Sunday 7 April 2013

Credit - Big in Japan

"The real reform Japan needs is decisive politics when we face issues that need to be decided." - Yoshihiko Noda, Japanese statesman.

While we already touched on the meteoric rise of the Japanese Yen in conjunction with the Nikkei and with a significant tightening of credit spreads as displayed by the Itraxx Japan index in our March conversation "The rise of the Kagemusha", the latest announcements from the Bank of Japan to buy up JGBs, especially longer-dated JGBS, has led us to refer to top hit from 1984 German band Alphaville namely "Big in Japan" in this week's title for our conversation.

And, in terms of "Alpha", no doubt, we have seen "lift-off in risky assets" or "Risk-On" that is, in Japan; as indicated in the below graph where we have been monitoring the USD/JPY exchange rate, the Nikkei index and the credit risk Itraxx Japan CDS spread (inverted) - source Bloomberg:
A typical central bank's intervention, the "reflation trade" lifting risky assets, reducing perceived credit risk and suppressing volatility as displayed in the bottom graph with Japanese equity volatility close to the lows of 2011.

When it comes to credit and spread tightening, the above significant correlation between rising equities and tighter credit spreads is clearly explained by the wealth effect induced by the Japanese QE as indicated by a note from the 4th of April from Bank of America Merrill Lynch entitled Japan SB and CDS Markets evade a harmful flattening:

"Rising stock market prices also act to tighten credit spreads BoJ purchases of ETFs and J-REITs can easily put upward pressure on Japanese equities and real estate markets. Under these conditions, the larger buffer for companies’ potential credit risk will likely act to tighten credit spreads. Also, as a result of aggressive quantitative easing, we think credit risk itself could lower due to the wealth effect on company assets and greater ease procuring large amounts of funds via debt financing." - source Bank of America Merrill Lynch

Truth is back in January in our conversation "If at first you don't succeed", we indicated that the BOJ had some catch up to do with the Fed and the ECB and even hinted what we had been doing investment wise precisely, a practice which we not necessarily do:
"We have to confide, that since our October post, we have continued "practicing" the effect of our magicians "secret illusions" by having been short JPY against USD (via proshare ETF YCS) and we have been as well long Nikkei but in Euros via a quanto ETF from Lyxor (more on the reason below) but until you all become magicians, we have to stop revealing tricks unless, of course, dear readers, you all swear to uphold the Magician's Oath in turn*, but we ramble again..."
We have become in essence the sorcerers' apprentice, the new magical spell being these days "whatever it takes", a powerful one that it...

The rationale behind our call was that our macro world is more and more "centrally driven" or led by Central banks (or sorcerers/magicians that is):
"In similar fashion to the 1866 artist depiction of 1866 by the magician Sangoku Taro, the rationale behind our "long Nikkei in Euros" stance was fairly simple given that until recently, arguably the Bank of Japan has been behind the curve when it came to "magic tricks" as indicated in the below Chart of the Day from Bloomberg which we used in the concluding remarks of our "Zemblanity" conversation in September last year:" - source Macronomics"If at first you don't succeed"

As far as global deflation is concerned, and in relation to Japan, another indicator we have been closely following has been the 30 year Swiss bond yields which had been nearly 100 bps lower than 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:
Back in March this year we even discussed this trade with some of our cross-asset and macro friends concluding that this relationship would converge due to the aggressive stance of the BOJ after all:
"The greatest trick Macronomics ever pulled on its readers was to convince them there is no "market tricks" displayed in their posts." - Macronomics

But, we have to confide, we did not expect the convergence to be that fast, because we did not expected the Bank of Japan to be that bold!
As indicated by Nomura's note from the 4th of April entitled - How does the BoJ's QE stack up against the Fed and the BOE, the BoJ's response in terms of QE as a percentage of GDP is impressive:

So in this week's conversation, we will look at the impact of the BoJ had on the euro area sovereign bond market as well as the importance of looking at global credit channels as well as why we still think France should be seen as the new barometer for Euro risk. We will also look at some of our January calls for the first quarter 2013 and our some of our thoughts for the second quarter in the process.

The European bond picture, with Spanish 10 year yields below 5% at 4.87, whereas Italian 10 year yields well  below 5% hovering around 4.50% and German government yields racing down towards 1.25% levels, but the most impressive move was on French OAT10 year bonds closing around 1.80% (13 bps down at some point) courtesy of "Big in Japan" - source Bloomberg:
Japanese have been net buyers of OATs in 2012 to the tune of 4.07 trillion JPY (44.2 billion US), the most since 2005. The gain in yen was 26% versus 15% for US Treasuries and they only bought for 3.35 trillion JPY worth of US debt in 2012.

As indicated by Nomura's 4th of April 2013 note entitled Post-BoJ / ECB thoughts on euro sovereigns, European sovereign bonds have been benefiting from the support of massive purchases from Japan regardless of the deteriorating macro picture. The BoJ impact is significant:

"Today's news from the BOJ was highly significant and has broad implications for global asset markets. Much like QE1 and QE2 in the US, we expect that the impact of it could filter out through global assets. To put it crudely, the price of assets, in toto, is a function of the amount of money in the system, divided by the number of assets. Increase the numerator without comparably increasing the denominator and the price must rise. The skill, of course is estimating which assets, and by how much.

This effect will, we believe, be felt in European government bonds, our area of focus. We note with interest that the onset of QE1 and QE2 from the US Fed led to France tightening to bunds, for example, albeit that the effect took two to three weeks to really take effect, consistent with this being a portfolio effect, not a signaling effect. The link between natural buyers of JGBs and natural buyers of EGBs is strong, which should make BOJ QE more impactful on EGBs.
We can already see some evidence of this in today's trading: France has outperformed Germany by 5bp, Netherlands has outperformed by 2bp, Austria by 3bp and so on. We do not believe that this is the move over and done with, and particularly think that there is room for performance at the long-end of the curves in the core and semi-core." - source Nomura

"The data up to January (February data are released on Monday) show very big buying of France throughout 2012, big buying of Germany coming through late in the year, decent buying of Netherlands relative to its market size and what we will generously call apathy towards Gilts.
What today's announcement by the BOJ has told the market is that there is now room for plenty more buying:
1). There will be relatively less JGBs and long-end JGBs for Japanese real money to buy.
2) The spread of non-JGBs to JGBs just pushed higher by 5-10bp in the 10yr and close to 30bp in the long-end.
3) Asset allocators may have more confidence in the higher risk segments of their portfolios (i.e. equities) and thus be happy to take spread in the less risky segments. Also there may be greater confidence in the stability of the yen at these weaker levels.
For us, the key point to note here is the duration requirements of the Japanese real money account base, as with their Dutch and British counterparts. This duration requirement can be met perfectly adequately with the purchase of cheap long-end euro area bonds." - source Nomura

The effect of the very aggressive policies of the Bank of Japan have indeed leading Japanese equities to catch up with Emerging Markets equities, they have not only closed the gap but are also racing ahead - graph source Bloomberg:
Since 2009, Emerging Markets had been outperforming Japanese equities, and as we posited in our conversation "Have Emerging Equities been the victim of currency wars?":
"The decline of the JPY is negative for emerging markets, obviously more for those in Asia, putting pressure on emerging company market shares for exported goods and leading to cuts in investments in Asian countries by Japanese companies." - source BNP Paribas

EM equities to continue to underperform in the second quarter of 2013:
So our call for the second quarter of 2013 is that Emerging Market equities will continue to underperform. There is a new sheriff in town, the BoJ and they really do mean business...

EUR/USD and Gold view for the 2nd quarter 2013:
In our first conversation of the year "The Fabian Strategy" on the 8th of January we made the following call in relation to Gold:
"Gold could recede towards 1550-1600 levels during this quarter before bouncing back when "Risk-Off" will materialise again." - source Macronomics

Dollar index versus Gold - source Bloomberg:
 In the second quarter and given the enlargement of the "whatever it takes club" to Japan, we expect gold to rally back towards 1700 level.

In terms of the EUR/USD, we still think in the second quarter that it should remain in the 1.30 region versus the US dollar, which were our views for the 1st quarter. As we posited in January 2012, when most strategists were bearish on the EUR/USD, the Fed swap lines in conjunction with the FOMC decisions at the time did put a floor to the euro and are delaying a painful adjustment in Europe. The latest decision by Japan will as well prolong the European agony. In the process the European recession can only be prolonged and the European economy will continue to suffer (unemployment rate now at 12%). 

The story for 2013 in Europe is still France:
This is what we argued in January and this is still what we are arguing now. While French politicians are benefiting from low rates on French debt issuance courtesy of on-going Japanese support, but, on the economic data front France is increasingly showing signs of growing stress. 

France should be seen as the new barometer for Euro Risk. With Industrial Production expecting to hit -3.7% next week, French minister Moscovici is seriously deluded on his growth assumptions: 0.1% in 2013, 1.2% in 2014 and 2% in 2015! 

French industrial production (white line), French GDP (orange line) and French Services PMI (blue line, data available since 2006 only) tell the story on its own, we think - source Bloomberg:
An industrial production at -3.3% equals zero growth.

A sobering fact, services in the French economy represent around 80% of the GDP versus 76% for the rest of the European union. the latest read at 41.3 for Services PMI is close to the lowest level reached in February 2009 which was at 40.2.

If the Services PMI contracts at such a rapid pace, it doesn't bode well for France's unemployment levels. Services represent the number one employment sector in France (34% of total employment in 2010 according to INSEE).

Normally "entrepreneurial economy" can’t do that well as long when they are no entrepreneurs in the picture but in the special case of France, given French civil servants have done their best to "kill" the entrepreneurs in France with great success, the economy will tank.

A tight credit channel, high inventory levels vs. order books, depressed consumer sentiment and a forced fiscal tightening create a dangerous economic environment for an already weak economy.

One would have thought you could have played it via a simple Bund vs OAT widener but given Japanese have thrown the money printing gauntlet to the world, and that we are close to the lowest point since April 2011 at 50 bps apart (lowest was around 28 bps apart) and with Friday's epic move in core government bond spreads shows that they are more "pain" than "gain" in the aforementioned strategy (French OAT were down 13 bps at one point!).

The divergence between the US PMI and European PMI divergence which we explained in our conversation "Growth divergence between the USA and Europe", is here to stay in 2013 - source Bloomberg:
Why is so? Europe is in deflation and much of a story of broken credit transmission channel to the real economy.

At this juncture, we think it is very important to understand how the "Global Credit Channel Clock" operates, to that effect we would like to thank our good friend Cyril Castelli from Rcube Global Macro Research for providing us with his great chart:

Europe is still struggling due to the necessary deleveraging that has to be undertaken by European banks, plaguing in essence the real economy due to the lack of loans provided. 

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.  In the US new borrowing surged and credit conditions continue to improve as reported by Deutsche Bank in their 2nd of April Quarterly credit impulse update:
"The main area of strength globally is the US, where new borrowing surged in Q4. The Senior Loan Officers Survey suggests credit conditions continue to improve, and we expect the credit impulse to remain positive and private demand growth to remain strong in the coming quarters. The main hurdle for the US is that consensus expectations are being revised up." - source Deutsche Bank
"The rise in the global credit impulse in Q4 was due largely to the US (Figure 3). We expect the US credit impulse to moderate in Q1 but remain positive, consistent with above-trend demand growth." - source Deutsche Bank

For instance Jeff Black, Jana Randow and Stefan Riecher in their Bloomberg article entitled - Draghi Considers Plan B as Sentiment Dims after Cyprus Fumble from the 4th of April, indicated the following in terms of the broken credit transmission channel:
"More than four times as many small businesses in Spain were rejected for loans in the second half of last year than in Germany, or walked away from an offer because it was too expensive, research published by Barclays Plc shows." - source Bloomberg.

Euro Area Credit Growth - source Deutsche Bank:

The recent Cyprus story has led to a significant weakness in the European banking sector which is still heavily relying on the ECB support as indicated by the recent rise in ELA (Emergency Liquidity Assistance)

Bloomberg indicated a 26 percent jump in a line item on the European Central Bank’s balance sheet  pointing to a rise in emergency borrowing by banks in Cyprus and Greece:
“Other claims on euro-area credit institutions” rose to almost 89 billion euros ($114 billion) for the week ended March 29, up from a 12-month low of 70 billion euros two weeks earlier. The balance-sheet item, published yesterday on the ECB’s website, includes Emergency Liquidity Assistance, or ELA, provided by national central banks when a country’s lenders don’t have enough collateral to borrow directly from the ECB." - source Bloomberg

When one looks at the below chart from Deutsche Bank's note, in Europe, credit demand is rising but European bank are failing to provide the necessary supply:

The Cyprus story has weighted heavily on the banking sector and given for us banks are a leverage play on the economy, the lack of economic growth means no doubt additional pressure on the banking sector as a whole. The impact on the banking sector in March was as follows as reported by Bloomberg:

"The Stoxx Europe 600 Banks Index dropped 6.8 percent between March 15 and 27, the day before banks reopened in Cyprus. The cost of insuring against default on European bank bonds surged 41 percent in that period, with the Markit iTraxx Europe Senior Financial Index of credit-default swaps on 25 lenders jumping 58 points to 201." - source Bloomberg
As indicated by Exane BNP Paribas's above chart on Senior Financial credit Risk:
"Eurozone unlikely to enjoy a sustained recovery; Italian politics/weak banking system pose downside risks".
We do not think current Itraxx Financial Senior Risk reflects correctly the rising impairment risks coming from the acceleration of the bail-in procedures which would impact senior unsecured bondholders which Mario Draghi, Germany, the Netherlands, Finland and Denmark would like to see put in place in 2015 rather than 2018.

There is no doubt risk of a stronger than expected deleveraging in Europe will mean yet another credit crunch in the process.
Post ECB conference we agree with Nomura's take from their 4th of April 2013 not entitled  - ECB states readiness to act:
"Mr Draghi acknowledged that the weakness in activity continuing from the end of last year is spreading to countries where “there is no fragmentation”, that is to the core of the region and most importantly Germany. The most recent PMI releases show for example the German composite PMI declined for two consecutive months in February and March and at an accelerating pace (by 1.1 points and 2.7 points, respectively) and is currently at 50.6, consistent with expansion but well off the level of 54.4 reached for January. More broadly, the PMI data for February, as we have highlighted in our post flash PMI note, is consistent with a rate cut this quarter and any further corroborating evidence of economic weakness will prompt the ECB into action, in our view." - source Nomura

Given that now Draghi is falling behind the Fed and behind Japan, we can expect that our "whatever it takes" European "magician" will react sooner rather than later given the increasing credit growth differences in Europe as displayed in the below graph from Deutsche Bank:

As we argued in "The Omnipotence Paradox", the Zero Rate policies induced by our "omnipotent" Central Banks are damaging capitalism in the sense that capital because of lack of return cannot be deployed efficiently and is once again "mis-allocated as reported by Sarika Gangar in Bloomberg in his article - High Grade’s Bottom Eclipses AAAs Over Rate Risk: Credit Markets:

"Offerings of bonds rated Baa3 made up 11.7 percent of the $310 billion in high-grade offerings in the first quarter, Bloomberg data show. Issuance of the lower-rated debt compares with $94.3 billion in all of last year and $60.4 billion in 2011. “When you look at single A rated and above industrials, it’s really very unattractive,” Hans Mikkelsen, a credit strategist at Bank of America in New York, said in a telephone interview. “You have insufficient spread cushion to offset the increase in interest rates. You have a lot of re-leveraging risk because these companies have access to very cheap financing.” - source Bloomberg

It is as well, to some extent, neutering volatility - evolution of VIX versus its European counterpart V2X - source Bloomberg:

Volatility, a story of a spring which has been coiled by Central banks actions.

On a final note, we agree with Bill Gross, namely that Kuroda's Big easing in Japan is going to drive treasuries as indicated by Bloomberg Chart of the Day:

"The CHART OF THE DAY shows yields on sovereign bonds around the world due in 10 years and longer were at the highest level relative to their Japanese peers since November 2011, based on Bank of America Merrill Lynch data. The spread widened to 2.07 percentage points yesterday from 2012’s low of 1.45. The chart also shows the yen plunging to touch 97.19 per dollar today, the weakest since August 2009.
Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., said the BOJ’s unprecedented easing may lead investors to favor securities outside the nation. Kuroda increased the BOJ’s monthly bond purchases to 7.5 trillion yen ($77 billion) and set an inflation goal of 2 percent in 2 years.
The BOJ has gone all in, in terms of the amount that they’re going to be buying,” Gross said yesterday on Bloomberg Television’s “Street Smart” with Adam Johnson and Sara Eisen. “That money now is expected to move out of Japan into Treasuries, into other high-quality markets at higher yields. Much more depreciation of the yen has to take place in order to get even close to 2 percent” inflation, said Gross, who is based in Newport Beach, California.
Japan’s 10-year yield tumbled to an all-time low of 0.315 percent today. Thirty-year rates slid to 0.925 percent, also a record. Comparable rates on U.S. Treasuries were 1.77 percent and 2.99 percent as of 1:13 p.m. in Tokyo.
Investors from Japan, the world’s third-largest economy, held $1.1 trillion of Treasuries as of January, second to China’s $1.3 trillion, according to U.S. government data." - source Bloomberg

So if you look back at the Global Credit Channel Clock, for the second quarter you should think about:
-Going long volatility
-Going long government bonds
-Going long gold
-Playing flattening yield curves

"Logic is the technique by which we add conviction to truth."Jean de la Bruyere, French philosopher

Stay tuned!


  1. So, when this Krugmanesque BOJ QE effort raises global asset values, but fails to resuscitate the Japanese (or global) economy, then what?

    1. we are witnessing three sisters rogue waves in this on-going crisis, namely:
      Wave number 1 - Financial crisis
      Wave number 2 - Sovereign crisis
      Wave number 3 - Currency crisis

      in similar fashion to the "three sisters" rogue waves that sank SS Edmund Fitzgerald.

      There will not be a happy ending.

  2. Hmm, good job! This is really something!

  3. This comment has been removed by the author.


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