Sunday 17 July 2016

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.

  • 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!

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