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

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