Monday 22 February 2016

Macro and Credit - The Monkey and banana problem

"There are three growth industries in Japan: funerals, insolvency and securitization." - Dominic Jones, Asset Finance International Nov., 1998
Looking at the evolution of markets and convolution in which central bankers have fallen, we reminded ourselves for our chosen title analogy of the "Monkey and banana problem", which is a famous toy problem in artificial intelligence, particularly in logic programming and planning. The problem goes as follows:
"A monkey is in a room. Suspended from the ceiling is a bunch of bananas, beyond the monkey's reach. However, in the room there are also a chair and a stick. The ceiling is just the right height so that a monkey standing on a chair could knock the bananas down with the stick. The monkey knows how to move around, carry other things around, reach for the bananas, and wave a stick in the air. What is the best sequence of actions for the monkey?" - source Wikipedia
While there are many applications to this problem. One is as a toy problem for computer science, the other, we think is a "credit impulse" problem" for central bankers. The issue at hand is given financial conditions are globally tightening, as shown as well in the US in the latest publications of the Fed Senior Loan Officer Survey and the bloodbath in European bank shares, the problem is how on earth our central bankers or "monkeys" (yes it's after all the Chinese year of the fire monkey...) are going to avoid the contraction in loan growth? As put it bluntly by our friend Cyril Castelli from Rcube, the European credit channel is at risk as banks' share of credit transmission is much higher in EU than US, which of course is bound to create a negative feedback loop and could therefore stall much needed growth:
- source Rcube - @CyrilRcube

Another possible tongue in cheek purpose of our analogy and problem is to raise the question: Are central bankers intelligent? Of course they are, and most of them have to deal with complete lack of political support (or leadership). It seems we have reached the limits of what monetary policies can do in many instances.

Although both humans and monkeys have the ability to use mental maps to remember things like where to go to find shelter, or how to avoid danger, it seems to us that in recent years central bankers have lost the ability to avoid danger. While monkeys can also remember where to go to gather food and water, as well as how to communicate with each other, it seems to us as of late, that central bankers are losing their ability to communicate, not only with each other but, as well with markets, hence our chosen title. Could it be that monkeys have indeed superior abilities than central bankers given their ability not only to remember how to hunt and gather but to learn new things, as is the case with the monkey and the bananas? Despite the facts that the monkey may never have been in an identical situation, with the same artifacts at hand (printing press), a monkey is capable of concluding that it needs to make a ladder, position it below the bananas, and climb up to reach for them. It seems to us that despite the glaring evidence that the "wealth effect" is not translating into strong positive effects into the "real economy", yet it seems central bankers have decided to all embrace the Negative Interest Rate Policy aka NIRP as the new "banana". One would argue that, to some extent, central bankers have gone "bananas" but we ramble again...

In this week's conversation we will voice our concern relating to the heightened probability of a credit crunch in Europe thanks to banking woes and the unresolved Italian Nonperforming loans issue (NPLs). We will as well look at the credit markets from a historical bear market perspective and muse around the relief rally experienced so far.

  • Macro and Credit - The risk of another credit crunch in Europe is real
  • Why NIRP matters on the asset side of a bank balance sheet
  • Credit spreads and FX movements - Why we are watching the Japanese yen
  • Final chart: US corporate sector leverage approaching crisis peak

  • Credit - The risk of another credit crunch in Europe is real
The fast deterioration in European bank stocks in conjunction with the rising and justified concerns relating to Italian NPLs, constitute a direct threat to the "credit impulse" needed to sustain growth in Europe we think. As we pointed out on numerous occasions, the ECB and the FED have taken different approaches in tackling their banking woes following the Great Financial Crisis (GFC). In various conversations we have been highlighting the growth differential between the US and Europe ("Shipping is a leading deflationary indicator"):
"We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe (US economy will grow 2.2% this year versus a 0.4% contraction in the euro area, according to the median economist estimates compiled by Bloomberg):
"Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation -The LTRO Alkaloid - 12th of February 2012."
Exactly. The issue with Italian NPLs is that the tepid Italian growth of the last few years is in no way alleviating the bloated balance sheets of Italian banks which would help sustain credit growth for consumption purposes in Italy as evidently illustrated in a recent Société Générale chart we have used in our conversation the "Vasa ship": 
"As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.
And no earnings thanks to NIRP means now, no reduction in Italian NPLs which according to Euromoney's article entitled "Italy's bad bad bank" from February 2016 have now been bundled up into a new variety of CDOs" - source Macronomics, February 2016
- source Société Générale.

So, all in all, the ECB is going to have to find a way to shift these impaired assets onto its balance sheet, if it wants to swiftly and clearly deal with the worsening Italian situation. While some pundits would point out that the new "bail-in" resolutions in place since the 1st of January are sufficient to deal with such an issue, we do not share their optimism. This is a potential "political" problem of the first order, should the ECB decides to deal with this sizable problem à la Cyprus. Caveat emptor.

You could expect once more politicians and the ECB to somewhat twist the rule book in order to facilitate through this "securitization" process and an ECB take up of part of the capital structure (Senior tranches probably) of these new NPLs CDOs. A new LTRO at this point might once again alleviate funding issues for some but in no way alter the debilitating course of the credit profile of the Italian banks. On a side note we joked in our last conversation around these new NPLs CDOs being the new "Big Short":
"If you want to make it big, here is what we suggest à la "Big Short," given last week we mentioned that Italian NPLs have now been bundled up into a new variety of CDOs and that the Italian state guarantees the senior debt of such operations and thinks it is unlikely ever to have to honor the guarantee (as equity and subordinated debt tranches will take the first hit from any shortfall to the price the SPV paid for the loans), maybe you want to find someone stupid enough to sell you protection on the senior tranche of these "new CDOs." - source Macronomics, February 2016
But, when it comes to the "credit impulse" and its potential "impairment" in Europe thanks to bloated banks balance sheets, and equities bleeding, we read with interest Deutsche Bank's take in their note Focus Europe note from the 19th of February entitled "Moving down a gear":
"The balance between the growth drivers and detractors is being tipped towards the negative as the questioning of confidence in European banks threatens to result in a less beneficial credit impulse. In last week’s Focus Europe we presented a scenario analysis to demonstrate the sensitivity of euro area GDP growth to the provision of bank credit. We did this via the credit impulse relationship. Our earlier assumption of 1.6% real GDP growth in 2016 was consistent with 2% credit growth. If, on the other hand, banks issue no net new credit this year, domestic demand would fall, confidence deteriorate and financial markets tighten. With no reaction from the ECB, 2016 GDP growth would fall to about 0.5%

The recent fall in bank equities and rise in bank debt costs combined with increasing economic risks, the balance of probabilities suggests that lending standards will tighten relative to what we expected previously. Therefore, to some degree the provision of bank credit, and hence economic growth, will suffer. The revision we are announcing is an attempt to capture this effect. There are considerable uncertainties as to the scale of the problem, but we feel a modestly weaker lending impulse is now a more appropriate baseline.
Credit (-0.2pp). Our previous baseline forecast of 1.6% GDP growth was consistent with an acceleration in bank credit growth from broadly zero in 2015 to about 2% this year. The improvement in credit conditions in the last Bank Lending Survey implied a modest upside risk relative to forecasts. The last Bank Lending Survey was conducted in December and published in January. There were no indications at that point of concern about capital, liquidity or risk. However, as we said above, the balance of probabilities implies that lending standards will now tighten. We are conservatively allowing for a scenario in which the contribution to GDP from bank credit is now 0.2pp weaker than our previous baseline.
The ECB can help minimize the damage… 
The onus is on the ECB to achieve two things at the next meeting on 10 March. First, to set an appropriately accommodative policy stance given the worsen outlook for both growth and inflation. Note, since December, our headline and core HICP inflation forecasts for 2016 have fallen from 0.9% and 1.3% to 0.2% and 1.1% respectively (see page 2 for updated country inflation forecasts).
Second, to set a policy stance that does not compound the pressures on a banking system that may be perceived as being more vulnerable.
We presented a detailed discussion of the ECB’s options in last week’s Focus Europe (pages 8-10)2. Suffice to say, the choice of policies will be affected by conditions in the banking system. Our expectation prior to this episode of banking stress in recent weeks was a 10bp deposit rate cut and a temporary acceleration in the pace of purchases. The bank stress implies that a further deposit rate cut may be unwise without a system of exemptions. A refi cut, for example targeted at TLTROs, would be more effective.
The bank stress also implies the ECB should offer some kind of supplementary liquidity tender. Excess liquidity is running at about EUR700bn, but if there was any sense of fragmentation re-emerging between strong and weak banks, it would be in the ECB’s interest to remove all doubt about bank access to liquidity. Finally, the justification for more QE has increased given the widening of credit and sovereign spreads. More QE would reduce the risk of a negative feedback loop between banks and sovereigns.
The ECB is conducting a technical review of the asset purchase programme (APP). This might result in some changes. In terms of broadening the eligible asset base, we suspect the ECB will remain in the sovereign/quasi-sovereign space for now. Corporate bonds are possible but not very impactful.
Purchasing unsecured bank debt might not be inconsistent with the Treaty but would be complex and politically controversial. Stresses would have to increase markedly to bring this option onto the table. 
There is no relaxation of regulation, however. Both Mario Draghi, President of the ECB, and Daniele Nouy, head of the ECB Single Supervisory Mechanism (SSM), were consistent in their messages this week that (a) the new regulatory regime is resulting is a more stable and sustainable banking system - there is no sense that regulation is a net cost - and (b) “all else unchanged” there will be no significant additional capital requirements imposed on banks.
Benoit Coeure, ECB Executive Board Member, said that if bank profits are under pressure the onus would be on governments to implement structural reforms and growth-friendly fiscal policies. In short, no change in ECB message.
…but negative feedback loops cannot be ruled out either 
Last week we showed how sensitive the economic cycle can be to the bank credit cycle. This negative dynamic can become self-reinforcing. One direction is via the private sector and another is through the public sector. A tightening of lending standards weakens demand, undermining growth and asset quality, triggering a second-order tightening in credit. At the same time, weaker demand undermines sovereign sustainability which can tightening bank funding cost and additionally contribute to second-order tightening. 
Fiscal dynamics have deteriorated. The primary balance gap is the difference between the debt-stabilising primary balance and the primary balance. It captures the underlying dynamic of the public debt-to-GDP ratio. A negative gap means the public debt ratio is falling. Our previous forecast was for a primary balance gap of -0.6% of GDP in 2016, the first genuine decline in the public debt ratio since the start of the crisis. Following the growth and inflation revisions, the primary balance gap is expected to be positive again. In other words, the benefits of lower funding rates thanks to ECB QE are not enough to compensate for the loss of economic momentum. Moreover, if the scenario of zero net new bank credit were to materialize, 2016 could see the primary balance gap rise back to levels not seen since 2012. That would imply a euro area public debt-to-GDP ratio of about 98%." - source Deutsche Bank

Whereas indeed we are waiting to Le Chiffre aka Mario Draghi to come up with new tricks in March to alleviate the renewed pressure on European banks, where we disagree with Deutsche Bank is that providing a new TLROs would provide much needed support for funding in a situation where some banking players are seeing their cost of capital rise thanks to a flattening of their credit curve (in particular Deutsche Bank as per our previous conversation), this intervention would in no way remove the troubled growing impaired assets from the likes of Italian banks. It is one thing to deal with the flow (funding) and another entirely to deal with the stocks (impaired assets). Whereas securitization of the lot seems to be latest avenue taken, you need to find a buyer for the various tranches of these new NPLs CDOs. Also more QE. will not deal with the stocks of impaired assets unless these assets are purchased directly by the ECB. 

When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys. In their latest survey, while it is difficult to assess for now a clear trend in the deterioration of financial conditions for French corporate treasurers, it appears to us that NIRP has already been impacting the margin paid on credit facilities given a small minority of French corporate treasurers are indicating that, since December, there is an increasing trend in margin paid on the aforementioned credit facilities:
"Does the margin paid on your credit facilities has a tendency, to rise, fall or remains stable?"

- source AFTE
Going forward we will closely be monitoring these additional signals coming from French corporate treasurers to measure up the impact on the overall financial conditions as well as the impact NIRP has on the margins they are getting charged on their credit facilities. For now conditions for French corporate treasurers do not warrant caution on the microeconomic level.

While we have recently indicated our medium to long term discomfort with the current state of affaires akin to 2007 in terms of credit markets, the recent "relief rally" witnessed so far is for us a manifestation of the "overshoot" we discussed last week. Some welcome stabilization was warranted, yet we do feel that the credit cycle has turned and that you should be selling into strength and move towards more defensive position, higher into the rating quality spectrum that is and rise your cash levels.

When it comes to enticing banks to "lend" more, as far as our analogy is concerned we wonder how the "monkey" bankers are going to react if indeed additional NIRP is going to remove more "bananas".

This brings us to our second point, namely that the flatter the yield curve, the less effective NIRP is.

  • Why NIRP matters on the asset side of a bank balance sheet
Whereas, Europe overall has been moving more into the NIRP phenomenon, with over $7 trillion worth of global government bonds now yielding “less” than zero percent, the FED in the US is weighting joining the NIRP club in 2016 apparently, NIRP being vaunted as the new "banana" tool in the box to stimulate the "monkeys".

The issue of course at hand is that NIRP does matter and particularly when it comes to the asset side of a bank balance sheet as put forward by Deutsche Bank in their note from the 22nd of February entitled "Three things the market taught me this year":
"Negative rates – much more complicated
Negative rates look powerful at face value. Bank profits can be protected by exempting excess liquidity while market rates are pushed down. The turmoil in Japan points to three considerations that mute this view.
First, the impact of negative rates on the asset side of banks’ balance sheet can matter much more than the charge on excess liquidity. Banks that own large amounts of fixed income assets relative to the size of their total balance sheet (and their excess liquidity) are hit the hardest as returns on these assets drop. Japan and the US stand out as economies where the cost to the banks is biggest, Switzerland and Sweden the least, while Europe is somewhere in between:

Second, super-flat yield curves reduce the impact of negative rates. When bonds don’t offer risk premia, a perfect Keynesian liquidity trap exists: fixed income is the same as cash, and negative rates instantaneously transmit to the entire yield curve. The portfolio rebalancing into riskier assets declines as the marginal holders of zero-yielding bonds are naturally risk-averse. Japan’s yield curve, the flattest in the world, failed to steepen when the BoJ cut rates earlier this month – all yields just shifted down. Sweden, the UK and Europe stand out as yield curves where there’s still more risk premium to be squeezed, Japan, Canada and Norway the least:

Third, sub-zero rates can send a negative forward-looking signal. Until the technological and institutional framework is designed to pass negative rates to depositors without triggering banknote withdrawal, there will eventually be a (negative) lower bound. As this is approached the signaling cost of easing being exhausted may be bigger than the benefit of lower rates. At the extreme  cash and bonds turn into “Giffen goods”: the substitution effect of lower return is more than offset by expected lower future income. Lower rates then end up raising, rather than lowering the demand for bonds as the saving rate goes up. The limitations of additional BoJ easing in addition to changing Japanese hedging behaviour, are some of the factors, that have led us to revise our USD/JPY forecasts for this year. We now think 2015 marked the peak in USD/JPY for this cycle and forecast a move down to as low as 105 this year." - source Deutsche Bank
Exactly, this negative feedback-loop, doesn't stop the frenzy for bonds and the "over-allocation process. On the contrary, as the "yield frenzy" gather pace thanks to NIRP. This push yields lower and bond prices even higher. This is exactly what we discussed in our conversation "Le Chiffre" in October 2015:
"The big benefactors of the Fed and Le Chiffre's gaming style, particularly since is brilliant 2012 bluff in the European Government bond poker game have been bonds. We came across this very interesting chart from Deutsche Bank (h/t Tracy Alloway from Bloomberg on Twitter) which clearly illustrates "overconfidence" and "over-allocation" to the bonds relative to the trend which are $755bn above the normal trend. This is entirely attributable to the distortions created by QEs:
 - source Deutsche Bank (h/t Tracy Alloway).
Furthermore the significant repricing in European equities (where many pundits had been "overweight" at the beginning of the year) has led to a significant switch from equities to bonds as indicated by Bloomberg in their article from the 22nd of February entitled "They'd Rather Get Nothing in Bonds Than Buy Europe Stocks":
  • "Estimates for Euro Stoxx 50 dividend yield at 4.3 percent
  • The region's government debt is yielding 0.6 percent

The cash reward for owning European stocks is about seven times larger than for bonds. Investors are ditching the equities anyway.
Even with the Euro Stoxx 50 Index posting its biggest weekly rally since October, managers pulled $4.2 billion from European stock funds in the period ended Feb. 17, the most in more than a year, according to a Bank of America Corp. note citing EPFR Global. The withdrawals are coming even as corporate dividends exceed yields on fixed-income assets by the most ever:
Investors who leaped into stocks during a similar bond-stock valuation gap just four months ago aren’t eager to do it again: an autumn equity rally quickly evaporated come December. A Bank of America fund-manager survey this month showed cash allocations rose to a 14-year high and expectations for global growth are the worst since 2011.
If anything, the valuation discrepancy between stocks and bonds is likely to get wider, said Simon Wiersma of ING Groep NV.
 “The gap between bond and dividend yields will continue expanding,” said Wiersma, an investment manager in Amsterdam. “Investors fear economic growth figures. We’re still looking for some confirmations for the economic growth outlook.”
Dividend estimates for sectors like energy and utilities may still be too high for 2016, Wiersma says. Electricite de France SA and Centrica Plc lowered their payouts last week, and Germany’s RWE AG suspended its for the first time in at least half a century. Traders are betting on cuts at oil producer Repsol SA, which offers Spain’s highest dividend yield.
With President Mario Draghi signaling in January that more European Central Bank stimulus may be on its way, traders have been flocking to the debt market. The average yield for securities on the Bloomberg Eurozone Sovereign Bond Index fell to about 0.6 percent, and more than $2.2 trillion -- or one-third of the bonds -- offer negative yields. Shorter-maturity debt for nations including Germany, France, Spain and Belgium have touched record, sub-zero levels this month." - source Bloomberg
In that instance, while the equity "banana" appears more enticing from a "yield" perspective, it seems that the "electric shock" inflicted to our investor "monkey" community has no doubt change their "psyche".

The sell-off this year has set up the stage for an operant conditioning chamber (also known as the Skinner box): When the central bank monkey correctly performs the "central bank put" behavior, the chamber mechanism delivers positive investment returns to the community and a buying behavior. In some cases of the Skinner box investment experience, the mechanism delivers a punishment for an incorrect or missing responses (central bankers). Due to the lack of appropriate response or incorrect response (Bank of Japan with NIRP) from central bankers in 2016, the investor monkey community has been delivered a punishment in the form of a violent sell-off, leaving the investor monkey community less inclined in going again for the "equity banana" for fear of another "electric shock" hence the reach for bonds.

When it comes to our outlook and stance relating to the credit cycle we would like to point out again towards chapter 5 of Credit Crisis authored by Dr Jochen Felsenheimer and Philip Gisdakis where they highlight the work of Hyman Minsky's work on the equity-debt cycle and particularly in the light of the Energy sector upcoming bust:
"His cyclical theory of financial crises describes the fragility of financial markets as a function of the business cycle. In the aftermath of a recession, firms finance themselves in a very safe way. As the economy grows and expected profits rise, firms take on more speculative financing, anticipating profits and that loans can be repaid easily. Increased financing translates into rising investment triggering further growth of the economy, making lenders confident that they will receive a decent return on their investments. In such a boom period, lenders tend to abstain from guarantees of success, i.e; reflected in less covenants or in rising investments in low-quality companies. Even if lenders knowsthat the firms are not able to repay their debt, they believe these firms will refinance elsewhere as their expected profits rise. While this is still a positive scenario for equity markets, the economy has definitely taken on too much credit risk. Consequently the next stage of the cycle is characterized by rising defaults. This translates into tighter lending standards of banks. Here, the similarities to the subprime turmoil become obvious. Refinancing becomes impossible especially for lower-rated companies and more firms default. This is the beginning of a crisis in the real economy, while during the recession, firms start to turn to more conservative financing and the cycle closes again" - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
The issue with NIRP and the relationship between credit spreads and safe-haven yields is that while the traditional pattern being lower government bond yields and a flatter yield curve is accompanied by wider spreads in "risk-off" scenarios, given more and more pundits (such as Hedge Funds)  have been playing the total return game, they have become less and less dependent on traditional risk-return optimized approach as they are less dependent on movements on the interest rate side. The consequence for this means that classical theories based on allocation become more and more challenged in a NIRP world because correlation patterns change in a crisis period particularly when correlations are becoming more and more positive (hence large standard deviations move).

But if indeed, the behavior of credit is affected in relation to safe-haven yields by changes in correlations, then you might rightly ask yourself about the relationship of credit spreads and FX movements given the focus as of late has been around the surge in the US dollar and the fall in oil prices in conjunction of the rise of the cost in capital since mid 2014.

In our next point we think that, from a credit perspective, once more you should focus your attention on the Japanese yen.

  • Credit spreads and FX movements - Why we are watching the Japanese yen
Whereas everyone has been focusing on the importance of the strength of US dollar in relation to corporate earnings and in similar fashion in Europe previously the focused had been on the strength of the Euro, we think, from a credit perspective, the focus should rather be on the Japanese yen going forward. Once again we take our cue from chapter 5 of Credit Crisis authored by Dr Jochen Felsenheimer and Philip Gisdakis:
"Many credit hedge funds not only implement leveraged investment strategies but also leveraged funding strategies, primarily using the JPY as a cheap funding source. A weaker JPY accompanied by tighter spreads is the best of all worlds for a yen funded credit hedge fund. However, these funds should be more linked to the JPY than the USD. One impact is obviously that the favorable growth outlook in Euroland triggers a strong EUR and tighter spreads of European companies (which benefit the most from the improving economic environment). However, the diverging fit between EUR spreads, the USD and the JPY, respectively, underpins the argument that technical factors as well as structural developments dominate fundamental trends at least in certain periods of the cycle. "  - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
However, NIRP doesn't reduce the cost of capital. NIRP is a currency play. This is clearly the case in Japan and has been well described in Deutsche Bank's note from the 22nd of February entitled "Yen hedging cycle risks rapid reverse":
"A lot of negative things have been said about negative rates, not least in Japan. Negative rates do not work by reducing financing costs materially, providing a ‘price of money’ stimulus. If negative rates do support activity, they primarily work through the exchange rate, adding to the portfolio substitution into risky asset.
For Japan the biggest problem is that macro policies have been directing capital toward risky assets for the last 4+ years. There are inevitably diminishing returns to this strategy, not least because ‘value’ matters. Value matters when it comes to the underlying domestic and foreign ‘risky’ asset, and the value of the exchange rate. Specifically on the latter, the yen even after the recent appreciation is still close to 20% cheap in PPP terms.
It is also cheap on a FEER and BEER basis, helped by a terms of trade shock that is seen lifting the Current Account surplus to near 5% of GDP in 2016. Figure 2 shows that in the last year, Japan has had the most favorable terms of trade shock of any major economy.

While FDI can recycle up to half of the C/A surplus, the question is whether other BoP components, notably net portfolio flows, will do the rest of the recycling, and at what exchange rate. For much of 2013 – H1 2015, vehicles like the GPIF were used to recycle (a much smaller) C/A surplus, that even briefly went into deficit in 2014. By June 2015, the GPIF’s portfolio of riskier assets inclusive of domestic stocks (22.3%), international bonds (13.1%), and international stocks (22.3%) was well within the desired base/benchmark ranges (see Figure 3).

For the latest data available for Q3 2015, GPIF domestic and international equity holdings declined led by weaker equity prices and a stronger yen – price action that underscores the risky nature of these investments.
As the C/A surplus grows and the above ‘structural’ pension shift toward capital flows abroad diminishes, there is a danger that we have already entered the realm where yen strength becomes self-fulfilling, as many of the hedging activities that were associated with a weak yen in the first four years of Abeconomics go into reverse.
Prior to Abeconomics, hedging on Japan equity flows was limited. Since 2011 when BOJ policy encouraged yen weakness, foreign inflows into Japan equities typically included much higher currency hedge ratios, while fully hedged instruments became popular. Precise numbers are not available, but it is estimated that as much as a quarter of the stock of foreign holdings of Japan equities of Y183tr has a currency hedge – a hedge that quickly becomes much less attractive with a stronger yen.
In contrast, for Japan investments abroad, FX hedge ratios declined. This particularly relates to USD investments, where expectations of USD gains increased rapidly in the Abeconomics years, and FX hedges on USD investments dropped. At the end of Q3 2015, Japan had a total of Y770trillion non-Central Banks assets abroad, inclusive of Y418tr portfolio assets, of which Y153tr are equity and investment fund shares, and Y266tr are debt securities. Even if much of the investment abroad has only limited hedges, one observation is that a very small adjustment in hedge ratios can have a huge flow impact. A shift in the hedge ratio on foreign fixed income assets by 10% is roughly equivalent to a year’s C/A surplus. Secondly, to the extent that hedge ratios are very low, as is the case for, say, the GPIF, there are sizable potential losses for funds recently adding to foreign exposure, and an emerging disincentive to invest in the most risky assets abroad.
Of the large players that actively hedge FX exposure, the life insurance companies’ activities can most closely be tracked through quarterly statements, and the time series can provide a useful standard to benchmark recent activity. Life insurance companies as of Q3 2015 had some Y65tr in foreign securities. As per Figure 4, their currency hedge ratios on dollar-based investments are estimated to have dropped to ~46% by the end of Q3 2015, the lowest levels recorded since the Great Financial Crisis in 2008. The hedge ratio is down from a peak of 79% in September 2009.
Life insurance company hedge ratios have likely reached a cycle nadir at the end of 2015, as concerns about JPY appreciation start to rise.
Among the other largest participants that have foreign portfolios of comparable size to the Lifers, both Toshins (foreign securities of ~77tr) and particularly public pension funds ( ~ Y57tr foreign securities) have very low currency hedge ratios and are heavily exposed to currency risk. Japan investments abroad, so actively encouraged by policymakers, are slowly being shown to have a familiar ‘catch’ – interest parity! Nominal yields may be more attractive abroad, but the long-term currency risks are enormous, at least when placed in the context of a yen that is still significantly undervalued.
A crucial element of hedging activity is the expected exchange rate. Here three bigger macro forces are at play for the remainder of 2016: i) Japan/BOJ policy; ii) the Fed; and iii) China FX policy. Firstly on BOJ intervention, the market should not expect any official BOJ intervention barring extreme FX volatility. It would run counter to G20 rules and risk a serious rift with the US. On rates policy, adding significantly to NIRP looks increasingly unpalatable, with our Tokyo Economics team expecting only one more 10bp cut in Q3. The next set of actions will likely need to revolve around ‘qualitative QE’ and the buying of more risky assets, notably securitized products.
On the Fed, we expect USD/JPY to remain sensitive to Fed expectations, but not to the point where more Fed tightening is likely to lead to new USD/JPY highs. The yen has a history of doing well in 5 of the last 7 Fed tightening cycles, although it did weaken in the two big USD upswings." - source Deutsche Bank
As we posited in our conversation "Information cascade" back in March 2015, you should very carefully look at what the GPIF, and their friends are doing:
"Go with the flow:
One should closely watch Japan's GPIF (Government Pension Investment Fund) and its $1.26 trillion firepower. Key investor types such as insurance companies, pension funds and toshin companies have been significant net buyers of foreign assets." - source Macronomics, March 2015
We also added more recently in our conversation "The Ninth Wave" the following:
"So, moving on to why US high quality Investment Grade credit is a good defensive play? Because of attractiveness from a relative value perspective versus Europe and as well from a flow perspective. The implementation of NIRP by the Bank of Japan will induced more foreign bonds buying by the Japanese Government Pension Investment Fund (GPIF) as well as Mrs Watanabe (analogy for the retail investors) through their Toshin funds. These external source of flows will induce more "financial repression" on European government yield curves, pushing most likely in the first place German Bund and French OATs more towards negative territory à la Swiss yield curve, now negative up to the 10 year tenor.
When it comes to Mrs Watanabe, Toshin funds are significant players and you want to track what they are doing, particularly in regards to the so-called "Uridashi" funds. The Japanese levered "Uridashi" funds (also called "Double-Deckers") used to have the Brazilian Real as their preferred speculative currency. Created in 2009, these levered Japanese products now account for more than 15 percent of the world’s eighth-largest mutual-fund market and funds tied to the real accounted previously for 46 percent of double-decker funds in 2009 with close to a record 80% in 2010 and now down to only 22.8%.
As our global macro "reverse osmosis" theory has been playing out, so has been the allocation to the US dollar in selection-type Toshin
Because GPIF and other large Japanese pension funds as well as retail investors such as Mrs Watanabe are likely to increase their portfolios into foreign assets, you can expect them to keep shifting their portfolios into foreign assets, meaning more support for US Investment Grade credit, more negative yields in the European Government bonds space with renewed buying thanks to a weaker "USD/JPY" courtesy of NIRP." - source Macronomics, January 2016
So from a "flow" perspective and like any trained "monkey" looking to reach out for "bananas", at least the slippery type, whereas other "monkeys" are focusing on the US dollar and Oil related woes, we'd rather for now focus our attention onto the Japanese yen, and the allocation implications of a stronger yen. For us, like others, a PBOC devaluation move on the Yuan would send a deflationary impulse worldwide but, in terms of risk assets, it would have serious consequences on Japanese asset allocations and would lead to an acceleration in capital repatriation (this would mean liquidation of some existing positions rest assured) as indicated in Deutsche Bank's note:
"Even modest JPY gains against the USD should translate to a strong yen against all the other G10 currencies and EMG Asia FX, not least because of global macro risks elsewhere. Nothing is capable of lifting the yen trade weighted index more than a speed up in the Rmb’s depreciation rate, leading to knock-on devaluations in EM Asia. This risk alone should encourage higher Japan hedge ratios for investment abroad, inclusive of the stock of Japan FDI assets abroad. A risk-off China shock would tend to concentrate JPY gains against currencies of other G4, but initially would likely include additional yen strength against all currencies. It should also drive the Nikkei sharply lower.
The Nikkei and yen have a long and sometimes tortured history of moving in lock-step. A stronger yen has hurt the Nikkei for obvious reasons, but a weaker Nikkei also tends to lead to a repatriation of capital and a stronger yen. Interestingly, the current Nikkei levels are already consistent with a USD/JPY below Y105."  - source Deutsche Bank
When it comes to the year of the Fire Monkey, the slippery banana type, no doubt could come from Japanese investors hurt by the violent appreciation of the Japanese yen, which has indeed been a significant "sucker punch" when it comes to the large standard deviation move experienced by the Japanese yen versus the US dollar. If Mrs Watanabe goes into "liquidation" mode, things could indeed become interesting to say the least.

When it comes to Minsky and the equity-credit cycle, whereas central banks can affect the amplitude and the duration of the cycle, in no way can they alter the character of the cycle. In our final chart, we once again indicate our 2007 feeling thanks to the rise in leverage, tightening financial conditions with the issuance markets closing down on the weaker players, which bode poorly from a risk-reward perspective.

  • Final chart: US corporate sector leverage approaching crisis peak
Like many pundits, we have voiced our concerns on the increasing leverage thanks to buybacks financed by debt issuance and the lack of the use of proceeds for investment purposes. Our final chart comes from the same Deutsche Bank note from the 22nd of February entitled "Three things the market taught me this year" quoted previously and displays the US corporate sector leverage which is approaching crisis peak:
"US deleveraging – not that great
US consumer deleveraging stands out as one of the major achievements of the Yellen Fed. Yet the corporate picture looks much less impressive. Total amount
of US corporate debt has approached the highs seen in the financial crisis (chart 3). 
Not only that but the bulk of the leverage has been directed towards corporate stock buybacks (chart 4), explaining how low investment but high borrowing have existed at the same time. Persistent volatility in the US credit market has highlighted vulnerabilities that weren’t a concern last year.
- source Deutsche Bank
While a respite is always welcome, when it comes to the rally seen recently, as far as the Monkey and banana problem is concerned as everyone is hoping from additional tricks from our "Generous gamblers" aka our central bankers, this rally might have some more room ahead but then again, it doesn't change our belief in the stage of the credit cycle and our focus on what's the Japanese yen will be doing.
"Life is full of banana skins. You slip, you carry on." - Daphne Guinness, British artist
Stay tuned!

Sunday 14 February 2016

Macro and Credit - The disappearance of MS München

"Hope, the best comfort of our imperfect condition." - Edward Gibbon, English historian

While thinking about correlations in particular and risk in general, we reminded ourselves of one of our pet subject we have touched in different musings, namely the fascinating destructive effect of "Rogue waves". It is a subject we discussed in details, particularly in our post "Spain surpasses 90's perfect storm":
"We already touched on the subject of "Rogue Waves" in our conversation "the Italian Peregrine soliton", being an analytical solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), and being as well "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, the latest surge in Spanish Nonperforming loans to a record 10.51% and the unfortunate Sandy Hurricane have drawn us towards the analogy of the 1991 "Perfect Storm".
Generally rogues waves require longer time to form, as their growth rate has a power law rather than an exponential one. They also need special conditions to be created such as powerful hurricanes or in the case of Spain, tremendous deflationary forces at play when it comes to the very significant surge in nonperforming loans.", source Macronomics, October 2012
You might already asking yourselves why our title and where we are going with all this?

The MS München was a massive 261.4 m German LASH carrier of the Hapag-Lloyd line that sank with all hands for unknown reasons in a severe storm in December 1978. The most accepted theory is that one or more rogue waves hit the München and damaged her, so that she drifted for 33 hours with a list of 50 degrees without electricity or propulsion.  The München departed the port of Bremerhaven on December 7, 1978, bound for Savannah, Georgia. This was her usual route, and she carried a cargo of steel products stored in 83 lighters and a crew of 28. She also carried a replacement nuclear reactor-vessel head for Combustion Engineering, Inc. This was her 62nd voyage, and took her across the North Atlantic, where a fierce storm had been raging since November. The München had been designed to cope with such conditions, and carried on with her voyage. The exceptional flotation capabilities of the LASH carriers meant that she was widely regarded as being practically unsinkable (like the Titanic...). That was of course until she encountered "non-linear phenomena such as solitons.

While a 12-meter wave in the usual "linear" model would have a breaking force of 6 metric tons per square metre (MT/m2), although modern ships are designed to tolerate a breaking wave of 15 MT/m2, a rogue wave can dwarf both of these figures with a breaking force of 100 MT/m2. Of course for such "freak" phenomenon to occur, you need no doubt special conditions, such as the conjunction of fast rising CDS spreads (high winds), global tightening financial conditions and NIRP (falling pressure towards 940 MB), as well as rising nonperforming loans and defaults (swell). So if you think having a 99% interval of confidence in the calibration of you VaR model will protect you againtst multiple "Rogue Waves", think again...

Of course the astute readers would have already fathomed between the lines that our reference to the giant ship MS München could be somewhat a veiled analogy to banking giant Deutsche Bank. It could well be...

But given our recent commentaries on the state of affairs in the credit space, we thought it would be the right time to reach again for a book collecting dust since 2008 entitled Credit Crisis authored by Dr Jochen Felsenheimer (which we quoted on numerous occasions on this very blog for good reasons) and Philip Gisdakis.

Before we go into the nitty gritty of our usual ramblings, it is important we think at this juncture to steer you towards chapter 5 entitled "The Anatomy of a Credit Crisis" and take a little detour worth our title analogy to "Rogue Waves" which sealed the fate of MS München. What is of particular interest to us, in similar fashion to the demise of the MS München is page 215 entitled "LTCM: The arbitrage saga" and the issue we have discussing extensively which is our great discomfort with rising positive correlations and large standard deviations move. This amounts to us as increasing rising instability and the potential for "Rogue Waves" to show up in earnest:
"LTCM's trading strategies generally showed no or almost very little correlation. In normal times or even in crises that are limited to a specific segment, LTCM benefited from this high degree of diversification. Nevertheless, the general flight to liquidity in 1998 caused a jump in global risk premiums, hitting the same direction. All (in normal times less-correlated) positions moved in the same direction. Finally, it is all about correlation! Rising correlations reduces the benefit from diversification, in the end hitting the fund's equity directly. This is similar with CDO investments (ie, mezzanine pieces in CDOs), which also suffer from a high (default) correlation between the underlying assets. Consequently, a major lesson of the LTCM crisis was that the underlying Covariance matrix used in Value-at-Risk (VaR) analysis is not static but changes over time." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
You might probably understand by now from our recent sailing analogy (The Vasa ship) and wave analogy (The Ninth Wave) where we are heading: A financial crisis is more than brewing. 

It is still time for you to play "defense", although we did warn you well advance of the direction markets would be taking at the end of 2015 and why we bought our "put-call parity" protection (long US long bonds / long gold-gold miners), given that if there is huge volatility in the policy responses of central banks, the option-value of both gold and bonds position would go up (it did...). Although some like it "beta" or more appropriately being "short gamma" such as the "value" proposal embedded in Contingent Convertibles aka CoCos (now making the headlines), we prefer to be "long gamma" but we ramble again...

Moving back to the LTCM VaR reference, the Variance-Covariance Method assumes that returns are normally distributed. In other words, it requires that we estimate only two factors - an expected (or average) return and a standard deviation. Value-at-Risk (VaR) calculates the maximum loss expected (or worst case scenario) on an investment, over a given time period and given a specified degree of confidence. 

LTCM and the VaR issue reminds us of a regular quote we have used, particularly in May 2015 in our conversation "Cushing's syndrome":
"The issue with so many pundits following "similar strategies" and chasing the "same assets" in a growing "illiquid" fixed income world is a Cushing's syndrome impact. Excess stimulants have compressed yield spreads too fast leading to "unhealthy" rapid bond prices gain.
The growing issue with VaR (Value at risk) and bond volatility is that it has risen sharply from a risk management perspective. This could lead to a sell-fulfilling "sell-off" prophecy of having too many pundits looking for the exit as the same time, namely "de-risking".
To that effect and in continuation to Martin Hutchinson's LTCM reference, we would like to repeat the quote used in the conversation "The Unbearable Lightness of Credit":
Today investors face the same "optimism bias" namely that they overstate their ability to exit.
“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
So what is VaR really measuring these days?

This what we had to say about VaR in our May 2015 conversation "Cushing's syndrome" and ties up nicely to our world of rising positive correlations. Your VaR measure doesn't measure today your maximum loss, but could be only measuring your minimum loss on any given day. Check the recent large standard deviation moves dear readers such as the one on the Japanese yen and ask yourself if we are anymore in a VaR assumed "normal market" conditions:
"On a side note while enjoying a lunch with a quant fund manager friend of ours, we mused around the ineptness of VaR as a risk model. When interviewing fellow quants for a position within his fund, he has always asked the same question: What does VaR measures? He always get the same answer, namely that VaR measures the maximum loss at any point during the period. VaR is like liquidity, it is a backward-looking yardstick. It does not measure your maximum loss at any point during the period but, in today "positively correlated markets" we think it measures your "minimum loss" at any point during the period as it assumes "normal" markets. We are not in "normal" markets anymore rest assured." - source Macronomics, May 2015
Therefore this week's conversation we will look at what positive correlations entails for risk and diversification and also we will look at the difference cause of financial crisis and additional signs we are seriously heading into one like the MS München did back in 1978, like we did in 2008 and like we are most likely heading in 2016 with plenty of menacing "Rogue Waves" on the horizon. So fasten your seat belt for this long conversation, this one is to be left for posterity.

  • Credit - The different types of credit crises and where do we stand
  • A couple of illustrations of on-going nonlinear "Rogue Waves" in the financial world of today
  • The overshooting phenomenon
  • The Yuan Hedge Fund attack through the lense of the Nash Equilibrium Concept
  • Credit - The different types of credit crises and where do we stand
Rising positive correlations, are rendering "balanced funds" unbalanced and as a consequence models such as VaR are becoming threatened by this sudden rise in non-linearity as it assumes normal markets. The rise in correlations is a direct threat to diversification, particularly as we move towards a NIRP world:
"When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing.The correlation between macro variables such as bund yields, FX and oil and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis." - source Macronomics, January 2016
When it comes to the classification of credit crises and their potential area of origins both the authors  for the book "Credit Crisis" shed a light on the subject:
  • "Currency crisis: A speculative attack on the exchange rate of a currency which results in a sharp devaluation of the currency; or it forces monetary authorities to intervene in currency markets to defend the currency (eg. by sharply hiking interest rates).
  • Foreign Debt Crisis: a situation where a country is not able to service its foreign debt.
  • Banking crisis: Actual or potential bank runs. Banks start to suspend the internal convertibility of their liabilities or the government has to bail out the banks.
  • Systemic Financial crisis: Severe disruptions of the financial system, including a malfunctioning of financial markets, with large adverse effect on the real economy. It may involves a currency crisis and also a banking crisis, although this is not necessarily true the other way around.
In many cases, a crisis is characterized by more than one type, meaning we often see a combination of at least two crises. These involve strong declines in asset values, accompanied by defaults, in the non-financials but also in the financials universe. The effectiveness of government support or even bailout measures combined with the robustness of the economy are the most important determinants of the economy's vulneability, and they therefore have a significant impact on the severity of the crisis. In addition, a crucial factor is obviously the amplitude of asset price inflation that preceded the crisis.
Depending on the type of crisis, there are different warning signals, such as significant current account imbalances (foreign debt crisis), inefficient currency pegs (currency crisis), excessive lending behavior (banking crisis), and a combination of excessive risk taking and asset price inflation (systemic financial crisis). A financial crisis is costly, as they are fiscal costs to restructure the financial system. There is also a tremendous loss from asset devaluation, and there can be a misallocation of resources, which in the end, depresses growth. A banking crisis is considered to be very costly compared with, for example, a currency crisis.
We classify a credit crisis as something between a banking crisis and a systematic financial crisis. A credit crisis affects the banking system or arises in the financial system; the huge importance of credit risk for the functioning of the financial system as a whole bears also a systematic component. The trigger event is often an exogenous shock, while the pre-credit crisis situation is characterized by excessive lending, excessive leverage, excessive risk taking, and lax lending standards. Such crises emerge in periods of very high expectations on economic development, which in turns boosts loan demand and leverage in the system. When an exogenous shock hits the market, it triggers an immediate repricing of the whole spectrum of credit-risky assets, increasing the funding costs of borrowers while causing an immense drop in the asset value of credit portfolios.
A so-called credit crunch scenario is the ugliest outcome of a credit crisis. It is characterized by a sharp reduction of lending activities by the banking sector. A credit crunch has a severe impact on the real economy, as the basic transmission mechanism of liquidity (from central banks over the banking sector to non-financial corporations) is distorted by the fact that banks do a liquidity squeeze, finally resulting in rising default rates. A credit crunch is a full-fledged credit crisis, which includes all major ingredients for a banking and a systemic crisis spilling over onto several parts of the financial market and onto the real economy. A credit crunch is probably the most costly type of financial crisis, also depending on the efficiency of regulatory bodies, the shape of the economy as a whole, and the health of the banking sector itself." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
The exogenous shock started in earnest in mid-2014 which saw a conjunction of factors, a significant rise in the US dollar that triggered the fall in oil prices, the unabated rise in the cost of capital.

If we were to build another schematic of the current market environment, here what we think it should look like to name a few of the issues worth looking at:
- source Macronomics

So if you think diversification is a "solid defense" in a world of "positive correlations", think again, because here what the authors of "Credit Crisis" had to say about LTCM and tail events (Rogue Waves):
"Even if there are arbitrage opportunities in the sense that two positions that trade at different prices right now will definitely converge at a point in the future, there is a risk that the anomaly will become even bigger. However typically a high leverage is used for positions that have a skewed risk-return profile, or a high likelihood of a small profit but a very low risk of a large loss. This equals the risk-and-return profile of credit investments but also the risk that selling far-out-of-the-money puts on equities. In case of a tail event occurs, all risk parameters to manage the overall portfolio are probably worthless, as correlation patterns change dramatically during a crisis. That said, arbitrage trades are not under fire because the crisis has an impact on the long-term-risk-and-return profile of the position. However, a crisis might cause a short-term distortion of capital market leading to immense mark-to-market losses. If the capital adequacy is not strong enough to offset the mark-to-market losses, forced unwinding triggers significant losses in arbitrage portfolios. The same was true for many asset classes during the summer of 2007, when high-quality structures came under pressure, causing significant mark-to-market losses. Many of these structures did not bear default risk but a huge liquidity risk, and therefore many investors were forced to sell." source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
You probably understand by now why we have raised the "red flag" so many times on our fear in the rise of "positive correlations". They do scare us, because they entail, larger and larger standard deviation moves and potentially trigger "Rogue Waves" which can wipe out even the biggest and most reputable "Investment ships" à la MS München. 

The big question is not if we are in a bubble again but if this "time it's different". It is not. It's worse, because you have all the four types of crisis evolving at the same time.
Here is what Chapter 5 of "Credit Crisis" is telling us about the causes of the bubble:
"A mainstream argument is that the cause of the bubbles is excessive monetary liquidity in the financial system. Central banks flood the market with liquidity to support economic growth, also triggering rising demand for risky assets, causing both good assets and bad assets to appreciate excessively beyond their fundamentally fair valuation. In the long run, this level is not sustainable, while the trigger of the burst of the bubble is again policy shifts of central banks. The bubble will burst when central banks enter a more restrictive monetary policy, removing excess liquidity and consequently causing investors to get rid of risky assets given the rise in borrowing costs on the back of higher interest rates.
This is the theory, but what about the practice? The resurfacing discussion about rate cuts in the United States and in the Euroland in mid-2005 was accompanied by expectations that inflation will remain subdued. Following this discussion, the impact of inflation on credit spreads returned to the spotlight. An additional topic regarding inflation worth mentioning is that if excess liquidity flows into assets rather than into consumer goods, this argues for low consumer price inflation but rising asset price inflation. In late 2000, the Fed and the European Central Banks (ECB) started down a monetary easing path, which was boosted by external shocks (9/11 and the Enron scandal), when central banks flooded the market with additional liquidity to avoid a credit crunch. Financial markets benefited in general from this excess liquidity, as reflected in the positive performance of almost all asset classes in 2004, 2005, and 2006, which argued for overall liquidity inflows but not for allocation shifts. It is not only excess liquidity held by investors and companies that underpins strong performing assets in general, but also the pro-cyclical nature of banking. In a low default rate environment, lending activities accelerate, which might contribute to an overheating of the economy accompanied by rising inflation. From a purely macroeconomic viewpoint, private households have two alternatives to allocate liquidity: consuming or saving. The former leads to rising price inflation, whereas the latter leads to asset price inflation." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
 Where we slightly differ from the author's take in terms of liquidity allocation is in the definition of "saving".  The "Savings Glut" view of economists such as Ben Bernanke and Paul Krugman needs to be vigorously rebuked. This incorrect view which was put forward to attempt to explain the Great Financial Crisis (GFC) by the main culprits was challenged by economists at the Bank for International Settlements (BIS), particularly in one paper by Claudio Borio entitled "The financial cycle and macroeconomics: What have we learnt?". 
"The core objection to this view is that it arguably conflates “financing” with “saving” –two notions that coincide only in non-monetary economies. Financing is a gross cash-flow concept, and denotes access to purchasing power in the form of an accepted settlement medium (money), including through borrowing. Saving, as defined in the national accounts, is simply income (output) not consumed. Expenditures require financing, not saving. The expression “wall of saving” is, in fact, misleading: saving is more like a “hole” in aggregate expenditures – the hole that makes room for investment to take place. … In fact, the link between saving and credit is very loose. For instance, we saw earlier that during financial booms the credit-to-GDP gap tends to rise substantially. This means that the net change in the credit stock exceeds income by a considerable margin, and hence saving by an even larger one, as saving is only a small portion of that income." - source BIS paper, December 2012
Their paper argues that it was unrestrained extensions of credit and the related creation of money that caused the problem which could have been avoided if interest rates had not been set too low for too long through a "wicksellian" approach dear to Charles Gave from Gavekal Research. 

Borio claims that the problem was that bank regulators did nothing to control the credit booms in the financial sector, which they could have done. We know how that ended before.

But, guess what: We have the same problem today and suprise, it's worse.

Look at the issuance levels reached in recent years and the amount of cov-lite loans issued (again...). Look at mis-allocation of capital in the Energy sector and its CAPEX bubble.
Look at the $9 trillion debt issued by Emerging Markets Corporates.
We could go on and on.

Now the credit Fed induced credit bubble is bursting again. One only has to look at what is happening in credit markets (à la 2007). By the way Financial Conditions are tightening globally and the process has started in mid 2014. CCC companies are now shut out of primary markets and default rates will spike. Credit always lead equities...The "savings glut" theory of Ben Bernanke and the FED is hogwash:
"Asset price inflation in general, is not a phenomenon which is limited to one specific market but rather has a global impact. However, there are some specific developments in certain segments of the market, as specific segments are more vulnerable against overshooting than others. Therefore, a strong decline in asset prices effects on all risky asset classes due to the reduction of liquidity.
This is a very important finding, as it explains the mechanism behind a global crisis. Spillover effects are liquidity-driven and liquidity is a global phenomenon. Against the background of the ongoing integration of the financial markets, spillover effects are inescapable, even in the case there is no fundamental link between specific market segments. How can we explain decoupling between asset classes during financial crises? During the subprime turmoil in 2007, equity markets held up pretty well, although credit markets go hit hard." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
As a reminder, a liquidity crisis always lead to a financial crisis. That simple, unfortunately.

This brings us to lead you towards some illustration of rising instability and worrying price action and the formation of "Rogue Waves" we have been witnessing as of late in many segments of the credit markets.

  • A couple of illustrations of on-going nonlinear "Rogue Waves" in the financial world of today
Rogue waves present considerable danger for several reasons: they are rare, unpredictable, may appear suddenly or without warning, and can impact with tremendous force. Looking at the meteoric rise in US High yield spreads in the Energy sector is an illustration we think about the destructive power of a High Yield "Rogue Wave":

- source Thomson Reuters Datastream (H/T Eric Burroughs on Twitter)

When it comes to the "short gamma" investor crowd and with Contingent Convertibles aka "CoCos" making the headlines, the velocity in the explosion of spreads has been staggering:
- graph source Barclays (H/T TraderStef on Twitter)
When it comes to the unfortunate truth about wider spreads, what the flattening of German banking giant Deutsche bank is telling you is that it's cost of capital is going up, this is what a flattening of credit curve is telling you:
- source Thomson Reuters Datastream (H/T Eric Burroughs on Twitter)
Also the percentage of High Yield bonds trading at Distressed levels is at the highest level since 2009 according to S&P data:
    2015: 20.1%*
    2013: 11.2%
    2011: 16.8%
    2009: 23.2%
    - source H/T - Lawrence McDonald - Twitter feed
In our book a flattening of the High Yield curve is a cause for concern as illustrated by the one year point move on the US CDS index CDX HY (High Yield) series 25:

- source CMA part of S&P Capital IQ

This is a sign that cost of capital is steadily going up. Also the basis being the difference between the index and the single names continues to be as wide as it was during the GFC. A basis going deeper into negative territory is a main sign of stress.

We have told you recently we have been tracking the price action in the Credit Markets and particularly in the CMBS space. What we are seeing is not good news to say the least and is a stark reminder of what we saw unfold back in 2007. On that subject we would like to highlight Bank of America Merrill Lynch's CMBS weekly note from the 12th of February entitled "The unfortunate truth about wider spreads":
"Key takeaways
• We anticipate that spread volatility, liquidity stress and credit tightening will persist. Look for wider conduit spreads.
• While CMBX.BBB- tranche prices fell sharply this week we think further downside exists, particularly in series 6&7.
As investors ponder the likelihood that economic growth may slow and that CRE prices may have risen too quickly (Chart 3), recent CMBX price action indicates that a growing number of investors may have begun to short it since it is a liquid, levered way to voice the opinion that CRE is considered to be a good proxy for the state of the economy.

In the past, this type of activity began by investors shorting tranches that were most highly levered to a deteriorating economy and could fall the most if fundamentals eroded. This includes the lower rated tranches of CMBX.6-8, which, as of last night’s close, have seen the prices for their respective BBB-minus and BB tranches fall by 13-17 points for CMBX.6 (Chart 4), 14-20 points for CMBX.7 (Chart 5) and 17-19 points for CMBX.8 (Chart 6) since the beginning of the year.
We agree that underwriting standards loosened over the past few years, which, all else equal, could imply loans in CMBX.8 have worse credit metrics compared to either the CMBX.6 or CMBX.7 series. Despite this, and although prices have already fallen considerably, for several reasons we think it makes sense to short the BBBminus tranche from either CMBX.6 or CMBX.7 instead of the CMBX.8. First, the dollar price of the BBB-minus tranche from CMBX.6 and CMBX.7 is materially higher that of CMBX.8 (Chart 7). 
Additionally, although the CMBX.8 does have more loans with IO exposure than series 6 or 7 do, we think this becomes more meaningful when considering maturity defaults. By contrast, the earlier series not only have lower subordination attachment points at the BBB-minus tranche, but they also have more exposure to the retail sector, which could realize faster fundamental deterioration if the economy does contract." - source Bank of America Merrill Lynch
Now having read seen the movie "The Big Short" and also read the book and also recently read in Bloomberg about Hedge Fund pundits thinking about shorting Subprime Auto-Loans, as the next new "big kahuna" trade, we would like to make another suggestion.  If you want to make it big, here is what we suggest à la "Big Short", given last week we mentioned that Italian NPLs have now been bundled up into a new variety of CDOs according to Euromoney's article entitled "Italy's bad bad bank" from February 2016 and that the Italian state guarantees the senior debt of such operations and thinks it is unlikely ever to have to honour the guarantee (as equity and subordinated debt tranches will take the first hit from any shortfall to the price the SPV paid for the loans), maybe you want to find someone stupid enough to sell you protection on the senior tranche of these "new CDOs". In essence, like in the "Big Short", if the whole of the capital structure falls apart, your wager might make a bigger return because of the assumed low probability of such a "tail risk" to ever materialize. and will be cheaper to implement in terms of negative carry than, placing a bet on the lower part of the capital structure. This is just a thought of course...

Moving back to the disintegration of the CMBS space, Bank of America Merrill Lynch made some additional interesting points on the fate of SEARS and CMBS:
"To this point, Sears’s management announced this week that revenues for the year ending January 31, 2016, decreased to about $25.1 billion (Chart 8) and that the company would accelerate the pace of store closings, sell assets and cut costs.
Why could CMBX.6 be more negatively impacted by the negative Sears news than some of the other CMBX series? Among the more recently issued CMBX series (6-9), CMBX.6 has the highest percentage of retail exposure. When we focus solely on CMBX.6 and CMBX.7, which have the highest percentage exposure to retail among the postcrisis series, we see that although the headline exposure to retail properties is similar, CMBX.6 has considerably more exposure to B/C quality malls than CMBX.7 does" - source Bank of America Merrill Lynch
Sorry to be a credit "party spoiler" but if U.S. Retail Sales are really showing a reassuring rebound in January according to some pundits with Core sales were 0.6% higher after declining 0.3% in December and the best rise since last May, according to official data from the Commerce Department, then, we wonder what's all our fuss about CMBS price action and SEARS dwindling earnings? Have we lost the plot?

Not really this is all part of what is known as the overshooting phenomenon.

  • The overshooting phenomenon
The overshooting phenomenon is closely related to the bubble theory we have discussed earlier on through the comments of both authors of the book "Credit Crisis. The overshooting paper  mentioned below in the book is of great interest as it was written by Rudi Dornbusch, a German economist who worked for most of his career in the United States, who also happened to have had Paul Krugman and Kenneth Rogoff as students:
"Closely linked to the bubble theory, Rudiger Dornbusch's famous overshooting paper set a milestone for explaining "irrational" exchange rate swings and shed some light on the mechanism behind currency crises. This paper is one of the most influential papers writtten in the field of international economics, while it marks the birth of modern international macroeconomics. Can we apply some of the ideas to credit markets? The major input from the Dornbusch model is not only to better understand exchange rate moves; it also provides a framework for policymakers. This allow us to review the policy actions we have seen during the subprime turmoil of 2007.
The background of the model is the transition from fix to flexible exchange rates, while changes in exchange rates did not simply follow the inflation differentials as previous theories suggest. On the contrary, they proved more volatile than most experts expected they would be. Dornsbusch explained this behavior of exchange rates with sticky prices and an instable monetary policy, showing that overshooting of exchange rates is not necessarily linked to irrational behavior of investors ("herding"). Volatility in FX markets is a necessary adjustment path towards a new equilibrium in the market as a response to exogenous shocks, as the price of adjustment in the domestic markets is too slow.
The basic idea behind the overshooting model is based on two major assumptions. First, the "uncovered interest parity" holds. Assuming that domestic and foreign bonds are perfect substitutes, while international capital is fully mobile (and capital markets are fully integrated), two bonds (a domestic and a foreign one) can only pay different interest rates if investors expect compensating movement in exchange rates. Moreover, the home country is small in world capital markets, which means that the foreign interest rate can be taken as exogenous. The model assumes "perfect foresight", which argues against traditional bubble theory. The second major equation in the model is the domestic demand for money. Higher interest rates trigger rising opportunity costs of holding money, and hence lower demand for money. In the contrary, an increase in output raises  demand for money while demand for money is proportional to the price level. 
In order to explain what overshooting means in this context, we have to introduce additional assumptions. First of all, domestic prices do not immediately follow any impulses from the monetary side, while they adjust only slower over time, which is a very realistic assumption. Moreover, output is assumed to be exogenous, while in the long run, a permanent rise in money supply causes a proportional rise in prices and in exchange rates. The exogenous shock to the system is now defined as unexpected permanent increase in money supply, while prices are sticky in the short term. And as also output is fixed, interest rates (on domestic bonds) have to fall to equilibrate the system. As interest-rate parity holds, interest rates can only fall if the domestic currency is expected to appreciate. As the assumption of the model is that in the long run rising money supply must be accompanied by a proportional depreciation in the exchange rate must be larger than the long term depreciation! That said the exchange rate must overshoot the long-term equilibrium level. The idea of sticky prices is in the current macroeconomic discussion fully accepted, as it is a necessary assumption to explain many real-world data.
This is exactly what we need to explain the link to the credit market. The basic assumption of the majority of buy-and-hold investors is that credit spreads are mean reverting. Ignoring default risk, spreads are moving around their fair value through the cycle. Overshooting is only a short-term phenomenon and it can be seen as a buying opportunity rather than the establishment of a lasting trend. This is true, but one should not forget that this is only true if we ignore default risk. This might be a calamitous assumption. Transferring this logic to the first subprime shock in 2007, it is exactly what happened as an initial reaction regarding structured credit investments. For example, investment banks booked structured credit investments in marked-to-model buckets (Level 3 accounting) to avoid mark-to-market losses.  
A credit crisis can be the trigger point of overshooting in other markets. This is exactly what we have observed during the subprime turmoil of 2007.
This is a crucial point, especially from the perspective of monetary policy makers. Providing additional liquidity would mean that there will be further distortions. Healing a credit crunch at the cost of overshooting in other markets. Consequently liquidity injections can be understood as a final hope rather than the "silver bullet" in combating crises. In the context of the overshooting approach, liquidity injections could help to limit some direct effects from credit crises, but they will definitely trigger spillover effects onto other markets. In the end, the efficiency of liquidity injections by central banks depends on the benefit on the credit side compared to the cost in other markets. In any case, it proved not to be the appropriate instrument as a reaction to the subprime crisis in 2007" - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
On that subject we would like to highlight again Bank of America Merrill Lynch's CMBS weekly note from the 12th of February entitled "The unfortunate truth about wider spreads":
"As spreads widened over the past few weeks, a significant number of conversations we’ve had with investors have revolved around the concern that the recent spread widening may not represent a transient opportunity to add risk at wider levels, but instead could represent a new reality earmarked by tighter credit standards, lower liquidity and higher required returns for a given level of risk. While it may be easy to look at CRE fundamentals and dismiss the recent spread widening as being due to market technicals, it is important to realize that while that may be true today, if investors are pricing in what they expect could occur in the future, there may be some validity to the recent spread moves. As a case in point, given the recent new issue CMBS spread widening, breakeven whole loan spreads have widened substantially over the past two months (Chart 16).
Not only do wider whole loan breakeven spreads result in higher coupons to CMBS borrowers, which, effectively tightens credit standards, but it also can reduce the profitability of CMBS originators, which may cause some of them to exit the business. As a case in point, this week Redwood Trust, Inc. announced it is repositioning its commercial business to focus solely on investing activities and will discontinue commercial loan originations for CMBS distribution. Marty Hughes, the CEO of Redwood said:
"We have concluded that the challenging market conditions our CMBS conduit has faced over the past few quarters are worsening and are not likely to improve for the foreseeable future. The escalation in the risks to both source and distribute loans through CMBS, as well as the diminished economic opportunity for this activity, no longer make our commercial conduit activities an accretive use of capital." 
If, as we wrote last week, CRE portfolio lenders also tighten credit standards, it stands to reason that some proportion of borrowers that would have previously been able to successfully refinance may no longer be able to do so. The upshot is that it appears that we have entered into a phase where it becomes increasingly possible that negative market technicals and less credit availability form a feedback loop that negatively affects CRE fundamentals.
To this point, although a continued influx of foreign capital into trophy assets in gateway markets can support CRE prices in certain locations, it won’t help CRE prices for properties located in many secondary or tertiary markets. If borrowers with “average” quality properties located away from gateway markets are faced with higher borrowing costs and more stringent underwriting standards, the result may be fewer available proceeds and wider cap rates." - source Bank of America Merrill Lynch
This is another sign that credit will no doubt overshoot to the wide side and that you will, rest assured see more spillover in other asset classes. Given credit leads equities, you can expect equities to trade "lower" for "longer" we think.

Furthermore, Janet Yellen's recent performance is confirming indeed the significant weakening of the Fed "put" as described in Bank of America Merrill Lynch's note:
"With Fed Chair Yellen’s Humphry Hawkins testimony, in which she stressed the notion that the Fed’s decision to raise rates is not on a predetermined course, the probability that the Fed would raise interest rates at its March 2016 plummeted as did the probability of rate hikes over the next year. During her testimony, however, the Fed Chair mentioned that the current global turmoil could cause the Fed to alter the timing of upcoming rate hikes, not abandon them. 
As a result, risky asset prices broadly fell and a flight to quality ensued due to the uncertainty of the timing of future rate hikes, the notion that the Fed put may be further out of the money than was previously anticipated and the prospect that a growing policy divergence among global central banks could contribute to a U.S. recession. While delaying the next rate hike may be viewed positively in the sense that it could help keep risk free rates low, which would allow a greater number of borrowers to either refinance or acquire new properties, we think it is likely that many investors will view it as a canary in the coalmine that presages slower economic growth, more capital market volatility, wider credit spreads and lower asset prices.
Ultimately, the framework that has been put in place by regulators over the past few years effectively severely limits banks’ collective abilities to provide liquidity during periods of stress. As global economic concerns have increased, investors and dealers alike have become increasingly aware of the extremely limited amount of liquidityavailable, which has manifested through a surge  in liquidity stress measures (Chart 21) and wider spreads across risky asset classes.
 - source Bank of America Merrill Lynch
When it comes to rising risk, it certainly looks to us through the "credit lense" that indeed it certainly feels like 2007 and that once again we are heading towards a Great Financial Crisis version 2.0. For us, it's a given.
When it comes to the much talked about Kyle Bass significant "short yuan" case, we would like to offer our views through the lens of the Nash Equilibrium Concept in our next point.

  • The Yuan Hedge Fund attack through the lense of the Nash Equilibrium Concept
Hyman Capital’s Kyle Bass  has recently commented on the $34 trillion experiment and his significant currency play against the Chinese currency (a typical old school Soros type of play we think).
Indirectly, our HKD peg break idea which  we discussed back in September t2015 our conversation "HKD thoughts - Strongest USD peg in the world...or most convex macro hedge?", we indicated that the continued buying pressure on the HKD had led the Hong-Kong Monetary Authority to continue to intervene to support its peg against the US dollar. At the time, we argued that the pressure to devalue the Hong-Kong Dollar was going to increase, particularly due to the loss of competitivity of Hong-Kong versus its peers and in particular Japan, which has seen many Chinese turning out in flocks in Japan thanks to the weaker Japanese Yen. This Yuan trade is of interest to us as we won the "best prediction" from Saxo Bank community in their latest Outrageous Predictions for 2016 with our call for a break in the HKD currency peg as per our September conversation and with the additional points made in our recent "Cinderella's golden carriage".

We also read with interest Saxo Bank's French economist Christopher Dembik's take on the Yuan in his post "The Chinese yuan countdown is on".

Overall, we think that if the Yuan goes, so could the Hong Dollar peg. Therefore we would like again to quote once again the two authors of the book "Credit Crisis" and their Nash Equilibrium reasoning in order to substantiate the probability of this bet paying off:
"Financial panic models are based on the idea of a principle-agent: There is a government which is willing to maintain the current exchange rate using its currency reserves. Investors or speculators are building expectations regarding the ability of the government to maintain the current exchange-rate level. An as answer to a speculative attack on the currency, the government will buy its own currency using its currency reserves. There are three possible outcomes in this situation. First, currency reserves are big enough to combat the speculative attack successfully, and the government is able to keep the current exchange rate. In this case there will be no attack as speculators are rational and able to anticipate the outcome. Second, the reserves of central banks are not large enough to successfully avert the speculative attack, even if only one speculator is starting the attack. Thus, the attack will occur and will be successful. The government has to adjust the exchange rate. Third, the attack will only be successful if speculators join forces and start to attack the currency simultaneously. In this case, there are two possible equilibriums, a "good one" and a "bad one". The good one means the government is able to defend the currency peg, while the bad one means that the speculators are able to force the government to adjust the exchange rate. In this simple approach, the amount of currency reserves is obviously the crucial parameter to determine the outcome, as a low reserve leads to a speculative attack while a high reserve prevents attacks. However, the case of medium reserves, in which a concerted action of speculators is needed is the most interesting case. In this case, there are two equilibriums (based on the concept of the Nash equilibrium): independent from the fundamental environment, both outcomes are possible. If both speculators believe in the success of the attack, and consequently both attack the currency, the government has to abandon the currency peg. The speculative attack would be self-fulfilling. If at least one speculator does not believe in the success, the attack (if there is one) will not be successful. Again, this outcome is also self-fulfilling. Both outcomes are equivalent in the sense of our basic equilibrium assumption (Nash). It also means that the success of an attack depends not only on the currency reserves of the government, but also on the assumption what the other speculator is doing. This is interesting idea behind this concept: A speculative attack can happen independent from the fundamental situation. In this framework, any policy actions which refer to fundamentals are not the appropriate tool to avoid a crisis. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
If indeed the amount of currency reserves is obviously the crucial parameter when it comes to assessing the pay off for the Yuan bet, we have to agree with Deutsche Bank recent House View note from the 9th of February 2016 entitled "Still deep in the woods" that problems in China remains unresolved:
"The absence of new news has helped divert attention away from China – but the underlying problem remains unresolved
  • After surprise devaluation in early January, China has stopped being a source of new bad news
  • Currency stable since, though authorities no longer taking cues from market close to set yuan level*
  • Macro data soft as expected, pointing to a gradual deceleration not a sharp slowdown
  • Underlying issue of an overvalued yuan remains unresolved, current policy unsustainable long-term
−At over 2x nominal GDP growth, credit growth remains too high
−FX intervention to counter capital outflows – at the expense of foreign reserves

- source Deutsche Bank

When it comes to the risk of a currency crisis breaking and the Yuan devaluation happening, as posited by the Nash Equilibrium Concept, it all depends on the willingness of the speculators rather than the fundamentals as the Yuan attacks could indeed become a self-fulfilling prophecy in the making.

This self-fulfilling process is as well a major feature of credit crises and a prominent feature of credit markets (CDS) as posited again in Chapter 5 of the book from Dr Jochen Felsenheimer and Philip Gisdakis:
"Self-fulfilling processes are a major characteristics of credit crises and we can learn a lot from the idea presented above. The self-fulfilling process of a credit crisis is that short-term overshooting might end up in a long-lasting credit crunch - assuming that spreads jump initially above the level that we would consider "fundamentally justified; for instance reflected in the current expected loss assumption. That said, the implied default rate is by far higher than the current one (e.g., the current forecast of the future default rate from rating agencies or from market participants in general). However the longer the spreads remains at an "overshooting level", the higher the risk that lower quality companies will encounter funding problems, as liquidity becomes more expensive for them. this can ultimately cause rising default rate at the beginning of the crisis; a majority of market participants refer to it as short-term overshooting. Self fulfilling processes are major threat in a credit crisis, as was also the case during the subprime meltdown. If investors think that higher default rates are justified, they can trigger rising default rates just by selling credit-risky assets and causing wider spreads. This is independent from what we could call the fundamentally justified level!
The other interesting point is that the assumption of concerted action is not necessary in credit markets to trigger a severe action. If we translate the role of the government (defending a currency peg) into credit markets, we can define a company facing some aggressive investors who can send the company into default. Buying protection on an issuer via Credit Default Swaps (CDS) leads to wider credit spreads of the company, which can be seen as an impulse for the self-fulfilling process described above. If some players are forced to hedge their exposure against a company by buying protection on the name, the same mechanism might be put to work." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
As we highlighted above with the flattening of MS München and/or Deutsche Bank and the flattening of the CDX HY curve, the flattening trend means that the funding costs for many companies is rising across all maturities:
"Such a technically driven concerted action of many players, consequently can also cause an impulse for a crisis scenario, as in the case for currency markets in financial panic models" - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
So there you go, you probably understand by now the disappearance of MS München due to a conjunction of "Rogue Waves":

"The laws of probability, so true in general, so fallacious in particular." - Edward Gibbon, English historian
And this dear readers is the story of VaR in a world of rising "positive correlations" but we are ranting again...

Stay tuned!

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