Tuesday, 22 July 2014

Credit - Perpetual Motion

"Oh ye seekers after perpetual motion, how many vain chimeras have you pursued? Go and take your place with the alchemists." - Leonardo da Vinci, 1494
Looking at the continuous new highs registered by the Dow Jones, we reminder ourselves of the quest of many scientists for perpetual motion when choosing this week's title:
"Perpetual motion is motion that continues indefinitely without any external source of energy. This is impossible in practice because of friction and other sources of energy loss. A perpetual motion machine is a hypothetical machine that can do work indefinitely without an energy source. This kind of machine is impossible, as it would violate the first or second law of thermodynamics." - source Wikipedia
Given that by now it is fairly evident that the Fed's balance sheet extension has had a significant impact on the performance in risky assets in general and the S&P 500 in particular as displayed in the below graph from Société Générale's recent report entitled "20 charts to understand the fragile equilibrium of US financial markets" published on the 15th of July, we wonder if indeed our "omnipotent" central bankers do not think they have indeed surpassed Leonardo da Vinci and invented "perpetual motion" in financial markets:
But we reminded ourselves of Adam Smith's quote in relation to real "price" formation:
"Labour was the first price, the original purchase - money that was paid for all things. It was not by gold or by silver, but by labour, that all wealth of the world was originally purchased."
Despite the fact that successful perpetual motion devices are impossible in terms of the laws of physics, the pursuit of perpetual motion remains popular particularly in the US central banking space we think.
So we decided to "ramble" around the definition of perpetual motion in financial markets and the lack of "labor participation" in the current on-going Fed induced rally when carefully choosing our title and came up with this:
"The Fed's perpetual motion machine of the first kind produces "income" without the input of "labor". It thus violates the first law of "thermo economics": the law of conservation of labor." - Macronomics
In fact the Fed's conundrum can be seen in the lag in wage growth given nominal wages are only up 2% yoy whereas real wage growth remains at zero. Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level.

If a country has 100% debt to GDP, it means that this country has roughly bought growth at a 2% rate for 50 years which is the case for France given the last time the books were balanced was 1974. 
In this week's conversation we will discuss around the risks of "hyper-deflation" happening as well as looking at the potential trajectory during the summer for US yields.
As we have argued in our conversation the "Molotov Cocktail":
When somebody has too much debt and cannot reimburse it, how do you bail him out? Obviously by restructuring his debts, which imply losses for his creditors.

But when one lends him more money in order for him to pay back what he owes, he is not bailing him out but rather pushing him in a bigger hole! The game until now has been to "print" more money and to add more debt on the shoulders on the indebted ones, to gain some time in the hope that growth will resume and reduce de facto the weight of the existing debt burden and the additional new debt issued to support the initial debt troubles.

This is a big misunderstanding of debt dynamics and its effects on the economy. When debt becomes too big, which it is now the case in many parts of Europe, the servicing drains all the available cash flows and reduces the growth potential."

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. We hate sounding like a broken record but: no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits and debt levels. 

What we are of course concern in this much vaunted "Perpetual Motion" infatuation in financial markets is that we are still sitting tightly in the deflationary camp. In fact we expected further yield compression on US Treasuries as discussed in our conversation "the Vortex Ring" back in May this year:
"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)." - Macronomics

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."
So seeing the 1st quarter US GDP print shocker at -2.9% made us wonder about the control effectiveness of the Fed. We can relate to some of the interesting points developed by Shelby Henry Moore III in his Bell Curve Economics long post
"In a vicious feedback spiral, as the GDP shrinks, the private sector income shrinks and needs more debt (or government subsidies) to pay the interest on prior debt, but the additional government debt spending destroys more of the useful production and capital of the private sector. The only way to make the marginal-utility-of-debt go positive, is to decrease the debt load back to a level where the private sector can produce more than its interest payments. At this terminal phase, both increasing or decreasing M (debt), shrink the GDP, i.e. hyper-deflation." - Shelby Henry Moore III.
Of course this is why extended QE in the US and the launch of QE in Europe would be highly destructive we think and could potentially lead to "hyper-deflation". 

When it comes to deflationary pressures we have been tracking the events in the shipping industry with great interest and in particular the numerous prices increases in the Drewry Hong-Kong-Los Angeles Container Rates - graph source Bloomberg:
"Drewry publishes its weekly Hong Kong-Los Angeles 40-foot container rate benchmark on Wednesday mornings EST. The benchmark provides insight into the price to ship a container across one of the busiest trading lanes and is therefore used as a proxy for the market. It fluctuates with changes in liner supply-and-demand dynamics and rate surcharges." - source Bloomberg
Another shipping indicator we have been following is of course the Baltic Dry Index as oversupply of vessels keeps hire costs below break-even levels. The index dropped 29.4% on average in 2Q from 1Q and  is 69.8% lower than the 10-year historical 2Q average, yet is 8.8% higher than 2Q13 levels. Panamax vessels declined 40.1% on average sequentially, and were down 19.6% yoy in 2Q.- graph source Bloomberg:
"The Baltic Dry Index, which tracks the costs of moving dry bulk freight via 23 seaborne shipping routes, has averaged 32.5% higher yoy this year through July 16. The index is a barometer of the health of the dry-bulk industry, as well as the broader global economy. It has declined roughly 34.5% yoy and down 66.4% from the recent December peak. The index should begin to rebound as seasonal trends, such as grain exports out of South America, take hold." - source Bloomberg
For us shipping is a leading deflationary indicator as we have argued in March 2012: 
"He who rejects restructuring is the architect of default." - Macronomics.
As we have argued in our conversation  in September 2012 "Zemblanity" (being "The inexorable discovery of what we don't want to know"):
"By keeping interest low to promote investment, like the Fed is currently doing, full employment would therefore be "attainable". For Keynes, the velocity of money would move together with the level of economic activity (and the interest rate)."
 As a reminder:
Our core thought process relating to credit and economic growth is solely based around the very important concept namely the accounting principles of "stocks" versus "flows":
"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."
Credit growth is a stock variable and domestic demand is a flow variable. We always asked ourselves the following when it came to the Fed's policies:
"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"
Back in our September 2012 conversation we came across this comment from a participant on a macro research forum from a prominent global research firm and we did find it very appropriate in relation to our past title analogy, namely "Zemblanity" and thought we had to share it at the time given we are at present discussing "Perpetual Motion" (which is impossible):
"Isn't QE3 in one sense a blow to the essence of America's prosperity, free markets and with that efficient capital allocation? Setting a target for unemployment rate by running the printing press sounds a lot like a planned economy. It might get us to the target (if not the drop in participation rate eventually will) but with that the economy risk be even more similar to Japan? Have we become so short sighted and spoiled that we can't face the hard facts of our previous reckless childish behavior? I can't think of any time in history when avoiding the truth ever was a sustainable choice. Only history will tell but FED, ECB, BOJ and BOE (soon BOC?) all being in the same boat makes you worried about unintended consequences.... I'm 100% long risk for the moment but long term I think this takes us further from a sustainable world."
And of course the credit "japonification" process has clearly been set in motion.
When it comes to our contrarian take on US yields since early January 2014 we argued the following in our conversation "Supervaluationism" back in May this year it comes from us agreeing with Antal Fekete's take from his paper "Bonds Defy Dire Forecasts but they are not defying logic":
"The behavior of the bond market has been consistent with Keynesianism. By his compassionate phrase “euthanasia of the rentier” Keynes meant the reduction of the rate of interest, to zero if need be, as part of the official monetary policy to deprive the coupon-clipping class of its “unearned” income. Perhaps it is not a waste of time to repeat my argument why, in following Keynes’ recipe, the Fed is acting contrary to purpose. While wanting to induce inflation, it induces deflation.
The main tenet of Keynesianism is that the government has the power to manipulate interest rates as it pleases, in order to keep unemployment in check. Keynes argued that the free market economy was unstable as it was open to the swings of irrational investor optimism or pessimism that would result in unpredictable and wild fluctuation of output, employment and prices. Wise politicians guided by brilliant economists − such as, first and foremost, himself  −  had to have the power “to prime the pump” (read: to pump up the money supply) as well as the power to “fine-tune” (read: to suppress) the rate of interest. They had to have these powers to induce the right amount of spending needed to put people to work, to entice entrepreneurs with ‘teaser interest rates’ to go ahead with projects they would otherwise hesitate to undertake. Above all, politicians had to have the power to unbalance the budget in order to be able to help themselves to unlimited funds to spend on public works, in case private enterprise still failed to come through with the money.
However, Keynes completely ignored the constraints of finance, including the elementary fact that ex nihilo nihil fit (nothing comes from nothing). In particular, he ignored the fact that there is obstruction to suppressing the rate of interest (namely, the rising of the bond price beyond all bounds) and, likewise, there is obstruction to suppressing the bond price (namely, the rising of the rate of interest beyond all bounds). Thus, then, while Keynes was hell-bent on impounding the “unearned” interest income of the “parasitic” rentiers with his left hand, he would inadvertently grant unprecedented capital gains to them in the form of exorbitant bond price with his right." - Antal Fekete

Capital gains in the form of exorbitant bond price? A game we have indeed played successfully given we have been learning a few tricks from our Keynesian magicians bankers as of late. We must confide we have indeed been playing this game and did in fact picked up some yield enticing junior financial subordinated bonds in late 2011 at a cash price of around 94.5, yielding around 14% at the time, to see the yield drop below 4%  these days and the cash price of our position rising by nearly 50% thanks to the generosity of our great "magicians" and given our observation of "Perpetual Motion" machine we decided at the time to buy this French Perpetual issue. We also suffered minimal volatility in the process as illustrated in the below Bloomberg graph:
Of course the main culprit behind our outsized gain is ZIRP (zero interest rate policy) given it has the effect of destroying capital. As the rate of interest is halved, the price of a long term bond is doubled.

Exorbitant government bond prices? The Core European bond market picture making new record lows such as the German bund 10 year yield at 1.14% and the French OAT 10 year at 1.56%, at the lowest level since 1746 - source Bloomberg:
"The continuing fall of interest rates in the 21st century, in the face of an unprecedented amount of Federal Reserve credit being created through bond purchases, is far from being illogical. Nor is the continuing bull market in bonds, now a third of a century old, is a conundrum to those of us who are not infected by the bug of Keynesianism. It is fully explained by the incentive to earn risk-free profits on a continuing basis, unconditionally offered to bond speculators by the policy of open market operations." - Antal Fekete, "Bonds Defy Dire Forecasts but they are not defying logic": 
In Europe of course, courtesy of our "Generous Gambler" aka Mario Draghi, ECB's president "whatever it takes" moment in July 2012 has indeed triggered the incentive to earn risk-free profits based on continuing "implicit" guarantees, a subject we discussed in our previous conversation last week.
Our dexterous "Generous Gamblerhas indeed been highly successful in propelling Spanish bonds gains above Germany. But what our "Generous Gambler" ignores is that generally hyper-deflation can lead to a deflationary spiral in which a deflationary environment leads to lower production, lower wages and demand, and thus lower price levels, which is continuing in Europe as far as we can see from the latest economic data releases.
Moving back to the important notion of the difference between stocks and flows we do agree with Antal Fekete's take in May 2010 in his article "Hyperinflation or Hyperdeflation" being akin to a Black Hole and the possibility of capital being destroyed thanks to ZIRP (as it is mis-allocated towards speculative endeavors) hence the risk of pushing to far the "Perpetual Motion" experience:
"Obviously, you need a theory to explain what is happening other than the QTM. I have offered such a theory. I have called it the Black Hole of Zero Interest. When the Federal Reserve (the Fed) is pushing the rate of interest down to zero (insofar as it needs pushing), wholesale destruction of capital is taking place unobtrusively but none the less effectively. Deflation is the measure of wealth in the process of self-destruction -- wealth gone for good. The Fed is pouring oil on the fire as it is trying to push long-term rates down after it has succeeded in pushing short term rates to zero. It merely makes more wealth self-destruct, and it makes the pull of the Black Hole irresistible.
But why is it that the inordinate money creation by the Fed is having no lasting effect on prices? It is because the Fed can create all the money it wants, but it cannot command it to flow uphill. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day. Their bets are on the house: if they lose, the losses will be picked up by the public purse. But why does the Fed under-write the losses of the bond speculators? What we see is a gigantic Ponzi scheme. The Treasury issues the bonds by the trillions, and promises huge risk-free profits to the bond speculators in order to induce them to buy. Most speculators believe that the Treasury is not bluffing and they buy. Some may believe that the Fed is falsecarding doubts and they sell. But every time they do they only see foregone profits. What we have here is a rare symbiotic relation between the government and the speculators." - Antal Fekete

Of course, what the ECB has done as well is tame the speculators and prevented so far a deeper adjustment in the European banking space leading to an outperformance of financial bonds versus equities. But, as we pointed out last week, the continuous need to raise capital for the European banking sector is facing more margin calls, meaning more need to raise capital and the need for more sovereign supports to avoid a depreciation of the liabilities. This infernal "Perpetual Motion" is no doubt delaying a very painful adjustment which could lead the European sector to produce more than what is need just to make the interest payments of the ever rising debt burden!

Therefore it appears to us that deflationary environment in Europe is continuing leading to lower production, lower wages and lower demand, and thus lower price levels.

Moving on the trajectory of US yields during this summer lull, we agree to a certain extent with Nomura's recent take on US treasuries in their note from the 18th of July entitled "Bonds over-reacting or forward looking?":
"Summers aren't the time to burn carry and be short duration - wait for the Fall
We started out the year with a strategic call for lower rates and that has largely run its course. However, we have constantly said that investors should not expect a v-shape rise in rates just because the rally in duration wasn't expected. We have been slowly shifting our trading profile, and for now we have a tactical play on this bond rally to carve out a low this summer versus it just having a one-touch feel to it, where most have been hoping the May dip of 2.4% on 10s, for a brief second, was the low for year; we don't.
As seen in Figure 1, the market participants have been fighting the urge of getting dragged into the air pocket created last year post taper was let out of the bag. However, the path of least resistance and our call until the September FOMC (where there is a risk for more hawkish news around exits and growth/rate expectations) is for 10s to go towards 2.35% and 30s towards 3.10% during the balance of the summer. 
August traditionally is a seasonally strong bond rallying month, and Q2 data excitement can burn out soon (where we are watching if next week's CPI flares out and if at the end of the month wage inflation take off or not). Meanwhile, although investors are not as short, mentally most investors want higher rates and there are some groups underinvested.
Lastly as we mention in our mid-year update, once rates start to normalize, given the lower fixed income supply projections in the second half, bond markets will be supported even as Fed exits, in our view. In Figure 2 we highlight that the Fed has obviously been the biggest buyer during QE; however, in the past other investors would come in and fill the void. 
Recently there has been a focus on China buying USTs and how that was probably another force driving rates lower. However, bank buying in the US has been just as equal of a force while Japan hasn‟t been buying as strongly lately. So that can all change if yields back up and actors like GPIF allocate abroad." - source Nomura

On a final note and as we posited at the beginning of our conversation unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively. As reported by Anna-Louise Jackson and Anthony Feld in their Bloomberg article from the 22nd of July entitled "Higher Wages Signaled by More U.S. Employees Quitting", the jury is indeed still out there when it comes to confirming the "escape velocity" of the US economy:
"More than 2.5 million U.S. workers resigned in May, a 15 percent increase from a year earlier, based on seasonally adjusted data from the Labor Department. These employees represent about 56 percent of total separations, the highest since November.
Such departures serve as a proxy for consumer confidence because people are more likely to quit when they have a new position secured or are convinced that another is readily available, said Nicholas Colas, chief market strategist at ConvergEx Group, an institutional equity-trading broker in New York. The most-recent quits data were “very positive,” which suggests sentiment finally has turned a corner, he said. The report is one that Federal Reserve Chair Janet Yellen has said she uses to judge the strength of the labor market.
The share of Americans who say business conditions are “good” minus the share who say they are “bad” turned positive in June for the first time since January 2008: 0.2 percentage points, up from minus 3.5 points in May, based on data from the Conference Board, a New York research group.
Feeling Emboldened 

“Consumer confidence has been the last piece to come back in this recovery,” Colas said. This suggests wages also could go up because as employees feel more emboldened to switch seats, their bosses may be willing to offer higher compensation in an effort to prevent such turnover, he said.
People working in the private sector could see stronger salary gains ahead, according to Bloomberg BNA’s Wage Trend Indicator, designed to predict and interpret compensation trends. This forward-looking index rose to 99.12 in the second quarter from 98.92 in the first, marking the third consecutive increase and highest level since March 2009.
Pay for these employees could increase more than 2 percent by year-end, according to Kathryn Kobe, an economist at Economic Consulting Services LLC in Washington, who helped develop and maintains the indicator. Wages rose 1.7 percent in the three months ended March 31, near a post-recession low of 1.3 percent,data from the Labor Department show." - source Bloomberg

What of course could derail this very "fragile" recovery is a renewed jump in gasoline prices. The latest US core CPI climbed 1.9 percent from June 2013, after a 2 percent increase in the prior 12-month period. Gasoline costs jumped 3.3 percent, their biggest gain since June 2013, accounting for two-thirds of the increase in total prices, today’s report showed, something to watch closely we think.

"I can calculate the motion of heavenly bodies, but not the madness of people." - Isaac Newton

Stay tuned!

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