Friday 31 October 2014

Credit - Pascal's Wager

"One person with a belief is equal to ninety-nine who have only interests." - John Stuart Mill

Watching with interest the results of the ECB's AQR (Asset Quality Review), we reminded ourselves of our July 2012 title "No test, no stress, no stress no test..." given the lack of deflationary scenario in the ECB's assessment. We also followed the minutes of the FOMC from the Fed in conjunction with the end of QE in the US while Japan launched another huge round of QE, which will no doubt export somewhat a "deflationary impulse" to the rest of the world in the process rest assured.

When it came to choosing this week's title, we decided to veer towards philosophy this time around with the end of QE in the US (which we think is temporary) and with the Bank of Japan adding 80 trillion yen ($720 billion) of QE (given core inflation dropped to 1% from 1.1% in October). Once again central bankers are challenging investors' belief in their "omnipotence" which we touched in our conversation the "Omnipotence Paradox" in November 2012 where we discussed central bankers and the market's perception of their "omnipotence" in sustaining asset price levels.

In fact, in our conversation "Perpetual Motion" we mused around the notion of "perpetual motion" and its physical impossibility. As far as deities and omnipotence go:
"1. A deity is able to do absolutely anything, even the logically impossible, i.e., pure agency.
2. A deity is able to do anything that it chooses to do.
3. A deity is able to do anything that is in accord with its own nature (thus, for instance, if it is a logical consequence of a deity's nature that what it speaks is truth, then it is not able to lie).
4. Hold that it is part of a deity's nature to be consistent and that it would be inconsistent for said deity to go against its own laws unless there was a reason to do so.
5. A deity is able to do anything that corresponds with its omniscience and therefore with its worldplan." - source Wikipedia.

So you might be already wondering why we chose Pascal's Wager as our title in this week's conversation. 

Pascal's wager was devised by 17th century French philosopher, mathematician and physicist Blaise Pascal (1623-1662). It posits that humans all bet with their lives either that God exists or not. In the investment world, we think investors are betting with their "life savings" that central bankers are either gods or not. 

Pascals Wager is of great importance and was groundbreaking at the time because it charted new territory in probability theory, making the first use of decision theory.

Pascal's Wager in the form of a decision matrix:
"Given these values, the option of living as if God exists (B) dominates the option of living as if God does not exist (~B), as long as one assumes a positive probability that God exists. In other words, the expected value gained by choosing B is greater than or equal to that of choosing ~B.
In fact, according to decision theory, the only value that matters in the above matrix is the +∞ (infinitely positive). Any matrix of the following type (where f1, f2, and f3 are all finite positive or negative numbers) results in (B) as being the only rational decision" - source Wikipedia

In similar fashion since 2009 investors have followed somewhat a similar decision matrix which we have tweaked for further explanation relating to our current choice as a title:

Therefore the only "rational" explanation coming from the impressive surge in stock prices courtesy of QEs and monetary base expansion has been to choose (B), belief that indeed, our central bankers are "Gods". 

Central bankers' omnipotence and balance sheet expansion:
- source Bank of America Merrill Lynch

Rest assured that at some point in time "belief" that "Central Bankers are not Gods" will ensure finite loss and in the end it might be the pagans who could have the final laugh in their "belief" in gold, this "relic of barbarism" to paraphrase Charles M Howell author of the book "Civilized Money "(1895) but that's another story...

In the meantime, the "barbaric relic" has indeed taken the proverbial spanking as illustrated by the sell-off in the ETF GDX - 1 year graph source Bloomberg:

ETF GDX from 31st of October 2007 until 31st of October 2014 - graph source Bloomberg:

In this week's conversation we will again focus our attention on central banks and the impact of their diverging monetary policies as well as the implications.

When it comes to stock prices, QEs, as displayed by a chart from Bank of America Merrill Lynch Thundering Word note entitled "The QE is Dead, Long Live the E!" from the 30th of October 2014 have been great propellers in conjunction with US corporate earnings:
"QE ends with deflation fear not inflation
As has been well-documented here and elsewhere, the Fed's QE has been the key driver of higher financial asset prices in the past 5-6 years (Chart 3). A recent US Treasury paper calculated that between Jan'09 and Apr'13 the S&P500 index rose 570 points in the weeks the Fed bought $5bn or more securities, 141 points in the weeks it bought up to $5bn, and fell 51 points in the weeks the Fed sold securities.
But the end of QE is coinciding with historically low levels of government bond yields and collapsing inflation expectations, rather than a surge in global growth. 10-year US Treasury yields are 50bps lower today than at the start of QE1, French 10-year yields are the lowest they have been in over 250 years (Chart 4),
and economists are cutting inflation forecasts rather than raising growth targets. All of this is great fodder for the Liquidity Bears who see QE as a failure, secular stagnation everywhere and warn of great, imminent bear markets in both credit and equities. For the bears the recent bout of volatility was merely a warning shot, in coming months will reveal unambiguous evidence that QE has failed to eradicate deflation and a loss of credibility in central bank policy will send asset prices into a tailspin in early 2015. "
- source Bank of America Merrill Lynch

For those who have listened to our musings from our last conversation, they should have applied the Pascal's Wager and its decision matrix to Japan. The recent big move by both the GPIF and the Bank of Japan have indeed been handsomely rewarding those short JPY (like ourselves) and long Nikkei FX hedged as indicated by the latest move in both the Japanese Yen and the Nikkei index:
"Given the Nikkei index is particularly more sensitive to away earnings, than by domestic earnings, going long again on the Nikkei currency hedged (Euro hedged) could make sense if ones would like to front-run again the Bank of Japan and their GPIF friends (we admitted in 2013 that we enjoyed being long Nikkei hedged in Euro)." - source Macronomics

In regards to Japan, we will reiterate what we posited in November 2013 in our conversation "Cold Turkey":
"While some recent "trade fatigue" did materialized in recent months on the Japan rocket "lift-off", we think that we are in an early second stage for the Multistage Japan rocket"

When it comes to adding rocket fuel to the Japanese rocket, the latest decisions by the Bank of Japan will accentuate further both the rise of Japanese equities and the fall of the Japanese yen as displayed by the below graph from Barclays displaying the size of the balance sheet expansion of various central banks as a percentage of GDP:
- graph source Barclays.

In terms of the implication for Europe (as discussed in the "Coffin Corner"), the aggressiveness of the Japanese reflationary stance spells indeed more deflation for Europe, unless the ECB of course decides to engage as well in a QE of its own:
"Moving on to Europe, we are unfortunately pretty confident about our deflationary call in Europe, particularly using an analogy of tectonic plates. Europe was facing one tectonic plate, the US, now two with Japan. It spells deflation bust in Europe unless ECB steps in as well we think." - Macronomics - 27th of April 2013.

Japan has already been the subject of numerous posts already on Macronomics, such as "Big in Japan", "Japan - the rise of the Kagemusha", "If at first you don't succeed..." or  "Have Emerging Equities been the victims of currency wars?".

When it comes to the end of the tapering from the Fed and the impact on some asset classes, all "inflation hedge" trades such as Gold, Gold miners and Tips have been impacted as displayed by Bank of America Merrill Lynch Flow Show note entitled "Death of the inflation" trade from the 23rd of October:
"Death of Inflation trade: flows into Gold & TIPS collapsed past 18 months…now Floating Rate outflows (Chart 2)"
- source Bank of America Merrill Lynch

In continuation to European woes, the much vaunted AQR and ECB's support, many pundits believe that the move towards the European Banking Union will enable credit growth to resume and therefore help economic growth in the process. We beg to disagree on this subject. We have long argued that no credit, meant no loan growth and no loan growth meant no economic growth and no reduction of budget deficits. 

The only thing that matters is QE being launched or not in Europe as we have argued in November 2013 in our conversation "In the doldrums" where we discussed the possibility of a credit-less recovery:
"So for us, unless our  "Generous Gambler" aka Mario Draghi goes for the nuclear option, Quantitative Easing that is, and enters fully currency war to depreciate the value of the Euro, there won't be any such thing as a "credit-less" recovery in Europe and we remind ourselves from last week conversation that in the end Germany could defect and refuse QE, the only option left on the table for our poker player at the ECB:
"The crux lies in the movement needed from "implicit" to "explicit" guarantees which would entail a significant increase in German's contingent liabilities. The delaying tactics so far played by Germany seems to validate our stance towards the potential defection of Germany at some point validating in effect the Nash equilibrium concept. We do not see it happening. The German Constitution is more than an "explicit guarantee" it is the "hardest explicit guarantee" between Germany and its citizens. It is hard coded. We have a hard time envisaging that this sacred principle could be broken for the sake of Europe."

When it comes to credit growth in Europe, Citi published an interesting note on the 31st of October entitled "Credit and The Eurozone Malaise":
"Overall, we expect the fall in credit growth to continue to moderate and for credit conditions to gradually improve from restrictive levels, with a modest boost from the end of the CA. However, we expect credit conditions to remain subdued. This is because private sector debt in many Eurozone continues to be very high, business sentiment is falling and the outlook remains very uncertain, which will continue to weigh on credit demand, while some pockets of credit supply constraints will probably persist even after the CA.
Credit availability matters, and particularly so in countries that do not benefit from strong FDI inflows and strong private liquidity positions such as France and Italy. But the relationship between credit growth and GDP growth has weakened in the post-financial crisis period and we therefore caution against using historical and in particular pre-crisis relationships between credit growth and GDP growth as good lead guides in the Eurozone. 
We also stress that the Eurozone malaise is unlikely to be resolved by improving credit conditions alone. Stronger aggregate demand is needed, and fixing credit supply is only one of many required steps. Additional measures required to reinvigorate the Eurozone economy include further monetary easing (including through large-scale asset purchases by the ECB), a looser fiscal stance, a restructuring of the debt of excessively indebted households and businesses as well as structural reforms to boost animal spirits." - source CITI

We have repeatedly highlighted the weakness in aggregate demand in the Eurozone. We argued in the past that the growth divergence between US and Europe were due a difference in credit conditions. This can be further illustrated by the following comments from the same CITI report displaying bank lending growth:
"Across countries, differences in credit growth remain large, with private sector borrowing still falling quite sharply in Greece, Ireland and Spain whereas it is growing at around 3%YY in France (Figure 5). 
Overall, however, credit trends remain very subdued in the Eurozone, both in historical comparison (growth in private sector borrowing in the Eurozone was 9% pa in 2003-07 and 7% pa in real terms) and relative to GDP growth (nominal private credit growth is running at 3pp below nominal GDP growth, whereas it was 4-5pp higher than GDP growth in 2003-07).

The question is why credit growth is so weak? ECB President Draghi has 
highlighted on various occasions that credit growth tends to lag GDP growth in 
recoveries and that the Eurozone’s current experience fits this pattern. By contrast, 
the IMF recently argued in its Global Financial Stability Reports that at least in 
stressed Eurozone countries credit growth is lagging behind the average experience 
in historical countries (see Figure 6). Whether the current experience in the 
Eurozone is in line with the historical evidence or not, that still leaves open the 
question of what holds back credit growth."

Indeed, bank lending standards in the Eurozone have tightened for most of the period between 2007 and 2014. However, there seems to be some light at the end of this tunnel: the ECB’s quarterly Bank Lending Survey published on 29 October showed that Eurozone banks‘ lending standards in Q3 eased for all loan categories for the second survey in a row (see Figure 7). 
Nevertheless, the level of lending standards is probably still very tight, at least in comparison with the pre-crisis period, given that lending standards tightened 26 quarters in a row until Q2 this year. Banks also recorded growing loan demand for all loan categories, for the third survey in a row, and banks expect credit standards to ease further and demand to rise further in the coming three months. But, again, having fallen 10 quarters in a row including Q1, the level of credit demand is probably still very low.
Interest rates are also still high, at least in some countries and in real terms. The 
ECB’s composite cost of bank borrowing measure for Eurozone NFCs was at 2.7% 
in August. This is roughly 150bp below the 2003-07 average in nominal terms and 
100bp lower than in 2011. However, in real (CPI-adjusted) terms, NFC borrowing 
costs are in fact 20bp above the pre-crisis average and have not fallen much at all 
recently, as Eurozone inflation has fallen faster than nominal borrowing rates (see
Figure 8). 
Cross-country divergences in real borrowing costs are also very high, 
with borrowing costs of 0-1% in Austria, Finland or Germany vs 5-6% in Cyprus, 
Greece or Portugal. The ECB’s Coefficient of Cross-Country Variation in bank 
borrowing costs of NFCs across Eurozone countries remains near all-time highs. In the periphery countries, the fall in inflation rates has meant that real borrowing costs have in fact risen in the last 12 months." - source CITI

The disinflationary factor and deflation risk of course have not been taken into account in the AQR. 
As we indicated in our conversation relating to the growth divergence between the United States and Europe ("Growth divergence between US and Europe? It's the credit conditions stupid..."), it is all about 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."

When it comes to Europe and Pascal's Wager, we have to mention once more the issue of circularity as pointed out previously by our friend Martin Sibileau (who used to blog on "A View From The Trenches"), here is a reminder from his work which we quoted in our conversation "The law of unintended consequences" in Macronomics on the 25th of January 2012:
"With a more expensive Euro, Germany is less able to export to sustain the rest of the Union and growth prospects wane. At the same time, the private sector of the EU looks for cheaper funding in the US dollar zone, which will eventually force the Fed to not be able to exit its loose monetary stance."  - Martin Sibileau

And as indicated by Martin Sibileau:
"The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital."

While the depreciation of the Euro is a welcome respite for European companies, the latest merry go round of Japanese QE risk offsetting an already precarious economic situation which has been aggravated by the sanctions taken against Russia and impacting particularly German exports in the process.

We are therefore coming back in full circle towards the need for QE in Europe as posited as well by our friend Martin Sibileau (which we quoted on numerous occasions in our posts):
"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." - Martin Sibileau

By tying itself to Europe via swap lines, the FED has increased its credit risk and exposure to Europe:
"If the ECB does not embark in Quantitative Easing, the Fed will bear the burden, because the worse the private sector of the EU performs, the more dependent it will become of US dollar funding and the more coupled the United States will be to the EU." - Martin Sibileau

Back in November 2013, in our conversation "Squaring the Circle" we argued:
"Markets being extremely feeble creatures in the face of uncertainty will obviously react "rationally" when it comes to being provided with "explicit guarantees".

Obviously the lack of German Constitutional support could indeed prevent the whole "whatever it takes" European moment from moving from the "implicit guarantees" towards more "explicit guarantees" we would argue.
As pointed out by Bloomberg editors in their column from the 6th of November 2013 entitled "Europe's unfinished business threatens another recession",the European Banking Union is a must have. For us Europe is just trying to "Square the Circle:
"The most important stalled reform is in banking. Another round of bank “stress tests” has just been announced -- and this time, the ECB says, it’s serious. But there’s still no agreement on what happens to the banks that fail the tests. It’s universally agreed that the euro area needs not just a single bank supervisor -- which it now has in the form of the ECB --but also a single bank-resolution mechanism. That won’t fly, because Germany and like-minded countries won’t hear of bailing out failing banks or their financially stressed national governments.
This reluctance is understandable. But without a single bank-resolution mechanism, the euro project remains fatally flawed. The toxic link between distressed banks and distressed governments will remain. So long as that’s true, recovery will be held back and the euro area’s supposedly integrated capital market will be at risk of further splintering into separate zones. If the euro is to survive and its member countries prosper, a real banking union is indispensable." - source Bloomberg

To illustrate further the horrible issue of circularity and European banking woes, we think the failing of Banca Monte dei Paschi in the AQR will be a proxy of what happen to a European bank that fail sthe test as well as the application of "bail-in" for bondholders.

Since the AQR MPS stock price has been down by more than 35%. MPS's capital shortfall is put at €2.1 billion and has until November 10 to deliver its solution to the ECB. MPS's market capitalization is now €3.1 billion compared to the €5 billion raised in right issues this year. Placing Contingent Convertible notes (CoCos) also called AT1 to cover the capital shortfall is impossible. On this specific issue we read with interest Bank of America Merrill Lynch's note entitled "Numbers do actually matter" published on the 31st of October:
This is the level of impaired assets that Monte Paschi was carrying in its balance sheet at the end of June. At the end of 2012, it was €29.5bn so in the last year and a half it has gone up by 30%. These impaired loans account for 25.8% of the loan book. With such a vast portfolio of impairments, it doesn’t surprise us that there was scope for extra provisioning. The large portfolio of impaired positions undermines MPS’ viability, in our view.
Note that the NPE ratio used by the ECB is the much more benign 18.1% on which there is apparently 40.1% coverage. The sample analysed by the ECB, on which they found such severe provisioning needs, is in fact a smaller one that what we would consider to be the full portfolio of impairments. However, it does extrapolate, to a degree, in an attempt to cover the whole book.

€4.2bn is the ECB’s assessment of the gross impact on capital from risk in Monte’s credit portfolio. The adjustments come from large corporate (an adjustment of €711m), real estate (€1.6bn) and large SMEs (€1.9bn) in Italy. Recall that, for the Italian banks in particular, we’d always thought that the stress test wasn’t even that stressful – so this is a poor result arguably for the bank.

In our view, it ends once and for all the idea, recently propagated in some quarters, that Italian banks’ NPL numbers are ‘optically’ worse only because they are more strictly classified vis-à-vis other European banks. We have never subscribed to that view and neither does the ECB, it appears. Italian NPLs are not more strictly classified. In fact the ECB exercise has found that they are consistently under-recognised.

€1,394.8m is, apparently, the offsetting tax impact at Monte Paschi, which reduces the capital needs to €2.9bn in the ECB’s analysis. It’s equivalent to a large (33%) ‘benefit’ to the bank. We’ve heard doubts expressed about its reliability, because it is a large offset.

Coincidentally, €4.2bn is the gross aggregated capital shortfall that the ECB has identified in the adverse scenario for Monte dei Paschi.

The Bank of Italy has put MPS’s capital shortfall, including all capital strengthening measures, at €2.1bn. This seems to us to be a minimum number – for a large bank such as Monte’s solvency to be supportive of economic growth, we’d imagine that its capital would have to be much higher than this basic shortfall would suggest. The difference between this number and the previous number is the €2bn rights issue that was retained in the bank.

This is the adjusted capital ratio for MPS in the adverse scenario under the EBA analysis.

The EBA discloses the fully phased CET1 of MPS as -3.5%. The market will judge the robustness of the capital of the bank on a fully phased basis, so we’d argue that any capital actions taken need to be robust and credible, not papering over the (rather large) cracks.

These two negative ratios together underline the work that needs to be done to ensure MPS is robust to get through a reasonable stress scenario.

€5bn, €3bn and €1bn
€3bn is the amount of capital that the bank returned to the Italian Government this year after the €5bn capital raise. Had it not done so, we would be writing a different note about MPS now. However, €3bn was the amount that was in the repayment schedule for 2014 for the state aid, so the bank had to repay it. 
There is still €1bn or so of state aid outstanding and the Italian Government, as a first step, could convert this into equity now. However, we believe it is reluctant to do so, and the State may instead sell on the Monti bond to a third party that could trigger the conversion and own 30% of the bank on the cheap, potentially. Perhaps there is a certain reluctance to do this, because of the dilution of the investors that provided €5bn to the bank earlier this year.

More likely, we are mindful that the state aid approvals relied on the repayment of the New Financial Instruments according to the following schedule (see Table). Whilst conversion of the state aid to equity is foreseen, it would be a major derogation from the agreement between Italy and the EC and we think could potentially necessitate the re-opening of the MPS file by the EC. See for example, paragraph 134 of the state aid approval which reads:
If MPS is unable to repay the new instruments, MPS commits to re-notify a modified restructuring plan with additional measures. The Commission welcomes that commitment as it underlines the credibility of the repayment plan.

The original plan was premised on the return of MPS to viability and seems to explain the problems of the bank in terms of its over-exposure to Italian sovereign debt, which was having a bit of confidence problem at the time. This is now obviously not the case – it is the significant amount of impairments that is causing the bank’s solvency problems, and the Bank of Italy has itself acknowledged a €2.1bn capital gap at the bank. Obviously the current plan as approved does not restore MPS to long-term viability because it focused on the wrong areas. Given the work that the ECB has now done, we think the opening of the file would necessitate some significant changes to MPS, perhaps quite drastic ones, with far reaching implications for the bank. We can quite understand the reluctance to re-open the file; yet we struggle to see how else it could be if there is a desire that MPS should survive in anything resembling its current form.

Zero is apparently the amount of capital that the Italian Government wants to give 
the banking sector to help it overcome the deficiencies that have been elucidated 
in the stress test – hence its insistence on a private solution. This reminds us of 
the Portuguese authorities’ hopes for a private solution in the recent restructuring 
of Banco Espirito Santo." - source Bank of America Merrill Lynch

As we argued in our conversation - "Peripheral Banks, Kneecap Recap"
"We believe debt to equity swaps will likely happen for weaker banks as well as full nationalization for some."
As our good credit friend said in November 2011:
"The path will be very painful for both shareholders and bondholders."

When it comes to MPS, for us it is the most likely option to happen. From the same Bank of America Merrill Lynch note:
We estimate that MPS has about €5.4bn of Tier 2 subordinated debt outstanding, about €2.6bn of LT2 and €2.8bn of UT2 (dated). It also looks like there was a further €406m of Tier 1 securities in circulation, though this may be even harder to track down and there’s the issue that they are deferring at the present time. Equitizing or part-equitizing these bonds in some way would resolve the capital problems of the bank, we think, but it doesn’t appear to be on the agenda at the moment. The old Tier 1 bonds (the old 7.99% ISIN XS0121342827) appear to have dropped 20 points from their summer highs though – and appear to trade rarely.
We believe the base of the problem is the undertakings given by the Italian Government to the European Commission at the time that the State Aid for the MPS restructuring was approved just over a year ago. These would have to be revisited, which could be embarrassing. In particular, amongst the commitments given by Italy to the EC, we read that:
BMPS will not undertake any Liability Management Exercise (including calls) unless it is implemented at conditions by which it occurs at a […] discount in percentage points from nominal value and at no more than […]% above the market price. Any Liability Management Exercise will be timely submitted to the Commission services for approval. (Commitment #11 from the State Aid approval, November 2013) " 

This commitment effectively limits the ability of the bank to do a generous debt-for-equity swap, we think. It appears it would have to be punitive. Our assessment is that there is also effective lobbying from a major holder of the UT2 bonds – remember that the EC, very exceptionally, allowed an UT2 coupon when it should have been deferred if precedent had been followed?

This seems more powerful to us than the argument that perhaps some of the 
bonds are held by retail and there are fears of contagion. But if the Government 
doesn’t want to put extra cash into the banks, perhaps this should be revisited, as 
options look very limited outside the subordinated debt to us. And it is not as if 
this hasn’t been a well-trodden path to help bank with limited capital options to 
recapitalize throughout the rest of Europe. However, reopening the MPS state aid 
file, which would effectively be what they would have to do to get a generous LME 
away, may not be considered appetizing.
The sub bonds usually have large minimum denominations which don’t 
necessarily suggest a big retail presence, we’d argue, with the possible exception 
of the €2.16bn issue of UT2 bonds which does appear to have been placed 
directly to retail.
Moody’s downgraded the senior subordinated bonds of MPS to Ca on Thursday 
According to the agency:
"In addition, MPS's senior subordinated ratings were downgraded and placed on review for further downgrade. This reflects an increased likelihood that the bank may require public support, in Moody's opinion, which would trigger state aid rules and bail-in of subordinated debt. Further, given the repeated instances of bailouts using state aid over the past years, the rating agency does not rule out the imposition of more extensive restructuring measures for MPS which could affect all creditors of the bank."

Since the AQR/stress test, MPS stock has fallen about 34%, from €1.03 to €0.68 on Thursday evening.

Credit has been more measured, mostly because the technicals are more favourable, we think. Monte senior cash bonds were still trading well above par (3.625% bonds at €101.3), in spite of the fact that this is quite a distressed bank, though spreads do look to have widened 15-20bps today. It is one thing not to believe that anything too nasty can happen to senior bonds in Italy, quite another to look at these levels and believe we are seeing anything like fair value. Also, Moody’s talked, in their review for downgrade, of the imposition of more extensive restructuring measures for MPS which could affect all creditors of the bank."  source Bank of America Merrill Lynch

We believe that the path will be very painful for both shareholders and bondholders of MPS and that not only subordinated bondholders but seniors as well will face the music in the case of MPS, making MPS the precedent for future bail-in processes in the European banking landscape.

On a final note we leave you with a graph from Nomura from their recent report entitled "The coming cycle of higher volatilities" displaying the need for investors for a higher rate of return in their "Pascal Wager" making it most likely that if US productivity cannot deliver, then there is indeed room for disappointment and price decline:
"While the current cycle is not too different from past secular bull markets, investors are requiring a higher rate of return (i.e. earnings yield)"
- source Nomura

"The risk of a wrong decision is preferable to the terror of indecision."- Maimonides, Spanish philosopher

Stay tuned!

Tuesday 21 October 2014

Credit - A Descent into the Maelström

"You drown not by falling into a river, but by staying submerged in it." - Paulo Coelho

Looking at the massive intraday surge on the 15th of October on the 10 year US T-note, the most liquid asset in the world (as an example to what can happen in directional volatility going forward), this move relative to the asset class (around 5%) would equate in the equity space to a +10% intraday move on an equity index, highlighting in effect our liquidity concerns we have frequently voiced on this blog. 
- graph source Bloomberg

To that effect and in the search of this week's analogy we reminded ourselves of the Maelström, being a very powerful whirlpool, a free vortex with considerable downdraft. A whirlpool is produced by the meeting of opposing currents, therefore one can argue that the "asset inflationary" policies followed by central banks around the world are in direct confrontation with the tremendous deflationary powers we have described in our musings, triggering in effect potential huge downdraft (or gaps) on asset prices. The more powerful whirlpools are properly termed "Maelström". A "Maelström" is created in narrow (poor liquidity), shallow straits with fast flowing water (capital flows).

While looking for our title analogy, we remembered the work of one of our favorite writer Edgar Allan Poe and his short story "A Descent into the Maelström" written in 1841, where a man recounts how he survived a shipwreck and a whirlpool. The story is told by an old man who reveals that he only appears old—"You suppose me a very old man," he says, "but I am not. It took less than a single day to change these hairs from a jetty black to white, to weaken my limbs, and to unstring my nerves." 

The old man goes to tell the story of the shipwreck he and his brothers encountered in their journey: "Driven by "the most terrible hurricane that ever came out of the heavens", their ship was caught in the vortex. One brother was pulled into the waves; the other was driven mad by the horror of the spectacle, and drowned as the ship was pulled under. At first the narrator only saw hideous terror in the spectacle. In a moment of revelation, he saw that the Maelström is a beautiful and awesome creation. Observing how objects around him were pulled into it, he deduced that "the larger the bodies, the more rapid their descent" and that spherical-shaped objects were pulled in the fastest." - source Wikipedia

In this week's conversation, we will reflexionate around the latest bout of volatility and what we think it entails in terms of risk/reward ideas.

"The larger the body, the more rapid their descent", as one can vouch from observing the death of the $55 billion tax inversion AbbVie -Shire deal in the Merger Arbitrage world. Obviously, what appears interesting to us is the change in the rules announced by the U.S. Treasury Department to make tax inversion deal more difficult in conjunction with the European Commission being on the offensive about Irish  and Luxemburg Tax deals involving the likes of Apple and Fiat.

It makes even more likely that these companies tax advantages may vanish at some point in the near future, making it possible for a "Maelström" to occur, generating in the process a powerful "downdraft" on the stock price in the process.

The effect of the cancellation of the AbbVie-Shire deal on Shire's stock price - graph source Bloomberg:
A powerful downdraft in the Maelström...

Biotech stocks, one of the biggest winners of the five-year bull market in a context of increasing tax risk appears to us considerably vulnerable from the rapacious appetite of over-indebted governments we think. "Lower Liquidity" is already causing "Higher Volatility".

We think that the "too much liquidity" popular trades of biotech, internet, gaming and small cap are up for more pain in the future. Technology and Health Care Companies in the S&P 500 index are both heavy users of adjusted earnings measures in their financial statements: Of 69 technology companies in the index, 56 use non-GAAP earnings, of 56 Health Care companies, 45 use them. (source "Earnings, but Without the Bad Stuff", Gretchen Morgenson, November 9 2013 - New-York Times). The vast majority of public biotech companies in the U.S. (87%) do not pay taxes because they lose money as they pursue breakthrough therapies and cures as well as using non-GAAP metrics to boast are more "positive" accounting picture. Young high tech companies often end up paying less than 10% of income in taxes whereas old railroads and utilities often pay more than 25% and cannot easily "jump" countries using M&A for tax inversion purposes.

The impact of the tax inversion related M&A 2014 frenzy on the Biotechnology and Drugs Industry - source CSIMarket:
- source

From a credit perspective, spreads in Merger Arbitrage situation widened on the back of risk adjustments spillover from the ABBV-Shire situation as portrayed in a note from the 16th of October from the UBS Special Situation team:
"Merger arbitrage spreads continued to widen:

o    Spreads are widening as a result of market volatility and now also as a result of risk adjustments arising from new developments in ABBV- Shire

o    The median annualized spread for definitive deals late in the day on October 15 was 11.0%, as compared with 9.6% on October 14, 8.0% on October 10 and an average level of 6.5% during the eight week period preceding the market stress period (restricting the sample to spreads between 0 and 30% annualized)

o    If we restrict the sample to spreads between 0% and 50% annualized, the median annualized spread late in the day on October 15 was 11.7%, as compared with 9.9% on October 14, 8.8% on October 10 and an average level of 6.8% during the eight week period preceding the market stress period

o    If we look at spreads on a non-annualized basis, the average level on October 15 was about 150 basis points wider than the average level in the preceding weeks (widening from ~2.9% to 4.4%)

o    This 450-500 basis point widening in annualized spreads and ~150 basis point widening in non-annualized spreads relative to pre-stress levels are comparable to maximum spread widening in prior market stress episodes" - source UBS

Please note the US convertibles space is more and more made up of tech/biotech new issues but in terms of Merger Arbitrage, the convertibles space is less concerned by the tax inversion trend.

In continuation to our recent conversation highlighting the relative protection offered by Investment Credit, the market changes since the 8th of October as displayed in Bank of America Merrill Lynch's note from the 17th of October entitled "Macro policy: no room for error" clearly indicates the relative protection offered by the asset class:
- source Bank of America Merrill Lynch.

No surprise as well that when it comes to "capital inflows" and our "Maelström", flows have indeed been driven towards safer asset as indicated by Bank of America Merrill Lynch's recent Flow Show note entitled "Crash Flows & Feedback" from the 16th of October:
"Equity stabilization ($2bn of redemptions) after big risk-off flows past 2 weeks
($23bn redemptions)
Big caveat: huge inflows to small cap (14% of IWM float) & energy (10% of XLE float) probable “ETF-creation” for new shorts
Note Aug’11 equity plunge coincided with much larger $42bn redemptions European capitulation: biggest outflows from EU equities ever ($5.7bn – Chart 1)
Quality king: Treasury & IG bond funds big winners with $10bn inflows combined
Risk out of favor: HY, floating-rate debt and EM equities extend outflow streak"
Fixed Income Flows
43 straight weeks of inflows to IG bond funds ($5.6bn)
Big $3.9bn inflows to govt/tsy funds (largest in 10 weeks) (Chart 2)
7 straight weeks of outflows from HY bond funds ($2.0bn)
14 straight weeks of outflows from floating-rate debt ($1.0bn)
6 straight weeks of outflows from TIPS" - source Bank of America Merrill Lynch

Go with the flow and don't fight the "Maelström"....

Of course, as we pointed out in our conversation "Wall of Voodoo" on the 23rd of September, CCCs in credit  have indeed been the canaries in the risky asset coal mine. When it comes to the "credit whirlpool" created by the meeting of opposing forces (aka our "Maelström"), we could not agree more with Bank of America Merrill Lynch's comments from their 17th of October note entitled "Zero rates vs Zero growth":
"The bond market’s great tug-of-war
Yet asset markets are really reflecting a tug-of-war between the conflicting forces of “zero rates” and “zero growth” in Europe. Nowhere can this be seen more clearly than in credit where high-grade and high-yield markets have totally decoupled. The chronic shortage of yield is – and will stay – the dominant force for high-grade tightening, we believe. But we think the growth downturn in Europe needs to be addressed (by central banks or policy makers) for high-yield to rally decisively." - source Bank of America Merrill Lynch.

Hence our comment in last week's conversation "Actus Tragicus" in relation to the appeal of Investment Grade credit in a deleveraging/Japanification world:
"While it is true that the "interest rate buffer" in case of a surge in rates is nearly exhausted in the current low yield environment, but the environment for investment grade credit is still favorable"

We also added:
"While the "Actus Tragicus" continues to play out in the deterioration in Europe of economic fundamentals putting additional stain on stretched equities valuation. In the credit space, at least in investment grade, thanks to the "Japanification" process, it continues to be "goldilocks" we think."

From a risk positioning perspective, we agree with our cross-asset friend and fellow "Macronomics" blogger "Sormiou" in the sense that given the relative recent moves, getting exposure to US High Yield via selling the CDX CDS index HY 5 year versus Short S&P 500 via long puts 3 to 6 months seems relatively enticing - graph source Bloomberg SPX vs CDX HY:
We have move back towards relatively high implicit probability of default on US High Yield whereas the S&P 500 remains close to the highest levels. If we do indeed move lower, being short US equities versus being long US High Yield could be of interest. If there is a rebound, the exposure of being long equity put options limits the downside and High Yield could potentially retrace towards the 300 bps mark. If you calibrate the trade to be carry flat/slightly positive, the risk/reward seems of interest we think.

In terms of additional risk positioning, a thematic trade idea based on Japan's latest pension allocation reforms and put forward by JP Morgan on the 21st of October in their note entitled "Thematic Trade Ideas on GPIF Reform Update" is interesting we think:
"Government Pension Investment Fund (GPIF) reportedly to boost domestic stock allocation to 25%. According to the Nikkei newspaper, GPIF is considering increasing its allocation target for domestic equities to about 25% as well as raising the allocation of foreign stocks and bonds. We concede there is a large amount of uncertainty about the composition of GPIF reform, but the much stronger potential allocation ratio for domestic equities versus our pervious expectation of 20% leads us to think that results of the GPIF reform could surprise positively and add to the gains of Japanese equities.

Implementation could occur before announcement of the new investment strategy. The Nikkei article also suggested GPIF will update its portfolio allocation targets later this month, although the timing of implementation is unclear. Nonetheless, advisors to GPIF are well aware of the adverse market impact of publishing target weightings beforehand. In fact, recent interviews with Professor Ito, the government’s top adviser on GPIF reform, suggest that the implementation could happen even before the announcement.

The allocation increase could spur buying of c.¥10 trillion of domestic stocks. We analyze the flow implication under the scenario suggested by the Nikkei newspaper. Due to the uncertainties on asset returns and fund redemption schedule, our analysis is solely based on the expected change in the allocation ratios and investment results at the end of June 2014. Our calculation suggests additional purchases of domestic stocks will be ¥9.8 trillion if the domestic stock allocation is boosted to 25%. After examining flows data, we believe positioning in Japan is light, and any surprise could easily lead the price action to change very quickly.

Bullish index options strategies: In view of renewed attention towards GPIF reform and an eventful Japan in the next few months, we recommend that investors add upside exposure in Japanese equities for the remainder of the year. In addition to outright calls and call spreads, investors may want to consider structures that take advantage of the current elevated skew, such as risk reversals (buying calls and selling puts, and possibly with knock-in barriers embedded in the puts). JPX-Nikkei 400 is our preferred underlying index among major Japanese benchmarks due to its lower volatility and direct linkage to the corporate governance reform theme." - source JP Morgan

Given the Nikkei index is particularly more sensitive to away earnings, than by domestic earnings, going long again on the Nikkei currency hedged (Euro hedged) could make sense if ones would like to front-run again the Bank of Japan and their GPIF friends (we admitted in 2013 that we enjoyed being long Nikkei hedged in Euro).

On a final note, Bloomberg's latest Chart of the Day, shows that the Yen's real effective exchange rate has fallen to the weakest since 1982 - graph source Bloomberg:
"The yen’s purchasing power is eroding to an unprecedented level with Japan’s trade deficit poised to increase from the widest on record, according to Mitsubishi UFJ Morgan Stanley Securities Co. 

The CHART OF THE DAY shows the Bank of Japan’s calculation of the yen’s real effective exchange rate against 59 trading peers fell last month to the weakest since 1982, as the nation posted an unprecedented 26th-straight month of trade shortfalls in August. Historically, a weaker currency boosted exports and squeezed imports, though that hasn’t happened this time, indicating a “structural shift” has taken place, said Daisaku Ueno, the brokerage’s Tokyo-based chief currency strategist. 

“If the trade deficit doesn’t noticeably narrow from here, the yen’s real effective rate could fall to levels never seen before,” he said. “From a supply and demand perspective, yen selling for foreign currency by Japanese importers will just continue endlessly.” 

A 26 percent decline in the yen versus the dollar over the past two years has left it 20 percent undervalued, the most among developed-market peers, according to a gauge of purchasing-power parity based on consumer prices. Japanese visiting the U.S. would have to pay 71 percent more for a McDonald’s Corp. Big Mac than at home, according to Bloomberg calculations based on the Economist magazine’s Big Mac index. The yen traded at 106.95 per dollar yesterday in New York.

Japan’s currency was at its weakest in the early 1970s, according to the BOJ’s measure. It was pegged at 360 to the dollar until President Richard Nixon broke the U.S. currency’s last link to gold in August 1971, ending the ability of foreign central banks to convert dollars into a fixed quantity of the precious metal. 

The yen’s real effective exchange rate is now in the range that the market considers “extremely cheap,” Ueno said. “In Japan’s post-float history, the strength of demand for dollars and other foreign currencies among importers has never been higher.” - source Bloomberg 

Of course we expect further downside to the Japanese currency in the medium term, in fact a much weaker levels hence our short positioning since late 2012 but that's another story...

"The depth of darkness to which you can descend and still live is an exact measure of the height to which you can aspire to reach." - Pliny the Elder, Roman author

Stay tuned!

Tuesday 14 October 2014

Credit - Actus Tragicus

"We live in an age of mediocrity." - Lauren Bacall

Looking at the dismal European data coming out of Europe with a plunging German Zew index in the October survey declining 10 month in a row ( -3.6 this month from 6.9 in September),  with German industrial output falling by 4% during the course of August (the biggest drop since January 2009) and weaker inflation in Europe with Spanish September HICP inflation coming in at -0.3% YoY, and French HICP inflation falling to 0.4% YoY (from 0.5% YoY in the previous month), with prices down 0.4% MoM and Eurozone Industrial Production coming at  -1.8% (below the expected -1.6%) in conjunction with new record lows on the German 10 year yield coming at 0.85%, we decided therefore to use another musical analogy, this time around drifting towards one of our favorite classical masterpieces, BWV 106, also known as Actus Tragicus, being a sacred cantata composed by Johann Sebastian Bach in 1708 when he was 22 years old in Mühlhausen and intended for a funeral. In the end it might be the most appropriate funeral cantata that could be used for the euro at some point given the growing dissent in both Italy and Germany, as well as the very open opposition between Mr Mario Draghi and Mr Jens Weidmann. Very few musical pieces touch our soul, arguably the first movement of BWV 106 aka "Actus Tragicus" is one of them, but we ramble again...

The tragedy playing out, of course, is the growing divergence between asset prices and economic fundamentals with central banks meddling with the most important variable in the capitalist system namely interest levels, more simply the "price of money", leading of course to "mis-allocation" of capital in the grand scheme of things. While large corporates in Europe have had no problem in gaining access to "credit", SMEs in Europe have been starved by the precipitation of the credit crunch leading to massive unemployment which has been accentuated by European banks deleveraging thanks to the EBA's fateful decision of "forcing" bank to reach 9% core tier one level by June 2012. We will not come back to that much commented and evident outcome which we have discussed at length on this blog.

What is of course of interest (and once again no surprise to us) is to see a continuation of the rally in US treasuries, which we had foreseen thanks to our contrarian stance which we indicated well in advance given our deflationary "bias" and our  "somewhat" understanding of the macro outlook. Since early 2014 we have indicated our long duration exposure, which we have partly played via ETF ZROZ as an illustration of us playing and understanding the "macro" game.

In this conversation, once again we have decided to focus on the credit cycle and where we stand when it comes to look at the "Global Credit Channel Clock", as designed by our good friend Cyril Castelli from Rcube Global Asset Management:

Last month we indicated the following in our conversation "Sympathy for the Devil":

"Whereas Europe sits more closely towards the lower right quadrant, it is increasingly clear that the US is showing increasing leverage in the corporate space, indicating a move towards the higher quadrant on the left of the Global Credit Channel Clock we think. What we have been seeing is indeed a flattening yield curve in the US with re-leveraging courtesy of buy-backs financed by debt issuance which is the point we made in last week Chart of the Day." - Macronomics, 9th of September 2014

We also argued:
"The continuation in the stability in credit spreads particularly in the High Yield space depends in the continuation of low fundamental default risk. On that subject, leverage matters."

Interestingly enough, high-yield outflows have continued for a 6th week in a row according to Bank of America Merrill Lynch's most recent Follow the Flow note published on the 10th of October and entitled "More in safety, less in yield":
"High-yield funds outflows continue for the sixth week
Even though US-domiciled HY funds flows bounced back, Euro-domiciled funds continued to see more outflows; the sixth week in a row. High-grade credit and money-market fund flows were on the positive side though, with the latter seeing the largest inflow so far this year. Note that over the past week, government bond funds saw a $1.9bn inflow, the largest in eight weeks.
Credit flows (week ending 8th October)
HG: +$1.5bn (+0.2%) over the last week, ETF: -$117mn w-o-w
HY: -$1.2bn (-0.5%) over the last week, ETF: -$114mn w-o-w
Loans: -$112mn (-1.3%) over the last week
Same patterns for another week in European credit funds, with more inflows into high-grade funds and more outflows from high-yield. "However, fund flows into W.E. regional funds (that we believe are more €-bond focused) have seen another inflow (of $478mn) last week. On the duration front, high-grade credit flows have been concentrated in the mid and long-term funds, with outflows continuing from the short-end for a second week.

More in safety, less in yield
Flows have been pointing to “safe” yield rather than any yield, lately. Over the past weeks, the trend has been notable, with more funds added in high-grade credit and government bonds, rather than high-yield credit and equity funds. YTD flows into high-grade and government bond funds have been in ~$65bn, while flows into highyield and equity funds have been a mere $22bn. Put that also on top of the record inflow into money-market funds last week  takes the 2014 YTD figure to $60bn." 

- source Bank of America Merrill Lynch

So much for the "Great Rotation" story of 2014 from bonds to equities...

Of course while the "Actus Tragicus" continue to play out in Europe in the "real economy", US and Europe Investment Grade credit continue to benefit from the flattening of the yield curve. The evolution of flows of course validates the "Great Rotation" namely the gradual move of investors from low beta towards higher quality while retail investors continue to be significantly exposed to lower quality credit as we concluded our last conversation.

And what has happened in the last few years courtesy of Central banks generosity has been the multiplication of carry trades in various segments of the market. The goldilocks period of "low rates volatility / stable carry trade environment of the last couple of years is likely coming to an end as we move in the US towards the upper quadrant of the "Global Credit Channel Clock".

Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is  the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...).

As we posited in our conversation on the 13th of June 2013 "The end of the goldilocks period of low rates volatility / stable carry trade environment?":
"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."

Looking at the continuation in both outflows from the equities space and the very strong compression in  the long end of core government bond space (US Treasuries and German Bund), it much more likely for us that we are indeed at risk of a significant "repricing" in the equities space.

Facts are as follows:
Commodity markets and the performance of global cyclicals versus defensives continue to point to a very, very subdued global growth environment.
Another "great anomaly" that investors should take into account is that low volatility stocks have provided the best long-term returns such as "Consumer Staples".

When it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:
Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data". Investors should had bought Treasuries if they had anticipated the Federal Reserve reduction in its purchases, based on the last two times that the biggest buyer of bonds stepped back from the market (The yield declined by 126 basis points between the end of the first round of Fed purchases in March 2010 and the beginning of the second round in November that year).

Of course our positive stance on Investment Grade Credit which we discussed again in August 2014 in our conversation  "Thermocline - What lies beneath" has been confirmed:
"For those that need to seek comfort in a safe haven, we believe Investment Grade credit while tight from an historical point of view, still benefits from positive exposure thanks to the Japanification process. In that sense, we expect the Fed to keep a dovish tone in this muddling through economic situation in the US meaning that the releveraging process taking place in the US is still positive for credit." - Macronomics, 19th of August 2014.

While it is true that the "interest rate buffer" in case of a surge in rates is nearly exhausted in the current low yield environment, but the environment for investment grade credit is still favorable as highlighted again last week:
"This somewhat validates Nomura's take on the golden age for credit we discussed back in 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets":
"-Corporates around the world have been deleveraging for longer than most people realise, starting around the time of the tech bubble in 2000.
-Deleveraging is generally bad for equities, but good for credit assets.
-In the US, Europe and Japan, credit has outperformed equities by any reasonable measure (e.g. volatility, drawdowns, absolute).
-As credit is far less volatile than equities, some leverage is sensible. Even leveraged credit can be less risky than unleveraged equities." - source Nomura

Of course the current interest rate differential between the US and Europe, supported by a weakening Euro and negative interest rates in the front-end of some European government bond yield curve points towards a larger allocation to US fixed income we think.

On that point we disagree with the latest take from Bank of America Merrill Lynch' s credit team in their recent Credit Market Strategist note from the 10th of October entitled "Breaking up is so easy to do" given they don't see an acceleration into US fixed income:
"Breaking up is easy to do. US-European interest rate differentials are near historical highs whereas credit spread differentials remain near – though notably off - historical lows. With the economies out of sync, and resulting opposite central bank policies, our global interest rate strategists expect the rates differential to increase even further. As our European credit strategist, Barnaby Martin, maintains a constructive outlook for EUR IG, and we are tactically short US IG, clearly we expect the US-EUR spread differential to widen further. 
The push-back. 
Investors’ biggest push-back against this outlook is that, with US yields much higher than global yields we should expect a global allocation change and/or diversion of flows into US fixed income – including credit. The direct effect of such flows would be to dampen interest rate differentials and add strength to US credit at the expense of European credit. Furthermore, as interest rate risk is the key uncertainty for US credit, these flows would provide additional indirect support for US spreads. Hence any divergence between interest rates, credit spreads would be more limited than we are looking for. We think that, while global weakness asserts downward pressure on US yields, the mere existence of wide global yield differentials do not.
Our push-back against the push-back. 
We find it unlikely that the existence of big global yield differentials will accelerate inflows to US fixed income for two reasons. First, while we would indeed expect inflows in a high return environment of both high and declining US yields, with rising US interest rates – which our interest rate strategists expect – returns are much less attractive, despite the higher yields. Second, there appears to be little mean-reversion in interest rate differentials – at least between US and German interest rates. In fact in a statistical sense they appear well characterized as random walks – i.e. can wander far from current levels, in either direction. Thus, even though the difference between US and European interest rates is high, from a statistical point of view we are just as likely to see further meaningful increases from here, as we are to see meaningful decreases." - source Bank of America Merrill Lynch

Unfortunately, we think that flow matters and interestingly another note from Bank of America Merrill Lynch from their Liquid Insight team from the 10th of October entitled "Investing in a sub-zero world" makes some interesting contrarian points which we agree with when it comes to the amount at stake when it comes to "financial repression" in Europe:
"We take a look at the broader challenge to portfolio managers posed by negative yields. Since the ECB decided to first venture into negative rates in June 2014, 30% of the EUR domestic government bond market now trades at negative yields (by notional). For German government bonds this number is 46%. Investors need to move as far as the 4y part of the curve to see positive yields. Expressed another way: investors are willing to pay euro area governments to look after €1.3tn (when including bills). To avoid paying negative rates, investors have to either take more duration risk or more credit risk" - source Bank of America Merrill Lynch

From the same note:
"€1tn looking for a new home
We focus on the impact of negative yields on bank treasury and central bank portfolios for a number of reasons: (1) both tend to get managed against relatively restrictive benchmarks in terms of duration and credit risk; (2) both will therefore be disproportionately affected by negative rates compared to a mutual fund or an insurance company; (3) both have anecdotally reacted strongly to the rate cuts in June and September.
Table 1 shows our estimates of what a typical central bank, peripheral bank, core bank, and non-euro-area bank treasury portfolio looks like. 
Table 2 shows what has likely happened to the weighted average yield of these portfolios since the beginning of June, when the ECB had not yet ventured into negative rates, as well as the amount of assets in each portfolio that now trade at negative yields.

Unlike mutual funds which receive investors’ funds with the specific mandate to replicate (and preferably outperform) the risk-reward profile of a specific benchmark, or indeed an ALM manager who is trying to match specific liabilities, central banks and bank treasuries can be thought of as total return investors subject to a liquidity mandate. As such, they can be expected to take steps to avoid paying negative rates on the roughly €1tn of their holdings that have moved into negative rates since the beginning of June.

€400-600bn of additional demand for risk
Table 2 also shows how much demand for additional risk the ECB has potentially generated through its decision to cut rates into negative territory. 

If bank and central bank portfolios were to try and offset the hit to interest income since the beginning of June, this would generate demand for duration or peripheral risk or a mix of the two between € 400-600bn.
Clearly this number is an exaggeration of what bank treasurers and central bank portfolio managers are actually likely to do. Some will be uncomfortable taking so much additional duration and/or credit risk. Banks that are not capital constrained may decide not to accumulate zero risk-weighted assets but instead lend to the real economy. Other banks may decide to take steps to encourage deposit outflows to reduce investment needs.
Yet, what this exercise shows very clearly is that even in the absence of QE, the ECB is creating a pseudo-portfolio effect, achieved in the US and the UK through the outright purchase of government bonds. With the ECB now actively targeting a balance sheet expansion, we expect yields to move further into negative territory, aggravating the challenges for investors outlined aboveTherefore, over time we may well see a migration into risk approaching these numbers above." - source Bank of America Merrill Lynch

We therefore do think (and so far flows in US investment grade are validating this move) that interest rate differential will indeed accelerate inflows towards US fixed income, contrary to Bank of America Merrill Lynch's views. We do not expect a rapid rise in US interest rates but a continuation of the flattening of the US yield curve and a continuation in US 10 year and 30 year yield compression and therefore performance, meaning an extension in credit and duration exposure of investors towards US investment grade as per the "Global Credit Channel Clock" (although the releveraging of US corporates means it is getting more and more late in the credit game...).

Of course the issue in Europe when it comes to the real economy has been weak aggregate demand plagued by high unemployment levels and the continuation of the "deleveraging" à la Japan.

The weaker macro outlook as part of the "Japanification" process is supportive of credit and the continuation of lower yields. On that specific subject we agree with Nomura's take from their latest Japan Navigator No. 590:
"As bond yields and stock prices apparently moved in line with the three-month cycle in the UST market until the first half of this week, we believed that investors should be positioned for lower stock prices and lower bond yields (bull flattening in the super-long space) until the 28-29 October FOMC meeting, which we view as the next turning point in monetary policy. However, the Fed demonstrated its dovish stance unexpectedly earlier in its 16-17 September meeting minutes, bringing rates lower substantially. Despite this, stock and crude prices continued to move lower this week. This suggests to us that the market has begun to expect changes in the real economy, i.e., a slowdown in the global economy, including the US, and potential easing by the Fed and other central banks, rather than looking at the excess liquidity-driven three-month cycle. This is only a tail risk at this point, but warrants due attention as it could have a substantial market impact. Indeed, we believe investors have added positions by pricing in this risk, likely adding momentum to risk aversion this week."
- source Nomura

Moving back to the subject of the credit cycle, JP Morgan's latest note from the 14th of October entitled "Where we are in the credit cycle?" highlights the situation based on credit fundamentals:
"A credit cycle is generally characterized by a rapid growth in the availability of credit, a decline in the cost of credit, and increased willingness of lenders to accept lower returns and to lend to riskier borrowers. At some point subsequent losses from this risky lending rise, and lenders retrench, leading to credit market stress and often a broader negative economic impact.

When companies have access to plentiful and historically cheap funding there is a risk that they use it in ways that support shareholders while making their credit profiles more risky. There are trends occurring in some credit markets that have historically been associated with a credit cycle that is reaching maturity. These include significant bond issuance, low spreads, a weakening of covenants, declining credit ratings, an increase in M&A activity, less favorable use of proceeds from issuance, and rising dividends and share buybacks. However, the starting point for deterioration is quite strong in some markets, and the extent of deterioration is not consistent across markets, and some are actually improving.
Monetary authorities globally are contributing to easy financing conditions for corporates through both low policy yields and a withdrawal of fixed income product supply through QE. A result of this is, since 2010, there has been a 33% increase in the outstanding amount of US corporate bonds, 166% increase in EM corporate bonds outstanding and 39% increase in European corporate bonds outstanding (figures exclude Financials). Some of this increase is substitution from other funding sources into the bond market. In EM markets some of it reflects a shift in funding from sovereign to state-owned (quasi-sovereign) issuers as well as substitution of syndicated loan facilities in 2012. In all regions low coupons have made the large debt burden more manageable from a cash flow perspective. Still, the rise in debt issuance has impacted leverage.
The key question is where we are in the credit cycle—are we at the 5th inning (for Americans, or halftime for Soccer/Football fans) or the 9th inning/close to full time? This varies by market, as shown below. The US HG market is perhaps the most advanced, exhibiting many signs of maturity. On the opposite end, Japanese credit metrics are improving sharply thanks to improved profitability driven by better growth and the weak yen.

-The credit cycle is not identical across market segments; we see the US High Grade market as most advanced in the cycle and the Japanese market as improving the most rapidly.

-In US High Grade markets the credit cycle is the most advanced, with increasing cash going to shareholders, rising leverage and increasing M&A.
-In US High Yield credit metrics are eroding modestly alongside new-issue quality, but robust corporate liquidity supports continued low default rates.
-In European HG leverage remains near historical highs, as the economic recovery has struggled to gain momentum. Companies are being conservative with dividends and M&A.
-In European HY markets companies are reducing debt but revenue is declining at about a similar rate, such that credit metrics are struggling to improve.
-In EM HG the rise in leverage has been driven by quasi-sovereigns where government policy remains a variable, but non-quasis have been stable.
-In EM HY credit fundamentals have weakened with slow GDP growth. There is still some pressure from commodity sectors, but maturities are light near-term.
-In Japan credit metrics are improving sharply with the pickup in growth and weak Yen. Companies are using the improved cash flow to pay down debt." - source JP Morgan

While the "Actus Tragicus" continues to play out in the deterioration in Europe of economic fundamentals putting additional stain on stretched equities valuation. In the credit space, at least in investment grade, thanks to the "Japanification" process, it continues to be "goldilocks" we think.

On a final note we leave you with the Chart of the day from Bank of America Merrill Lynch note from the 10th of October entitled "Investing in a sub-zero world" displaying our negative yields are indeed moving out the curve:
- source Bank of America Merrill Lynch

"Politicians fascinate because they constitute such a paradox; they are an elite that accomplishes mediocrity for the public good."- George Will, American novelist

Stay tuned!

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