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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