Sunday 30 June 2013

Credit - The Daisy Cutter

"A credit rating is no substitute for thought" - Jens Weidmann - President of Bundesbank

Looking at the on-going volatility in the credit and fixed income space, courtesy of the tapering / non-tapering discussions, we thought this time around we would venture towards military ordnance analogies for our chosen title, namely the BLU-82B, a 15,000 pounds (6,800 kg) conventional bomb nicknamed "Daisy Cutter" in Vietnam for its ability to flatten a forest into a helicopter landing zone. One just need to look at the devastating effect of the "QE Tapering Bomb" aka the Daisy Cutter (to prepare for an eventual QE "helicopter  Ben" landing zone), has had on financial markets which flattened in a single month the YTD fixed income gains in many different asset classes, to see the appropriatness of our chosen title. While originally the "Daisy Cutter" was used during the Vietnam war to clear helicopter landing zones, later, bombs were dropped as much for their psychological effect as for their anti-personnel effects, but we digress slightly. On another note China did as well drop its own "Daisy Cutter" which had similar devastating effect on "feral hogs"...

The "Daisy Cutter" effect as displayed by the evolution of the Merrill Lynch MOVE  index, which has been  slightly receding and CVIX indices closely followed by a rise in the VIX index albeit more muted - graph source Bloomberg:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

In this week's conversation, we would like once again to point out the deflationary forces at play, given the "Daisy Cutter" explosion has indeed created a worrying trend, namely rising yields and a rising dollar, which could have some greater implication down the line and also the evolution towards a European Banking Union  following the discussions which took place this week in Brussels. But first our usual market overview.

We have long argued that France should be seen as the new barometer of Euro Risk, looking at the data that keeps coming out of France, it is increasingly becoming evident to us that things will get much worse than anticipated by the current French government when one looks at the level reached by consumer confidence in France, at the lowest level since 1974 - graph source Bloomberg:
This lack of confidence no matter how "improved" the recent PMI Manufacturing and for Services look like, doesn't bode well for rising consumption levels, in particular with a continued surge in unemployment levels.

France unemployment rate at 11% versus Germany at 6.90% - graph source Bloomberg:
Not only France's economic growth prospects face serious headwinds with rising unemployment and lack of consumer confidence, the "Daisy Cutter" has also led to some serious repricing of government bonds in Europe leading to some higher yields going forward for government issuance.

The volatility jitters in the bond space, have led to a surge in European Government Bonds yields in the process as indicated in the below graph with German 10 year yields rising towards the 1.70% level and French yields now around 2.30% - source Bloomberg: - graph source Bloomberg:

What we found of interest as of late has been the repricing in the fixed income space which has left no bonds or bucket immune as witnessed by the significant rise of the Swiss 30 year bond yields which had remained fairly muted throughout 2012 versus the 30 year Japanese bond yields - graph source Bloomberg:
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.

The "Daisy Cutter" explosion has also created a worrying trend, namely rising yields and rising credit spreads, indicative of a repricing of credit risk. For instance, the Itraxx Senior Financial 5 year CDS index has been rising in conjunction with the German 10 year yield, leading to a significant weakness in the Investment Grade space, with high beta financials (subordinated financial bonds and peripherals) taking the brunt of the widening move - graph source Bloomberg:

While the big beneficiary of the latest sell-off courtesy of the "Daisy Cutter" has been the US dollar, one of the most impacted asset commodity classes since the beginning of the year has been gold as of late - graph source Bloomberg:
As we discussed last week in our conversation "Singin' in the Rain" on why gold prices had further to fall (and they did) was as follows:
"To answer our friends Martin Sibileau's questions commodities have further to fall including gold.
Gold 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, ("The Night of the Yield Hunter" - Macronomics)."

What the falling gold prices are indicative of is that, like we posited in "The Night of the Yield Hunter", is that no matter how much liquidity has been injected (remember Fisher's equation - MV = PQ. Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.), the Fed has failed in igniting inflation to offset the decline in velocity. The Fed's expanding balance sheet has failed in stoking inflation expectations as displayed in the below Bloomberg graph:
"The CHART OF THE DAY shows gold prices surged 90 percent in the four years through 2012, moving in tandem with increased debt purchases by Fed policy makers. Bullion in New York has dropped 20 percent this quarter, heading for a record loss, even as the central bank’s balance sheet reached an all-time high. Consumer prices climbed 1.1 percent in the 12 months through April, according to a measure watched by the Fed that excludes food and fuel -- matching the smallest increase since records began in 1960. The speed at which money changes hands, measured by the U.S. economy’s supply of cash and equivalents known as M2, is the least in records going back to 1959, according to data compiled by Bloomberg." - source Bloomberg.

As far as Gold is concerned, we agree with the recent note from Nomura from the 26th of June entitled "Golden sell-off":
"On a longer-term basis, we think that gold is in the later stages of a fall and indeed, it is edging towards the mining cost of gold. We think that Asian buyers are likely to come into the market at some point as well, when the dip in gold prices becomes sufficiently large. This should eventually offer support as well. However, because of the change in market dynamics following the FOMC meeting, longer term we think that the size of any recovery in gold prices once flows turn is likely to be comparatively small." 
- source Nomura

In the previously mentioned conversation from April this year we added the following comment:
"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"

Container rates, which we follow, have dropped 6.2% to the lowest level since March 2012 - graph source Bloomberg:
"The Drewry Hong Kong-Los Angeles 40-foot container rate benchmark fell 6.2% to $1,836 in the week ended June 26. Below the $2,000 mark for the fourth straight week, rates are at their lowest since March 2012 ($1,771). Even with three increases, rates are down 17.1% ytd, as slack capacity pressures pricing. Carriers are expected to raise rates by $400 on containers from Asia to the U.S. West Coast, and by $600 to all other destinations, effective July 1." - source Bloomberg.

So our "Daisy Cutter" explosion has indeed created a worrying trend, namely rising yields and a rising dollar with rising container rates and weaker global demand, a recipe that could spell for default for weaker container shipping companies already strained by weaker demand.

If you think rising yields are only putting global trade at risk, think as well how it will ripple through in various sectors and countries.

For instance, as reported by Frances Schwartzkopff in Bloomberg on the 26th of June in her article "World's Most Indebted Households Face Rate Pain":
"Danish consumers, who owe banks more than three times their disposable incomes, are about to find out how sustainable that debt load is as interest rates rise. Signals from the U.S. Federal Reserve that it’s preparing to scale back monetary stimulus have already sent mortgage costs higher as yields rise across global bond markets. The Nykredit Index of Denmark’s most traded mortgage bonds sank this week to its lowest in more than four months after investors sold assets once coveted for their haven status." - source Bloomberg.

Danish households owed 310 percent of disposable incomes in 2010, government debt is less than half the euro-zone average at only 45 percent of gross domestic product this year, the European Commission estimates.

On top of that, Student-Loan Interest Rates are set to double next week because the US Congress will act in time to prevent the rate hike as indicated by James Rowley and Caitlin Webber in Bloomberg on the 26th of June in their article "Student-Loan Interest Rates Set to Double as Fix Eludes Congress":
"About 7 million undergraduates borrow for college using the subsidized loans, for which the government pays the interest while these students are in school. Students must show financial need to qualify for these loans.
The rate for unsubsidized Stafford loans is already at 6.8 percent; those loans are available to any undergraduate, regardless of financial status, and to graduate students who are no longer considered their parents’ dependents. Students with unsubsidized loans pay monthly interest while in school; if they don’t, their interest charges during that time are added to their loan balance. Both subsidized and unsubsidized loans are taken out annually and are based on anticipated costs for the next academic year." - source Bloomberg

Finally rising mortgage rates and the recent REIT rout are likely to curtail the number of property purchases as indicated by Brian Louis in Bloomberg on the 26th of June in his article "REIT Rout Seen Curtailing Deals as Rising Rates Cut Share Sales":
"Property purchases by U.S. real estate investment trusts are likely to be curtailed after almost $36 billion of deals this year as a tumble in share prices makes a key source of capital costlier.
The Bloomberg REIT Index has dropped 11 percent from an almost six-year high in May as the yield on 10-year Treasury notes surged amid speculation the Federal Reserve would reduce bond purchases, which have kept borrowing costs low. The decline was three times the slump in the Standard & Poor’s 500 Index.
Just five U.S. property REITs have sold shares this month, down from 14 in May and eight in April, according to data compiled by Bloomberg, and Tom Barrack’s house-rental trust Colony American Homes Inc. postponed an initial public offering in early June. Because federal tax laws require REITs to distribute most of their earnings to investors through dividends, the companies rely on stock and debt sales to raise money for real estate purchases." - source Bloomberg.

From the same article:
"A decline in deals may limit a rebound in commercial-property values. A Green Street index of prices, compiled from estimates of REIT holdings, had recovered all of its losses from the real estate collapse and as of May was 4 percent higher than its previous peak in August 2007.
With bond yields low, REITs have been an attractive investment alternative with their higher, steady returns -- an advantage disappearing with rising interest rates. Since REITs rely on the equity and debt markets to raise money for acquisitions, they are vulnerable to jumps in interest rates. They have access to capital through credit agreements that they can use for short-term funding obligations, said Keven Lindemann, real estate group director at SNL Financial in Charlottesville, Virginia." - source Bloomberg.

The Bloomberg single-tenant index has dropped 19 percent since May 21, and the health-care REIT index has slumped 16 percent with Mortgage rates for 30-year surging to 4.46%, the highest in two years and the biggest one-week increase since 1987. Bonds tied to mortgages are on track to be the worst in almost two decades, such as Fannie Mae’s 3 percent, 30-year securities fell about 0.2 cent on Friday to 97.6 cents on the dollar as of 11:19 a.m. in New York, down from about 103 cents on March 28, according to data compiled by Bloomberg. A Bank of America Merrill Lynch index tracking the more than $5 trillion market lost 2 percent this quarter through yesterday, the most since the start of 1994. The shock and awe tactic of dropping a "Daisy-cutter" bond on pure beta plays. 
Oh well...

All in all the Daisy-Cutter Fed bomb has had "unintended consequences" which are yet to ripple on a global basis in the coming weeks and months, but has already been devastating in the fixed income space as reported by Bloomberg on the 27th of June in their article "U.S. Bond Funds Have Record $61.7 Billion in Redemptions":
"U.S.-listed bond mutual funds and exchange-traded funds saw record monthly redemptions of $61.7 billion through June 24 amid signs the country’s central bank may scale back its unprecedented stimulus.
The redemptions surpassed the previous monthly record of $41.8 billion, set in October 2008, according to an e-mailed statement by TrimTabs Investment Research in Sausalito, California. Investors withdrew $52.8 billion from bond mutual funds and $8.9 billion from ETFs during the period, said Richard Stern, a spokesman for TrimTabs." - source Bloomberg

This is why we pondered the following in our last conversation "Singin' in the Rain":
"If the dollar goes even more in short supply courtesy of Bernanke's "Tap dancing" with his "Singin' in the Rain", could it mean we will have wave number 3 namely a currency crisis on our hands? We wonder..."

Already some countries have had to take drastic measure to preserve their balance of payments, for instance Vietnam's central bank just devalued its currency for the first time since 2011 as reported by Bloomberg on the 28th of June:
"Vietnam’s central bank devalued its currency for the first time since 2011 and cut the interest-rate cap on dollar deposits to help “improve” the balance of payments and boost foreign-exchange reserves.
The State Bank of Vietnam weakened its reference rate by 1 percent to 21,036 dong per dollar, effective today, according to a statement released yesterday. The currency, which can trade up to 1 percent either side of the rate, fell 0.8 percent to 21,195 as of 12:01 p.m. at banks in Hanoi, the most since Aug. 9, 2011, according to data compiled by Bloomberg. The fixing has been kept at 20,828 since Dec. 26, 2011, and the spot rate touched a record 21,036, the lower limit of the band, on most days in June.
The change in the reference rate is the biggest since a record 8.5 percent cut in February 2011 and comes after the government announced yesterday that imports exceeded exports by $1.4 billion in the first half of this year. " - source Bloomberg.

To summarize the deflationary forces at play in the current environment, we have read with interest Russell Napier's CLSA note from the 7th of June entitled "Great reset revisited":
"The world has been in disinflation since 2011: deflation is next. Japan has won the currency war and its cheaper exports are forcing others to cut prices. Meanwhile, slowing growth and weakening currencies in emerging markets augur a debt crisis; and commodity prices continue to fall amid a global slowdown and rising supply. Most worryingly, both real interest rates and the US dollar are rising. The great reset’s deflationary shock is at hand and investors should hold as much cash as they can.

US inflation has fallen despite QE
- QE is not delivering: the Fed's balance sheet has grown by 18% since September 2011, while inflation has fallen from 3.9% to 1.1%.
- The US 30-year bond yield has remained unchanged over this period: thus US real rates have risen by 280bps despite QE.
- US nominal rates bottomed a year ago and have risen by 83bps since then, while inflation has fallen by 33bps.
- Moreover, the Treasury inflation-protected securities (TIPS) market indicates that inflation expectations are falling, while nominal yields are rising.

EM growth is slowing and exchange rates are under pressure
- Weakening emerging-market (EM) currencies augur a balance-of-payments crisiswhich means either lower domestic growth or lower exchange rates and defaults.
- As the EM growth outlook deteriorates, global inflation will fall further.
- EM foreign-currency bond prices are cracking, indicating that the large capital inflows that funded current-account deficits are ending.

Japan has won the currency war and is now exporting deflation
- On the back of yen depreciation, Japan is cutting its US-dollar selling prices.
- Japan¡¦s actions have forced competitors to follow suit: now Korea and China are also exporting deflation to the USA.
- The Bank of Japan's need to prevent JGB yields from rising will mean ever greater intervention and even more deflationary pressure from a weakening yen.

Cash is the place to be
- Cash does well as inflation turns to deflation and real interest rates rise.
- Cash can finally be utilised profitably as central bankers fail to sustain asset prices.

The S&P 500 and the US 10 year breakeven, indicative of the deflationary forces at play, graph source Bloomberg (28th of June 2013):

Moving on to the subject of the evolution towards a European Banking Union  following the discussions which took place this week in Brussels surrounding the Bank Recovery and Resolution Directive (BRRD), European Finance ministers (ECOFIN) came to an agreement on the 26th of June which will have to go through the European parliament, with the objective of adoption before year end.

No timing has been given for when the resolution authorities will have to use the bail-in tools and earlier indication were for 2018, but countries will have the flexibility to adopt it earlier it seems. National resolution authorities will be in charge of the implementation of the resolution plans which comply with some common rules, in particular bail-in measures imposing losses following order of seniority.

What will be included in the bail-in?
All bank creditors will see haircuts on the principal in line with the following order of seniority:
Shareholders > Hybrids > subordinated debts > Senior debt (including CP > 7days) + unguaranteed deposits of large corporations

What will be excluded in the bail-in?
-Guaranteed deposits of individuals and SMEs (<100 -covered="" bonds="" br="" days=""> -Payables to employees
-Some commercial claims

Debts with payment systems maturing in less than 7 days, and interbank market debts with an initial maturity of less than 7 days  before debts <30days days--="">

The entry of public capital will take place once at least 8% of liabilities have absorbed losses. Direct recapitalization from the ESM would only come into play in a second phase, once all possible haircuts have been exhausted, if the bank still needs help.

The issue of course is that the consequences of rising government bond yields could accelerate the realization of losses for senior bondholders particularly if one takes into account that in the last couple of years, rather than severing the links between banks and sovereigns, governments in Europe have increased that link with the help of banks which have been big buyers of government debt as indicated by a recent post from Dr Constantin Gurdgiev on "true economics" entitled - Bank-Sovereign Contagion - It's getting worse in Europe:
"•Italy EUR404bn (26% of 2013 GDP) up on EUR177bn at the end of 2008
•Spain EUR303bn (29% of 2013 GDP) up on EUR107bn at the end of 2008

Now, recall that over the last few years:

European authorities and nation states have pushed for banks to 'play a greater role' in 'supporting recovery' - euphemism for forcing or incentivising (or both) banks to buy more Government debt to fund fiscal deficits (gross effect: increase holdings of Government by the banks, making banks even more too-big/important-to-fail)
•European authorities and nation states have pushed for separating the banks-sovereign contagion links, primarily by loading more contingent liabilities in the case of insolvency on investors, lenders and depositors (gross effect: attempting to decrease potential call on sovereigns from the defaulting banks);
European authorities and nation states have continued to treat Government bonds as zero risk-weighted 'safe' assets, while pushing for banks to hold more capital (the twin effect is the direct incentive for banks to increase, not decrease, their direct links to the states via bond holdings).

The net result: the contagion risk conduit is now bigger than ever, while the customer/investor security in the banking system is now weaker than ever. If someone wanted to purposefully design a system to destroy the European banking, they couldn't have dreamt up a better one than that..." - source "true economics", Dr Constantin Gurdgiev.

While the "Daisy Cutter" is no doubt an impressive military ordnance, it looks like the European politicians have built the ultimate bomb,  similar to the "father of all bombs", equivalent to the Russian Aviation Thermobaric Bomb of Increased Power (ATBIP),but we ramble again...

On a final note, stocks and housing may take down US confidence as indicated by Bloomberg in a recent Chart of the Day (25th of June):
"Consumer confidence in the U.S. may fall victim to the Federal Reserve’s foreshadowing of reduced
bond buying, according to Brian G. Belski, chief investment strategist at BMO Capital Markets.
As the CHART OF THE DAY depicts, consumer sentiment has typically mirrored a ratio of household net worth to disposable income during the past decade. The confidence figures come from surveys by the Conference Board. The Fed compiles data on net worth, and the Commerce Department tracks income.
Swings in stock and house prices largely explain this relationship, Belski wrote in a June 21 report with a similar chart. That’s why it has lasted through the economy’s four-year expansion even though jobs and income have risen more slowly than in past recoveries, the New York-based strategist wrote. “Consumers should not become overly reliant on these ‘paper gains’ for self-assurance,” Belski wrote. “Obstacles are beginning to develop” that may hamper further advances.
Fed policy looms over stocks and housing, the report said, because possible cutbacks in bond purchases have lessened the appeal of equity dividends and made home loans more expensive.
More houses may be put up for sale as the number of homeownerswhose debt exceeds their properties’ value falls, Belski wrote. The U.S. economy has added an average of 105,000 jobs a month in the current expansion. The pace trails an average of 178,000 in similar post-World War II periods, according to data cited in the report. The comparable growth rates for disposable income are 0.9 percent and 3.8 percent, respectively." - source Bloomberg

"There is no IQ in QE but no QE = NO IQ" - Macronomics

Stay tuned!

Thursday 27 June 2013

Chart of the Day - Mortgage Debt and Housing Wealth

"He is richest who is content with the least, for content is the wealth of nature." - Socrates 

Looking at Pending home sales,  moving up 6.7% in May from a month earlier and 12.1% higher than a year ago with May’s index reading of 112.3 marks, the first time contract activity has grown at this rate since December 2006, when it hit 112.8, we thought the below Chart of the Day from Bank of America Merrill Lynch note entitled "Taper? Not so fast" from the 27th of June was fairly illustrative of both the deleveraging of the private sector and the wealth effect induced QE recovery courtesy of the Fed:
"Housing wealth increasing while mortgage debt declines: The rebound in housing construction is only one outcome of the recovery. We are also seeing a notable gain in home prices – running at 10% yoy – and a recovery in household balance sheets. The gain in home prices has translated to a $1.8tr increase in housing wealth, recovering nearly a third of the cumulative loss from the peak. Along with the gain in housing wealth, households have reduced mortgage debt burdens. Indeed, the decline in debt has been even more notable than the gain in housing wealth." - Bank of America Merrill Lynch

No doubt the link between consumer spending, housing, credit growth and shipping, a subject we discussed in January this year, has seen some improvement since the beginning of the year.

While US Family Housing Starts looks to be on the mend in conjunction with US Furniture sales, we have seen lately a small pick-up in the Baltic Dry Index - graph source Bloomberg:
 Since 2006:
- in yellow the Baltic Dry Index,
- in orange US Family Housing Starts
- in white US Furnitures Sales.

As we indicated in our January conversation:
"If there is a genuine recovery in housing driven by consumer confidence leading to consumer spending, one would expect a significant rebound in the Baltic Dry Index given that containerized traffic is dominated by the shipping of consumer products."

A resurgence in international container volumes is dependent on the housing market and any change in consumer spending trends is depending on a more pronounced housing market revival and will directly impact container traffic.

But, the latest dip in US Family Housing Starts and white US Furnitures Sales, warrants caution. As per the Fed's tapering comments, now it is all about economic data in the coming weeks and months.

Also Mortgage Rates for 30 years jumping to highest since 2011 from 3.93% to 4.46%, the biggest one week increase since 1987 according to Bloomberg and with the average 15 year rate climbing to 3.5% from 3.04% could also slow down the deleveraging process and dent somewhat the housing recovery process. The average rate for a 30-year mortgage in the 10 years through last week was about 5.3 percent, according to data compiled by Bloomberg. 

Unsurprisingly, the Mortgage Bankers Association shows credit availability has eased since last year, which again validates the points made back in our January 2013 about the link between consumer spending, housing, credit growth and shipping.

"Be careful to leave your sons well instructed rather than rich, for the hopes of the instructed are better than the wealth of the ignorant." - Epictetus 

Stay tuned!

Tuesday 25 June 2013

Rates volatility & Cross Asset volatilities - a follow up on the "Regime Change"

"Hope in reality is the worst of all evils because it prolongs the torments of man." - Friedrich Nietzsche 

As a follow up to our end of May post where we indicated the risk of repricing of bonds courtesy of a surge in bond volatility, which to some effect has spilled into both the currency sphere as well as the equities sphere, it is time for a follow up courtesy of our good cross-asset friend in relation to the relation between credit and equities volatilities and the potential further surge in equities volatility.

The meteoric rise in bond volatility. The MOVE and CVIX indices rising contagion spilling to the equities sphere closely followed by a rise in the VIX index albeit more muted - graph source Bloomberg:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

As displayed by the move in MOVE, US rates volatility has been exploding and spilling to FX (CVIX). So far Europe and US volatilities have been underperforming on a relative basis. The stress in the equity space has so far been confined to Emerging Markets.
Volatility ETF EEM US (MSCI Emerging Markets) versus Volatility S&P 500 3 months ATM (At The Money) - graph source Bloomberg:

It is difficult to envisage some stability in the Emerging Markets space until US interest rates stabilize.

US T-Note curve (5th of May 2013 versus 25th of June 2013 - graph source Bloomberg:

Credit wise, although early May in Europe the Investment Grade credit index (Itraxx Main) and High Yield  credit index (Itraxx Crossover) appeared too tight relative to equities, the recent violent moves and surge in spreads in the last two weeks have triggered a reconnection between those two risk indicators (credit versus equities). 

Spreads and Equities volatility are now in line with their two years historical levels. A similar trend has happened between spreads and spot equities according to our good cross-asset friend.

Itraxx Crossover (roll-adjusted) versus Eurostoxx 50 volatility 1 year ATM (At The Money) - history two years:

Itraxx Crossover (roll-adjusted) versus Eurostoxx 50 spot index  - history two years:

"The huge rally in risky assets has been similar to the move we had seen in early 2012, either, we are in for a repricing of bond risk as in 2010, or we are at risk of repricing in the equities space."
Looks like we have both...
We strongly believe higher USD rates vol will ripple through other asset classes and provide more cross-asset opportunities going forward. 

Here are Morgan Stanley's views in relation to the potential "regime change" courtesy of the latest US central bank jitters:
"VIX has rallied 60% since May 15th lows, however, it is not very high by long term standards (57th percentile back to 1990).  VIX of ~20 tends to be a transitory level – in a risk-off regime volatility could rise significantly higher, while in a normalization over the coming weeks it could fall to the low teens.  
We have seen several spikes in VIX over the last six month. What is different this time around is the persistency in the move higher (vol has been steadily rising for the last month), and the dynamics across the volatility term structure – risk premiums have been reprised over longer time horizon, not just in the near term. This dynamics suggests a broader change in risk aversion among equity investors and reflects a potential transition to a different volatility regime

Volatility tends to show persistent characteristics over time - clustering effects and mean reversion. Early spikes in returns help detect future volatility clusters. QDS team has developed a number of proprietary signals to help identify potential shifts in volatility regimes.  One of the signals used in our VolNet suite of systematic volatility trading strategies is designed to avoid volatility clusters, which if otherwise exposed to, can lead to large losses on short volatility positions. The triggers are activated if we see outsized moves in the underlying cash market. Historically, these risk off events were often followed by significant spikes in volatility (red dots in the 2nd chart below indicate when the product has no short vol exposure due to the risk off features). 

VolNet risk off trigger was activated on SX5E on May 29th, 2013 and on SPX last Thursday, June 20, 2013. The VolNet Indices have been live since Apr 2011 and the signal was successful at avoiding the Aug 2011 vol spike in SPX.

VolNet Risk-Off Trigger would have avoided many large volatility spikes in the last 20 years:

Looking across asset classes, US equity volatility remains relatively low versus interest rate and FX implied volatility, despite the moves higher (3rd chart below).  Volatility in all asset classes has increased in recent weeks, but equity volatility had declined more in late 2012 and early 2013 than other asset classes, and has more room to rise should uncertainty in the rates market continue."

 Vol has picked up across all assets, but US equity vol still has room to rise relative to Rates and FX vol

- source Morgan Stanley.

We agree with Morgan Stanley, namely that the latest market jitters courtesy of the Fed, clearly indicates that volatility in the US equity space as well as in the European space (V2X) have room to rise relative to FX and Rates volatilities. 

Evolution of VIX versus its European counterpart V2X since 18th of April 2011 - source Bloomberg:

"We are more often frightened than hurt; and we suffer more from imagination than from reality." - Lucius Annaeus Seneca 
Stay tuned!

Saturday 22 June 2013

Credit - Singin' in the Rain

"You learn to know a pilot in a storm." - Lucius Annaeus Seneca 

Looking at the epic bloodbath this week which started with the mechanical resonance of bond volatility in the bond market which we cautioned about recently, with carry trades in FX and High Yield ETFs (HYG) taken to the cleaners, and with equity starting to feel the spillover heat, you might think our title this week is a little bit "over the top" as far as sarcasm is concerned and you might not at first glance see the irony in it.

The epic bloodbath caused by a surge in bond volatility. The MOVE and CVIX indices rising contagion spilling to the equities sphere. We have added the VIX index as well - graph source Bloomberg:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

Let us explain our title choice. While "Singin' in the Rain" is a 1952 American musical comedy film directed by Gene Kelly, it does involve "Tap Dancing". In similar fashion to Gene Kelly's routine in the movie, credit investors have been "tap dancing" to the Fed's liquidity "rain" for the last couple of years until the music stops 'in true Citigroup - Chuck Prince fashion ("As long as the music is playing, you've got to get up and dance"). Well, it looks to us that the music has indeed stopped. After all, should be we surprised that "Tap dancing" follows "Operation Twist"?

On a side note, we would have used "Spinal Tap" as a title, in reference to this cult movie but it had already been used two days ago by the WSJ, and by Jeremy Warner in the Telegraph in December 2012 and in many other instances.

Therefore in this week's conversation, while we will review some of the market action driven by liquidity issues, we will ponder what the implications are for some risky assets and the underlying issue of "convexity".

As we posited in the conversation "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

The correlation between the US, High Yield and equities (S&P 500) since the beginning of the year is broken. US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG  - source Bloomberg:
We got seriously wrong-footed by the market's reaction to the "tapering QE" scenario and we still think at some point the Fed will maybe redirect its buying towards MBS, given that rising rates could seriously dent any hope of a "housing recovery" should the move continue at a rapid pace like it has this week.

The name of the game, we have kept saying is as follows:
"It is all about capital preservation rather than a hunt for yield".

As we have argued in our March 2012 conversation "Modicum of relief":
"In relation to systemic risk, credit risk conditions can significantly and persistently be decoupled from macro-financial fundamentals as indicated by Bernd Schwaab, Siem Jan Koopman and André Lucas in their December 2011 paper "Systemic risk diagnostics: coincident indicators and early warning signals":
"We demonstrate that a decoupling of credit risk conditions from macro financial fundamentals has preceded financial and macroeconomic distress in the past with non-negligible lead time (about four quarters)."

Looking at the market reaction with liquidity withdrawal, makes us indeed feeling rather nervous as we have long posited that liquidity crisis always lead to financial crisis:
"So as credit investors, yes we are indeed still dancing as the music is playing, but, given the liquidity levels closer to 2002 than 2007, we'd rather be dancing close to the exit door" - Macronomics - Pain & Gain

Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:
"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given 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
 In relation to our previous post, the Peregrine soliton, being an analytic solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), it is "an attractive hypothesis to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace" - source Wikipedia." - Macronomics - 15th of November 2011

Why are we feeling rather nervous?

If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?

It is a possibility we fathom. 

Here is why:

As indicated by Andrea Wong in Bloomberg on the 21st of June, Asian countries have been on the receiving end of the Fed's latest "Tap dancing" - Asian Currencies Tumble Most in 21 months on Fed Exit Outlook
“The prospect of less quantitative easing has caused outflows and selloffs in Asian assets,” said Tobby Lin, a fixed-income trader at Yuanta Securities Co. in Taipei. “The countries that had experienced the most inflows, like South Korea and Southeast Asian nations, are being hit the most.” More than $19 billion has been withdrawn from funds investing in developing-nation assets in the three weeks to June 12, the most since 2011, according to data from EPFR Global. The Dollar Index, which tracks the greenback against six major counterparts, was up 1.3 percent for the week, while the MSCI Asia Pacific Index of shares slumped 3.4 percent." - source Bloomberg

As we indicated back in May 2012 in our conversation "Risk-Off Correlations - When Opposites attract":
"When investors are most concerned about risk, “positive correlation between growth assets is most notable. Everyone is looking at the same threats to growth, and so they are all selling together.” - Shane Oliver, head of investment strategy at AMP Capital Investors
"In fact, the only commodity that appears to be running scarce in "Risk-Off" periods appears to be the dollar" .

Dollar index versus Gold - graph source Bloomberg:
Looking at the ongoing predicament in the markets, in similar fashion to our May 2012, the Greenback remains the only place to hide as confirmed by Lu Wang, Inyoung Hwang and John Detrixhe in Bloomberg in their 21st of June article - Nowhere to Hide as Dollar Posts Only Gains Amid Stock, Bond Drops:
"The dollar is proving to be investors’ only haven as stocks, commodities, bonds and other currencies fall in unison for the first time since 2011.
Concern governments will curtail aid to economies pushed the MSCI All-Country World Index down 3 percent, spurred declines of 2.5 percent or more in gold, copper and crude oil, and sent bonds of all types to losses of 0.4 percent this week, according to Bank of America Merrill Lynch’s Global Broad Market Index. Currencies from Australia to Mexico slipped against the dollar.
Rallies that have lifted everything from Japanese banks to Italian government debt during a four-year global expansion are being revalued amid signs central bank stimulus through quantitative easing, or QE, is poised to slow. Global equities posted the biggest two-day retreat in 19 months after Federal Reserve Chairman Ben S. Bernanke said he may phase out stimulus and China’s cash crunch worsened.
The old risk on/risk off trade is broken,” said Walter “Bucky” Hellwig, who helps manage $17 billion at BB&T Wealth Management in Birmingham, Alabama. “The stress in the markets as the result of the pullback in QE and concurrent higher rates is causing the unwind of many kinds of trades. The liquidation and the deleveraging forces more unwinding as asset prices decline and the dollar strengthens.” The world’s 10 biggest equity markets slumped yesterday, according to data compiled by Bloomberg. They have fallen in sync three times in the past two months, accounting for half of the occurrences over five years." - source Bloomberg.

Indeed the old risk on / risk off trade is broken, we have to agree and we had no choice but to shelve our beloved indicator which we had been monitoring, namely the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes - source Bloomberg:
In "Risk Off" periods we noticed that the 120 days correlation was close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation was falling to significantly lower level.  The correlation between both the German Bund and US 10 year note is not telling us anything anymore. 
Nota Bene: ("Risk On" refers to a period of time in which investors are putting money into risky assets such as stocks, commodities, etc. "Risk Off" meaning the exact opposite with investors putting money into safe haven assets such as cash and treasuries or German Bund). 
Bye bye indicator...

According to John Detrixhe from Bloomberg on the 29th of May 2012:
"The dollar is proving scarce, even after the Federal Reserve flooded the financial system with an extra $2.3 trillion, as the amount of the highest-quality assets available worldwide shrinks."

Could the reason behind the "Tap Dancing"stance from the Fed be coming from the increasing shrinkage of the highest-quality assets available worldwide and in particular US Treasuries because the Fed's vacuum cleaner had been running on full steam with its QE program has posited by Zero Hedge in their recent note "Is This The Chart That Scared Bernanke Straight"?

And if the dollar goes even more in short supply courtesy of Bernanke's "Tap dancing" with his "Singin' in the Rain", could it mean we will have wave number 3 namely a currency crisis on our hands? We wonder...

We have to agree with Barclays recent note on FX trends entitled "Let the tapering begin". The genie is out of the bottle as far as the dollar is concerned:
"• A robust recovery in the US is leading to repricing of market expectations of future Fed asset
• Higher risk premia typically lead to lower prices for risky assets and higher volatility.
In FX, this implies weakness in high-carry and EM currencies versus the USD.
• A broader USD rally, which would include low-yielding currencies, however, will have to wait for expectations of rate hikes to be priced.
• The broad resurgence in the USD is likely to gain strength as H2 progresses.
• It is likely that the Fed will attempt to smooth market expectations of a premature exit. However, it
is unlikely that it will be able to put the genie of an eventual exit from unconventional monetary policy back in the bottle.
• Recommendations:
• We favor being long USD versus JPY, CHF and EUR.
• Additionally, we remain out of USD funded carry trades despite the recent selloff." - source Barclays

We do agree with Barclays that we are in an early stage of dollar strengthening as well:
"• Markets have been given a little taste of how tricky the Fed’s exit from extraordinarily loose
monetary policy will be in the months and years ahead.
• Even at its near-term peak, the USD saw muted gains of about 2% on a broad basis; however,
the average rise in the USD against risky currencies has been much larger, at more than 8%."
- source Barclays

As per Lu Wang, Inyoung Hwang and John Detrixhe Bloomberg's article published on the 21st of June entitled "Nowhere to Hide as Dollar Posts Only Gains Amid Stock, Bond Drops", outflows in funds have been significant in recent weeks:
"More than $19 billion left funds investing in developing-nation assets in the three weeks to June 12, the most since 2011, according to EPFR Global. Foreign investors dumped an unprecedented $5.6 billion of Brazilian stocks and $3.4 billion of Indian bonds this month, exchange data show. The MSCI Emerging Markets Index slid 4 percent yesterday while the rupee and Turkish lira hit record lows." - source Bloomberg

Basically "carry monkeys investors" as described by Macro-Man in his recent post "Beatings will continue until morale improves"  have been hammered. All the investors that piled in high beta trade, namely High Yield, Emerging Debt Bonds and Emerging Currencies are being hit hard. They thought they were "smart investors", playing "alpha", when it was a pure beta play. 

"As pointed out by Bank of America Merrill Lynch's note stable carry thrives in low rates volatility environment, the recent spike in US bonds volatility has had some devastating effect in high yielding assets:
"Carry trades love low risk-free interest rates, but they love low interest rate volatility even more. This is why over the past three years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving their risk premiums to abnormally low levels."

Why the move could potentially accelerate?

Because of real yields...graph source Bloomberg:
"U.S. government debt is the cheapest in more than two years with inflation not a threat as the Federal Reserve provides a timetable for the eventual end of its bond-buying program.
The CHART OF THE DAY shows the difference in U.S. Treasury 10-year note yields and the annual inflation rate, known as the real yield, rose past 1 percent for the first time since March 2011 this week after Fed Chairman Ben S. Bernanke said the central bank may start reducing bond purchases later this year and end them by mid-2014. Consumer inflation climbed 1.4 percent in the 12 months to May, less than the Fed’s 2 percent goal. Benchmark yields touched 2.47 percent yesterday, the highest level since October 2011.
“The 2.40 percent 10-year is a very good buying opportunity,” Guy LeBas, chief fixed-income strategist in Philadelphia at Janney Montgomery Scott LLC, said in the telephone interview. “For the first time in a couple years, there’s good value in the current level of interest rates.” Higher real yields tend to attract foreign investors to a country’s bonds. Rising yields, along with unprecedented easing by major and emerging-market countries, have contributed to the dollar outpacing all but two of the 31 currencies tracked by Bloomberg over the last five days. Easing refers to a country’s central bank purchasing assets from commercial banks to increase the monetary base." - source Bloomberg.

This is what happens when you take the proverbial punch bowl away. Volatility which has been repressed by Central Banks meddling with setting up the price of risk by artificially suppressing up interest rates movements via the increase in M (Money Supply). MV = PQ as per the great Irving Fisher's equation. (Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.)

Let's move on to the underlying issue of "convexity":

Like a spring severely coiled, when volatility is released, the destructive energy is massive because of convexity as indicated by our friend Martin Sibileau on his Popular Macro blog:
"Technical aspects that may matter tomorrow: While the Bank of Japan seems to have failed to control market forces, the Fed appears to have won the repression battle. However, there is an aspect that may be out of their reach: Convexity. The reach for yield (i.e. greed) has been such a powerful force that the rumor is that approx. only 15% in High Yield and 50% in Investment Grade portfolios are rate hedged.

Remember: When an investor wants to be long credit risk only, as the yield is driven by: US Treasury yield + swap rate + credit spread or Libor+ credit spread, said investor will buy the credit (i.e. bond, loan) and sell the rate, to keep only the credit spread. 

But if only 15% and 50% of positions in HY and IG are rate hedged, if Ben triggers a sell off in credit with the insinuation of tapering, the dealers on the other side, making the bid for the investors, will be forced to do the rate hedge their investors did not do, because they must be interest rate neutral! That means selling US Tsys for an average of 85% and 50% of positions in HY and IG respectively! In other words, the potential sell-off tomorrow may trigger a surprising self-feeding convexity. How are precious metals to react in such scenario?" - Martin Sibileau, Popular Macro blog

So all in all this is the perfect storm because market makers are running inventories at 2002 levels and they are always interest rates neutral...You buy a bond from a mutual fund, you sell treasuries, feeding even more the rising pressure on treasuries yield to rise further.

There is no place to hide except cash at the moment and in dollars...(or shorting treasuries for the  short term tactical braves out there...we like the ETF TBT out there as of late...)

To answer our friends Martin Sibileau's questions commodities have further to fall including gold.

Gold 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, ("The Night of the Yield Hunter" - Macronomics).

The S&P 500 and the US 10 year breakeven, indicative of the deflationary forces at play,  graph source Bloomberg (21st of June 2013):
As indicated above, we got seriously wrong-footed (long US bonds) by the market's reaction to the "tapering QE" scenario, because as per "The Night of the Yield Hunter" and David Goldman article about Gold and Treasuries and bonds in general he wrote in August 2011 (the former global head of fixed income research for Bank of America):
"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."

So not only our Risk-On / Risk-Off indicator is broken, but our thermos bottle is lately behaving strangely (could it be caused by global warming we wonder) because central bankers have been busy trying to ignite inflationary expectations with various QE programs, but the YTD movements in 5year forward breakeven rates is still  falling are indicative of the strength of the deflationary forces at play - source Bloomberg:
So we will patiently monitor 5 year breakeven given last time the Fed put on its dancing shoes and started "Twisting" again, it was when we hit the 2% level.

When it comes to credit, at the moment, we are happy to sit on the sidelines and enjoy the show given poor liquidity, convexity issues, and rising yields do not mix very well with "total return" or preservation of capital that is. After all Shares of BlackRock Inc.’s $21 billion investment-grade bond ETF have plunged 3.7 percent this month as of 11:58 a.m. in New York, the biggest decline for a month since February 2009, according to data compiled by Bloomberg. Shares have dropped the furthest below corporate-bond prices since August 2011, signaling that the fund may reduce holdings to lower its net asset value, the data show according to Bloomberg.

As Friday came to a closure after an eventful week where market participants age in dog years, clearly there was a weaker tone by the end of the day as indicated by a market maker in the cash market:
"While holding stable for the most part of the day we saw a proper collapse into the close in corp cash bonds. Market depth is basically non existent with no place to hide at the moment it seems. The pain is coming from everywhere being it wider swap spreads, wider indices or weaker stocks. With swap spreads moving wider so will new issue spreads vs bunds if and when. It feels a bit overdone at current levels and I would advise to hold things near the ground since there is also the possibility of a strong squeeze back in but going into the weekend it feels very weak out there. Low beta bonds close between 2-6 bps wider again with the bid side the tough one to trade. Not all is panicky in the market though with still the strong low beta names holding well compared. Have a nice weekend." - source undisclosed market maker.

And when you come under pressure, with outflows due to heavy redemptions and with poor liquidity you sell the good liquid stuff first, and the illiquid stays at the bottom. 

So all in all the quality of the leftovers such as in a leveraged loans mutual fund for instance is not optimal to say the least as indicated by Sridhar Natarajan in Bloomberg in his article - Loans Penalized as Funds Attempt to Stem Losses:
"Leveraged loan prices are dropping from a six-year high on speculation managers of high-yield funds are discarding the floating-rate debt to contain steeper losses from junk bonds amid record redemptions.
The average price for the 100 largest, most liquid loans declined 1.22 cents to 97.66 through yesterday from 98.88 cents on the dollar on May 22, the highest level since July 2007, according to the Standard & Poor’s/LSTA U.S. Leveraged Loan 100 index. Bonds sold by speculative-grade companies fell 4.53 cents to 102.06 cents from 106.6 cents, Bank of America Merrill Lynch index data show.
Investors pulled $9.4 billion from high-yield funds since May 22, including two weeks of record outflows, according to a June 13 report from Bank of America Corp., as Federal Reserve officials signaled they may pare back their extraordinary stimulus measures this year. Loans have held up better because they have rates that fluctuate, offering some defense against higher borrowing costs.
High-yield fund managers who sought the rate protection of senior loans to reduce their duration risk earlier this year and last year were now forced to sell those very instruments to meet the deluge of investors running for the exit,” said Bill Housey, a Wheaton, Illinois-based money manager at First Trust Advisors LP. “It really comes down to prices as loans are holding up better” than bonds, he said." source Bloomberg.

From the same article:
"“It is counterintuitive that they’d be selling off the loans, but yet they are because it’s the best place for them to fund the redemptions without having to realize much of a loss,” said Alex Jackson, the head of the bank loan group in Armonk, New York at Cutwater Asset Management, which manages about $30 billion in fixed-income assets. “It is better to sell off a loan with a one point loss rather than take a bigger hit on a similar quality bond.” "- source Bloomberg

On a final note, we discussed "convexity" with a very wise credit friend former head of credit research and this is what he had to say on the subject:
"Convexity is a bigger issue in all the pensions + fixed income funds. That's one reason mortgages have been whacked. the Fed will basically have to do a ECB - stop buying USTs and start buying RMBS. But pensions (or Fannie / Freddie) do not hedge MBS with USTs - they do it with LIBOR"

US 5 year Swap spreads - graph source Bloomberg:

All in all, as we indicated last week in our conversation "Lucas critique", while it did cost us not to believe in  the "Tap Dancing" skills of Ben Bernanke and given Mr. Jeff Gundlach's opinion is that the Fed is likely to step in and actually increase QE to try and hold rates down, because mortgage rates have spiked substantially over the last month from a low of around 3.5% to around 4.3%, we have to agree with our friend that a "new dance" routine from the Fed might be coming. 
As recently commented by Marc Faber"I am tempted to buy a 10 year treasury at a yield of 2.5%. I think we will rebound in the treasury market. Yields will go down first, and if they go up further, it will kill the economy including the housing market." 

There is indeed a risk for the Fed, and like our wise credit friend said, the Fed might do a ECB in the end. Should we call that new dance "B-boying"? We wonder...and keep "Singin' in the Rain".

"If you are caught on a golf course during a storm and are afraid of lightning, hold up a 1-iron. Not even God can hit a 1-iron." - Lee Trevino 

Stay tuned!

Sunday 16 June 2013

Credit - Lucas critique

"Excess generally causes reaction, and produces a change in the opposite direction, whether it be in the seasons, or in individuals, or in governments." - Plato 

While we mused around Goodhart's law, prior to taking a much needed break, unfortunately interrupted by the unavoidable and repetitive French strikes, we thought this week, on the back of a friend's recommendation, we would make a reference to Lucas critique, named after Robert Lucas' work on macroeconomic policymaking. Robet Lucas argued that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. In essence the Lucas critique is a negative result given that it tells economists, primarily how not to do economic analysis:
"One important application of the critique (independent of proposed microfoundations) is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions. Said another way, just because high inflation was associated with low unemployment under early-twentieth-century monetary policy does not mean we should expect high inflation to lead to low unemployment under all alternative monetary policy regimes.

For an especially simple example, note that Fort Knox has never been robbed. However, this does not mean the guards can safely be eliminated, since the incentive not to rob Fort Knox depends on the presence of the guards. In other words, with the heavy security that exists at the fort today, criminals are unlikely to attempt a robbery because they know they are unlikely to succeed. But a change in security policy, such as eliminating the guards for example, would lead criminals to reappraise the costs and benefits of robbing the fort. So just because there are no robberies under the current policy does not mean this should be expected to continue under all possible policies." - source Wikipedia

So, as one can infer from the point made above and in continuation to the points made in our conversation "Goodhart's law", Ben Bernanke's policy of driving unemployment rate lower is likely to fail, because monetary authorities have no doubt, attempted to exploit the Phillips Curve.  

In the 1970s, new theories came forward to rebuke Keynesian theories behind the Phillips Curve by monetarists such as Milton Friedman,  such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur:
"Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve." - source Wikipedia

In similar fashion to what we posited in our conversation "Zemblanity", both Keynesians and Monetarists are wrong, because they have not grasped the importance of the velocity of money. QE is not the issue ZIRP is as we recently discussed.

The issue with NAIRU:
"The NAIRU analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed." - source Wikipedia

In respect to our chosen title, and looking at the evolution of inflation expectations, via TIPS, we still believe deflation is currently the on-going problem, not inflation as indicated by Bloomberg's chart displaying 10-year TIPS which have turned positive:
"Treasuries have dropped far enough during the past six weeks that investors no longer have to pay for the privilege of guarding against inflation when they buy 10-year notes.
As the CHART OF THE DAY illustrates, 10-year Treasury Inflation-Protected Securities yielded more than zero for the past two days. The last time that happened was in November 2011, according to data compiled by Bloomberg. Yields on the notes, known as TIPS, fell as low as minus 0.93 percent last December. Investors who bought the securities and held them to maturity were assured of receiving less than they paid before any adjustments to principal and interest payments, reflecting changes in consumer prices. “The idea that you’re going to have inflation, I think, is coming off,” Ira F. Jersey, director of U.S. rates strategy in New York at Credit Suisse AG, said yesterday in an interview on Bloomberg Radio.
The Federal Reserve’s preferred inflation gauge shows the pace of price increases has slowed even though the central bank is buying bonds and holding its key interest rate near zero to aid the U.S. economy. The indicator, the personal consumption expenditure deflator, rose 0.7 percent in April from a year earlier. The increase was the smallest since 2009.
Lower prices for Treasuries may do more to explain the above-zero yield for 10-year TIPS than the inflation outlook, Jersey said. Ten-year notes that aren’t indexed had a negative return of 4.2 percent from May 1 through yesterday, according to data compiled by Bloomberg."  - source Bloomberg

As a reminder in relation to the Taylor Rule and inflation expectations, as indicated in a Bloomberg article from the 15th of November 2012 by John Detrixhe entitled "Citigroup Seeing FX Signals of Early End to Stimulus: Currencies":
"Traditional measures of monetary policy such as the Taylor Rule that are based on growth and inflation suggest the Fed should end its stimulus efforts. John Taylor, an economist at Stanford University, published the formula in 1993. It signals the Fed’s benchmark should be 0.65 percent, or 40 basis points above the upper range of the current target interest rate for overnight loans between banks, assuming an inflation of 1.7 percent, unemployment of 7.9 percent and a nonaccelerating inflation rate of unemployment, or NAIRU, of 5 percent. NAIRU is the lowest unemployment rate an economy can sustain without spurring inflation.
About a year ago, the Taylor Rule model indicated policy rates should be minus 0.47 percent. The Fed has a target for price increases of 2 percent. The consumer-price index increased by that much in October 2012 from a year earlier, the Labor Department said on November 14. If “unemployment rate gets below 7 percent, you could have a Taylor Rule that suggests rates should go up and the question becomes do they overturn the Taylor Rule?” Steven Englander, Citigroup’s New York-based global head of G-10 strategy said. “When perceived commitments are at stake, it’s a nightmare.” - source Bloomberg

As far as we are concerned when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion, but we ramble again

Therefore in this week's conversation, after a quick market overview, we would like to touch again on the deflationary forces at play, given, as Plato's quote rightly said, excess generally causes reaction, and produces a change in the opposite direction .Our "omnipotent" central bankers, and investors alike should pay more attention to this quote...

In our quick market overview, we will not delve too much into the recent surge in rates volatility which has spilled over other asset classes given we have tackle this issue in our post from the 13th of June entitled "The end of the goldilocks period of low rates volatility / stable carry trade environment"

The recent move in the MOVE and CVIX indices are now starting to spillover to the equities sphere. We have added the VIX index to our previous chart - source Bloomberg:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

The spike in volatility in Japan has been preceding the widening move in CDS Spreads of the Itraxx Japan, a move we saw coming:
"Should the volatility in the Japanese space continue to trend higher, which is currently the case, we would expect credit spreads to continue to widen, particularly for Japanese financials." - Macronomics, Japanese Whispers, 25th of May 2013.
Nikkei Index - 3 Month 100% Moneyness Implied Vol versus Itraxx Japan 5 year CDS since January 2010 until today - source Bloomberg:
Back on the 25th of May the Itraxx Japan CDS, we indicated that a surge in volatility in Japan would lead to a surge of Japanese credit risk. The Itraxx Japan has surged from 82 bps to 111 bps in the continuation of this surge in equity volatility.

More interestingly the surge in bond volatility has led to some serious outflows in the fixed income space. For instance, as indicated by Credit Suisse, the ICI fund flow data which was out for week ended June 5; showed equity mutual fund outflow of -$942m;  the big number was bond outflow of - $10.9bn. It was second-largest bond mutual fund outflow in history of weekly ICI series, which extends back to Jan 2007:
"The Investment Company Institute estimated that bond mutual funds posted a huge net outflow of $10.9bn in the week ended June 5. This was the second largest weekly outflow in the history of this series, which extends back through 2007. The largest outflow recorded was during the darkest days of the financial crisis, in the week ended October 15, 2008 (-$17.6bn). Investors apparently didn’t rotate into equity mutual funds in early June, as equities also saw a net outflow, albeit a much smaller one. In the week ended June 5, investors withdrew a net of $942mn from equity mutual funds.  Hybrid mutual funds posted a small net inflow of $347mn in that week." - source Credit Suisse

So much for the "great rotation" story: 
"Since the beginning of the year we have not bought into the story of the "Great Rotation" from bonds to equities. One of the reason being on one hand demography with the growing numbers of baby boomers retiring, the other one being pension asset allocation trends." - Macronomics, "Goodhart's law".

We will touch more on the deflationary forces at play and the importance of demography after our overview.

When one looks at the relative performance of the S&P 500 versus MSCI Emerging, one can easily see EM equities have been clearly lagging. Emerging markets (MXEF) continue to underperform developed markets  - source Bloomberg:
The absolute spread between the S&P 500 and MSCI Emerging Markets has touched a record low level.

"QE tapering"soon? We do not think so. Markets participants have had much lower inflation expectations in the world, leading to a significantly growing divergence between the S&P 500 and the US 10 year breakeven, indicative of the deflationary forces at play,  graph source Bloomberg (5th of June 2013):

While some central bankers are busy trying to ignite inflationary expectations with various QE programs, the YTD movements in 5year forward breakeven rates which have been falling are indicative of the strength of the deflationary forces at play - source Bloomberg:

We recently commented that Investment Grade is a more volatility sensitive asset to interest rate changes meaning a surge in the MOVE index is leading to increasing volatility in the investment grade bond space where record lows yields on long bonds can lead to some vicious losses on highly interest sensitive long bonds (Apple 30 year bond being a good example of the repricing risk)., High Yield is a more default sensitive asset. The correlation between the US, High Yield and equities (S&P 500) since the beginning of the year has weakened dramatically recently. US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG  - source Bloomberg:
We recently commented on the latest sell-off in the ETF High Yield credit space with our good cross asset  friend in our conversation "High Yield ETF - The Fast and The Furious":
"If you do not believe in the "tapering QE" scenario, which led to a recent surge in US yields on government bonds and this recent sell-off on credit, then the relative value of High Yield, is starting to be compelling again (6.50% in YTM - yield to maturity versus S&P 500)." - source Bloomberg.

So if you do not believe in the "tapering", like ourselves, and like Mr. Jeff Gundlach, maybe at these levels the ETF HYG is starting to be compelling again. Mr Gundlach's opinion is that the Fed is likely to step in and actually increase QE to try and hold rates down, given mortgage rates have spiked substantially over the last month from a low of around 3.5% to around 4.3% today.

Moving on to the subject of the deflationary forces at play, shipping has always been for us, the best significant example of the reflationary attempts of our "omnipotent" central bankers. For instance, containership lines have announced eight rate increases, totaling $3,650, but have failed to maintain the momentum because of the weak global economy and the excess capacity which has yet to be cleared in similar fashion to the housing shadow inventory plaguing US banks balance sheet, graph source Bloomberg:
"Containership lines have announced eight rate increases, totaling $3,650, on Asia-U.S. routes since the beginning of 2012. The increases have largely failed to hold because of excess capacity and a weak global economy. As such, benchmark Hong Kong-Los Angeles rates have only risen by 36% since the end of 2011 and are down 11.6% ytd. In a Bear Case scenario, operators will continue struggling to sustain rate increases. The Drewry Hong Kong-Los Angeles 40-foot container rate benchmark was broadly unchanged in the week ending June 12, remaining below the $2,000 mark for the third time in 2013. Rates are down 27.5% yoy and 11.6% ytd, even with three rate increases, as slack capacity pressures pricing. Carriers are expected to raise rates by $400 per 40-foot equivalent on containers from Asia to the U.S. West Coast, and by $600 to all other destinations, effective July 1. " - source Bloomberg.

Of course high unemployment which continues to plague developed economies will continue to weight on the economic recovery in general and shipping in particular, graph source Bloomberg:
"Unemployment within the euro zone is expected to increase to 12.2% in 2013 from 11.4% in 2012, and remain broadly unchanged at 12.4% in 2015, according to consensus forecasts. Falling unemployment is crucial for expanding global demand for goods, soaking up excess capacity and firming shipping rates. The recovery in the shipping industry will not be fully realized without improving unemployment trends." - source Bloomberg.

Deflationary forces at play in the shipping space? You bet!
This is what was indicated by Rob Sheridan and Isaac Arnsdorf in their Bloomberg article from the 7th of June - Panamaxes Have Longest Losing Streak as Glut Magnifies Downturn:
"Rates for ships hauling coal and grains posted the longest losing streak on record as the merchant fleet’s largest glut magnified seasonal declines in demand from South America and India.
Earnings for Panamaxes fell 0.1 percent to $6,078 a day, the 32nd drop in a row and the longest stretch in data going back to 1999, according to the Baltic Exchange, the London-based publisher of shipping costs on more than 50 trade routes. Panamaxes can carry about 75,000 metric tons of dry-bulk commodities." - source Bloomberg.

We still are seeing creative destruction at play and deflationary forces in the shipping space as the gradual excesses of too many ships built on ship credit are being dealt with, graph source Bloomberg:
"Excess capacity and depressed charter rates have increased the number of container ships sent to be scrapped by 538% since June 2005. This is creating a more efficient fleet as older ships are replaced by newer models. For instance, Maersk is set to introduce triple-E ships that consume about 35% less fuel per container and are able to carry 16% more boxes. In May, the total number of scrapped container vessels surpassed tankers." - source Bloomberg

Global Economic growth remains weak and vulnerable as indicated by the dry bulk market:
"The dry bulk market continued to show weakness, as time charter rates fell for most carriers in 1Q. Dry bulk rates declined 36% yoy on average and were down 10% sequentially. Torm (down 14.2% yoy) and D/S Norden's (20.2% lower yoy) dry bulk rates decreased the least. D/S Norden noted dry bulk fleet growth has moderated, and scrapping will continue as long as rates remain low. The Baltic Dry Index declined 8.2% yoy in 1Q, and fell 16.5% from 4Q." - source Bloomberg.

In similar fashion to the extend and pretend game being played by banks relating to their real estate exposure and negative equity, some German banks, which total exposure to shipping loans amount to 125 billion USD with a nonperforming ratio of 65%, have resorted to avoid recognizing the losses by acquiring some ships in a bid to salvage their bad loans as reported by Nicholas Brautlecht in Bloomberg on June 13 in his article "Commerzbank Acquires First Ships in Bid to Salvage Bad Loans":
"Commerzbank AG, the German lender whose soured shipping loans prompted a ratings downgrade by Standard & Poor’s last month, is taking the helm as it tries to salvage some of the 4.5 billion euros ($6 billion) it holds in bad debt from the crisis-hit industry.
It plans to take over two feeder ships from debtors this month, holding off on a sale until values recover, said Stefan Otto, 42, the head of the shipping unit. The vessels, which can transport as many as 3,000 standard 20-foot containers, or TEU, are the first the Frankfurt-based bank will actively manage as part of a goal to reduce shipping losses and exit ship financing.
“We focus on ships where we see significantly more upside than downside in the future, and where it seems smarter to hold them for a limited time period and wait with the divestment until the value has increased,” said Otto in an interview, declining to reveal the value or the names of the ships.
The collapse of Lehman Brothers Holdings Inc. in September 2008 and the ensuing sovereign-debt crisis propelled the shipping industry into a slump from which it has yet to recover, suffocating demand and generating a glut of vessels. Commerzbank decided a year ago to wind down its shipping portfolio to stem the losses.
The company, which had shipping loans of 18 billion euros in the first quarter, became the world’s second-biggest financier of ships with the 2009 acquisition of Dresdner Bank. Norddeutsche Landesbank Girozentrale has a similar-sized loan portfolio, while leader HSH Nordbank AG’s ship loans stood at 27 billion euros in the first quarter." - source Bloomberg

Given that Container ships make up more than one-third of Commerzbank’s 18 billion-euro shipping loan portfolio and looking at the trend in Dry Bulk Cargo described above, and that Commerzbank has had its 5th capital increase in four years, you can expect additional pressure to come for Germany's second largest bank. By 2016, Commerzbank wants to further reduce its portfolio by 4 billion euros to about 14 billion euros, while a date for a complete exit is too difficult to predict according to Stefan Otto. Exit? What exit?

As we have argued in our conversation "Dumb buffers", taking ownership from debtors will not change the fact that Commerzbank's outlook due to its shipping exposure remains deeply concerning:
"Not only have overbuilding occurred due to cheap credit that fuelled an epic bubble in the Baltic Dry Index, but, the on-going decline on vessel prices, will no doubt exert additional pressure on recovery values for Commerzbank's loan book".

Size matters? In shipping it does as indicated by Deutsche Bank in their 7th of June report on the Container Shipping industry, (a point we had made back in August 2012 in our conversation "The link between consumer spending, housing, credit and shipping"):
What are the competitive advantages of the ultra-large vessels?
"Breakeven point is substantially lower in the ultra-large vessels
Container ships have become larger because they can take advantage of economies of scale, diluting the operating costs of the vessel among a larger number of containers. We estimate the freight rates at which a 18k TEU vessels could reach cash breakeven in Asia-Europe trades (USD916) is 21% lower than a 8.5k TEU vessel (USD1,160) and 28% lower than a 6.5k TEU vessel (USD1,268) (calculations made at 18 knot speed, 90% load factor and bunker price USD650/ton)."  - Source Deutsche Bank.

In this deflationary environment, as we repeatedly pointed out, only the strongest will survive. In the shipping space,  Maersk Line, will be the biggest beneficiary we think and agree with Deutsche Bank:
"Given the current order book for new vessels in the sector, the operation of truly ultra large vessels, those larger than 14k TEU, looks almost like a de-facto oligopoly mainly in the hands of Maersk Line, MSC and CSCL, which together will have 78% of the capacity in the segment by 2016, versus a total market share of 33%. This data is based on the global order book as of 11 January 2013 (source Alphaliner) and it does not include the latest order for five 18,000TEU vessels made by CSCL, on which we comment in the specific company pages below in this report." - source Bloomberg

What are "inflationistas" of the world and "tapering believers" fail to take into account in their analysis is the importance of demography we think in true Lucas critique fashion. Therefore we agree with Andrew Cates as reported by Simon Kennedy and Shamin Aman in their Bloomberg article from the 7th of June entitled "Aging Nations Like Low Prices Over High Income":
"The older a country’s population, the lower its inflation rate, posing a challenge for central banks in the world’s industrial nations, according to a UBS AG report.
Singapore-based economist Andrew Cates of the Swiss bank’s global macro team plotted average inflation levels over the last five years against changes in the dependency ratio, which compares the very old and very young to the working-age population.
The resulting chart showed nations that have aged in recent years typically faced very low inflation and, in the case of Japan, deflation. By contrast, those that have been getting younger, such as India, Turkey and Brazil, have relatively strong price pressures.
“Since ageing demographics will now start to feature more prominently in the outlook for many major developed and developing countries this is clearly of some significance for how inflation might evolve,” said Cates in a May 30 report.
The finding clashes with the view of economics textbooks, according to Cates, which tend to say a slowdown in population growth should put upward pressure on wages -- and therefore inflation -- as labor supply shrinks. Still, this ignores how demographics influence demand for durable goods and property, Cates said.
He cited a Federal Reserve Bank of St. Louis study that says because the young initially don’t have many assets, wages are their main source of income. The young are therefore comfortable with relatively high wages and the resulting inflation.
By contrast, because older generations work less and prefer higher rates of returns on their savings, they are averse to inflation eating away at their assets.
“Whichever group predominates in any economy will therefore have more ability to control policy and more ability to control economic outcomes,” said Cates." - source Bloomberg

On a final note, dormant inflation in the US is giving plenty of time to the Fed, as indicated as well by the current trajectory of TIPS, graph source Bloomberg:
"The Federal Reserve may be able to take its time in adopting a more restrictive monetary policy because inflation is relatively tame, according to Pavilion Global Markets Ltd.
As the CHART OF THE DAY illustrates, the U.S. core consumer price index’s increase since the latest recession ended in June 2009 is the smallest for any multiyear recovery since the 1970s. The gauge of prices excluding food and energy rose 6.3 percent through April, according to the Labor Department.
“There is no pressure on inflation that could lead the Fed to act more quickly than it would like” in scaling back a bond-buying program and raising interest rates, Pierre Lapointe, the Montreal-based head of global strategy and research at Pavilion, and two colleagues wrote yesterday in a report.
Core consumer prices were 7 percent higher at the same point in the previous recovery, which started in December 2001, as the chart shows. The biggest increase in the inflation gauge was 29 percent, posted in a recovery that began in April 1975.
These and other inflation statistics are at odds with the magnitude of losses in U.S. bonds, according to David R. Kotok, chief investment officer at Cumberland Advisors. The decline in 10-year Treasury notes sent their yield surging 60 basis points from this year’s low, reached on May 2, through yesterday. Each
basis point amounts to 0.01 percentage point. “The bond-market adjustment is too extreme and has created
bargains,” Kotok wrote. He added that Cumberland, a firm that’s based in Sarasota, Florida, is buying tax-free bonds and taking more interest-rate risk with its holdings." - source Bloomberg.

"We are not retreating - we are advancing in another direction." - Douglas MacArthur 

Stay tuned!

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