Monday 29 April 2013

Cross-asset - Outperformance of Crossover/HY versus Volatility and Spot Equities

"It is far better to grasp the universe as it really is than to persist in delusion, however satisfying and reassuring." - Carl Sagan 

As our good cross-asset friend pointed out to us today, the tightening of the Itraxx Crossover index (High Yield risk gauge in Europe based on 50 European entities) has been very impressive. The Itraxx Crossover 5 year CDS index was tighter by 70 bps over the course of April, whereas volatility on the Eurostoxx 50 was unchanged and equities were up 4%. The significant tightening in credit spreads is testament to the frenzy in yield chasing in the credit space. 

Itraxx Crossover 5 year index since March 2010 (roll adjusted) - source Bloomberg:

The decorrelation with implied 1 year ATM (at the money) Eurostoxx 50 equity volatility (chart 2 below) and versus the Eurostoxx 50 equity index is rising (chart 3).

Chart 2 - Itraxx Crossover versus implicit Itraxx Crossover spread via 1 year ATM Eurostoxx 50 volatility (18 months regression analysis):

Chart 3 - Itraxx Crossover index versus implicit Itraxx Crossover spread via Eurostoxx 50 index (18 months regression analysis):

Another disconnect or decorrelation can be seen as well in the below graph from CITI weekly credit research from Matt King and published on the 26th of April displaying the Itraxx Main Europe 5 year index (Investment Grade credit risk gauge on 125 European entities) versus CITI European Economic Surprises:
The gap between market levels and economic reality has seldom been larger, and it seems to be taking ever more credit growth to produce the same growth in GDP. Unless more of the central bank stimulus finds its way through to the economy, this opens up the risk of sudden corrections as markets fall back to earth. Markets may be right that the implementation of excessive austerity is bad news for growth, and hence for sovereign solvency. But not implementing austerity seems unlikely to lead them to fare any better — a realisation which seems yet to have dawned.
How long will it take for that to occur, and for markets to become scared once again? It is hard to tell, and yet we have been in this situation before. The chart below shows Citi’s European Economic Surprise Index plotted against iTraxx. Over the past few weeks, the economic data have plummeted relative to expectations, yet spreads have continued to tighten in. Similar divergences occurred at this point in each of the past three years; in every case, after a delay, spreads moved to follow the data. In 2009-10, the divergence lasted a good six months (Oct09-Apr10); in 2011 it took four months (Jan-May); in 2012 it took just one month." - source CITI

"The temptation is to say that something has changed, that we are immune to these problems, after the shocks to date which have failed to move spreads. But we doubt it. Tightening valuations and increasingly long investor positions ultimately create an obstacle larger than any individual news headline.
Most likely in the near term is markets just continue to follow the liquidity – and yet here too we think they are overestimating central banks’ largesse. Recent speeches suggest that the ECB, in particular, remains anxious that action on its part may lead to inaction on structural reforms elsewhere. Our economists expect a rate cut next week, but no major relaxation of collateral requirements just yet. Indeed, the opinion penned by the Bundesbank for Germany’s constitutional court, which leaked into the press this week, is a reminder of how the backstop on which the peripheral rally is predicated rests on remarkably shaky ground.
Where stimulus feels more assured (the US and Japan), where the gap to fundamentals feels smaller and risk-reward seems more symmetric (US HY and global equities), and especially where tranches and options can be used to tailor profiles so as to be long the tails, not short them, we are much more comfortable chasing the market. The same applies where there is a good micro argument for being long, such as our old favourites £ vs € (below), or bank sub CDS vs cash or senior fins, even when these have been working already. But in € credit in general, and in peripherals in particular, we see nothing to suggest this time is different." - source CITI

Liquidity rules...for now...and no ones wants the punch bowl to be taken away. Oh well...

"You can judge a leader by the size of the problem he tackles. Other people can cope with the waves, it's his job to watch the tide." - Antony Jay, British writer

Stay tuned!

Saturday 27 April 2013

Credit - The Coffin corner

"There are old wise central bankers (Paul Volcker) and bold bankers (Ben Bernanke now joined by Haruhiko Kuroda ); we have no old central bankers, just bold central bankers". - Macronomics.

While watching with bemusement, or disbelief the "Yield famine" central banks induced rally turning to a credit feeding frenzy, and looking at a dealer's bond run on our Bloomberg on Ford company with no offer, but bid only, we could not resist but use again an aeronautical analogy in our title in similar fashion to our previous post "Bold Banking" where we stated:
"When it comes to "reckless banking" and "reckless piloting", we found it amusing that current leaders have repeatedly failed to correct central bankers' policies, like the ones pursued by former Fed president Alan Greenspan and current Fed president Ben Bernanke, or, the ones pursued by Japan. These policies are instigating, bubbles after bubbles at an inspiring rate. When one looks at the fragile state of the "House of cards" and the "boldness" of credit investors dipping their toes, once again in very risky credit structures such as CLOs made up more and more with Cov-lite loans, we think our title, and our analogy to the crash of "Czar 52" is this time around very appropriate, but once again our thoughts keep wandering."

As we indicated at the time, the demise of "Czar 52" on the 24th of June 1994 also called the BUFF (the nickname among pilots for the B-52 meaning Big Ugly Fat Fellow) which saw the tragic crash of a Boeing B-52H "Stratofortress" assigned to 325th Bomb Squadron at Fairchild Air Force Base during practice maneuvers was due to Colonel Bud Holland's decision to push the aircraft to its absolute limits. He had an established reputation for being a "hot stick" like our bold bankers.

"The coffin corner (or Q corner) is the altitude at or near which a fast fixed-wing aircraft's stall speed is equal to the critical Mach number, at a given gross weight and G-force loading. At this altitude the airplane becomes nearly impossible to keep in stable flight. Since the stall speed is the minimum speed required to maintain level flight, any reduction in speed will cause the airplane to stall and lose altitude." - source Wikipedia

"When an aircraft slows to below its stall speed, it is unable to generate enough lift in order to cancel out the forces that act on the aircraft (such as weight and centripetal force). This will cause the aircraft to drop in altitude. The drop in altitude may cause the pilot to increase the angle of attack (the pilot pulls on the stick), because normally increasing the angle of attack (pulling up) puts the aircraft in a climb. When the wing however exceeds its critical angle of attack, an increase in angle of attack (pulling up) will lead to a loss of lift and a further loss of airspeed (the wing "stalls"). The reason why the wing "stalls" when it exceeds its critical angle of attack is that the airflow over the top of the wing separates.
When the airplane exceeds its critical Mach number (such as during stall prevention or recovery), then drag increases or Mach tuck occurs, which can cause the aircraft to upset, lose control, and lose altitude. In either case, as the airplane falls, it could gain speed and then structural failure could occur, typically due to excessive g forces during the pullout phase of the recovery.
As an airplane approaches its coffin corner, the margin between stall speed and critical Mach number becomes smaller and smaller. Small changes could put one wing or the other above or below the limits. For instance, a turn causes the inner wing to have a lower airspeed, and the outer wing, a higher airspeed. The aircraft could exceed both limits at once. Or, turbulence could cause the airspeed to change suddenly, to beyond the limits. Some aircraft, such as the Lockheed U-2, routinely operate in the "coffin corner", which demands great skill from their pilots."  - source Wikipedia

Looking at the desperate attempts by the Bank of Japan to cancel out the deflationary forces at play by increasing the "angle of monetary attack" with the "bold" central pilot banker Kuroda pulling very strongly on the stick, we wonder if Japan will indeed endure structural failure in the end. Maybe Kuroda is a gifted pilot such as pilots from the famed Lockheed U-2 spy plane, but, maybe he isn't. On another note, movie buffs like us will remember the 1983 epic movie "The Right Stuff" depicting at one point Colonel Chuck Yeager crashing his NF-104 Lockheed Starfighter on the 4th of December 1963 (also known as the Widow maker, interestingly the same nickname as the  famous short Japanese JGB trade).

So how did Chuck Yeager encountered the "Coffin Corner" in his "Widow maker"? Why did this legendary test pilot crash?
"The flight data from Chuck’s last two flights, including the accident proved there was not a single system failure on either his first flight that day or during the entire accident flight.  The data was undamaged in the accident, due to the low impact falling in a flat spin, with virtually no fuel on board and no resulting fire in the airplane.  The aircraft had performed flawlessly!
The facts are clear.  Chuck Yeager proved incapable of doing the job.  He was totally outside his element.  He was a natural pilot who had learned by experience and feel, but never really understood stability, just ‘sensed’ how airplanes would act, but aerodynamics and space dynamics are night and day.  If he was to fail, I expected it to be outside the aerodynamics region.
But not even that can excuse his accident, which was his fault, alone and was an error of bad pilot technique during normal, aerodynamic flight.  His shortcoming was inability to gain and maintain the 70 degree climb angle.  That required strict and delicate airplane control.  No more and no less.
 His failure to do that made the space flight moot.  He made the mistake, not once but on each of his four zooms, exaggerated on each until his accident was inevitable long before he departed his familiar flying region. His failing started at the moment he began a 3½ g pull up to the required 70 degree climb.  He never once made his immediate angle close to 70 degrees thus losing so much energy that he could not fly high enough to stay out of trouble.  Worse yet, he repeatedly started climb at a lower angle, then pulled the nose up later losing energy even faster and making the situation far more critical.  He needed time outside the atmosphere to use the reaction controls to nose over and he denied himself that time with poor piloting in his element of expertise, aerial flight.
In effect, what he did was climb far too shallow and then pulled up very steep in aerodynamic flight to a hammerhead stall, which in any F-104 meant an irrecoverable pitch-up and likely spin." - source

We found most interesting that the "Coffin Corner" is also known as the "Q Corner" given that in our post "The Night of The Yield Hunter" we argued that what the great Irving Fisher told us in his book "The money illusion" was that what mattered most was the velocity of money as per the equation MV=PQ. Velocity is the real sign that your real economy is alive and well. While "Q" is the designation for dynamic pressure in our aeronautic analogy, Q in the equation is real GDP and seeing the US GDP print at 2.5% instead of 3%, we wonder if the central banks current angle of "attack" is not leading to a significant reduction in "economic" stability, as well as a decrease in control effectiveness as indicated by the lack of output from the credit transmission mechanism to the real economy.

In similar fashion to Chuck Yeager, Alan Greenspan made mistakes after mistakes, and central bankers do not understand that negative real rates always lead to a collapse in velocity and a structural decline in Q, namely economic growth rate! Maybe our central bankers like Chuck Yeager, just ‘sense’ how economies act or work.

We believe our Central Bankers are over-confident like Chuck Yeager was, leading to his December 1963 crash. Central Bankers do not understand stability and aerodynamics...

In relation to Quantitative Easing program, our "bold" pilots/central bankers should really check the "structural" soundness of their "confident" policies given that in similar fashion to QEs the F-104 "Widow maker" series all had a very high wing loading (made even higher when carrying external stores), which demanded that sufficient airspeed be maintained at all times...Even Erich Hartmann, the world's top-scoring fighter ace, who commanded one of Germany's first jet fighter-equipped squadrons deemed the F-104 to be an unsafe aircraft with poor handling characteristics for aerial combat. To the dismay of his superiors, Hartmann judged the fighter unfit for Luftwaffe use even before its introduction. 

Maybe it is the reason why the German ace bankers from the Bundesbank are reluctant to retaliate with more QE in Europe, to the dismay of Mario Draghi at the ECB. 

The Class A mishap rate (write off) of the F-104 in USAF service was 26.7 accidents per 100,000 flight hours as of June 1977, (30.63 through the end of 2007), the highest accident rate of any USAF Century Series fighter. Some international operators lost a large proportion of their aircraft through accidents, although the accident rate varied widely depending on the user and operating conditions; the German Air Force lost about 30% of aircraft in accidents over its operating career, and Canada lost over 50% of its F-104s.

Overconfident pilots? Or poor structural design? You decide, but we ramble again.

So this week we will look again at the "unintended consequences of our "bold pilots".

The recent meteoric rise in the Japanese Yen, the Nikkei index and the receding pressure on Itraxx Japan credit spreads courtesy of Abenomics is validating we think, this week's aeronautical analogy - graph source Bloomberg:
Looking at Japan's consumer price index falling 0.9% in March from a year earlier, we do think Japan is indeed pushing towards the "Coffin corner":"The relationship of stall speed to critical Mach narrows at high altitudes, to a point where any sudden increases in angle of attack or roll rate and disturbances, such as clear-air turbulence, can lead to a stall." - source AINonline - Understanding High-altitude Aerodynamics Is Critical

Moving back to our Lockheed Starfighter reference, at extremely high angles of attack the F-104 was known to "pitch-up" and enter a spin, which in most cases was impossible to recover from. We think QEs  like the F-104 are very sensitive to control input, and extremely unforgiving of pilot error. No wonder another nickname for the plane was the Flying Coffin.

When it comes to Japan, the decade-high volatility in Japanese government bond debt induced by Bank of Japan Governor Haruhiko Kuroda, similar to Chuck Yeager's flying antics in the NF-104 Starfighter may have the unwelcomed effect of weakening bond prices and therefore undermine economic-growth goals, that  famous Q, in MV=PQ. Excess volatility, or "pull-up" for a Japanese plane can be seen, we think in the rise in JGBs volatility - source Bloomberg:
"The CHART OF THE DAY shows that the pace of swings in 10- year Japanese government bonds, known as JGBs, surged to levels not seen in more than 10 years, according to a gauge known as historic volatility. The measure, which represents the annualized standard deviation of price changes for a specific time period, surged amid swings in yields that came after the central bank increased monthly bond buying to 7.5 trillion yen ($76 billion) to reach a 2 percent inflation goal." - source Bloomberg.

In the case of Japan in general and JGBs in particular, another indicator we have been closely following has been the 30 year Swiss bond yields versus the Japan 30 year bond yields throughout 2012 until the recent "Big in Japan" bang moment following the Bank of Japan "all in" move - source Bloomberg:
As one can see for the above chart, it hasn't been really "plain flying" to say the least recently with the absolute spread widening from near zero to -54 bps again.

As far as the Nikkei is concerned versus Emerging Markets (MSCI EM), our Japanese Chuck Yeagers have really been pushing the envelope - source Bloomberg:

Push the envelope meaning:
"To attempt to extend the current limits of performance. To innovate, or go beyond commonly accepted boundaries."
This phrase came into general use following the publication Tom Wolfe's book about the space programme - The Right Stuff, 1979:
"One of the phrases that kept running through the conversation was ‘pushing the outside of the envelope’... [That] seemed to be the great challenge and satisfaction of flight test."
In aviation and aeronautics the term 'flight envelope' had been in use since WWII, as here from the Journal of the Royal Aeronautical Society, 1944:
"The best known of the envelope cases is the 'flight envelope', which is in general use in this country and in the United States... The ‘flight envelope’ covers all probable conditions of symmetrical maneuvering flight."

So good luck to our Japanese pilot Kuroda. We wonder if this latest surge in QE wars does not amount to a "Kamikaze" approach in dealing with deflation.

Moving on to Europe, we are unfortunately pretty confident about our deflationary call in Europe, particularly using an analogy of tectonic plates. Europe was facing one tectonic plate, the US, now two with Japan. It spells deflation bust in Europe unless ECB steps in as well we think.

As we posited on a number of conversation, the difference in the United States PMI and Europe's PMI and the growth outlook is purely a question of credit conditions - PMI US vs Europe (top graph) and US Leverage Loans versus European Leverage Loans (bottom graph) - source Bloomberg:
Any similarities are purely fortuitous? We think not...The S&P/LSTA U.S. Leveraged Loan 100 Index was little changed at 98.49 cents on the dollar. The measure, which tracks the 100 largest dollar-denominated first-lien leveraged loans, has gained 2.6% this year. What's the latest US GDP growth figure? 2.5%.

We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits (our case for Europe...). 

And, when we look at credit growth for non financial corporates in Europe, the picture cannot be clearer than this:

The absolute level of core European government yields has been falling even more with the anticipation of a 25 bps rate cut next week in conjunction with the expectations of unconventional measures which should be taken by the ECB to restore, somewhat the credit transmission mechanism to the real economy, which has been so absent as of late - source Bloomberg:
Both Italian and Spanish government yields are closed to the level they had back in 2010.

But, the new record set up by the Spanish unemployment rate moving at 27.2% in conjunction with Spanish minister Mariano Rajoy seeking a two year extension to tackle its soaring budget deficit to cut its current 10.6% shortfall towards the European limit of 3% by 2016 instead of 2014 is interesting for us for a very simple reason which ties up nicely with this week analogy, namely the non-linearity of public deficits when growth is either absent or very weak. A violent reaction of budget deficits to a loss of economic growth, in similar fashion to a high altitude stall can be very simply explained by a sudden and continuous rise in unemployment levels.
"Past-due loans in Spain have fallen to 161 billion euros ($210 billion) from a high of more than 191 billion euros in November 2012, according to the Bank of Spain, helped by transfers to a `bad bank,' reforms, increased provisions and write-offs. March's estimate-busting surge in unemployment will likely endanger this trend by further pressuring asset quality at both a corporate and retail level." - source Bloomberg

The case for Spain is interesting, but looking at the alarming rise in unemployment levels in France, at 3.2 million, the highest level since 1997 and an 11.5% annual increase , France looks increasingly close to the "coffin corner" we can argue. In relation to France, in our conversation "A Deficit Target Too Far" from the 18th of April, we argued: "We also believe France should be seen as the new barometer of Euro Risk".
As indicated by a recent note from Natixis on France and the non-linearity of deficits, when growth falls strongly (like in 1975, 1993 and 2009), the budget deficit is important, in particular when growth has stalled for two consecutive years. They indicated that if GDP growth falls by 2 points, the budget deficit, due to its non-linearity feature, rises not by 0.88 points of GDP in the case of France but by 1.32 points of GDP. So when the French Minister of Economy and Finance Mr. Moscovici targets 3.7% of budget deficit for 2013 with 0.1% of positive growth, we think he is seriously deluded given we think GDP growth for France will be between -0.5% to -1% in 2013.

France unemployment level versus Germany - source Bloomberg:

Meanwhile in the credit space the ""spring-loaded bar mousetrap" continues to be coiled. For instance on the 23rd of April in the US credit space the market has witnessed the lowest yield ever recorded (2.21%) out of more than 3000 observations spanning 12 years of iBoxx history.

We could not agree more with Societe General recent credit comment:
"Not quite speechless, but we're out of superlatives. The iBoxx junk index yield is at a record low of 6.19%, IG at a record low of 2.21%; returns YTD at 3.38% and 1.51% respectively - and it doesn't feel overheated. 
Annoyed at the poor liquidity? Frustrated at the level of the market and the low levels of supply? Well, we're going to have to get used to it. We're resigned to going tighter, all-in yields will likely go lower while secondary market accommodation of a trade will remain the exception rather than the rule. An exaggeration perhaps, but the point is made. It's not all about throwing in the towel - well, maybe it is - but performance will come from embracing risk. We think it is also about recognising that policy is forcing us to take higher risk on further massive (potential) manipulation of yields, while new marginal buyers emerge to take assets out of the market. If it has yield attached to it, there's pretty much a bid. The more nervous February and March months seem very far away now. Into the weakening eurozone economy, risks of corporate bond downgrades will be ignored for the foreseeable future; while the addition of risk assets outside of our comfort zone will be a necessity, but hopefully a measured investment in most cases. The recent data (PMIs, for example) paint a bleak picture with downside risks to the eurozone's Q2 GDP growth story. Much more of the same (as is likely) and the ECB might cut soon enough; and while the lower interest rate might have little direct impact on valuations, the sentiment behind it will matter more. Additionally, the use of non-conventional tools could lead to a new marginal buyer of credit risk - and this would heighten investor frustrations substantially. After all, we're waiting for the Japanese to put their buying boots on as well. If these buying cares eventually materialise - well, scary. And the way equities and fixed income assets are moving - higher in tandem into the bleak economic outlook - suggests that the market is expecting its next fix from further central bank policy response. There is some room for immediate disappointment, but it will come, and not too far down the road. There's no point in fighting it; instead embrace it, make yieldier assets your friend - single name event risk permitting. There will be a pull-back at some stage, but the feared structural unwind of credit positions isn't likely to be coming any time soon." - source Societe Generale.

And, like our credit friends, we keep dancing, but close to the door, knowing well enough, at some point the music will stop, and given the poor liquidity in the secondary space, the feeding frenzy on any new issues coming to the market, even with a miserable yield (Nestlé 7 year bond at mid-swaps +25 bps), when it will, it will no doubt be messy, like a NF104 Lockheed Starfighter falling from the sky.

But until then enjoy the liquidity party as indicated by Bank of America Merrill Lynch in their recent note from the 25th of April entitled "Great Divergences and Yogi Berra:
"The liquidity party continues: best performing asset in the past week = Italian equities; past month = Greek government bonds; YTD = Japanese equities.
“When you come to a fork in the road, take it.”
The financial markets are currently riddled with divergences and contradictions. High debt, low growth; record high stocks, record low bond yields; a bull market in US and Japanese real estate stocks; a bear market in Chinese real estate stocks. The Great Divergences are best explained by the war between deflationary debt fundamentals and aggressive reflationary policies. Real estate and banks remain the best barometer of policy success." - source Bank of America Merrill Lynch.

Could the below picture be the picture of the "Coffin Corner? Low growth and high debt:
- Source Bank of America Merrill Lynch.

Or could that be the one when one looks at the discrepancy between record low bond yields and record high equities?
- Source Bank of America Merrill Lynch.

Or maybe this one, when one looks at the discrepancy between low commodity prices and higher stock prices?
- Source Bank of America Merrill Lynch.

Just a fact in relation to the defensive nature of the S&P rally, year to date, 2013 buyback authorizations are at around $275 billion, +102% from a year ago and +8% vs 2007.

So what's the risk for our bold pilots / central bankers you might rightly ask? Well, on that very point we agree with Citi's recent note from the 25th of April entitled "Too much money, not enough assets to buy", which for us is reminiscent of the crazy days of 2007:
"What's the risk?

While the unconventional policies and the artificial inflation of asset prices has had few discernible negative side effects to date, the exit risk is clearly extremely large.
Part and parcel of the argument that we have made above is the fact that enormous volumes of non-dedicated money has been encouraged into risk assets, not least across fixed income markets.

Sharp adjustments like the one we have recently seen in gold are likely to become more commonplace in our view. More broadly, the reaction to the mini-backups in US yields early this year also illustrates how prone markets are to withdrawal symptoms.
Credit, in particular, has benefited from being a half-way house, offering less sensitivity to the global downturn than equities and retaining the upside benefit from falling yields. Our US credit strategists calculate that two-thirds of the inflows into US IG credit since 2009 has been through mutual funds and ETFs. A large portion of that will be retail money, more sensitive to total return prospects." - source Citi

Mutual funds and ETFs have seen significant inflows and at the same time inventories in the dealer space are nowhere near the 2007 levels, hence us still "credit dancing" but close to the exit door or ready to pull the handle on the ejection seat. As Matt King from Citi recently put it in his note from April 2013 - Mind the Gap:
- source Citi

And if you think liquidity in the credit space has improved, the unintended consequences of ZIRP from our "Top Guns" means that the turnover in IG corporate bonds is still falling, in similar fashion as velocity is as we move towards the "Coffin corner":
- source Citi

As we posited in "The Unbearable Lightness of Credit":
“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital

Flying a "Central Bank" or a NF-104 Starfighter requires strict and delicate airplane/monetary control:
"Tightening policies to preserve price stability and unwind some of the trillions of dollars pumped into global economies since 2007 via quantitative easing will require interest rate hikes, and may also necessitate asset sales by central banks, according to April's IMF Stability Report. Increased credit and securities losses would be the major negative impacts for banks as rates rise. Bank funding may also be disrupted if asset sales do take place." - source Bloomberg.

So buckle up, because our Central bankers Yeagers are indeed pushing on a string we think as indicated by the "altitude records", or spread tightening levels which are being broken as indicated by the level reached by corporate bonds worldwide as described by John Glover in his Bloomberg article entitled - Record Risk Discounted as Bonds Pass 110 Cents from the 25th of April:
"Corporate bond prices worldwide are poised to set a record as easy money policies by central banks
push investors into riskier investments even with the potential for losses at about an all-time high. Bondholders are paying an average of 110.22 cents on the dollar for the right to receive 100 cents back at maturity plus the interest from coupon payments, according to Bank of America Merrill Lynch’s Global Corporate & High Yield Index. At the same time, the so-called effective duration that measures how sensitive bond prices are to changes in yield has jumped, making the securities about the riskiest to hold ever.
Central bank purchases of government bonds to contain borrowing costs and stimulate economic growth have led investors to pour money into the $10 trillion global market for corporate bonds as they search for yield. Besides betting that interest rates won’t rise anytime soon, investors also face increased risk from restructurings." - source Bloomberg

And as indicated by the same article:
"For every 50-basis-point jump in yields, prices would drop an average 2.85 percent, compared with a low of 2.36 percent in September 2008, according to the average effective duration of the Bank of America Merrill Lynch index. Bond prices rose to a record 110.28 cents on the dollar in November. In 2009, the securities were trading below par." - source Bloomberg.

On a final note, we leave you with a Bloomberg chart indicative of the limited room which stock investors could benefit from a falling US savings rate:
"As the CHART OF THE DAY shows, household savings equaled 2.2 percent of disposable income in January and 2.6 percent in February, according to data compiled by the Commerce Department. The rate for March will be released on April 29. This year’s readings are the lowest since 2007, when the rate dropped as low as 2 percent. The chart shows the trend in savings since a peak of 8.3 percent was recorded in May 2008, when the economy was in a recession. “The potential for a further drop in the savings rate is obviously more limited,” Lapointe and two colleagues wrote in a report yesterday. “The best-case scenario” for stocks would be for savings to stabilize at less than 2 percent of disposable income or to rise gradually, they wrote. Quarterly increases of more than 1 percentage point since 1950 preceded declines in the Dow Jones Industrial Average for the next three, six and 12 months, according to data cited in the report. The Dow industrials moved higher on average when rates rose less than 1 point or declined. “The risk is that the savings rate rapidly bounces back to a more ‘normal’ level of 5 percent,” the report by the Montreal-based strategist and his colleagues said. “This would put additional pressure on equities.” The rate was 6.5 percent in December, when President Barack Obama and Congress were struggling to avert automatic tax increases and spending cuts." - source Bloomberg.

We still think deflation is the name of the game, the rest is poetry, and maybe the 1600 level for the S&P is the "Coffin corner" altitude for stalling where oxygen is rare and lift is low - triple top? - source Bloomberg:
Chuck Yeager made the mistake, not once but on each of his four zooms in the NF-104 Starfighter, and exaggerated on each until his accident was inevitable long before he departed his familiar flying region....just a thought...

"A kamikaze is a surprise attack, according to our ancient war tactics. Surprise attacks will be successful the first time, maybe two or three times. But what fool would continue the same attacks for ten months? Emperor Hirohito must have realized it. He should have said 'Stop.'" 
- Saburo Sakai, IJN flying ace

Saturday 20 April 2013

Credit - The Awful Truth

Lucy: It's enough to destroy one's faith, isn't it?
Jerry: Oh, I haven't any faith left in anyone.
The Awful Truth (1937)

Following up on last week conversation in relation to the deflationary forces at play and in continuation to last week's analogy to one of our favorite movies of all time, we thought this week we would as well use one in our title, this time 1937 classic starring Cary Grant, namely "The Awful Truth", which catapulted is career. 
In the movie, Lucy and Jerry Warriner having filed for divorce have to settle in court for the custody of their dog Mr Smith. Abandoning the law books, the judge leaves the "final decision" of custody up to the dog:  "The custody of the dog will depend upon his own desire"

In similar fashion, to last week's argument about inflation and deflation and the gold sell-off, in the movie, the dog, Mr Smith, swiveled his head back and forth between his two owners (inflation or deflation) unable to choose until Lucy lured him by cheating, surreptitiously with a glimpse of its favorite squeeze toy. 

All that glitters is not gold, and while some central bankers managed to trigger inflationary expectations with various QE programs, the recent sell-off in gold might indeed be the boogeyman in this deflationary environment. In similar fashion to QE2, QE3 triggered a significant rise in Inflation Expectations, but since the beginning of the year, 5 year forward breakeven rates have been falling, indicative of the strength of the deflationary forces at play - source Bloomberg:
The Fed’s five-year, five-year forward break-even rate, fell to 2.69% last week, the lowest since before the central bank said in December it would buy $45 billion of Treasuries a month on top of the $40 billion of mortgages it was already purchasing.

Yes, QE is supposed to create inflation and should be supportive of gold, but looking at this chart from a recent Bank of America Merrill Lynch report from the 16th of April entitled "The Curious Case of Stocks and Credit", as indicated above the recent fall in break-even inflation rates is a not a good sign:

In this week's conversation we will therefore look at various deflationary signs that signal caution in this very complacent environment, as displayed by the on-going disconnect between equities and bond yields.

As indicated by Bank of America Merrill Lynch's recent note, stocks should normally be reacting to an ease in inflation expectations:
"Everybody is getting worse but stocks and credit are getting better. US economic data is deteriorating, there are global growth concerns in Europe and most recently in China reflected in sharply dropping commodities, and inflation expectations are coming down hard. Yet stocks and credit are moving back toward their peaks. Every time over the past several years when inflation expectations have eased significantly stocks have declined and credit spreads widened meaningfully. But not this time. We continue to side with the weakening macro backdrop and retain our tactical (short-term) short positioning in investment grade credit. Perhaps stocks and credit are holding up on the perception that US and Japanese QE will push investors into US risk assets regardless of fundamental weakness – in other words, that strong technicals will overcome weak fundamentals. That appears uncharted territory, as what we have seen in the past is that QE can work to push investors into risk assets when perceived to boost economic activity and thus create inflation (Figure 3). We have little evidence that QE alone can do the job, without being perceived to improve fundamentals. Thus, again, we expect the weakening macro backdrop to prevail. However, in the meantime the technicals are undeniably strong despite the lack of retail inflows to long and intermediate high grade bond funds. Clearly we are seeing foreign institutional investors – especially from Asia – moving into US corporate bonds. However, this process has been ongoing for at least a year and is unrelated to the expansion of Japanese QE." - source Bank of America Merrill Lynch

For us the 5 most dangerous words have always been:
"It is different this time"

As we clearly indicated last week, in the US, High Yield credit has remained in line with equities since the beginning of the year. The de-correlation between credit and equities is nearly exclusively coming from Investment Grade credit and we indicated the relationship between High Yield and Consumer Staples in our conversation "Equities, playing defense - Consumer staples, an embedded free "partial crash" put option" how defensive the rally in the S&P500 has been so far - source Bloomberg:
While Bank of America Merrill Lynch's short term positioning in investment grade seemed obvious early April,  the recent weakness in both the S and P500 and High Yield, in conjunction to weaker macro data warrants caution we think. 

Maybe we ought to be worried that something not great is unfolding in Asia, probably the reason why the US is so nervous about Abenomics. Is China at risk of social unrest due to labor conditions and weaker inventories signaling a much weaker economic outlook than expected?

With Japan playing "beggar thy neighbor", it is risks stirring trouble in the entire Asian region which is already hurting badly South-Korea with companies like Bridgestone and Sumitomo Rubber being the biggest winner so far of the weaker yen - source Bloomberg:
"The CHART OF THE DAY shows the best and worst performers this year among 46 companies in the MSCI World/Automobiles & Components Index, with Japan’s Sumitomo and Bridgestone, the world’s largest tire maker, surpassed by only Mazda Motor Corp. Their rivals Milan-based Pirelli & C SpA and Michelin & Cie., which is headquartered in France and is Europe’s biggest tire producer, are among the worst performers. The euro-zone economy has contracted for five straight quarters and the jobless rate rose to a record in early 2013, crimping vehicle sales. Bridgestone, which had 77 percent of its sales from abroad last year, said in February profit would climb to a record high in 2013, even under the assumption the yen would average 89 per dollar. Japan’s currency slumped to 99.66 per dollar on April 9, the weakest level since April 2009, after the Bank of Japan took unprecedented stimulus last week to end 15 years of deflation." - source Bloomberg.

On top of that, the European automative market's weakness continued in March and new car registrations were down 10.3% YoY following a 10.2% decline in February and 8.5% decline in January. It marks the 18th consecutive months of YoY decline. European car sales are sliding to a 20 year low. Not even Germany is immune to the deflationary trend given its auto market plunged by 17%. European car sales are a clear indicator of deflation as we indicated in April 2012. Our concerns have unfortunately been confirmed by these latest figures and as indicated by Tommaso Ebhardt in Bloomberg on the 17th of April in his article - "Europe Car Sales Heading for 20-Year Low as Germany Plummets", not even mighty Germany is immune:
"The German car-sales drop was the steepest among Europe’s five biggest auto markets, and compared with an 11 percent fall in February. The U.K., where sales increased 5.9 percent, overtook Germany in deliveries in March, according to the ACEA. Spain, Italy and France all posted declines.
The western European passenger-car market is on track this year to hit levels last seen in 1993, and Germany seems to be in a free-fall,” Max Warburton, an analyst at Sanford C. Bernstein Ltd. in Singapore, wrote in a report to clients yesterday. “While unit profitability in Germany is not nearly as high as China, it’s still a critical driver of German carmakers’ earnings and the current trend is quite disturbing.” Deliveries at Wolfsburg-based VW, the regional market leader, dropped 9.3 percent, with the namesake brand posting a 15 percent decline. BMW, the world’s biggest luxury-car producer, sold 4.7 percent fewer vehicles in Europe last month." - source Bloomberg.

And if France is in trouble as we currently think it is, Germany will be too, very soon, given motor vehicles are Germany's biggest export to France as indicated by the below graph from Exane BNP Paribas:

As far as motor vehicles and China, should the Chinese economy weakens further, Germany will no doubt have issues:
- source Exane BNP Paribas - 28th of March 2013 report.

German exports and Chinese PMI showing a disconnect - source Exane BNP Paribas:

China accounts by the way 34% of global demand for rubber and inventories have climbed to 117,696 tons according to the Shanghai Futures Exchange, the highest in more than three years. 

Evolution of rubber in the largest exchanges in China and Japan since March 2010 - source Bloomberg:
"The CHART OF THE DAY tracks rubber on the largest exchanges in China and Japan since March 2010, with the gap reaching a 27-month high on Feb. 20 amid a weakening yen and strengthening yuan. The material used in tires and medical gloves traded at an  equivalent of about 404 yen in Shanghai on Feb. 11, the most  since September 2011. The Tokyo price had an 11-month peak of  334 yen per kilogram on Feb. 6, data compiled by Bloomberg show.  The Tokyo price last exceeded the Shanghai price in May 2011, the data show. Japanese Prime Minister Shinzo Abe’s monetary easing, dubbed “Abenomics,” has contributed to the yen’s more than 15 percent decline since mid-November. The yen fetched 93.50 per dollar as of 7 p.m. in Tokyo yesterday. By contrast, the yuan rose to a 19-year high of 6.2073 per dollar. Even as rubber futures in Tokyo fell 2.6 percent yesterday into a bear market, the most active contract in Shanghai lost 3.2 percent. Along with the currency market, China’s efforts to boost stockpiles in the world’s largest rubber market had contributed to the premium. With the inventory program set to decelerate, prices in Shanghai could fall, particularly as Southeast Asian producers have stepped up shipments to China to take advantage of the price differential, Tang said. Inventories in the Shanghai Futures Exchange were the most in about three years as of March 29, at 117,696 tons, according to the bourse. “Buying in Tokyo and selling in Shanghai may be the most profitable trade to get exposure.” Tang said." - source Bloomberg.

As we indicated in our conversation 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." - source Bloomberg.

In true Pareto efficient economic allocation, while some pundits wager about simultaneous developments having contributed to the weakness in Emerging Market equities, for us Emerging Markets have been simply the victims of currency wars and "Abenomics", a subject we approached in last month conversation "Have Emerging Equities been the victims of currency wars?" - MSCI EM versus Nikkei - source Bloomberg:

If you look again at the Bloomberg table displaying the worst performers this year among 46 companies in the MSCI World/Automobiles & Components Index, the most affected, in true Pareto efficient allocation process are the Europeans, sinking deeper in a secondary depression.

While the strength of the Euro has been supported by the FOMC's January 2012's decision to maintain US rates low until late 2014, has in effect prolonged the European recession, delaying in effect a painful adjustment in Europe and to make matters worse, Europe is facing prolonged agony, with now Japanese joining the party with "Abenomics".

Like any cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content, and using another analogy, Europe is now facing pressure from two tectonics plates, initially pressure from the US and now Japan.

We always thought that the on-going crisis had a path similar to a particular type of "rogue waves" called "three sisters" ("three sisters" rogue waves sank SS Edmund Fitzgerald - Big Fitz) which were used as a comparable analogy by Grant Williams in November 2011.

We are witnessing three sisters rogue waves in our European crisis, namely:
Wave number 1 - Financial crisis
Wave number 2 - Sovereign crisis
Wave number 3 - Currency crisis

Another sign of the deflationary forces at play is the Euro-zone Corporate Credit Supply which continues to be elusive - source Bloomberg:
"A lack of corporate loan supply continues to hamper economic recovery across the euro zone. Lending to non-financial corporates (NFCs) fell in 11 of the 17 euro area countries in early 2013, with the Netherlands the sole large economy to show an increase in loans outstanding. Unless there is a pick-up in supply, growth forecasts will likely remain anemic and recovery slow." - source Bloomberg.

In numerous conversations, we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced. The decline in the oil price to a nine-month low may prove to be another sign of deflationary pressure and present itself as a big headwind. Why is so?

Whereas oil demand in the US is independent from oil prices and completely inelastic, it is nevertheless  a very important weight in GDP (imports) for many countries. Monetary inflows and outflows are highly dependent on oil prices. Oil producing countries can either end up a crisis or trigger one.

Since 2000 the relationship between oil prices and the US dollar has strengthened dramatically.  As we highlighted in our conversation in May 2012 - "Risk-Off Correlations - When Opposites attract": Commodities and stocks have become far more closely intertwined as resources have taken on a greater role with China's economic expansion and increasing consumption in Emerging Markets.

We believe that the current disconnect between oil prices, the Standard and Poor's index and the US 10 year Treasury yield warrants caution, as it seems to us that the divergence is very significant as displayed in this graph from Bloomberg from the 12th of April:

In a recent note entitled "The asymmetric beta of credit spreads" , Bank of America Merrill Lynch points as well to a weakness of oil prices which might be indicative of weaker growth expectations:

"Is oil re-pricing growth expectations?
A slowing economy could push Brent down below $95/bbl Brent prices have declined by almost $20/bbl on a combination of seasonal and cyclical headwinds. Some of these cyclical pressures are too large to ignore, such as China’s drop in energy demand growth or Europe’s sharp contraction in credit supply. In addition, emerging and developed markets face mounting structural challenges. To name a few, energy importing countries like China, Japan or India are seeing $15/MMBtu nat gas prices at the margin, while others like Brazil are struggling with high labor costs and rising inflation. In Italy or Spain, a high cost of capital poses a major challenge to a recovery. Should the global economic recovery stall further, Brent oil prices could fall below $95/bbl in the near-term.  
Our economists see few downside risks to EM growth…
At any rate, our economists still expect China to post GDP growth of 8.0% in 2013 and 7.7% in 2014. These numbers are consistent with our expectations of 360 and 485 thousand b/d in oil demand growth, respectively. A robust China outlook should translate into strong EM growth and hence oil demand. Having said that, Chinese oil demand in March grew by just 255 thousand b/d, consistent with average GDP growth of around 5 to 6%. Surely, solid EM demand has been a constant in the oil market for decades, so a structural slowdown in economic activity would not bode well for global crude oil prices."
 …so we keep our $112/bbl Brent forecast in 2014 for now
For now, we stick to our 2014 Brent forecast of $112/bbl despite the weaker data, as OECD ex-US inventories remain low. But we are concerned about the structural headwinds facing many economies. Whether it is high energy costs, expensive labor costs, a rising cost of capital, declining profitability, or misdirected investment into unproductive assets, the dislocations created by five years of zero interest rate policy in DMs will likely have some negative consequences in EMs. With oil demand growth exclusively supported by buoyant EM growth for years, lower global GDP trend growth (say from 4% down to 3%) could push Brent firmly out of the recent $100-120/bbl band into a lower $90-100/bbl range." -source Bank of America Merrill Lynch  - 17th of April 2013.

The issue of course is that we believe that "Abenomics" is a game changer from a pareto efficient allocation approach and that Emerging Markets in the vicinity of Japan which are already suffering, will be facing even more suffering in the second quarter hence our negative stance on emerging market equities, and on commodities as well.

On a final note, the latest hedge fund monitor from Bank of America Merrill Lynch from the 19th of April shows that they are positioning for a market correction:
"Based on our exposure analysis, macro hedge funds sold the S&P 500, NASDAQ 100, and commodities to a net short while increasing long exposure to the US Dollar Index. This suggests that macro funds are positioning for a market correction. Macros also sold 10-year T-notes to a net short. Within equities they switched to favor small caps from size neutral but are not at an extreme reading." - source Bank of America Merrill Lynch.

And as we posited before, if it is time for a pullback, get some greenbacks, at least that's what Dr Copper,  the metal with the economics Ph.D, is telling us given that as per a graph from Barclays, CFTC Comex positioning is the shortest on record:
"Copper plunged through $7,000 a metric ton in London for the first time in almost 18 months and
headed for a bear market on concern that demand from China to the U.S. and Europe may falter. Tin was also poised to enter a bear market. Copper for delivery in three months on the London Metal Exchange slumped as much as 4 percent to $6,800 a ton, the lowest level since October 2011, and was at $6,850.50 at 2:56 p.m. Seoul time. A close at the current level would be more than 20 percent below the metal’s last bull market peak in February 2012." - source Bloomberg, 18th of April 2013, Copper Poised to Enter Bear Market as Industrial Metals Slide.

Is Copper finally is telling us something about the real world, which equity markets are not currently focused on in true Zemblanity fashion, Zemblanity being "The inexorable discovery of what we don't want to know"? We wonder...

And, what if the trigger will be in Asia like in 1997 (as suggested by Albert Edwards recently) and not Europe after all? We wonder as well...

"Wonder rather than doubt is the root of all knowledge." - Abraham Joshua Heschel, Polish educator.

Stay tuned!

Sunday 14 April 2013

Credit - The Night of The Yield Hunter

"Ah, little lad, you're staring at my fingers. Would you like me to tell you the little story of right-hand/left-hand? The story of good and evil? H-A-T-E! It was with this left hand that old brother Cain struck the blow that laid his brother low. L-O-V-E! You see these fingers, dear hearts? These fingers has veins that run straight to the soul of man. The right hand, friends, the hand of love. Now watch, and I'll show you the story of life. Those fingers, dear hearts, is always a-warring and a-tugging, one agin t'other. Now watch 'em! Old brother left hand, left hand he's a fighting, and it looks like love's a goner. But wait a minute! Hot dog, love's a winning! Yessirree! It's love that's won, and old left hand hate is down for the count!" - Reverend Harry Powell - The Night of the Hunter - 1955 American Thriller by Charles Laughton

While watching with interest gold hitting an intraday low of $1,493.35 per ounce, putting it 22.3% below September 2011's intraday peak of $1,921.41, with Cyprus selling its bullion in the process, we thought this week we had to use as a title analogy one of our favorite movies of all time being "The Night of the Hunter". 

In the movie Reverend Harry Powell, a serial killer and self-appointed preacher has tattooed across the knuckles of his right and left hands two words "LOVE" and "HATE" so that he can use them in a sermon about the eternal struggle between good and evil. As investors, we think you should have two words tattooed across your hands: "INFLATION" and "DEFLATION" so that you can use them in assessing the eternal struggle between inflation and deflation in this current environment.

The sell-off in gold, a clear "sucker punch" moment - chart source Bloomberg:

 But as indicated by David Goldman, the former global head of fixed income research for Bank of America,  in a previous article about Gold and Treasuries and bonds in general he wrote in August 2011:
"Why should gold and Treasury bonds go up together? Gold is an inflation signal and bonds are a deflation hedge. At first glance it seems very strange for both of them to rise together. Why should this be happening?
 The answer is simple: bonds are an option on the short-term interest rate, and gold is a perpetual put option on the dollar. Both rise with volatility.
 It’s like the old joke about the thermos bottle: “How does it know if it’s hot or cold?” If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. By put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

We also agree with David Goldman's previous comment on gold, namely that it is not an inflation hedge; it is a hedge against the end of the dollar’s status as a reserve currency, a deep out-of-the-money put against the US currency as a whole.

So after all, our call last week for higher gold prices in the second quarter might be premature and some people might see the right hand "LOVE" (inflation) as "a goner" in similar fashion to Reverend Harry Powell's sermon.
It appears to us that old left hand "HATE", namely deflation, to the great sorrow of our self-appointed "preachers" aka central bankers, is currently having the "upper hand". Therefore in this week conversation, we would like to review some of the key indicators we are seeing as evident signs of the deflationary forces at play in this eternal struggle between "LOVE" (inflation) and "HATE" (deflation). 

As we posited in "Zemblanity", being "The inexorable discovery of what we don't want to know", we have always found most interesting the "relationship" between US Velocity M2 index and US labor participation rate over the years. Back in July 1997, velocity peaked at 2.13 and so did the US labor participation rate at 67.3%. Now at 63.5% the US is back to 1981 and velocity is still falling (1.58), even lower than 1960's levels- source Bloomberg:
The great Irving Fisher told us in his book "The money illusion" and in his equation MV=PQ that what matters is the velocity of money which is the real sign that your real economy is alive and well. We do not see any sign of rebound in velocity.

We do agree with James G. Rickard's view of the situation, a partner at JAC Capital Advisors, which he made in a presentation at the recent Global Investment Risk Symposium which was summarized in an article entitled "The Fed is playing with a Nuclear Reactor" at the CFA Institute:
"To really understand what is going on, you have to start with the quantity theory of money, or MV = PQ. (Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.) The issue here is that the theory doesn’t hold up in the real world because velocity — the number of times money changes hands, or turns over — is not constant. ”Velocity is collapsing,” Rickards said. “You can think of monetary policy as a desperate race between increasing money supply and decreasing velocity, and the Fed is printing money to offset the decline in velocity. . . . So the Fed’s problem is best understood as one of trying to bend this velocity curve."
A similar disconcerting image is the growing disconnect between Oil prices, US Treasuries, which have seen their yield falling and the S&P500 - source Bloomberg:

We think there is currently an accumulation of worrying signs that the global economy is decelerating and that old left hand deflation has indeed a solid grip when one looks at China's shrinking electricity use, a bearish sign for a price index of industrial metals that, according to Bloomberg, has posted a first-quarter decline for the first time in 12 years - source Bloomberg:
"The CHART OF THE DAY shows that a gauge of six prices from the London Metal Exchange fell 5.6 percent in the three months ended March, the first drop for the period since 2001. China’s electricity demand in January and February gained 5.5 percent from a year earlier, compared with an increase of 6.7 percent in those months in 2012 and more than 12 percent in 2011.
China, the world’s biggest consumer of metals from aluminum to zinc, targets economic expansion of 7.5 percent in 2013. Factory production, which accounts for two-thirds of power use, increased 9.9 percent in the first two months of the year, the weakest start since 2009. Profit at industrial companies still rose for the fourth straight month, indicating higher corporate investment to fuel growth." - source Bloomberg

While our friend Cullen Roche from Pragmatic Capitalism tracks Rail Traffic as an economic activity indicator, we, at Macronomics, tend to track shipping and Air Cargo Traffic, because they are not only economic activity indicators but as well as credit/deflationary indicators as we pointed out in our conversation "Shipping is a leading credit indicator":
"For us the Baltic Dry Index is another indicator in the deterioration of credit as well as an indicator in deteriorating credit conditions leading to a surge in Non-performing loans on Banks' Balance Sheets."

For instance, Shanghai's containerized freight is 6% lower year on year as of the 22nd of March, 23% below its peak in May 2012 as indicated by Bloomberg:
"The Shanghai Export Containerized Freight Index (SCFI) fell 6% yoy in the week ending March 22, the fourth straight yoy decrease. The SCFI is 23% below its May 2012 peak, while the China Export Containerized Freight Index is 3.2% higher yoy and 17.1% below the May peak. Containerized traffic is driven by consumers, and changes in spending have a direct effect on global traffic volume." - source Bloomberg

In similar fashion the burst of the credit bubble had a dramatic impact on housing, shipping was as well not spared as cheap credit did indeed fuel a bubble of epic proportion - source Bloomberg:

"The Baltic Dry Index aggregates the costs of moving freight via 23 seaborne shipping routes. It covers the movement of dry-bulk commodities, such as iron ore, coal, grain, bauxite and alumina. During 1Q, the index typically increases from its seasonally weak period. In 2013, it has been no exception, as the index declined 30.2% sequentially in 1Q. The gain was driven by the tightening panamax market." - source Bloomberg

The Baltic Dry has yet to recover.

China's slowdown is the reason behind the difficulties encountered by shipbuilders such as STX Group as indicated by Kuynghee Park on the 4th of April in his Bloomberg article - China Turns Graveyard From Goldmine Hurting Ship Makers:
"For shipbuilders such as STX Group, China was once a goldmine. Now it’s a graveyard. China’s lower appetite for commodities undermined the group’s plan to sell its shipping line, wiping out a combined $435 million of investor wealth at the South Korea-based conglomerate’s three main companies this week. That also threatens the group’s ability to repay $1.2 billion of debt by the end of the year. STX’s crisis comes after last decade’s boom prompted the group to set up a shipbuilding and offshore complex in Dalian, northeastern China. With Asia’s biggest economy slowing down and the European crisis adding to a plunge in cargo rates, China Cosco Holdings Co., the nation’s biggest mover of bulk commodities and containers, last week reported a loss for 2012, a third straight annual loss."  - source Bloomberg

From the same Bloomberg article:
"Since the credit crisis, orders to build new ships have plunged. Contracts for new vessels halved to $84.7 billion last year, compared with $174.7 billion in 2008, according to Clarkson Plc, the world’s biggest shipbroker."  - source Bloomberg

For financial institutions such as Germany's second largest bank Commerzbank and impaired German bank HSH Nordbank, a large part of their recovery is linked to the fate of new ship deliveries given their shipping loan books have been seriously damaged by over-supply in the container ship markets as reported by Michelle Wiese Bockmann in Bloomberg on the 1st of March in her article - German Banks With Record Soured Ship Loans Forgo Seizing Vessels:
"Deutsche Bank AG and two other German lenders providing about 14 percent of credit to ship
owners are forgoing seizing vessels even after soured loans to the industry rose to a record. Europe’s biggest bank by assets, as well as HSH Nordbank AG, the largest in the market, and Norddeutsche Landesbank Girozentrale, which finances 1,500 ships, are restructuring loans and setting money aside instead of repossessing vessels, officials from the companies said. They have about $69 billion in loans to the industry out of $500 billion in total, according to data compiled by the banks and Petrofin Research SA, an
Athens-based consultant. Owners from Denmark to Indonesia defaulted in the past year, while U.S. tanker company Overseas Shipholding Group Inc. sought bankruptcy protection and ship earnings fell to a record last month. An unprecedented $80 billion out of $125 billion of German loans to the industry aren’t performing as they should, estimates Paul Slater, chairman of Naples, Florida-based ship-finance consultant First International Corp." - source Bloomberg.

HSH Nordbank has shipping loans of 29 billion euros covering about 2,800 vessels, but looking at weak trading conditions, as indicated in a recent note by JP Morgan on HSH Nordbank published on the 4th of April, some ship owners are pushing for new ship deliveries originally scheduled in 2013 to be delivered later in 2014, with additional deferrals expected:

But looking at the deflationary depressed level of Dry-Bulk Shipping rates which are down 9% YoY, but up 78% from 2012 lows - source Bloomberg:

In that context of depressed rates, it is currently driving ship owners to scrap vessels at a strong pace as indicated by Bloomberg:

"This year is expected to be the third straight year of strong scrapping of dry-bulk vessels, according to Eagle Bulk, with scrap rates at about $450 per lightweight ton. Eagle Bulk management forecast in its 4Q call that scrapping rates could equal 4% of the world fleet, or 30 million deadweight tons in 2013. Scrapping should be strongest for sub-panamax vessels, given that about 16% of this type are 20 years old or older." - source Bloomberg

Bulk vessels and Container ships have seen a steady number of ships being broken up due to weak rates and  tied up to the weakness in global economic activity - source Bloomberg:
"Excess capacity and depressed charter rates have increased the number of container ships sent to be scrapped by 503% since June 2005. This is creating a more efficient fleet as older ships are replaced by newer models. Triple-E ships consume about 35% less fuel per container and are able to carry 16% more containers, according to Maersk." - source Bloomberg

This deflationary environment, and "Schumpeter" like creative destruction is enabling innovation, in the container shipping space benefiting, the fittest to survive such as Danish Maersk currently busy upgrading massively its container fleet.

Whereas German HSH Nordbank's survival is depending on renewed global economic activity and its fate  is tied up to shipping and so is the fate of its subordinated bondholders who, at some point could indeed face the same "restructuring" music as Dutch SNS bondholders as indicated in JP Morgan's note:
"We remain negative on the T1 instruments, as we believe that the next catalyst for these bonds would provide negative pricing pressure due to our expectation that there will need to be a retroactive charge for the increased risk shield at HSH which will impact the cash flow expectations of the T1 instruments. We acknowledge the bonds are pricing in a significant number of deferrals already, however, we do not see a positive catalyst in the near term. For both the LT2 and T1 instruments we will be keeping a keen eye on the deliveries of ships and any delays into future years as this could potentially prolong the turn in the shipping cycle out into 2015. If this were to happen we would become much more concerned for the outlook of HSH and its debt securities." - source JP Morgan

Another economic activity and deflationary indicator we have been tracking has been Air Cargo. It is according to Nomura a leading indicator of chemical volume growth and economic activity:

"Over the past 13 years’ monthly data, there has been an 84% correlation between air cargo volume growth and global industrial production (IP) growth, with an air cargo lead of one to two months. In turn,
this has translated into a clear relationship between air cargo and chemical industry volume growth" - source Nomura:

"Our air cargo indicator of industrial activity came in at -3.8% (y-o-y) in March, following -7.8% in February and -8.3% in January. As a readily available barometer of global chemicals activity, air cargo volume growth is a useful indicator for chemicals volume growth."  - source Nomura.

Of course another sign of that old left hand "HATE", namely deflation, has been the absolute level of core European government yields, which have no doubt been supported by "Abenomics" like we indicated last week - source Bloomberg:
Government bond market yields across the euro zone dropped near 2-year low as the aggressive Japanese monetary action ripples through. Italy sold 7.2 billion euros of debt and French and Belgian government bond yields declined as well to record lows. The European bond picture, with Spanish 10 year yields  well below 5% at 4.71%, whereas Italian 10 year yields well  below 5% now around 4.35% and German government yields stable around 1.25% levels, but the most impressive move was on French OAT10 year bonds closing around 1.80%.

No doubt Kuroda's "whatever it take" moment has delivered a powerful right hand "LOVE" moment, inflating its Nikkei index in the process and surging past emerging markets equities surging now well above the MSCI EM index - source Bloomberg:
In relation to our title being "The Night of The Yield Hunter", it appears to us that Japan, is having a very strong effect on global yields, in similar fashion to a gigantic black hole or a powerful vacuum cleaner.  So on that premise although last week we indicated that France's economy was in trouble, selling OATs is "NO GO" at the moment for that specific "Japanese" reason. We would therefore be incline to go for duration and look for visible, stable sources of income.

This Night of The Yield Hunter is as well marking the return of the famous retail Uridashi funds also known as Double-Deckers which we discussed in February in our conversation "The surge in the Brazilian real versus the US dollar marks the return of the "Double-Decker" funds."
The Brazilian Real is one of the top "Double-Deckers" preferred currency play for its interesting carry:
"As we indicated in October 2011, in our conversation "Misery loves company", the reason behind the large depreciation of the Brazilian Real that specific year was because of the great unwind of the Japanese "Double-Decker" funds. These funds bundle high-return assets with high-yielding currencies. "Double Deckers" were insignificant at the end of 2008, but the Japanese being veterans of ultralow interest, have recently piled in again."

And as indicated by Boris Korby and Julia Leite on the 11th of April in their Bloomberg article - "Kuroda’s $75 Billion Lets Gerdau Win Lowest Yield", Brazilian corporate credit is benefiting from this Yield Hunt from yet another self-appointed preacher namely Kuroda:

"Fixed-income money managers are scouring emerging markets for higher returns after Bank of Japan Governor Haruhiko Kuroda said last week that he would double bond purchases to $75 billion a month to help revive growth in the world’s third-largest economy. As the yen fell to a four-year low and the nation’s government bond yields sank to a record, Japanese and investors following them may have bought about $13.5 billion of non-Japanese bonds since the announcement, 10 times more than the previous period, Societe Generale SA said." - source Bloomberg

In that global hunt for yield which has been further stigmatised by Kuroda's monetary policies, even the lowest rated Brazilian issuers are taking advantage of the on-going hunt as indicated in the same article:
"Brazil’s lowest-rated investment-grade issuers are taking advantage of the absence of Brazil’s largest and most creditworthy borrowers from the market to raise funding and reduce borrowing costs, according to Henrique Catarino, the head of international sales at Banco Votorantim SA in Sao Paulo.
Lenders Itau Unibanco Holding SA and Banco Bradesco SA as well as state-run oil company Petroleo Brasileiro SA and iron-ore producer Vale SA, which sold a combined $13 billion abroad in the first quarter of 2012, have refrained from issuing bonds this year, flush with cash and willing to delay issuance until borrowing costs retreat further, according to Catarino. All four companies are rated at least Baa2 by Moody’s and BBB by S&P, on par with Brazil’s government." - source Bloomberg

We made the following point in "Structural Instability":
"The great Hyman Minsky thesis was "stability leads to instability", we would argue that dwindling liquidity and excessive spread tightening in core quality credit spreads courtesy of zero interest rates policy in both the US and Europe is extremely concerning and are already indicative of a great build up in structural instability."
We also added our previous "Hooke's law" ending remarks:

"Given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates."

When reading the following article from Lisa Abramowicz entitled "Hardest-to-Sell Junk Lures Buyers Hooked on Fed", no doubt the self-appointed preachers of this world, namely central bankers have set this credit mousetrap:
"Investors are favoring the riskiest, hardest-to-trade junk bonds by the most in 17 months as confidence mounts that central banks from Japan to the U.S. will prop up debt markets through year-end.
The extra yield investors demand to buy the least-traded bonds with the lowest speculative-grade ratings instead of more liquid securities narrowed to 1.2 percentage points on April 9, the smallest gap since November 2011, according to Barclays Plc data. Yields on the smallest and oldest CCC rated notes contracted by 1.9 percentage points this year, three times the drop on yields for more active notes with comparable grades. Bond buyers seeking to escape the financial repression brought on by near zero interest rates are venturing deeper into the market in search of returns. They are bidding up the debt of companies that would otherwise be the most vulnerable to bankruptcy had the Federal Reserve not injected more than $2.3 trillion into the financial system since 2008." - source Bloomberg

Moving back to our "The Night of the Hunter" analogy, we  think that Japan is a well a great illustration for assessing this LOVE / HATE relationship between inflation and deflation in this current environment. One just have to look at gold priced in yen and the weakening of the yen versus the dollar to get the point - source Bloomberg:
"The CHART OF THE DAY shows gold priced in yen jumped 2.9 percent in March as the currency slid 1.8 percent against the dollar. The metal rose another 4.3 percent this month through yesterday, and may reach 165,842 yen ($1,675) an ounce this year, the highest since February 1980, according to Bart Melek, TD’s head of commodity strategy. Bank of Japan Governor Haruhiko Kuroda said on April 4 that the central bank would boost its monthly bond purchases to 7.5trillion yen ($76 billion) in a bid to fight deflation and revive the economy. The bank suspended a cap on some bond holdings and dropped a limit on debt maturities as they set a two-year horizon for their goal of 2 percent inflation." - source Bloomberg.

We would like to make the following points in relation to the deflationary forces at play in Europe:
-Without private credit growth, how exactly do you get inflation in Europe? It would be the only big reason to sell core European governments bonds and French OATs, or another reason would be 'The Big One" (to use another analogy, this time an earthquake analogy), meaning the unwind of the European project.
-Unless European banks start lending to the private sector again – and this seems unlikely – how is this scenario not deflationary?
Consumer credit, which represents 12% of lending to households, decreased on average by 2.8% over 2011.
-Lower banking profits are a symptom of deflation as well, you are getting smaller ROE in the European banking space, well below double digits
The place to buy banks is where there is economic growth. Banks are the second derivative of an economy. For us, it is a leverage play. (Brazilian banks have double digits ROE in the region of 15% - 17% but that's another subject...).

 -Falling home prices in Europe are a symptom of deflation
 -Governments restructuring debt is a symptom of deflation.
 -A contraction in Europe of banks balance sheets is deflationary.

We believe Europe face the risk of a disinflationary aka deflation bust.
A great definition of a disinflationary bust was made by the Gavekal team:
"Disinflationary Bust: If credit conditions tighten too much then capitalism is strangled: companies pull back on investment, their customers put away their wallets, and economic growth slows. These conditions encourage the marginal equity investor (some of whom have bought with leverage) to exit the market. Investors then typically head for the safety of long-term bonds, as there is little sign of inflation and short rates are likely to fall in response to slowing growth and/or deflation fears." 

In similar fashion UBS in their March 2012 note entitled "The Ides of March" made an interesting point which could validate the on-going weakness in both commodities and Emerging Markets:
"The end of Federal Reserve and European Central Bank (ECB) stimuli will cause an acceleration of capital flows out of emerging markets, hitting commodity demand."  - source UBS

They published last year on that subject an interesting investment clock:
- source UBS.

UBS indicated at the time they were following the HY ETF HYG as a stress indicator:
"We follow the HYG US high yield bond ETF to signal the state of US credit conditions."

In the US, High Yield credit has remained in line with equities since the beginning of the year. The de-correlation between credit and equities is nearly exclusively coming from Investment Grade credit and we indicated the relationship between High Yield and Consumer Staples in our conversation "Equities, playing defense - Consumer staples, an embedded free "partial crash" put option" how defensive the rally in the S&P500 has been so far - source Bloomberg:

The risk of a deflationary bust, validates our negative stance towards commodities and emerging markets as indicated last week for the second quarter. Here comes that "HATE", that old left hand.

On a final note, the 30 year-year interest-rate swap spread is approaching zero again linked to the fact that Dodd-Frank is forcing swaps to become cleared which will be supportive for US Treasuries as indicated by Bloomberg:
"The CHART OF THE DAY shows the 30-year interest-rate swap spread approaching zero. The swap rate has held below the similar-maturity Treasury yield, causing the spread to be negative, for almost every day since November 2008. The spread fell below zero for the first time following the September 2008 collapse of Lehman Brothers Holdings Inc., which prompted dealers to shore up balance sheets.“Part of Dodd Frank is forcing derivatives to become exchange cleared and creating the need to post margin on swap trades,” said Michael Cloherty, head of U.S. interest-rate strategy at Royal Bank of Canada’s RBC Capital Markets unit in New York. “That has made it cheaper for investors to use Treasuries and Treasury futures, rather than swaps, to obtain the duration they need." - source Bloomberg.

As far as Europe is concerned one could argue in similar vein to Reverend Harry Powell that:
"Salvation is a last-minute business, boy."

Stay tuned!

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