Wednesday 26 November 2014

Credit - The Hidden Fortress

"Even if it seems certain that you will lose, retaliate. Neither wisdom nor technique has a place in this. A real man does not think of victory or defeat. He plunges recklessly towards an irrational death. By doing this, you will awaken from your dreams." - Yamamoto Tsunetomo, Hagakure: The Book of the Samurai

Watching with interest, Japan hit again with recession, with Shinzo Abe's response by delaying the sales-tax increase while the GPIF increasing its share of risky assets, with neighboring China throwing as well the proverbial gauntlet with both a surprise rate cut as well as with its rising up-and-coming industrial technologies and industrial companies, we reminded ourselves of one of our favorite film directors of all time Akira Kurosawa's 1958 masterpiece "The Hidden Fortress" when choosing our title as an analogy. After all, Kurosawa's movie is all about epic self-discovery and heroic action as described by Armond White in The Criterion Collection in 2001: "Kurosawa always balances valor and greed, seriousness and humor, while depicting the misfortunes of war."

In our investment world it is all about balancing valor and greed while we, pundits continue to depict the misfortunes of currency wars we think.

What is as well of interest in our chosen analogy and movie reference is that in the movie, the two peasants heroes while driven by their ecstasy for gold end up with only one single Ryō gold coin: "A Ryō was a gold currency unit in pre-Meiji Japan Shakkanhō system. It was eventually replaced with a system based on the yen." - source Wikipedia. On a side note movie buffers like us know that Georges Lucas was heavily influenced by Kurosawa's movie which inspired him to create the lowliest characters C-3PO and R2-D2 in Star Wars. 

The Currency Museum of the Bank of Japan states that one Ryō had a nominal value equivalent 300,000-400,000 Yen, but was worth only 120,000-130,000 Yen in practice, or 40,000 Yen in terms of rice which but half of what an ounce of gold is in terms of weight (16.5 g vs 31.103 g). From an historical point of view it is interesting to note that in 1695 during the Togugawa shogunate, the government decided to debase the Ryō. By 1736, the government decided to stimulate the economy and raise prices, again by debasing the gold content of the Ryō until it was abolished in 1871 and replace by the yen but we ramble again...

When looks at the YTD returns of various cross-asset classes, as presented by Bank of America Merrill Lynch in their Thundering Word report of the 7th of November 2014 entitled "Humiliation, Hubris & Gold", one could fathom that the real "Hidden Fortress" has indeed been the US dollar:

In this week's conversation and in continuation to our musings relating to central bank intervention we will look at why the "japanification" process has been favorable to the on-going rally in credit as well as how the market has been playing the banking sector deleveraging through credit rather than through equities (a pure capital structure play we think).

While there has been a lot of noise recently around the SPX vs HY US widening spread as clearly indicated by our good friends Rcube Global Asset Management. in their note "US Equity / Credit Divergence: A Warning", this credit uneasiness is also visible in Europe with Investment Grade / High Yield renewed divide - graph source Bloomberg:

Itraxx Main 5 year CDS index versus Itraxx Crossover 5 year CDS index - roll adjusted as of the 20th of November 2014:

What has also been of interest in 2014 when it comes to the performance of credit, yet another "Hidden Fortress" we think, has been the total return performance in the US of High Grade versus High Yield in terms of Total Return as displayed in a chart from Bank of America Merrill Lynch from their 2015 2015 HG Outlook entitled "Un-reaching from yield":
"As our title suggests we expect US high grade corporate credit to come under pressure next year as the Fed begins its rate hiking cycle. The exemplary behavior of credit spreads in recent years stands as the key consequence of strong inflows to the asset class. As inflows disappear/turn to outflows we expect extended periods of spread widening – and high spread volatility - as interest rates go up, and thus continued positive correlation between interest rates and credit spreads" - source Bank of America Merrill Lynch

Of course we agree that one of the top main reasons in the behavior of credit spreads has indeed been strong inflows in the asset class as indicated by Bank of America Merrill Lynch in their recent Follow the Flow note entitled "Quality is king" from the 21st of November:
"Non-stop flows into ‘safety’
More of the same for another week it seems. More inflows into high-grade credit funds, and more outflows from equity funds in Europe. Note that euro IG cash is now trading at 2007 levels. So far this year more than $60bn has been added to high-grade funds, while equities have seen inflows of only $14bn. If the recent trend of outflows from equity funds continues at the same pace for the rest of the year, cumulative flows might be close to flat.
Government bond funds have continued to see outflows for a fourth consecutive week, with money-market funds down for a second week in a row. Note that over the last week, only high-grade credit and loan funds have seen inflows.

Credit flows (week ending 19th November)
HG: +$2.0bn (+0.3 %) over the last week, ETF: +$669mn w-o-w
HY: -$700mn (-0.3%) over the last week, ETF: +$20mn w-o-w
Loans: +$41mn (+0.5%) over the last week
Flows into high-yield funds dipped into the negative territory. After a short stint of inflows European HY funds saw a $700mn outflow. YTD outflows now point to $2.5bn. Should HY flows remain in negative territory for the rest of the year that would mark the first year since 2011 of negative flows for the asset class. On the other side, high-grade credit with another $2bn+ inflow last week is set to have its best year according to EPFR data.
Mid and long-term high-grade funds continued to see strong inflows, while short-term funds suffered moderate outflows, as investors are reaching for quality yield.
- source Bank of America Merrill Lynch

In total YTD inflows in Investment grade represents $60 billion versus only $14 billion in equities. So much for the "Great Rotation" story of 2014...

When it comes to the gradual move towards higher quality in the credit rating spectrum, this adds validity to what we argued back in October in our conversation "Sprezzatura":
"When it comes to the "credit clock" and leverage in the High Yield space, since mid-2013 the net leverage has increased at a faster space. This is confirming the gradual move of institutional investors from low beta towards higher quality while retail investors continue to be significantly exposed to lower quality credit."

In fact, as per Bank of America Merrill Lynch AAA-rated US corporate bonds (9% annualized) outperformed CCC-rated bonds (2%) validating the “flight to quality” theme and quality credit being a somewhat a "Hidden Fortress".

In terms of the impact the rate hiking cycle we have a preference with scenario number two from Bank of America Merrill Lynch's 2015 US HG Outlook entitled "Un-reaching from yield":
"Why the rate hiking cycle is different for credit this time
There are three reasons why we are particularly concerned about the rate hiking cycle this time. First, we are at the tail end of an unprecedented five years of zero interest rates, which led to an unprecedented reach for yield. Thus we are about to see an unprecedented un-reach from yield. Second, dealer balance sheets have collapsed due to new regulation, and are thus unable to mitigate a situation with heavy outflows. Finally, the less stable mutual fund/ETF ownership share of our market has jumped compared with the 1990s (Figure 5).
#1 risk to our outlook – Upside to the economy
The #1 risk to our outlook is that the US economy really takes off and leads to a more rapid rate hiking cycle and much higher long term interest rates. To us the economy looks really strong, and the November reading on Philly Fed being the highest since December 1993 (Figure 6) reminds us about the biggest risk scenario for 2015 – a repeat of 1994, where a strong economy forced the Fed’s hand and financial market conditions became disorderly. 
In that scenario we think HG credit spreads could widen to 200bps, taking global credit spreads wider too. That could lead to excess and total return losses of about 200bps and 8%, respectively.

#2 risk – Downside to the economy
We also find it entirely possible that that the US economy slows down meaningfully from here to around 2%-2.5% GDP growth in 2015 (compared with our house forecast of 3.1%). This #2 risk to our outlook would mean that the rate hiking cycle is pushed beyond 2015, and that global investors may become sufficiently comfortable with US interest rate risk that we get a big global reallocation into US fixed income, given ultra-low global yields. Such scenario could lead to lower interest rates and much tighter credit spreads – say, as tight as100bps, with US HG spreads compressing significantly to EUR HG spreads. This provided that the economy does not slow too much. In this scenario HG excess and total returns could be as much as +330bps and +9%, respectively

#3 risk – Upside to the global economy
As #3 risk to our outlook we have that strong US economic growth pulls up the global economy. As we have argued, the US is a relatively closed economy and thus unlikely to be pulled down meaningfully by the weak global economy. However, the US economy is big enough that its imports can serve as an important driver of global economic growth. The problem with this scenario is that it lessens the downward pressure on long term US interest rates asserted by the weak global economy. That means more outflows from credit and further credit spread widening." - source Bank of America Merrill Lynch

When it comes to credit and liquidity, it has been a recurring theme in our musings. On the subject of liquidity we agree with our good friend and former colleague Anthony Peters, strategist at SwissInvest and regularly featured in IFR from his last post entitled "A confidence in crisis":
"Bloody, ugly

ICMA, the International Capital Markets Association – I am honoured to be sitting on one of its committees – has just published a paper titled “The current state and future evolution of the European investment grade corporate bond secondary market: perspectives from the market”. It is based on a series of interviews with senior market participants from both sides of the street. We might nod knowingly at most of its conclusions but it finely articulates knowledge and concerns of the bond markets for those who don’t fully understand them but who are, nevertheless, responsible for their governance.

It is a fine piece of work by Andy Hill but it carries one big and stark warning which is that most players are patently aware that debt markets are living in a liquidity fed vortex and that nobody has a clue what might happen when if, as and when the cheap money is withdrawn. What they are certain of, it would seem, is that whatever the outcome might be, it will be pretty bloody and ugly." - source IFR - Anthony Peters

A good illustration from this report pointed out by our good friend is the RBS Liqui-o-Meter graph measuring market liquidity we think:
"The RBS Liquid-o-Meter, which attempts to quantify US bond market liquidity, suggests that liquidity in the US credit markets has declined by 70% since the crisis, and continues to worsen. Anecdotal evidence suggests that this is equally applicable to the European corporate bond markets.
The RBS ‘Liquid-o-Meter’ attempts to quantify bond market liquidity by combining measures of market depth, trading volumes, and transaction costs. Currently it is only modeled for US markets." - source ICMA report "The current state and future evolution of the European investment grade corporate bond secondary market: perspectives from the market.

As we posited in the conversation "The Unbearable Lightness of Credit":
Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital

We remind ourselves from the wise word from our friend and credit mentor Anthony Peters when it comes to liquidity:
"Somewhere out there, the next big bubble is forming and it will catch the unwary cold. Banks no longer have the risk capital to make big markets in all issues, least of all unconventional ones, and investors would be well served to ask themselves now where the pockets of liquidity will be when they are most needed. Don't disregard the old definition of liquidity as being something which, when needed, isn't there. I can't say where that there will be but I can be pretty certain that it won't be in corporate perp land. I rest my case." - Anthony Peters - IFR - Investors queue up for perp walk

From the same Bank of America Merrill Lynch's 2015 US HG Outlook entitled "Un-reaching from yield" here is another illustration of the lack of liquidity premium in the credit space:
"When the tide goes out
Currently we think that investors are not getting paid sufficiently for taking liquidity risk. Furthermore the most obvious consequence of the lack of retail inflows and institutional outflows, when short term interest rates go up, is that liquidity deteriorates. Hence we prefer positioning in liquid bonds.
For credit the most prominent unintended consequence of increased financial regulation is reduced liquidity via the collapse in dealer balance sheets (among other things, Figure 12).
As we have argued, that means high grade credit spreads should be permanently wider as the fair liquidity premium is much higher – in the appendix we update our analysis to estimate potential cycle tight HG spread levels of 100bps, compared with 79bps during the previous cycle.
However, this effect has been masked as strong technicals from significant inflows to HG, and credit spreads moving toward new tights meant investors were forced to reach for yield in off-the-run names and maturities. As a consequence, again, the liquidity premium has collapsed (although very recently there has been a small increase, Figure 13).
However, with the Fed expected to hike interest rates next year obviously inflows are destined to weaken and even turn to outflows. That means the liquidity premium is going to widen back out to – we estimate – about 10% of on-the-run spreads as a rule of thumb. Hence we continue to think investors are better off in liquid on-the-runs, as they are not being compensated for taking liquidity risk.
This also means that our HG index spreads of presently around 130bps are artificially tight. In fact, if our index is priced under next year’s deteriorating liquidity conditions we think spreads would be about 10bps wider (given that the vast majority of bonds are illiquid). That represents formidable headwinds for HG credit next year. Add a rate hiking cycle to much worse liquidity conditions and we look for HG credit volatility to increase significantly next year from currently around 44% (1m ATM options on the CDX IG) to 80% - thus exceeding levels seen last year during the taper tantrum" - source Bank of America Merrill Lynch

The Hidden Fortress in the credit space lies therefore in high quality and liquid bond we think.

Moving back to the subject of the potential downside to the US economy, what we find of interest is that the "Cantillon Effects" have indeed generated positive correlations. The world is much more intertwined macro wise.

The "japanification" process and the growing risk posed by "positive correlations" is a subject we touched in our conversation "Misstra Know-it all" back in September 2013 and we referred to Martin Hutchinson's take on these correlations:
"Negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. 

Since central banks worldwide are now pursuing the same easy-money policies as the Bernanke Fed, the same correlations are appearing elsewhere, with the exception of the majority of emerging markets, where economic reality remains in play." - source Asia Times, Martin Hutchinson

We commented at the time that the credit markets and equities markets were no exception to "rising forced correlations". In recent years, credit and equities have correlated closely, but, as credit has moved towards a lower bound, Investment Grade for instance have become even more sensitive to interest rates movement, making it incredibly likely that any rate rises will have a large impact given the disappearance of the interest rate risk buffer in the asset class given the on-going spread compression supported by large inflows into the asset class.

As we reminded ourselves from the conversation "The Monkey's paw" when discussing too much liquidity in the world:
"It seems to us the central bank "deities" are in fact realising the dangers of using too much the "Monkey's paw" in the sense that the Fed paved the way for "mis-allocation" and the rise in inflows into the credit space, but that even the Fed's generosity cannot offset the rising risks of a broad exit in a disorderly fashion in credit funds given that the Fed's role is supposedly one of "financial stability"." 

Back in August 2013 in our conversation "Alive and Kicking" we argued the following when it comes to convexity and bonds:
 Moving on to the subject of convexity and bonds, how does one goes in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":
"CDS benefits from positive convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays

As a reminder:
Convexity measures how duration changes as yields change. For a positively convex bond, the duration increases as the yield declines, and decreases as the yield rises. Positive convexity means that the price increase for a given decline in yields is greater than the price decrease for the same rise in yields. Non-callable bonds are positively-convex. Bonds with traditional call options, such as preferreds, and mortgage-backed securities, or some specific callable high yield notes are generally negatively convex. If you expect yields to rise, you should avoid bonds with long duration, such as those with longer maturities and lower coupons, and favor bonds that have shorter duration and higher yields. In periods were you can expect higher volatility in yields, you should avoid low or negative convexity bonds such as callable bonds in the High Yield space.

We concluded at the time:
"With positive convexity from using CDS, the sensitivity of the price to yield changes (i.e., duration) works in your favor whereas with negative convexity, duration works against you as the price of the bond is becoming more sensitive to yield changes. The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..."

Of course another issue to take into account is the liquidity in the CDS space which has been affected as well by the new regulatory environment and the fact that recently one of the largest player in the single names CDS trading space, Deutsche Bank has decided to exit entirely the business, which is no doubt another headache for the credit players looking for duration risk mitigating tools.

When it comes to interest rates risk and positive correlations we find of interest that all global sovereign rates declined together in 2014. Most investors were positioned for higher interest rates, we were not. 

Several factors come to play when asserting the reason behind the global decline. On this subject we read with interest Bank of America Merrill Lynch recent Liquid Insight note entitled "The world is flat":
"Is this a coincidence or a trend?
Is the global decline in rates a mere coincidence in 2014, or is it a recurring theme? Chart 1 illustrates the time series of 10y rates in the US, Euro area, UK, Japan, Canada and Switzerland, suggesting strong co-movement over time. 
To see the strength of the correlation, we conduct a Principal Component Analysis (PCA), and compute the fraction of total variance that can be explained by the first principal component (PC). On average, the first PC can explain 85% of total variance in global rates over the last 10 years. 

As one would expect, during crisis periods such as the Lehman collapse (2008) and the European peripheral crisis (2010-12), the fraction is particularly high. There is either a growth shock or a flight quality move, which spills over across markets. However, the first PC has remained very high in 2013 and 2014 even though we are not at a crisis period per se. This suggests recently global rates seem to be as correlated as they were during crisis periods. This could reflect deeper inter-linkages in the macro economy as well as financial markets globally post crisis. Some research also suggests uncertainty shocks such as the Lehman crisis can put downward pressure on terminal rates globally." 

What drives co-movement across global rates?
A recent IMF study3 attributes co-movements in global rates to the usual three 
factors: level, slope and curvature. Interestingly, the authors associate these 
factors with a clear economic interpretation of global inflation, global growth and 
future financial and economic instability, respectively.

Since global growth and global inflation are closely related to US growth and US 
inflation, it is important to differentiate whether the correlation in global rates is 
merely a reflection of correlation of macro fundamentals, or whether global factors 
provide additional information. In other words, do global factors impact US rates 
beyond US growth and inflation factors? This question is of particular interest 
currently as growth dynamics seem to be diverging, with the US outperforming 
much of the developed world.
To this end, we compare two regressions: In one, we only include US growth 
measures as proxied by the PMI indices. In another, we include global PMI in 
addition to US PMI measures. Regression results are tabulated in Table 1 and 
Table 2. 

When we take account of global PMI, the fit improves, and R-square 
increases from 12% to 30%. This signals that global PMI provides explanatory 
power for US rates that go beyond US PMI measures. Another way to see the 
relevance of global PMI is that the coefficient in front of global PMI is significant 
(with t-stat 3.72). These results suggest that global growth measures provide 
additional information for US rates beyond US growth measures.
This finding does not contradict our previous finding that 10y German rates do not granger cause 10y US rates. While granger causality examines whether lagged 10y German rates provides explanatory power for 10y US rates in addition to lagged 10y US rates, the discussion above focuses on macroeconomic fundamentals that drive movements in 10y US rates. It is quite possible that lagged 10y German rates do not contain new marginal information of global growth over lagged values of 10y US rates.

Market implications: Mind the globe
Even though US domestic factors of a narrower output gap and slowing demand from price inelastic sources argue for higher US rates currently, we think investors should be mindful of global factors. The recent weakness in global growth (as evidenced from global PMI) and inflation can prevent a significant move higher in US 10y rates. By the same logic, any pick-up in global growth or inflation will likely have a disproportionate effect on US rates, all else being equal.- source Bank of America Merrill Lynch.

Given the disappearance of the interest rate risk buffer in the investment grade asset class, mind the volatility gap in 2015 and hedge accordingly.

Another factor explaining the global trend in lower yields has of course been the role played by Japan and its pension funds allocation, in particular the GPIF which is reducing its domestic bonds exposure aggressively while pursuing a higher share in risky assets: domestic equities, foreign equities as well as foreign bonds as disclosed its July-September quarter financial results published on the 25th of November and as reported by Nomura in their note entitled "GPIF still has room for a portfolio shift":
"The GPIF, the biggest pension fund, announced its Jul-Sep quarter financial result today. The share of domestic bonds in its portfolio declined to 49.6%, the lowest share ever, from 53.4% the previous quarter (Figure 1). 
The share undercut 50% for the first time and it was lower than the minimum share under the old target portfolio. We estimate that the share fell to 52.3% by end-September owing to valuation effects. Thus, the fund reduced its domestic bond exposure aggressively, more than valuation effects suggest. Trust accounts, which manage pension fund money, were net sellers of JGBs in August and thus, the decline is not necessarily surprising" - source Nomura

We note that the allocation to international bonds from end of June at 11.1% increased to 12.1% and given the maximum target portfolio new target has increased from 16% to 19% and the target portfolio is set at 15% therefore there is room for further yield compression we think in the global sovereign space.

Moving to another case of "Hidden Fortress", we continue to think US treasuries are compelling, particularly in the long end as we believe the US is far from normalizing and investors might yet again be disappointed in 2015.

The potential catalyst for US Treasuries has been summed up nicely by Societe Generale in their November publication entitled "The Japanization of the US economy? What if the US follows Japan (and the Eurozone) down the rabbit hole of deflation?":
"Potential catalysts for US Treasuries:
• Differential between US, Eurozone and Japan rates are at historically high levels, in part based on the belief that US can avoid global deflation
• What could push US into same vicious spiral as Europe and Japan?
• Consensus has not priced in risk of deflationary conditions in the US
• Deflation in the US would be very bullish for US Treasuries but there are additional factors driving capital flows into US Treasuries
1) Chinese official sector buying Treasuries - underinvested in Treasuries since Fed started QE-III
2) ECB negative discount rate policy drives EM reserves out of € into US reserve deposits
3) Return of the geopolitical crises; Greece and Venezuela/Argentina induced by China
4) US dollar should continue to appreciate, which is disinflationary and compresses rates
5) US elections – GOP control over Congress leads to lower deficits, lower growth
6) Lack of alternative, dollar denominated, risk free assets
7) Mortgage pre-payment hedging – Mortgage investors have to buy Treasuries to hedge pre-payment risks
8) Fed will likely remain more dovish than many currently forecast
9) Demographics - Surging retirement of 75ml baby boomers will drive investments into Treasuries
10) Regulation – Fed and US regulators forcing financials to hold more Treasuries"- source Societe Generale

As a reminder, 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).
When it comes to Europe, the deleveraging continues and amounts to goldilocks period for credit particularly in the banking space whereas banking equities will continue to underperform we think.

We pointed out in our conversation "Actus Tragicus" the attractiveness of European investment grade credit:
"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
We also argued at the time:
"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...)."

The continued underperformance of European banks equities versus credit can be explained by the simple underlying mechanism of capital arbitrage as explained by Exane BNP Paribas Research in their note from the 13th of November entitled "How the market plays the banking sector deleveraging":
"The relative fall in banks’ shares vs credit reflects a capital structure analysis
The banking sector has underperformed the whole market by 9% since the beginning of November. At the same time, the credit spreads of banks have accompanied those of the whole market. This is a normal capital structure pattern. The market anticipates a value transfer from equity holders to debt holders. This is the case when a company or a sector reduces its leverage, for example through disposals, capital increases, or improved market conditions. Such moves reduce the risk borne by debt holders but reduce the speculative time value of equity holders."
The underlying mechanism
The banking system arbitrage is so simple that it can be explained using the Merton model, notwithstanding the model can be refined. To allow for complex capital structure analysis and arbitrage, we generally use our proprietary ALRG™ model.
The simplified Merton view states that the sole driver of a firm’s value is its asset value. As long as the asset value covers the nominal of the debt, the firm continues to operate. If not, the firm is liquidated and the proceeds go to the debt-holders.

Debt and equity are seen as options on the assets.
– The debt holder gets back the nominal debt value if the company is solvent and receives the residual value of the assets in the event of default; the payoff of the position is MIN (debt, asset). The equity value is seen as a call option on the assets, the amount of debt is the strike.
– The equity holder owns the net asset value if the company is solvent but loses everything in the event of default; the payoff is MAX (0, asset - debt). The credit spread is the premium of a put option on the assets, the amount of debt is the strike.
The equity (call option) value includes intrinsic value (asset value less the amount of debt) and time value (speculative value).
The put option has no intrinsic value, as long as the value of the assets is greater that the debt amount. Yet, it essentially has time value.

A deleveraging is a very simple move: the strike is lowered. Doing so, the risk borne by debt holders is reduced. This is reflected by the value of the put option sold by the bond holder. With a lower strike, its value is lower. And of course, due to the call/put parity, this value is taken from the equity holder. The speculative value of equities is reduced.

In the real world, things are more complex and worse:
1) Banks hold an implicit guarantee “offered” by central banks and/or governments. Its value is reduced by the deleveraging. This is the target of the too-big-to-fail regulation. Consequently, the deleveraging also has a negative impact on assets value, increasing the transfer from equity to debt holders.
2) Like any other company, a bank has to bear significant operating costs – which do not come down with reduced leverage. The expected equity return is reduced, but the costs to obtain this return will remain the same.

To offer a caricature, a “perfect” bank would only hold treasury bonds and would be fully financed with equities. In this case, the shareholder’s return is defined by the treasury yields minus operating expenses and taxes. This is not a very good investment." - source Exane BNP Paribas Research

On a final note we leave you with a chart for Bank of America Merrill Lynch latest Thundering Word note entitled "Humiliation, Hubris & Gold" which displays Europe earnings as % of global earnings:
"The Berlin Fall
25 years on from the Fall of the Berlin Wall and Europe is arguably one recession away from severe political and social stress. 24,512,000 men and women are currently unemployed across the continent and anti-establishment political parties are surging in popularity across the continent. Monetary convergence between 1989 and 1999 (as disinflation from Eastern Europe and the promise of good fiscal behavior initiated a decline in interest rates toward German levels) and the monetary union of 1999 and 2008, has been replaced by a monetary divorce as bond markets price-in various sovereign risks. Meanwhile, Europe’sshare of global profits has collapsed (see Chart 4)." - source Bank of America Merrill Lynch

When it comes to QE in Europe in general, and the ECB in particular, we think our last quote resume appropriately the "Japanication" situation:
"If you keep your sword drawn and wield it about then no one will dare approach you and you will have no allies. But if you never draw it, it will dull and rust and people will assume that you are feeble." - Yamamoto Tsunetomo, Hagakure: The Book of the Samurai

Stay tuned!

Monday 17 November 2014

Guest Post - US Equity / Credit Divergence: A Warning

"One thorn of experience is worth a whole wilderness of warning." - James Russell Lowell, American poet.

Please find below a great guest post from our good friends at Rcube Global Asset Management. In this post our friends go through the growing divergence in the US between credit and equities:

Major equity / Credit divergences should always be taken very seriously.

They were among the best forward looking indicators at almost every major turning point for equities over the last 20 years.

To recap:

In 1998, equities were rallying hard, but US HY spreads failed to print new lows. Instead, they started widening in late 1997. Credit was telling us back then that Asia and Russia were severely slowing down while corporate balance sheet health was deteriorating. It preceded the 1998 crash.

In 1999/2000, the divergence was even more pronounced. The S&P500 not only recovered from the Asian crisis but rallied strongly during the Tech bubble. US HY spreads had bottomed 3 years earlier! Corporate balance sheet were at the time very stretched. As a result, banks were tightening lending standards. The equity market eventually crashed, tracking the signal sent by widening credit spreads.

During 2007/2008, credit spreads bottomed in May 2007 and started widening immediately after, while equities kept moving higher for another 5 months (October 2007). Spreads were telling us just like in 2000 that private sector leverage had reach such an elevated level that banks were starting to close the credit flows. Again, the divergence timed the bear market that followed.

In 2008/2009, spreads topped out in December while equities made new lows that were not confirmed by a new high on HY spreads. At that time, corporate balance sheet had started to adjust violently to the crisis. Capex had been cut to zero, the corporate sector was issuing equity (net positive liquidity impact) and cash flows had already bottomed and were starting to rise. Balance sheet health was improving, as evidenced by tightening credit spreads. The bullish divergence timed the end of the bear market.

In 2011, spreads bottomed in February while equities made a new high in April, as spreads widened further due to the European sovereign crisis. Equities reversed shortly after.

Today, the divergence is visible again. US High Yield spreads bottomed in June and have widened substantially since then. Equities are still printing new highs. Are US HY spreads telling us that global growth is weaker than expected, a message also sent by flattening yield curves, depressed bond yields, defensive massive outperformance relative to cyclicals. Is it Europe? Russia? Emerging Markets?

The fact that all this is happening while bullish sentiment in the US is at record highs is of particular worry. Everyone is expecting higher equities due to lower yields and depressed food and energy prices. But when everyone is thinking alike, no one is really thinking….

The expanding wedge pattern, has a target for US equities below the October low.

Investors should at least start hedging risk. The most aggressive can simply trade the downside. Volatility has crashed, especially on the very short expiries, as no one is expecting any hiccups before early 2015. This makes short dated puts quite attractive.

"History is a vast early warning system." - Norman Cousins, American author

Stay tuned!

Wednesday 12 November 2014

Credit - Chekhov's gun

"One must never place a loaded rifle on the stage if it isn't going to go off. It's wrong to make promises you don't mean to keep." -  Anton Chekhov

Listening with interest to our "Generous Gambler" aka Mario Draghi monthly ECB conference, where no doubt, our poker player has indeed regained some of his "Sprezzatura", given the dovish surprises contained in his latest press conference with his explicit reference to the planned balance sheet expansion of the ECB in the introductory statement, we reminded ourselves of Russian writer Anton Chekhov's dramatic principle when choosing this week's analogy given the continuous hope for the ECB to unleash at some point a QE program of its own:
"Remove everything that has no relevance to the story. If you say in the first chapter that there is a rifle hanging on the wall, in the second or third chapter it absolutely must go off. If it's not going to be fired, it shouldn't be hanging there." Anton Chekhov

One could argue as well that Chekhov's analogy amounts simply to Tuco's philosophy from The Good, the Bad and the Ugly:
"When you have to shoot, shoot. Don't talk" - Tuco

And when it comes to central bankers, it looks to us that Bank of Japan has indeed recently applied Tuco's recommendation when it comes to its latest merry go round of QE but we ramble again...

Of course this post is a continuation of what we discussed in our last conversation in relation to the need of QE in Europe:
"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

Therefore in this week's conversation we will discuss into more details the need for a European QE and the potential effects the various QEs have had on the real economy.

When it comes to QE and its impact on asset prices, we have largely discussed its effect in our September 2013 conversation "The Cantillon Effects":
"Cantillon effects" describe increasing asset prices (asset bubbles) coinciding with an increasing "exogenous" (central bank) money supply.

We also commented at the time about the increase of money supply on the art market as posited by our friend Cameron Weber, a PhD Student in Economics and Historical Studies at the New School for Social Research, NY, in his presentation entitled "Cantillon effects in the market for art":
"The use of fine art might be an effective means to measure Cantillon Effects as art is removed from the capital structure of the economy, so we might be able to measure “pure” Cantillon Effects.

In other words, the “Q” value in the classical equation of exchange is missing all together for the causal chain, thus an increase in the money supply might be seen to directly affect the price of art.

Economic theory is that as money supply increases, the “time-preferences” of art investors decreases (art becomes cheaper relative to consumption goods) and/or inflationary expectations mean that art investors see price signals (“easy money”) encouraging investment in art." - Cameron Weber, PHD Student.

It is was therefore not a surprise for us  to hear that a Portrait by Edouard Manet reached $65M at a fall art sale in NYC, making this auction a new record for the artist (the previous record was $33.2 million for a Manet). Sotheby's sale totaled $422.1 million, the highest for any auction in its history. This is yet another sign of central bankers' "generosity" and a clear effective mean of measuring "Cantillon Effects". As per our previous conversation, a clear application of "Pascal's Wager":

The only "rational" explanation coming from the impressive surge in asset prices (stocks, art, classic cars, etc.) courtesy of QEs and monetary base expansion has been to choose (B), belief that indeed, our central bankers are "Gods".

Back in September 2012, in our conversation "Zemblanity", (Zemblanity being defined as the inexorable discovery of what we don't want to know), we discussed the relationship between credit growth and domestic demand and why ultimately our central bankers will fail in their useless reflationary attempts:
"credit growth is a stock variable and domestic demand is a flow variable"

We even asked ourselves at the time the following question:
"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"

The importance of domestic demand being a flow variable should not be underestimated particularly in the case of Europe due to the lack or slack in aggregate demand thanks to high unemployment levels and in many cases what Richard Koo has coined as "Balance Sheet Recession" (think Spain and Ireland when it comes to real estate bubbles and "damaged" households balance sheet).

As a reminder from our conversation "Zemblanity", it is very important to understand the core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on from their post entitled - How central banks contributed to the financial crisis: "We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b). 
 To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth. 
We have called the change in debt (or the change in credit growth) the 'credit impulse'. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit."  - Mr Michael Biggs and Mr Thomas Mayer on

So you might wonder where we going when it comes to discussing "Chekhov's gun" and the impact QEs have had on real economy, Japan being a good illustration.

On that specific case, we agree with Richard Koo, chief economist at the Nomura Research Institute in his latest note from the 11th of November entitled "BOJ's surprise announcement: monetary easing by a currency interventionist":
"QQE has had almost no impact on real economy
What effect has QQE had in the 18 months since it began? It has clearly had a major influence on the forex and equity markets, where surprises can be very effective tools, but has had almost no impact on the real economy.
Figure 1 shows Japan’s monetary base, the money supply, and domestic bank lending before and after QQE. If we rebase these aggregates to 100 at the point just before Mr. Kuroda became head of the BOJ and announced QQE, we can see that while the monetary base had surged to 187 as of this October, the money supply—the money actually available for the private sector to use—had risen only to 105, while bank lending stood at 104. Indeed, the money available for the private sector to use is expanding no faster than it did under Mr. Kuroda’s predecessor, Masaaki Shirakawa, in spite of QQE. In other words, QQE had no effect on the growth rates for either of these aggregates.

Central bank-supplied liquidity has nowhere to go without real economy borrowing
As I have repeatedly pointed out, the central bank can supply as much base money (liquidity) as it wants simply by purchasing assets held by private-sector banks.
But a private-sector bank cannot give away that liquidity, it must lend it to someone in the real economy for that liquidity to leave the banking sector.
For the past 20 years, Japan’s private sector has not only stopped borrowing money but has actually been paying down existing debt and increasing its savings in spite of zero interest rates.
Traditional economics never envisioned this kind of behavior, but the collapse of debt financed bubbles in Japan in 1990 and the West in 2008 left many businesses and households owing as much or more than they owned, prompting them to focus on repairing their damaged balance sheets.
QE without private demand for funds only generates mini-bubbles
While Japan’s private sector finally cleaned up its balance sheet around 2005–06, the debt trauma lingered on. That, together with the collapse of Lehman Brothers in 2008, led to a situation in which Japan’s private sector is still saving 5.7% of GDP in spite of zero interest rates and aggressive quantitative easing.
Unless the government borrows and spends this 5.7%, the funds supplied by the BOJ under quantitative easing would never leave the banking system and neither the money supply nor private credit would have increased—in fact, they might actually have decreased.

No matter how much the BOJ eases policy during this kind of balance sheet recession, the liquidity it supplies will not enter the real economy as long as there are no private sector borrowers. The only result is likely to be the creation of mini-bubbles in the financial markets.
While funds supplied under quantitative easing may provide a temporary boost to the prices of stocks and other assets, at some point those prices will correct unless they are justified by corporate earnings growth and other appropriate measures, and that will be the end of the mini-bubble." 
- source Richard Koo, Nomura Research Institute

If domestic demand is indeed a flow variable, the big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.
QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think.

In textbook macroeconomics, an increase in AD can be triggered by increased consumption. In the mind of our "Generous Gamblers" (aka central bankers) an increase in consumer wealth (higher house prices, higher value of shares, the famous "wealth effect") should lead to a rise in AD.

Alternatively an increase in AD can be triggered by increased investment, given lower interest rates have made borrowing for investment cheaper, but this has not led to increase capacity or CAPEX investments which would increase economic growth thanks to increasing demand. On the contrary, lower interest rates have led to buybacks financed by cheap debt and speculation on a grand scale.

In relation to Europe, the decrease in imports and lower GDP means consumer have indeed less money to spend. We cannot see how QE in Europe on its own can offset the deflationary forces at play.

In the case of Europe, deflationary forces can be ascertained by slowing global trade in the shipping industry as we discussed in our conversation of  January 2013entitled "The link between consumer spending, housing, credit and shipping - a follow-up":
"The relationship between container shipping and consumer spending, traffic is indeed driven by consumer spending".
Any changes in consumer spending will directly impact global containerized traffic volumes. Containerized traffic is dominated by the shipment of consumer products."

The latest warning in slowing global trade sent across by shipping leader and giant Maersk as reported in the Financial Times in their article entitled "Maersk warns of slowing global trade" should not be ignored:
"“We see a slowdown in emerging markets, partly driven by a lower need for raw materials from China. Europe – it’s very slow growth, if any, at the moment, and there’s no reason to expect a big change here,” said Nils Andersen, Maersk’s chief executive." - source Financial Times

As indicated by the weaker outlook in shipping for Europe, QE on its own will therefore not be sufficient to have an impact on the real economy given the "japanification" process at play and as illustrated by Japan.

On the subject of the risk of continued QE and its negligible impact on AD and the real economy, we read with interest RBS's take on the subject in their note entitled "The Silver Bullet - The risks of QE infinity:
"The supporting idea for QE is that a positive wealth shock can support spending and confidence, and absorb other negative shocks to the economy. But what happens if QE continues, and consumers expectations' adapt to a QE-after-QE environment? 

In a basic (rational) economic model of consumption, households try to maximise lifetime income, i.e. the maximum value they can achieve with their wages. In a QE infinity world with stable/low interest rates and flat/negative inflation, the price of goods stays stable or declines over time, while the value of financial assets is expected to grow. The incentive for those holding financial assets can become to delay spending or investment. 

There are of course many factors in play when it comes to consumer spending and corporate investment decisions: expectations of long term permanent income, the life cycle, interest rates, confidence, etc. 
But there's consistent evidence across some points:

1. Rich people save more and spend less. There's plenty of historical evidence on this. As we show in the chart above, the saving rate for the top 1% and top 5% of the population is a multiple than the bottom 50% (see also  Do the Rich Save More?). 

2. Income inequality has increased since the crisis. The share of wealth owned by the top 0.1% is now over 20% in the US, vs around 15% in the 2000s. Inequality measured as such is as high as it was in 1916, according to the  Economist. The  debate still goes on, but there's evidence that QE may have contributed to rising inequality, and central bankers including the Fed are becoming more vocal on the topic.

3. The marginal impact of an increase in wealth to translate into consumption is lower for the richer brackets of the population. A recent ECB paper shows this clearly: as you can see in the chart above, the propensity to spend if wealth increases is 2-3x higher for the bottom 50% of the population.

4. Even when it comes to corporate investment, there is little relationship between QE and lower interest rates and more investment, which instead depends on other factors (economic outlook, fiscal policy, etc.)

Adding up points 1-4 highlights one risk. If QE is accompanied by other policies – like fiscal spending or a reduction in taxes – then it can work effectively. But if central banks are left alone with the burden of stimulating the economy, the risk of entering a cycle of QE after QE, or QE infinity is high, and the results can be self-defeating. 

For now, credit investors continue to anticipate more action from the ECB (and BoJ) – the next one being potential purchases of corporate bonds. But the impact on the real economy still depends on government action on spending, and support to the ABS programme, and so far we have seen little of it. 
Our view here remains: don't confuse QE with growth. If anything, QE infinity could be self-defeating without fiscal and reform support, as the ECB itself has warned. We expect more tightening in investment grade and double-B bonds on potential ECB action, but fundamentals for banks and lower-rated firms will remain weak into year-end and 2015, hurt by deflationary and weak growth (IFO institute head Hans Werner-Sinn just warned about an economic crisis being "really close", even in Germany).The ECB ABS plan is potentially a game-changer, and the ECB may start buying over the coming days, as Yves Mersch said yesterday. Let's hope that this time around, they'll get some help from governments." - source RBS 

Our take on QE in Europe can be summarized as follows:
Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…).

“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?

When it comes to the Current European equation, we note with interest that civil unrest is a rising global trend as indicated by Nomura by Alastair Newton on the 11th of November in his note entitled "Civil unrest: Going global - More economies look prone to protests":
"Common factors
The (largely) common factors remain those I identified last year, ie:
-A high level of economic inequality (using the World Bank’s assessment of individual economies’ Gini coefficient);
-A high level of perceived corruption (using Transparency International’s (TI) index);
-A 'local' – sometimes minor and often hard to anticipate – issue sparking widespread protests rooted in general unhappiness with the regime;
-Increased 'middle-classing' of civil society, often confirmed by a ‘core’ of the protestors being in or having had tertiary education;
-Effectively leaderless protests organised primarily over social networks, ie, in common with the 'Arab Spring';
-A shared sense among the protestors of not being listened to by allegedly corrupt and self-serving elites;
-Widespread protester use of mobile phone cameras in the 'propaganda war'; and,
-Allegations of police brutality escalating, rather than deterring, the protestor numbers.

As the recent demonstrations in Hungary underline, we should not assume that civil protest is limited to emerging markets. Notably in many EU countries we are increasingly seeing what are essentially protest parties capturing a significant share of the popular vote in elections. In 2015, look out in particular, therefore, for UKIP in the 7 May UK general election and for Podemos in Spain’s December elections (not forgetting the – related, in my view – drive towards independence in Catalonia)." - source Nomura

Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)

On a side note and on this "French" matter, we think it is time to revisit our August 2012 OAT / Bund Yield Spread Widener as per our conversation "France - Playing the nonchalance". While we highlighted at the time the lack of catalyst, this trade had been put in the drawer given market capitulation and Japanese investment support in buying French bonds.

We still believe France should be seen as the new barometer of Euro risk, particularly when one realizes that France will issue €188 billion of bonds in 2015 (same record amount as in 2010) and for the following reasons:
-The European Commission latest macroeconomic forecast for France expects a budget deficit of -4.5% in 2015 and -4.7% in 2016. France will be the worse European country in terms of budget deficit. If indeed global trade is slowing down, there is indeed a high probability the deficit could even reach the important psychological level of 5%.
-With the recent comments from Hedge Fund manager David Einhorn, fast money could potentially put back the trade on.
-While Japanese investors have in the past been very supportive of French OAT bonds, the real yield of US Treasuries (0.6%) in conjunction with a rising US dollar make the US bond market much more appealing than the French bond market

As a reminder from our conversation "Big in Japan", Japanese have been net buyers of OATs in 2012 to the tune of 4.07 trillion JPY (44.2 billion US), the most since 2005. The gain in yen was 26% versus 15% for US Treasuries and they only bought for 3.35 trillion JPY worth of US debt in 2012.

This makes more likely a slowdown of the Japanese support for French OAT bonds in 2015. If one looks at GPIF assets and expected changes in portfolio allocation as displayed in Nomura's Japan Navigator number 593 published on the 3rd of November, the greatest change will be on international stocks rather than international bonds:
- source Nomura

French 10 year OAT vs German 10 year Bund - graph source Bloomberg:
On current levels, this trade appears to us very "convex". Downside appears to us limited to 10 bps, roughly 1 point on OAT Futures on current sensitivity levels, carry is around -35 bps over one year. One can target 20 to 50 bps of widening in the next 6 months if indeed there is finally a catalyst playing out. One could as well play the trade flat carry by buying more German bund, which would of course be an even more bearish growth outlook trade. Why not...

This trade could be seen as a little convex trade versus a book of high beta risky assets (periphery credit, equities, etc.). 

Moving back to our "Chekhov's gun" theme of European QE and in the case of Europe, the equity rally that followed the press conference of Mario Draghi doesn't appear warranted as it seems to us that investors have jumped the proverbial "Chekhov's gun". On this subject, we agree with Deutsche Bank's Behavioral Finance Daily Metals Outlook note from the 7th of November entitled "The far-out-of-the-money Draghi Put:
"Anyone who thought Mario Draghi would strike a more conciliatory tone in yesterday’s ECB press conference, following a Reuters report of dissatisfaction with his leadership style among members of the Governing Council, was doubly unsettled. Not only did he not backpedal on any of his more contentious statements about QE and the future size of the Bank’s balance sheet, he even made them more explicit, and presented an endorsement of his stance signed by all members of the Council. This dovishness lit a fire under European asset prices. Equity benchmarks rallied strongly as investors priced in the prospect of broad-based asset purchases. This reaction was perhaps overenthusiastic because the pre-condition for QE is that the economic situation in the eurozone worsens and/or that the current measures prove inadequate (which means precious time would have been spent finding out). So a ‘Draghi Put’ exists, but it is struck far-out-of-the-moneyEven gold in euro terms recorded its first positive session in over two weeks.
But it was far from being the most sought-after asset of the day; investors still preferred the dollar and US-based assets. If the global economic situation becomes gloomier, they reasoned, the Fed would probably still take more aggressive action than the ECB, and sooner. The strike price of the ‘Yellen Put’ is much closer to the money." - source Deutsche Bank

Indeed, when it comes to the ECB we have a case of "Chekhov's gun, whereas when it comes to the Fed and the Bank of Japan it is more akin to Tuco's philosophy: "When you have to shoot, shoot. Don't talk"

What we find of interest is that both the Fed and the Bank of Japan have been trigger "QE " happy, As we have argued in our last conversation, investors' belief in central bankers' omnipotence and deity status enabling them to sustain over extended asset price levels is being threatened we think by the changes in the communication of the conduct of monetary policy as indicated by Richard Koo, chief economist at the Nomura Research Institute in his latest note:
"The problem is that treating monetary policy like currency intervention also has side effects. Over the last decade it has become standard practice around the world to conduct monetary policy with a minimum of surprises based on careful dialogue with market participants.
Until the mid-1980s, monetary policy decisions tended to be made in closed rooms, something then-Fed chairman Paul Volcker was very good at. In Japan, it was even considered “acceptable” for authorities to openly lie in the lead-up to decisions on the official discount rate (or the timing of snap elections).
Since the Greenspan era, however, transparency has gradually come to be viewed as a desirable characteristic in the conduct of monetary policy. This trend gathered momentum under the leadership of Mr. Bernanke, who had been making a case for greater transparency in monetary policy since his days in academia. During his tenure at the Fed, this view was reflected in the shortening of the time required for FOMC minutes to be released, the holding of press conferences by the Fed chair, and the release of interest rate forecasts by FOMC members.

Kuroda abandons forward guidance
It was because of this approach that the Fed has been able to conduct policy now known as forward guidance based on expectations of its future actions, something that had not been possible in the past. It was precisely because the Fed avoided surprises that market participants trusted it when it said it would keep interest rates at exceptionally low levels for a considerable amount of time.
Policymaking evolved in this direction because of a growing awareness that monetary policy has a major impact on the economy and is fundamentally different from intervention on the currency market, which basically involves only a handful of participants.
But with the 31 October easing announcement Mr. Kuroda deliberately chose to shock the markets. By doing so, he effectively removed forward guidance from the BOJ’s toolkit.
When the head of the central bank enjoys surprising the market, market participants will no longer take anything he says at face value. Mr. Kuroda claimed in his Upper House testimony just three days before the announcement that the economy was making “steady progress” towards achieving the 2% price stability target even as he was secretly moving ahead with preparations for the surprise easing.

Ending QE will now be far harder for BOJ than for Fed
The BOJ governor’s decision to utilize the element of surprise could lead to major problems when it comes time to bring quantitative easing to an end. Careful dialogue with the market—including forward guidance—is essential when winding down such a policy, as the IMF has repeatedly warned.
There is, of course, no guarantee that the exit from QE will proceed smoothly simply because the central bank maintains a close dialogue with the markets. Even Mr. Bernanke, with his reputation for being a good communicator, caused a great deal of turmoil in both the developed and the emerging economies when his remarks on 22 May 2013 concerning the possibility of tapering sent US long-term interest rates sharply
The Fed’s intensive forward guidance under both Mr. Bernanke and his successor, Janet Yellen, succeeded in calming markets by persuading them the Fed had no intention of raising rates in the near future. It remains to be seen how Mr. Kuroda will respond when he finds himself in the same situation.
In summary, the BOJ’s shock announcement could make it far more difficult for the Japanese central bank to end quantitative easing than it has been for the Fed." - source Richard Koo, Nomura Research Institute

To some extent, both the Bank of Japan and the Fed have been fast QE gun drawers, but, when it comes to winding down QE, the exit from the program will not proceed that smoothly, rest assured.

While it has been easy to somewhat front-run the QE cowboys thanks to "Pascal's Wager", the end of QE in the US coincide with a renewed period of weaker global trade, historically high asset price levels and record low bond yields making it more likely we will see a return of higher volatilities regime in the near future making future equities return questionable and long bond US Treasuries enticing (we are keeping on our very long duration exposure via ETF ZROZ).

On a final note we leave you with a chart for Bank of America Merrill Lynch latest Thundering Word note entitled "Humiliation, Hubris & Gold" displaying Japan's free-float market cap as a percentage of world:
"Tokyo's all-out War against Deflation
Finally, Japan’s humiliating decline as % of world market cap (Chart 10) and the explicit war on deflation launched by the Bank of Japan keeps us overweight Japan, in contrast to China and Europe. In addition, Japan has high operating leverage and stronger earnings momentum. Our bullish view on volatility, particularly currency volatility, is strengthened by the knowledge that liquidity trends in the US and Japan will be moving in different directions over coming quarters." - source Bank of America Merrill Lynch.

"Every gun makes its own tune." - Blondie, The Good, the Bad and the Ugly

Stay tuned!

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