Saturday, 15 September 2012

Credit - Pareto Efficiency

"This is no time for ease and comfort. It is time to dare and endure." - Winston Churchill

While in last week conversation we mused around our "uneasiness" in the current "easiness", the latest round of Quantitative Easing iteration number 3 courtesy of Dr Ben Bernanke at the Fed, made us wander towards an important economic as well as engineering concept for our title, namely the Pareto Efficiency:
"In a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off. Given an initial allocation of goods among a set of individuals, a change to a different allocation that makes at least one individual better off without making any other individual worse off is called a Pareto improvement. An allocation is defined as "Pareto efficient" or "Pareto optimal" when no further Pareto improvements can be made." - source Wikipedia

The impact QE2 has had on commodity prices has been clearly analyzed in a very interesting paper from the Bank of Japan - Recent Surge in Global Commodity Prices back in March 2011.
Given that in a Pareto efficient economic allocation, "no one can be made better off without at least one individual worse off", looking at the causality between the Arab Spring and the rise in commodity prices, one has to wonder what will be this time around the impact worldwide of this latest round of "easing" from the Fed, hence our title.

Historically the highest prices touched by wheat prior to the French Revolution were in 1789. Between 1780 and 1788, the average price for  a "setier" of wheat (setier was an old French units of capacity equating to 156 liters), was stable between 19 pounds and 13 shillings and 25 pounds and 2 shillings. Between 1786 and 1787 the price was stable at 22 pounds a setier. In 1788 it rose by 15% but in 1789 it rose by 36% in one year, touching 34 pounds and 2 shillings. The harvest for 1788 was one third lower and this impact was sufficient enough to trigger the doubling of prices in the period 1788-1789. Just before "Bastille Day" on the 14th of July, there was a tremendous storm on the 13th of July 1789 which caused massive destructions to crops. 

Wheat prices in "pounds per setier" units on the 24 of June every year from 1728 until 1789, source - "Le prix du blé à Pontoise en 1789" by Dr Florin Aftalion.

The proper French revolutionary period (1789-1794) was characterized by poor harvests and very similar meteorological factors witnessed in 1788 and 1789, namely very hot spring-summer periods with very bad weather followed by very cold winters (-21 degrees Celsius in Paris during the winter of 1788), of course any similarities with this year's meteorological events are purely fortuitous given we are rambling again...Are we?

In similar fashion to QE2, QE3 has already triggered a significant rise in Inflation Expectations - source Bloomberg:
"The CHART OF THE DAY shows the gap between yields on 10- year Treasuries and same-maturity inflation-protected notes, a gauge of consumer-price expectations, jumped to the widest since May 2011 after Bernanke said the central bank will buy $40 billion of mortgage debt a month. It also charts five-year U.S. inflation swaps that let holders exchange fixed interest rates for returns equal to price gains. The figures suggest inflation will climb after dropping to the lowest since 2010. “We will see higher inflation pressure in the next few years,” said Hiroki Shimazu, an economist in Tokyo at SMBC Nikko Securities Inc., a unit of Japan’s third-largest publicly traded bank by assets. “It will be difficult to control.”
The breakeven rate -- the difference between yields on 10- year notes and Treasury Inflation Protected Securities -- widened to as much as 2.54 percentage points today, the most in 16 months. The swaps climbed 12 basis points to 2.50 percent yesterday, the biggest one-day jump since February 2011, data compiled by Bloomberg show. Annual inflation was 1.4 percent in July, about half the 3 percent pace at the end of 2011." - source Bloomberg

Those who follow us know that 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 was announced - source Bloomberg:
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.

We discussed asset correlation back in May in our conversation "Risk-Off Correlations - When Opposites attract". Whereas in "Risk-Off" periods the dollar acts as a powerful magnet for investors seeking safe haven, whenever there is a Fed meeting week, it ultimately weighs on the Dollar index as indicated by Bloomberg:
"The CHART OF THE DAY shows the gauge, which measures the dollar against the currencies of six major trading partners, has fallen the week of FOMC meetings four out of five times this year. The Dollar Index fell 1.7 percent in the week of Jan. 25 when the central bank extended its pledge to keep interest rates near zero until 2014. The measure declined 0.3 percent in the week of the March 13 gathering even as the Fed raised its assessment of the economy." - source Bloomberg.

This time was not different. The Dollar Index fell to around 79 with Gold rising in the process as indicated in the below graph displaying the Dollar Index versus Gold since June 2011:

"Pareto efficiency is an important criterion for evaluating economic systems and public policies. If economic allocation in any system is not Pareto efficient, there is potential for a Pareto improvement—an increase in Pareto efficiency: through reallocation, improvements can be made to at least one participant's well-being without reducing any other participant's well-being." - source Wikipedia.

Therefore in this week credit conversation we would like to delve into the diminishing returns QE has on the real economy following our usual credit overview.

The Itraxx CDS indices picture displaying yet another very significant rally in the credit derivatives space below the March lows for some indices - source Bloomberg:
The High Yield risk gauge indicated by the Itraxx Crossover index (50 European entities) is tighter this week by another 40 bps courtesy of the third round of QE triggered by the Fed. The move tighter for credit derivatives indices was significant on Friday with the Itraxx Crossover index tighter on the day by 35 bps and with the Itraxx Financial 5 year subordinated index closing below its March lowest point of 313 bps at around 300 bps. It wasn't only the Itraxx Financial Subordinated 5 year index falling to the lowest levels since the series 17 was launched in March, the Itraxx SOVx index (15 Western Europe sovereign CDS including Cyprus) declined by 10 bps towards 173 bps, retreating for a 10th straight week, the longest-ever streak.

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:
Clearly, the HY risk gauge indicated by the Itraxx Crossover is moving towards expensive territory close to 400 bps falling in synch with volatility. The gap between the Itraxx Crossover and Eurostoxx volatility has closed.
As well as the European High Yield market, the US High Yield market continues to perform and becoming a cause for concern as a market maker put it bluntly:
Why has the market rallied and stayed bid? Here's one reason.....Massive credit issuance continues. Monday was the LARGEST day of US corporate issuance ever (14 deals, $19bn) and the largest day for European corporate issuance this year (9 deals, E7.5bn). Yield! Yield! We know that companies are using this money for one thing more than any other: Buybacks. Non directional activity in US stocks (gamma hedging, liquidity providers, quant strategies) has become over 65% of activity...."
From a credit point of view, we believe buybacks are credit negative.

Yes, the last two weeks have seen an "avalanche" of new issues coming to the market given the prevailing tone in markets leading to 19.3 billion euros worth of new issues coming to the markets with 12 billion alone last Monday. While core non-financial issues are getting more and more unattractive, there was a flurry of new issues coming from peripheral countries, such as Energias de Portugal on Friday which came to the market with 750 million euros worth of bonds which drew 7.5 billion in orders from 475 investors at a yield of 5.875% from an initial 6.25%. It was the first issue for Energias de Portugal (EDP) in the last 18 months. Effectively EDP had been shut out of the markets since February 2011.

This directly a translation of the pressure easing on Portugal sovereign CDS 5 year spread, as indicated in the below graph displaying Portugal 5 year sovereign CDS versus Ireland sovereign 5 year CDS:
Both Ireland and Portugal's respective CDS continue to Converge from -891 bps apart early 2012 towards -170 bps apart.

But, the severing of the link between Sovereign risk / Financial risk has yet to happen. The main concern of European authorities as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index and the Itraxx Financial Senior 5 year index has been trying to break that close relationship, expecting that the European Banking Union will finally break this relationship. We doubt it will - source Bloomberg:
The ECB is to be given new powers in the framework of the single supervisory mechanism for Eurozone banks. The EBA and national supervisory authorities will continue to carry out day-to-day tasks. While this change in profile is akin to an additional step towards a banking union, it is as well a precondition of the ESM's ability in lending directly to banks and part of the move towards fiscal, economic and political union. Given our "bipolar disorder" markets are in a positive "mania" phase, this ECB expanded role has been so far well received leading to further tightening in Itraxx Financial Spreads, sovereign CDS spreads and rising European financial stocks. The "unelected" President of the European Commission José Manuel Barroso set out this week his "vision" for Europe, namely a "federation of nation states". CreditSights recent report entitled - ECB Bank Supervision - The Road to Banking Union, indicated the following important points: "According to the commission between October 2008 and October 2011, European countries "mobilised Euro 4.5 trillion in public support and guarantees to their banks". It wants to break "the vicious circle between banks and sovereigns". However, whether this is achievable through a banking union is doubtful. The majority of most banks' assets are located in their home country and therefore intertwined with their local economy, and banks tend to hold large (and increasing) portfolios of home country government securities, which itself makes the link between the sovereigns and banks difficult to break. However the Commission is more concerned with removing the burden on national governments of bailing out their banks. It would probably be more logical to reduce sovereign risk first, but that is more difficult, practically and politically, than trying to fix the banks".

In relation to the European bond picture, the move was less dramatic for peripheral bonds this week with Spanish 10 year yields around 5.80%, slightly below 6% whereas Italian 10 year yields still well below 6% around 5.00% whereas German government yields continued rising, this time around towards 1.70% levels with other core European bonds yields rising as well in the process - source Bloomberg:

As far as "Flight to quality" picture is concerned, it is clearly pointing towards "Risk-On" with Germany's 10 year Government bond yields rising towards 1.70% and the 5 year CDS spread at 52 bps converging - source Bloomberg:

Both the Eurostoxx and German 10 year Government yields are still moving in synch in "Risk-On" mode in with rising German Bund yields towards 1.70% yield level and a stronger Eurostoxx 50 at the end of the week converging with the Itraxx Financial Senior 5 year index - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:
It's definitely called capitulation in the credit (bear?) space. The flattening of CDS curves is indeed happening with forward prices collapsing especially on 2/5 CDS curves, 3/5 and 1/5. On top of that the Itraxx Crossover 5 year CDS index versus the Itraxx Main Europe 5 year index is compressing, meaning the bull is back for now.
As a market maker rightfully commented: "Pure capitulation from Macro Funds is round the corner".
Back in our previous conversation "The Uneasiness in Easines" we argued:
"The lag in European stocks given the very recent negative tone in Europe has made them much more volatile. Should the "Risk-On" scenario persist in the coming weeks it should lead to an outperformance of European stocks versus US stocks."
We stick to our call.
We have been tracking over the months the growing divergence in the performance of the Standard and Poor's 500 index and the Eutostoxx in conjunction with Italian 10 year government yields - source Bloomberg:

In fact Spain's falling CDS may indicates additional extension of the on-going rally as displayed by Bloomberg:
"As the CHART OF THE DAY shows, Spain’s benchmark IBEX 35 Index has moved inversely to credit-default swaps on the country’s five-year bonds since 2010. The CDS contracts have tumbled since Sept. 6, when European Central Bank policy makers agreed to implement an unlimited bond-buying plan to boost confidence in the euro. The IBEX 35 has jumped 34 percent from this year’s low on July 24 as ECB President Mario Draghi pledged to do whatever it takes to preserve the single European currency and Federal Reserve Chairman Ben S. Bernanke said he would provide further
Moving on to the subject of the diminishing returns QE has on the real economy, we recently commented in the blogosphere our discontent with Dr Bernanke's latest round of QE and for obvious reasons we think. Namely that QE3 will only prove that monetary policy alone cannot prop up the labor market because in normal times triggering inflation expectations should trigger a credit boom, but given this is not your normal recession but a Balance Sheet Recession (BSR), it will eventually fail again.

We could not agree more with Cheuvreux's latest Microscope publication by Nicolas Doisy namely that:
"So far, only QE-2 is actually a quantitative easing as it has elicited banks into pure cash hoarding, while QE-1 (an emergency action) was credit easing. But QE-2's ability at capping nominal yields is stumbling against the law of diminishing returns: the impact of QE-2 is just around half that of QE-1.
While unmistakably signaling a real credit crunch, the QE-2 cash-hoarding also elicited an actual but temporary pent-up in inflation expectations.
If it has thus managed to reduce real interest rates, QE-2 has proved unable to prop up wage inflation, the effective driver of trend price inflation. Likewise, a QE-3 would just prove that monetary policy alone cannot prop up the labor market, as banks would keep hoarding cash and not lend it."

Indeed QE2 was arguably a period of credit crunch due to banks hoarding cash and QE2 did trigger inflation expectations upwards (via resumption of credit) but insufficiently to sustain credit expansion according to Nicolas Doisy's recent note:
We already touched on the impact credit conditions have had to the US growth versus Europe back in our conversation with the help of our friends from Rcube Global Macro Research in our conversation - "Growth divergence between US and Europe? It's the credit conditions stupid...":
But avoiding a non-deflationary growth would entail fiscal stimulus in order to avoid a Japanese style deflation.
"The CHART OF THE DAY shows the yield on the benchmark Treasury 10-year note since 2005 has closely tracked the first seven years of Japan’s slow-growth period that started in 1990. That is a correlation central bankers should keep in mind when formulating policy, said Porter, deputy chief economist at BMO Capital Markets in Toronto. “It’s a tad unnerving,” Porter said in an interview. U.S. rates have followed Japan’s even as the Federal Reserve has been more successful than the Bank of Japan in fighting deflation, or a protracted drop in prices. “This could be a long-grinding episode where yields bounce around at low levels for an extended period of time,” he said. While there are plenty of differences between the two countries -- such as their rates of inflation, the aging of the population in Japan and the relative strength of U.S. financial institutions -- there are also similarities, said Porter. These include severe financial crises and protracted periods of weak growth that are difficult to shake off, he said. If U.S. Treasuries were to continue following the trajectory of securities for the world’s third-largest economy, the yield on the 10-year note over the next 15 years would decline to about 0.75 percent -- in line with the current level of Japan’s 10-year bond." - source Bloomberg.

Because, a decline in wage inflation is indeed a clear deflationary sign (paradox of thrift). Wage inflation has kept trending down since November 2008 with the exception of a short-lived plateau in November 2010 to August 2011 according to Nicolas Doisy' s recent report. QE2 has been running out of steam since with wages driving price inflation down again:
"The continued decline in wage inflation is a sign of deflation taking root as it is translating into rising household saving rate and decelerating consumption. Both reflect the impact of paradox of thrift / paradox of toil.
-aggregate demand is insufficient to kick-start growth (paradox of thrift).
-labor productivity gains are not accurately compensated (paradox of toil).
The final lesson is that any QE3 is pretty unlikely to ever be able to turn wage inflation around with no other pro-active policy aimed at the labor market. This is yet another sign of the paradox of thrift / paradox of toil: even unconventional, monetary policy is pushing on a string as long as fiscal policy does not come to the rescue to prop up the labor market. This one of Bernanke's recurrent messages."
"The central reason behind the QE's inability at durably triggering upward inflation expectations is that the Fed's cash does not leave the banking system. In simpler terms, the Fed's cash sits idly on the commercial banks current account at the Fed. It thus never sees the light of the real economy, just as if banks were anticipating an indefinitely continued decline in wage inflation and, thus aggregate demand." - Nicolas Doisy, Cheuvreux.

Fed's new easing will do little to lift bank lending:
"As the CHART OF THE DAY illustrates, banks reduced the amount of reserves held at the Fed’s regional banks and made more money available to businesses in the past 12 months. The shifts took place even though the central bank’s total assets were little changed, as Michael Shaoul, CEO of Oscar Gruss and Son Inc's wrote on the 11th of July in a report.
“This point is sadly missed by those looking for a new round of quantitative easing,” the report said. Between 2008 and last year, the Fed bought $2.3 trillion of debt securities in two rounds of easing to support economic expansion. Bolstering reserves through a third round of purchases “will not increase the supply of or demand for credit,” the New York-based analyst wrote. Reserves for the week ended July 4 were $179.2 billion lower than their peak last July, according to data compiled by the Fed. The decline coincided with a $171.2 billion increase in commercial and industrial loans, based on central-bank data. “This is precisely how monetary policy can affect domestic activity,” wrote Shaoul, who also helps oversee more than $2 billion as Marketfield Asset Management LLC’s chairman. “What it cannot do is magically increase employment.” - source Bloomberg

In addition to cash sitting idling on the commercial banks current account at the Fed, the business bank-balances boom is as well hurting the US economy (yet another sign of the paradox of thrift at play):
"Companies may have to tap into their bank balances in order for U.S. economic growth to accelerate, according to Pierre Lapointe, Brockhouse and Cooper Inc.’s global macro strategist.
As the CHART OF THE DAY depicts, U.S. non-financial companies held a record $931 billion of checking and savings deposits as of March 31, according to figures compiled by the Federal Reserve for quarterly flow-of-funds reports. Deposits more than doubled from June 2009, when the latest recession ended, as the economy grew 6.3 percent. “Corporations are still cash rich and could provide a much-needed boost to the economy,” Lapointe wrote on the 12th of September in a report that presented a similar chart. “We need companies to come in and start spending.” Cash is rising as companies guard against the risk of another slump, the Montreal-based strategist wrote. Data on capital spending, dividends, stock repurchases and takeovers
point toward the same conclusion, according to Lapointe, who prepared the report with two colleagues. “Even though they have cash in the bank, companies do not feel as rich as they used to,” he wrote. The ratio of cash to assets for the Standard & Poor’s 500 Index has declined about half a percentage point in the current economic expansion and now stands at 8 percent, according to the report. Checking accounts held 40 percent of non-financial companies’ deposits at the end of the first quarter, and the
other 60 percent was in savings. Deposit figures at the end of the second quarter will be included in the Fed’s next flow-of-funds report, due Sept. 20." - source Bloomberg.

Nicolas Doisy concluded is recent note with the following important point which we agree with:
“All in all, the US strategy to exit the current deflation(ary) trap misses the point by focusing only on monetary policy, while a fiscal stimulus is also needed. In other words, labor is insufficiently compensated for the sole reduction in real interest rates to kick start growth. So, either labor is given a larger bargaining power or it must receive massive money transfers to start spending again.”

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 is concerned courtesy of yet another round of QE, 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!"

The fight against deflation goes on...
"Trouble springs from idleness, and grievous toil from needless ease." - Benjamin Franklin

Stay tuned!

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