Sunday, 12 January 2014

Credit - Third time's a charm‏

"Luck is a matter of preparation meeting opportunity." - Lucius Annaeus Seneca 

As we move into 2014, our chosen title reflects the third time strategists put forward the case for a weaker euro. So could indeed 2014 see finally the much anticipated weaker euro forecasted by so many pundits?

In terms of our prognosis in both 2012 and 2013, we did not believe in a weakening of the Euro versus the dollar and we reiterated our stance in numerous occasions such as in our conversation from April 2013 "Big in Japan":
"In terms of the EUR/USD, we still think in the second quarter that it should remain in the 1.30 region versus the US dollar, which were our views for the 1st quarter. As we posited in January 2012, when most strategists were bearish on the EUR/USD, the Fed swap lines in conjunction with the FOMC decisions at the time did put a floor to the euro and are delaying a painful adjustment in Europe. The latest decision by Japan will as well prolong the European agony. In the process the European recession can only be prolonged and the European economy will continue to suffer (unemployment rate now at 12%)."

When it comes to Europe, we will not change our stance in 2014 either. As we pointed in a "Tale of Two Central banks", we would like to repeat our friend Martin Sibileau's view we indicated back in October 2011 when discussing circularity issues:
"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

Unless Mario Draghi unleashes in Europe QE to fight off the growing deflationary risks we have been tracking and warning about, we do not see a weakening of the Euro in 2014. Therefore we do not fully agree with Bank of America Merrill Lynch's recent take on the subject in their note entitled "Will the Euro stop defying gravity in 2014?" published on the 9th of January:

"Our case for a weaker Euro in 2014...
We argue that real economic indicators, inflation differentials, rate differentials, technicals and quant analysis, all point towards a weaker EURUSD in 2014. Indeed, we project EURUSD at 1.25 by the end of the year. Our analysis suggests that the strength of the Euro in 2013 was because of forces that are either losing steam, or will be absent in 2014, including: the Fed’s much more dovish monetary policy stance, the substantial adjustment from short Eurozone positions in FX and in European assets more broadly, and an improving current account balance in the Eurozone.
..and the case against us
The risks to our thesis for a weaker EUR in 2014 include: a slowing in US growth, a reduction in the inflation differential between the Eurozone and the US and an increase in the Euro share of global central bank reserves. We argue that these are low probability risks." - source Bank of America Merrill Lynch.

But, where we agree with Bank of America Merrill Lynch's take on the subject is no doubt on the importance of central bank policies, which are indeed the driving force behind many markets:
"In our view, one of the key forces supporting the Euro is relative monetary policies. Although both the Fed and the ECB loosened policies last year, the Fed remains much more accommodative. Indeed, the Fed has been reluctant to exit quantitative easing too early, while the ECB has been avoiding quantitative easing all along (see Global Rates & Currencies Year Ahead).
Relative central bank policies would actually justify an even stronger Euro. The strengthening of the EUR/USD during 2013 is consistent with the expansion of the Fed's balance sheet compared with that of the ECB (Chart 16).
Indeed, this correlation would be consistent with EUR/USD at 1.45. A comparison of the monetary policy stance between the Fed and the ECB based on a Taylor rule would justify a similarly strong EUR/USD (Chart 17).
We expect the ECB to continue being reactive rather than pre-emptive in 2014. We believe that the ECB will deviate from its current stance and loosen policies further only in risk scenarios, primarily linked to disinflation and deflation risks, such as:
-If liquidity conditions were to tighten further and for a larger number of banks in the wake of uncertainty generated by the bank asset quality review and the stress test that will follow. In this case, we expect the ECB to introduce a new LTRO, for more than a year and with fixed rate (possible within H1);
-If inflation was to stay below 1% for more than a quarter and 2015 projections were to decline towards 1%. We would then expect the ECB to cut by a small amount its refi and possibly its deposit rate (unlikely before Q2);
-If the euro zone was to show outright signs of deflation. Only in this case we would expect the ECB to move to asset purchases (most likely government bonds), a tail risk scenario in our view."

 After all, the "Growth divergence between US and Europe? It's the credit conditions stupid...", it is all about Stocks versus Flows. Yes, we ramble again in 2014:
"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

When it comes to depreciation of liabilities and deflationary forces, credit conditions in Europe have yet to improve, as bank credit to companies and households in the euro area has shrank for the 19th month in November even after the ECB rates cut in 2013 while euro inflation has been below the 2% target for the last 11 months.

We have argued that improving credit conditions and severing the link between banks and sovereigns would amount to "squaring the circle". European Banking Union or not, we do not see it happening. Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation which is what we are seeing in Europe and what a 0.8% inflation rate is telling you. It is still the "D" world (Deflation - Deleveraging). As illustrated by Bank of America Merrill Lynch's graph from their note from the 6th of January entitled "The mixed blessings of better markets", we have yet to see any meaningful loan growth in the euro area and with the upcoming AQR in 2014 with continued deleveraging, don't expect improvements anytime soon:

And when it comes to the deflationary trajectory and continued deleveraging pressure the evolution of nonperforming loans in peripheral countries are clearly indicate of ECB liabilities having to depreciate further. The graph below from the previously quoted Bank of America Merrill Lynch note clearly underlines the issues faced by the ECB, which cannot sustain both the demand for sovereign government bonds and credit availability for the private sector, something will have to give unless Mario Draghi comes up with new "unconventional" tricks in 2014:
"That largest pool of problem credit is in Spain, where there is as yet no sign of NPLs slowing up in Spain: the last three months saw a €12.2 billion rise in system NPLs, compared with €11.6bn in the prior quarter" - source Bank of America Merrill Lynch

In relation to government bonds holdings, as we posited in our last 2013 conversation, it is after all, all about the carry which remains attractive for peripheral banks which have been soaking up on their domestic bonds at a rapid pace for the last couple of years. Third time's a charm as well when it comes to the carry trade.

The European bond picture, some convergence as of late, with Italy and Spanish continuing to perform and providing carry and earnings to their respective financial institutions - graph source Bloomberg:

Some additional convergence as well can be seen credit wise in the evolution between the spread of the 5 year CDS index Itraxx Main Europe (Investment Grade risk gauge based on 125 European entities) and the 5 year Itraxx Financial Senior index which has been trending towards zero - graph source Bloomberg:

With so much "Greed" and no "Fear", risky assets have rallied hard at year end, particularly in December, as displayed in the rally seen in High Yield and the continuous rally in the S&P 500, but increasingly the performances for credit  investment grade is being capped  - graph source Bloomberg:
The correlation between the US, High Yield and equities (S&P 500) is back thanks to "yield hunting". US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG.

The surge in risky assets has been of course driven by the fall in volatility as a whole in various asset classes as displayed in the below Bloomberg graph although the recent announcement of "tapering" in December has led to a surge in 1 month Treasury options volatility as of late:
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.
EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market currencies. The index is based on three-month at-the-money forward options, weighted by market turnover.

Of course, credit has not been the shining star of 2013 as it was the shining star of 2012. In 2013 the S&P500 delivered its best return since 1997.

The rise of the S&P 500 a story of growing divergence between the S&P 500 and trailing PE since January 2012 - graph source Bloomberg:
Of course 2014 is already a continuation of 2013 in terms of multiple expansions when one looks at the recent announcement of FedEx which will issue $2 billion of bonds to speed up stock buybacks. While shareholders have been celebrating, bondholders have no doubt been licking their wounds given that FedEx’s  $500 million, 4.1 percent portion due April 2043 and issued last year traded Dec. 18 at 86.2 cents on the dollar to yield 5 percent, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority and as reported by Bloomberg. For Apple's long bond issued last year it is a similar story of bond losses.

The "Cantillon Effects" at play, the rise of the Fed's Balance sheet, the rise of the S&P 500, the rise of buybacks and of course the fall in the US labor participation rate (inversely plotted) - source Bloomberg:
In red: the Fed's balance sheet

In dark blue: the S&P 500
In light blue: S&P 500 buybacks
In purple: NYSE Margin debt
In green: inverse US labor participation rate.

As we posited in our conversation "Misstra Know-it-all":
"By suppressing interest rates through ZIRP, the Fed has allowed risks to be "mis-priced" leading to global aggressive "mis-allocation" of capital in the search for returns."

In terms of the "dash for trash", it can be illustrated we think by looking at the performance of Small-Cap, Utility Stocks versus the S&P 500 since December 2012 - graph source Bloomberg:

Or by looking at  the S&P500 index versus High, Low Quality Stocks since March 2009 - graph source Bloomberg:

Looking at the S&P 500 against Margin Debt at NYSE members firms and the estimated annual interest cost for margin debt at broker call rate, we wonder at what point this rally induced more and more by leverage players will come to an abrupt end - graph source Bloomberg:
After all it is the third time central bank induced asset bubble does indeed seem to be working like a charm as our title goes.

And looking at the success by the Fed in "bending" the velocity curve and curbing the fall in the labor participation rate, we wonder if playing the "wealth effect" via asset prices inflation is worth the risk being taken - graph source Bloomberg:
Back in July 1997, velocity peaked at 2.13 and so did the US labor participation rate at 67.3%. Now at 62.8% the US is back to 1981 and velocity is still cratering (1.54), even lower than in the 1960s.

What investors fail to assess is the growing global deflationary risk which, we agree with CLSA Strategist Russell Napier, is significant:
“Investors are cheering the direct impact of QE on their equity valuations, but ignoring its failure to produce sufficient nominal-GDP growth to reduce debt. In a market where such bad news has been seen as good news (as it leads to more QE), the reality of QE’s failure will become bad news as we head towards deflation ….. The failure of monetary policy to defeat deflation is about to become apparent, with dire consequences for equity prices”. - CLSA Strategist, Russell Napier

Just note that the ThomsonReuters/Jefferies Commodities Index is now back to where it was at the end of 2009 and 25% below its early peak in 2011. Of course Gold's 28% decline in 2013 has been the worse since 1981.

Of course one of the principal culprit in exporting deflation on a global scale, has no doubt been Japan, as we have posited back in 2013. For the first time since 1992, as reported by Bloomberg, prices in Japan's consumer durables are indicating somewhat a tentative escape from the deflationary forces which have been plaguing for decades Japan - graph source Bloomberg:
"Prices in Japan of consumer durables such as computers and mobile phones rose for the first time since 1992, signaling progress in the nation’s campaign to defeat deflation.
The CHART OF THE DAY shows a 0.3 percent gain in November from a year earlier, after a 21-year slide, boosted by price increases for desktop and notebook computers. The gauge has a weighting of about 7 percent in the overall consumer-price index, which rose 1.5 percent.
The increase came seven months after the Bank of Japan unveiled record monetary easing in pursuit of a 2 percent inflation target. The jump defies a trend of technological improvements leading to lower prices and shows manufacturers are moving away from aggressively competing on cost, according to economist Yoshiki Shinke.
“Inflation is spilling across a whole range of products,” said Shinke, chief economist at Dai-ichi Life Research Institute in Tokyo. “The weakening yen has contributed to higher prices for these products as Japan is importing many final goods given that production is shifting overseas.”
Declines in the Japanese currency, which fell last month to its lowest against the dollar since 2008, led companies such as Apple Inc. to raise prices last year of computers and smartphones. Increases of 24 percent and 12 percent for desktop and notebook computers, respectively, in the November consumer- durables data outweighed a 0.3 percent fall in auto prices.
The narrower household durables index, which includes refrigerators and washing machines, fell 0.9 percent. Technological advances for such appliances lag behind those for gadgets, holding back demand and price gains, according to Naoki Murakami, chief economist at Monex Inc. in Tokyo." - source Bloomberg.

On a final note, as we posited in our conversation from December 2013 "All that glitters ain't gold", we still believe the following:
"2014 will also see Europe still facing the pressure from two tectonic deflationary plaques, which have been the US QE but more importantly in 2013 the outpacing of the Fed led by "Abenomics" which is indeed sending a tremendous deflationary force around the world which means that even the US is not immune to, hence our repeated doubts in seeing a "tapering" in 2014." 

Therefore unless, the ECB starts another round of QE or some additional "unconventional" policies, with Japan exporting deflation on a global scale, and the recent lackluster US nonfarm payroll numbers, we have a hard time seeing a much lower EUR/USD for the time being.

"Faith consists in believing when it is beyond the power of reason to believe." - Voltaire

Stay tuned!


  1. Have you guys looked at the Baltic Dry - what do you think if anything that signals?

  2. The Baltic seems to be quite "volatile" but then again, there has indeed been an increase in Housing Starts and Furniture sales. The lack of rebound for the last couple of years has been the lack of price elasticity for the shipping industry as well as the glut in shipping capacity. Normally consumer demand drives Asia-originated containerized traffic and freight flows to Europe and North America. Any changes in consumer spending will directly affect global containerized traffic volumes. Have a look at our previous post entitled "The link between spending, housing, credit growth and shipping - a follow up" from the 10th of January 2013. Best, Martin


View My Stats