Wednesday, 4 May 2016

Macro and Credit - When Doves Cry

"Bad logicians have committed more crimes involuntarily than bad men have by design" - Pierre Samuel du Pont de Nemours, French writer, economist, publisher and government official. 
During the French Revolution his two sons and their families immigrated to the United States. His son Éleuthère Irénée du Pont was the founder of E.I. du Pont de Nemours and Company. He was the patriarch and progenitor of one of the United States' most successful and wealthiest business dynasties of the 19th and 20th centuries.
While taking some much needed R&R (Rest and Recovery) far away basking in the sun, and in the process, we attended a few "board meetings" (windsurfing that is...) which explains our recent lack of weekly musings dear readers, not only did we manage to follow the news and Bank of Japan's predicament, which created yet some additional "sucker punches" and VaR nightmares for the short yen crowd and Nikkei holders, but, we also learned about the sudden disappearance of the maverick musician Prince, being for us the ultimate guitar hero hence yet another reference to the "artist" in our title analogy. Our "Prince" song analogy and central bankers reference follows previous analogies: "All that glitters ain't gold" in 2013 as our 2015 post "While My Guitar Gently Weeps". 

On a side note, about Prince being the "ultimate guitar hero" we would like to point towards the year 2004, when George Harrison was inducted posthumously into the Rock and Roll Hall of Fame as a solo artist. "While My Guitar Gently Weeps" was played in tribute by Tom Petty, Jeff Lynne, Steve Winwood, Steve Ferrone, Marc Mann, and Dhani Harrison, and concluding with arguably one of the most  memorable guitar solo by fellow inductee Prince

"When Doves Cry" was the lead single from Prince's 1984 album Purple Rain. While listening to this seminal title, we also managed the read a fascinating account on the "assignat" which was a type of a monetary instrument used during the time of the French Revolution (money printing on a grand scale with dire consequences...), in a book written by French economist Florin Aftalion in 1987 entitled "The French Revolution - An Economic Interpretation" hence our opening du Pont de Nemours quote. In similar fashion to our quote and chosen title, and our reference to the dreaded "assignat", we think our "generous gamblers" aka central bankers are indeed "bad logicians". At the time of the French Revolution, Pierre Samuel du Pont de Nemours observed that by issuing "assignats", the French nation was not really paying its debts:
"In forcing your creditors to exchange an interest-bearing proof of debt for another which bears no interest, you will have borrowed, as M. Mirabeau has said, at sword-point".
The issue with the assignats was that in no way it was capable of facilitating the sale of public lands, that ones does not buy with a currency, which is merely an instrument for the settlement of a transaction, but with accumulated capital. With QE becoming a global phenomenon with South Korea's president indicating that the country needs to look at possible 'selective' QE and Negative Interest Rate Policy becoming rapidly the "norm", one might wonder how on earth "capital" is going to continue to be "accumulated", particularly when one looks at negative yielding assets as illustrated by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 29th of April entitled "Show me the yield":
"Reaching for yield in a negative-yielding world 
Negative yielding assets now represent 23% of the global fixed income market, growing substantially from 13% at the beginning of the year. As commodity prices have stabilised and macro risks have receded - at least for now - risk sentiment has improved. Amid scarcity of yield investors are moving to higher yielding pockets of the FI world. This will be further aggravated in the months to come as credit investors will find less and less paper to buy as the ECB becomes essentially a competitor to them.
The ECB corporate bond QE is a clear win for cash bonds. However, synthetics have been lagging over the past month. This has been the case in parts of the market – highgrade non-banks - that the ECB will start buying in June, but also in places the ECB will not touch – like high-yield. While the high-yield non-fins index is almost 70bp tighter, since the day post the ECB corporate-QE announcement, the Crossover index is less than 10bp tighter." - source Bank of America Merrill Lynch
To paraphrase du Pont de Nemours, in forcing credit investors to exchange an interest-bearing proof of debt for another which bears no interest (recent issues in the European Investment Grade land are zero coupons...), you will have borrowed at the sword point of the ECB. And when it comes to the "ultimate value" of the "assignat" (and the end result with NIRP...), a simple picture clearly display the trajectory of their final value:
Source: Le marché des changes de Paris à la fin du XVIIIe siècle (1778-1800) -1937 
As far as we are concerned, we continue to enjoy our exposure to gold miners "When Doves Cry". 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 was huge volatility in the policy responses of central banks, the option-value of both gold and bonds position would go up. Of course, both did in Q1 and will continue to do so in Q2.

In this week's conversation, we would like to point out that thanks to "Doves Crying", given the continuation of NIRP, Investment grade credit in particular appears to us more favorable as an asset class versus equities thanks to the on-going support from Japanese investors.

  • Macro and Credit - Investment Grade Credit or when Haruhiko Kuroda got your back
  • Macro and Credit  - The consequences from a flow perspective for credit
  • Final chart: When "doves" get a break from the "breakeven"

  • Macro and Credit - Investment Grade Credit or when Haruhiko Kuroda got your back
As indicated in early April in our conversation "Paradise Lost", Investment Grade Credit, at least in the US appears to us more appealing from a flow perspective thanks to "flows" and on-going support from Japan's large institutional basis:
"As we move into the second Quarter, not only does Investment Grade appear enticing, but, from an allocation perspective US TIPS still remain particularly attractive. But, moving back to Investment Grade, we do believe that "Paradise" is not "Lost" and if indeed as we pointed out, Mrs Watanabe, Japan's GPIF and its pension friends are looking for yield abroad in a more aggressive fashion then indeed adding duration with less credit risk than High Yield makes sense" - source Macronomics, 5th of April 2016
In fact it seems to us that from a "flow" perspective, the rotation from equities to credit is no doubt a validation of our stance as pointed out by Bank of America Merrill Lynch from their Follow the Flow note from the 29th of April entitled "Outflows accelerate from equity funds":
"More inflows into credit…more outflows from equities 
The ECB corporate QE has been the catalyst for a U-turn on credit flows. The sudden course of action the ECB ignited for credit might have also caused another consequence for flows: with inflation expectations still anchored, equities have seen more outflows.
Flows in credit continued for another week. High grade fund flows, even though they slowed down, remained positive for a seventh week. However, inflows into high yield almost doubled w-o-w.
On the contrary European equity funds have suffered another week of outflows. The asset class recorded its biggest outflow in 80 weeks, losing close to $4.8bn of assets. This was also the 12th consecutive outflow week for the asset class, bringing the YTD cumulative outflows from equity funds to more than $24bn.

Government bond funds recorded a third week of outflows in a row, while money market funds recorded their largest outflow in four weeks. 
Commodity fund flows went back to positive territory after taking a breather last week, supported again by inflows into gold funds. The asset class is currently the best performer, with year to date % of AUM inflow at 15%, far ahead of all other asset classes.
Global EM debt flows reflected the bullish turn of the market on EMs, recording the tenth consecutive week of positive flows.
On the duration front, short-term funds recorded a marginal inflow, keeping a positive sign for the last four weeks. The mid-term IG funds continue to record strong inflows for a ninth week. But it looks like investors have started to embrace duration to reach for yield, as inflows into longer-term funds have recorded a cumulative 0.8% inflow in the past two weeks. " - source Bank of America Merrill Lynch
Whereas 1999, which was as well a Prince's 5th album from Prince, saw record inflows into equity before the 2000 internet bubble burst, it seems to us that this time around, our "crying doves" are instigating an "epic bond bubble". The recent decision by the ECB will no doubt boost the rally into credit in Europe into "overdrive" and as expecting we are already seeing more and more large corporate issuers issuing de facto "zero coupon" thanks to our "Generous Gambler" aka Mario Draghi. 
As we pointed out in our previous missive before going for our R&R, it seems to us that the ECB is failing because it is enticing the money "uphill" namely into "bond speculation" where all "the fun is",  not downhill, to the real economy. Flow wise this exactly what is happening. The "fun" is in the bond market and particularly in the European investment grade market as explained in Bank of America Merrill Lynch previous Follow the Flow note from the 24th of April entitled "Global QE - here we go":
"CSPP: clearer, bigger, broader 
The ECB was bolder than expected. With an eligible pool of assets that seems to be broader than initially thought, the ECB is now in the driving seat. Investors are “front running” the ECB, by buying more credit at the expense of equities. With inflation expectations still pointing to the downside, investors were directed to high-grade paper, while government, money market and equity funds saw outflows.Over the past eight weeks high-grade and high-yield funds have seen combined inflows of $10.6bn vs. more than $17bn of outflows from equity funds. Credit has still has room to go, as the YTD flow number remains in the negative territory as $11bn have left on aggregate from the asset classThe main target of the CSPP – namely investment grade credit – recorded its sixth week of positive flows with a significant volume compared to the previous week.High yield on the other hand saw only modest inflows, the second in a row. We also note that latest EPFR monthly data reveal that investment grade funds had their first monthly inflow in 10 months, and high yield funds their first in 4 months. 
Elsewhere in fixed income, government bond funds recorded another weekly outflow, the second in a row, while monthly flow numbers were also pointing to the downside for March. Money market funds had their first outflow in three weeks.
Equities fund flows were yet again negative, and have been so for the last 11 weeks. The asset class now approaches $20bn of outflows since the start of the year, the biggest among all asset classes we track with EPFR. On a monthly basis, in March equities had their biggest outflow in 17 months and the second in a row. 

 - source Bank of America Merrill Lynch
Whereas the issue with the assignats was that in no way it was capable of facilitating the sale of public lands (us thinking about Greek "privatisation" and the original goal of getting 50 billion euros, now reduced to 15 billion euros) in no way the ECB's recent policy will facilitate the "accumulation of capital", on the contrary, capital will eventually be destroyed. In similar fashion Pierre Samuel du Pont de Nemours explained on the 25th of September 1790 in front of the French National Assembly the mechanisms which enabled shrewd speculators to use devalued assignats to buy "biens nationaux" (collateral being the church's real estate) for next to nothing as written by Florin Aftalion in his book:
"Events were to prove him right, as huge fortunes were amassed by these same means. He also announced that, in the last analysis, the Assembly would be asked for much more than the issue of 1,900 billions that was necessary for the settlement of the exigible debt. In this case too, Dupont was to be proved right" - source Florin Aftalion, "The French Revolution - An Economic Interpretation
With NIRP and cheap credit, bond speculation, buybacks and takeovers can operate on a grand scale and generate outsized returns for the "shrewd speculators" on Spanish Real Estate and now on Italian Real Estate. Easy as 1, 2, 3...

Thanks to the ECB's latest and with Bank of Japan sticking with NIRP, Japanese investors are now facing an even bigger competition from the ECB to get hold of foreign bonds. In relation to having Kuroda's backing when it comes to investing in global investment grade, we read with interest Bank of America Merrill Lynch's Credit Market Strategist note from the 29th of April entitled "2bps per month":
"What can Kuroda do for you?
From the perspective of US HG corporate bond investors - probably not much more than presently. Easy BOJ monetary policy benefits the US corporate bond market in two main ways. First, and most importantly by far, through negative interest rates and QE the BOJ has more or less purged the Japanese fixed income market for yield. As result Japanese fixed investors - such as insurance companies and banks - are in a very challenging position where they are forced to buy foreign fixed income instead (Figure 10). 
For example Nikkei in an article on Thursday titled: "Japan insurers flock to foreign bonds as BOJ kills golden geese" estimated that the top-10 Japanese Life Insurance companies alone plan to buy $46.6bn of foreign bonds in the current fiscal year (that began April 1st). This is a big and long lived positive development for US corporate bonds. Second as we saw this week the BOJ affects global risk sentiment, but this effect should be relatively small and short lived. With JGBs trading at negative yields out to 10-years in maturity (Figure 12), and 30-year JGBs at just 33bps (Figure 13), there is very little the BOJ can do to drive even more Japanese investors into the US HG corporate bond market.

Even if the BOJ stepped up their buying of Japanese corporate bonds the impact would be limited, as the size of that market is just 3% of the size of the USD HG corporate bond market - an order of magnitude smaller than the EUR denominated HG market (Figure 11).

Hence, given the limited ability in the first place of the BOJ to provide further tailwind to the US corporate bond market, we expect that the surprising non-action by the BOJ at this week’s meeting will only work through the second channel - market sentiment - a likely small short term negative.Japanese investors being forced out the curve
The more interesting question is what foreign bonds Japanese investors buy. While clearly the US HG corporate bond market is the main game in town, the big rally in US credit spreads over the past two-and-a-half months works to push Japanese investors to take more risk in order to preserve yields. That means either moving out the curve in credit, or dialing down their currency hedges. Within HG this means chiefly longer maturities and also, but likely to a lesser extent given ratings mandates, down in quality.
However, beyond our own asset class we think many large Japanese investors will increasingly be looking at higher yielding asset classes - chiefly structured products for investment grade ratings, but in the case of less ratings constrained money also higher quality HY.
To understand corporate bond math for Japanese investors consider that in order to buy US corporate bonds they need USD funding. One way to get that on a fully currency hedged basis is through a JPY/USD cross-currency basis swap for the life of the bond. However, because funding in USD is relatively scarce that comes at a steep cost. But as that annual premium tends to increase relatively little, or even decrease, with maturity of the contract, and 
However, beyond our own asset class we think many large Japanese investors will increasingly be looking at higher yielding asset classes - chiefly structured products for investment grade ratings, but in the case of less ratings constrained money also higher quality HY. To understand corporate bond math for Japanese investors consider that in order to buy US corporate bonds they need USD funding. One way to get that on a fully currency hedged basis is through a JPY/USD cross-currency basis swap for the life of the bond. However, because funding in USD is relatively scarce that comes at a steep cost. But as that annual premium tends to increase relatively little, or even decrease, with maturity of the contract, and because the US corporate spread curve is relatively steep, currency hedging costs as percentage of US corporate spreads declines with maturity (Figure 14). 

On adding the negative basis swap to the US corporate spread curve in Figure 14 we translate USD spreads into currency hedged JPY spreads on a 3-month Libor basis (Figure 15, Figure 16).

We also show in these figures credit spreads in the Japanese corporate bond market on a 3-month JPY Libor basis - because the quoting convention in Japan is on a 6-month Libor basis we add the 3-6 month LIBOR swap for the average four year maturity of the Japanese corporate bond market. Note that, because of the small size of the Japanese corporate bond market - and the lack of long paper - we assume a flat spread curve for simplicity.
Other ways for Japanese investors to reach for yield
Instead of extending out the maturity curve Japanese investors that have ratings flexibility can reach down the credit curve and even into higher quality high yield (Figure 17). In particular BB-rated HY bonds are one of the most effective sectors that offer significant yield-pick-up.
Alternatively, since a significant proportion of Japanese money is ratings constrained we suspect that a lot of investors will instead reach for yield in investment grade rated securitized products.Finally it is increasingly obvious that a lot of Japanese investors are dialing down their currency hedges in order to increase yieldsThat of course leaves them exposed to some extent to this year’s big appreciation of the yen Japanese, and we would expect that some investors are forced to pull out of US corporate bonds for that reason even as other investors put more money to work.
As our rates strategists discussed (see: Liquid Insight: The Japan flow playbook 04 April 2016), an alternative hedging strategy is to roll three month forward exchange rate contracts - a strategy that does not eliminate all currency risk and thus pays more a fully hedged strategy. The idea is to exchange JPY to USD in the spot foreign exchange market, buy US corporate bonds and at the same time enter a 3-month forward contract to sell USDs back to JPY in three months at a fixed price. While this currency hedges the first three months of the trade, if the Japanese investor wants to keep holding the US corporate bond after that he/she must at the time roll into a new 3-month forward contract – hence there is currency risk. The cost of this strategy is around 130bps annually, and thus a yield of around 3.4% on a 10-year US corporate bond becomes a roughly a 2.1% yield in JPYs using this approach. Figure 18 shows the significant yield advantage offered by such partially currency hedged spread curves over their fully hedged counterparts. 

- source Bank of America Merrill Lynch

Of course as well as in Japan, doves have been crying given that they much vaunted currency depreciation scheme has been put in reverse as of late. But given the mounting evidence of a global slowdown, one would expect the Bank of Japan to return to the QQE game during the second part of this year. Now that the ECB is directly in competition of the likes of Mrs Watanabe, Japanese insurance companies, the GPIF and their pension funds, one would expect that the "fun" uphill, namely bond speculation, continues to run unabated, for the real economy, we are not too sure...

When it comes to credit, we expect some more tightening in the second quarter thanks to "Doves crying", ECB's buying spree and Japan's foreign appetite for risky assets.

  •  Macro and Credit  - The consequences from a flow perspective for credit

The consequences are that from a "flow" perspective, we are going to see a continuation of the "Great Rotation", namely from "equities" to "fixed income" until we get another merry go round of QEs. but that's another story. For the time being thanks to the ECB and its global corporate bond buying binge, it is forcing at sword point investors and particularly Japanese investors to switch to overdrive, leading a clear widening gap between equities and bonds as pointed out by Bank of America Merrill Lynch's Credit Market Strategist note entitled "2bps per month" from the 29th of April 2016:
"Mind the gap, redux 
One of the more striking decouplings last year occurred mid-August between spiking credit spreads and declining equity vols, before the equity market finally caught up (see: Situation Room: Mind the gap 13 August 2015). We are now seeing the opposite, as credit spreads are tightening hard in April while equity vol has been relatively constant (Figure 22).  
This time it appears that one of the key reasons for the decoupling is very favorable excess demand conditions in the high grade corporate bond market, as an influx of foreign investors meet less than expected supply. The foreign demand part of the equation is becoming particularly obvious as some of the biggest Japanese investors – including life insurance companies – have recently publicly announced expanded investments in foreign bonds for the new fiscal year that began April 1st." - source Bank of America Merrill Lynch.

Excess demand + weak supply+ Foreign buying from Japan = continuation of credit spreads tightening. A very simple equation, making credit more enticing versus equities for the time being we think from an asset allocation perspective.

When it comes to Japan's life insurance companies, they intend to increase their credit risk exposure compared to 2015 according to Nomura's note entitled "Major Life Insurers FY16 Bond investment" from the 4th of May:
"Comments suggest lifers are looking to credit risk to improve returns 
n comments on bonds other than domestic bonds, Insurer B said, “In addition to ramping up JPY-denominated investments such as infrastructure projects, we will consider buying major banks’ subordinated debt compliant with Basel III.” Insurer C said, “We will slow our purchases of super-long JGBs and buy more credit instruments as we expect yen bond yields to remain low,” and Insurer E said, “We plan to invest in AT1 bonds issued by major banks. These instruments do not have a long history, but have adequate market liquidity. We bought these bonds in FY15. Falling domestic rates mean that the only way we can secure investment returns is to take duration risk or credit risk.” Insurer F noted, “We will not buy JGBs, and will only buy corporate bonds,” while Insurer G said “We plan to limit reinvestment in domestic bonds to a low amount, focusing on domestic bonds with relatively high yields, primarily corporate bonds.” These comments suggest many lifers plan to take credit risk to improve return. 

Lifers are investing in a wider range of options 
Lifers commented on regions (markets) and the types of bonds that they target for investment. According to Insurer A, “We significantly increased balances of both hedged and unhedged bonds in FY15, particularly US bonds, and have not changed our stance in FY16. However, we plan to reduce the weighting of UST investments owing to higher hedging costs, and diversity into euro area bonds. We will invest flexibly based on yields and hedging costs.” Insurer B said, “For currency-hedged foreign bond investments, we plan to buy not only government bonds, but also corporate bonds, diversifying our investments in terms of bond type and maturity.” Insurer C stated, “We plan to invest in a wider range of regions, including peripheral countries in addition to core countries, and will also lengthen the duration of our investments. We will also look to corporate bonds. We aim to improve return by increasing investments in foreign credit assets.”

Insurer E commented, “We will focus on US bonds rather than EU bonds, whose yields are declining, and invest in credit instruments such as USD-denominated notes issued by domestic mega-banks and others.” Insurer F said, “We expect the Fed to raise rates twice in FY16 and currency hedging costs to rise accordingly, so we will invest in corporate and other higher-yielding US bondsIn the euro area, we will invest in peripherals.”
Insurer G noted, “We have primarily invested in USTs and EUR bonds, but we have diversified to include Australian and Mexican bonds, among others. Government bonds made up a high percentage of our foreign bond investments, but we will increase the weighting of credit instruments.” Insurer H stated, “We will continue to buy certain amounts of investment-grade US corporates, in addition to USTs. European bonds, including corporates, will also remain an option.”
Insurer G noted, “We have primarily invested in USTs and EUR bonds, but we have diversified to include Australian and Mexican bonds, among others. Government bonds made up a high percentage of our foreign bond investments, but we will increase the weighting of credit instruments.” Insurer H stated, “We will continue to buy certain amounts of investment-grade US corporates, in addition to USTs. European bonds, including corporates, will also remain an option.”

As bond yields continue to fall globally, lifers will likely look to add investments in a wider range of markets, in our opinion." - source Nomura
Because, Mrs Watanabe, Japanese Life insurers, GPIF and pension funds will continue to shift their portfolio allocation from JGBs into foreign assets and in particular credit, we believe the acceleration of the move will be Japanese yen negative and the current level of USD-JPY below 107, looks enticing we think to re-initiate a short on the Japanese currency. Maybe at some point the Japanese Yen will end up like the dreaded French Revolution "assignat"...

For our final chart below, while we have discussed on numerous occasions the attractiveness of US Tips in the current environment, when it comes to US breakeven levels, it seems to us that the Fed and its "doves crying" have been shedding "crocodile tears" and are indeed getting a welcome respite from US breakevens.
  • Final chart: When "doves" get a break from the "breakeven"
As we discussed back in March in our conversation "Unobtainium", we argued that the FOMC was more willing to allow inflation to overshoot, hence our preference at the time for US TIPS and Gold Miners:
" If indeed the slope of the bond yield curve which was negatively correlated to short term rates, is now fully inelastic from a strategy perspective, we believe being long US TIPS (given their embedded deflation floor), long gold miners and long US long bonds still represent a relatively attractive "allocation". - source Macronomics, March 2016

When it comes to our final chart and inflation expectations, we would like to point out towards Bank of America Merrill Lynch's chart from their Securitization Weekly note from the 29th of April 2016 indicating that the 10 year breakeven inflation rate is somewhat validating the "inflation accommodative" stance of the Fed 
"The 10-year breakeven inflation rate seemed to break out to the upside of the downward channel that started with taper talk in mid-2013 (Chart 1).  

We view this as big news, as it seems to be saying that the Fed will tolerate or even wants further gains in inflation expectations. Data dependency says that is subject to change, but for now, we assume that we have transitioned to a new accommodative phase for the Fed. This should be good news for securitized products credit and create upside risk for the near term." - source Bank of America Merrill Lynch
If indeed "breakeven" are "breaking out", this is indeed showing than "when doves cry", it seems their are shedding "crocodile tears" given they'd rather tolerate inflation than deflation.
"There seems to be no limit to which some men will go to avoid the labor of thinking. Thinking is hard work." - Thomas Edison  
Stay tuned!


  1. I guess you didn't spend your entire R&R windsurfing the caribbean sea... Good readings and great writing. Stay tanned!

  2. Great stuff. While the b/e inflation rate is at the top of the channel, doesn't the expected yen weakness (and coincidental $ strength create its own deflationary headwind, regardless of the Fed's desires?

    1. Hi Tim,
      The big market event last week was the sharp reversal of the 10yr breakeven inflation rate, thanks to Fed speakers. After reaching a high of 1.72% last week, close to the upper channel of the last three years, it dropped to a low of 1.62%. The Fed is the primary driver of prices and spreads in credit. The fact that we did not have a "breakout" is showing that once again the Fed is failing in spurring inflation. There is therefore more downside potential for real rates which will be "bullish" for gold (see our post Gibson's paradox) and good for US long bonds (30 year). You can expect additional yield compression on the long end of the US curve. Deflationary headwinds are increasing again. That's what transportation and shipping have been telling us no matter what the Fed is trying to "spin".


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