Sunday 30 October 2016

Macro and Credit - The Grapes of Wrath

"When anger rises, think of the consequences." -  Confucius

Looking at the impervious performance of credit markets and in particular US High Yield since this year lows while noticing no doubt a rise in global discontent and populism, it seems to us appropriate this time around for our title analogy to steer towards John Steinbeck's 1939 masterpiece "The Grapes of Wrath". In recent musings we have been pretty vocal about our pre-revolutionary mindset, not because we are of the revolutionary breed but, as we noted in our conversation "Empire Days", there is in Europe growth in disillusion / social tensions which can be ascertained for instance in France with the daily demonstrations of the French police and growing discontent hence our title. The Grapes of Wrath was set during the Great Depression and focuses on a poor family of tenant farmers which when they reach their Californian destination finds out that the state is oversupplied with labor, wages are low and workers are exploited to the point of starvation while big corporate farmers are in collusion and smaller farmers suffer from collapsing prices. When preparing to write the novel, Steinbeck wrote: "I want to put a tag of shame on the greedy bastards who are responsible for this [the Great Depression and its effects]."
The intensity of the US presidential election is indeed resonating with Steinbeck's work as it is representative in similar fashion to the growing global discontent with "elites" and the rising disconnect given the rise in inequality thanks to soaring asset prices courtesy of central banks "wealth effect" policies. It might still be goldilocks period for asset prices and in particular credit with additional melt-up but, no doubt in our minds that political clouds are lining up, while the tide is slowly but surely turning for the credit cycle.

In this week's conversation, we would like to look at the relationship between inflation, wages and labor growth, which would entice us to "buy" the recovery mantra of some sell-side pundits. Furthermore, we believe that for the "stagflation" story to play out it is conditional on a continued rebound of oil prices and an overall surge in commodity prices.

  • Macro and Credit - Is inflation truly rearing its ugly head? A look at the United States, Japan and Europe
  • Final chart: The ongoing deterioration of credit fundamentals in the US remains the key market risk

  • Macro and Credit - Is inflation truly rearing its ugly head?
With the intensification of the use of the dreaded "stagflation" word and in continuation to our most recent musing, we continue to believe that rising 10 year US breakevens have been mostly driven by the change in oil prices as illustrated by the below Bank of America Merrill Lynch chart from their CMBS Weekly note from the 28th of October entitled "Still neutral for now":
- source Bank of America Merrill Lynch

In terms of validating the "recovery mantra", we believe that meaningful wage inflation is a necessary condition. When it comes to inflation expectations, demographics and additional components in different parts of the world such as Japan, the United States and Europe have to be assessed differently.

For instance, in the United States, the recent decline in apartment rents in some big cities points towards near term "inflation headwinds" for the stagflationary camp we reported in the Wall Street Journal on the 4th of October:
"Rents in San Francisco declined 3%, while they fell about 1% in New York and edged lower in Houston and San Jose, Calif., the first drops in those markets since 2010, according to apartment tracker MPF Research. Across the U.S., rent growth was 4.1% on average." - source WSJ
As a reminder, rising rents have been an important factor in keeping US inflation expectations alive given the importance of the shelter component in US CPI calculations which represents one third of headline CPI and 42% of core CPI. When it comes to assessing some of the drivers of inflation, labor demographics are a key driver of real long-term fed funds as posited by Société Générale in their American Themes note of the 19th of October entitled "Equilibrium fed funds: how low and for how long? Demographics the answer!":
"Historic observation: Labor demographics key driver of real long-term fed funds rate
An equilibrium fed funds rate—or interest rate—can depend on many factors that vary over time. The biggest driver under consideration is the inflation rate. Inflation is a straight-forward driver, and more scrutiny is placed on movement in the real interest rate. Economic growth and demographics are key. The perception of equilibrium is an issue too. In the current environment, we believe 2.0% inflation is achieved in balance. In the post-war period, the US economy has operated mostly out of inflation equilibrium with an average inflation rate of 3.64% (CPI) since the 1950s. So far in the 2010s, inflation is averaging 1.53%, just about the closest the US economy has been to a sense of equilibrium, and we are generally worried about deflation risks. The 2.0% inflation-equilibrium may be a challenge for a fed funds equilibrium rate, but we use it.
Drivers and rules of thumb for the Fed Funds rate
Old rules of thumb for determining the fed funds rate have lost prominence over the past decade as the rules appear to have changed. The fed funds rate is substantially lower than these rules of thumb might have suggested. Yet an examination of why they may have worked in the past but fail today is insightful. There are two key rules of thumb:
  1. Fed funds rate should equal nominal GDP. Traditionally, nominal GDP has exceeded fed funds, yet the components of GDP are all the same and influence long-term GDP, namely inflation and real growth. Real growth is determined by demographics, productivity and investment. These latter variables are all the key variables contributing to a dynamic real fed funds determination.
  2. Fed Funds equal 2% plus inflation. This rule coincides with the Taylor rule (In appendix) which originally had 2.0% as a real component. If output gaps and inflation gaps zero out over time, then the fed funds rate rule would be 2% plus inflation. Since the original formulation, however, the 2.0% is now in question. The rule was dependent on the time period examined and later updates used a lower real rate as the time horizon expanded or shifted. We can select a different fixed rate. Yet it is the dynamism of the real rate that is now in question. A different time period could yield a different fixed rate and we could fit the data but gain no insight into an evolving real rate. Today, we assume the real rate component is lower than the past but don’t know how low. Also important, if the real rate turns higher again, will we observe or be aware of the upturn?
The real short-term rate can depend on a large set of factors. In fact, the number of variables that can influence the real rate, and the inability to observe these variables, renders many ambitious under-takings to model the real rate useless. The potential growth rate, or GDP, is likely a top choice as a variable determining the real interest rate. However, the real potential GDP can only be estimated. Further, changes in potential GDP growth are difficult to detect and often require a period of time before a consensus can build on what the potential GDP growth is and how it has changed.
Historically, the nominal GDP averaged a rate significantly higher than the fed funds rate. Nominal GDP is composed of two easy parts, inflation plus real GDP. Like the fed funds rate, it suggests that the real fed funds would over time be equal to real growth. Over the six decade period of examination, nominal GDP exceeded the fed funds rate by 1.55%, and the standard deviation of that spread was 4.45%. Historically, we conclude that nominal GDP has not offered an appropriate guide.

Using a simple benchmark as nominal GDP for the fed funds rate is clearly an oversimplified approach. Yet much of the modeling approaches to consider the long-term fed funds rate are decomposing GDP and weighting the components.
Inflation is the first component, and in the long term, we expect inflation and inflation expectations to converge. The inflation component is assumed one-for-one in the long-term GDP. The real components to GDP are demographics, productivity and technological change. We can model and weight these components, but the approach is fraught with limited transparency. Productivity and technological change are observed with certainty only in hindsight, and sometimes many years after revisions. Additionally, it takes several years to distinguish between a temporary or a more permanent change in these variables.
Labor force and demographics – a more observable component of real growth.
Examining the different components of real GDP over the long term such as labor demographics and productivity as well as the aggregate real GDP growth rate, the movement in the labor force commanded strong interest. What is most compelling about the labor force growth is that it has some predictability, at least far more so than productivity or real GDP growth. Labor force growth is determined by population growth and retirement. Many of these features we can predict long in advance. On a monthly basis, we find the labor force participation rate (percent of working age population that has employment or is looking for job), but large moves can be predicted by the aging of the population. Another interesting characteristic is that the labor force data is not subject to major quarterly revisions like productivity and GDP.
In the tables above, we created another fed funds benchmark, which is the simple addition of inflation and the labor force growth rate. The aim is to generate a function based upon more readily observable components of potential growth. The goal is also to keep it simple. The two components, labor force and inflation, together offer an easy, dynamic calculation for long-term GDP. Over six decades, such an easy measure posted the narrowest spread to the fed funds rate. Moreover, the standard deviation on the spread was only modestly higher than using a fixed real rate benchmark. Labor force movements appear to be capturing a key, dynamic portion of the real rate movement, and importantly, the labor force variation is more observable, less prone to revision, and easier to project going forward relative to other fundamental explanatory variables.
Labor force growth has slowed appreciably in the 21st century and particularly after the crisis. The slowdown is a chief factor explaining a slowdown in GDP. Since 2009, the labor force has grown at just a 0.5% pace. That was down from 0.8% in the 2000s and 1.3% in the 1990s. Adding to that an equilibrium inflation rate of 2.0% would generate an equilibrium fed funds rate of 2.5% in the 2010s, versus 2.8% in the 2000s and 3.3% in the 1990s. Inflation was higher or lower than 2.0% during the decades and our historical calculation uses the actual CPI inflation measure.
Reasons to use such a simple labor force and CPI construct for considering long-term equilibrium:
  1. Historical accuracy: If we consider a long-term analysis assuming that short-term rates find their needed equilibrium, the simple rate has been accurate. Moreover, the points of departure in the 1970s and 1980s are of interest. Fed funds were arguably held too low in the 1970s, giving rise to high inflation. Conversely, in the 1980s the fed funds was higher than it should have been due to abnormally high inflation expectations. Back testing this simple measure offers intriguing results. Over a six decade history, a simple benchmark of adding the labor force and the CPI inflation rate than GDP that implicitly moves with productivity and technological innovation.
  2. Observable: A black-box model on the real rate can be constructed. Transparency and ease of observations are strong positives. Many important concepts behind a real rate—from demographics, real growth, productivity, potential growth—are not directly observable. Furthermore, the variables can be revised substantially over time. Variables used to fit a model could be materially altered at a later date. Labor force counts and the CPI are less subject to revisions.
  3. Robustness of time varying real rate: Demographics pay a large role in potential GDP growth and additionally on the supply/demand for savings/investment. Having a simple demographic measure such as that has historically had a degree of accuracy, which offers a neat tool for gaining insight. The aging US population and the slowdown in immigration are captured indirectly in the labor force statistic.
There are weaknesses as well that are a narrowly focused driver of the real fed funds and the labor force overall. First, consider the chart on US labor force growth on the preceding page. Volatility argues against using this variable as any short-term guide for the fed funds rate. Second, the swings are numerous enough that deciphering a temporary versus a more permanent change is not straight forward. Yet variation could be minimized with more judgment, given that the aging labor force and the growing participation of women in the workforce were robust elements for change. Labor force gains accelerated into the late 1970s and have been decelerating since.
Estimates of the long-term fed funds rate remain well above current levels and therefore do not offer any short-term guidance for the fed funds rate. Demographics may be suggesting that we have reached a low point. At present, we expect labor force growth of 0.5-1.0%. With an inflation goal of 2.0%, the fed funds rate needs to converge to a 2.5-3.0% range. That range encompasses the Fed’s view and that of many other forecasters as well. It would also allow for further revisions downward. Yet, there is a growing risk that the next step in labor force growth will be faster. We see workers putting off retirement until later and /or the effects of the baby boomers entering retirement fading.
Has the drop in interest rates reached its bottom? 
That is a question regarding most bond maturities. Beyond the inflation question, a bottoming of labor force growth suggests that real rates have reached a bottom. This is an interesting outcome that we stress. The  models now used to explain the persistence of low rates may not yet be ready to determine whether an upturn is underway. Two contributions to slowing labor force growth since 2000  have been the retirement of the baby-boom generation and the slowdown of immigration. The oldest baby boomers are now 70, and the mid-point of the baby boom generation (those born in 1955) reach 62 in 2017.

Meanwhile, we know we have not considered productivity and technological change in this analysis. The question of productivity growth is immensely important, but even more difficult to answer relative to labor force growth as a driver of the economy. In terms of our six-decade view, productivity appears useful in explaining current low interest rates, but not much prior to the current period." - source Société Générale
While Société Générale has an interesting take in relation to demographics, the question of productivity growth is paramount we think, particular when one looks at the quality of the jobs created since the onset of the Great Financial Crisis (GFC)., mostly of low quality. On top of that we do not agree with Société Générale that real rates have reached a bottom. The effect of ZIRP has in effect pushed many baby boomers to postpone taking their retirement due to lack of returns and until we see a clear change in the Fed's monetary policy, we disagree with Société Générale and do not think workers putting off retirement until later and /or the effects of the baby boomers entering retirement  will be fading anytime soon.

When it comes to Japan and Europe (which is undergoing a clear "Japanification" process), both countries face different inflation expectations than the US mostly due to demographics headwinds as we have pointed out in numerous conversations. Interestingly enough, when it comes to demographics, Japan leading the timing of Europe, it does boast a key advantage compare to Europe which is indeed its much tighter labour market leading to some creeping wage inflation as highlighted by Société Générale Albert Edwards in his latest note from the 26th of October:
"After consolidating around ¥100 for about one year, the yen saw a second step decline in H2 2014 towards ¥125. This additional competitiveness caused Japanese corporate profits to boom. The downside was that household incomes were squeezed as higher import prices pushed up headline CPI inflation - this sounds much like the UK today! Although all this was exactly the intention of government policy, the trick is, like kick-starting a motorcycle, to get this one-off stimulus to profits to fire up the engine into a virtuous wage/price spiral and sustainable growth. And from long experience of kick-starting a BSA 1954 M21 600cc single cylinder, it often takes repeated attempts and bruised ankles to get it fired up - link.
Having driven the yen down towards the key 30-year support level of ¥126 at the start of 2015, the BoJ blew its big chance to drive it down through ¥126. If the yen had broken ¥126, I felt it would have quickly run down to ¥145. But having failed to break below this key support level, this year saw it rapidly head in the opposite direction to peak at ¥100 by June, hence squeezing profits (see chart above) and stalling growth. This led foreigners to take flight by selling a record ¥6tn of Japanese shares in the first nine months of the year. I felt the BoJ had blown their chance of reviving the economy via QE and that Abenomics was doomed.
But I might yet be premature in writing Japan off. One key advantage Japan has in trying to produce inflation is, perversely, its appalling demographics. Why? Because even quite moderate GDP growth has resulted in a very tight Japanese labour market (see chart above), and this has resulted in wage inflation crawling higher. In real terms, wage inflation is now rising above 1% (see charts below – indeed Japan’s real wages are rising faster than the US).
Much to my surprise, despite this year’s H1 yen strength hitting growth badly, the Japanese PMI has actually revived in H2 (see left-hand chart below). But this H2 Japanese PMI recovery may be coming at the cost of the US recovery as PMIs now seem to move inversely (see chart below) – especially with the dollar now surging on expectations of a Fed rate hike).

Leo Lewis of the FT wrote a very interesting Short View, essentially concurring with Andrew’s front page chart, that Japanese companies are heaving with surplus cash. He notes a record high 55 per cent of Japanese non-financial companies now hold more cash than debt, in contrast to less than 20% of the S&P 500. And with valuations where they are (see chart below), which equity market do you think QE has set up to collapse in the next recession?
- source Société Générale

Whereas the United States have yet to experience a significant rise in labor participation and has seen as well a significant fall in its productivity, the Japanese economy has overall achieved productivity growth with continuous deleveraging and hefty corporate cash balances and a tight labor market thanks to poor demographics and rising women participation rate in the labor market. As we posited in June this year in our conversation "Road to Nowhere":
"When it comes to Japanese efficiency and productivity, no doubt that Japanese companies have become more "lean" and more profitable than ever. The issue of course is that at the Zero Lower Bound (ZLB) and since the 29th of January, below the ZLB with Negative Interest Rate Policy (NIRP), no matter how the Bank of Japan would like to "spin" it, the available tools at the disposal of the Governor appears to be limited.
While the Japanese government has been successful in boosting the labor participation rate thanks to more women joining the labor market, the improved corporate margins of Japanese companies have not lead to either wage growth, incomes and consumption despite the repeated calls from the government. The big winners once again have been the shareholders through increased returns in the form of higher dividends. In similar fashion to the Fed and the ECB, the money has been flowing "uphill", rather than "downhill" to the real economy due to the lack of "wage growth". This is clearly illustrated in rising on the Return Of Invested Capital (ROIC) " - source Macronomics, June 2016
We concluded at the time:
"If indeed Japan fails to encourage "wage growth" in what seems to be a "tighter labor" market, given the demographic headwinds the country faces, we think Japan might indeed be on the "Road to Nowhere. Unless the Japanese government "tries harder" in stimulating "wage growth", no matter how nice it is for Japan to reach "full-employment", the "deflationary" forces the country faces thanks to its very weak demographic prospects could become rapidly "insurmountable". - source Macronomics, June 2016
Either you focus on labor or on capital, end of the day, Japan has to decide whether it wants to favor "wall street" or "main street".

For Europe, the story is as well different, though from a credit perspective, the on-going Japanification means that Europe, in similar traits to Japan has been deleveraging overall (except Italy and Spain) whereas in the United States and as illustrated by Albert Edwards' note the US has been releveraging thanks to cheap credit and buybacks favoring in the process multiple expansion on a grand scale:
"In a low-growth world, debt is dangerous; in a deflationary world, debt is toxic. Japanese companies, through years of experience, probably understand this and have deleveraged as a result; US corporates, perhaps foolishly, have done the exact opposite.” No “perhaps” about it Andrew. This is nuts!
- source Société Générale

Exactly, in a low yield environment, defaults tend to spike as low yields tend to coincide with higher spreads and default rates. Often low yields are associated with slow growth which eventually should evolve towards wider credit spreads when the credit cycle eventually turns but, we are not there yet. If growth eventually picks up while yields stay low then spreads could indeed normalize but it is not our core scenario.

Why inflation matters therefore? Because in low inflation environment, like the one we are going through often tend to be associated with spiking defaults historically (deflation bust of the energy sector earlier this year).

But, moving back to Europe and its inflation conundrum, when it comes to wage growth, it could put additional pressure on its inflation expectations due to decelerating wage growth as highlighted by Ban of America Merrill Lynch in their Euro Area Economic Watch note from the 28th of October entitled "Wage growth: potential for worse":
"Wage growth: potential for worse
This is a half-hearted labour market recovery
Employment growth in the Euro area is continuing its relatively steady recovery. The number of employees (excluding self-employed) rose 1.7% and 1.6% in 1Q and 2Q16, respectively, predominantly driven by the services sectors. The number of employees is back at 2008 levels now (Chart 1).

However, robust headline employment growth masks a much shallower recovery in hours worked, which continue to stand nearly 4% below their 2008 level in the economy as a whole (Chart 2). 

Meanwhile, Euro area wage measures, including compensation, wages and salaries, contractual wages, etc, continue a gentle downward trajectory. Wages and salaries per employee, for example, slowed to 1.4% yoy in 1H16 on average compared with 1.5% in 2015 and 2.1% on average since 2001.
Some blame sector composition for slower wage growth – we disagree
A predominantly services sector-driven labour market recovery is not surprising given the composition of the Euro area growth recovery: domestic demand components, public and private consumption in particular, are a lot more service-intense than capex or exports. Services, in turn, are more labour-intense.
Some hawkish ECB council members have cited the sector composition of the labour market recovery as the driver of slowing wage growth, as services wage growth typically underperforms that of industry.
We believe this line of argument is flawed and not supported by the data. On the contrary, our findings suggest that wage-setting behaviour may have changed also in the services sector post-crisis, which would be disconcerting. Even if we assume that wage structures did not change, wage growth prospects would still be rather gloomy and under pressure to decelerate further.
Sector drag on aggregate wage levels? Not if you look at hourly wages
Since 2002, the share of employment in industry excluding construction has fallen by more than 4pp to 17% in the Euro area, while that of the services sector has risen 6pp to 77%. We wanted to know if and how much drag this reshuffle of employment poses to average wage levels. To do this, we calculated a counterfactual wage level measure, assuming the composition of employment and the composition of working hours had remained at the 2002 level. Results are shown in Chart 3.
We find that wages per employee are currently some 1.5% lower than they would have been if the sector shares of employment had not changed. The trend has been very steady, however, lowering wage growth per headcount by 0.1pp every year – hardly enough to justify the wage growth deceleration we have seen post-crisis.
Wage growth per employed, however, does not reflect the rise in part-time employment. So we run the same exercise for hourly wages. We find that, if anything, wage levels today are marginally higher than they would have been (blue line in Chart 3). This would suggest that sector composition cannot really be held responsible for what we see in the recovery.
Wage growth has slowed across most sectorsIf sector composition were solely to blame, we would also expect wage growth to have remained intact across sectors, particularly in those where wage growth is typically lower but employment growth currently faster. Again, data suggests that things are not so simple.
Chart 4 shows hourly wage growth in the industry (excl. construction) and services sectors (including the public sector). In both aggregates, dynamics have slowed from pre-crisis standards (although industry wages have continued to decelerate more quickly recently).

We have equally checked standard deviations of wage growth across 10 different sectors at any point in time (grey area in Chart 4). During 2012-14, wage growth was more harmonious across sectors, but it has started to reflect typical dispersion again (as has the differential between the fastest and slowest sector wage growth). This could suggest the entire spectrum has shifted a gear lower.
Slowing wage growth in response to inflation – even in services
Generally, a lower wage level could be “normal” if it results from a) lower productivity growth and/or b) more economic slack now than before. But again we find that more may be at play here, both in the economy as a whole and in individual sectors.
We replicate an exercise we ran over the summer, when we were warning to be vigilant of second round effects of inflation on wages. As a reminder, we had found at the aggregate level that the deviation in compensation growth from its long-term average could be explained by slack (high unemployment), but also larger and more persistent than usual negative contributions of inflation. These, we argued, were tentative signs of second-round effects."  -source Bank of America Merrill Lynch
So, if wages are a backward looking indicator of inflationary pressures and labor markets continue to weaken in the US and in some parts of Europe such as France and oil prices finally recede, we have a hard time buying the stagflationary story for the time being. We also have a hard time buying the Q3 US GDP at 2.9% but that's another story.

What we are seeing we think, is more akin to the development of "biflation" rather than "stagflation" in the sense that we could see the development of the simultaneous existence of inflation and deflation in an economy. This would lead to a resurgence in inflation in commodity prices with deflation in debt-based assets. Biflation can occur when a fragile economic recovery causes central banks to "overmedicate" via their monetary policies. This may results in higher prices for certain assets such as energy and precious metals with declining prices for leveraged assets such as real estates and automobiles (see our July conversation on declining prices for classic cars "Who is Afraid of the Noise of Art?"). With biflation,  the economy is tempered by increasing unemployment and decreasing purchasing power. As a result, a greater amount of money is directed toward buying essential items and directed away from buying non-essential items. Debt-based assets (mega-houses, high-end automobiles and other typically debt based assets) become less essential and increasingly fall into lower demand. The illustration of buying essential items is clearly shown by Visual Jeff Desjardins on the 28th of October:
"Prices Are Skyrocketing, But Only For Things You Actually Need

"The average price increase, as shown by the CPI (Consumer Price Index), is 55% over the last 20 years. Meanwhile, the prices of individual sub-categories have a much wider variance." - source Visual Capitalist, Jeff Desjardins.
Of course the consequences of central banks meddling with interest rates is in our mind seeding "The Grapes of Wrath" and is causing biflation to some extent. This is leading to not only rising cross asset correlations as of late between stocks and bonds, but, leading to wider variances and larger standard deviation moves. Instability is not only brewing in financial markets but is leading as well towards instability in various countries and risks of social unrest.

Whereas the United States, Japan and Europe face different situations when it comes to dealing with inflation expectations and wage pressure in conjunction with different demographics, back in October we recommended (a little bit early) to look at US TIPS  in our conversation "Sympathetic detonation" from a great diversification perspective:
"Given secular stagnation, and "Japanification" of the economy (which has long been our scenario, Europe wise), indeed US TIPS are more "compelling" than UK linkers and still are less positively correlated to nominal bonds for a very simple reason: their embedded "deflation floor" - source Macronomics, October 2015
In March again in our conversation "Unobtainium" we commented that we continued to like US TIPS:
"We continue to like US TIPS particularly if pundits started claiming inflation in the US is rearing its ugly head, particularly for the specific deflation floor embedded in US TIPS. It works both ways, so what's not to like about them in the current "reflationary" environment?" - Macronomics, 19th of March 2016
So from a biflation allocation perspective, US TIPS still remain particularly attractive particularly given their embedded deflation floor. While "balanced funds" are getting "unbalanced" by recent correlated move downwards for both bond prices and stocks, what is not to like about the lower correlation offered between linkers and equities/sovereign bonds? Inflation-linked bonds still provides you with very interesting diversification benefits. For instance the Ishare TIPS bond ETF exposed to US TIPS has delivered you a total return of 6.53% so far. For the long duration braves out there Pimco's 15 years + ETF has LPTZ has rewarded them with handsome year to date total return after fees of 18.70%. Who said there wasn't sometimes some "embedded" actionable ideas in our musings? We rest our case.

In our final chart, while we have been monitoring the credit cycle as it is slowly turning in this "overmedicated" central bank meddling environment, we continue to look at the slow but evident deterioration in credit fundamentals particularly in the US which has been "releveraging" thanks to cheap credit.

  • Final chart: The ongoing deterioration of credit fundamentals in the US remains the key market risk
While the relentless liquidity provided to the credit markets thanks to Japanese NIRP and the ECB and now BOE being competing with investors in the credit investment world, when it comes to default in a low yield environment, leverage matters and so does credit fundamentals. Our final chart displays US debt growth relative to EBITDA and comes from JP Morgan's Credit and Market Outlook and Strategy note from the 20th of October:
"The ongoing deterioration of credit fundamentals remains the key market risk, however. Debt issuance continues to grow much faster than EBITDA, even if the expected uptick in revenue growth this quarter materializes. Investors are aware of this, but are focused on the strong technicals outweighing these risks. This has been the right view since 1Q of this year. However, our sense is that some investors are uncomfortable with market valuation given these technicals, and if there is a catalyst for a risk off market, this concern about fundamentals would reassert itself.
Fundamental credit metric deterioration is not itself likely to be a catalyst as it occurs slowly and it is difficult to define a red line for specific metrics that causes a problem. A renewed trend of rating downgrades, as occurred in 1Q in the Energy sector, could refocus markets on these risks, but if and when this will happen is difficult to predict." - source JP Morgan
While the party has been running strong "uphill", mostly to the bond market that it, courtesy of the "wealth effect", and not downhill to the real economy, if real assets are positively correlated with inflation and deflation fears are subsiding, we believe that some commodities could stage a comeback, US TIPS will be as well one of the beneficiaries rest assured. Meanwhile, our politicians and central bankers alike have indeed sowed "The Grapes of Wrath", putting financial assets at risk of heightened political backlash from the have not of the real economy namely "Main Street" versus "Wall Street". 

"You will not be punished for your anger, you will be punished by your anger." - Buddha
Stay tuned!

Saturday 15 October 2016

Macro and Credit - An Extraordinary Dislocation

"The only true wisdom is in knowing you know nothing." -  Socrates
Watching with interest our barbell strategy (long gold/gold miners - long US long bonds) getting trounced, in conjunction with the infamous "flash crash" of the British pound, with terrible exports data coming from Asia as of late somewhat validating our fears expressed in our most recent post made us wander towards a cinematographic analogy for our chosen title this time around. "An Extraordinary Dislocation" is a short movie dating from 1901 by French illusionist and film director Georges Méliès famous for leading many technical and narrative developments in the earliest days of cinema. Georges Méliès was a prolific innovator in the use of special effects such our central bankers of today, popularizing such techniques as substitution splices, multiple exposures, time-lapse photography, dissolves, and hand-painted color. He was also the first filmmaker to use storyboards. Georges Méliès directed over 500 films between 1896 and 1913, ranging in length from one to forty minutes. In our case our title refers to a movie lasting a mere 2 minutes as per the linked provided above to the short movie "An Extraordinary Dislocation". In subject matter, these films are often similar to the magic theatre shows that Méliès had been doing, containing "tricks" and impossible events, such as objects disappearing or changing size such as the balance sheets of central banks. While most of his early special effects films were essentially devoid of plot, the special effects were used only to show what was possible (such as QE, TWIST, NIRP and other central banks tricks), rather than enhance the overall narrative or in the case of "The Cult of the Supreme Beings" aka central bankers, the overall situation of the global economy as a whole, slowly but surely falling when it comes to assessing the true global trade situation, particularly in Asia.

While one might wonder why we chose this particular short movie, we would like to provide some explanations before we move on to the nitty-gritty of our conversation. "An Extraordinary Dislocation" is probably the funniest of all mystical pictures yet produced by Georges Méliès. In this picture several body parts of a dancing clown float away from his body and come back again. In similar fashion as we have been warning in numerous conversations and in particular our February conversation "The disappearance of MS München" about the rising risk of large standard deviations moves thanks to rising cross-asset correlations due to central banks meddling with the most important allocation signal namely interest rates. The most recent "Extraordinary Dislocation" of the British pound is yet another reminder of the risk induced by repressed volatility. When it comes to dislocations and dancing clowns such as our central bankers of today, rest assured that many more extraordinary dislocations will continue to appear from nowhere such as "rogue waves" such as the recent sell-off in the British pound. While rogue waves have long been a fascination of ours as per our February musing, what "The Cult of the Supreme Beings" aka central bankers fail to grasp in their numerous "wealth effect" experiences is the Wicksellian Differential. 

Before we start our usual Macro and Credit musing we would like as a reminder to discuss Wicksell Differential and the credit cycle (linked to the leverage cycle). Wicksell argued in his 1898 book Interest and Prices that the equilibrium of a credit economy could be ascertained by comparing the money rate of interest to the natural rate of interest.  This simply equates to comparing the cost of capital with the return on capital. In economies where the natural rate is higher than the money rate, credit growth will drive a positive disequilibrium in an economy. When the natural rate of interest is lower than the money rate which is the case today (rising Libor), the demand for credit dries up (our CCC credit canary are being shut out of credit markets) leading to a negative disequilibrium and capital destruction eventually. In a credit based global macro world like ours, the Wicksellian Differential provides a better alternative estimation of disequilibrium than the more standard Taylor Rule approach of our central bankers. At the Bank for International Settlements since 1987, Claudio Borio and his colleague Philip Lowe wrote in 2002 a very interesting paper entitled “Asset prices, Financial and Monetary Stability: Exploring the Nexus”, BIS Working Papers, n. 114. In this paper the authors made some very important points that are worth reminding ourselves today:
"Widespread financial distress typically arises from the unwinding of financial imbalances that build up disguised by benign economic conditions […] Booms and busts in asset prices […] are just one of a richer set of symptoms […] Other common signs include rapid credit expansion, and, often, above-average capital accumulation" - source BIS
So when we hear Janet Yellen at the Fed saying the following:
 "Asset values aren’t out of line with historical norms." -Janet Yellen, 21st of September 2016
We reminded ourselves that Wicksell used just the housing sector to illustrate his theory. Excess lending dear Mrs Yellen, always lead to "overinvestment". Just because the Taylor Rule used by the Fed doesn't include asset prices, it doesn't mean in our book that asset values are not out of line of historical norms.

Why is the Wicksellian Differential so important when it comes to asset allocation? Either profits increase due to an increase in the return of capital and/or a fall in the cost of capital (buybacks funded by a credit binge). This is clearly reminded by Credit Capital Advisors' note from July 2012 entitled "Navigating the business cycle: A new approach to asset allocation":
"The calculation of the Wicksellian Differential is however an ex-post measure, so is unhelpful for investors to use as an investment trigger, hence an ex-ante model needs to be constructed based on the underlying drivers of growth in the Wicksellian Differential, which is of course leverage. However, an ever-increasing amount of leverage is clearly unsustainable and will cause expectations to shift at some point, resulting in a period of deleveraging and falling profits. As a result, an investment trigger can be set up based on the dynamic relationship between leverage ratios and the rate of profit, which requires constant recalibration as new data is made available.
The relationship between each leverage ratio and the rate of profit is unique and dynamic through time. For example, the slowdown and fall in the consumer leverage ratio caused the Wicksellian Differential to reverse between 1990 and 1992. Furthermore, during the tech bubble between 1996 and 1999, corporate leverage fell followed by consumer leverage, causing the rate of profit to fall. This highlights that there was no real basis for rising equity returns during the tech bubble as the rate of profit growth was falling. Thus the dotcom bubble ought to be seen as akin to John Law’s South Sea bubble, which was purely based on a rather large misconception. The extent of the credit bubble leading up to the recent financial crisis is highlighted by the substantial rise in consumer leverage, the rate of which began falling at the end of 2006, highlighting the downturn in the rate of profit growth in 2007, and thus a shift to bonds. Finally consumer leverage rose again in 2009, signaling a recovery in profits, although the recovery was short-lived. In 2011 the trend fell again, and the 2012 signal highlights a continuing slowdown in the underlying trend of profit growth. 
There are of course other factors that impact profits, such as significant changes in the general price level and in output per worker, as well as other known variables such as the tax rate; however, the most important driver with respect to the turning points is the realisation that a period of credit expansion has become unsustainable, leading to changing expectations." - source Credit Capital Advisors, July 2012
And of course dear readers, we have long been warning that the credit cycle was slowly but surely turning thanks to credit "overmedication". End of our Wicksellian Differential parenthesis.

In this week's conversation, while credit markets are still strongly technically driven thanks to central bank competing with credit investors, we would like to look at Japan's latest bending the curve experiment as well as rising inflation expectations leading to some pundits asking themselves about the potential return of the much dreaded "stagflation" word.

  • Macro and Credit - Can the Bank of Japan bend the yield curve?
  • Macro and Credit  - Is reflation around the corner and leading to stagflation?
  • Final chart: Balance sheets are out of sync with the economy

  • Macro and Credit - Can the Bank of Japan bend the yield curve?
While following the latest market gyrations and various "sucker punches" delivered to the investing crowd, the latest "The Cult of the Supreme Beings" experiment coming from the Bank of Japan picked up our interest given the changes in policy target from quantity to interest rates, in their latest "reflationary/inflationary" attempt. On this subject we read with interest Bank of America Merrill Lynch Liquid Insight latest note from the 14th of October 2016 entitled "Will yield curve control work in Japan?":
"BoJ switches policy target from quantity to interest rates; what about prices?
At its September Monetary Policy Meeting (MPM), the BoJ carried out its comprehensive assessment and introduced QQE with yield curve control. The new policy consists of: (1) yield curve control, by which the BoJ will manipulate short- and long-term yields; and (2) an overshoot commitment, whereby the BoJ pledges to keep expanding the monetary base until CPI inflation exceeds and stays stably above 2% YoY. The sustainability of huge JGB purchase operations totaling ¥80tn annually caused some concern, and the risk that yields would decline without limit prompted the BoJ to switch its target from quantity to interest rates and thereby make purchase operations more flexible. On the price side, we see some evidence that inflation is trending downward again, such as the core CPI’s dip into year-on-year negative territory (Chart of the day).

The BoJ’s strengthened commitment to 2% inflation runs the risk of postponing the exit from monetary easing until even further in the future. In this note, we consider the BoJ’s new monetary policy, including the extent to which it can contribute to raising prices.
Yield curve control – the balancing act
The BoJ’s “yield curve control” means that a rate of -0.1% will be applied as the short-term rate to policy-rate balances in current accounts held at the BoJ. For the long-term rate, the BoJ will conduct long-term JGB purchase operations in such a way that the 10yr yield stays at about 0%. At the same time, the BoJ aims to maintain the pace of annual JGB purchase operations at the current ¥80tn while guiding interest rates, so doubts remain about the simultaneous use of yield curve control and quantity. The BoJ maintains that yield curve control is at the center of its new framework.
Indeed, as the 10yr yield approached -0.1%, the BoJ reduced purchase operations on 30 September. This reminded market participants that -0.1% was the yield’s lower limit. The purchasing cutback was small, but in light of the possibility that operations could be reduced again, the 10yr JGB will probably be seen as difficult to buy the next time its yield approaches -0.1%. Given the small size of the purchasing cutback, it might appear that tight supply-demand is likely to push the yield below -0.1% again, but the BoJ first indicated that the target yield level was 0% and then showed its intention by reducing purchase operations. If the 10yr yield approaches -0.1% again, market participants will likely start to expect another purchasing cutback. The BoJ has declared that it will control short- and long-term rates, so with the short-term rate set at -0.1%, it is difficult to envision the BoJ doing nothing if the 10yr yield sinks below that level. Therefore, the BoJ might be able to keep the 10yr yield at about 0% without reducing purchase operations very much.
The BoJ’s Summary of Opinions at the Monetary Policy Meeting (20-21 September), released on 30 September, says: “It is uncertain whether the pace of JGB purchases will slow down as intended and the sustainability of monetary easing consequently improve under yield curve control.” The goal of slowing JGB purchases is clearly mentioned, and the BoJ’s stance on “quantity” and “policy sustainability” does not appear to be settled. The BoJ is probably wary of reducing quantity only to see the yen strengthen or stocks weaken. Nevertheless, we believe it will gradually move in the direction of reducing quantity.
In any case, it would be difficult to hold the 10yr JGB yield down to 0% without purchase operations, but the BoJ itself will have to continue searching for the right amount of purchases to do the job. Even if the BoJ shifts entirely to an interest rate target, there is no guarantee that it can control the yield curve, so uncertainty would be high. The important point is how fast the BoJ can shift to an interest rate target. The BoJ for now seems to be targeting the shape of the yield curve at the time of the September MPM, so yield targets are 0% for the 10yr yield, 0.4% for the 20yr yield and 0.5% for the 30yr yield (Rates forecast: Attention on BoJ operations when yields decline).

Reflation credibility of the new framework
History shows that when prices and the economy overheat, rate hikes can be deployed to exert some control. But is it possible at normal times, in the absence of a financial or liquidity crisis, to boost prices by making monetary policy more accommodative? At this point in Japan, the effort is not going very well. In general, QE by purchasing T-Bills with 0% interest rates is not thought to be effective. Because highly liquid T-Bills with 0% interest rates have about the same value as cash, and exchanging one for the other has almost no economic effect. On the other hand, expanding the monetary base by purchasing long-term JGBs has a strong experimental aspect. Although long-term JGBs have low yields and high liquidity, they are not equivalent to cash. The BoJ introduced QQE in April 2013, and the yen’s sharp depreciation and rise of prices made the policy look effective. After three and a half years, however, inflation is heading downward again, while there was some impact from the decline in oil prices.
Since the beginning of the Abe administration at end-2012, it is true that the yen has weakened owing to a certain sense of inflation expectation. Another factor behind the yen’s depreciation is that the then Federal Reserve Board (FRB) Chairman Ben Bernanke mentioned tapering in May 2013, and tapering began in December of that year. From then until rate hikes actually began in December 2015, the US appeared to approve of some USD appreciation. In 2008 and later, amid the financial crisis that stemmed from the US subprime loan crisis and the Greek debt crisis, the FRB and the European Central Bank (ECB) implemented a variety of operations, including asset purchases. Their contribution to reducing risk premiums, raising asset prices and stabilizing the financial system helped to raise expectations of the BoJ’s QQE.
Immediately after QQE was deployed, prices steadily rose, owing in part to the weak yen effect, but the inflation trend turned downward with the decline of oil prices beginning in summer 2014. This was unfortunate for the BoJ, but even though the year-on-year decline in oil prices has shrunk considerably, inflation remains low (Chart 1).

Even the CPI inflation excluding energy prices is trending lower, suggesting that this may be the effect of the yen’s recent strength. Although the yen’s depreciation from 2013 did help to boost prices, that effect has peaked out because of the yen’s appreciation this year. The forex rate affects prices with a lag of six months to one year, so forex will be a price-lowering factor for the time being (Chart 2).

Based on the results of the September MPM, the possibility of JGB purchasing cutbacks gave rise to concern that the yen would strengthen further. Ironically, or perhaps fortunately, expectations of US rate hikes rose and this may have weakened the yen instead.
In the end, the major determinant of inflation will be the extent to which tighter labor market conditions push up wages. In 2014, when the weak yen and a consumption tax rate hike raised prices, wages did not see a commensurate rise, and as a result, consumption was sluggish. According to the Ministry of Health, Labor and Welfare’s Monthly Labor Survey, total cash earnings (nominal wages) climbed 1.2% YoY in July. However, scheduled cash earnings (basic wages, etc.) rose only 0.3%, while bonuses and other special payments boosted the overall figure. In August, total cash earnings declined 0.1%, their first downturn in three months, but scheduled cash earnings were up 0.5%. If the BoJ is aiming for 2% inflation, wage hikes are still insufficient, but the unemployment rate has declined to about 3% and companies facing labor shortages have started hiring more full-time workers, including permanent employees. Favorable changes like these are starting to be seen in the labor market (Chart 3).

The corporate sector’s retained earnings have hit a record high, while the labor share is declining, so there is plenty of room for improvement (Chart 4).

Price-lowering pressure from the strong yen will continue for a time, but we expect to see modest price rises over the medium to long term. However, is it possible for monetary easing to cause sustained inflation? We cannot give a definite answer, but let us consider this matter by looking back on the BoJ’s monetary policy and its ripple effect.
Effect of quantitative expansion
Under the BoJ’s QQE, asset prices rose strongly starting in 2013. Normally stock and JGB prices have a negative correlation with one another, but at that time they had a positive correlation and rose together (Chart 5).

That relation seems to have broken down since the start of this year, but for at least three years asset prices rose in a way not normally seen. The problem is that rising asset prices were not reflected in general prices. This was likely resulting from the fact that the BoJ expanded the monetary base at a rapid rate, but the expansion of money stock was limited (Chart 6).

To put it another way, even though the monetary base expanded, bank lending increased only slightly. Since 2000, Japan’s monetary environment has been accommodative, and bank deposits have continually increased, but bank lending has not. To cover the deposit-loan gap, domestic banks increased investment in JGBs (Chart 7). 

Therefore, even when the banks’ JGB holdings were exchanged for cash under QQE, the lending situation of banks did not greatly change. The asset composition of domestic banks shows that in the three years after QQE started, the share of bank assets in JGBs declined, while the share in cash increased by a similar percentage. Other asset classes did not change much (Chart 8).

Although the absolute amount of lending did increase, it mainly went into real estate-related projects. Lending growth to manufacturers for capital goods was limited. Even though the monetary base expanded, the amount of funds circulating in the real economy (money stock) did not change much, so the kinds of price increases seen in assets were not seen in general prices.
Effect of negative interest rates
At the January 2016 MPM, the BoJ applied a negative interest rate of -0.1% to a portion of current accounts held at the BoJ. It introduced a three-tiered structure for current accounts and other measures to avoid negative impact on banks, which until then had cooperated with QQE. In the JGB market, however, about three years of JGB purchase operations had tightened the supply-demand relationship, causing yields to decline sharply, the yield curve to flatten, and arousing concern about pressure on the earnings of financial institutions (Super long JGB supply-demand balance). In Europe, which introduced negative interest rates before Japan, the side effect of reduced bank margins was conspicuous, but it did not lead to much of an increase in lending to corporations, the intended benefit. With interest rates on deposits remaining positive, loan rates could only be lowered to a certain extent without eating up the margins. In particular, Japan has already experienced a long period of low interest rate policy, and interest rates on loans are already low, so further downside room is limited (Chart 9).

In Japan, with its high ratio of indirect financing, the effect on the real economy is only slight. Moreover Danish banks responded to the decline of bank margins by raising service charges on mortgages and other products. According to a 7 October Nikkei Shimbun article, Japanese banks are also considering higher service charges on mortgages. This will have a de facto monetary tightening effect. However, a low-interest rate environment is generally positive for corporate funding. Amid the limited decline of interest rates on loans, corporate bond issuance is picking up in Europe. In Japan, the corporate bond market did not expand, partly because Japanese companies have large reserves, but issuance did swell this summer (Japan Credit Monthly, September 2016). As the yield curve flattened, issuance increased at maturities over 10yr (Chart 10).

The wider variety of corporate funding alternatives can be described as a benefit, but the BoJ’s monetary policy change might also bring about a change in this trend. As the BoJ points out, the costs and benefits of policies must be watched.
With the April 2013 introduction of QQE, called a monetary “bazooka” at the time, the BoJ tried to work on people’s expectations and raise CPI inflation to 2% within two years, but the attempt failed (Looking back at three years of QQE). In the absence of any clear reason why expansion of the monetary base should lead to a higher inflation rate, the BoJ’s action was even called a social experiment. Monetary policy is a crucial means of stabilizing prices and the financial system. When the economy overheats, for example, it can be treated with a rate hike, and when liquidity dries up in a financial crisis, the central bank can supply liquidity. Although there were a number of different factors that make it difficult to blame the failure solely on the BoJ, it has proven very difficult to raise prices by monetary policy alone in normal times.
Liquidity is already adequate owing to Japan’s extended monetary easing. It is so adequate, in fact, that banks have trouble finding worthwhile investments for their funds. With the supply of even more funds beyond this point, the costs of this policy are starting to become more pronounced than the benefits. In early July, the 20yr JGB yield dipped into negative territory, a sign of low yields overall and a very flat curve. As the cost of funding foreign currency rose, the possibility arose that domestic investors would have nowhere to invest. “The lower the better” is not a phrase that applies to interest rates. Excessive monetary easing by the central bank can inadvertently rob the market of low-risk assets and heighten financial system risk. The G20 finance ministers and central bank governors have also expressed concern about the side effects of prolonged monetary easing and extremely low interest rates environment.
The increasingly easy monetary policy favored by nearly everyone until recently might now gradually change direction on a global basis. In future, a monetary policy that more closely matches the pace of real economy’s growth might be sought, as well as a policy that is more sustainable. On that point, we believe the BoJ’s switch from quantity to an interest rate target is effective, but it will raise new questions, what the appropriate shape of the yield curve is and whether that will lead to inflation." - source Bank of America Merrill Lynch
The same pattern in Europe and Japan is happening, namely that the new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day and now credit speculators are joining the party with both hands even in Japan.

From our perspective, there are a couple of points we would like to make relative to Bank of America Merrill Lynch's comments. First of all we believe that the bending of the curve will be ineffective in triggering the much desired inflation the Bank of Japan is seeking given as we indicated before when commenting on the "Japanification of Europe, both Europe and Japan's deflationary headwinds are stemming from poor demographics. In terms of Wicksellian Differential and real estate and Japan, we note with interest that the prognosis for Japanese real estate is some more pain ahead as NIRP is translating into banks trying to recoup some profitability through higher mortgage rates as indicated by Bloomberg in their article from the 13th of October entitled "Tokyo Condo Prices May Fall 20%, Deutsche says":
"The Bank of Japan’s shift to controlling bond yields is driving up mortgage rates, prompting Deutsche Bank AG to predict Tokyo apartment prices may fall 20 percent or more by 2018.
The BOJ’s negative-rate policy was already hurting buyer sentiment, and its move to boost longer-term yields is a double-blow to the industry, according to Yoji Otani, a real estate analyst at Deutsche Bank in Tokyo. The 35-year fixed mortgage rate has climbed for two straight months after touching a record low of 0.9 percent in August, and sales of new condominiums in Tokyo this year have fallen to the lowest since the nation’s property bubble collapse in the early 1990s." - source Bloomberg
Second point, the impact on real estate prices and rising mortgages thanks to very aggressive monetary policies can be as well ascertained in Switzerland. Of course when it comes to "capital destruction" and Wicksellian Differential, you can rest assured that once prices go down in "bubbly" real estate markets, it leaves people in negative equity territory for an extended period of time. The most interesting comment from the Bloomberg article relative to Bank of America Merrill Lynch's conclusion where they think the Bank of Japan will be successful in "bending the yield curve" (which we don't think they will!) is as follows from Yoji Otani, a real estate analyst at Deutsche Bank in Tokyo:
"The one positive thing about negative rates was that it lowered borrowing costs, and now that is going to end," said Otani, who expects prices to fall 20 percent to 30 percent by the end of 2018. "The collapse of this silent bubble has begun."
"The BOJ is operating a negative-rate policy but it is trying to push up long-term yields, which totally lacks sense,” he said. “There’s a contradiction." - source Bloomberg
You can rest assured that this new NIRP trick is going to blow in the face of "The Cult of the Supreme Beings" aka central bankers members from the Bank of Japan and lead to some additional "Extraordinary Dislocation". As a reminder from our previous conversation where we quoted our April article "Shrugging Atlas" in which we discussed Japan and the kite string theory:
"That is the very difficult situation that lies with "easy policy", there is an easy way in, but no easy way out. So as goes 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
If indeed real estate turns "South" in Japan then banks will have to increase credit provisions which de facto will reduce credit availability and therefore credit impulse and economic growth. On top of that if indeed Japanese households fall into negative equity thanks to their real estate exposure then again, as a textbook Richard Koo explanation, these households will have no other choice but to reduce their spending and borrowing as they try to repair their balance sheet. Yet another potential for Richard Koo's Balance Sheet Recession theory playing out again in Japan we think.

As well as having a contradictory approach, the Bank of Japan has played the NIRP game given it's mostly has we have explained before a currency play, but then again, anchoring the 10 year Japanese Government Bond around the 0% threshold is conditional of USD/JPY evolution. Furthermore, the Bank of Japan is playing a very difficult balancing act. This is clearly indicated by Nomura in their Japan Navigator note number 691 from the 10th of October entitled "Diminishing room for JGB rates to fall further":
"Conditions for 10yr rates to become positive
We believe 10yr yields are unlikely to reach positive levels unless, as mentioned above, the BOJ allows the pace of its JGB purchases to fall further below its target of “about JPY80trn” in annual absorption, in which case the market would determine that the Bank is unlikely to ease further.
Once expectations of further BOJ easing fade, we believe negative 10yr JGB yields would no longer attract short-term long traders, but only purchases from investors looking to buy for holding until maturity. In this case, we believe 10yr rates would trade above levels that are determined by bank deposit rates and deposit insurance premiums. This is not included in our base case for FY16, but we believe this scenario may materialize in H1 FY17, as the BOJ’s JGB purchases would fall more substantially below its target.
If the BOJ continues buying JGBs at the current pace, it would absorb a net JPY75trn in FY16. However, if the current pace continues beyond end-FY16, it would absorb only a net JPY72trn in FY17, in which case the BOJ would have to either abandon its quantitative target or allow greater flexibility (adopting a proviso) from next spring, in our view.
At that point, if the Fed is discussing another hike (following a hike in December), we would expect the risk of a strong JPY to have declined, but otherwise the BOJ could cut rates further to alleviate investor concerns over QQE tapering." - source Nomura
It appears therefore that further reaction from the Bank of Japan is conditional on the Fed's action in December. What is a cause for concern in the footsteps of our previous conversation relating to our US dollar strengthening fears is that if indeed USD funding tightens further, then USD/JPY basis widens even more which means in effect that strong buyers such as lifers will continue their purchase of US bonds without any FX hedging due to the rising cost. This particular point is worth noting and was highlighted by UBS in their recent Global Credit Comment from the 12th of October entitled "What is the consensus view? And where could it be wrong?":
Hedging FX exposure was brought up in a majority of client meetings, as widening basis swaps reduce the relative yield advantage of US credit. We found that clients are largely hedging FX exposure via short-dated swaps (3 months). But interestingly, a rising fraction noted they are no longer hedging as the costs become less economical. In continental Europe, where negative rate pressures are particularly severe, the rotation into anything with yield is driven largely by institutional pressures (rather than fundamental credit assessments). There are simply few other investment alternatives in a market structure where managers must invest incoming flows and coupon/maturity proceeds. A number of investors reported more recent interest in longer-dated US IG – and a majority of investors continue to report holding a long position in EU financials.
Among the bigger themes, UK and European clients were focused on the outlook for central bank policy, political fragmentation in Europe, the foreign demand for global credit, the state of the US credit cycle3 and US election outcomes. On risks ahead clients were quick to cite many of the known unknowns ahead: Brexit, the Italian Referendum, the December FOMC meeting and other core European elections next year. Based on our discussions, we believe the larger and more underpriced risk scenarios for European credit investors would include: 1) timing and pace of ECB tapering of CSPP, 2) rising systemic risks stemming from idiosyncratic stress among European banks, and 3) significant spread widening in US credit spreads. Note that none of these outcomes are our base case." - source UBS
Whereas there is indeed some clear sign of global US dollar shortage increasingly indicated by widening basis swaps, the yield differential still favor having US credit exposure, even long dated to Investment Grade as we feel more and more incline to look for quality rather than chasing yield in US High Yield given the late stage of the current credit cycle and significant build up in leverage with week CAPEX, poor EBITDA and rising defaults. The next US Senior Loan Office Surveys (SLOs) will be paramount for the technical bid in credit and in particular US High Yield to continue we think.

For our second point, we would like to steer towards reflationary expectations and the much commented fears of a return of "stagflation".

  • Macro and Credit  - Is reflation around the corner and leading to stagflation?

Back in March 2016 in our conversation "Unobtainium" we pointed out that the time that US TIPS were more compelling than UK linkers thanks to their deflation floor, but given the very significant performance of UK linkers thanks to Brexit and the British pound de facto devaluation, we should have noted what the UK linkers market was telling us at the time, namely that further depreciation of the British pound was coming hence the rise of inflationary expectations and the significant performance of this asset class in particular during the month of August.

Our renewed interest in rising expectations can be tracked down from our comments from our March 2016 conversation:
"A very interesting 2015 paper by the Bank of Israel ( (Sussman, N and O Zohar 2015, “Oil prices, inflation expectations, and monetary policy”, Bank of Israel DP092015.) indicates that since the Great Financial Crisis (GFC) of 2008, a 10% change in oil prices moves 5Y5Y expected inflation by nearly 0.1% in the US and 0.05% in the Euro area. Therefore, given the recent significant surge in oil prices towards the $40 mark, we do not think it is such a surprise to see a rise in inflation expectations in that context. This latest rise in inflation expectations could after all be transitory as well as the sudden rise in oil prices, particularly in the light of the tight relationship between the US dollar and oil prices. We think that the latest dovish stance of the Fed all has to do with their concerns relating to the "velocity" of the US dollar and the "unintended consequences" a too rapid rise of the "Greenback" could have on Emerging Markets (EM)." - source Macronomics, March 2016
Many pundits have noticed the current reflationary trend particularly in the 10 year breakeven rate in the US over the past couple of weeks. This trend is as well highlighted in Bank of America Merrill Lynch's Securitization Weekly Overview entitled "Reflation takes flight" from the 7th of October:
"This week, we take note of the steady rise in the 10yr breakeven rate over the past few weeks, moving from 1.50% on September 20 to 1.66% as of Friday (October 6) morning, post-September payrolls. Using our breakeven inflation rate valuation framework, we consider what a 2% breakeven rate might mean for securitized products and competing sectors. We choose 2% since we think it is a reasonable target level to assume: in other words, although the Fed downplays the importance of market-based inflation expectations, we think it is likely an implicit target anyway.

Chart 1 and Chart 2 show two different longer term views of the 10yr breakeven inflation rate. We think they both tell us that the recent rise in the breakeven rate is very important and that the chances of continuing to move higher, possibly reaching 2% over the next 3-6 months, are good. At long last, central bank reflationary policies might actually be working.

Chart 1 shows that the recent rise in the breakeven rate has pushed the level through the upper end of the downward trend channel that has persisted since taper talk in 2013. Chart 2, which looks at 30-, 40-, and 50-week moving averages along with the weekly level, suggests that, in recent weeks, the trend may finally have shifted from downward to upward. The weekly reading has crossed through all the moving averages to the upside, and for now, the 30-week moving average is moving higher.
We’re as skeptical about the inflation risk as most, but the view in these charts tells us that, finally, the tide may have shifted in recent weeks towards higher inflation expectations. We’ll consider our breakeven valuation framework in a moment but first we consider what rising inflation expectations means for Fed rate hike potential.
Chart 3 compares the 10yr breakeven rate with the probability that there is at least one rate hike by December 2016; the probability currently stands at 64%.

In recent months, they have moved in similar directions, although not always at the exact same time. Over the past month, since September 2, the 10yr breakeven rate has risen by roughly 16 basis points, from 1.48% to 1.64%. If the same increase applies over the next two  months, bringing the breakeven inflation rate to 1.96%, we are confident the Fed would have hiked at least once by the December meeting (as BofAML economists expect); moreover, based on Chart 3, it also seems possible that the market probability of such a hike would be approaching 100%. In other words, the Fed would have reached a perfect position to hike: the market is fully expecting it, and would not react adversely to the hike.
It should be recognized that there is a chicken-and-egg situation here: if the rate hike probability jumped quickly to 100%, say over a day, the breakeven inflation rate would likely quickly reverse the recent rising trend; but if both gradually move higher, in line with the Fed’s gradualist approach, reaching the end state on both the rate hike and the inflation expectation becomes more achievable. The recent breakeven trend reversal to the upside, seen in Chart 1 and Chart 2, makes us believe the latter scenario is the higher probability scenario." - source Bank of America Merrill Lynch
The trajectory for inflation expectations and rising 10 year US breakevens in our book is clearly being driven by the change in oil prices, that simple. We have yet to meaningful wage inflation which would entice us to validate the recovery mantra of some sell-side pundits. Nonetheless wages are a backward looking indicator of inflation pressure.

Whereas the rise in US inflation has put indeed some pressure relative to the US yield curve, in effect pushing the US 10 year towards 1.80 % yield level, we do not have such a sanguine approach for the long end looking at the recent downward revision by the Atlanta Fed from their GDPNow latest forecast for 1.9 % on October 14th for the Third Quarter. We therefore believe we are once again approaching compelling levels for US long dated treasury and we will be monitoring the situation closely. As a reminder, when it comes to our contrarian stance in relation to our "long duration" fondness it is fairly simple to explain:
"Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data." So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you."
We hope, at some point, this will become "Common knowledge" and that some sell-side pundits will stop defying this simple yet compelling "Wicksellian" logic which in terms of allocation can prevent  "Extraordinary Dislocation" when eventually equities will correct.

When it comes to the stagflationary fears out there, they seem to us relatively premature given the impact rising oil prices have had on inflation expectations. What seems to us much more worrying from a potential bear market perspective is the velocity in the surge in oil prices which in the past have always preceded significant corrections in stock markets. As past history has shown, what matters is the velocity of the increase in the oil prices, given that a price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years. This, dear friends is based on facts, not conjecture.

Finally, for our final chart, and given we highlighted the importance of leverage when looking at Wicksellian Differential, we think it is important to note the growing divergence between corporate balance sheets with the economy as the credit cycle moves towards the last inning.

  • Final chart: Balance sheets are out of sync with the economy
While much of the performance of US equities has been driven to a large extent by multiple expansion thanks to buybacks funded by cheap credit, it is worth noting that eventually, what matters in a credit cycle at a late stage is the level of leverage in the system from a Wicksellian perspective. In relation to this statement we would like to point towards Bank of America Merrill Lynch's chart from their Credit Market Strategist note from the 14th of October entitled "3Q=stabilizing, 4Q=improving fundamentals" where they show that corporate balance sheets are at much later stage in the cycle:
"Balance sheets are out of sync with the economy
As we have argued (see: Monthly HG Market Review: June ’16: Brexit and the decline in yields 01 July 2016 ). due to unprecedented monetary policy easing globally, in response to the challenges emerging from and financial crisis and sovereign crises, corporate balance sheets are at a much later stage in the cycle (Figure 17). 

This disconnect between the economic cycle and corporate balance sheets is highly unusual and perhaps never seen before. But these times are indeed highly unusual. As the economy moves through the last half of its cycle we thus expect that corporate balance sheets improve a bit over the coming years - although companies are not going to undergo a traditional deleveraging cycle. Then when the economy eventually goes into recession we should see the traditional spike in corporate leverage ratios driven by declining earnings." - source Bank of America Merrill Lynch
So dear Janet Yellen, if you think that asset values aren’t out of line with historical norms, balance sheets are and you can expect down the line "Extraordinary Dislocation" and very low recovery rates in the next downturn thanks to Wicksellian Differential rest assured.

"I believe in social dislocation and creative trouble." - Bayard Rustin, American leader in social movements for civil rights, socialism
Stay tuned !
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