Monday, 26 May 2014

Credit - The Vortex Ring

"When a system is in turbulence, the turbulence is not just out there in the environment, but is a part of the organization or organism that you are looking at." - Kevin Kelly

While looking at the burst of turbulences last week in the credit and government bond high beta space, in conjunction with the expected results coming out of the European elections and given our fondness for "flying" analogies which we abundantly used in our conversation "The Coffin Corner", in this "Tapering" environment we reminded ourselves of the Vortex Ring when it came to choosing our post title. The famous Vortex Ring also known as the "Helicopter Stall" can happen easily under certain specific conditions particularly when approaching landing, as illustrated more recently in the movie Bravo Two Zero when the Special Operations 160th SOAR helicopter came crashing down in Abbottabad during Operation Neptune Spear after experiencing the infamous vortex ring state.

You are probably already asking yourselves where we are going with this analogy already but, given Ben Bernanke's various QE programs have been compared to "helicopter money", we thought a reference to a "helicopter stall" given the Fed's tapering stance would be more than appropriate for this week's chosen title. 

Therefore in this week's conversation we will review various states of central banks at play, between the Fed, Japan and the much expected ECB move in June.

In a "helicopter stall" or vortex ring state, the helicopter descends into its own downwash. Under such conditions, the helicopter can fall at an extremely high rate (deflationary bust). 

For such structural failure or crash to occur you need the following three factors to be present as indicated by Helen Krasner in her article entitled "Vortex Ring: The 'Helicopter Stall'":
"To get into vortex ring, three factors must all be present:
  • There must be little or no airspeed.
  • There must be a rate of descent.
  • There must be power applied.
Note that all three of these must be going on at the same time."

  • There must be little or no airspeed.
In our conversation"The Coffin Corner" we indicated the following:
"We found most interesting that the "Coffin Corner" is also known as the "Q Corner" given that in our post "The Night of The Yield Hunter" we argued that what the great Irving Fisher told us in his book "The money illusion" was that what mattered most was the velocity of money as per the equation MV=PQ. Velocity is the real sign that your real economy is alive and well. While "Q" is the designation for dynamic pressure in our aeronautic analogy, Q in the equation is real GDP and seeing the US GDP print at 2.5% instead of 3%, we wonder if the central banks current angle of "attack" is not leading to a significant reduction in "economic" stability, as well as a decrease in control effectiveness as indicated by the lack of output from the credit transmission mechanism to the real economy."
With the latest reading from the US GDP coming at 0.1% for the 1st quarter indicates for us little or no "airspeed" for the US economy and the aforementioned "economic" stability we mused on last year.

For Europe the latest inflation readings indicates little or no "airspeed" on top of the very weak economic growth reading making it paramount for the ECB to act sooner rather than later in order to avoid the Vortex Ring state.
  • There must be a rate of descent.
Tightening policies to preserve price stability and unwind some of the trillions of dollars pumped into global economies since 2007 via "helicopter"easing will require interest rate hikes, and will also necessitate asset sales by central banks, according to April's IMF Stability Report. The tapering stance of the Fed does include indeed a rate of descent of $10 billion a month.

Of course another rate of descent which we have been following has indeed been US Velocity. What we have found most interesting is the "relationship" between US Velocity M2 index and US labor participation rate over the years. Back in July 1997, velocity peaked at 2.13 and so did the US labor participation rate at 67.3% - Graph source Bloomberg:
It has been downhill from 1997 with velocity falling linked to factor number three of the "vortex ring" namely "There must be power applied" (ZIRP in conjunction with the various iterations of QE).

Yet, the recent fall in unemployment has been masking the Fed's progress in avoiding the dreaded Vortex Ring as seen in the lack of breakout in the employment population ratio. The Fed has not been able yet to reach "escape velocity" from this vortex ring as displayed in the Bloomberg graph below indicative of the conundrum:

The lack of "recovery" of the US economy has indeed been reflected in bond prices, which have had so far in 2014 in conjunction with gold posted the biggest returns and upset therefore most strategists' views of rising rates for 2014 (excluding us given we have been contrarian). Those who read between our lines have done well so far in 2014 given we hinted  a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed":
"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. Buy put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

  • There must be power applied.
When it comes to applying power, like many pundits, we have been baffled by the action in US Treasury bond buying from Belgium which increased its holdings in US debt by $201 billion in five months to $381 billion at the end of March this year, making it the third largest holder after China and Japan - graph source Bloomberg:
Helicopter pilot students, have a tendency to slow down, if they are afraid of overshooting their landing point, which can put the helicopter they are flying in a vortex ring state. In similar fashion, central bankers have a tendency to slow down if they are afraid of overshooting. 

It is not only the Fed and its central bankers which have a tendency to overshoot, likewise, Governor Haruhiko Kuroda in Japan has failed to convince he had done enough to spur 2% inflation and that his policies will be enough to pull Japan out of 15 years of deflation, risking in effect another Vortex Ring state for the Japanese markets as displayed by the below graph plotting the performance of the Nikkei index, the USD/JPY currency pair and the inverse Itraxx Japan indicative of credit risk for corporate Japan:

If one looks at unemployment levels and inflation levels for a gauge of the respective situation of various central banks it seems that, while Japan has achieved full employment, it has failed for many years to spur inflation, while the US as well as the United Kingdom, have achieved to reduce their unemployment levels, Europe is still closer to the Vortex Ring State (deflationary bust) given it boasts very low inflation levels compared to the other G4 and record unemployment level, as displayed in this Barclays graph from their recent Market Strategy note entitled "Japan at the end of the post VAT hike tunnel" from the 26th of May:
"Monetary policy: Potential growth & expected inflation, quantity & quality
Opinion regarding deflation in Japan has long been divided between those who believe the problem cannot be solved by monetary policy alone, ie, potential growth is tied with inflation expectations, and those arguing conversely that inflation is a pure monetary phenomenon that can be controlled by monetary policy independently of potential growth. For some reason, the latter group appears to overlap almost completely with those claiming that the degree of monetary easing can be measured unambiguously via the monetary base (monetarists). We agree with the second group that deflation can be overcome by monetary policy without a change in potential growth, and believe that this is in fact occurring at present. However, we think that the driving force behind the BoJ’s present Quantitative and Qualitative Easing (QQE) is not the quantitative but the qualitative side.
Japanese market participants tend to subscribe to the former view. This may reflect a general feeling based on experience rather than the result of academic study. The nation has failed to quash deflation despite 15 years of sundry monetary easing measures, which may have convinced many that inflation expectations are being affected by factors that cannot be controlled by monetary policy, such as a decline in potential growth (including demographic trends). For those holding to this argument, the opposing view sounds like a vacuous theory ignoring a decade and a half of actual events. In particular, since the majority of those supporting the second view are “reflationists”, who believe monetary policy should give greatest weight to quantity, the two sides basically find themselves talking at cross purposes.

Those taking the former view, which is the market consensus, feel that events in 2001-06 proved that the size itself of the BoJ’s balance sheet has no impact. They claim therefore that if the QQE focuses solely on increasing this volume, it cannot achieve a change in inflation expectations. However, we think instead that the important point is the quality of the bank’s balance sheet; ie, the volume of risk in the bank’s acquired assets. We believe the effectiveness of the monetary easing by the Fed and BOE after the Lehman shock and the rapid turnaround in the Japanese economy after the launch of the BoJ’s QQE stemmed from their purchases of long government bonds and risk assets, pushing supply/demand above levels (in other words, pushing yields below levels) that the economic fundamentals would indicate as fair. The general social principle that economic policy should not intervene in the free market, which prior to the Lehman shock also applied tacitly to monetary policy and financial markets, prevented the BoJ from turning to asset purchases in JGB markets even in deflation-racked Japan. The serious crisis brought about by the Lehman collapse led to market intervention by countries worldwide and a shared belief that the ideology itself needed to change. With the success of this monetary policy approach in the US and UK, the BoJ also shifted its focus from quantity to quality, carrying out a market intervention of unprecedented scale with the QQE.
That is, QQE is a new monetary easing stance that had not been tried in over 15 years of deflation. Still, the markets perceived this to be little more than an extension of previous policy and assumed from past experience that it would have no effect on inflation expectations. A good number of market participants still dismiss the claim by BoJ Governor Haruhiko Kuroda and other BoJ executives that the bank’s 2% price stability target is achievable. Some likely hold the view that the BoJ itself is simply maintaining the 2% target in the hope of raising inflation expectations in the market.
In contrast, we think the bank is conducting an easing policy with entirely different effects than its earlier efforts, and we do not believe its past inability to beat deflation means that it will be unsuccessful this time as well. Furthermore, we suspect that the BoJ itself likely shares this view. Its confidence in the price stability target may well have deepened in light of ongoing developments in the Japanese economy. The statement from last week’s Monetary Policy Meeting noted anew that “QQE has been exerting its intended effects”. As we have explained, we see this not as calculated optimism designed to perk up the Japanese public but as a straightforward reflection of the bank’s actual belief at this time. As long as the bank maintains this stance, we think it is unlikely to alter its monetary policy. At the same time, we believe it will be relatively flexible in adjusting its current policy in the event of any upward or downward risk to the economy." - source Barclays.

When it comes to the US and the United Kingdom, it is interesting to note the very strong correlation between 10 year bond yields throughout the years as displayed in the below graph from Bloomberg comparing yields for UK gilts and US treasuries since March 1994:

And on a shorter time frame since 2011, UK 10 year yields versus US 10 year yields - graph source Bloomberg:
The question on everyone lips is of course who will blink first (raise rates that is), the Bank of England or the US Fed? One thing we are certain of, not anytime soon.

So in relation to the veiled question from our title and from Barclays take, the big question is of course can the "Vortex Ring" (aka deflationary bust) can be avoided by monetary policy alone?

We are still sitting tightly in the deflationary camp and expect further yield compression on US Treasuries. As such, we agree with the Wall Street Rant Blog on that subject:
"Many Government Bonds Yielding Less Than United States
I can't listen to a talking head, bond manager, strategist or seemingly anyone without hearing about how "Rates can only go higher from here". When in reality THEY CAN go lower! In fact, when you look around the world, on a relative basis, THEY SHOULD!" - source Wall Street Rant Blog

Indeed they should. To add ammunition to this, one should closely watch Japan's GPIF (Government Pension Investment Fund) and its $1.26 trillion firepower, in particular its upcoming reforms and asset shift scenarios as reported by Nomura in their recent report from the 23rd of May:
"The yen bond market remains range-bound as market participants’ interest in Abenomics and expectations of additional BOJ action fall. The consensus view is that the USD/JPY outlook is dependent on the US economy and yields. However, it is increasingly likely that the government’s June growth strategy will exceed market expectations, which have dropped markedly. We are focused on the likely scenario that the GPIF and other public pensions will start shifting from a yen bond bias in the near future. In our upside scenario, these reforms would lead to approximately JPY20trn in foreign securities investment in the next 12-18 months, potentially weakening JPY by about 10%." - source Nomura

Here are the two potential "re-allocation" scenarios according to Nomura's paper:
"As of end-
December 2013, the GPIF had JPY128.6trn ($1.3trn) in managed assets. Of 
the three associations, KKR had JPY7.8trn ($78bn), Chikyoren had JPY17.5trn ($175bn) 
and Shigaku Kyosai had JPY3.6trn ($36bn, all as of end-March 2013). Total managed 
assets for the four pension funds amount to almost JPY160trn ($1.6trn). The GPIF has 
attracted the most attention because of the sheer scale of its assets, but the three 
associations manage about JPY30trn or $300bn in assets.

The GPIF‟s weighting of Japanese bonds had fallen to 55% as of end-December 2013. It was reported that after the Industrial Competitiveness Council‟s follow-up section meeting on 8 April, the GPIF‟s head office explained that this weighting had dropped to 53.4% on the withdrawal of pension benefits. Thus the weighting of Japanese bonds is already below 55% and could be nearing the 52% floor of the allowable deviation. At the same time, the weighting of Japanese equities stood at 17.2% at end-December 2013, close to the maximum allowable deviation of 18%. Foreign bonds. weighting was 10.6%, close to the standard median value of 11.0%. At 15.2%, foreign equity's weighting is still some way from the maximum deviation (17.0%). Trends in the weightings of Japanese bonds and Japanese equities suggest that, as described in the FY14 investment plan, the GPIF has already been investing flexibly within the permissible range of deviation, and it may be investing such that the respective weightings do not approach the median value. As the strong equities/weak JPY trend has continued since end-2012 and the fund has changed its basic portfolio in June 2013, the GPIF.s portfolio is already shifting gradually from domestic bonds to risk assets.

Asset shift scenarios based on the new basic portfolio
We look at simulations for fund shifts following changes in the basic portfolios of the GPIF and the three public pension funds, in line with two scenarios, based on their current portfolios as described above. In Scenario (1), the four funds lower the weighting of Japanese bonds to 40% and allocate 8% of the money thus freed up to Japanese equity (from 12% to 20%) and 6% each to foreign bonds (11% to 17%) and foreign equity (12% to 18%), as Panel Chairman Takatoshi Ito recommended. Scenario (2) assumes more moderate changes, with the Japanese bond weighting lowered 10% to 50%, the Japanese equity weighting raised 4% (12% to 16%) and the foreign bond and foreign equity weightings raised 3% each (from 11% to 14% and from 12% to 15%). As we expect a compromise between the stance of President Mitani, who is cautious about portfolio changes, and Mr. Ito, who is more aggressive, a reduction in the Japanese bond weighting to about 50% is close to our main scenario for now. If the aggressive scenario (1) advocated by Mr Ito is realized, the GPIF.s balance of Japanese bond holdings would drop by about JPY19.6trn ($196bn), from JPY71.0trn ($710bn) at end-2013 to JPY51.4trn ($514bn). This JPY19.6trn decrease would translate into a JPY3.6trn ($36bn) increase in Japanese equity, a JPY8.3trn ($83bn) rise in foreign bonds and a JPY3.6trn ($36bn) increase in foreign equity. This scenario assumes that the weighting of short-term assets would recover to 5% of the basic portfolio, with short-term assets rising by JPY4.1trn ($41bn). Assuming that the ratio of short-term assets is fixed at the 1.8% level of end-2013 and that money is allocated to risk assets, the increase in respective assets would expand accordingly. When including the three public pension funds, the decrease in the Japanese bond balance would balloon to JPY26.8trn ($268bn), and the funds could allocate JPY5.8trn ($58bn) to Japanese equity, JPY10.8trn ($108bn) to foreign bonds and JPY6.0trn ($60bn) to foreign equity.

In Scenario (2), the GPIF.s and three public pension funds. balance of Japanese bond holdings would decrease about JPY11.1trn ($111bn). The GPIF.s Japanese equity weighting has already increased to 17.2%, so if we assume that it returns to the median after the basic portfolio change (16%), the balance of Japanese equity would fall about JPY0.5trn ($5bn). At the same time, the balance of foreign bonds would rise by JPY6.1trn ($61bn) and the balance of foreign equity would increase about JPY1.2trn ($12bn).

The above figures are rough estimates that do not take valuation gains or losses into account. Amounts may also differ considerably depending on fluctuations in short-term assets and investments within the permissible range of deviation. As noted above, our main scenario at this point expects changes in the basic portfolio to be around the scale of Scenario (2) in the near term. However, in what we can Scenario (2)-2, we assume that Japanese bonds account for 50% of the basic portfolio, the permissible range of deviation expands to }10“, the ratio of risk assets is kept higher than the median value to avoid a sharp drop in Japanese bonds as a result of a sharp acceleration in the inflation rate, and the weighting of short-term assets is kept at about 2% (permissible range of deviation from median value set at -10% for Japanese bonds, +5% for Japanese equity, +4% for foreign bonds, 4% for foreign equity and -3% for short-term assets). In this case, similar to Scenario (1) the balance of Japanese bonds held by the GPIF and the three public pension funds would decrease by JPY26.8trn ($268bn), the balance of Japanese equity would increase JPY7.4trn ($74bn), the balance of foreign bonds would rise JPY12.4trn ($124bn) and the balance of foreign equity would increase JPY7.5trn ($75bn). At first glance, Scenario (2) looks like a conservative change, but depending on the actual stance on investments after the basic portfolio is changed, the asset mix could be significantly changed as envisioned by Mr. Ito." - source Nomura

No wonder peripheral bonds in Europe have been benefiting from Japan's appetite as displayed by Bloomberg's recent Chart of the Day entitled "Euro-Area Periphery Hooked on BOJ stimulus":
"The CHART OF THE DAY shows Europe’s peripheral bond rally stalled this month as the yen strengthened versus the euro. Last week the Bank of Japan refrained from adding to the 60 trillion yen ($589 billion) to 70 trillion yen poured into the monetary base each year that has encouraged Japanese investors to put money into higher-yielding European assets.
“Peripheral yield spreads appear vulnerable to a correction following the strong rally and the yen tends to often strengthen on credit risk,” said Anezka Christovova, a foreign- exchange strategist at Credit Suisse Group AG in London.
“Japanese portfolio flows usually have an impact. Those flows could now divert elsewhere. We don’t expect any substantial action from the Bank of Japan in coming months and that could also lead the yen to strengthen.”
Japanese investors bought a net 1.41 trillion yen of long-term foreign debt in the week ended May 16, the most since Aug. 9, data from the finance ministry in Tokyo showed on May 22.
Flows into Europe may be tempered as yields in Europe’s periphery climb. The average yield spread of 10-year Portuguese, Greek, Spanish and Italian bonds over German bunds has risen 20 basis points this month to 270 basis points, after touching 239 basis points on May 8, the lowest since May 2010, based on closing prices.
New York-based BlackRock Inc., the world’s biggest money manager, said on May 8 it had cut its holdings of Portuguese debt, while Bluebay Asset Management said on May 9 it had seen the majority of spread tightening it was looking for.
Trading euro-yen based on movements in the bond-yield spreads of the euro area’s peripheral nations would have been a successful strategy, Credit Suisse strategists, including Christovova, wrote in a May 21 note." - source Bloomberg.

It is worth noting Japanese have bought a record $86 billion of US treasuries in the last 12 months according to Bloomberg data. It is important to note as well that for the Japanese investors, adjusted for living expenses, US treasuries still yield more this year than Japanese government debt than at any time since 1998,  as per monthly data compiled by Bloomberg showed recently. So if the GPIF starts deploying its "allocation firepower" in June, maybe you ought to cling to your US treasuries a little bit longer, and maybe after all the Belgian central bank is just a very "astute" investor after all...

One thing for sure our "Generous Gambler" aka Mario Draghi has shown he is truly a magician when it comes to driving market expectations and given all of the above, maybe just a few tricks such as a rate cut and negative deposit rates will do the trick nicely to provide continued support for European government bond markets. Eurozone-residents' demand for foreign assets could be further extended and exacerbated if the ECB were to try introducing negative rates on deposits rather than the proverbial QE bazooka unless of course he goes for the €1 trillion option. The current account excesses which so far have been supportive of a strong euro versus the dollar have been the result of Eurozone residents wish of increasing savings as security against an uncertain future. The willingness of Eurozone residents to accept net receipts of foreign-currency assets  has weighted on the value of the euro in recent years and has forced the current account into surplus. Given that surplus it seemed unlikely for us until recently that the euro would fall much against other currencies unless credible fears of currency break-up re-emerge. Of course the latest European elections results could has well re-ignite fears in the coming months and allow for Mario Draghi to enjoy a depreciation of the euro without having to resort to the proverbial QE bazooka in conjunction with the help from the Japanese pension funds allocation.

In recent months, thanks to the US Fed tapering, the 1 year/1 year forwards for the US dollar and the Euro have significantly diverged as displayed in the below Bloomberg chart:
Mario Draghi is definitely the greatest central bank magician and probably an astute student of Sun Tzu and the Art of War we think:
"The best victory is when the opponent surrenders of its own accord before there are any actual hostilities... It is best to win without fighting." - Sun Tzu

It is as well probably worth taking Sun Tzu's wise quote in anticipation of the next ECB meeting:
"All warfare is based on deception. Hence, when we are able to attack, we must seem unable; when using our forces, we must appear inactive; when we are near, we must make the enemy believe we are far away; when far away, we must make him believe we are near."

On a final note, when it comes to avoiding the dreaded helicopter stall aka the Vortex Ring,  as per Helen Krasner in her article entitled "Vortex Ring: The 'Helicopter Stall'" it is supposed very easy. It wasn't for the ace helicopter pilots of the 160th SOAR during Operation Neptune Spear, There is "no easy day", same goes with QEs:
"It is actually very easy to get out of vortex ring… at least in the incipient stage when the juddering and yawing starts. Some say it is impossible to get out of the fully developed state, but when you start to perceive signs of vortex ring, all you need to do is remove one of the three factors noted above. So, you push the cyclic forward to increase airspeed, or lower the collective to reduce power.  It is not possible to reduce the rate of descent to stop vortex ring, as that would involve increasing power.  In practice, pilots usually increase the airspeed, as unless the helicopter is very high, you don’t want to lower the collective and risk hitting the ground!" - source Helen Krasner - Decoded Science - January 8, 2013.

Unfortunately, getting out of vortex QE ring won't be that easy rest assured, particularly given we have not been in the incipient stage given Japan, the Fed and the Bank of England have all been repeated "QE offenders", but we ramble again...

"Well, I think we tried very hard not to be overconfident, because when you get overconfident, that's when something snaps up and bites you." - Neil Armstrong

Stay tuned!

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