Thursday 11 December 2014

Credit - The QE MacGuffin

"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up." - F. Scott Fitzgerald

In continuation to our conversation "Chekhov's gun",  and with the on-going hope for our "Generous Gambler" aka Mario Draghi to unleash QE in Europe, given the growing German dissent from Bundesbank's Jens Weidmann and German Finance Minister Wolfgang Schaeuble as well as some other members of the ECB council, we reminded ourselves for our chosen title of yet another cinematographic analogy, the MacGuffin. The MacGuffin technique is common in films, especially thrillers: 
"Usually the MacGuffin is the central focus of the film in the first act, and thereafter declines in importance. It may re-appear at the climax of the story, but sometimes is actually forgotten by the end of the story. Multiple MacGuffins are sometimes derisively identified as plot coupons." - source Wikipedia
In similar fashion our "Generous Gambler" has very aptly used this technique with the previous OMT and now with QE. Great film director Alfred Hitchcock explained the term "MacGuffin" in a 1939 lecture at Columbia University:
"It might be a Scottish name, taken from a story about two men on a train. One man says, "What's that package up there in the baggage rack?" And the other answers, "Oh, that's a MacGuffin". The first one asks, "What's a MacGuffin?" "Well," the other man says, "it's an apparatus for trapping lions in the Scottish Highlands." The first man says, "But there are no lions in the Scottish Highlands," and the other one answers, "Well then, that's no MacGuffin!" So you see that a MacGuffin is actually nothing at all." - Alfred Hitchcock
It seems to us that the much vaunted OMT was in fact a MacGuffin, namely, nothing at all. The OMT MacGuffin was a successful ECB apparatus for snaring bond investors into buying peripheral debt. Benoît Cœuré, described it: 
"OMTs are an insurance device against redenomination risk, in the sense of reducing the probability attached to worst-case scenarios. As for any insurance mechanism, OMTs face a trade-off between insurance and incentives, but their specific design was effective in aligning ex-ante incentives with ex-post efficiency." 
So despite never being used, the OMT instrument was evaluated to have been a successful instrument, in true MacGuffin fashion.

For filmmaker and drama writing theorist Yves Lavandier, in the strictly Hitchcockian sense, a MacGuffin is a secret that motivates the villains. In our investment world the villains are yield scoundrels and central bankers as we have argued in our conversation "The last refuge of a scoundrel":
"A scoundrel being by definition villainous and dishonorable, when one looks at the "Cantillon Effects" of Ben Bernanke's wealth effect, no doubt that the big beneficiaries of the Fed's liquidity "largesse" has benefited the most to Wall Street's "scoundrels""
In Europe, the carry players, namely peripheral banks, benefited from the LTROs as well as the MacGuffin OMT to continue to invest massively in their respective domestic bond market.  As a reminder the German Constitutional Court expressed doubts about the legality of OMT under German and EU law. The European Court of Justice heard the case in October 2014, but has not yet issued its ruling.

For us, in the end, the discussions surrounding QE in Europe are indeed akin to a MacGuffin given the definition of Princeton's Wordnet defines a MacGuffin as simply "a plot element that catches the viewers' attention or drives the plot of a work of fiction".

In this week's conversation we would like to share again our concerns in relation to a particular type of rogue wave (currency crisis) we discussed in November 2011, the three sisters, that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:
"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: Wave number 1 - Financial crisis Wave number 2 - Sovereign crisis Wave number 3 - Currency crisis In relation to our previous post, the Peregrine soliton, being an analytic solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), it is "an attractive hypothesis to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace" - source Wikipedia." - Macronomics - 15th of November 2011
We would like also like to discuss in this conversation the never ending struggle between inflationary forces and deflationary forces, given it looks to us that deflation is indeed appearing to have the upper hand we think.

Wave number 3 - Currency crisis:
We voiced our concerns in June 2013 on the risk of a rapid surging US dollar would cause with the Tapering stance of the Fed on Emerging Markets in our conversation "Singin' in the Rain":
"Why are we feeling rather nervous?
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?
It is a possibility we fathom." - Macronomics - June 2013
At the time we stated that we were in an early stage of a dollar surge, in fact the global total returns YTD for the US dollar is 10.8%.

The situation we are seeing today with major depreciation in EM currencies is eerily similar to the situation of 1998, with both China and Japan at the center of the turmoil. On China specifically we will go into more details next week with a guest post from our friends at Rcube Global Asset Management.

In relation to the expected continued dollar surge in 2015 we read with interest Societe Generale FX Outlook H1 2015 entitled "Life Below Zero":
"Lots of USD upside, but Fed will want to rein rally inA year ago in “The reluctant dollar” we predicted that the US dollar would win by elimination in 2014. On a spot basis, the dollar has been the world’s best year-to-date performing currency (okay, we left the Sudanese Dinar aside). The Fed’s broad trade-weighted US dollar index is up some 7% year-to-date and our equal-weight USD/G10 and USD/EM indices are up by more than 10% each (Graph 1).
 Not bad. Our in-house economic views overwhelmingly support further dollar strength in 2015. There is plenty of room to the upside (Graph 2).
 We are confident about the view, but occasionally lose sleep on: 1) the fact that it is consensual, and we don’t like sitting with the crowd; and 2) fears that the raging currency war may have a bigger impact on the Fed’s reaction function than our economists think."
Central banks in the driving seat.
Graph 3 shows the year-to-date (YTD) change in 1y2y G10 rates relative to 1y2y USD, and the YTD spot currency move.

If the correlation does not appear to be as strong as it has often been in the past, this is to an extent because at the zero lower bound (ZLB), monetary policy isn’t just about the price of money, but also its quantity.
Typically the JPY undershoot is a function of the BoJ printing more money – don’t fight that trend, particularly when that policy looks increasingly impotent. The NOK has undershot too, thanks to the falling oil price. The SEK has done even worse, on fear the Riksbank would do more than just cut rates. AUD, NZD and GBP have been resilient (above the regression line) and might have some catch-up to do on the downside."            - source Societe Generale
Of course what we find of interest is that under the ZLB, many pundits have expected a recovery. When one looks at the commodity complex breaking down in conjunction with a weakening global growth picture which can be ascertained by a weakening Baltic Dry Index. No wonder yields in the government bond space are making new lows and that our very long US duration exposure we have set up early January (in particular via ETF ZROZ) has paid us handsomely and will continue to do so we think.

The Baltic Dry Index, indicative of a weakening growth outlook as of late - graph source Bloomberg:

The demise of the commodity complex in conjunction with weaker industrial production in Europe as well as a clear degradation in the shipping outlook are all elements highlighting the deflationary forces at play we have been so vocal about in our numerous conversations around the "japanification" process.

There has been no doubt a growing divergence between fundamentals from the real economy with asset prices levels courtesy of central banks meddling. While our central banks deities so far have benefited from the benefit of the doubt on the promise for some of more generosity in the form of a QE MacGuffin in Europe, we would have to agree with Societe General's take from their FX outlook on central banks meddling:
"It’s broken, and they don’t know how to fix itIt is remarkable that after so many years of super easy monetary policy, the global economy still feels wobbly. On the positive side the US continues to recover and the lower oil price will provide a boost to global growth in H1 2015. Yet the growth multipliers seem to be much weaker still than they have been historically, highlighting a lack of confidence, be it because of post-crisis hysteresis, the demographic shock, the excessive levels of non-financial debt, etc.‘Secular stagnation’ is the buzz word. The theory encompasses two ideas: 1) potential growth has dropped; 2) there is a global excess of supply, or a chronic lack of demand. If true, the implications are clear. First, excess supply creates global disinflation forces. Second, to fight lowflation and to help demand meet supply at full employment, central banks may need to run exceptionally easy monetary policy ‘forever’. In other words, real short-term rates need to remain very low, if not negative.
Life below zero. At the ZLB, central banks do what they know: they print money. But such policy seems to follow a law of diminishing marginal returns. It has worked well for the US, because the Fed had a first-mover advantage, and the support from pro-growth fiscal policy and a swift clean-up of the household and bank balance sheet. The BoJ and ECB aren’t as lucky. Let’s consider three transmission channels: 1) The portfolio channel. By pushing yields lower, central banks force investors into riskier assets, boosting their prices. But trees don’t grow to the sky. And the wealth effect on spending is constrained by high private and public debt. 2) The latter also gravely impairs the lending channel. And with yields already so low, it’s questionable what sovereign QE can now achieve. 3) The FX channel. This is where the currency war starts, as central banks try to weaken their currency to boost exports and import inflation. It however is a zero-sum game that won’t boost world growth.-The battle to win market shares highlights a fierce competitive environment, which tends to depress global inflation. Adding insult to injury, oversupply in commodities, especially oil and agriculture, currently add to the deflationary pressure. That leads central banks to get ever bolder, when instead they’d need to be more creative (e.g. a bolder ABS plan from the ECB would be far more effective than covered and government bond purchases) and get proper support from governments (fiscal policy, structural reforms).
Looking for a 2015 surprise. The BoJ has just sped up the race to the bottom. It may just help spread out the currency war. Consider Asia ex-Japan FX. It has been resilient relative to CEEMA and Latam (Graph 7), with the Chinese yuan (CNY) an anchor. But is has started to weaken in H2 2014, with the KRW, MYR and SGD weakening some 5-7% vs USD. For a long time China was happy to see CNY strengthen vs USD, as long as the latter was falling vs other currencies. 
But the trade-weighted CNY is now soaring, along with that of the USD (Graph 8). 
The CNY REER is up 27% over five years. It is increasingly difficult for China to afford such strengthening, given the local economic slowdown and deflationary pressure (PPI around -2% for almost three years)." - source Societe Generale
Of course, what Societe Generale is highlighting is what we discussed this year in April, namely "The Shrinking pie mentality":

"When the economic pie is frozen or even shrinking, in this competitive devaluation world of ours, it is arguably understandable that a "Winner-take-all" mentality sets in. Shrinking economic growth resulting from the financial crisis means that, from a demographic point of view in Europe with a shrinking working age population, low birth rates and a growing population of older people, it means to us that Europe does indeed face a critical choice: meet their unfunded pension liabilities and go bust, or cut drastically in entitlements in order to compete with emerging countries that don't have these large "legacy" costs associated with aging developed countries." - source Macromics, April 2014
When it comes to currency wars and currency crisis, we do expect China to seek a weaker yuan in order to deflate its epic credit bubble as we pointed out as well in our April 2014 conversation:
"In similar fashion, the US would thrive on a strong revaluation of the yuan, which would no doubt precipitate China into chaos and trigger a full explosion of the credit bubble in China, putting an end to the "controlled demolition" approach from the Chinese authorities. A continued devaluation of the yuan, would of course be highly supportive of the Chinese attempt in gently deflating its credit fuelled bubble, whereas it would export a strong deflationary wave to the rest of the world, putting no doubt a spanner in the QE works of the Fed, the Bank of Japan and soon to be ECB."
 As we posited before, if it is time for a pullback, get some greenbacks, at least that's what Dr Copper,  the metal with the economics Ph.D, is telling us as of late.

When it comes to dollar global liquidity, we agree with Societe Generale's take from their FX outlook, watch the US current account:
"It will soon be the ECB’s turn to embrace ‘proper’ (i.e., sovereign) QE. But the chances of ECB bond-buying doing much for bank lending or for demand are very remote. Bond yields will fall – but only a bit, given how low they are already. Equities will rise but, likewise, only slightly.
The main effect of QE will be to weaken the euro, but a big enough fall to really boost exports is hard to imagine yet. And the effect on inflation expectations is likely to be quite limited. So the danger, as ever, is that we see QE but don’t see much economic benefit. So, we’ll see more QE. And so on. So both the ECB and the BOJ response to low US rates is very different from what we saw in the last US recovery. Meanwhile, the big driver of dollar weakness pre-2008 – capital outflows to higher-yielding currencies and assets – is substantially weakened by the fact that these are now correcting from excessive valuations. And finally, the US current account deficit, which was almost 6% of GDP in 2006, is now 2.25% and falling even as the US economy outperforms.
 The US current a/c deficit is melting thanks to the shale oil revolution
All of this is enough to make us believe that we are at the start of a period of further dollar strength, even if real US interest rates will rise modestly, not dramatically. The dollar’s rally could be much bigger if asset markets suffer a major loss of confidence or if those trying to revive inflation expectations through currency weakness take that policy to its logical conclusion and engineer a downward spiral. Imagine a world with USD/JPY back in real terms at 1982’s level – USD/JPY 140 at today’s rate. What would that do for the rest of Asia, including perhaps for China? Imagine what happens if ECB QE has absolutely no impact and the ECB finds itself, in a year’s time, with inflation still at or below zero? Furthermore, if a falling euro or yen drives inflation expectations up and therefore real rates down (which is one of the major benefits of it), while a stronger dollar anchors US inflation expectations and supports real rates, then currency trends could tend to become self-sustaining until they overshoot – and that happens when US real rates become a drag on activity, which would probably take a big currency move.
All of which is to say that a very strong dollar is not inconceivable, even if it’s more likely that there is a 5-10% gain. In other words USD/JPY 120-130, EUR/USD 1.10-1.20, GBP/USD 1.1.40-1.50." - source Societe Generale
When it comes to oil and the velocity of the fall, we would like to re-iterate what we said in April 2013 in our conversation "The Awful Truth":

"In numerous conversations, we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced. The decline in the oil price to a nine-month low may prove to be another sign of deflationary pressure and present itself as a big headwind. Why is so?
Whereas oil demand in the US is independent from oil prices and completely inelastic, it is nevertheless  a very important weight in GDP (imports) for many countries. Monetary inflows and outflows are highly dependent on oil prices. Oil producing countries can either end up a crisis or trigger one.
Since 2000 the relationship between oil prices and the US dollar has strengthened dramatically.  As we highlighted in our conversation in May 2012 - "Risk-Off Correlations - When Opposites attract": Commodities and stocks have become far more closely intertwined as resources have taken on a greater role with China's economic expansion and increasing consumption in Emerging Markets."

A structural slowdown in economic activity like we are seeing is accentuating the fall in oil prices we think. Declining profitability and misdirected investments into unproductive assets and infrastructure projects have been triggered by years of Zero Interest Rate Policy (ZIRP) in Developed Markets (DM). This is having negative consequences in Emerging Markets given oil demand growth has been exclusively supported by strong EM growth. Lower GDP growth trend is therefore pushing for lower oil prices. 

We concluded our April 2013 as follows:
"Is Copper finally is telling us something about the real world, which equity markets are not currently focused on in true Zemblanity fashion, Zemblanity being "The inexorable discovery of what we don't want to know"? We wonder...
And, what if the trigger will be in Asia like in 1997 (as suggested by Albert Edwards recently) and not Europe after all? We wonder as well..."
Moving on to the subject of deflation having the upper hand, we think Bank of America Merrill Lynch's graph of 5-year 5-year forward breakevens (%) from their Liquid Insight note from the 9th of December 2014 entitled "Anchors Away", indicates the strength of the deflationary forces at play:
"Breaking bad
In recent years inflation hawks have been warning that aggressive monetary policy could cause inflation expectations to become “unanchored”. After all, stable expectations are not a birthright, but must be earned with a demonstrated track record of success. Unfortunately, there is building evidence that inflation expectations have already become unanchored; however, the unanchoring is to the downside.
The most obvious evidence is the plunge in 5-year 5-year forward breakevens in the Euro Area and the US (Chart of the Day). Euro Area breakevens are now even lower than during the 2008 crisis. US breakevens have not quite plumbed those depths, but are about 50bp or 70bp lower than normal. Both ECB and Fed officials have downplayed the drop. For example, in a speech on December 1, New York Fed President William Dudley argued that “despite some softness in market-based measures of inflation compensation, inflation expectations still seem well-anchored and this should also work to pull inflation gradually higher.”
We disagree and see four reasons to take this drop seriously. First, some survey measures of inflation expectations already shows signs of eroding. For example, in the Consumer Sentiment survey normally inflation expectations for five years ahead bounce around 3%, but now they have dipped to 2.6%. This is the lowest since the 2008-09 crisis." - source Bank of America Merrill Lynch.
We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed":
"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

But what has been clear with the demise of the commodity complex during the summer has been as well validated by the capitulation in inflation hedges trade as shown recently by Bank of America Merrill Lynch in their Flow Show note from the 4th of December entitled "Chasing Winners, Selling Inflation":
"Selling inflation hedges: redemptions from TIPS ($0.7bn – largest in 14 months), EM equities ($2.8bn - largest in 8 weeks), bank loans & precious metals"
- source Bank of America Merrill Lynch
When it comes to deflationary environment and defaults, we will re-iterate what we have argued in  July 2012 in our conversation of Jul 2012 entitled "Hooke's law":
"Moving on to the "unintended consequences" of this low yield environment will have to corporate balance sheets, to some extent, it tends to explain, why defaults tend to spike in a low rate deflationary environment such as today. The fall in interest rates increases bond prices companies have on their balance sheets, exactly like inflation (superior to what an increase of 2% to 3% of productivity and progress) destroys the veracity of a balance sheet for non-financial assets. The conjunction of low interest rates with higher taxations will undoubtedly damage companies, particularly in Europe, and in a country like France, for instance, where public expenditure as a % of GDP is much higher (57%) than in Germany (45%)." - Macronomics July 2012
High inflationary environments allow corporations to inflate away their nominal debt as their assets (and revenues) grow with inflation, leading to lower default rates but, Low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike.

The end of a low volatility period tends to a strong and sudden crash in prices, that is what you can fathom from Bayesian learning which leads to strong rise in asset prices courtesy of central banks generosity.

In credit markets, liquidity can fast become a problem and losses can be sudden and acute as witnessed this summer with the Phones4U debacle witnessed in the UK High Yield space as displayed by Societe Generale from their High Yield and Crossover Compass in December:
"Fixed income credit investment is as much about avoiding the losers as spotting the winners, and the growth in the number of discrete borrowers accessing the European High Yield market makes this task harder by the day. Juicy though the credit spread may have appeared at the time, investors in the Sterling bonds of Phones 4U must rue the day that they took exposure to the UK mobile phone retailer. Now in administration, even modest exposure will have impacted portfolio returns given how far and fast the senior and PIK notes fell when Vodafone and EE announced in quick succession that they were terminating their distribution agreements with the high street retailer.

Since the early September sell off of Phones4U bonds, the retail sector has come under continual pressure as investors take a second look at their holdings and consider just how robust some of these businesses are in the context of a continuing weak economic environment across Europe. Poor trading results can rapidly snowball into a rout as a “shoot first, ask questions later” approach by investors runs head long into poor secondary market liquidity." - source Societe Generale
Credit has always been a leading indicator. Recently widening spread as clearly indicated by our good friends Rcube Global Asset Management. in their note "US Equity / Credit Divergence: A Warning",  have been indeed signaling a sign of caution. We would add that the European High Yield market is as well showing some divergence as well as displayed by Bank of America Merrill Lynch's graph from their Thundering Word note of the 4th of December entitled "I'm a Commodity...Get Me Out of Here":
- source Bank of America Merrill Lynch

QE in Europe appears to be the central focus in true MacGuffin fashion but, rest assured that the widening in credit spreads and the deterioration of the economic outlook regardless of how the fall in oil prices is being presented in positive fashion by many pundits, deserve, we think much more attention.

On a final note, we leave you with a chart for Bank of America Merrill Lynch latest Thundering Word note entitled  "I'm a Commodity...Get Me Out of Here" displaying the stock price of ailing Italian oldest banking giant Banca Monte Dei Paschi di Siena:
- source Bank of America Merrill Lynch

We still believe in what we argued in our conversation "Pascal's Wagerabout the ultimate fate of Banca Monte Dei Paschi di Siena bondholders and shareholders alike:
"We believe that the path will be very painful for both shareholders and bondholders of MPS and that not only subordinated bondholders but seniors as well will face the music in the case of MPS, making MPS the precedent for future bail-in processes in the European banking landscape."

"The hardest tumble a man can make is to fall over his own bluff." - Ambrose Bierce, American journalist
Stay tuned!

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