Macro and Credit - Confusion

"When a man's knowledge is not in order, the more of it he has the greater will be his confusion." - Herbert Spencer, English philosopher

Looking at the reversal of our previous thoughts relating to the potential for yen weakening and Nikkei surging in the process given our expectations for new tricks from the Bank of Japan, while disappointed on our recent call, we did not trigger and added on going long Nikkei hedged this time around given the on-going "Confusion" in both macro data and weaker flows at least in gold miners for the time being, we decided that for our chosen title analogy, given our fondness for the music from the 80s and in particular for New Order that our title should reflect our state of mind as well as August 1983 maverick single from the British group. On a side note, we have made a previous reference to New Order's music in our July 2015 conversation entitled "Blue Monday".

While Emerging debt seems to be flow wise the new darling of investors (or "yield hogs"), and when it comes to US High Yield disregarding "safety" for "yield", as pointed recently by BlackRock's recent chart of the week, it seems for them that double-digit returns going forward will be a thing of the past it seems:

- source BlackRock

Given the upcoming European Banking Association "stress tests", we would like to look this week to re-iterate our preference for credit instruments rather than equities when it comes to European banks. We will as well look at Japan again given the details of the fiscal stimulus so far have disappointed the "central banking addicted" investor crowd and the much anticipated decisions coming from the Bank of Japan as well as the FOMC hence the on-going "Confusion".

Synopsis:

• Macro and Credit - European banks - So you wanna play "beta"? Stick to senior credit
• Macro and Credit  - Japan looking for a "helicopter stall"
• Final charts: Europe, "Mind the Gap" - Dividend yield is high relative to Earnings yield

• Macro and Credit - European banks - So you wanna play "beta"? Stick to senior credit

As we pointed out on numerous occasions, when it comes to the attractive "valuations" levels pointed out by some "confused" pundits, when it comes to assessing this "value play", we have long been recommending you stick to "credit". In fact, that's exactly we pointed out in our November conversation "Fluctuat nec mergitur":

"In this "beta" chasing game, some pundits would point out to the attractive "valuations" level of European banks. We continue to dislike the sector as the deleveraging and low profitability of the sector makes us prefer to play it through credit instruments à la "Japan".
Equities wise, we believe the banking sector will continue to underperform "high beta financial credit", regardless of the bullish and overweight stance of Société Générale's Equities team

No matter how our "equities friends" want to "spin it", we are not "buying it" and we will stick to "credit" when it comes to banking exposure in this "japanification" on-going process. There is much more "deleveraging" to go in Europe, in 2016" - source Macronomics, November 2015

And of course no "Confusion" there, we were right from the onset of 2016 on this very subject. To further make our point clearer, we read with interest Deutsche Bank's European Banks Capital Structure note from the 27th of July:

"Unlike the sell-off early in the year, the market has generally differentiated quite well between bank credit and equity. The former has been supported by historically high capital ratios and strong liquidity buffers, whereas the latter has suffered from downward earnings pressures.

This is clearly illustrated by Figure 28 and Figure 29.

While the Stoxx Europe Banks equity index is down 27% YTD, the iBoxx EUR Banks Senior index spread is now at 108bp, exactly where it was at the end of 2015. Moreover, while equities are down 13.4% since the Brexit vote, senior credit is 5bp tighter.

Even at the bottom of the debt capital structure, Additional Tier 1 (AT1) securities have done remarkably well relative to equities when compared to their performance in the market sell-off in February. This is shown in Figure 30 and Figure 31.

In total return terms, EUR AT1s are down 2.6% YTD whereas the total return on equities over that period is -24.5%. Since the Brexit vote, it has been 0.1% and -11.8%, respectively.

In February, however, concerns that some banks might miss an AT1-coupon payment led to an abrupt sell-off in those instruments, partly due to the (self-fulfilling) fear that such an event might spark massive volatility across the AT1 market. This was compounded by a lack of clarity about when the so-called Maximum Distributable Amount (MDA) restrictions kick in, preventing banks from paying discretionary coupons among others. As we explained in our report at the height of the sell-off, AT1s are contingently junior to equity both in payouts and capital, which increases their sensitivity to market moves once a certain stress level has been reached. A missed AT1 coupon is lost forever whereas dividends are retained for the benefit of shareholders (in fact just like the unpaid coupon).

Since then, the European Commission has cited precisely this argument as a reason to introduce more transparency and less rigidity into the application of the MDA rules by splitting the so-called Pillar 2 SREP capital buffer into a disclosed formal requirement and a guidance component where the breach of the latter should not constitute an MDA trigger (the “guidance” part would sit at the top of the capital stack rather than below the Combined Buffer, making the latter less likely to be breached and thus trigger MDA restrictions). This was confirmed in early June by the ECB stating that it will refine its SREP methodology in this fashion. This has reduced ambiguity and lowered AT1 coupon risks, bringing down volatility of these instruments as highlighted in Figure 30 and Figure 31.

AT1s need new buyers and we think that the relative resilience of this asset class this time around could bode well for future demand for the product. This is in contrast to February when the P&L damage to many accounts resulted in some key investors withdrawing from this market."  - source Deutsche Bank.

Where we disagree with Deutsche Bank entirely is that regardless of the future demand for AT1s, from a risk/reward perspective, we will re-iterate that we think that CoCos offer very poor value, no "Confusion" there from our perspective. Any serious trader out there will always tell you that you never ever want to be "short gamma". This is exactly what we pointed out in our February conversation "The disappearance of MS München" dealing with risk, VaR and much more:

"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..." - source Macronomics, February 2016

When you buy CoCos, you are effectively the "insurer", bear that in mind. Banks are benefiting from your generosity given you are providing the "crash protection" insurance and to do so they entice investors by offering higher coupons. There is no free lunch there...

Credit wise, we have been advising for a while to play the "quality" game rather than the "beta" game for investors willing to get "carried away and play the lower capital structure part of European banks credit. It comes to us as no surprise from reading Deutsche Bank's note that indeed senior unsecured bonds have had the best performance across the bank capital structure:

"Figure 32 and Figure 33 summarise relative spread performance across the bank debt capital structure. 

Compared to a year ago, bank EUR bond benchmark spreads are wider at all levels of seniority but their changes differ meaningfully:

• Covered bonds: 9bp wider (at 54bp now)

• Senior unsecured bonds: 1bp wider (at 108bp)

• Tier 2 bonds: 47bp wider (at 244bp)

• AT1 bonds: 292bp wider (at 870bp)

While this compares unfavourably with corporate non-financial senior bonds (16bp tighter at 94bp), senior unsecured bonds have had the best performance across the bank capital structure (including equity as shown before). Banks have been able to obtain term funding at relatively stable levels but their capital instruments have sold off meaningfully in spread terms due to broader concerns about compressed profitability and also potential solvency in weaker parts of the banking system.

On the one hand, regulation has brought explicit bail-in risk to bank creditors. On the other, regulatory policy over the last few years has ensured that banks have effectively been run for creditors. We have seen continued build-up of capital, de-risking of balance sheets and strengthening of liquidity profiles, all of that being bank credit positive. While we have shown that some banks are under obvious asset quality and capital pressures, major European banks have maintained reasonably strong credit profiles and this is why their credit has been relatively insulated from the equity turmoil." - source Deutsche Bank

Of course, this should not come as a surprise in the on-going "Japanification" process of the credit markets with the ECB as of late joining the bond buying spree. There is no "Confusion" there for this process to happen because it has all to do with central banks meddling with risk premiums and asset prices. They are indeed the first culprits in asset prices manipulation. This was as well clearly illustrated in Deutsche Bank's report:

"Investors have a behavioural bias towards absolute return targets. Even as ever lower rates and quantitative easing inflate asset prices and expected future market returns necessarily fall, they are reluctant to fully adjust their targets to the new reality. They reach for yield, moving down the risk spectrum to hit their return targets in a low-yielding world.
They take on more duration and credit risk, squeezing risk premia on the way. In the case of some term premia, for instance, these can turn negative as hold to- maturity considerations are overshadowed by a hope for a short-term capital gain or at least avoidance of the negative carry of shorter-duration instruments. (Locally, there seems to be particular aversion to negative yields although the initial resistance has been broken even in corporate bonds) Many investors, such as insurers and pension funds, also seek yield in less liquid and/or structured products, the latter often with greater tail risks.
Reaching for yield is an inherent part of the portfolio substitution channel that transmits QE to the financial conditions in the wider economy. As direct central bank purchases of sovereign and corporate bonds removed some downside risk, at least for now, they naturally contributed to a further drop in required risk premia. Investors then reach for yield in riskier asset classes.
There is nothing wrong with the willingness to accept lower risk premia. However, reaching for yield has limits and there is a risk of a yield over-reach.
To an extent, central banks trade off monetary and credit easing for potentially less financial stability down the road. At some point, however distant, reversal of the reach-for-yield phenomenon (repricing of risk premia) might be quite abrupt and lead to a sharp tightening of financial conditions, with macroeconomic and financial-stability consequences. But that is a worry for another day.
The financial sector has been a collateral victim of this environment. As maturity transformers, banks are notable earners of term premia, liquidity premia and credit risk premia. Consequently, their diminishment has been a drag on bank profitability. Given the difficulty in passing negative rates on to depositors, the competitive nature of the (in parts overbanked) industry and soft demand for credit, European banks seem to have been unable to reprice loans to preserve their margins. Also, eurozone banks increasingly compete with markets in which the ECB has been buying non-bank corporate bonds, driving spreads down relative to banks’ own cost of market funding despite bank bonds’ better ratings. The 3-6-3 banking rule most certainly does not apply here. Given the state of the economy, demand for credit and potential capital constraints, the required increase in loan volumes to compensate for tighter margins seems unlikely to be reached soon.
Low rates and QE have also had benefits for banks, such as lifting the value of sovereign holdings and improving asset quality relative to the counterfactual (of no such policies). Also, the ECB’s TLTROs or BoE’s Funding for Lending have been designed to provide funding cost benefits to banks, which should be positive for earnings if not fully competed away. Overall, however, the extraordinary rate environment has been deeply damaging to the prospects for bank profitability and it might potentially be structural if the “secular stagnation” hypothesis turns out to be correct.

Figure 5 summarises the dramatic shift in the rate environment over the years, spelling rather dire prospects for the European economy.

Banking in low-growth, low-inflation and flat-curve environment is simply a challenge. Globally, flattening curves and rates falling towards or below zero at ever longer maturities have been a vote of ever lower confidence in the adequacy of current policies to restore inflation and growth.
While one could have a long metaphysical discussion about whether 30-year bond yields near or below zero reflect true economic risks or duration overreach, their levels are not driven purely by QE purchases. Swiss 30-year government bonds have a negative yield even if the SNB is not buying. Clearly, peripheral sovereign credit has been a great beneficiary of ECB QE.

We review these market phenomena because they matter for the bank lending business as well, in addition to some of these bonds sitting directly in banks’ liquidity portfolios. In the corporate space, reaching for yield has been equally relentless. As we calculated recently, 3 over a third of AAs and As and nearly a quarter of BBBs, by amount outstanding, among non-financial corporate EUR bonds traded with negative ask yields.
Most recently, we have seen the first non-financial corporate (AA-rated Deutsche Bahn) issue a zero-coupon EUR bond with a yield of -0.006%. “Income” is disappearing from “fixed income”. These developments have pushed many bond investors down the credit quality spectrum but with BB yield at 3.06%, “high yield” is becoming a bit of a misnomer too, at least relative to its history.

All this weighs heavily on banks’ credit intermediation business. With interest rates on loans to households and firms on a multi-year downward trajectory, helped also by the ECB’s TLTROs, lending margins have been falling. Margins in our selected eurozone countries are mostly at 50-70% of their 2010 levels, with many worrying that the downward trend has more to go. Note that this
refers to new business only. There will be a further lagged response on the full loan book’s net interest margins (NIM) as it gets gradually repriced, eroding net interest income more.
In a negative-rate world with limited hopes for a change any time soon, NIM pressure is here to stay. Indeed, the collateral damage to bank stability and ultimately to economic growth from the negative-interest-rate policy has increasingly been seen as an impediment to more aggressive rate cuts by the ECB. At the same time, it has to be accepted that in a negative-rate world with much higher capital ratios than before the crisis, returns on bank equity below 10% might well be a fair compensation to shareholders. Current profitability measures cannot be compared to the “old days” of high interest rates and thin equity cushions.
To get on a higher earnings path, banks also have to continue to adjust their business models and cut costs. In banking systems with clear inefficiencies and overcapacity, especially as more European corporations raise funds via markets rather than banks, consolidation among smaller players and downsizing by some larger players may need to accelerate. There is a common interest in Europe in having a stable and adequately profitable banking system that promotes sustainable growth. That also requires overcoming some legacy challenges in pockets of potential instability." - source Deutsche Bank

Death by a thousand rates cuts and cost cutting, thanks to the stupidity of NIRP which is slowly but surely weighting on bank profitability and destroying NIM. At least from a credit investing perspective you have the ECB as your "buyer of last resort", avoiding in effect default risk to materialize for the time being but, just postponing the end result we think.

On a side note, we might be sounding yet again like a broken record but, for instance loan growth in Italy is constrained because Italian banks are "capital impaired" (to say it in a politically correct way...). Forget "bail-in" because if you do crush the retail crowd you can rest assured that Renzi's days will be over and that the whole European project would unravel with Italy threatening to leave the European project with a new majority such as the Five Star Movement. Even the leader of the populist movement is acutely aware of the risk "bail-in" would have on Italian savers.

The only way, we think is for the ECB to monetize NPLs to restore the credit transmission mechanism, because without growth, there is no reduction in both NPLs and budget deficits, that simple.
We also made a more in depth analysis of the Italian NPLs problem back in April in our conversation "Shrugging Atlas":

"Either you remove the NPLs from the bloated Italian Banks' balance sheets and the ECB monetizes the lot, or they don't. Anything in between is an exercise of dubious intellectual utility." - source Macronomics, April 2016

Also, back in our February conversation "The disappearance of MS München" we joked in 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

Reading through Deutsche Bank report, indeed, the Atlas plan was doomed from inception:

"With the aforementioned gap between market and book valuation of NPLs, disposals have been slow as banks are reluctant to book losses given their capital positions. In February, to facilitate disposals, the government introduced a scheme of state guarantees (GACS) of IG-rated senior tranches of NPL ABS at a cost linked to a basket of equally-rated Italian corporate CDS. While this introduced a handy hedging service, from the very start it stood little chance of solving the actual problem. To comply with EU State-Aid rules, these guarantees had to be offered at “market prices”. If that is the case, then by definition no amount of tranching and hedging can overcome the fact that if the securitisation vehicles acquire NPLs above their market values, investors in the junior tranches are unlikely to see the expected returns meet their targets. In reality, the scheme does offer guarantees that might not be readily available in the market otherwise and their pricing may be seen as marginally attractive. It just is not a silver bullet and can only be part of a bigger solution.

With no private buyers forthcoming, it has been increasingly clear that a comprehensive solution will require government involvement. The government coordinated the set-up of the €4.25bn Atlante fund by mostly private investors, which has been available for backstop recapitalisations (up to 70%) and NPL purchases (at least 30%). Its size, however, has been inadequate for the size of the NPL problem in Italy and at this point some €1.75bn remains available after recapitalising Banca Popolare di Vicenza (€1.5bn) and Veneto Banca (€1bn). It does not look like Atlante could dispose of those equity stakes soon, at acceptable prices, to free up resources for further purchases.
There have been reports that efforts are under way to set up Atlante 2 (to be called Giasone) with additional €2-3bn, particularly aimed at addressing NPL concerns around the largest troubled bank Monte Paschi. Even if such efforts succeed, however, the size of these private funds would be insufficient for a comprehensive solution." - source Deutsche Bank

Of course, these solutions are as we said earlier, an exercise of dubious intellectual utility. We might even suggest Italian banking authorities name Atlante Fund "iteration n" simply Danaus or Danaids (also Danaides or Danaïdes) because in Greek mythology the Danaids were condemned to spend eternity carrying water in a sieve or perforated device. In the classical tradition, they come to represent the futility of a repetitive task that can never be completed such as setting up private funds to resolve Italian NPLs.

Nonetheless, the ECB's credit buying spree is still supportive of credit versus equities when it comes to the European banking sector as a whole.

Moving on to our next "Confusion" point, we believe Japan, once more will have to play catch up to the tune of the ECB and stealth devaluation from China in order to revive "animal spirits", namely its stock market through yet another round of "unconventional" measures.

• Macro and Credit  - Japan looking for a "helicopter stall"

With Friday’s Bank of Japan meeting, every pundit is expecting "shock and awe" once more to induce yet another weakening bout of the yen as well as a rally in the Nikkei. In our last missive we indicated that re-initiating a short position on the Japanese yen could be of interest. While initially our timing was poor and faced an initial set back, we still believe Bank of Japan will again come to the rescue of its massive ETF equity exposure on its own local index.

What we find of interest in the discussions surrounding "helicopter money" and Japan is the analogy that can be made with Mario Draghi much discussed "bumblebee" reference in his 2012 speech that led to his "whatever it takes moment":

"And the first thing that came to mind was something that people said many years ago and then stopped saying it: The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does. So the euro was a bumblebee that flew very well for several years. And now – and I think people ask “how come?” – probably there was something in the atmosphere, in the air, that made the bumblebee fly. Now something must have changed in the air, and we know what after the financial crisis. The bumblebee would have to graduate to a real bee. And that’s what it’s doing."- Speech by Mario Draghi, President of the European Central Bank at the Global Investment Conference in London, 26 July 2012.

The issue with bumblebee according to 20th century folklore, the laws of aerodynamic prove that they should be incapable of flying:

"The calculations that purported to show that bumblebees cannot fly are based upon a simplified linear treatment of oscillating aerofoils. The method assumes small amplitude oscillations without flow separation. This ignores the effect of dynamic stall (an airflow separation inducing a large vortex above the wing), which briefly produces several times the lift of the aerofoil in regular flight. More sophisticated aerodynamic analysis shows the bumblebee can fly because its wings encounter dynamic stall in every oscillation cycle" - source wikipedia

 When it comes to "helicopter money" and vortex stall and Japan, we touched on this very subject in our May 2014 conversation "The Vortex Ring":

"In a "helicopter stall" or vortex ring state, the helicopter descends into its own downwash. Under such conditions, the helicopter can fall at an extremely high rate (deflationary bust).
For such structural failure or crash to occur you need the following three factors to be present as indicated by Helen Krasner in her article entitled "Vortex Ring: The 'Helicopter Stall'":

"To get into vortex ring, three factors must all be present:

• There must be little or no airspeed.

• There must be a rate of descent.

• There must be power applied.

Note that all three of these must be going on at the same time." - source Macronomics, May 2014

We also argued at the time:

"It is not only the Fed and its central bankers which have a tendency to overshoot, likewise, Governor Haruhiko Kuroda in Japan has failed to convince he had done enough to spur 2% inflation and that his policies will be enough to pull Japan out of 15 years of deflation, risking in effect another Vortex Ring state for the Japanese markets." - source Macronomics, May 2014

Given the relative dismal results induced by QQE on the Japanese results, we expect more of the same from Japan as posited by our friend Michael Lebowitz from 720 Global in his latest missive called Kyōki (Insanity):

"Eventually, due to the mountain of money going directly in to the economy, inflation will emerge. However, the greater likelihood is not that inflation emerges, but that it actually explodes resulting in a complete annihilation of the currency and the Japanese economy. In hypothetical terms as described here, the outcome would be devastating. Unlike prior methods of QE which can be halted and even reversed, helicopter money demands ever increasing amounts to achieve the desired growth and inflation. Once started, it will be very difficult to stop as economic activity would stumble." - source Michael Lebowitz, 720 Global

This is exactly what will eventually happen to the Japanese "bumblebee", under a Vortex ring state thanks to "helicopter money" a country can fall at an extremely high rate (deflationary bust).

We totally agree with our friend Michael Lebowitz about the dangers of "perpetual bonds", or bonds with no maturity date as well with is astute reference to the French money printing exercise ultimately leading to economic ruin and a leading factor fueling the French revolution. All of this is described by French economist Florin Aftalion in his 1987 book entitled "The French Revolution - An Economic Interpretation"

This is what we discussed in May 2016 in our conversation "When Doves Cry" when it comes to "assignat" and "helicopter money" leading to a Vortex ring state (helicopter crash...or deflationary bust leading to "hyperinflation"):

"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." -  source Macronomics, May 2016

"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".

As we pointed out at the time and in relation to the ECB:

"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." - source Macronomics, May 2016

In similar fashion, the Japanese idea of "perpetual bond" is very close to the dreadful "assignat" and its dire consequences are well documented in Florin Aftalion's seminal book:

Source: Le marché des changes de Paris à la fin du XVIIIe siècle (1778-1800) -1937 

We also commented at the time in our May 2016 conversation:

"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..." - source Macronomics, May 2016

But returning to "helicopter money", Japan and its much anticipated 28 trillion yen ($265 billion) fiscal package announced by Prime Minister Shinzo Abe, we have yet to see how the Bank of Japan is going to make good on Abe's promises. When it comes to Ben Bernanke idea of perpetual bond, this has been tried before in the form of the "assignat". If Japan issue a perpetual bond, to paraphrase du Pont de Nemours, Japan will have borrowed more!

On the issue of "perpetual bonds" we read with interest Nomura's Richard Koo's take in his latest note from the 26th of July entitled "Cost-benefit analysis of helicopter money":

"Four versions of helicopter money (3): government scrip and perpetual zero-coupon bonds

A third version of helicopter money involves government money printing or the replacement of the JGBs held by the BOJ with perpetual zero-coupon bonds.

The people proposing these policies hope that fiscal stimulus financed by government scrip or perpetual zero-coupon bonds, which are not viewed as government liabilities, will elicit spending from people who are currently saving because of concerns about the size of the fiscal deficit and the likelihood of future tax increases.

Economists refer to this reluctance to spend because of worries about future tax hikes as the Ricardian equivalence. If true, it implies that consumption will increase each time the government raises taxes since higher taxes mean lower deficit in the future. The fact that this phenomenon has never once been observed in the real world suggests it is nothing more than an empty theory.

Moreover, there are serious issues that must be confronted once the economy picks up and the liquidity supplied by the monetary authorities via government scrip or zero-coupon perpetuals must be drained from the system. Perpetual zero-coupon bonds are essentially worthless, which means the BOJ cannot sell them—no one in the private sector would be stupid enough to buy them.

That means the only way to mop up the excess reserves created via the issue of perpetual zero-coupon bonds is for the BOJ to ask the MOF to issue equivalent amounts of coupon-bearing bonds.

The same would be true when trying to mop up reserves created by government scrip. Once this scrip starts circulating, it becomes part of the monetary base, and draining it from the system will require the government to absorb it by issuing bonds. And in the case of both perpetuals and government scrip, the government that issued the bonds cannot spend the proceeds. If the government spends them, the liquidity that had been mopped up will flow back into the economy again.

Those recommending the issuance of government scrip or perpetual zero-coupon bonds say that one advantage of this approach is that it does not lead to an expansion of government liabilities (upon issuance). However, they will become massive government liabilities when the economy eventually recovers and they must be mopped up.

Helicopter money proponents silent on issue of mopping up reserves

In other words, the biggest issue with helicopter money—as with quantitative easing—is the question of how to drain these funds from the system. It becomes clear just how problematic both policies are when the difficulty of draining reserves is taken into account.

Yet in all the discussion about helicopter money and quantitative easing in Japan and elsewhere, almost no one has touched on the massive costs involved in mopping up the excess reserves created under these policies. Everyone emphasizes the benefits of these policies when introduced while ignoring that those benefits are small indeed when we examine the costs and benefits over the policy’s lifetime.

As one example of this bias, Waseda University professor Masazumi Wakatabe argued in a Nikkei column titled “Easy Economics” that helicopter money is preferable to quantitative easing inasmuch as it enables the government to undertake fiscal stimulus without increasing its liabilities.

I suspect that the helicopter money envisioned by Mr. Wakatabe involves the issuance of government scrip or direct central bank underwriting of perpetual zero-coupon bonds. However, he makes no mention whatsoever of how the liquidity created via these methods will be drained from the system once private-sector demand for loans recovers.

Helicopter money offers no benefits whatsoever over policy’s lifetime

As described above, the only way to mop up liquidity that has been created using these methods is for the government to issue bonds and not spend the proceeds. I think this would be more difficult from both a legal and practical perspective than winding down quantitative easing, which in itself is no easy task.

Moreover, the amount of government debt that must ultimately be acquired by the private sector is no different from a case in which the government had issued bonds to fund fiscal stimulus from the outset.

In short, whether fiscal stimulus is funded with government scrip and zero-coupon bonds or with the ordinary issue of government debt, the size of the government’s liabilities will be the same in the end. Helicopter money offers no benefits whatsoever when viewed over the lifetime of the policy, including the eventual need to mop up liquidity." - source Nomura

In similar fashion to "assignat" perpetual bonds are essentially worthless and there is indeed a heightened risk that Japan will face significant consequences to the value of its currency and eventually trigger a Vortex ring state (helicopter crash...or deflationary bust leading to "hyperinflation"), hence our long term very short view on the Japanese yen (our target might even scare you...).

Of course these are longer term risks that will eventually play out, closer to home and short term wise, there is growing dividend risk in Europe going forward.

• Final charts: Europe, "Mind the Gap" - Dividend yield is high relative to Earnings yield

 While European banks are slowly but surely dying thanks to NIRP and with Japan increasingly looking for its "helicopter stall", no "Confusion" there, in Europe what we think is of interest for our final chart is the growing gap between European Dividend Yield (DY) versus European Earnings Yield (EY). As indicated in the below graphs from Deutsche Bank Equity strategy note entitled "A new hope?" from the 25th of July , we agree with them that, going forward, given the level attained by the European payout ratio (55%), there is growing dividend risk going forward so "Mind the Gap":

"The European dividend yield (DY) is at a 20-year high relative to the corporate bond yield, suggesting equities have yet to catch up with the recent performance of corporate bonds. However, unlike the DY, the relative European earnings yield (EY) remains firmly within its four-year range, suggesting equities are not clearly cheap relative to corporate bonds. The real issue here is that the DY is high relative to the EY, which means that the payout ratio is elevated, pointing to downside risks for dividends." - source Deutsche Bank

As far as we are concerned, "hope" is never a good strategy. We cannot resist but to chuckle again and remember a comment we read in the past from a credit desk:

"Equities = Hope, Credit = Reality, unfortunately, Reality follows Hope until the Hope dies, then Reality settles in."

So, yes indeed, mind the gap between DY versus EY, watch Japan and fade the sell-side pundits telling you that European banks are "cheap" from a valuation perspective (that's what many told you at the beginning of the year...). Like we posited before, the problems facing Europe and Japan are driven by a demographic not the financial cycle.

 As we concluded our April conversation "Shrugging Atlas":

"The very difficult situation that lies with "easy policy", there is an easy way in, but no easy way out. So as goes the the kite string theory, you can control a kite by pulling its string, but not pushing it. Once you reach the ZLB and implement NIRP on top of QE, it seems to us monetary policies become ineffective." - source Macronomics, April 2016

The game is moving towards capital preservation we think...

"Confusion of goals and perfection of means seems, in my opinion, to characterize our age." - Albert Einstein

Stay tuned! 

Macro and Credit - Eternal Sunshine of the Spotless Mind

"Right now I'm having amnesia and deja vu at the same time." - Steven Wright, American comedian

While watching with interest our home team France losing the Euro 2016 final against Portugal, being yet another case of "Optimism bias" coming from our fellow countrymen, and looking at the significant rally in various asset classes such as iShares iBoxx Investment-Grade Corporate Bond ETF, or LQD, taking in $1.1bn last Thursday, the largest ever recorded inflow as if "Brexit" had never happened, we reminded ourselves for our chosen title of the 2004 romantic comedy "Eternal Sunshine of the Spotless Mind". With various markets returning to dizzying heights such as the S&P500 or US High Yield markets, it seems to use that once again investors have found "romantic love" with risky asset classes and in many ways their bad memories have been erased, hence our title reference. As far as we are concerned, we haven't gone through the memory erasure procedure and we continue to feel that when it comes to credit in general and in in particular US High Yield, we are in the last inning of the game, particularly when we look at the most recent Fed Senior Loan Officers survey which clearly shows a slowly but surely deteriorating trend when it comes to financial conditions.

In this week's conversation we would like to focus on the on-going deteriorating trend in credit fundamentals and discuss why we think we are in the final inning and therefore one could indeed expect a final and important melt-up in risky asset prices which could last well into September. We will as well discuss Japan as there are indeed increasing "helicopter" noises in the background.

Synopsis:

• Macro and Credit - Bondzilla, the NIRP monster is more and more "made in Japan"
• Macro and Credit  - US High Yield has gone through the memory erasure procedure but nonetheless, financial conditions are tightening
• Final charts:  the Gold rush into gold funds is feeding on Bondzilla, the NIRP monster

• Macro and Credit - Bondzilla, the NIRP monster is more and more "made in Japan"

As we have pointed out in numerous conversations, just in case some of our readers went through a memory erasure procedure, when it comes to "investor flows" Japan matters and matters a lot. Not only the Government Pension Investment Funds (GPIF) and other pension funds have become very large buyers of foreign bonds and equities, but, Mrs Watanabe is as well a significant "carry" player through Uridashi funds aka the famously known "Double-Deckers". This "Bondzilla" frenzy leading our "NIRP" monster to grow larger by the day is indeed more and more "made in Japan". On the subject of this Japanese foreign allocation, we read with interest UBS Global Rates Strategy "What Japanese Investors Are Buying" from the 8th of July:

"Which government bond and credit markets benefit from Japanese demand?

We have previously described how Japanese investors have been significant net buyers of foreign assets – predominantly DM government bonds – in light of the BoJ’s negative interest rate policy. Net purchases have recently regained momentum, following a slowdown around the turn of the Japanese fiscal year. Today’s data of overseas purchases by destination for May highlights which markets are benefitting.

DM: US Treasuries on top; continued inflows into France, Canada, Italy

Japanese net buying of sovereign bonds recovered in May (¥1.8tn vs. ¥0.2tn in April), though still below the record level seen in March (¥5.5tn). US Treasuries made up for nearly 50% of all net purchases. France, Japan's historically preferred euro market, saw modest net buying of ¥159bn, roughly unchanged from April. Elsewhere, Canada and Italy saw continued net purchases, albeit at a slightly slower pace than in April.

EM: Reducing exposure to LatAm and High Yield

In May investors reduced positions in high yield EM markets. Mexico monthly outflows were the largest in five months; Brazil, Indonesia and South Africa were also net sold. China short-term bonds were net bought, other Asian markets were flat. Overall allocations into EM have been small relative to DM asset purchases, with the largest EM market (Mexico) accounting for less than 1% of all bond holdings.

- source UBS

What is as well of interest in UBS note is that since the implementation of NIRP by the Bank of Japan (BOJ), Japanese life insurance companies have gone into "overdrive":

"Japanese life Insurance companies’ net purchases of foreign long-term debt securities; subset of Figure 13 (¥bn). Lifers' hefty buying since Feb-16 continued in Jun-16 (¥1056bn, 3rd largest since the start of data in 2005), overall the 10th consecutive month of net purchases." - source UBS

No surprise therefore that "Bondzilla's size" has indeed been increasing at a rapid pace. This sudden acceleration in negative yielding bonds has been clearly "made in Japan" we think. The acceleration in "Lifers" bond purchases is as well confirmed by Nomura in their JPY Flow Monitor entitled "Foreign Investment continues amid increased uncertainty" from the 8th of July:

"Japanese foreign portfolio investment continued in June. Excluding banks, Japanese investors bought JPY2264bn ($22.6bn) of foreign securities in June, a slightly weaker pace than in May. Life insurance companies’ foreign bond investment accelerated again, while we judge most of them were on an FX-hedged basis. Pension funds and toshin companies remained net buyers of foreign securities too. Retail investors’ foreign investment is likely to stay weak for now, as risk sentiment among them deteriorates after the Brexit vote. Pension funds will probably remain dip buyers, even though the pace is likely slower than in 2015. May BoP data show that the current account surplus narrowed for the second month in a row, suggesting that the improved phase of the Japanese current account balance has likely ended for now, as oil prices recover and JPY appreciates." - source Nomura

If indeed "Bondzilla" is "made in Japan" this is clearly thanks to the acceleration of "Lifers" in the global reach for yield particularly since the implementation of NIRP by the Bank of Japan, but as pointed out by Nomura's note, this time around with a higher hedge ratio:

"Lifers continued strong foreign bond investment, likely with high hedge ratio
Life insurers bought a net JPY1056bn ($10.6bn) in foreign long-term bonds for the 10th month in a row. Although the pace of net buying has slowed over the past two months, this is the first time in three months that the pace of net buying has accelerated to above JPY1trn. Downward pressure on yields has strengthened globally in response to the decline in Fed rate hiking expectations after US NFP data early June and uncertainty over the Brexit referendum. 20yr JGB yields have fallen to almost 0%, forcing lifers to seek higher yields and shift to foreign bond investments. With JGB yields trending near 0% in all maturities, lifers are likely to continue to invest in foreign bonds at a high level
(Figure 2).

That said, we expect that most of their foreign bond investments will be FX hedged for the time being. After FX hedging, UST investment may not be so attractive owing to higher hedging costs. Nonetheless, Fed rate hiking expectations by year-end have almost completely disappeared. The Brexit vote has lowered USD/JPY, JGB and UST 10yr yields to the lower range of major lifers’ FY16 forecast, or even below, but on an unhedged based foreign bond investment may not accelerate anytime soon, amid increased political uncertainty (see “JPY: The shift into foreign assets by lifers should continue”, 27 April 2016). With risk tolerance falling, we think there is little chance that lifers will shift to unhedged foreign bonds in the near future.

In the medium term, we still expect their interest in investing in hedged foreign bonds to wane gradually, as a result of the expected rise in hedging costs. Nonetheless, the timing of their shift from hedged to un-hedged foreign bond investment will likely be delayed after the Brexit vote and associated market volatility." - source Nomura

From the above we think that the implications are as follows in the short term, we have most likely seen the lows for now on Developed Markets' long term sovereign bonds and in terms of the Japanese Yen, further depreciation of the currency depends on the implications of the deployment of some form of "helicopter money" in Japan. We must confide we have re-initiated therefore a short Japanese yen position and thinking about adding going long Nikkei but in "Euros" via a quanto ETF (currency hedged).  Given we have not fallen to a memory erasure procedure, we reminded ourselves clearly of our April 2015 conversation "The Secondguesser":

"1. To criticize and offer advice, with the benefit of hindsight.

2. To foresee the actions of others, before they have come to a decision themselves.

We have to confide, that we have continued to become clear "Seconguessers" as per definition number 2 above when it comes to "second-guessing" the "Black Magic" practices of our magicians of central bankers and their "secret illusions"." - source Macronomics, April 2015

On a side note, in our April conversation, we showed that flows had lagged performance in Emerging Markets. We think now the time is ripe to add on some EM equity expsore which can be relatively easily done through the ETF EEM. EM equity funds saw $1.6 billion of inflows recently...


When it comes to the benefits of "helicopter money", we read with interest Bank of America Merrill Lynch's take from their Japan Watch note from the 15th of July entitled "Japan for “whatever it takes”; monetaryfiscal coordination not helicopter money":

"The monetary-fiscal hand-off

In recent months we have been writing more about the importance of and prospects for fiscal easing. In March we argued that “while monetary policy may be over-stretched in places, we think there is plenty of scope for fiscal policy to support global growth.” In particular, “low interest rates and sufficient fiscal space in many countries make now an opportune time for increased public-sector investment spending.” However, we worried arbitrary political constraints on policy would limit spending, delaying more decisive action until the inevitable recession arrives.

It has taken a long time, with monetary ammunition running low, but finally fiscal easing seems to be starting to kick in. In May, we noted that fiscal expansion had started in a number of regions, including the US, Europe, and China, although much of that easing has been more by accident than design. At the time, we thought Japan would delay its second consumption tax, but could not be certain they would not make another policy mistake.

Japanese for “whatever it takes”

Recent news makes us increasingly confident Japan will join the fiscal expansion and both Europe and the US will increase their stimulus efforts. Policy decision making in Japan often seems like a ritual kabuki play. In the first act, facing whether to delay the consumption tax hike, Prime Minister Abe met with three advocates of easy policy—Paul Krugman, Joseph Stiglitz and Christina Romer. Then at the G-7 meeting in Japan in late May, he warned of risks of a Lehman-like economic crisis. Recall that earlier he had said that only a major event similar to the 2011 earthquake or a Lehman-like crisis could delay the tax hike. Weeks later, in the second act, there was no sign of Lehman II in sight, but sure enough the consumption tax hike was delayed.

In the third act, policy was put on hold awaiting the results of the upper-house election, which returned a solid victory for Abe. He then announced work on a “bold” stimulus package, which major Japanese media outlets suggest to be at least ¥10tn. Former Fed Chairman Bernanke was invited to offer policy advice in the fourth act this week. It is not hard to imagine what Bernanke told them.

The fifth and final act, in our view, will be a major stimulus package, of ¥15-20tn in total, financed by at least a ¥10tn supplementary budget, likely coupled with additional easing by the Bank of Japan at end-July. We look for the BoJ to double its ETF purchases to around ¥6tn annually and potentially lift its JGB purchase pace in line with the increased issuance from the fiscal stimulus plan. Inclusion of municipal and agency bonds is also possible, but given their small market and limited liquidity, we see this as a more symbolic gesture. We do not expect a further cut in interest rates at this time, but we would not completely rule it out either. The BoJ would need to find a way to minimize the adverse impact upon banks from a more negative policy rate.

Risk markets have responded well to this potential program: Japanese equity markets just about reversed their post-Brexit funk, having risen 9.5% since 24 June. The global spillover is palpable; US stocks are up 8% over the same period, while most European markets have rebounded as well. The USDJPY also weakened to above 105, having touched 100 after Brexit. This is a fairly small retrenchment: the yen has appreciated over 12% against the USD on net this year alone. A top advisor to Abe suggested this week that Japan cannot defeat deflation with the USDJPY around 100." - source Bank of America Merrill Lynch

Once again, you probably want to think about "front-running" the Bank of Japan hence our interest in going long the Nikkei index but currency hedged.

When it comes to the options Abe and Kuroda have to reverse the deflationary woes of Japan, Bank of America Merrill Lynch makes some interesting points:

"Can Abe-Kuroda beat high expectations?

Implicit fiscal-monetary coordination

Expectations of fiscal and monetary easing are building in the financial markets, but there seem to be different ideas about the degree of coordination.
1. Implicitly coordinated fiscal-monetary easing: The government unleashes huge economic measures with a supplementary budget of more than ¥10tn. The BoJ expands monetary easing, potentially including through increased purchases of JGBs. The two are “synchronized” with roughly concurrent announcements.

2. Explicit coordination between the government and BoJ: In addition to the above fiscal-monetary easing, the government and BoJ announce an accord of commitment to fiscal expansion financed (semi-)directly by the BoJ’s JGB purchases until the inflation target is met (from the 13 July Sankei Shimbun’s front page).

3. Debt monetization: The BoJ restructures its existing JGB holdings to zero coupon perpetual JGBs, and/or the government issues perpetual bonds to the BoJ directly. (leaving legal issues aside; where there is a will there is a way).

Options (2) and (3) could be called the soft and hard versions of helicopter money, and the likelihood of either being adopted in the near term is low, in our view. This is because (1) Japan's economy, with its 3.3% unemployment rate, can hardly be defined as in crisis; (2) such drastic policies could shake the JGB market and JGB investors; and (3) there have been no cases of developed economies resorting to dropping helicopter money in recent history, and considerable uncertainty surrounds the consequence of such a plan.

We, especially those based in Tokyo, find it hard to believe anyone or any groups in Japan, including the Abe Administration, the MoF, the BoJ, or the public, aspires for hard helicopter money at the moment. Even if they did, nobody seems to have the political capital to pull it off and conduct it for a prolonged period of time. As such, “implicitly coordinated fiscal-monetary easing” – or some other bold fiscal expansion, and expansion of the existing monetary easing – is the most likely possibility." - source Bank of America Merrill Lynch

While it is always hard to fathom the impossible, where we slightly disagree with Bank of America Merrill Lynch is that we could have yet another case of "Optimism bias" and that Japan decide to be even bolder. We touched on the "boldness" of Japan in our April conversation "The Coffin corner":

"There are old wise central bankers (Paul Volcker) and bold bankers (Ben Bernanke now joined by Haruhiko Kuroda ); we have no old central bankers, just bold central bankers". - Macronomics.

"Looking at the desperate attempts by the Bank of Japan to cancel out the deflationary forces at play by increasing the "angle of monetary attack" with the "bold" central pilot banker Kuroda pulling very strongly on the stick, we wonder if Japan will indeed endure structural failure in the end. Maybe Kuroda is a gifted pilot such as pilots from the famed Lockheed U-2 spy plane, but, maybe he isn't.
We found most interesting that the "Coffin Corner" is also known as the "Q Corner" given that in our post "The Night of The Yield Hunter" we argued that what the great Irving Fisher told us in his book "The money illusion" was that what mattered most was the velocity of money as per the equation MV=PQ. Velocity is the real sign that your real economy is alive and well. While "Q" is the designation for dynamic pressure in our aeronautic analogy, Q in the equation is real GDP and seeing the US GDP print at 2.5% instead of 3%, we wonder if the central banks current angle of "attack" is not leading to a significant reduction in "economic" stability, as well as a decrease in control effectiveness as indicated by the lack of output from the credit transmission mechanism to the real economy.
In similar fashion to Chuck Yeager, Alan Greenspan made mistakes after mistakes, and central bankers do not understand that negative real rates always lead to a collapse in velocity and a structural decline in Q, namely economic growth rate! Maybe our central bankers like Chuck Yeager, just ‘sense’ how economies act or work.
We believe our Central Bankers are over-confident like Chuck Yeager was, leading to his December 1963 crash. Central Bankers do not understand stability and aerodynamics..." - source Macronomics, April 2013

If central bankers are now joining force with Ben Bernanke advising directly the Bank of Japan there is indeed a strong possibility they will go for "bolder" policies such as "helicopter money". This policy is fraught with danger we think and agree with Nomuras's take on the subject from their Japan Trade Ideas note from the 15th of July entitled "The danger of helicopter money":

"The adoption of helicopter money by Japan is being discussed a lot more frequently these days. Until recently it was principally by international investors, but, with “Helicopter” Ben Bernanke meeting both BOJ Governor Kuroda and Prime Minister Abe this week, local media is giving it much more coverage. According to a Bloomberg article on Thursday, Mr Bernanke suggested during an April meeting with Abe adviser Etsuro Honda that “helicopter money – in which the government issues non-marketable perpetual bonds with no maturity date and the Bank of Japan directly buys them – could work as the strongest tool to overcome deflation.” Mr Honda said he relayed this message to Prime Minister Abe, although according to another key official, Koichi Hamada, the former Fed Chairman reportedly stuck to more orthodox policies in his meeting with Mr Abe on Tuesday (Bloomberg).

The two main sources of helicopter money views cited by international investors that I have met in recent months are Mr Bernanke’s blog and Adair Turner’s book “Between Debt and the Devil: Money, Credit, and Fixing Global Finance.” 

Mr Turner's suggestion for JGBs is as follows: “That debt could be written off and replaced on the asset side of the Bank of Japan’s balance sheet with an accounting entry – a perpetual non-interest-bearing debt owed from the government to the bank. The immediate impact of this on both the bank’s and the government’s income would be nil, since the interest which the bank currently receives from the government is subsequently returned as dividend to the government as the bank’s owner. So in one sense a write-off would simply bring public communication in line with the underlying economic reality. But clear communication of that reality would make it evident to the Japanese people, companies, and financial markets that the real public debt burden is significantly less than currently published figures suggest and could therefore have a positive effect on confidence and nominal demand.”

The assertion that there would be no immediate difference from the current situation is not strictly correct. The average yield on the BOJ’s current JGB portfolio is about 0.42%. While some of the income from this will indeed be returned to the government, a large portion is used to 1) pay higher rates to banks on most of its deposits than the official minus 0.1% policy rate; 2) cover losses and build reserves against losses on its riskyasset purchases; and 3) subsidize its efforts to lower yields across the curve – the central bank is currently buying JGBs at an average yield of around -0.26%, well below its cost of funds.

While restructuring the asset side of the BOJ’s balance sheet may seem like a worthwhile idea, the picture is not nearly as rosy when we take into consideration its liabilities. Narayana Kocherlakota, former president of the Federal Reserve Bank of Minneapolis, has pointed out that, “The apparent attractiveness of the helicopter approach ignores something important: Money has a cost, too. When the Treasury spends the $100 billion, it will appear in bank accounts. Banks, in turn, will deposit the money at the Fed – a liability on which the central bank pays interest.”

Mr Bernanke acknowledges this problem in his April blog on helicopter money. “Moneyfinanced fiscal programs (MFFPs), known colloquially as helicopter drops, ….present a number of practical challenges of implementation, including integrating them into operational monetary frameworks and assuring appropriate governance and coordination between the legislature and the central bank. As my former Fed colleague Narayana Kocherlakota has pointed out, the fact that the Fed (and other central banks) routinely pay interest on reserves has implications for the implementation and potential effectiveness of helicopter money. A key presumption of MFFPs is that the financing of fiscal programs through money creation implies lower future tax burdens than financing through debt issuance. In the longer run and in more-normal circumstances, this is certainly true…..In the near term, however, money creation would not reduce the government’s financing costs appreciably, since the interest rate the Fed pays on bank reserves is close to the rate on Treasury bills. Here is a possible solution. Suppose that the Fed creates $100 billion in new money to finance the Congress’s fiscal programs. As the Treasury spends the money, it flows into the banking system, resulting in $100 billion in new bank reserves. On current arrangements, the Fed would have to pay interest on those new reserves; the increase in the Fed’s payments would be $100 billion times the interest rate on bank reserves paid by the Fed (IOR). As Kocherlakota pointed out, if IOR is close to the rate on Treasury bills, there would be little or no immediate cost saving associated with money creation, relative to debt issuance. However, let’s imagine that, when the MFFP is announced, the Fed also levies a new, permanent charge on banks – not based on reserves held, but on something else, like total liabilities – sufficient to reclaim the extra interest payments associated with the extra $100 billion in reserves. In other words, the increase in interest paid by the Fed, $100 billion * IOR, is just offset by the new levy, leaving net payments to banks unchanged. (The aggregate levy would remain at $100 billion * IOR in subsequent periods, adjusting with changes in IOR.)”

Adair Turner’s suggestion for getting round this IOER cost of money-financed deficits is as follows: “the rate would have to be zero on at least some reserves to ensure that money finance today does not result in an interest expense for the central bank in the future or in central bank losses that would need to be paid for by government subsidy and ultimately by taxpayers. Setting a zero interest rate for reserve remuneration might in turn seem to impair the central bank’s ability to use reserve remuneration as a tool to bring market interest rates in line with its policy objective. But central banks can overcome this problem, for instance, by paying zero interest rates on some reserves, while still paying the policy rate at the margin.“

So it turns out that for helicopter money to work as its advocates envisage, there needs to be a scheme in place to stop/offset IOER payments to banks. Without that, losses at the central bank will rise quickly when policy rates rise. In the current policy framework, the average yield in the BOJ’s portfolio has been gradually dropping, which is why I think it will be slow to raise rates in the future and I particularly like long-term conditional bear steepeners on the front part of the curve. However, the average yield will recover gradually as the central bank re-invests maturing JGBs at higher yields, allowing the BOJ eventually to raise rates without incurring too many losses. This would not be the case if the central bank has locked up its portfolio in perpetual bonds. With JGB yields the lowest on record, locking in 10yr borrowing costs of -0.24% and 40yr costs of 0.23% seems like a much more sensible policy.

From a strategy perspective, I would treat helicopter money as a very low-probability, high-risk event. It may start out with some seemingly good, risk-on results, but, given the points mentioned above, it is easy to imagine eventual panics among policymakers and/or investors. Rather than his prescription for Japan, I prefer Mr Turner's approach for the euro zone, “If the European Investment Bank funds infrastructure investment, raising money with long-term bonds that the ECB buys, we edge closer to money finance without quite crossing the line.” As outlined in last week’s report., I believe that Japan’s policy mix has reached a stage where it makes sense to begin transitioning from QQE quantity and rates to QQE quality (such as ETFs) and fiscal policy. Nomura expects the BOJ to focus on a combination of rate cuts and ETF purchases at its policy meeting at the end of this month. Although there is very little chance, in our view, of a helicopter-type policy being adopted in Japan any time soon, the current debate could prompt a greater willingness to stretch the boundaries of monetary policy. For example, the central bank has traditionally limited its risky-asset purchases such as ETFs to amounts where potential mark-to-market swings can be comfortably absorbed by its earnings/reserves. Perhaps running the risk of a little negative equity is the right amount of crazy for the BOJ." - source Nomura

And perhaps indeed that running the risk of negative equity is not the right amount of "crazy" for the bold pilots running the Bank of Japan. And if indeed money has a cost too, ultimately the cost will be beared by Japanese taxpayers and in the process the Japanese currency could depreciate rapidly in conjunction with horrendous liquidity problems for the foreign investors still holding to their Japanese Government Bonds (JGBs).

So overall its risk-on again and most likely in Japan but then again, if we are tactically short term bullish, our long term appreciation of the credit cycle is telling us we are in the last inning as shown by the continued deterioration in financial conditions which we develop in our next point.

• Macro and Credit  - US High Yield has gone through the memory erasure procedure but nonetheless, financial conditions are tightening

What is ultimately driving default rates you might rightly ask?

For us and our good friends at Rcube Global Macro Research, the most predictive variable for default rates remains credit availability.  Availability of credit can be tracked via the ECB lending surveys in Europe as well as the  Senior Loan Officer Survey (SLOSurvey):

"Senior Loan Officer Survey of 60 large domestic US banks and 24 US branches and agencies of foreign banks. This is updated quarterly such that results are available in time for FOMC meetings. Questions cover changes in the standards and terms of the banks' lending and the state of business and household demand for loans. We have used the net percentage of banks tightening standards for commercial and industrial loans to small firms as tightening credit standards should have a direct effect on the credit market." - source UBS.

For the US you need to follow the Senior Loan Officer Survey of 60 large domestic US banks and 24 US branches and agencies of foreign banks. This is updated quarterly such that results are available in time for FOMC meetings. Questions cover changes in the standards and terms of the banks' lending and the state of business and household demand for loans.

From a medium term perspective and assessing the "credit cycle" we believe the latest US Senior Loan Officer Survey points to yet another "warning" sign in the deterioration of the on-going credit cycle which has been so far pushed into "overtime" by central banks with ZIRP and their various iterations of QEs.

As we indicated in our "Bouncing bomb" October 2015 conversation, given the strong inflows in the asset class (US High Yield in particular), we remain Keynesian bullish short term when it comes to credit:

"While we have been "tactically" short-term "Keynesian" bullish, when it comes to our recent "credit" call, we remain long term "Austrian" bearish, particularly when it comes to our "credit" related "Bouncing bomb" analogy and the High Beta gamblers. We would recommend moving into a higher quality spectrum in terms of "credit ratings" and exposure." - source Macronomics

From a tactical and leverage perspective, we would continue to be overweight European High Yield versus US High Yield and remain more inclined towards US Investment Grade credit versus Europe.

We would not at the moment go against the "flow" given the latest inflows so far in US High Yield have been very significant, hence our tactical "Keynesian" bullishness, but then again the latest survey is validating our heigtened concerns as highlighted bu Deutsche Bank in their US Fixed Income Weekly note from the 8th of July:

"Bank lending standards continue to tighten for the business sector. The Fed’s Senior Loan Officer Survey (SLOS) measures lending standards of the largest commercial banks. Similar to tax receipts and motor vehicle sales, the SLOS data do not get revised. There are four broad categories of lending: commercial and industrial (C&I), commercial real estate, consumer, and residential mortgages. On balance, the SLOS data are flashing a cautious signal. In Q2, the net percentage of commercial banks tightening lending standards for C&I loans increased a little over three percentage points to 11.6%, which was the highest reading since Q4 2009. This was the third consecutive quarter in which banks tightened C&I lending standards, a troubling development. As the below chart from our Deutsche Bank colleague Jim Reid illustrates, tightening C&I lending standards are a leading indicator of high-yield default rates.

With respect to the other aforementioned categories, the net percentage of banks tightening lending standards for commercial real estate loans showed an even sharper increase in Q2 (+24.2% vs. +13.6% previously). This was the highest level since Q1 2010 (+27.3%). The only positives in the Q2 SLOS were consumer and residential mortgage lending standards, where, on balance, banks continued to ease in Q2. This should prove to be a mild tailwind for consumer spending and the housing market in the near term." - source Deutsche Bank

Since February we have highlighted the Commercial Real Estate Market (CRE) and particularly through CMBX series 6, the most exposed to retail, the latest survey does indeed confirm the debilitating trend of the underlying. In our recent conversation "Through the Looking-Glass" in May we indicated the following:

" When it comes to the CRE cycle being less advanced than the C&I cycle, we do think that the price action in both US retail CDS and CMBX shows that the CRE cycle will catch up fairly quickly with the C&I cycle. It is yet another indication that should worry "Humpty Dumpty" aka Janet Yellen and clearly shows that indeed, as we posited, the Fed is in a bind of its own making. We remember clearly that Charles Plosser, the head of Philadelphia Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2." - source Macronomics, May 2016

We do think you need to track both the CRE and its derivatives CMBX series, as well as the US Senior Loan Officer Survey in the near future.

In our final point we will revisit what represents to us yet again a manifestation of Gibson paradox.

• Final charts:  the Gold rush into gold funds is feeding on Bondzilla, the NIRP monster

While we won't bother going into much the details of Alfred Herbert Gibson's 1923 theory of the negative correlation between gold prices and real interest rates. We believe that the real interest rate is the most important macro factor for gold prices. When it comes to the deflationary forces of our very potent "bondzilla monster", this can be assessed by the below chart from Bank of America Merrill Lynch displaying the relationship between negative yielding assets and gold fund flows from their Credit Derivatives Strategist note from the 14th of July entitled "Deflationary flows, the Central Banks' put and yield hunting":

- source Bank of America Merrill Lynch

This relationship was as well confirmed in another note from Bank of America Merrill Lynch in their Follow the Flow note entitled "Deflationary flows into gold, IG and govies":

Deflationary flows into gold, IG and govies

The size of negative yielding assets has reached new highs. Amid rising
deflationary pressure investors are moving into gold and “ECB-eligible” assets like
government and high-grade bonds. A clear theme so far this year has been assets
that are backed by CBs’ policies and “deflationary” plays like gold are in vogue. On
the other hand, assets like equities have been suffering record outflows amid
concerns that the global recovery is losing steam." - source Bank of America Merrill Lynch

 Obviously the more our NIRP monster grows, the more inflows gold funds will get given Gibson 's paradox. What we are monitoring from a tactically more bearish approach is that very recently surprises, real rates and breakevens are on the rise as displayed in this final chart from Bank of America Merrill Lynch's latest Securitization note from the 15th of July:

"Since Brexit, economic numbers have increasingly surprised to the upside; last week’s June employment report was especially surprising. In “Navigating the summer doldrums (June 3),” we noted that in recent years, the Citigroup economic surprise index has tended to be weak in the first half of the year, bottom in June, and rise in the second half of the year. In Chart 1, we show the seasonal pattern of the average for 2011-2015, along with the 2016 performance. The rise in the index over the past two weeks suggests the “normal” H2 scenario of relatively good economic performance and fundamental data is off to a good start.

If so, it could mean the June plunge in interest rates that pushed the 10yr treasury yield to as low as 1.32% created a near term low for rates. Note that the official BofAML call is for the 10yr yield to end Q3 at 1.25%, and then rise to 1.50% by the end of 2016 (the nominal 10yr is at 1.58% as of writing). If rates and fundamentals have in fact bottomed, at least locally, it’s good news for securitized products, as prepayment risk for agency MBS and credit risk for the credit sectors are reduced. Given the possibility of the worst for rates and fundamentals being seen in June, we have moved to an overweight across most securitized products sectors. 

Chart 2 gives some sense of what rising economic surprises mean for the real 10yr rate, comparing it with the economic surprise index over the past two years. We observe common directionality from 2014 through early 2016, although the coincidence of the timing of the moves is loose at best. 2016 shows a somewhat sustained break in the pattern, however. The surprise index has been trending higher since the low in February. Meanwhile, the real rate has steadily moved lower since the Fed hiked rates last December, as the market has steadily faded the Fed’s ability to hike rates further; for example, the recent bottoming of the real rate on July 6 coincided with the peaking of the no hike probability by December 2016 at 93%.

The bottom line here is that if the economic numbers continue to surprise to the upside, which may have improved chances because real rates got so low, due in part to exogenous global factors, Fed hike probabilities will likely rise, as will the real 10yr rate. For now, though, we think the divergence seen in 2016 between economic surprises and the real rate is a big positive for risky assets: the real rate is probably far too low, and stimulative, relative to fundamentals.
The other side of the coin for nominal rates is breakeven inflation rates, which due to observed correlations over the past year, is the central component of our crosssector valuation framework for securitized products. Chart 3 shows the history of the 10yr breakeven rate in recent years; it remains in the downward trend channel that started around the time of taper talk in 2013.

Chart 4 shows the seasonal view of the breakeven rate in 2016 versus the 2011-2015 average."

- source Bank of America Merrill Lynch

So overall, tactically we think that indeed "risk-on" can further continue and that we could have seen the lows for now on Government bond yields which, would entice further short term weakness on both bond prices as well as gold in true "Gibson's paradox fashion.

Given Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact.

"Memories are the key not to the past, but to the future." Corrie Ten Boom, Dutch author

Stay tuned!