Thursday 28 July 2016

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".

  • 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 Münchenwe 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! 

1 comment:

  1. Agree that AT1s are short gamma by design. This is further exacerbated by holders that don't realize they hold an equity product and don't understand what it means to be 'short gamma'. I would highlight, however, that it remains less expensive to hedge the short gamma of the product than what you are paid to hold it. This has been true since inception and remains true today.

    Great post!


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