stock market corrections. The Fed may be making small tactical mistakes, but their goslow-and-hesitate strategy makes an economically meaningful tightening error very unlikely.

Damned if you do; damned if you don’t

The bond market sees a relatively low probability of a rate hike in the second half of the year (Chart 2).

Presumably this is partly because of the looming Presidential election. Clearly the Fed is under political pressure: some candidates have been quite critical of the Fed, there are several bills in Congress designed to reduce Fed independence and a move near the election is likely to attract a good deal of criticism. In our view, political pressure on the Fed is the highest since Paul Volcker broke the back of inflation in the early 1980s. A risk-averse central bank may decide to go into hibernation around the election." - source Bank of America Merrill Lynch

In relation to Bank of America Merrill Lynch's point about inflation tending to be low early in business cycles and then rising late in the cycle, we reminded ourselves that equity bear market tend to coincide with high global core inflation as we wrote about in June 2014:

"Interestingly, back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008:

 - source TradingEconomics.com

When it comes to "inflation" being the "Unobtainium" element we wrote about in March this year, we still think as per our conversation "Perpetual Motion" from July 2014 that real wage growth is indeed the "most important" piece of the puzzle the Fed has so far been struggling to "generate":

"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, July 2014

And if historically, a true peak in the equity market always happens between 2 and 14 months before recessions, a sudden burst of inflation on conjunction with heightened velocity in the rise in oil prices could indeed have severe consequences on equities we think. Given the on-going complacency and significant rally seen since the bottom of the first quarter, and the low level attained by the Vix, it seems to us that the time is right to start thinking about "hedging" your US equity risk as per our final chart.

• Final chart: Now is the right time to "hedge"

As clearly we are moving towards the final inning of this credit cycle and given the signs we pointed out recently coming from the Commercial Real Estate market (CRE) indicative of tightening financial conditions, we have to agree with Société Générale's Cross asset Quant Research note from the 26th of May entitled "The Right Hedge for You", now is the right time to hedge as per their table below:

"We’ve been here before

We also looked at buying options opportunistically, using various tactical indicators. We find that it is relatively easy to identify economic crises of a more cyclical nature by monitoring such indicators as the valuation of the stock market, high-yield spreads and the cost of hedging. Forecasting financial and geopolitical crises is a much more daunting task.
Using risk indicators can help reduce the cost of hedging in good times, and possibly buy more options in times of stress. But in the long run, such tactical choices matter less than such seemingly mundane issues as selecting the right expiry, leverage, and strike.
It is interesting to note that most of the indicators we have selected show that now is the right time to hedge equity risk. Volatility is cheap, especially for the S&P and Eurostoxx. As Andrew Lapthorne argues in ‘High aggregate PE valuations and weak profits and not wholly down to Energy’ [GS5], price/earnings valuations are high and profits weak. US high-yield spreads are wide, as they were in the late 1990’s and before the subprime crisis.

Nobody can predict exactly what will happen next, but we think it is a good time to take a serious look at hedging strategies." - source Société Générale

While nobody can predict exactly what will happen next, from our point of view, we know from the early signs of the growing stress in some segments of the credit markets, that it will happen, how it will happen, namely what will be the trigger remains a big unknown. Revisiting hedging strategies, we agree with Société Générale is essential particularly if one believes the US economy is indeed, like Japan on  a "Road to Nowhere".

"Fun without sell gets nowhere but sell without fun tends to become obnoxious." -  Leo Burnett, American businessman

Stay tuned!

Macro and Credit - Through the Looking-Glass

"Always speak the truth, think before you speak, and write it down afterwards." - Lewis Carroll

While parsing through the FOMC's latest "hawkish" statement, which somewhat reversed "The return of the Gibson paradox" as per our 2013 rambling, making our gold miners exposure on the receiving end of a proverbial "sucker punch", we reflected on the semantics (the study of meaning) and pragmatics (the ways in which context contributes to meaning) of the Fed's latest musing in similar fashion the character Humpty Dumpty discussed with Alice in Lewis Carroll's Through the Looking-Glass (1872), hence our chosen title analogy:

    "I don't know what you mean by 'glory,' " Alice said.    Humpty Dumpty smiled contemptuously. "Of course you don't—till I tell you. I meant 'there's a nice knock-down argument for you!' "    "But 'glory' doesn't mean 'a nice knock-down argument'," Alice objected.    "When I use a word," Humpty Dumpty said, in rather a scornful tone, "it means just what I choose it to mean—neither more nor less."    "The question is," said Alice, "whether you can make words mean so many different things."    "The question is," said Humpty Dumpty, "which is to be master—that's all." - source, Lewis Carroll's Through the Looking-Glass (1872)

One could have had a similar discussion with Fed chair Janet Yellen on the very subject of the supposed upcoming rate hike in June or July we think:

"I don't know what you mean by 'incoming data consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee’s 2 percent objective' " Alice said.
Janet Yellen smiled contemptuously. "Of course you don't—till I tell you. I meant 'there's a nice knock-down argument for you!' "
"But 'incoming data consistent with economic growth picking up' doesn't mean 'a nice knock-down argument'," Alice objected.
"When I use a word," Janet Yellen said, in rather a scornful tone, "it means just what I choose it to mean—neither more nor less."

Indeed, the question is whether the Fed can make its words mean so many different things. What we also find of interest with our analogy is that Humpty Dumpty has been used to demonstrate the second law of thermodynamics. This law describes a process known as "entropy", a measure of the number of specific ways in which a system may be arranged (the Global Financial system as a whole), often taken to be a measure of "disorder". The higher the "entropy", the higher the disorder (hence our take on rising "positive correlation" and "disorder" with more and more large standard deviation moves in recent musings). After Humpty Dumpty's tragic fall and subsequent shattering, the inability to put him together again is representative of this principle, as it would be highly unlikely (though not impossible) to return him to his earlier state of lower entropy, as the entropy of an isolated system never decreases in similar fashion it has been incredibly difficult to return the Global Financial system to some state of "normalcy/lower entropy" but we ramble again...

In this week's conversation, we will start by looking at why the ECB is failing regardless of its QE, ZIRP and now NIRP and other tricks in spurring credit growth in Europe through the lens of European banks lack of "profitability". We will as well look at lending growth and the credit cycle.

Synopsis:

• Macro and Credit - Regardless of QE, ZIRP and now NIRP, the ECB is failing in spurring credit growth
• Macro and Credit  - Lending growth and the credit cycle and why the Fed is in a bind
• Final chart: US bond market - The warning sign from the long end

• Macro and Credit - Regardless of QE, ZIRP and now NIRP, the ECB is failing in spurring credit growth

While many pundits are highlighting "Price to book valuations" for global banking stocks. and are asking themesleves if banks cheap enough to take a risk here, we reminded ourselves our conversation from February 2015 entitled "The Pigou effect" where we clearly indicated our discomfort with European banking stocks:

"As we have stated on numerous occasions, when it comes to European banks, you are better off sticking to credit (for now) than with equities given the amount of "deleveraging" that still needs to happen in Europe." - source Macronomics, February 2015

We also quoted at the time Berenberg's take on the "Japanification" of Europe "Through the Looking-Glass" of its banking sector:

"In short, until there is true clarity in the value of European banks’ assets, then the value of the equity is highly uncertain, making European banks uninvestable. In our view, what Europe needs to do, and what happened in Japan, is to force banks to dispose of a material proportion of their non-performing loans." - source Berenberg as per Macronomics note from February 2015

Given our recent April conversation "Shrugging Atlas", musing around "Atlante", the Italian structure set up to tackle the sizable issue of Nonperforming loans (NPLs) plaguing the Italian banking sector, the performance of Italian banking stocks in particular and European banking stocks in general does validate our preference for financial "credit" than for financial "stocks" in Europe:

"No matter how low interest rates on corporate loans have fallen and has been much vaunted by the ECB and many pundits as a "great success", lack of "Aggregate Demand" (AD) and loans flowing to SMEs thanks to insufficient demand, this will not, rest assured, resolve the on-going woes, which have been much increased by the recent implementation of Negative Interest Rate Policy (NIRP), of the Italian banking sector. Either you remove the NPLs from the bloated Italian Banks' balance sheets and the ECB monetizes the lot, or they don't. Anything in between is an exercice of dubious intellectual utility, hence our chosen title. Also as per our analogy, we wonder if, at some point, in similar fashion to Ayn Rand's book, investors will not go on "strike" when it comes to helping out the Italian banking sector as a whole." - source Macronomics, April 2016

Through the looking glass of the European banking sector, one can ascertain the futility of the ECB's policy in terms of QE, ZIRP and now NIRP in not only stabilize the "equity value" of Italian banks, but as well in resuming "credit growth". In continuation to us "Shrugging Atlas", we read with interest Bank of America Merrill Lynch's Money in the Bank note from the 20th of May entitled "Europe’s riskiest bank bonds":

"From bel canto to bank analysis 

It would be fair, we think, to typify the first trimester of this year for the Italian banks as a torrid one. It’s been tough for all global financials but Italian banks have particularly suffered. YTD Unicredit’s stock has fallen -43%, Monte dei Paschi -53%, Banco Popolare -65% and Intesa -25%. There are a number of reasons for this underperformance but at the base we see the systemic asset quality, credibility and capital problems in Italy as the drivers of investor concerns.

From bel canto to bank bond analysis: we measure the empirical riskiness of bonds by looking at the standard deviation of daily excess returns. We are not surprised that the Top 5 riskiest bonds in Europe YTD are all Italian banks, specifically Monte dei Paschi Tier 2, Veneto Banca T2 and Unicredit USD AT1. Excluding DB, Italian bank bonds occupy all 9 places of the Top 10 most volatile bonds. Following the 1Q reporting season and the recent events in the Italian banking sector, perhaps it’s a good time to reassess whether the market’s assessment is really a robust one.

We’re mindful that Italian financials are a significant part of the HY Index. There is €27.5bn of Italian paper in the HY Fins Index which is 45% of the total. It’s one thing to be negatively positioned in these when they are in decline but what if there is a turnaround in the assessment of the fortunes of these banks?" - source Bank of America Merrill Lynch

We do not think there will be a turnaround through the looking glass of their "better earnings" thanks to "lower provisioning levels". On this subject we read with interest Bank of America Merrill Lynch's take from the same note:

In 2014, some banks briefly circulated the idea that they were more conservative in their classification of NPLs than other European peers as the reason for the high quantum – this got quashed when the AQR clearly demonstrated the opposite. There have also variously been tax reasons and legacy lending issues, amongst others. We think the reasons may encompass many of these, but at root the answer is probably simpler: Italian banks did not seem to be very good at underwriting, in our view. We think high levels of NPLs are, in some respects, a management choice. To be fair, up to 2016, no one seemed to care and we could get little traction with investors when we talked of asset risks in Italy. This indifference possibly explains the relatively high level of complacency on the part of the banks on the NPL front. Remember this is a jurisdiction where a bank with a 16% NPA ratio is considered best in class.
In contrast to what we might describe as the pusillanimity of the banks in face of this significant challenge, we think the Italian Government has moved relatively proactively to try and address systemic concerns. It orchestrated a fund to help recapitalize some of the banks and avoid failed IPOs which would likely have caused further systemic issues, we think. Importantly, there have also been a series of measures which have been designed to reform insolvency practice in Italy and address tax issues around provisioning. There has even been an attempt to create a kind of bad bank, or more precisely to kick start a more liquid market for NPLs, through the provision of a Government-guarantee to NPL securitisations. We consider the efficacy of these operations in turn. 

Atlante 

Initially, we assessed the Atlante fund as a positive development for the Italian banks as we saw it as an attempt to break the cycle of bad news around the banks. We were slightly disappointed that the fund raised only €4.25bn compared to the €5-6bn that was originally mooted. Originally designed to ensure the success of the BP Vicenza IPO, and in our view, also help rescue Unicredit from its ill-fated decision to be sole underwriter for said transaction, the IPO of BP Vicenza has now passed, with Atlante having to take up the entirety of the €1.5bn in stock that was offered, because outside investors did not take up any allocation in sufficient quantity. According to Borsa Italiana, 10 insitutions offered to buy 5.1% of the shares which was insufficient free float. Atlante now has €2.75bn in resources left. The IPO of Veneto Banca is upcoming (pre-marketing was to start at the end of this week) and has been widely considered e.g. in the Italian press to have a greater chance of success when compared with Vicenza, not least because the bank is trying to place a smaller amount (€1bn). Market conditions remains hazardous though, we think, as recent comments by CONSOB underline. We have seen some discussion in the Italian press that the fund could be scaled up but we haven’t seen anything concrete on this – Bloomberg reported on Wednesday that the Italian Finance Minister was suggesting in an interview that it could be enlarged. Atlante is in any case a closed fund now but 66% of holders could vote to expand it, so we can’t exclude that the fund will grow, especially if it needs to.

In spite of being ostensibly private to avoid the state aid rules in Europe, Atlante seems to us to be serving a specifically public policy role, on our reading of its presentation, ‘by eliminating excessive supply with respect to the demand for shares’ though it is supposed to have the ‘interest of investors as its sole objective’. It seems to be an unusual set-up even by European standards.
Atlante has already served one of its primary purposes, we think, in subscribing to the Vicenza increase and sub-underwriting the IPO thereby reducing the risk to Unicredit ofbeing left with a significant overhang of shares. 70% of the funds resources are designed to be available for the support of capital raises, with the balance, or just under €1.3bn currently, for the purchase of NPLs. On NPLs, the idea is not that Atlante replaces the NPL market, but that it promotes ‘the creation and development of an efficient market of distressed assets in Italy’. In other words, Atlante may facilitate the sales of NPLs e.g. by buying mezzanine or equity tranches of NPL securitisations – especially those that take advantage of the Government guarantee (the so-called GACS) for the senior/investment grade tranche of the structure. The first bad loan securitization, with a GACS guarantee, is already happening in Italy with a €500m 3 year transaction for BP Bari. However, as the chart shows, loan sales in Italy have been relatively few. The expectation is that Atlante, plus GACS (plus the legal reforms, below) might provide the conditions to accelerate the creation of a more active market for bank bad loans.

We keep an open mind on the Atlante structure and its benefits – the market has been skeptical hitherto. We recall Fitch’s warnings that Atlante potentially drags healthy banks down in their rescuing less healthy institutions. But we still believe perceptions can quickly change as e.g. NPL transactions materialize using GACS, whether or not Atlante participates. Currently, in our view market sentiment around the Italian banks is still overwhelmingly bearish, especially after the last reporting season which was, in summary, rather underwhelming, in our view. We think it’s rather soon to assess the potential benefit from Atlante. We will need to see successful transactions concluded, however. Positive conclusions for the upcoming IPOs of other Italian banks would also be helpful, we think." - source Bank of America Merrill Lynch

We do not think it is rather "too soon" to assess the potential benefit from "Atlante", as we reiterated earlier on, either you remove the NPLs from the bloated Italian Banks' balance sheets and the ECB monetizes the lot, or they don't. Anything in between is an exercice of dubious intellectual utility, and through the "looking glass" of Italian banking woes and credit growth, the ECB is failing we think because with its QE and NIRP, it has not enticed Italian banks to accelerate the clean up of their balance sheets on the contrary as indicated in Bank of America Merrill Lynch's note:

"Perhaps the banks are anticipating the benefits of the patto marciano and so believe there is less need to keep provisions high (we understand that many European banks are also eager to anticipate the -0.40% rate at which they may be able to borrow from the ECB, even though that rate strictly speaking can’t be calculated ex ante). Lower provisions was a driver of many of the beats to consensus expectations in Italy, though, it seems. " - source Bank of America Merrill Lynch

Exactly, why bother? On a side note, and in similar fashion, for some countries and in particular France, why bother launching structural reforms when the ECB enables you to borrow for close to nothing (0.5%) for 10 year?

But moving back to why the ECB is failing is once again its lack of basic understanding of "stocks" versus "flows". We have long argued that for Eurozone members, if credit growth does not return, economic recovery may prove to be difficult in the absence of sizable real exchange rate depreciation. Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. The change in credit growth is a flow variable and so is domestic and global demand!

The big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth. 

When it comes to assessing "banking revenues", it is actually pretty straightforward as presented by Société Générale in their European Banks note from the 20th of May entitled "The revenue crisis":

"Net interest income is nothing more complicated than the revenue spread on the balance sheet. It depends on three pretty straightforward variables: the size of the balance sheet, the yield on assets and the cost of liabilities. It is the first two of these variables that have been under consistent, sustained pressure across the sector. Liabilities have not got cheap enough, quickly enough to compensate.
Across the sector, NII contributes c. 60% of the revenue base, and so is the major part of the dynamic. Non-interest income is more volatile, and spread between a multitude of different business lines. Essentially, fee income is a flow on the franchise value of the bank: the branches, the product range, the staff, etc. The outlook is less clear, and the drivers can change quickly. Strong markets would tend to be the biggest single force." - source Société Générale

We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of budget deficits and NPLs.

Furthermore, the ECB's NIRP policy has aggravated the "deflationary" spiral in the deleveraging process by limiting the possibilities for banks to offset their NPLs woes with more revenues as pointed out by Société Générale in their note:

"Revenue wipe-out European banks are suffering. Every bank we cover has reported a year-on-year drop in Q1 16 revenue. A heady mix of zero rates, tough markets, weak CIB and stagnant lending volumes is taking a heavy toll. This matters for the sector. While nearterm earnings have been underpinned by better credit quality, this is not a theme that can continue forever. Sector earnings are stuck in a downgrade cycle, and pressure on the revenue line is at the heart of this." - source Société Générale

As we have argued before QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think. Although the ECB has been trumping the convergence in Europe in interest rates charged on new corporate loans, as we stated before, the "fun" is uphill, in the bond market, not downhill, in the "real economy". If there is one chart displaying the failure of the ECB we believe it is the below chart from the same Société Générale note that illustrates the ECB's failure in spurring credit growth:

- source Société Générale

With the ECB's NIRP, there is no revenue, and there is as well no loan growth, so some pundits might be highlighting "Price to book valuations" for global banking stocks, we haven't change our views and we would rather play the "credit" side than the "equity" side from an investment perspective particularly "Through the Looking-Glass" of "consensus" EPS trend as displayed by Société Générale in their note:

"The weak revenue environment helps to explain a major anomaly with the Q1 16 results season: the sector generally ‘beat’ consensus on earnings, but consensus EPS downgrades have continued unabated." - source Société Générale

Indeed thanks to the ECB and its NIRP policy, when it comes to European banks stocks, you can no doubt, expect lower, for longer, that's a given. Whereas, the leveraging in the US has run fast and furious in the US credit markets, courtesy of the Fed, as we pointed in our last conversation we expect the impact of the ECB's much anticipated "credit binge" to materially deteriorate the credit quality of European credit markets which had been in recent years much more defensive of their balance sheets, no doubt even in High Yield than in the US. This leads us to our second point namely that, "Through the Looking-Glass", the Fed appears to us to be in a bind, with its "hawkish" stance, highlighting more and more the law of diminishing returns when it comes to its "credibility".

• Macro and Credit  - Lending growth and the credit cycle and why the Fed is in a bind

As indicated in our conversation "The disappearance of MS München", we have been tracking the price action in the Credit Markets and particularly in the CMBS space. The reason behind us starting to track à la 2007 is that the CMBX price action indicates that a growing number of investors may have begun to short it since it is a liquid, levered way to voice the opinion that CRE (Commercial Real Estate) is considered to be a good proxy for the state of the economy. And, if indeed investors are pondering the likelihood that the US economic growth is slowing and that CRE valuations have gone way ahead of fundamentals, then it makes sense to track what is going on in that space for various reasons, particularly when it comes to assessing lending growth and the state of the credit cycle we think. 

As a reminder from our February conversation, CRE portfolio lenders also tighten credit standards, it stands to reason that some proportion of borrowers that would have previously been able to successfully refinance may no longer be able to do so in the future.

For instance, the continued weakened price action noticed in some space of the CMBX market as per the below chart from Bank of America Merrill Lynch from their latest Securitization Weekly note from the 20th of May illustrates why we are watching closely that space:

- source Bank of America Merrill Lynch

"Through the Looking-Glass" of "retail" CDS price action and the link between retail and CRE, given we told you about this relationship in February with Sears’s management announcing in February that the company would accelerate the pace of store closings, sell assets and cut costs, this is clearly a "headwind" for CMBX and CRE. This is ncreasingly a sign that all is not well in the much vaunted "economic recovery" picture painted by the Fed and Humpty Dumpty aka Janet Yellen and her 'incoming data consistent with economic growth picking up in the second quarter'. As an illustration of the tailwind facing the Fed, the CDS price action depicted by DataGrapple on the 13th of May is indicative of the risk facing CRE investors:

"The above grapple depicts the weekly change of the risk premia of the constituents of the US Corporate cluster identified by DataGrapple. Retailers are easy to spot. In an otherwise resilient market as shown by the greenish shades of most boxes, all of them are red (and some bright red). Most of them reported first quarter numbers, and all of them managed to disappoint. Today, JCP (J C Penney Company, Inc) posted revenues that trailed analysts’ estimates and joined fellow discount-oriented KSS (Kohl’s Corporation) which missed estimates yesterday. Higher end rivals did not fare any better. M (Macy’s, Inc) reported lacklustre results and lowered EPS guidance for the year by 57cts (to $3.15-$3.40 from $3.80-$3.90), while JWN (Nordstrom, Inc) also added to evidence that the department store industry is mired in a deep slump when it cut its annual earning forecast. Shoppers across the income spectrum appear to pull back on purchases of apparel and other discretionary goods." - source Datagrapple, 13th of May 2016

For those with a "short bias mentality", please note that CMBX.6 has the highest percentage of retail exposure. CMBX.6 has considerably more exposure to B/C quality malls...just saying. 

And when we say the Fed is in a bind because of this relationship between "retail" and CRE we are not the only one meaning it. For instance Bank of America Merrill Lynch make the following interesting points in their Weekly Securitization note:

"While limited issuance might otherwise provide a powerful tailwind for spreads, myriad uncertainties remain on the horizon lead us to adopt a more cautious near term view. 

First, as we mentioned above, is the increasing probability that the Fed may raise rates over the next two months. Although a rate hike in and of itself won’t be overwhelmingly negative, it is likely, if not probable, that any near-term hike will be negatively viewed by many investors and could possibly be interpreted to signify that the Fed will be overly zealous as they seek to normalize interest rates against what they believe is an improving economic environment. Second, to the extent higher rates exacerbate the recent credit tightening, it is reasonable to fear that CRE price growth, which is already showing signs of slowing, could be exacerbated to the downside. While the recent Federal Reserve Senior Loan Officers Survey showed that bank lending standards have tightened since the end of 2015, rising recent conduit debt yields (Chart 52) and stabilizing Moody’s stressed LTV (Chart 53) metrics indicate the same is true within CMBS. Risk retention, which dealers are actively planning for, is likely to tighten lending standards further.

The combination of better underwriting, subdued new issuance activity and shrinking dealer balance sheets (Chart 54), which make it difficult for investors to add bonds in size away from the new issue market, have likely contributed to the cash bond spread rally. 

Recent CMBX spread/price movements, however, tell a different story and may provide insight into the macro-related nervousness investors are feeling.

On the week, CMBX prices, especially for tranches at or near the bottom of the capital structure, fell by as much as three points (Chart 55) and have fallen by as much as five points since the beginning of the month (Chart 56).

Again, to the extent that oil prices remain rangebound or increase and no major economic disruptions occur over the next month, we anticipate that CMBX spreads will trade directionally with broader markets." - source Bank of America Merrill Lynch

And of course, "Through the Looking-Glass" of the price action of CDS in the "retail" sector and CMBX, this is indeed a cause for concern regardless of "Humpty Dumpty" aka Janet Yellen's rethoric.

This brings us further "Through the Looking)Glass" of the relationship between lending growth and the credit cycle thanks to UBS's recent take on the subject from their Global Credit Comment note from the 17th of May 2015 entitled "Bank vs nonbank lending signals: the plot thickens...":

"In corporate (non-household) lending markets we believe the proverbial plot has thickened considerably. The two key lending segments are commercial and industrial (C&I) and commercial real estate loans (CRE). For C&I lending, banks comprise less than 20% of total lending; the bond markets are the new marginal provider of liquidity (Figure 2). 

Our non-bank proxy, incorporating bond and trade finance measures of credit conditions, has been indicating more tightening than bank proxies (i.e., the Fed's SLOOS survey) for several quarters. And our proxy is still suggesting further tightening ahead, primarily given that new issuance in US high yield and leveraged loan markets remains sluggish despite recent outperformance (US HY and institutional LL issuance are down 47% and 33%, respectively, in 2016; CLO issuance is off 68% YTD). That said, the rate of tightening has slowed, as HY issuance and trade-credit standards improved in April (Figure 3). 

In short, the trend in lending conditions is still tighter – but there has been some easing in funding conditions.
Conversely, lending conditions in commercial real estate have deteriorated. Banks comprise about 55% of total lending, so the Fed's SLOS survey is more telling. And, in the last quarter, banks tightened lending conditions in CRE, specifically in multifamily and construction/land development vs nonfarm non-residential (36% and 24% net tightening versus 12%, respectively, Figure 4; CMBS issuance is also down 38% through April). 

Why are banks tightening?

The most important factor cited was not CRE fundamentals, cap rates, competition nor funding, but 'other' factors – and by a large margin. What is our interpretation? Increased regulation was the underlying cause. We have previously flagged concerns around the pervasive easing of underwriting standards for corporate lending broadly 5 . Since 2007 FDIC-insured banks have increased nonfarm, nonresidential loans (ex-owner occupied) approximately 82% to $730bn; multifamily loans rose by roughly 142% to $344bn6 . In December, the OCC released its Statement on Prudent Risk Management for CRE Lending in response to "significant growth in CRE lending, increased competitive pressures, historically low cap rates and rising property values". This guidance was originally issued back in 2006, requiring banks with higher CRE concentrations to tighten risk and managerial controls.
We estimate approximately 8% and 16% of FDIC-insured banks by count and CRE debt outstanding, respectively, were above at least one of the concentration levels at YE 2015 (i.e., >100% CLD vs total capital, or >300% CRE vs total capital and >50% growth prior 3 years). For comparison, in 2006 about 31% and 40% of banks, respectively, exceeded one of the thresholds. Last month an American Bankers Association survey suggested similar, but modestly higher, figures in terms of bank concentration levels among respondents. Further, 40% indicated they expected a measurable reduction in credit availability to certain CRE sectors, while another 25% suggested a measurable reduction in credit availability across all sectors from the guidance. 

Why is this important? First, regulation can have a significant impact on the supply of credit, with US leveraged loans a recent case in point8. Back in 2006, the CRE guidance for banks also coincided with a significant tightening in CRE lending conditions. Second, changes in lending conditions for C&I and CRE loans have been quite highly correlated in the past (see Figure 4 above ).

One study finds banks that were above CRE guidance concentrations not only slowed CRE loan growth, but also tended to reduce C&I loan growth. Simply put, macroprudential regulation can have a more broad-based and severe effect on commercial bank lending. One could argue that constraints on lending as the credit cycle matures may guard against excess losses; conversely, an exogenous shock to the supply of credit at a time of lacklustre global growth and upcoming risk events could exacerbate
funding pressures.
And the linkages between CRE and C&I lending are multi-faceted. The lenders – in particular regional and community banks – tend to have higher concentrations of commercial and C&I loans, and some smaller business loans are collateralized by commercial property. Second, borrowers can also be concentrated in certain sectors across C&I and CRE. According to the Fed's Shared National Credit Review the largest industries in the leveraged C&I portfolio included Healthcare (14%), Media/Telecom (13%), Finance/Insurance (12%), Materials/Commodities (6%) and  Retail (5%)10. In CRE portfolios, larger concentrations lie in multifamily (28%), office (18%), retail (16%), industrial (12%), hospitality (8%) and healthcare (7%) according to the ABA. Much of the CRE growth has occurred in coastal cities. This implies, while not directly comparable, C&I and CRE depend more heavily on similar industries – media/telecom, finance (non-bank), retail and healthcare.

The conclusion is that the plot is thickening with respect to the signals of corporate lending conditions, and we believe clients should increasingly view them in a holistic framework. While there are signs of moderation in the rate of tightening for C&I loans, we are already seeing rising delinquencies and defaults weigh on corporate profits and growth (stages 3 and 4 of our rudimentary credit cycle model outlined earlier). But for CRE loans we think there is greater cause for concern as potential harbingers of greater credit constriction emerge.

Importantly, we have yet to see much rise in delinquency and default rates – although examiners noted rising concerns over CRE credit risk for 75% of banks and expected credit risk to rise in 50% of all commercial loans at year-end. The ESRB provides a simple but useful framework for the CRE cycle (Figure 5); while the CRE cycle appears less advanced than the C&I cycle, we believe investors should closely watch for evidence of potential negative effects on credit availability in CRE and potential broader spillover to C&I lending.

In particular, investors should closely watch the media/telecom, finance (non-bank), retail and healthcare industries given the linkages across both markets. In terms of investments, our view of recent trends in corporate lending conditions does not support 'reach for yield' or down-in-quality trades. In corporate credit, we continue to prefer longer duration US high grade bonds versus high yield." - source UBS

We agree with UBS's preference for US longer duration US high grade bonds exposure versus High Yield. When it comes to the CRE cycle being less advanced than the C&I cycle, we do think that the price action in both US retail CDS and CMBX shows that the CRE cycle will catch up fairly quickly with the C&I cycle. It is yet another indication that should worry "Humpty Dumpty" aka Janet Yellen and clearly shows that indeed, as we posited, the Fed is in a bind of its own making. We remember clearly that Charles Plosser, the head of Philadelphia Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2.

This leads us to our final chart, indicating as well that "Humpty Dumpty" aka Janet Yellen should pay attention to what the long end of the US bond market is telling her no matter what she thinks whether or not she can make words mean so many different things in the FOMC...

• Final chart: US bond market - The warning sign from the long end

What "Humpty Dumpty" aka Janet Yellen doesn't seem to realize is that the credibility of the Fed, is "decaying" in similar fashion as the "theta" (time value) of the "put" option of the Fed. Given the recent "hawkish" tone to somewhat "dampen" the "credibility risk", we tend to agree with Bank of America Merrill Lynch's take on the warning sign being sent by the long end of the US yield curve as per their recent US Rates Watch note from the 18th of May entitled " Fed vs. bond market: The warning sign from the long end". The final chart taken from their note plots long term real rates in five major countries vs. the miss to the respective central bank’s inflation target:

"Bond market vs. Fed speak: look at the long end, not EDs 

Recent Fed speak and a slew of important speakers lined up to talk before the June meeting (Dudley, Yellen, Fischer) has shifted attention back to the front end of the rates curve. Eurodollar bears that were forced into hibernation since March have woken up, revisiting similar arguments of dots vs. the Fed, rates vs. US data surprises etc. To us, there is one worrying sign in the reaction of the bond market to the better data and hawkish Fed speak unlike 2013: instead of the optimistic signal the yield curve sent during the taper tantrum, long end rates now suggests a re-ignition of the policy mistake trade. Raising June/July probabilities is a small victory that is coming at the cost of dealing with higher probability of inverted yield curves 2-years forward, in our view. 

This is not 2013: reigniting the policy mistake trade 

A critical difference between 2013 and today is the inability of Fed optimism to filter through into higher long end yields. Chart 1 plots OIS forwards in mid and end 2013 (pre and post taper tantrum).

The combination of better data and shift in messaging from the Fed in 2013 was viewed to be a sign of an optimistic longer term growth picture – the resulting rise in yields was a healthy combination of 1) higher terminal rates 2) higher term premiums 3) and thereby a license for the Fed to hike sooner and faster than was originally thought. Recent communication however struggled in this regard: hawkish Fed talk and better US data has only helped 1) strengthen the dollar and weaken inflation expectations 2) lower terminal rates priced in 3) increase hike probabilities for the near meetings without shifting medium term expectations. 

Lack of credibility constrains effectiveness 

The policy mistake angle assigned to the Fed is visible in more areas than the yield curve. Chart 3 plots long term real rates in five major countries vs. the miss to the respective central bank’s inflation target. The market continues to believe that the Fed will deliver real rates that are far too high and miss on its long term inflation target by at least 50bp. To us, this inability of the Fed to improve longer term expectations priced in to the market tows the line of igniting a bigger concern: getting dangerously close to the market pricing in inverted yield curves, 2 to 3 years forward." - source Bank of America Merrill Lynch

So go ahead "Humpty Dumpty", hike, because looking through the "Looking-Glass" of retail earnings, their respective CDS price action, the state of CRE versus lending standards continuing to tighten and the state of the "long end" of the US yield curve, we do think that you will not be able to return the US economy to its earlier state of lower entropy...

"If you stop being scared, that's when entropy sets in, and you may as well go home." -  Tamsin Greig, English actress

Stay tuned!