Monday 28 March 2016

Macro and Credit - The Pollyanna principle

"Skepticism: the mark and even the pose of the educated mind." - John Dewey, American philosopher
While watching with interest the much more positive tone in credit markets in recent weeks, with the rally in High grade credit erasing in effect the losses for the year after having spent virtually the entire year in negative territory, we reminded ourselves for our chosen title analogy of the Pollyana principle. The Pollyanna principle, also called the positivity bias is a tendency for people to remember pleasant items more accurately than unpleasant ones. Research in psychology indicates that our mind tend to focus on the optimistic at the subconscious level while, at the conscious level, it has a tendency to focus on the negative. Our subconscious bias towards the positive is described as the Pollyanna principle and the name derives from 1913 novel Pollyanna by Eleanor H Porter. This novel describes a girl who plays the "glad game" (like the sell-side pundits) trying to find something to be glad about in every situation (oil prices lower, Fed's cautious stance, the ECB's generosity, etc.). The issue with the Pollyanna principle, such as with unabated liquidity injections by central banks is that researchers Margaret Matlin and David Stang provided substantial evidence that the more people expose themselves to positive stimuli and avoid negative stimuli, the longer they take to recognize what is unpleasant or threatening than what is pleasant and safe, and they report that they encounter positive stimuli more frequently than they actually do. Of course, any similarities with today's financial markets would be as the saying goes totally fortuitous.

In this week's conversation, we would like to reiterate our focus on NIRP in Japan and in particular the Japanese yen and flows, given as we posited in our previous conversation "The Monkey and banana problem", when it comes to "risky assets" yen matters more and more.

  • Macro and Credit - Japanese investors' life under NIRP
  • Macro and Credit - In Europe, pricing is not the problem. Credit isn't growing.
  • Final chart: Front-running Mrs Watanabe and the ECB

  • Macro and Credit - Japanese investors' life under NIRP
While we pointed out in numerous conversations on our concerns on the Japanese yen in particular and Japanese flows from the Government Pension Investment Fund (GPIF) and his pension friends, we think, that from a global flow perspective and "risky assets" Japan matters and even more under Negative Interest Rate Policy (NIRP). 

More recently in our conversation "the Paradox of value", we indicated that courtesy of Bank of Japan's latest trick, US Investment Grade credit would benefit from increased allocation from Japanese large funds such as the sizable GPIF. Japanese investors are more likely to continue buying US Treasuries while as we have shown in our previous conversation NIRP has effectively "killed" the Japanese Money Market funds industry with all 11 Japanese asset managers closing their money market funds (MMF) and returning assets to investors,

Given the behavior of the Japanese long bonds discussed in our previous conversation, it is clear to us that the "carry" game played by "leveraged" players has gone into overdrive. This is particular clear to us in the USD/JPY basis and currency hedging costs as explained by Nomura in their report from the 22nd of March entitled "Key investor behaviour under negative policy rates":
"Impact of changes in USD/JPY basis and currency hedging costs
Currency basis swaps fell deeper into negative levels in reaction to the BOJ’s adoption of negative policy rates. This, coupled with a fall in JPY LIBOR since the BOJ rate cut, has raised basis swap costs for Japanese investors. As this coincided with a fall in UST yields, super-long JGBs looked more attractive than currency-hedged 10yr USTs at one point.

However, the current rise in UST yields and the drop in super-long JGB yields have made currency-hedged 10yr USTs look more attractive again. Investor stances should change depending on the relationship between super-long JGB and foreign bond yields after excluding the impact of currency-hedging costs.

As currency-hedged foreign bonds look less attractive than they did before (although they have become less expensive recently), investors may opt for markets with lower currency hedging costs (e.g., EUR over USD) and/or look to add risk exposure in their currency-hedged non-domestic credit investments, in our view.
- source Nomura

Indeed, not only have Japanese institutional increased their duration risk by buying longer-dated JGBs, they will as well most likely increase their credit risk exposure by raising aggressively their foreign investments we think. Therefore it is very likely that their interest in foreign corporate bonds will increase, in particular from the likes of lifers as indicated by Nomura in their report:
"Lifers may react to higher currency hedging costs by taking on foreign credit risk or increasing the weighting of unhedged foreign bonds
Lifers have continued to increase currency-hedged foreign bonds as an alternative to their yen bond investments, but currency-hedged foreign bonds do not look attractive as before due to higher currency hedging costs, particularly after the 29 January BOJ policy board meeting. Judging from cases in which currency hedging costs rose when the Fed was raising rates in 2004-2007, lifers could either take more credit risk overseas or increase the weighting of unhedged foreign bonds in their portfolios, in our view.

In February, lifers’ foreign bond investment was the highest level since April 2008 Currency-hedged foreign bonds look increasingly attractive now as super-long JGB yields fall. Lifers’ foreign bond investments reached JPY1,003.9bn in February, the highest level since April 2008 (no breakdown of whether they are hedged or unhedged, nor whether government and non-government bonds is available). We believe lifers’ demand for foreign bonds as an alternative investment to yen bonds, whose yields have fallen dramatically, may increase.
According to a Bloomberg report, one major lifer had no choice but to shift the focus of its bond investment to foreign bonds from yen bonds, and that it will raise the weighting of unhedged foreign bonds if the Fed continues with its rate hikes. Another insurer said it would increase the weighting of foreign bonds making up its investments as part of its effort to increase risk assets.

Its foreign bond investments are currently evenly divided between currency hedged and unhedged, but it is considering increasing hedged investments as JPY is currently strengthening.

Impact on pension funds
Corporate pensions have increased their weighting of foreign securities, investment trusts, cash and deposits and call loans under QQELooking at corporate pensions’ investment trends since the BOJ adopted QQE (April 2013), we find that they increased the weighting of foreign securities, investment trusts, cash and deposits and call loans while the weighting of JGBs in their portfolios has been almost unchanged or fell slightly.While they increased their weighting of risk assets such as foreign securities and investment trusts or alternative assets, they also seem to have increased the weighting cash (or cash equivalents).We believe the BOJ’s adoption of negative rates will make it more difficult for pension funds to hold cash and deposits and call loans, in our view. During the QE period from March 2001 and March 2006, the weighting of JGBs, cash and deposits, and call loans fell, while that of foreign securities and investment trusts rose. 

We will watch to see if they will further increase their investments in foreign securities and investment trusts." - source Nomura
We will as well track as well to see if indeed Japanese institutional investors do follow the Pollyanna principle and continue with their foreign investment binge (most likely).

As we pointed out in our previous conversation "The Monkey and banana problem", NIRP doesn't reduce the cost of capital. NIRP is a pure currency play:
"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
On the subject of "carry" play and leveraged funding strategies primarily using the JPY as a cheap funding source, it does look that NIRP is providing such an opportunity as highlighted by the astute Christopher Wood from CLSA in his Greed and Fear note from the 24th of March 2016:
"GREED & fear heard this week that it is now possible to earn about a 100bp spread by swapping dollars into yen to take advantage of negative JGB yields. This probably explains why foreign buying of JGBs is rising. Foreigners have bought a net Y3.6tn worth of Japanese bonds so far this year, after buying a net Y7.6tn in 2015. But it has to be wondered quite where such a process will end. GREED & fear has no idea. But the consequences will certainly not be positive. Meanwhile, GREED & fear is grateful to a London-based colleague for pointing out the remarkable fact that the price of the 20-year JGB has risen by 12% in yen terms and 19% in US dollar terms so far this year." - source CLSA
So, if one thinks about the Japanese yen "carry leveraged community play" and the Pollyanna principle, it seems to us that the more investors expose themselves to this kind of "dangerous basis play", the longer they take to recognize what is unpleasant or threatening it can become.

One thing for sure, there is a clear relationship between the USD/JPY 5 year basis spread and US credit spreads as displayed in the below chart from Nomura Japan Navigator no. 662 report from the 21st of March:

"While negative policy rates have created distortions in the JGB market, they have prompted a shift of investor funds into other assets more than the previous policy did. Recently, investors have looked to currency-hedged foreign bonds as alternatives to JGBs, particularly euro area government bonds, which have low hedging costs, and US credit, which can cover hedging costs. We believe these investor flows are likely pushing bond yields lower and credit spreads narrower overseas."
 -source Nomura

If negative rates do support activity, it primarily works through the exchange rate, adding to the portfolio substitution into risky asset via the previously mentioned yen carry play and the Pollyanna principle we think.

And when it comes to NIRP, it does not work by reducing financing costs materially, providing a ‘price of money’ stimulus. This brings us to our second point, namely that lowering the price of capital in Europe is not sufficient to trigger credit growth.

  • Macro and Credit - In Europe, pricing is not the problem. Credit isn't growing.
While many pundits have lauded Mario Draghi's latest efforts and effectively decided to play the "glad game", we think differently of the efficiency of the measures taken by "Le Chiffre". In no way the latest raft of measures is dealing with the bloated balance sheets of Italian banks plagued by rising and significant nonperforming loans (NPLs). Also, why many pundits have illustrated the success of the ECB supremo thanks to the fall in corporate lending prices. Credit is not growing enough to provide a sustainable growth exit path to the European project.

On this matter we read with interest Société Générale European Banks note from the 21st of March entitled "ECB - new hope, new danger":
"A dangerous step forwards
We are entering a new phase of ECB influence. The focus of support has switched from funding to underwriting. That is how the TLTRO2 should be read – Draghi is encouraging banks to move 40bps up the risk curve by subsidising this ‘first loss’. This starts to take ECB policy debate into the area where it can have the greatest impact: supporting front book and (more crucially) back book credit quality. It’s a step forwards, but the ECB could be opening up a dangerous new chapter of irrational lending.
The end of ever more negative rates
We believe that the most important step forward has been the realisation that we are realistically sitting at or near the ECB rate floor. This has quelled concerns that the ECB would just keep blindly pushing rates into unknowable sub-zero depths. The drag grows substantially the further we plunge and the longer we stay there. Ending this revenue risk is a positive. The ECB toolkit is focused elsewhere.
The start of the Draghi Donation
Everyone says that credit supply is abundant, and demand is the problem. We disagree – good quality borrowers can get credit, but supply is still weak to lower tiers of borrowers. SME credit rejection rates are still high in periphery Europe. Banks are still hesitant on writing new NPLs, and so seemingly strong credit supply is misleading. The TLTRO2 Draghi Donation of 40bps can help banks to move up the credit risk curve. We would be more positive if it was supported by co-ordinated efforts to clean up the existing NPL stock." - Société Générale.
Once again the ECB's ambition of restoring the credit transmission mechanism in Europe has been failing and will continue to fail because as we pointed out before, contrary to the Fed, it hasn't dealt with the "stocks" namely the NPLs still intoxicating many Southern European banks. While the ECB has provided cheap funding, to repeat ourselves, in no way the ECB has modified the credit profile of these ailing banking institutions. These assets have yet to be dealt with hence the risk of "japanification" given the time taken in dealing with these issues à la Japan. This is clearly illustrated in Société Générale's report:
"For all its sins, it is impossible to argue that the potent cocktail of negative rate policy and funding support brought no benefits. The ECB have been bent on improving the credit transmission mechanism, particularly in the European periphery. Over 2013, the European lending market clearly had a two-speed game: cheap funding for the corporate sector in the core, pricey funding in the periphery. This game was driven by the vast differences in funding availability and cost for banks.

Looking across Europe, it is clear that lower rates can help in a limited capacity. There are still categories of lending that look too expensive and are likely to strangle growth. SME lending in particular is more expensive the further south you travel.

Pricing is not the problem
The improvement in pricing masks an altogether deeper problem. Credit isn't growing. Regardless of the better pricing dynamic, it is somewhat meaningless if corporate credit demand remains too anemic to support sustained growth.
In terms of volumes, Europe still runs as a two-speed game. Household good, corporate bad. Core good, periphery bad.
When looking at the two charts below, keep in mind that the Draghi Donation kicks in at 2.5% lending growth for banks that are growing. On total eligible lending, that is equivalent to €150bn of new lending over the next two years. In reality, the requirement is lower, as some  banks are still shrinking. It does not make much of a dent in the c.€600bn of ‘lost’ corporate lending since 2009.

Looking at the detail, too many periphery banking markets are still in reverse. At the eurozone level, the trend is weak positive – with an overall recovery at 0.5pct YTD. This masks growth in Germany, France and the Netherlands, offset by more contraction in Spain and Italy. The three markets that have delevered the most remain in contraction:

The problem of the 'right' credit supply
The root of the growth problem is always put down to credit demand. The standard conclusion is that credit supply is vibrant, but the corporate sector just does not seem to need the money.
We believe this is the wrong conclusion. Credit supply is only fine for the highest quality credits. This is a subset of lending demand, and one that is already ably serviced by direct issuance. Indeed, with an extension of QE into IG corporate bonds, we believe this part of the corporate lending market will be even better supported.
Credit supply dries up when banks are asked to take on some credit risk. Particularly in the periphery, banks are groaning under the weight of soured loans. The incentive to avoid adding to this stock is more powerful than the need to grow.
While the data do show that bank lending prices are coming down, a more granular survey of actual SME opinions reveals a more difficult lending context. In the periphery, SMEs are still highly likely to find credit availability either non-existent or too expensive:
Rejection rates are high. For many SMEs, the demand for lending is there, but lending applications are either rejected (in whole or part) or offered at much less favourable terms and discouraged. As shown below, rejection rates are as high as 60% of applications in Greece and 30-35% in Spain and Italy. This compares to <15 blockquote="" core="" european="" in="" markets.="" the="">
The Draghi Donation – a credit risk subsidy
Funding has never been the issue for the European banking sector. Banks have been swimming in virtually free, virtually unlimited funding for months, and the impact on lending volumes has been stunted. The focus of the ECB has shifted from improving funding to finding ways to clear the backlog of credit quality issues and NPLs, particularly in the periphery.
Even with abundant funding, banks are hesitant on writing loans which will eventually sour, adding to the elevated stocks of NPLs.
This has been a much more consistent focus of ECB messaging in recent months. To quote Benoit Coeure:
“To reduce uncertainty, both policymakers and financial institutions need to play their part. They need to ensure that the financial system is fit for purpose and able to finance the recovery. And they need to do so today, not tomorrow.” ...“All the preconditions are now there to accelerate NPL resolution… The challenge now is to speed up the process of writing off and/or disposal. There are various policy measures that can facilitate this process.”
The 40bps is to subsidise credit risk, not funding
In this context, we view the 40bps ‘Draghi Donation’ as an incentive for banks to move up the risk curve, and extend lending to a broader group of corporate customers. The credit demand needs to follow, but banks at least need to be open to extending their new loan books outside the very top end of the credit risk spectrum.
We view the subsidy as 40bps of first loss underwriting by the ECB, rather than an attempt by the ECB to cut corporate lending pricing through the credit transmission mechanism." - source Société Générale
The issue at stake we have discussed on numerous occasions is that many of these Southern Europe banking institutions are capital constrained and cannot increase their lending capacity until the NPLs issues have been resolved!
Maximizing the funding via TLTRO2 in no way helps SME credit availability. The deleveraging has well is an on-going  exercise. What the new ECB funding does is slow down the deleveraging but in no way provides sufficient resolution to the "stock". NPLs are a"stock" variable but, Aggregate Demand (AD) and credit growth are ultimately "flow" variables. Until the ECB understands this simple concept, the "japanification" process will endure hence our "Unobtainium" analogy of last week:
"Unobtainium" situation. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day and now credit speculators are joining the party with both hand" - source Macronomics, March 2016
This means of course that thanks to the Bank of Japan and the ECB, we believe that the rally in credit has more room to go and that both central banks will again not be the benefactors of the "real economy".
One thing for sure, by applying the Pollyanna principle, we think that Investment Grade Credit will benefit strongly and that we will see large inflows into the asset class as per our final point and chart, for SMEs where not too sure...

  • Final chart: Front-running Mrs Watanabe and the ECB
As discussed in our conversation the "the Paradox of value", it looked like the US investment grade market was the only game in town but given the significant tightening of credit spreads in recent weeks, it also means that not only Mrs Watanabe will be playing it into overdrive, but over investors as well will be having a field day as per our final chart from Bank of America Merrill Lynch Credit Derivatives Strategist note from the 23rd of March entitled "How to trade credit in an ECB driven world":
"Front-running” the ECB
We have seen it in the past. When the ECB announces a government bond buying program, inflows accelerate into the asset class. With the help of the ECB, credit flows have broken free from a long period of outflows. Last week’s positive inflow into high grade and high-yield funds was the third consecutive and the biggest in 53 weeks.
We draw some parallels between the government bond buying program and corporate buying program. In March 2014 (more here), as inflation expectations started to deteriorate, market begun pricing the possibility that the ECB should have had to resort to more unconventional policies. In the following year or so government bond funds have seen significant inflows, with investors “front-running” the ECB government bond purchasing program.
In late February this year, investors’ expectations of an expansion of the QE program into corporate bonds instigated a strong rebound for credit spreads and a revival of the primary market. So far in three weeks, credit funds – high-grade and high-yield combined – have seen almost $5bn of inflows." - source Bank of America Merrill Lynch
Applying the Pollyanna principle to credit market inflows, one could indeed expect the yield compression to continue further. It looks we have moved back to early 2007 thanks again to the Fed's dovish stance and the ECB's additional generosity in conjunction with Bank of Japan enticing more duration and more credit risk... 
"Anyone who has begun to think, places some portion of the world in jeopardy." -  John Dewey, American philosopher
Stay tuned!


  1. Very interesting piece. I would be interested to know the exact mechanism by which foreign investors can earn "a 100bp spread by swapping dollars into yen to take advantage of negative JGB yields", thus boosting foreign holdings of JGBs. Intuitively, this does not make sense to me. This would also presumably be Yen-bullish?

    1. From BAML - Liquid Insight - 18th November 2015:
      "Buying 2y JGBs asset swapped to dollars: 2y UST +77bp (current: 2y UST+79) or Libor + 70bp (current: L+71bp)
      The recent moves in the yen basis swap market have been stark and now present an attractive opportunity for dollar investors to create synthetic floating rate or fixed rate USD assets. Using the long route, this would involve (1) buying 2y JGBs; (2) asset swapping them into semi-annual Yen floaters; (3) using a 3s/6s basis swap to convert semi-annual cash flows to quarterly; (4) entering a cross currency basis swap to convert payments to a USD floater; and (5) this could be left as is for a floating asset, or, a receive fixed in US swaps against this would convert it into a fixed-rate US asset.
      An alternative would be a fixed-for fixed cross currency basis swap that collapses the above five transactions into one trade." - source BAML

      Easy as 1,2,3...




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